Cost Accounting: Theory & Practice 9789389872149

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Cost Accounting R. PALANIAPPAN • N. HARIHARAN This is a comprehensive text book which covers the syllabus of all Indian universities for B.Com., BBA., BCS., BCA., M.Com., MBA., MCS., MCA., PGDBM., PGDFM., PGDM., and professional courses like CA, ICWA and ACS at intermediate level. This book is divided into five parts containing 22 chapters. Topics are arranged in a logical order and theory is dealt with in a simple style to make it student friendly and self-understanding. Numerous illustrations and exercises are included taking into consideration the present syllabi of various universities. Objective-type questions, short answer theory and numerical problems are the main highlights of the book. Questions asked in various universities and professional examinations are included at the appropriate places. Diagrams and charts are presented wherever required to make the subject more appropriate. ABOUT THE AUTHORS

978-93-89872-14-9

` 725/9 789389 872149

R. PALANIAPPAN • N. HARIHARAN

N. Hariharan, is Professor and Head of Finance and Accounts at Amplify Mindware Academy for Development of Education and Research [AMADER], Pune, Maharashtra. He was former VicePrincipal, Shree Chandraprabhu Jain College, Chennai, Tamilnadu. He obtained his Masters Degree [Rank Holder] from St. Joseph’s College, Trichy and Master of Philosophy from Loyola College, Chennai, Tamilnadu. He has attended and presented papers at various state and national level seminars. He has presented a proposed research paper to Cambridge University, UK. He has been teaching Income Tax, Finance and Accountancy for more than 15 years at undergraduate and postgraduate levels. He is a visiting faculty at the Institute of Company Secretaries of India, Southern India Regional Council, Chennai, Tamilnadu. He is board member of studies/examiner in various institutes/autonomous colleges and professional bodies. He specializes in the field of Taxation, Finance and Accountancy and has written books on Income Tax Law & Practice published by Tata McGraw-Hill Publications.

Theory & Practice

R. Palaniappan, was Former Head, Department of Commerce, Government Arts College, Salem. He has more than 33 years experience in teaching financial accounting, cost accounting and management accounting both at under graduate and post graduate level. He is a visiting faculty at the Southern Chapter of Cost and Works Accountant of India and Salem Chapter of Institute of Company Secretaries of India. He has wide experience in coaching students for CA, ICWA and ACS courses.

Cost Accounting

Theory & Practice

Cost Accounting Theory & Practice R. PALANIAPPAN N. HARIHARAN

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COST ACCOUNTING THEORY AND PRACTICE FIRST EDITION

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COST ACCOUNTING THEORY AND PRACTICE FIRST EDITION R. PALANIAPPAN Former - Head Department of Commerce Government Arts College, Salem. Visiting Faculty, Institute of Cost and Works Accountants of India And Institute of Company Secretaries of India [Salem Chapter]

N. HARIHARAN Professor & Head - Finance Amplify Mindware Academy for Development of Education and Research [AMADER], Pune Director i/c, CIMA Programme, Amplify Study Centre, Pune [Chartered Institute of Management Accountants, London] Former Vice-Principal Shree Chandraprabhu Jain College, Chennai. Visiting Faculty, Institute of Company Secretaries of India, Southern India Regional Council, Chennai.

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©Copyright 2020 I.K. International Pvt. Ltd., New Delhi-110002. This book may not be duplicated in any way without the express written consent of the publisher, except in the form of brief excerpts or quotations for the purposes of review. The information contained herein is for the personal use of the reader and may not be incorporated in any commercial programs, other books, databases, or any kind of software without written consent of the publisher. Making copies of this book or any portion for any purpose other than your own is a violation of copyright laws. Limits of Liability/disclaimer of Warranty: The author and publisher have used their best efforts in preparing this book. The author make no representation or warranties with respect to the accuracy or completeness of the contents of this book, and specifically disclaim any implied warranties of merchantability or fitness of any particular purpose. There are no warranties which extend beyond the descriptions contained in this paragraph. No warranty may be created or extended by sales representatives or written sales materials. The accuracy and completeness of the information provided herein and the opinions stated herein are not guaranteed or warranted to produce any particulars results, and the advice and strategies contained herein may not be suitable for every individual. Neither Dreamtech Press nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. Trademarks: All brand names and product names used in this book are trademarks, registered trademarks, or trade names of their respective holders. Dreamtech Press is not associated with any product or vendor mentioned in this book. ISBN: 978-93-89872-14-9

EISBN: 978-93-90078-76-9

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Preface to First Edition Indian business is operating in a globally competitive environment. Indian companies are under great pressure to control and reduce their operating costs. Hence, the study of cost accounting is gaining more importance. Recognising this fact, many Indian universities and professional bodies have included cost accounting in their curriculum and have also updated the contents of the subject. Keeping the above in mind this FIRST EDITION is brought out as a comprehensive text book to cover the syllabi of all universities and professional bodies. Theory part of the book is written in a simple language. Solved numerical problems in large numbers are given in illustrations in each chapter to help the students for their easy understanding of the subject. Many exercises (both theory and numerical questions) are given at the end of each chapter. One special feature of the book is that numerous objective types’ questions, short answer theory questions and short answer practical problems are given to suit the needs of the students of many universities. Especially the short answer problems given at the end of each chapter will help even a beginner to understand and solve comprehensive numerical problems in an easy way. We have also included recent development in the subject at appropriate places. This book has been divided into 05 parts containing 22 chapters as mentioned below: PART-1: COST CONCEPTS C-1: Introduction C-2: Cost Analysis, Classification and Cost Sheet PART-2: ELEMENTS OF COST C-3: Materials Cost Control C-4: Materials Costing C-5: Labour Cost Control C-6: Methods of Wage Payment C-7: Overheads - Nature and Classification C-8: Accounting for Overheads and Control C-9: Administration, Selling and Distribution Overheads PART-3: ACCOUNTING METHODS C-10: Cost Ledger C-11: Reconciliation of Cost and Financial Accounts C-12: Integral Accounting

