Cost and Management Accounting SLM (BMS&BBAFIA)

Department of Distance and
Continuing Education
University of Delhi
Bachelor of Business Administration

(Financial Investment Analysis)
Discipline Specific Core (DSC-4)
Bachelor of Management Studies

Discipline Specific Core (DSC-4)
Course Credit - 4
Semester-II
As per the UGCF - 2022 and National Education Policy 2020

Editorial Board
Dr. Rishi Taparia
Dr. Kumar Bijoy
Content Writers
Dr. Saumya Jain, Dr. CA. Madhu Totla, CA. Vishal Goel
Ms. Priya Dahiya, Ms. Chandni Jain, Ms. Rinki
Dahiya, Ms. Shalu Garg, Mr. Anil Kumar
Academic Coordinator
Mr. Deekshant Awasthi
© Department of Distance and Continuing Education

ISBN: 978-81-962177-7-8
1st edition: 2023
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management@col.du.ac.in
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Cost and Management Accounting
INDEX
Lesson 1: Introduction to Cost and Management accounting………………………………...01
1.1 Learning Objectives

1.2 Introduction
1.3 Meaning, nature and scope of Cost Accounting
1.4 Meaning, nature and scope of Management Accounting
1.5 Comparison between Cost Accounting & Management Accounting
1.6 Cost Control, Cost Reduction & Cost Management
1.7 Components of Total Cost & Preparation of Cost Sheet
1.8 Cost Ascertainment: Cost Unit and Cost Centre
1.9 Summary
Lesson 2: Overhead……………………………………………………………………………….31
2.1 Learning objectives
2.2 Introduction
2.3 Classification of overheads
2.4 Distribution of overheads
2.5 Accounting of factory overheads
2.6 Types of overhead rates
2.7 Accounting of office and administrative overheads
2.8 Accounting of selling and distribution overheads
2.9 Treatment of over absorbed or under absorbed overheads
2.10 Concepts related to capacity
2.11 Treatment of certain items in costing
2.12 Summary
Lesson 3: Classification of Costs…………………………………………………………………..78

3.2 Introduction
3.3 Nature or Element Cost
3.4 Function cost
3.5 Variability, or behaviour cost
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3.6 Controllability-based cost

3.7 Normality-based cost
3.8 Managerial decision-making
3.9 Summary
Lesson 4: Cost Volume Pofit Analysis………………………………………………………………96

4.2 Introduction
4.3 Marginal Costing
4.4 Advantages of Marginal Costing
4.5 Limitations of Marginal Costing
4.6 Difference between Marginal costing and Absorption costing
4.7 Cost-Volume-Profit analysis
4.8 Break Even Analysis
4.9 Various decision-making problem
4.10 Summary
Lesson 5: Relevant costs and Decision Making……………………………………………….128

5.2 Introduction
5.3 Relevant Costs and Decision Making
5.4 Key Factor
5.5 Product Profitability
5.6 Dropping a product line
5.7 Make or Buy
5.8 Export Order
5.9 Shut down vs. Continue operations.
5.10 Summary
Lesson 6: Budgets and Budgetary Control……………………………………………………152

6.2 Introduction
6.3 Meaning of Budget and Steps in Budgetary Control
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6.4 Types of Budgets

6.5 Zero-Based Budgeting
6.6 Summary
Lesson 7: Standard Costing………………………………………………………………….177

7.2 Introduction
7.3 Objectives of Standard Costing
7.4 Setting up of standards
7.5 Difference between Standards Costs and Estimated Costs
7.6 Difference between Standard Costing and Budgetary Control
7.7 Advantages of Standard Costing
7.8 Limitations of Standard Costing
7.9 Variance Analysis
7.10 Material Cost Variances
7.11 Labour Cost Variances
7.12 Summary
Lesson 8: Contemporary Issues in Cost Accounting and Management Accounting….200

8.2 Introduction
8.3 Activity Based Costing
8.4 Target Costing
8.5 Life Cycle Costing
8.6 Quality Costing
8.7 Summary
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UNIT-I
LESSON 1
INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING
Priya Dahiya
Assistant Professor
Department of Commerce
Jesus and Mary College
University of Delhi
Email-Id: priyadahiya@102gmail.com
STRUCTURE
1.2 Introduction
1.3 Meaning, nature and scope of Cost Accounting
1.4 Meaning, nature and scope of Management Accounting
1.8 Cost Ascertainment: Cost Unit and Cost Centre
1.9 Summary
1.10 Glossary
1.11 Answers to In-Text Questions
1.12 Self-Assessment Questions
1.13 References
1.14 Suggested Readings
1.1 LEARNING OBJECTIVES
At the end of studying the course material, the learner will be able to:
● Understand the purpose and use of cost and management accounting within an organisation.
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● Develop an understanding of the difference between cost accounting and management

accounting
● Describe the nature and scope of cost and management accounting.
● Describe the roles of cost accounting and management accounting.
● List and explain the components of cost.
● Describe the costs associated with production, office and administration, selling, and
distribution.
1.2 INTRODUCTION
A business is a structure in which fundamental resources (inputs), such as labour and raw
materials, are brought together and processed in order to produce goods or services (outputs)
for consumers. Small neighbourhood coffee shops to large, multi-billion dollars multinational
organisations are various types of businesses. The majority of businesses want to be profitable.
But have you ever wondered, what function does accounting serve in business? The simplest
response is that accounting gives managers information to utilise in running the company.
Accounting also gives information to other users so they may evaluate the financial health and
performance of the company. As a result, accounting may be characterised as an information
system that offers users reports about the financial activities and state of an organisation. You
may consider accounting to be the "language of business".
Financial accounting, cost accounting, management accounting, social accounting, inflation
accounting, value-added accounting, and human resources accounting are the seven branches of
accounting. Cost accounting calculates and measures the resources that are used for various
company operations, typically for manufacturing and service provision. It has to do with
figuring out cost per unit by utilising various costing methodologies. In contrast, management
uses all of the data collected and processed by cost accounting in management accounting. In
this unit, we shall be discussing the nature, scope and functions of cost accounting and
management accounting.
1.3 MEANING, NATURE AND SCOPE OF COST ACCOUNTING
A financial analyst must apply several management accounting methodologies in order to