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PART-4: METHODS OF COSTING C-13: Output/Unit/Single Costing C-14: Job and Batch Costing C-15: Contract/Terminal Costing C-16: Process Costing C-17: Joint Products, By-Products and Main Products Costing C-18: Service/Operating Costing PART-5: TECHNIQUES OF COSTING C-19: Marginal Costing and Cost Volume Profit Analysis C-20: Budgetary Control C-21: Standard Costing and Variance Analysis C-22: Miscellaneous Topics The following are the main highlights of the book: • Simple and Lucid style of presentation • Self-Explanatory notes • Logical organization of Topics • Numerous Illustrations for Graduate, Postgraduate and Professional Courses • Numerous exercises including Objective Type Questions, Short answer theory and practical problems along with comprehensive problems to practice and solve • Step by step approach in solving practical problems • Various University and Professional Courses Questions are adopted in Illustrations and Exercises • Proforma, Tables and Charts at appropriate places This book will be useful for the students pursuing the courses of B.Com, B.C.S, B.B.A, (Hons), M.Com, MCS, M.B.A., MCA, PGDBM, PGDFM, PGDM, CA (Inter), ICWA (Inter) and ACS (Inter). R. PALANIAPPAN N. HARIHARAN

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Acknowledgements We thank Mr. Krishan Makhijani, Managing Director of I. K. International Publishing House for publishing this book. We thank Ms. Shruti Raj, Mr. Babu VR, Mr. Kalimuthu of I. K. International Publishing House and Mr. M. Srinivasan, typesetter for their excellent time integrity in bringing out this edition. We thank our friend Mr. A. K. Sukumaran, General Manager, UBS Publishers’ Distributors Pvt. Ltd, Coimbatore, for introducing us to the publisher. Special thanks to our PGDFM students Ms. Garima Parmar, Ms. Parul Sharma, Ms. Priya Mehta, Ms. Aparna Gupta, Mr. Ankit Singh Lohiya, Mr. Sudhanshu Upadhyah, Mr. Anil Singh Rawat and Mr. Sahil Sharma for helping towards proof reading in this Edition. We also thank all other students who have helped us to bring out this edition successfully. We thank our family members for co-operating with us to make this attempt a success. Finally we wish to thank all others who were helpful to us in some way or the other to complete this project successfully.

WE WELCOME YOUR COMMENTS AND SUGGESTIONS FOR FURTHER IMPROVEMENT OF THE BOOK R. PALANIAPPAN N. HARIHARAN R. Palaniappan - Mobile: +91 9442140387 Mail: [email protected] N. Hariharan

- Mobile: +91 9960522279/+91 9444210843 Mail: [email protected]/[email protected]

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CONTENTS

Preface to First Edition Acknowledgements

1. Introduction 1.1

Evolution of Cost Accounting 1.1.1 Cost Accounting in Indian Context 1.2 Cost Accounting 1.3 Objectives of Cost Accounting 1.4 Need and Importance of Cost Accounting 1.5 Advantages and Disadvantages of Cost Accounting 1.5.1 Advantages 1.5.2 Disadvantages 1.6 Methods of Cost Accounting 1.7 Essentials of Good Cost Accounting System 1.8 Various Terms 1.8.1 Cost 1.8.2 Costing 1.8.3 Cost Accounting 1.8.4 Cost Accountancy 1.8.5 Cost Centre 1.8.6 Profit Centre 1.8.7 Historical Costing 1.8.8 Absorption Costing 1.8.9 Marginal Costing 1.8.10 Uniform Costing 1.9 Cost Accounting vs. Financial Accounting 1.10 Cost Accounting vs. Management Accounting 1.11 Exercise

v vii 1 1 2 3 3 4 5 5 6 6 7 8 8 8 9 9 9 9 9 9 10 10 10 11 12

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2. Cost Analysis: Cost Classification and Cost Sheet 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13

Classification by Nature or Element By Relation to Cost Centre By Function By Behaviour or Variability By Time By Controllability For Decision Making Purpose By Payment By Normality Miscellaneous Cost Terms Non-Cost Items Cost Sheet or Cost Statement Exercises

3. Materials Cost Control 3.1

3.2

3.3 3.4

3.5

Meaning 3.1.1 Objectives of Materials Control 3.1.2 Requirements of Materials Control Purchase Control 3.2.1 Purchase Department 3.2.2 Functions of Purchase Department Receiving and Inspection Bill of Materials 3.4.1 Storekeeping 3.4.1.1 Duties of storekeeper 3.4.1.2 Stores location 3.4.1.3 Stores layout 3.4.1.4 Classification and codification of materials 3.4.1.5 Types of stores 3.4.2 Stores Records Inventory Control 3.5.1 Setting Various Stock Levels 3.5.1.1 Re-order level 3.5.1.2 Maximum level 3.5.1.3 Minimum level or safety level

13 14 15 15 16 17 17 17 18 18 19 21 21 41 53 54 54 54 55 55 56 63 65 66 66 66 66 66 67 67 69 70 71 71 72