ascertain and adopt an objective viewpoint of what lies beneath the surface of accounting
figures. Due to the fact that accounting handling of costs is sometimes both difficult and
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financially significant, cost approaches take precedence over the other techniques. for instance,
if a company intends to increase output by 10%, is it acceptable to anticipate total costs to
increase by less than 10%, exactly 10%, or more than 10%.? These inquiries focus on the cost
behaviour, or how costs alter as activity levels change.
Since the projections and earnings of a company serve as the foundation for all financial
choices, the answers to these questions are crucial for management accountants or financial
analysts. Therefore, it is essential for a financial analyst to have a solid working understanding
of the fundamental cost principles and patterns. These are all included in the scope of cost
accounting.
Cost accounting was previously only thought of as a method for determining the costs of goods
or services based on historical data. Over time, it was understood that managing costs was more
crucial than determining costs due to the market's intense competition. Cost reduction has been
included in the scope of cost accounting as a result of technical advancements in all industries.
Therefore, cost accounting is concerned with documenting, categorising, and summarising
costs in order to calculate the costs of goods or services, planning, regulating, and minimizing
such costs, as well as providing management with information so that they can make decisions.
Cost accounting is a method for gathering, reviewing, summarising, and assessing many
alternative strategies. Its objective is to give management advice on the best course of action
based on cost effectiveness and capacity. Cost accounting provide the thorough cost data that
management requires to oversee ongoing operations and make long-term plans.
According to the Chartered Institute of Management Accountants, London, “cost accounting is
the process of accounting for costs from the point at which its expenditure is incurred or
committed to the establishment of the ultimate relationship with cost units. In its widest sense,
it embraces the preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of the activities carried out or planned”.
Cost accounting is usually a large part of management accounting. As its name suggests, it is
concerned with establishing costs. The main goal of cost accounting is to make it easier for
management to perform the planning, control, and decision-making tasks. Cost accounting
emphasize on calculating costs and profits for a control period. It helps in valuing inventories
of raw materials, work in progress, and finished goods, and controlling inventory levels. Cost
accounting is not confined to the environment of manufacturing, although it is in this area that
it is most fully developed. Cost accounting data is used by service companies, federal, state,
and local governments, as well as accountancy and legal professions. Additionally, it includes
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expenses for administration, marketing, sales, and distribution in addition to manufacturing and
operational expenditures.
Cost accounting provides information for management accounting and financial accounting.
The expenses associated with acquiring or using resources inside an organisation are measured,
analysed, and reported using cost accounting. For instance, determining a product's cost is a
cost accounting function that satisfies the requirements of management accounting and
financial accounting for inventory value and decision-making, respectively. But contrary to
financial accounting, which is supposed to adhere to rules and standards, cost accounting
systems and reporting are not constrained by regulations like the Generally Accepted
Accounting Principles.
NATURE OF COST ACCOUNTING
Let us discuss the nature of cost accounting under the following headings:
1. Cost accounting is a branch of knowledge:
Despite being regarded as a subset of financial accounting, cost accounting is a discipline unto
itself and one of the most significant fields of knowledge. It is a disciplined body of knowledge
with its own principles, concepts and conventions.
2. Cost accounting is a science.
Cost accounting is a body of systematic knowledge relating to a wide range of disciplines,
including laws, office practise and procedure, data processing, production and material control,
etc. In order to carry on his daily tasks, a cost accountant needs to be quite knowledgeable in
each of these fields of study. However, it must be acknowledged that it is not a flawless
science, unlike natural science.
3. Cost accounting is an art:
Cost accounting is an art in the sense it requires applying the concepts, procedures, and
techniques of cost accountancy to varied management issues that demands the expertise and
skill of the cost accountant. These issues include cost determination, cost control, and
profitability determination, among others.
4. Cost accounting is a profession:
In recent years, cost accounting has emerged as one of the prominent and demanding
professions. These two facts make this opinion clear. First, a number of professional
organisations have been established, including the The Institute of Cost and Works
Accountants in India (ICWAI) in India, National Association of Accountants (NAA) in the
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United States and the Institute of Chartered Accountants of Nigeria (ICAN) in Nigeria. The
Institute of Cost and Management Accountants in the United Kingdom, and other professional
organisations in developed and developing nations have contributed to the public's rising
knowledge of the costing profession. Second, many students have registered in these
institutions in order to get certifications and memberships that will help them support
themselves.
OBJECTIVES OF COST ACCOUNTING
The main objectives of cost accounting can be summarized as follows:
1. Estimating the Selling Price
Cost accounting act as a guide for setting goods prices and determining the profitability of each
product. Businesses operate with the goal of making a profit. Therefore, it is essential that
income be higher than the cost of producing the items and services from which the revenue is
to be obtained. Numerous details about the expenses incurred in producing and selling such
goods or services are provided by cost accounting. Of course, before settling on a price,
management takes into account a number of other aspects, including the state of the market, the
area of distribution, the quantity that can be supplied, etc. but cost still has a disproportionate
influence.
2. Assessing and Optimizing Efficiency
The study of various production processes utilised in the creation of goods or the rendering of
services is a component of cost accounting. The study makes it easier to gauge an
organization's overall or departmental efficiency and come up with strategies for doing so.
For cost control, cost accounting employs a variety of techniques, such as standard costing and
budgetary control. At the beginning of a period, a budget is created for each item, including
labour, materials, and expenses. The actual expenses incurred are then compared to the budget.
This significantly improves an enterprise's operational effectiveness.
3. Offering Basis for Operating Policy
It makes recommendations to management for future expansion policies. Cost accounting
assists management in developing operational policies. Policies and decision relating to
continuing to use the current equipment and plant or replacing them with more efficient
models; closing or operating at a loss; producing for or purchasing from external suppliers.
4. Making it easier to prepare financial and other statements.
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It provides timely information for decisions and prepare internal audit systems. The objective
of cost accounting is to generate reports whenever management requests them. According to
financial accounting, the financial statements are typically prepared once a year or every half-
year and are too far apart in time to suit the needs of management. Reviewing production, sales,
and operating data on a regular basis is crucial for management in order to run a business with a
high level of efficiency. Cost accounting provides suitable analysis along with daily, weekly, or
monthly volumes of units produced and accumulated costs. A well-designed cost accounting
system gives quick access to data on raw material, work-in-progress, and finished goods
inventories. The quick preparation of financial statements is made possible by this.
SCOPE OF COST ACCOUNTING
The scope of cost accounting is very wide. For the purpose of determining costs and controlling
them, numerous techniques, tools, procedures, processes, and programmes are employed in cost
accounting. However, in general, we will categorize its scope into three main categories:
1. Cost Ascertainment
Cost accounting compiles a product's material, labour, and overhead costs and attempts to
determine the overall and per-unit costs of the product in this category. The overall cost will be
determined using historical, market, or predicted data. The cost accountant will then employ
any method of costing, such as direct costing technique, order processing costing, and operation
costing. Within the same business, different natural products may be calculated using these
methodologies and procedures.
2. Cost Control
This seems to be where the definition of the scope of cost accounting ends. Different
approaches and methods were employed by cost accountants in this area to control costs.
Therefore, budgetary control, standard costing, break-even point analysis, and many other
approaches are used by cost accountants to control costs.
3. Cost Records
Cost accountants maintain cost books, vouchers, ledgers, reports, and other cost-related
documentation in this area of cost accounting for comparison and future use. Making sure that
accurate records are preserved, will fall under the purview of cost accounting.
1.4 MEANING, NATURE AND SCOPE OF MANAGEMENT
Management accounting collects, evaluates, and disseminates financial and nonfinancial data to
assist managers in reaching organisational objectives. It helps managers inside businesses to
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make wise business decisions and improve their management and leadership capabilities. It
focuses on the provision and use of accounting information. Information and reports in
management accounting do not have to adhere to predetermined standards or regulations.
Management Accounting is all about obtaining information from cost accountants and utilizing
it for decision-making. Information from management accounting is used by managers to
create, discuss, and carry out strategy. In order to coordinate choices about product design,
production, and marketing as well as to assess performance, they also employ management
accounting information. Overall, to make wise future decisions, management accountants use
management information.
Different authorities have provided different definitions for the term Management Accounting.
Some of them are as under:
Management Accounting is concerned with accounting information, which is useful to the
management - Robert N. Anthony
Management Accounting is concerned with the efficient management of a business through the
presentation to management of such information that will facilitate efficient planning and
control - Brown and Howard
Any form of Accounting which enables a business to be conducted more efficiently can be
regarded as Management Accounting - The Institute of Chartered Accountants of England
and Wales
The Certified Institute of Management Accountants (CIMA) ,UK defines the term
Management Accounting as an integral part of management concerned with identifying,
presenting and interpreting information for:
• Formulating strategy
• Planning and controlling activities
• Decision taking
• Optimizing the use of resources
• Disclosure to shareholders and others, external to the entity
• Disclosure to employees
• Safeguarding assets
The primary purpose of Management accounting is to provide information for use within an
organisation. Management accountants offer the data necessary to develop short-, medium-,
and long-term plans. Internal users, such as departmental managers, will require a variety of
information to ensure the smooth running of their department. It is also possible that some
external users, such as banks, may also review the management accounts of a business.
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The fundamental difference between financial and managerial accounting is that financial
accounting serves the interests of individuals outside the company, but managerial or
management accounting serves the needs of managers who are employed within the business.
Because of this fundamental difference in users, financial accounting places a strong emphasis
on the financial ramifications of past actions, objectivity and verifiability, accuracy, and
company-wide performance. Whereas management accounting places a strong emphasis on
decisions affecting the future, relevance, timeliness, and segment performance. Finally,
financial accounting is required and must adhere to rules like generally accepted accounting
principles (GAAP) or international financial reporting standards (IFRS) for external reports.
Whereas in management accounting is not required and is exempt from rules imposed by
external parties.
The aim of management accounting is to assist management in decision making, planning,
coordinating, controlling, communicating and motivating. Generally managerial accounting
helps managers perform three vital activities— planning, controlling, and decision making.
Setting objectives and outlining a plan for achieving them constitute planning. To guarantee
that the plan is being adequately carried out or amended as circumstances change, controlling
entails receiving input. Making decisions entails choosing a course of action from a range of
competing options.
NATURE OF MANAGEMENT ACCOUNTING
1. No Fixed Norms Followed
For the purpose of establishing ledgers and other account books in financial accounting, we
adhere to several standards and guidelines. But in management accounting, there is no
requirement to adhere to rigid standards. The tool used for management accounting may
vary from one organisation to another. The effectiveness of the various management
accounting technologies depends entirely on the users. So, the rules and regulations for
applying management accounting are influenced by the business policies of each
corporation.
2. Enhanced Effectiveness
Management accounting is utilised to boost organisational efficiency since that is simply
how it works. Through study of accounting data, it looks for inefficiencies. By taking
appropriate action organizations can boost its efficiency.
3. Provides Data but Not Decisions
Accounting facts and data are provided by management accountants, who also provides
interpretation, but final decision-making rests entirely with higher authorities. Management
accounting is merely a reference.
4. Concerned with Forecasting
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The management accounting temperament is wholly preoccupied with predicting. To determine