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3.6

3.7 3.8

3.5.1.4 Danger Level 3.5.2 Average Level 3.5.3 Determination of Economic Order Quantity Economic Order Quantity (EOQ) 3.6.1 Mathematical Model 3.6.2 Graphical Model 3.6.3 Trial and Error Model 3.6.4 Use of Perpetual Inventory System and Continuous Stock Verifications 3.6.5 Use of Material Management Techniques 3.6.5.1 ABC analysis 3.6.5.2 Just-in-time purchase (JIT) 3.6.5.3 VED inventory analysis 3.6.5.4 FNSD analysis Comprehensive Illustrations Exercise

4. Materials Costing 4.1 4.2

4.3

4.4

Need for Pricing Actual Price Methods 4.2.1 First In First Out (FIFO) Method 4.2.2 Last In First Out (LIFO) Method 4.2.3 Highest In First Out (HIFO) Method 4.2.4 Base Stock Method Average Price Methods 4.3.1 Simple Average Price Method 4.3.2 Weighted Average Price Method 4.3.3 Periodic Simple Average Price Method 4.3.4 Periodic Weighted Average Price Method 4.3.5 Moving Periodic Simple Average Price Method 4.3.6 Moving Periodic Weighted Average Price Method 4.3.7 Standard Price Method 4.3.8 Inflated Price Method 4.3.9 Specific Price Method Exercises

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72 72 76 77 77 78 78 81 83 83 85 85 86 86 95 107 108 108 108 111 114 114 117 117 118 118 118 119 119 125 127 129 153

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5. Labour Cost Control 5.1

Introduction 5.1.1 Labour Cost Components 5.2 Types of Labour 5.3 Labour Cost Control 5.4 Personnel Department 5.4.1 Labour Turnover 5.4.2 Causes of Labour Turnover 5.4.3 Effects of Labour Turnover 5.4.4 Cost of Labour Turnover 5.4.5 Remedial Steps to Reduce Labour Turnover 5.5 Engineering Department 5.6 The Rate or Time and Motion Study Department 5.6.1 Importance of Merit Rating 5.6.2 Limitations of Job Evaluation 5.6.3 Difference between Job Evaluation and Merit Rating 5.7 Timekeeping Department 5.7.1 Manual Methods 5.7.2 Mechanical Method 5.7.3 Essentials of a Good Timekeeping System 5.7.4 Time Booking 5.7.5 Idle Time 5.7.6 Overtime 5.8 Pay Roll Department 5.9 Computation of Labour Cost Rate for Absorption of Labour Cost 5.9.1 Labour Productivity 5.10 Comprehensive Illustrations 5.11 Exercises

6. Methods of Wage Payment 6.1 6.2

6.3 6.4

Introduction Methods of Wage Payment 6.2.1 Time Rate System 6.2.2 Piece Rate System 6.2.3 Incentive and Bonus Plans Other Incentive Schemes Exercises

165 165 166 166 166 167 168 170 171 172 174 174 174 176 176 176 176 177 177 179 179 183 185 191 197 199 200 209 219 219 220 220 222 228 236 263

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7. Overheads: Nature and Classification 7.1

7.2 7.3 7.4

Introduction 7.1.1 Meaning 7.1.2 Importance Classification of Overheads Collection and Codification of Overheads 7.3.1 Methods of Codification Exercises

8. Accounting for Overheads and Control 8.1

8.2

8.3 8.4 8.5 8.6

8.7 8.8

Introduction 8.1.1 Meaning 8.1.2 Allocation and Apportionment 8.1.3 Sources of Factory Overheads Process of Charging Overheads to Cost Units 8.2.1 Departmentalisation of Overheads 8.2.2 Principles of Apportionment of Overheads Apportionment of Service Department Overheads to Production Departments Absorption of Overheads 8.4.1 Overheads absorption rate Methods of Overhead Absorption Computation of Machine Hour Rates 8.6.1 Computation of Number of Machine Hours 8.6.2 Types of Machine Hour Rates Concept of Capacity and Overhead Recovery Rates Exercises

9. Administration, Selling and Distribution Overheads 9.1

9.2

Office and Administration Overheads 9.1.1 Meaning 9.1.2 Collection and Apportionment 9.1.3 Absorption of Administration Overheads 9.1.4 Accounting for Administration Overheads 9.1.5 Control of Administration Overheads Selling and Distribution Overheads 9.2.1 Collection and Apportionment of Selling and Distribution Overheads

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277 277 277 278 278 288 288 293 299 299 299 300 300 300 300 301 302 311 312 317 320 321 321 329 356 383 383 383 384 384 385 385 386 386

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9.3

9.4

9.5

9.6

9.2.2 Absorption of Selling and Distribution Overheads 387 9.2.3 Control of Selling and Distribution Overheads 387 Depreciation 392 9.3.1 Objectives of Providing Depreciation 392 9.3.2 Other Terms Relevant to Depreciation 393 Methods of Depreciation 394 9.4.1 Straight Line Method (Fixed or Equal Instalment Method) 394 9.4.2 Diminishing Balance Method (Written Down Value or Reducing Balance Method)395 9.4.3 Annuity Method 395 9.4.4 Sinking Fund Method (Depreciation Fund Method) 396 9.4.5 Insurance Policy Method 396 9.4.6 Machine Hour Rate Method 396 9.4.7 Depletion Method 396 9.4.8 Revaluation Method 397 9.4.9 Sum of the Years Digits Method 397 Treatment of Miscellaneous Items in Cost Accounts 397 9.5.1 Depreciation on Fully Depreciated Asset 397 9.5.2 Depreciation on Replacement Value of Assets 397 9.5.3 Accelerated Rate of Depreciation 398 9.5.4 Interest on Capital 398 9.5.5 Arguments In Favour 399 9.5.6 Arguments Against 399 9.5.7 Research and Development Cost 399 9.5.8 Packing Expenses 400 9.5.9 Carriage and Freight Charges 400 9.5.10 Cost of Rectification of Defective Products 401 9.5.11 Bad Debts 401 401 9.5.12 After-Sales Services Cost 9.5.13 Advertisement Cost 401 9.5.14 Market Research Cost 402 9.5.15 Rent 402 9.5.16 Training Expenses 402 9.5.17 Canteen Expenses 402 9.5.18 Fringe Benefits 402 Exercises 402