the likelihood of the upcoming fact, management accountants evaluate historical accounting
data using ratio analysis, fund flow analysis, and accounting data trend. Projection could be
related to cost forecasting, earning forecasting, sales forecasting and production forecasting.
SCOPE OF MANAGEMENT ACCOUNTING
The area of management accounting encompasses a wide range of corporate processes and has
a very broad scope. The main objective of management accounting is to support management
in its planning, directing, controlling, and areas of expertise that fall within its purview. The
following can be used to study the management accounting's scope:
1. Financial Accounting
Financial accounting forms the basis for analysis and interpretation, for furnishing
meaningful data to the management. The component of control is based on documented
facts and statistics, performance evaluation, and financial data. Therefore, there are
numerous ways in which management accounting and financial accounting are similar.
2. Cost Accounting
The methods and process of determining costs are known as cost accounting. The
fundamental managerial functions are planning, making decisions, and controlling. The cost
accounting system offers the essential equipment for successfully completing such tasks.
Standard costing, inventory control, variable costing, and other instruments are among them.
3. Budgeting and Forecasting
Budgeting is the process of outlining a company's future objectives, rules, and goals. On the
other hand, forecasting makes predictions about what will occur as a result of a specific set
of circumstances. Budgeting is an organisational goal, whereas forecasting is a judgement.
These are helpful in preparing for management accounting.
4. Inventory Management
Since inventory includes a sizable sum of money, it must be managed from the moment it is
obtained until it is finally disposed of. Management should use different stock levels to
control inventories. Making managerial decisions will benefit from the inventory control
strategy.
5. Statistical Approach
Statistical tools are very helpful for planning and forecasting in addition to improving the
information's impressiveness, comprehensiveness, and understandability.
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6. Data Interpretation
An essential component of managerial accounting is the analysis and interpretation of
financial statements. The management is given the reports derived from the analysis of the
financial accounts after it has been completed. The main function of management
accounting is to explain the accounting information to the management authorities.
7. Reporting to Management
It is necessary to share the interpreted information with individuals who are interested in it.
The report may include statements of profit and loss, cash flow, and funds flow, among
other things.
8. Tax accounting and internal audit
Management accounting investigates all tax-related issues to support management's
investment decisions in light of tax planning as a tool for tax reduction. An internal audit
system is required to evaluate each department's performance. Internal audit enables
management to be aware of performance variances. Additionally, it aids management in
allocating duty among various people.
9. Methods of Procedures
This covers the upkeep of efficient data processing and other office administration functions.
It may have to deal with organising, communicating, managing, and duplicating information
systems. It also has to report on the usefulness of various office equipment.
Overall, Financial accounting, cost accounting, revaluation accounting, inventory control,
statistical methods, interim reporting, taxation, office services, and internal audit are all
included in the scope of management accounting.

In this section, we shall be discussing accounting as segmented parts. Most frequently, financial
accounting comes to mind when you hear the word "accounting." It is typical to anticipate that
when asked to describe accounting, you will begin by describing what you perceive accounting
to be based on financial accounting. As time goes on, accounting has changed, revealing
different areas of accounting as a piece of information requiring attention.
In most cases, the phrases "cost accounting" and "management accounting" are interchangeable
and have the same meaning. However, there are conceptual and practical distinctions between
these two concepts.
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Forecasting the price per unit of an item or service is a component of cost accounting, which is
also frequently referred to as the cost method of accounting. The per unit cost derivation is not
limited to a single unit of a thing; it may also be used to estimate the cost of operating a single
production line, the amount of materials needed by a single machine, etc. The various costs
associated with producing each unit are calculated.
Whereas in management accounting, incomes and expenses are tracked, revised, planned, and
analysed. The purpose of management accounting is to support managerial choices with some
kind of rational, financially based mathematics. In order to handle information about
transactions, comparison, analysis, and business logic are required. Simply, management
accounting is the process of obtaining data from cost accountants and using it to influence
decisions.
In terms of practise, cost accounting entails computing cost per unit from several aspects. For
instance, cost accounting in a steel mill will principally involve the computation of cost of one
ton of steel. For this, the wage of a foreman who helped produce that tonne of steel is
calculated. The cost of coke, electricity, labour, real estate, and factory equipment are a few
additional elements that are adding to the prime prices (cost of raw material which in this case
is iron and other metals). Management accounting goes one step forward and generates
significant comparative analyses and statements of data derived from financial accounting and
cost accounting. The examination of every potential transaction and estimating the pattern of
transactions are two additional duties of managerial accounting. Management accounting help
answering questions like "What is the financial productivity of the factory?". "How expensive
has raw material become?". "What can we do to reduce costs?" or "How can we increase
profitability?"
Comparison between Cost Accounting & Management Accounting
Basis Cost accounting Management accounting
Meaning • The classification, recording, • Management accounting
allocation, and reporting of collects, evaluates, and
the numerous expenses disseminates financial and
incurred throughout an nonfinancial data to assist
enterprise's operation are managers in reaching
done through the process of organisational objectives.
cost accounting.
• It aims at planning, • Management accounting makes
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regulating, and minimizing use of financial accounting and

such costs, as well as cost accounting principles.
providing management with
information so that they can
make decisions.
• Cost accounting merely • Management accounting assists
assists the management with and assesses the management
functioning. performance.
Deals with The ascertainment, allocation, The influence and impact of costs
and apportionment accounting on the firm are the subject of
aspects of expenses are dealt management accounting.
with in cost accounting.
Objective The primary goal of cost The main goal of management
accounting is to support accounting is to supply the
management's efforts to control management with the data which is
costs and make decisions. needs for decision-making,
planning, controlling, and
performance evaluation.
Functions The two main functions of cost The main function of management
accounting are cost accounting is to ensure an
determination and cost control. organisation performs efficiently
and effectively.
Foundation/Base The foundation of cost Data from cost accounting and
accounting is cost-related data financial accounting are the
gleaned from financial foundation of management
accounting. accounting.
Status Cost accounting serves as the Management accounting is derived
foundation for management from cost accounting and financial
accounting. accounting,
Outlook Cost accountant has a narrow Management accountant has a
approach. broader approach.
Short or Long term Cost accounting is concerned Management accounting is
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planning with short term planning. concerned with short range and long
range planning.
Information used Cost-related information is the Data from cost accounting and
exclusive focus of cost financial accounting are both used
accounting. It only makes use of in management accounting.
cost accounting principles.
Installation The management accounting Sound Cost and financial
system is not necessary for cost accounting is necessary for
accounting to be successful. management accounting to succeed.
Scope Tax planning, tax accounting, Financial, cost, tax, and tax
and financial accounting are not planning are all included in
included in cost accounting. management accounting.
Role Cost accounting can be installed Management accounting cannot be
with management accounting installed without cost and financial
accounting.
Audit Report Cost accounting reports may There is no legal necessity for
occasionally require a statutory auditing reports.
audit, particularly for large
corporations.
Data used • Cost accounting is based on • Management accounting gives
historical cost data and decision-makers access to both
provides decisions about past and future knowledge.
future costs.
• Data that is both quantitative
• Quantitative cost data that and qualitative are used in
can be monitored is used by management accounting.
cost accounting systems. Additionally, it makes use of
information that cannot be
valued in monetary terms.
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Tools and Tools and techniques in cost The management accountant use
Techniques accounting include Marginal techniques like fund and cash flow
Costing, Break-even analysis, statements, budgeting and
variable costing, uniform budgetary control, standard costing,
costing, direct costing, standard ratio analysis, responsibility
costing, etc. accounting etc.,
Users The management of a company, Reports prepared by management
together with the shareholders accounting are only intended for the
and creditors, might benefit from management.
cost accounting reports.

Cost control and cost reduction are alike since they both focus on ensuring effective resource
management and involve setting of standards after conducting a preliminary cost analysis. But
they both have quite different purposes, and they employ various methods and techniques to
achieve their objectives.
Cost control and cost reduction are two distinct concepts. Cost control is achieving the cost
target as its objective whereas cost reduction is directed to explore the possibilities of
improving the targets. As a result, cost reduction is a never-ending process and has no obvious
end while cost control stops when goals are met.
• Cost control
Cost control focuses on maintaining costs within reasonable caps/limits. This cap will either
be stated in the form of a standard cost, target cost cap, operational plan, or budget. It
regulates how much it costs to run a corporation. Cost control methods are required when
actual costs significantly exceed budgeted expenditures. Cost control is a useful tool for
practising sound bookkeeping and preventing the wasteful use of an organization's precious
and limited resources.
Implementing cost control methods entails putting in place control limits that track costs
continuously and alert management of resources to the need for action. The first step in cost
control procedure includes setting the acceptable or expected level of cost for specific
operations, monitoring the actual cost of those activities as they happen, then comparing
those real costs to the predetermined costs, and, if necessary, remedial action are all included
in this process.
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• Cost Reduction
This is a deliberate positive action with the goal of bringing down the price of goods or services
without degrading their usability or quality. In order to lower the overall cost of operations,
cost reduction efforts are typically concentrated on anticipated costs. Cost reduction starts with
the premise that current cost levels or planned cost levels are too high. While cost control is
about keeping actual costs within allowable bounds, cost reduction maintains that even those
pre-determined amounts might be too high.
The main challenges with cost reduction are: employee resistance to cost-cutting pressure,
usually because they don't fully understand it; application may be restricted to a small area of
the business only to find that it reappears as an additional cost to another cost centre; and cost-
cutting campaigns are frequently introduced as a last-minute, desperate measure rather than a
carefully planned, well-thought-out exercise.
The scope of cost reduction includes all business operations, from production to marketing, and
all organisational levels, from the lowest to the highest.
Cost-cutting/ reduction measures could include the following:
a) Material costs, which may include cash discounts for early payment to suppliers or quantity
discounts.
b) Labour costs, which include replacing labour-intensive positions with jobs related to
automated machinery.
c) Finance costs: By properly managing cash flow, bank overdraft fees may be more
effectively decreased.
d) Rationalization measures: As a business grows in its operations, there may be duplication of
efforts in the many areas of its operations. However, by concentrating resources inside the
company, or through rationalisation initiatives, which attempt to reduce costs while
increasing workplace productivity, this duplication can be eliminated.
The difference between the two can be summed up as follows:
Cost Control Cost Reduction
1. Cost control is static with the core Cost reduction seeks to reduce expenses
objectives of cost containment within pre- or cost from some predetermined target
set target. without reducing the advantages gained
from the product or the services
provided.
2. Cost control tries to maintain costs in line Cost reduction focus on cutting costs.
with accepted norms. It continually aims
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to raise the bar and modifies all norms.