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10. Cost Ledger 10.1 Introduction 10.1.1 Cost Accounting Ledgers 10.1.2 Control Accounts 10.2 Journal Entries in Cost Ledger 10.3 Exercises

11. Reconciliation of Cost and Financial Accounts 11.1 Reconciliation 11.1.1 Need for Reconciliation 11.1.2 The Reasons for Disagreement in Profits in Two Sets of Account Books 11.1.3 Procedure for Reconciliation 11.1.4 Memorandum Reconciliation Account or Statement 11.2 Exercises

12. Integral Accounting 12.1 12.2 12.3 12.4

Introduction Scheme of Making Entries Journal Entries Exercise

13. Output Costing/Unit Costing/Single Costing 13.1 13.2 13.3 13.4 13.5 13.6 13.7

Meaning Sources of Cost Information Treatment of Stocks Cost Sheet Treatment of Defective Materials, Scrap, by Products and Defective Products Tender or Quotation or Estimated Cost Sheet Exercise

14. Job Costing and Batch Costing 14.1 Cost Accumulation 14.2 Routines of Job Costing 14.2.1 Receiving customer’s enquiry 14.2.2 Preparing cost estimates, tender or quotation

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407 407 407 408 410 432 439 439 439 440 442 443 462 467 467 467 469 483 491 491 492 492 492 502 504 521 535 537 538 538 538

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14.2.3 Receiving customer’s order 14.2.4 Production order 14.2.5 Completion of job 14.2.6 Computation of profit/loss 14.3 Batch Costing 14.3.1 Economic Batch Quantity (EBQ) (or) Economic Batch Size 14.4 Exercise

15. Contract Costing or Terminal Costing 15.1 Contract Costing 15.1.1 Features of Contract Costing 15.1.2 Difference between Job Costing and Contract Costing 15.1.3 Nature of Contract Account 15.2 Treatment of Important Cost Items 15.2.1 Materials Cost 15.2.2 Abnormal Loss of Materials 15.2.3 Normal Loss of Materials 15.2.4 Transfer of Materials from One Contract to Another 15.2.5 Labour Cost 15.2.6 Special Plant and Equipment 15.2.7 Subcontract Cost 15.2.8 Overheads 15.3 Incomes of Contracts 15.3.1 Cost of Maintenance and Rectification of Defective Work 15.3.2 Profit from Contract 15.3.3 Methods of calculating profit on incomplete contract 15.4 Other Terms Related to Contract 15.4.1 Retention Money 15.4.2 Work certified 15.4.3 Work uncertified 15.5 Exercise

16. Process Costing 16.1 Meaning 16.1.1 Distinction between Job Costing and Process Costing 16.2 Accounting Procedure

538 538 539 539 550 550 557 567 567 567 568 569 569 569 569 569 569 569 570 570 570 570 570 570 571 572 572 573 573 611 639 639 641 642

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16.2.1 Materials 16.2.2 Wages 16.2.3 Overheads 16.2.4 Determination of Process Cost when there is no Process Loss 16.2.5 Steps for Calculation of Abnormal Loss or Abnormal Gain 16.3 Valuation of Work-in-Progress and Concept of Equivalent Production 16.3.1 Steps Involved in Valuation of Work-in-Progress 16.4 Methods of Valuation of Work-in-Progress 16.5 Exercise

17. Joint Products, By-products and Main Products Costing 17.1 Meaning 17.1.1 Joint Products 17.1.2 Main Product 17.1.3 By-product 17.1.4 Joint Costs 17.1.5 Split-off Point 17.2 Joint Products Costing 17.2.1 Physical Units Method 17.2.2 Average Unit Cost Method 17.2.3 Survey Method 17.2.4 Contribution Margin (or) Gross Margin Method 17.2.5 Standard Cost Method 17.2.6 Market Value Method 17.2.6.1 Market value at the point of separation 17.2.6.2 Market value after further processing 17.2.6.3 Net realisable value (or) relative sales value method 17.2.6.4 Net value or reverse cost method 17.3 By-products Accounting 17.3.1 Non-Cost Method or Sales Value Method 17.3.1.1 Miscellaneous income or other income method 17.3.1.2 Total sales less total cost method 17.3.1.3 Total cost less sales value of by-product method 17.3.1.4 Sales value of by-product less selling expenses credited to process account or deducted from total cost 17.3.1.5 Sales value of by-product less selling expenses and further processing cost credited to process Account

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17.3.1.6 Reverse cost method 17.3.2 Cost Methods 17.3.2.1 Replacement or opportunity cost method 17.3.2.2 Standard cost method 17.3.2.3 Apportionment on suitable basis 17.4 Production Planning 17.4.1 Sales after further processing (or) Sales at split-off point 17.5 Comprehensive Illustrations 17.6 Exercise

18. Service Costing or Operating Costing 18.1 Meaning 18.1.1 Cost Unit 18.2 Transport Costing 18.2.1 Cost Accumulation 18.2.2 Treatment of Certain Items 18.3 Operating Cost Sheet 18.4 Hotel (Lodging) Costing 18.5 Hotel - Boarding/Canteen Costing 18.6 Hospital costing 18.7 Powerhouse Costing 18.8 Cinema House 18.9 Boiler House Costing 18.10Operation Costing 18.11Comprehensive Illustrations 18.12Exercise

19. Marginal Costing 19.1 Cost Behaviour 19.1.1 Definitions 19.1.2 Features of Marginal Costing 19.1.3 Assumptions of Marginal Costing 19.1.4 Advantages of Marginal Costing 19.1.5 Limitations of Marginal Costing 19.2 Cost - Volume - Profit Analysis 19.2.1 Profit-Volume Analysis

733 735 735 736 736 736 736 741 756 769 769 769 770 773 774 774 785 792 794 797 799 802 804 805 818 839 840 840 842 842 843 843 851 851

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19.4

19.5

19.6

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19.2.2 Break-even Analysis 19.2.2.1 Composite break-even point 19.2.3 Margin of Safety Break-Even Chart or Graph 19.3.1 Special Break-even Charts 19.3.2 Cost Break-Even Point/Indifference Point Application of Marginal Costing Technique 19.4.1 Key Factor or Limiting Factor 19.4.2 Shutdown or Continue 19.4.3 Profitable Sales Mix/Product Mix 19.4.4 Accepting Orders at a Price Below the Total Cost 19.4.5 Sell or Process Further 19.4.6 Fixation and Alteration of Selling Price 19.4.7 Plant Merger 19.4.8 Make or Buy 19.4.9 Discontinuance of a Product 19.4.10 Maintaining a Desired Level of Profit Comprehensive Illustrations 19.5.1 Calculation of P/V Ratio, BEP, Profit, Required Sales and Margin of Safety 19.5.2 Profit Planning 19.5.3 Key Factor 19.5.4 Make or Buy 19.5.5 Optimum Sales Mix 19.5.6 Accepting Special Orders at Price Below Cost 19.5.7 Discontinuing a product line 19.5.8 Key Factor and Product Mix 19.5.9 Plant Merger 19.5.10 Indifference Point 19.5.11 Miscellaneous Exercise

856 857 858 869 872 876 880 881 885 887 894 897 898 901 905 907 913 917 917 930 937 942 945 947 951 956 961 964 965 968

20. Budgets and Budgetary Control 20.1 Introduction 20.1.1 Features of a Budget 20.2 Budgetary Control 20.2.1 Objectives of Budgetary Control 20.2.2 Advantages of Budgetary Control

987 987 988 988 988 989

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20.3

20.4 20.5 20.6 20.7

20.2.3 Differences between Budget and Forecast 20.2.4 Limitations of Budgetary Control Classification of Budgets 20.3.1 Materials Budget 20.3.2 Production Budget 20.3.3 Sales Budget 20.3.4 Direct Labour Budget 20.3.5 Administration Overheads Budget 20.3.6 Capital Expenditure Budget 20.3.7 Research and Development Budget 20.3.8 Selling Overheads Budget 20.3.9 Plant Utilisation Budget 20.3.10 Cash Budget Control Ratios Budget Reports Comprehensive Illustrations Exercise

21. Standard Costing and Variance Analysis 21.1 Introduction 21.1.1 Types of Standards 21.1.2 Prerequisites for Installation of Standard Costing 21.1.3 Standard Costs and Estimated Costs 21.1.4 Standard Costing and Budgetary Control 21.2 Setting Up of Standards 21.3 Overhead Standards 21.4 Variance Analysis 21.5 Computation of Variances 21.5.1 Direct Materials Cost Variance 21.6 Revision Variance 21.7 Overhead Variances 21.7.1 Variable Overhead Variances 21.7.2 Fixed Overhead Variances 21.8 Sales Variances 21.8.1 Type of Sales Variances 21.9 Accounting Methods 21.10Standard Cost-Reporting

989 990 991 992 995 995 998 999 1000 1000 1000 1000 1000 1008 1010 1011 1029 1043 1044 1045 1045 1046 1047 1049 1050 1050 1051 1051 1081 1084 1084 1085 1101 1101 1118 1120

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21.10.1 Standard Cost Report 21.10.2 Disposal of Variances 21.10.3 Control of Variances through Ratio Analysis 21.11Exercise

22. Miscellaneous Topics 22.1 Uniform Costing and Inter-firm Comparison 22.1.1 Uniform Costing 22.1.1.1 Meaning 22.1.1.2 Objectives 22.1.1.3 Advantages 22.1.1.4 Disadvantages 22.1.1.5 Essential requisites for uniform costing 22.1.2 Inter-firm Comparison 22.1.2.1 Meaning 22.1.2.2 Essentials requisites of inter-firm comparison 22.1.2.3 Advantages 22.1.2.4 Disadvantages 22.2 Activity Based Costing (ABC) 22.2.1 Evolution 22.2.2 Meaning 22.2.3 Objectives and Purposes or Why ABC? 22.2.4 Merits 22.2.4.1 Specific 22.2.4.2 General 22.2.5 De-merits 22.2.6 Various Terms 22.2.6.1 Cost driver 22.2.6.2 Activity cost pool 22.2.6.3 Activity based budgeting 22.2.6.4 Activity based accounting 22.2.6.5 Activity based management 22.2.7 Steps to be followed in ABC System 22.2.8 Conventional Costing and ABC - Differences 22.3 Transfer Pricing 22.3.1 Meaning 22.3.2 Methods of Transfer Pricing