3. Cost control strives to achieve the lowest Cost reduction does not acknowledge
cost achievable under current conditions. any state as permanent because a
change will lead to lower costs.
4. Cost control is a continuous/permanent Cost reduction occurs on a temporary
activity. basis.
5. The focus is on the past and present when The focus is on the present and future
it comes to cost control. when it comes to cost reduction.
6. Cost control is a preventive function. Cost reduction is a correlative function.
• Cost Management
The phrase "cost management" is one that businesspeople regularly use. Unfortunately, there is
no consensus on what the phrase means. Cost management is the term used to describe how
managers use resources to increase value to consumers and accomplish organisational
objectives. Making judgements about entering new markets, implementing new organisational
procedures, and changing product designs are all examples of cost management considerations.
Accounting system data assists managers in cost management, but neither the data nor the
accounting systems are cost management tools in and of themselves.
Cost management has many different objectives and is not only about reduction in costs. In
order to increase sales and profits, cost management decisions may be made to incur additional
costs, such as those made to develop new goods and improve consumer happiness and quality.
Cost management is the application of management accounting principles, techniques for
gathering, analysing, and presenting data to produce the data required for cost planning,
monitoring, and control. Thus, the process of managing and monitoring a company's operating
costs is known as cost management.
Cost management uses a variety of cost accounting techniques with the aim of enhancing
business cost effectiveness through cost reduction or, at the very least, by putting safeguards in
place to prevent cost rise. A cost management system is useful for locating, gathering,
classifying, and compiling data that managers can use for planning, managing, and making
wise decisions to maintain costs within acceptable bounds. The process of establishing and
managing the company's budget is known as cost management. It aids in forecasting the
business's expenses.
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IN-TEXT QUESTIONS
1. Indicate whether each of the following Statements are true or false:
(a) Cost accounts only deal with cost-related elements, while financial
accounts deal with all expenses, losses, revenue, and gains as a whole.
Direct labour refers to the wages of labour that cannot be allocated but
that can be distributed among or absorbed by cost centres or cost units.
(b) Financial accounts typically cover a week-long time frame.
(c) The cost of indirect materials, indirect labour, and other costs, such as
services, that cannot be conveniently paid directly to certain cost units
may be referred to as overheads.
2. The primary goal of cost accounting is ………
a) Profit analysis b) Cost ascertainment
c) Tax compliance d) Financial audit
3. The development of cost accounting was driven by:
a. The management accounting's drawbacks.
b. The financial accounting's limits.
c. The double entry accounting's drawbacks.
d. The accounting for human resources has limits.
4. A section of a plant for which costs are accumulated separately is
referred to as a____________________
5. Cost classification is helpful.
a. to calculate gross profit
b. to calculate net profit
c. To calculate costs.
d. to determine effectiveness.
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Since cost accounting is concerned with costs, it is essential to have a clear understanding of
what costs actually mean. Cost in business and accounting refers to the money that a company
has spent to produce a good or service. Cost is the amount of money spent by a business to
produce or create goods or services. It excludes the profit margin mark-up. Cost, in general,
refers to the amount of money spent on or related to an item, whether it be real or hypothetical.
Cost, however, is a difficult concept to describe precisely. Cost, in the viewpoint of a seller, is
the sum of money used to create a good or a product. A seller would break even, or not lose
money on their sales if they sold their goods for the production price. He would not, however,
generate a profit. Whereas, the price of a product is what it costs from the perspective of the
consumer. This is the price the seller sets for a product, which takes into account both the cost
of manufacture and the mark-up the seller adds to earn a profit.
The nature of the industry or business and the setting in which it is employed mainly determine
how to interpret it. The cost of an object may be determined without taking selling and
distribution overheads into account in a business where those costs are quite little. At the same
time, in a firm where a product's nature necessitates high selling and distribution costs, the cost
calculation without taking the selling and distribution costs into account as expenses may prove
very costly to a business. As a result, the term "cost" can be misleading when used without
context. Therefore, for various objectives, different costs are identified.
Components of Cost
In accounting, the term cost refers to the monetary worth of expenditures for raw materials,
equipment, supplies, services, labour, goods, etc. It is a sum of money that is accounted for in
bookkeeping records as an expense. Materials, labour costs, and expenses make up the three
components of cost.
Costs can be broadly categorised into direct cost and indirect costs:
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Direct Cost
Direct Cost are those that directly relate to a unit of operation, such as organising a process or
activity, manufacturing a product, etc. Direct costs, then, are those expenses that can be clearly
and directly identified. A certain product or process is connected to the nature of the direct
costs. They vary and have variances. As a result, all direct costs are erratic. "Traceable costs" is
another name for it.
Direct costs are those costs for materials and labour that are reasonably and readily traceable
for a good, a service, or a project. In the process of manufacturing of a product, materials are
acquired, labourers are hired and wages are paid to them. Other costs are also paid directly in
some cases. All of them are considered direct costs since they play an active and direct role in
the production of a certain good.
• Direct Material: Direct materials are those whose costs may easily be linked to the
finished product, and which are included into the final product.
So, all materials that are used to create a final product and whose costs are totally and
directly charged to the prime cost of those physical units are referred to as direct
materials. Some of the materials in this category include the following- materials that are
manufactured, acquired, or bought especially for a given task, order, or procedure; basic
packaging supplies (e.g. carton, wrapping, cardboard, etc.) and materials used as inputs in
one operation and outputs in another.
Costs including import duties, dock fees, and material transit costs are added to the
invoice price to determine the cost of the material.
Material that was once believed direct may later turn out to be indirect. When making
wooden boxes, nails are classified as direct materials; nevertheless, when fixing an
industrial structure, nails are treated as indirect materials.
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• Direct labour: All labour that is used and directly involved in transforming the product's
condition, composition, or construction is referred to as direct labour. Costs associated with
an individual product that can be physically and conveniently tracked down are referred to
as direct labour costs. Because direct labourers frequently touch the product while it is being
manufactured, direct labour is occasionally referred to as "touch labour."
Direct wages, also referred to as direct labour costs, are the salaries paid to both skilled and
unskilled people who perform manual labour or operate machinery. These salaries can be
specifically attributed to a certain unit of production. It can easily and specifically be traced
to the relevant products. Assembly-line workers at the Toyota car manufacturing company,
carpenters at a nearby furniture industry, and electricians who install equipment on
automobiles, goldsmith for creating gold ornaments are a few examples of direct labour.
• Direct expenses: Direct expenses are those costs that are expressly incurred and that can be
directly and entirely attributed to a single good, task, or service. Examples of such costs
include inbound transportation, royalties, interest on loans utilised for production, etc. These
are likewise referred to as “chargeable expenses”.
Indirect Cost
Direct costs are those that can be directly linked to a factory, a product, a process, or a
department. Indirect costs cannot. Indirect costs are constant, in contrast to direct expenses. In
other words, their nature may or may not be variable. However, the type of indirect costs
incurred depends on the costing at issue. Because they may or may not change as a result of the
planned changes in the manufacturing process, etc., indirect costs might be either fixed or
variable in nature. Non-traceable expenses are another name for indirect costs.
Indirect costs are those costs incurred for those things that aren't directly related to production.
For instance, the pay for storekeepers, foremen, and timekeepers. The indirect costs are
additional costs incurred for maintaining the administration. Since none of these can be easily
devoted to production, they are all indirect cost.
• Indirect material: All materials that are not easily ascribed to particular physical units are
referred to as “indirect material”. These products are not included in the completed goods.
So, tracing the expenses of relatively unimportant ingredients to finished goods isn't always
worth the effort. These small items are considered as indirect material. Indirect materials
include consumable goods, lubricant, office supplies, and spare components for machinery.
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• Indirect labour: The term "indirect labour" refers to labour that is used to carry out tasks
that are incidental to the manufacturing of commodities or for office, sales, and distribution
activities. Example: The driver of the delivery vehicle that was utilised to distribute the
product was paid a salary.
Indirect labour is defined as labour expenses that cannot be directly linked to specific
products. Wages paid to night security guards, material handlers, and salary paid to
managers are examples of indirect labour. Even if these workers' efforts are crucial, it would
be difficult or impossible to correctly link their costs to particular product units. As a result,
these labour costs are considered indirect labour.
• Indirect expenses: The term "indirect expenses" refers to all costs that cannot be directly
and entirely attributed with a specific good, task, or service, except indirect material and
indirect labour. Repairs to the machinery, insurance, lighting, and building rent are a few
examples of such costs.
Cost Sheet
Based on the classification of each expense, a cost sheet is used to display the breakdown of the
costs associated with producing output. For a single unit or a projected volume of production, a
cost sheet can be created. An example of a cost card for an anticipated level of production, or
overall, is shown in the cost sheet.
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A cost sheet is a statement that is created on a regular basis to show the precise costs associated
with a cost unit or cost centre. A cost sheet displays both the total cost and the numerous costs
that make up the total cost. A cost sheet's time frame can be a year, a month, a week, etc. The
cost sheet performs the following functions: it reveals different cost components, it shows the
per-unit cost as well as the total cost of production, it helps with tender price preparation, and it
helps with cost comparison.
There are two factors to keep in mind at the time of classification during the early step of
creating the product's cost statement.
1. Classification of direct costs
2. Classification of indirect costs
Overheads: It consists of the aggregate of indirect costs, indirect labour, and indirect materials.
Examples include the cost of cleaning supplies, office supplies, consumables, superman costs,
employee bonuses, indirect worker salary, and so forth.
Categories and types of overheads
a) Production Overheads: Also known as factory or manufacturing overheads. These are the
unrelated expenses incurred during the production of a cost unit, such as materials used in the
factory, indirect costs of production, such as indirect factory salaries and other indirect costs.
Indirect materials, indirect labour, maintenance and repairs of production equipment, heat and
light, real estate taxes, depreciation, and insurance on manufacturing facilities are all examples
of manufacturing overhead. The expenditures a company incurs for heat and light, property
taxes, insurance, depreciation, and other expenses related to its selling and administrative
activities are not counted as manufacturing overhead. The only expenses included in
manufacturing overhead are those related to running the factory.
b) Office and Administration Overheads: These are the expenses associated with creating
policies and managing activities that are not immediately related to production, sales,
distribution, or research & development. In contrast to manufacturing, administrative
expenditures encompass all expenses related to general management of a business. Executive
remuneration, general accounting, secretarial, public relations, and other expenses related to the
overall, general management of the business are a few examples of administration overheads.
c) Selling and Distribution Overheads: Also known as marketing expenses. All expenses
incurred to acquire customer orders and deliver the finished product to the customer are
considered selling and distribution overhead. These expenses are also known as order-getting
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and order-filling expenses. Advertising, shipping, payments for salespeople's wages and
commissions, warehouse rent and insurance, sales travel, commissions, salaries, fees for
collecting bad debts, and cash discount allowed etc. are a few examples of selling expenses.
Format of Cost Sheet
Cost Sheet
for the period……………….
Number of units manufactured…….
Particulars Per Unit (in Rs.) Total (in Rs.)
Raw Materials
Opening Stock
Add: Purchase of Raw Material
Less: Closing Stock
Raw Material Consumed (Direct Material)
Direct Labour
Direct Expenses
PRIME COST
Factory Overheads
Add: Opening Work – in progress
Less: Closing Work-in-progress
WORKS COST
Office & Administrative Overheads
COST OF PRODUCTION OF GOODS
MANUFACTURED
Add: Opening Finished Stock
Less: Closing Finished Stock
COST OF PRODUCTION OF GOODS SOLD
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Selling & Distribution Overhead