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1120 1121 1121 1155 1173 1173 1173 1173 1174 1174 1175 1175 1175 1175 1176 1176 1177 1177 1177 1178 1178 1178 1178 1179 1179 1179 1179 1180 1180 1180 1180 1181 1181 1182 1182 1182

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Contents

22.4 Cost control and Cost reduction 22.4.1 Meaning 22.4.2 Cost Control and Cost Reduction - Differences 22.5 Life Cycle Cost - LCC 22.5.1 Meaning 22.5.2 LCC Process (Fabryck) 22.5.3 LCC Tree 22.6 Exercises

1183 1183 1183 1183 1183 1184 1185 1186

Index

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INTRODUCTION

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+ Evolution of cost accounting + Cost accounting + Objectives of cost accounting + Need and importance of cost accounting + Advantages and disadvantages of cost accounting + Methods of cost accounting + Essentials of good cost accounting system + Various terms + Cost accounting vs. Financial accounting + Cost accounting vs. Management accounting

1.1 EVOLUTION OF COST ACCOUNTING Nathan Kranowski (1977) claims that the contemporary cost accounting began around 1885 though it had been in use for many years or centuries prior in a limited form. Previts and Merino (1998) support Kranowski’s assertion that cost accounting came into use after 1800 and expanded during the American industrial revolution in the mid to late 1800’s. The industrial revolution had a major impact on methods and costs of manufacturing. Because of this enormous development in manufacturing processing, both engineers and accountants began to look at the complete process. Both groups worked to detail the process for both the production and accounting flow process. As the

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industrial revolution evolved, trusts, such as the Standard Oil Trust and U.S. Steel, dominated the economy. The Olds Motor Works began in Detroit in 1899 using interchangeable parts that would lead the way to mass manufacturing and the need for more advanced cost accounting. In addition, Ford made the first Model T in 1908. Various literatures towards cost accounting tells that the main reason for dissemination of cost accounting systems in the late 1800’s and early 1900’s was that often firms considered their accounting systems to be secrets that were not to be made available to competing firms. Most companies did not even reveal their system to their own labourers. It is said that during the seventeenth century in France, the Royal Wallpaper Manufactory had a Cost Accounting System. Some iron masters and potters in the eighteenth century in England too began to produce Cost Accounting information before the Industrial Revolution. Subsequently, with the advent of the industrial revolution, large sized process industries performing single activities (e.g. textiles, railways etc.,) came into being. During this period, there was a lack of market for intermediary products because of which cost information gained importance as a tool for measuring efficiency of different processes. The period, 1880 - 1925 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. Widespread growth of industrialisation in the western world during the last half of the nineteenth century gave rise to the development of cost accounting. With the advent of the factory system, necessity for accurate cost information was felt to bring efficiency in production. In spite of that, there was slow development of cost accounting during the nineteenth century. To quote Eldon S. Hendriksen, “Not until the last 20 years of the nineteenth century was there much literature on the subject of cost accounting in England and even then very little was to be found in the United States”. The most rapid development in cost accounting took place after 1914 with the growth of heavy industry and mass production methods when costs (i.e. overheads) other than materials and labour constituted a significant portion of the total cost of production. The scientific management movement led by Taylor gave impetus to the development of cost accounting because it contributed to the use of standard costs in planning manufacturing operations and in evaluating performances.

1.1.1 Cost Accounting in Indian Context The need for the application of cost accounting methods in Indian industries was felt in the beginning of the twentieth century. The development of cost accounting in India started gaining importance after the independence of the country when the Indian Government started laying emphasis on the industrial development of the country. Further, provisions of cost audit under section 233B of the Companies Act gave impetus to the development of cost accounting in India. The Vivian Bose Enquiry Commission brought to light the various malpractices prevalent in the manufacturing establishments and it was thought that the audit of financial accounts at the end of the year was insufficient to judge the real efficiency of the working and manufacturing organisations as a result, the concept of cost audit emerged best utilise the resources of the country, and the government was given the power for ordering cost audit under section 233B of the Companies Act, 1956.

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Introduction

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The following factors have accelerated the system of cost accounting in our country. 1. Increased awareness of cost consciousness by Indian industrialists with a view to ascertain costs more accurately for each product or job. 2. Growing competition among manufacturers led to fixation of prices at a lower level so as to attract more customers. 3. Economic policy of government which laid emphasis on planned economy with a view to achieve the targets led to cost reduction programmes by Indian industrialists. 4. Increased government control over pricing led the Indian manufacturers to give utmost importance to the installation of cost accounts. 5. The establishment of National Productivity Council in 1958 and the statutory recognition of Institute of Cost and Works Accountants of India in 1959 gave further encouragement to instal cost accounting system in Indian industries.

1.2 COST ACCOUNTING “Cost accounting is the process of determining and accumulating the cost of product or activity. It is a process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and interpretation of cost. In other words, it is a system of accounting, which provides the information about the ascertainment, and control of costs of products, or services. It measures the operating efficiency of the enterprise. It is an internal aspect of the organisation.” “Cost accounting is accounting for cost aimed at providing cost data, statement and reports for the purpose of managerial decision making.” The Institute of Cost and Management Accounting, London (CIMA) defines “Cost accounting is the process of accounting from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units. In the widest usage, it embraces the preparation of statistical data, application of cost control methods and the ascertainment of profitability of activities carried out or planned.”