COST OF SALES
Sales
Profit
Conversion cost and prime cost

Prime cost and conversion cost are two additional cost categories that are frequently mentioned
when talking about production costs. Direct labour and material costs are combined to form the
prime cost. Direct labour expense and manufacturing overhead expense are added to determine
conversion cost. The cost of converting raw materials into finished goods is referred to as
conversion cost. The overall cost of direct material, direct labour, direct expenses, and
production overheads are typically taken into account. Direct labour expenses and factory
overhead are referred to as conversion costs since they must be paid in order to transform raw
materials into finished goods.
1.8 COST ASCERTAINMENT: COST UNIT AND COST CENTER

You must understand the distinction between cost units and cost centres. Cost unit means an
individual unit of a good or service for which costs can be determined independently. Whereas,
cost centre means the locations or functions in respect of which costs are accumulated.
Cost unit
Businesses frequently need to compute a cost per unit of production to aid in planning, control,
and decision-making. It becomes vital to choose a unit with which expenditures can be
associated when creating cost accounts. A unit of cost or cost unit is the amount that can readily
be used to assign costs. A unit of cost, according to the Chartered Institute of Management
Accountants (CIMA), London, is a quantity of a good or service or a period of time that can be
used to calculate or represent costs.
Cost units are tools used to divide costs into more manageable portions. Typically, a cost unit
will be expressed as a count, weight, dimension, etc. The unit of measurement for various
product kinds is the cost unit. For instance, a tonne for coal, a yard for fabric, a litre for
gasoline, etc.
What exactly we understand by a "unit of output" or "cost unit" is a crucial point. For many
firms, this will mean different things, but we always consider what the company produces.
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• For a company that makes paint, the unit might be a litre of paint.
• In a printing business, a specific customer order may be the cost unit.
• A car manufacturer will need to know how much each automobile costs, as well as possibly
how much different components cost.
Service organisations may use several different cost units to measure the different kinds of
service that they are providing. For examples the cost unit for a hotel might include:
• Meals served for the restaurant employees
• Rooms occupied by the housekeeping staff
• Hours worked by the front desk personnel.
The chosen unit should be clear, straightforward, and frequently used. The units of cost
examples are as follows:
Electrical Companies: per unit of electricity generated.
Brickworks: per 1,000 bricks manufactured
Textile Mills: per yard or pound of cloth manufactured.
Transportation: per passenger km
Collieries: per tonne of coal raised
Educational Institutions: Number of Students
Printing press: per copy or no. of copies
Flour: Tonne
Carpets: Square foot
Cost centre
Cost centre is defined as "a location, person, or item of equipment (or collection of these) for
which costs may be identified and used for the purpose of cost control" by the Chartered
Institute of Management Accountants, London. Cost centres are thus one of the practical
divisions that have been made for costing purposes to split the entire manufacturing or
organisation.
Each of these units is made up of a department, a sub-department, a piece of machinery or
equipment, and an individual or group of individuals. Occasionally, for costing purposes,
closely related departments will be merged and treated as one unit. For instance, in a laundry,
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tasks including gathering, sorting, labelling, and washing items are completed. Every activity
can be viewed of as a separate cost centre, and each expense associated with a given cost centre
can be identified independently.
The smallest area of responsibility or segment of activity for which costs are amassed or
determined is known as a cost centre. For the purpose of cost estimation and control, the
organisation naturally divides into cost-effective units called cost centres.
These cost centres can be categorised:
Production, Service, and mixed cost centers
Production Cost centres are ones that are genuinely producing goods. Although service or non-
productive cost centres support the productive centres, they do not produce the goods
themselves. Here are some instances of these service centres: administrative division
Department of maintenance and repairs a section of shops and a drafting office.
Mixed cost centres are ones that occasionally do both service and production tasks. For
instance, a tool shop acts as a productive cost centre when it creates dies and jigs that are
charged to particular works or orders, but it acts as a service cost centre when it fixes factory
equipment.
Personal cost centre
A personal cost centre consists of a person or a group of people, whereas an impersonal cost
centre is one that is made up of a department, a facility, or a piece of equipment. A cost centre
is referred to as an operation cost centre if it includes individuals or machines that perform the
same task. A cost centre is referred to be a process cost centre if it includes a continuous series
of operations.
Operation cost centre
In operation cost centre, objective is to determine the cost of each operation, regardless of
where it is located within the organization. For example, in chemical industries, oil refineries,
and other process industries, cost is examined and tied to a number of processes that are
performed in order.
Cost Drivers
Cost drivers are used in Activity Based Costing. Cost drivers are underlying factors which
causes incurrence of cost related to the activity. Examples of a few activities and their cost
drivers are:
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Activities Involved Cost Drivers
Issue of purchase orders No. of purchase orders
Storing the materials Value of materials stored
Inspection and verification No. of times inspected
Recruitment of employees No. of employee recruited
Attendance and leave records No. of employees
Training of employees No. of employees trained
Labour Turnover Labour turnover
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1.8 SUMMARY
Cost and management accounting is an important course to an accountant and management
team. This is because management would be better able to fulfil organisational goals if they had
a solid understanding of cost and management accounting.
In this lesson, we discussed the topic cost accounting versus management accounting. You may
remember that cost accounting is concerned with the calculation and assessment of resources
used for various business activities, often production and service providing. It has to do with
figuring out cost per unit utilising various costing techniques.
In contrast, management uses all of the data collected and processed by cost accounting in
management accounting. Getting information from cost accountants and using it for decision-
making is what management accounting is all about.
1.9 GLOSSARY
Cost: Cost is the monetary value of the materials utilised or obligations taken on in order to
accomplish a goal, such as purchasing or producing a good, completing an activity, or
providing a service.
Cost centres: For the purpose of cost estimation and control, the organisation naturally divides
into cost-effective units called cost centres.
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Cost control: Involves comparing actual performance to the standard and correcting variances.
Cost management: It involves gathering, analysing, and presenting data to control costs.
Cost Object: Anything for which costs can be determined is a cost object.
Cost reduction: Reducing costs without sacrificing quality is known as cost reduction.
Cost Unit: A cost unit is a unit of a good or service in relation to which cost are ascertained.
Direct cost: Direct Cost are those that directly relate to a unit of operation, such as organising a
process or activity, manufacturing a product, etc.
Indirect cost: An indirect cost is one that cannot be directly linked to or tracked to a single cost
object in a way that is economically viable.
Prime cost: Direct labour and material costs are combined to form the prime cost.
1. (a) True 3. (b)

(b) False 4. Cost centre
(c) False 5. (c)
(d) True
2. b) Cost ascertainment
1.11 SELF-ASSESSMENT QUESTIONS

1. What is cost accounting? Briefly discuss its nature and scope.
2. Do cost accounting and management accounting vary in any way? Explain
3. “Cost accounting has become an essential tool of the management”. Comment.
4. Define cost accounting. And what are the functions of management accounting.
5. Write a note on cost management.
6. What is cost reduction? Give examples.
7. Differentiate between cost control and cost reduction.
8. Explain the concept of Cost. Differentiate between direct cost and indirect cost.
9. Write a short note on:
(a) Cost Unit
(b) Cost Centre
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1.12 PRACTICAL PROBLEMS
1. The following particulars are extracted from the books of a company relating to commodity
“A” for the half year ending 30th June 2022.
Purchase of raw materials Rs.1,32,000
Direct wages 1,10,000
Rent, rates, insurance and works on cost 44,000
Carriage inward 1,584
Stock as on 1/1/2022
Raw materials 22,000
Finished product (1600 tonnes) 17,600
Stock as on 30/06/22
Raw materials 24,464
Finished products (3200 tonnes) 35,200
Work-in-progress on 1/1/22 5,280
Work-in-progress on 30/06/22 17,600
Factory supervision 8,800
Sales – Finished products 3,30,000
Advertising discount allowed and selling cot @ Re.0.75 per tonne sold.25,600 tonnes of
commodity was sold during the period.
You are required to prepare the Cost Sheet and ascertain Prime Cost, Factory Cost, Cost of
Sales, Profit and No. of tonnes of the commodity manufactured.
(Ans.: Profit = Rs.46,800)
2. The Modern Manufacturing Company submits the following information on March 31,
2022.
Sales for the year Rs.2,75,000
Inventories at the beginning of the year
Work-in-progress 4,000
Finished goods 7,000
Purchase of raw materials for the year 1,10,000
Material inventory
Opening 3,000
Closing 4,000
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Direct Labour 65,000

Factory Overheads 60% of Direct Labour
Inventories at the end of the year
Work-in-progress 6,000
Finished goods 8,000
Selling expenses 10% of sales
Administrative expenses 5% of sales
Prepare a Statement of Cost. (Ans.: Profit: Rs.23,750)
1.13 REFERENCES
• Arora, M. N. Cost and Management Accounting-Principles and Practice. Vikas Publishing
House, New Delhi.
• Jain, S.P., and K. L. Narang. Cost Accounting: Principles and Methods. Kalyani Publishers,
Jalandhar.
• Lal, Jawahar & Seema Srivastava. Cost Accounting. McGraw Hill Publishing Co., New
Delhi.
• Maheshwari, S. N., & S. N. Mittal. Cost Accounting. Theory and Problems. Shri Mahabir
Book Depot, New Delhi.
• Singh, Surender. Elements of Cost Accounting. Kitab Mahal, Allahabad/New Delhi.
1.14 SUGGESTED READINGS

• Barfield, J. T., Raiborn, C. A. & Kinney, M. R. Cost accounting: traditions and innovations.
New York, NY: West Publishing Company.
• Eldenburg, L. G. & Wolcott. Cost management: measuring, monitoring and motivating
performance. United States of American, USA: Susan Elbe.
• Jhamb, H. V. Fundamentals of Cost Accounting. Ane Books Pvt. Ltd, New Delhi.
• Lucey, T. Costing (latest edition). United Kingdom, UK: Book Power
• Warren, C. S., Reeve, J. M. & Fees, P. F. Financial and managerial accounting. United
States of America, USA: International Thomson Publishing.
• Nigam Lall and I.C. Jain, Cost Accounting Principles and Practise, PHI Learning Pvt Ltd,
pp
• 683-690; 730-737.
• Okoye, A.E. (2011). Cost Accountancy: Management operational application. Mindex
Publishing Co. Ltd, Benin City.
• Adeniji A.A. (2012). An Insight into Management Accounting; 6th Ed. El-Toda Ventures
Limited, Lagos Nigeria.
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LESSON 2
OVERHEADS
Chandni Jain
Assistant Professor
University of Delhi
chandni.90.jain@gmail.com
STRUCTURE
2.1 Learning objectives

2.2 Introduction
2.3 Classification of overheads
2.3.1 On the basis of elements
2.3.2 On the basis of function
2.3.3 On the basis of behaviors
2.4 Distribution of overheads
2.4.1 Collection of overheads
2.4.2 Departmentalisation of overheads
2.4.3 Absorption of overheads
2.5 Accounting of factory overheads
2.5.1 Collection of factory overheads
2.5.2 Departmentalisation of factory overheads
2.5.3 Absorption of factory overheads
2.6 Types of overhead rates
2.6.1 Actual rates or pre-determined rates
2.6.2.1 Blanket rate or departmental rate
2.7 Accounting of office and administrative overheads
2.7.1 Apportioned between production and selling divisions.
2.7.2 Charging to Costing Profit and Loss Account
2.7.3 Treatment as a separate functional element of cost
2.8 Accounting of selling and distribution overheads
2.8.1 Collection of selling and distribution overheads
2.8.2 Departmentalisation of selling and distribution overheads
2.8.3 Absorption of selling and distribution overheads
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2.9 Treatment of over absorbed or under absorbed overheads.

2.9.1 Supplementary rate
2.9.2 Write off to costing profit and loss account.
2.9.3 Carry forward to next period.
2.10 Concepts related to capacity.
2.11 Treatment of certain items in costing
2.12 Summary
2.13 Glossary
2.14 Answers to In-text Questions
2.16 References/ Suggested Readings

After studying this chapter, students will be able to:
• Understand the concept of overheads.
• Comprehend the method of overhead classification.
• Discuss the concepts of allocation, apportionment and re-apportionment.
• Know the various methods of overhead absorption
• Under the overhead variance and their accounting treatment
• Understand the treatment of certain overhead items in costing.
2.2 INTRODUCTION
As has been already discussed, a cost can a direct cost and indirect cost. The sum of all the
direct costs (direct material, direct labour and direct expenses) is termed as prime costs. And
the sum of all the indirect costs (indirect material, indirect labour an indirect expenses) is
termed as overheads. Thus, overheads cost is total of all indirect expenses. The term overheads
is synonymous with the other terms like supplementary costs, on costs, burden or
nonproductive cost.
The expenditures which cannot be easily and conveniently identified with a cost unit are called
as overheads.
“Overhead costs are the operating costs of a business enterprise which cannot be traced
directly to a particular unit of output.” Blocker and
Weltmer
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These costs are essential element of the total cost as these are to be required be incurred to
manufacture the goods. They may occur outside the factory example salary of foreman or
outside the factory like depreciation of office building or sales commission.
2.3 CLASSIFICATION OF OVERHEADS

The overheads can be classified on the basis of different criteria as discussed below:
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2.3.1 On the basis of elements/nature