1.3 OBJECTIVES OF COST ACCOUNTING The following are the main objectives of cost accounting: 1. To ascertain cost (cost of production) of every unit, job, process, service or department. 2. To control cost by using various techniques such as budgetary control, standard costing and inventory control. 3. To help management in taking decisions based on CVP relationship (cost volume profit).

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4. To identify costing profit. 5. To identify stock of raw material, semi-finished and finished goods as and when required. 6. To study profit relationship based on capacity operations (say profit at 60% or 80% operating capacity). 7. To compare actual cost with budgeted cost to identify the variances. 8. To help the management in budgetary control. 9. To ascertain sales mix to maximise profit. 10. To facilitate preparation of financial and other statements.

1.4 NEED AND IMPORTANCE OF COST ACCOUNTING Cost accounting provides valuable help to the management. It is not easy to quantify the need and importance since it cannot be concluded about where the work of a cost accountant comes to an end. The following points can be taken under the concept of “need”. The same points are also the main advantages of cost accounting. ※ Helps to ascertain cost ※ Helps in price fixation ※ Helps to eliminate wastages ※ Helps to identify and eliminate unprofitable activities ※ Helps to check statement accuracy ※ Helps in inventory control ※ Helps for cost and revenue estimation ※ Helps to increase productivity and earning capacity ※ Helps investor’s, moneylenders and other financial institutions to know about the business ※ Helps in formulating efficient policy for day-to-day business activities ※ Helps cost control

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1.5 ADVANTAGES AND DISADVANTAGES OF COST ACCOUNTING 1.5.1 Advantages ※ Helps to identify idle capacity ※ Helps inter-firm comparison ※ Helps to ascertain cost ※ Helps in price fixation ※ Helps to eliminate wastages ※ Helps to identify and eliminate unprofitable activities ※ Helps to check statement accuracy ※ Helps in inventory control ※ Helps for cost and revenue estimation ※ Helps to increase productivity and earning capacity ※ Helps investor’s, moneylenders and other financial institutions to know about the business ※ Helps in formulating efficient policy for day-to-day business activities ※ Helps cost control ※ Helps to increase production by comparing records of output ※ Helps to develop pricing strategy ※ Helps to generate information based on a. Products b. Periods c. Departments/sections etc. ※ Helps to prepare production plan ※ Helps to identify and allocate overhead costs to respective departments/sections/products ※ Helps to reconcile cost and financial results ※ Helps in anticipating profits ※ Helps to provide proper performance records

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1.5.2 Disadvantages ※ Involves heavy expenditure since the system has to maintain numerous records ※ Not applicable for all types of industry ※ No standard system for all industry ※ It is mechanical in nature ※ It is stereotyped ※ Common notion is that it cannot control costs and can contribute for operating efficiency. But can only give information on the same. ※ “Cost Concept Terminology” interpretation during decision making according to the convenience of cost accountants acts as a hurdle for standards ※ Considered “Empirical Science”

1.6 METHODS OF COST ACCOUNTING Different industries follow different methods for ascertaining cost of their products. The method to be adopted by business organisations will depend on the nature of the production and the type of output. The following are the important methods of costing. Job costing Contract costing Batch costing Process costing Methods Service costing (Operating)

Operation costing

Multiple costing (Composite)

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1. Job Costing: Job costing is concerned with finding the cost of a specific job or work order. This method is followed by those concerns where work is carried on the customer’s request. Under this system a job cost sheet is prepared to find out profit or losses for each job or work order. Duration of the job will be short. Example: Printing job in a printing press, repair job in a garage etc., 2. Contract Costing: Contract costing is applied for contract work like construction of dam, building civil engineering contract etc. Each contract or job is treated as separate cost unit for cost ascertainment and control. It is also called “Terminal Costing”. Firms engaged in ship-building, civil engineering for roads, industrial estates and factory construction follow this type of costing. 3. Batch Costing: A batch is a group of identical products. Under batch costing a batch of similar products is treated as a separate unit for the purpose of ascertaining cost. The total costs of a batch are divided by the total number of units in a batch to arrive at the costs per unit. This type of costing is generally used in industries like bakery, toy manufacturing etc. Other examples include engineering equipment, drugs and footwear. 4. Process Costing: This method is used in industries where production is carried on through different stages or processes before becoming a finished product. Costs are determined separately for each process. The main feature of process costing is that output of one process becomes the raw materials of another process until the final product is obtained. This type of costing is generally used in industries like textile, chemicals, paper, oil refining etc. 5. Service (Operating) Costing: This method is used in those industries which render services instead of producing goods. Under this method cost of providing a service is also determined. It is also called service costing. Undertakings such as transport, electricity, gas, hospitals, educational institutions etc., are examples of this type. 6. Operation Costing: This is suitable for industries where production is continuous and units are exactly identical to each other. Examples: Mines or drilling, cement works, manufacture of bicycles, ceiling fans etc. 7. Multiple Costing: This refers to the combination of two or more of the above-mentioned methods of costing or mix of any methods mentioned above. Where a product comprises many assembled parts or components (as in case of motor car) costs have to be ascertained for each component as well as for the finished product for different components for which different methods of costing may be used. This composition comes under multiple costing method. It is also known as composite costing. This type of costing is applicable to soft drinks, automobiles and similar products.

1.7 ESSENTIALS OF GOOD COST ACCOUNTING SYSTEM An ideal system of costing is that which achieves the objectives of a costing system and brings all the advantages of costing to the business. The following are the main characteristics which an ideal system of costing should possess or the points which should be taken into consideration before installing a costing system.