Indirect material: These are those material costs which cannot be traced directly to a cost unit
or a cost centre. So, they are to be apportioned or absorbed. They do not become a part of the
finished product.
Indirect labour: Those wages which have to be apportioned or absorbed by the cost units or
cost centres since they cannot be directly traced to a cost unit and hence cannot be allocated.
Indirect expenses: Those expenses which have to be apportioned or absorbed by the cost
centres or cost units are indirect expenses. They cannot be conveniently and directly allocated
to a cost centre. Some examples include depreciation, rent, insurance, tax, power, etc.
2.3.2 On the basis of function
Production overheads: These are the indirect expenses concerned with production function.
These are also called factory overheads, works overheads or manufacturing overheads. They
are also a total of indirect material, indirect labour, and indirect expenses. This can be
elaborated as follows:
• Indirect material: Stationery used in factory, oil and grease used in machines, sweeping
broom brush, etc.
• Indirect labour: Salary of factory staff, salary of factory manager, salary of sweeping staff,
wages of factory watchman, etc.
• Indirect expenses: Insurance of factory building, rent of factory, depreciation of plant and
machinery, factory power and lighting expenses, repair and maintenance of plant, etc.
Office and administrative overheads: The expenses incurred in formulation of policies and
plans, direction and motivation of personnel and accounting, secretarial and financial control of
the operations of the organization fall under this category of overheads. These indirect expenses
are of a general nature and do not have a direct connection with either production or sales
function. That is why they are also called general overheads. These are also a sum of indirect
material, indirect labour and indirect expenses incurred in general administrative office.
• Indirect material: Stationery used in general office, postage and stamps, sweeping brush,
etc.
• Indirect labour: Salary of directors, salary of office staff, salary of managing directors, etc.
• Indirect expenses: Rent and rates of office, insurance of office building, office lighting and
power, depreciation of office furniture, legal expenses, telephone expenses, accounts and
audit expenses etc.
Selling and distribution overheads: Selling overheads are the costs of seeking to creation or
stimulation of demand or the cost of securing orders in other words, costs of creating customers
34 | P a g e

and retaining them. Examples are: Advertising costs, salary of sales personnel, samples and
free gifts, bad debts, travelling expenses, showroom expenses, and catalogues.
Distribution overheads are the costs of making the product available to the customer. That
means the cost incurred after the product completion till the time it is delivered to the customer.
Examples: Carriage outwards, warehousing and cold storage expenses, insurance of goods in
transit, upkeep and maintenance of delivery vans, etc.
Both selling and distribution overheads are related to sales function of the organization and so
they are combined into one category and referred to as ‘Selling and Distribution Overheads’.
They are also called ‘after production costs’ because of the fact that they are incurred after the
production work is completed. Selling and distribution costs are a sum of indirect materials,
indirect labour and indirect expenses incurred in making sakes and distributing the products. It
is elaborated as follows:
• Indirect materials: Secondary packing material, oil and grease for delivery vans, sample
costs, stationery used in showroom, etc.
• Indirect labour: Sales office salary, salary of sales manager, salary of delivery van drivers,
warehouse staff salaries, etc.
• Indirect expenses: Advertisement expenses, warehouse rent, transit insurance, carriage
outwards, bad debts and others.
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2.3.3 On the basis of behaviour

Fixed overheads: Fixed overheads do not change with the change in the level of activity. They
remain unaffected by the output quantity in total amount within certain output levels ad for a
given period. They do not remain fixed per unit. Or they vary when calculated in per unit terms.
Examples are rent and rates, insurance, legal expenses, stationery and postage expenses, etc.
Variable overheads: Variable overheads change with the change in the level of activity. They
vary in direct proportion with the change in volume of output. If the output increases, they
increase in total (or aggregate) and vice versa. They remained fixed per unit. Example: indirect
material, indirect labour, fuel, light, etc.
Semi variable overheads: They are partly constant and partly vary with the change in
production volume. Example: Salary of supervisor, repairs and maintenance, etc.
NOTE- it is important to note here that it is the same overhead and we are just classifying it in
different ways on the basis of different criteria. For example, take factory insurance. Based on
nature/elements, it is an indirect expense. On the basis of behaviour, it is a fixed overhead and
on the basis of function, it is a factory overhead.
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The classification of overheads according to function is the most commonly used. Hence, in the
present text we will be discussing overheads based on their classification according to function.
IN-TEXT QUESTIONS
1. Fixed overhead costs remain fixed per unit with changes in output level. True or
false?
2. Overhead cost is an aggregate of?
3. Overheads are also known as indirect expenses. True/false?
4. Warehousing costs are a part of?
a) Selling overhead c) Distribution overhead
b) Production overhead d) Office overhead
2.4 DISTRIBUTION OF OVERHEADS

As we have already discussed overheads are those indirect costs which cannot be directly
traced and identified with a product or a cost unit. But since overheads form an important part
of the total cost of the products or the services, we need to find a way to distribute this cost
over the various units of production.
This is one of the most complex problems of cost accounting. Such costs have to be distributed
on some arbitrary basis. This is because there is no way of exact distribution as is possible in
the case of direct costs. For example, it is not possible to determine the exact amount of factory
rent attributable to a unit of product and thus it will have to be charged on some arbitrary basis.
We will have to will search some suitable basis to apportion the factory rent to various
production departments first. For example, the factory rent may be apportioned to various
departments on the basis of area occupied by each department. The cost assigned to each
department is, then, absorbed by the cost units produced in these departments by means of
calculation of an overhead absorption rate.
For the distribution of overheads, the actual overheads can be used. But to do so, we will need
to wait till the end of the accounting period to know the exact figures of overheads incurred.
Following this procedure will lead to delay in provision of costing information to management
for important decision making. The cost sheet will lose it vitality and essence as the decisions
regarding fixation of selling price and filling of quotations and tenders need to be taken
immediately and a firm cannot wait for the accounting period to end. Hence, there is a need to
find out a way through which these overheads can be charged to the products’ cost as soon as
the cost of direct material, direct labour and other direct expenses are known.
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BMS/BBA(FIA)
One way is that the amount of overheads and the activity levels are estimated in advance for the
period and a pre-determined overhead rate is calculated. Using these pre-determined overheads
rates, the overheads are absorbed in the units of production. Then, when the period ends and the
actual amount of overheads incurred are known, they are compared with the amount of
overheads absorbed and the difference is found out. The difference can be either under
absorption or over absorption of overheads and is then adjusted using methods discussed later
in this chapter.
The procedure for the distribution of overheads is explained in the ensuing text.
We have already discussed the classification of overheads into production, office and
administration and selling and distribution heads and the various expenses that fall under each
of these heads like depreciation of office building, depreciation of factory, rent of factory,
salesman salary, etc.
The expenses under each category of overheads are grouped together and given suitable
account headings. For example, depreciation of factory building, factory furniture and factory
machine may be suitably grouped under the heading depreciation with suitable sub headings.
Grouping of like items under a common heading in this manner makes it easy to collect the
overhead items. Each expense heading like depreciation in this example is allotted a code.
Different codes are assigned to different groups consisting of expense items of similar nature.
These codes are known as standing order numbers.
This process of allotment of codes to different head of expenses is known as codification.
These codes maybe numerical or alphabetical or alphabetical cum numerical. Taking an
example of numerical codes for better understanding. Codes in form of number are allotted to
each heading of expense and sub heading of expense. Taking example of factory overheads,
within factory overheads we can have depreciation, repairs, insurance, etc. they are codified as
follows:
Item Code
Repairs A
Machine A1
Furniture A2
Building A3
Depreciation B
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Plant B1
Furniture B2
Building B3
Once codification is done, the process of collection of overheads can be done in an easy
manner.
Codes has other benefits as well:
• Codes replace the lengthy descriptions of different expense heads
• Ensures secrecy.
• Particularly useful in computerized accounting systems
Once the overheads are collected under suitable codes, the next step is the departmentalization
of overheads to different departments or cost centres on a suitable basis. Departmentalisation
can be done in either of the two ways:
1. Allocation
2. Apportionment
Allocation: When the nature of overhead is such that they can be easily and conveniently
identified with a particular cost centre or department, they are directly charged to that cost
centre or department. This process is known as allocation. For example, if a separate power
meter is installed for a particular department, it will be charged directly to that department.
Taking another example, salary of a foreman working in a particular production department
will be charged to that department only.
Apportionment: When an overhead cost benefits more than one department and such cost
cannot be easily and conveniently traced directly to one particular department, it has to be
distributed among them on the basis of some criteria/bases. This process is known as
apportionment. For example, salary of a works manager who works for the whole factory
cannot be identified with a particular production department. Such expense then will have to be
apportioned among all departments of the factory using some suitable bases.
2.4.3 Absorption of overheads
Now once the overheads have been distributed among different departments, the overheads of
each of these departments are charged to the cost units. This process is known as absorption.
Absorption may also be referred to as recovery of overheads or application of overheads.
Absorption is done by means of an overhead absorption rate.
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BMS/BBA(FIA)
The rate at which overheads are charged to different cost units is known as overhead rate. This
overhead rate can be calculated either in form of percentage or a rate per unit.
Once the overhead rate is calculated, the next step is to apply the rate to the cost units in order
to arrive at the overhead cost of each cost unit. So, the step of absorption of overheads involves
mainly two steps:
• Computation of overhead absorption rate
• Application of this rate to cost units to determine the overhead cost absorbed by them.
Computation of overheads rate involve dividing the total overhead cost of a cost
centre/department with the number of units in the base like labour hours, machine hours, etc.
Absorption rate =
Application of this rate to cost units involve multiplying the absorption rate calculated above
with the number of units of base in the cost unit.
Overheads absorbed = No. of units of base in cost unit * Overhead absorption rate
Example
Total overheads of a department of a factory are ₹2, 50,000 and machine hours in this
department are 10,000 hours. One cost unit requires 15 hours of machine.
So, here the machine hours are taken as the base. The number of units in base = 10,000 hours.
Overhead rate will be calculated by taking total overhead of this department and dividing them
by machine hours.
Overhead absorption rate =
Overhead absorption rate = 2, 50,000 / 10,000 = ₹25 per machine hour

This overhead rate of ₹25 per machine hour will be applied to the cost unit to determine the
amount of overheads absorbed by it.
Overheads absorbed = No. of units of base in cost unit * Overhead absorption rate
Since machine hours is the base and one cost unit requires 15 hours of the base (machine
hours), we take,
Number of units of base in cost unit = 15 hours (given)
Overhead absorption rate = ₹25 per machine hour (calculated above)
Overheads absorbed = 15 machine hours * ₹25 per machine hour
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The distribution of all overheads– production, office and administration and selling and
distribution is mainly done in accordance with the procedure discussed above. But still a
detailed explanation for stages of distribution of each category pf overheads – production,
office and administration and selling and distribution is explained below.
IN-TEXT QUESTIONS
5. _____ is the allotment of whole items of cost to cost centres.