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※ It should be tailor-made ※ It should be practical, simple and capable of meeting business requirements ※ Data used should be accurate enough for its intended purpose ※ Co-operation and participation of various department executives are a must for a good system ※ Cost of installing and operating should justify the results to have a good system ※ The system should not have or introduce unnecessary procedures. Overloading should be avoided ※ System should be complete in all aspects. Say the system should provide all users wealth of information that is necessary and required. ※ For system information to be valuable, it should be relevant to the objective and for the intended user ※ It should have clarity so that the user can understand and comprehend the information properly ※ Timely information is essential since it helps effective decision making ※ System should validate the information so that competence and integrity can be evolved to produce confidence among auditors ※ It should be cost-efficient. Say valuable information should not cost more to produce than it is worth ※ The system should have an appropriate communication channel which should adhere to standards

1.8 VARIOUS TERMS 1.8.1 Cost It refers to the actual or notional expenditure incurred on or attributable to a given thing. In other words, cost is the amount of resources used for something which can be measured in terms of money.

1.8.2 Costing It is defined as “the technique and process of ascertaining costs”. In other words “costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management.”

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1.8.3 Cost Accounting It is defined 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”. It mainly accounts for the cost of products, services or operations.

1.8.4 Cost Accountancy It is defined as “the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profitability as well as presentation of information for the purpose of managerial decision making”. In simple words it is the application of costing and cost accounting principles with specific purpose of cost control to facilitate decision making.

1.8.5 Cost Centre It refers to location, person or item of equipment for which the cost may be ascertained and used for the purpose of cost control. Cost centre is a sub-unit for which cost allocation is attempted. Examples, each department in an organization can be considered cost centre. Say, production department, selling department etc. A cost centre in which a specific process or continuous sequence of operations is carried out is known as “Process Cost Center”.

1.8.6 Profit Centre It is defined as “a segment of the business entity by which both revenues received and expenses incurred are controlled”. It is a sub-unit of an organization to which both revenues and costs are assigned. This centre helps to evaluate actual and budgeted performance. Note: “Cost centre” is one where only “costs” are assigned whereas “profit centre” is one where both “costs and revenues” are assigned.

1.8.7 Historical Costing It is a system where costs are ascertained only after they are incurred. It is helpful for analysis (post-mortem) of costs incurred in the past. This system will help to identify the trend movement of costs over a period of time and will also be useful to estimate costs for future, based on the trends.

1.8.8 Absorption Costing It is also known as “Full Cost Method”. Absorption costing method is an inventory valuation and costing model which includes all costs irrespective of whether they are variable or fixed in nature. It is based on the principle that costs should be charged or absorbed to whatever is being, whether it is a cost unit or cost centre.

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1.8.9 Marginal Costing This is also called “Direct costing method” or “Variable costing method”. In this only variable costs are considered for unit cost of a product and decisions are mostly based on variable costs. The principle followed in this case is that since fixed costs are largely period costs, they should not enter into the production units.

1.8.10 Uniform Costing It is not a distinct method of costing. It is adoption of identical costing principles and procedures by several units of the same industry or by several undertakings by mutual agreement in order to facilitate easy comparison. The principles and methods of compilation, analysis, apportionment and absorption of overheads differ from one concern to the other in the same industry; but if a common or uniform pattern is adopted by all, it will mutually help in cost control and cost reduction.

1.9 COST ACCOUNTING vs. FINANCIAL ACCOUNTING S. No.

Cost Accounting

Financial Accounting

1.

It is prepared mostly for internal management

It is prepared mostly for outsiders like investors, government, creditors, owners etc.

2.

The reports prepared are on the formats as required and designed by the management.

The reports prepared are specific in format prescribed by GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards)

3.

Focuses on the financial position of specific products, product lines etc.

Focuses on the entire financial position of the company

4.

No regulatory framework

Regulated mostly by GAAP and IFRS

5.

Cost reports can be prepared as and when required at frequent intervals. There is no specific time

Financial reports are prepared once in every twelve months

6.

Past data and future aspects are taken into consideration while preparing reports

Only past data are taken into consideration while preparing reports

7.

Cost of raw material, WIP and finished goods are compiled by cost accounting

It only incorporates the information compiled (in cost accounting) into the Balance Sheet

8.

Main purpose is to analyse, ascertain and control cost

Main purpose is to record financial transactions and find out profit or loss

9.

It is voluntary to meet the requirements of the management

It is compulsory to meet the requirements of Companies Act and Income Tax Act

10.

It is objective in nature towards recording transactions (costs)

It is subjective in nature towards recording transactions (nature of expenses)

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It aims at computing cost of production

It aims at finding out results in the form of profit or loss

12.

It is subject to cost audit to verify whether cost accounts disclose true and fair view of the cost of production

It is subject to statutory audit to verify whether financial accounts disclose true and fair view of the profit and loss as well as financial position

13.

Stocks are valued at cost price

Stocks are valued at cost or market price whichever is lesser

14.

Monetary and non-monetary data are considered

Only monetary data is considered

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1.10 COST ACCOUNTING vs. MANAGEMENT ACCOUNTING Usually the terms, cost accounting and management accounting, are used interchangeably and are used in one and the same sense. Therefore, cost accounting supports management accounting and in turn management accounting pushes cost accounting further according to the needs of the management. Because of this strong bondage between the cost accounting and management accounting are one and the same thing nowadays. However, the following points can be taken as di