6. Absorption of overheads is also known as?
2.5 ACCOUNTING OF FACTORY OVERHEADS
2.5.1 Collection of factory overheads

All the factory overheads are classified into various sub headings like rent, depreciation,
insurance, lighting, etc. after such classification into suitable headings, each heading is given a
code which is known as standing order number. After the codes are allotted to different heads
of expenses under factory overheads, the factory overheads are collected under suitable
standing order numbers. The min sources for the collection of factory overheads are as follows:
• Stores requisition – for collection of indirect materials
• Invoice – for collection of indirect expenses
• Wages analysis sheet – for collection of indirect wages
• Journal entries – for those overheads which didn’t involve cash expense right now and need
adjustments like depreciation, outstanding rent, etc.
2.5.2 Departmentalisation of factory overheads
Once the factory overheads are collected under various standing order numbers,
departmentalisation is done. The term departmentalisation means that the factory/production
overheads are allocated or apportioned to various production and service departments. This is
known as primary distribution of overheads. The factory is divided into a number of
departments based on the activity performed by each of them like purchase department, stores
department, crushing department, and melting shop, etc. these departments are of two types:
• Production departments
• Service departments
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Production department is the one directly involved in the manufacture of a product. This
means it is involved in changing the shape, nature or form of the raw material.
Examples of production include:
• Weaving department
• Spinning department
• Mixing department
• Crushing department
Service departments are the ones not directly involved in changing the nature, shape and form
of the raw materials by provide a service to the production departments and indirectly
contributing/helping the manufacture of the product.
Examples of service department include:
• Purchasing department
• Store keeping
• Personnel department
• Inspection department
• Time keeping department.
Departmentalisation will involve following steps:
1. Primary distribution of overheads (Allocation and Apportionment)
Firstly, we either allocate or apportion the factory overheads to various production and
service departments.
a) Allocation: Allocation is defined as “The assignment of whole items of cost to a centre.”
When certain items of expenses under factory overheads can be identified directly with a cost
centre or a department, such costs are allotted to those departments directly. This process is
known as allocation.
When a particular factory overhead cost is the result of existence of a particular cost centre
only, those overheads are charged to that cost centre/department directly.
Allocation is possible only when the exact amount of overheads incurred in a cost centre is
known. For example, amount of indirect wages, indirect material, supervision costs, etc.
incurred for a particular cost centre can be exactly known and hence can be allocated. But rent,
for example, is paid, generally, for the entire factory and not for a particular department. So, the
exact amount of rent attributable to a given department cannot be ascertained accurately. So, it
cannot be allocated. Rather it will be apportioned.
b) Apportionment: When certain overheads are incurred for the benefit of a number of
department and cannot be directly and easily identified with one particular department, such
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cost have to be assigned to the department on some suitable criteria. This process is known as
apportionment of overheads. The example of rent discussed above can be used here fir better
understanding.
2. Secondary distribution or Re-apportionment of service department costs
Once the factory overheads are allocated and apportioned over the various production and
service departments, the next step is to re-apportion the overheads costs allocated/a
[apportioned to service departments over the various production departments. This procedure is
important and has to be performed because the ultimate objective is that the overheads costs be
absorbed by various cost units. But no units are produced in the service departments as they are
not directly involved in production process. Since the production departments are directly
involved in producing cost units, and they are directly in contact with cost units, the overhead
costs assigned to service departments have to be re-apportioned to the production departments.
The re apportionment of service department costs is done on the basis of benefits received by
the production departments.
The method involved in the re-apportionment of service department costs to production
department is almost same as that involved in the apportionment of overheads discussed earlier.
Some of the basis of apportionment of service department overheads to production departments
are discussed in table below:
Name of Service department Basis of apportionment
Purchasing department Machine operating hours
Inspection department Number of employees in each department
Store keeping department Number of material requisitions placed by each
department
Time keeping department Total labour hours or total machine hours or
number of employees in each department
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BMS/BBA(FIA)
a) Apportionment to only production departments

Under this method, the service department overheads are re apportioned only to the productions
departments and not the other service departments. An overheads distribution summary is
prepared showing the allocation, apportionment and re-apportionment of factory overheads
costs.
This method is explained with an example below:
Example:
The following data regarding KM Company is given below. Prepare a departmental distribution
summary.
Production departments Service departments
P Q R A B
Direct 6,000 5,000 4,000 3,000 2,000
materials
(₹)
Direct 5,000 4,000 3,000 2,000 1,000
wages (₹)
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No. Light 20 25 25 10 10
points
Area 800 600 800 400 400
occupied
(in square
yards)
Number 500 300 300 200 200
of
employees
Electricity 4,000 2,000 4,000 3,000 2,000
(in kWh)
Value of 40,000 20,000 10,000 20,000 30,000
assets (₹)
The overheads for the period under consideration are as follows:

Depreciation ₹ 12,000
General overheads ₹ 15,000
Electric lighting ₹ 360
Labour welfare ₹ 4,500
Stores overheads ₹ 800
Rent and taxes ₹ 300
Repairs and maintenance ₹ 600
Motive power ₹ 3,000
Apportion the expenses of service departments A and B to production departments as follows:
Expenses of department A in the ratio of 3:2:5.
Expenses of department B in ratio of direct wages.
Solution:
Expense Basis of Total Production departments Service departments
item apportionment (₹)
P Q R A B
Direct Actual 5,000 - - - 3,000 2,000
materials
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BMS/BBA(FIA)
Direct Actual 3,000 - - - 2,000 1,000

wages
Depreciation Value of assets 12,000 4,000 2,000 1,000 2,000 3,000
General Direct wages 15,000 5,000 4,000 3,000 2,000 1,000
overheads
Electric No. of points 360 80 100 100 40 40
lighting
Labour No. of 4,500 1,500 900 900 600 600
welfare employees
Stores Direct 800 240 200 160 120 80
overheads materials
Rent and Area occupied 300 80 60 80 40 40
taxes
Repairs and Value of assets 600 160 120 160 80 80
maintenance
Motive KWh 3,000 800 400 800 600 400
power
Total 44,560 11,860 7,780 6,200 10,480 8,240
Department 3:2:5 (given) 3144 2096 5240 (10,480) -
A
Department Direct wages 3433 2747 2060 - (8240)
B (5:4:3)
Total 44,560 18437 12623 13,500 - -
Note: Direct material and direct wages of service department A and B are indirect costs.
b) Apportionment to production and service departments
Sometimes, a service department provides services to not only the production departments but
also to other service departments. An example of this can be a service department supplying
power. It supplies electricity to not just the production departments but also to other service
departments like canteen, material handling department, maintenance departments, etc.
In such a case, the overheads of service departments are apportioned not just to production
departments but also to the other service departments. This can further involve two cases:
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• Non-Reciprocal basis
• Reciprocal basis
Apportionment on Non-Reciprocal basis
This method is used when service departments are not dependent on each other. This means
that a service department provides services to other service departments but it does not receive
any services from other service departments, this method is used. This method is also known
as Step Ladder method.
Procedure for apportionment
The most serviceable service department is found out. By most serviceable, we mean that
service department which provides services to the largest number of departments. The
departments are arranged in descending order of their serviceability. Then the cost of the most
serviceable department is apportioned to the other service departments and production
departments. After this, the next largest serviceable department is taken. The cost of this
department (including prorated cost of most serviceable department) is apportioned to other
service departments (excluding the first service department) and production departments. In the
same way, the cost of the next most serviceable department (including prorated cost of first and
second service departments) is apportioned to the pother service departments (excluding first
two service departments whose costs have been a[rationed already). Continuing in this manner,
the costs of all service departments are apportioned till we reach the last service department.
Please keep in mind that the cost of the last service department will be apportioned to only
production departments.
Let us understand this with an example.
Paliwal Manufacturing Limited consists of three production departments and four service
departments. Service department provides services to production departments and other service
departments. The service department providing services to other service departments does not
receive any services in return.
Factory overhead estimates of all the departments are given below. Data required for
distribution is also shown below.
Department Factory Area (square Number of Direct labour

overhead meters) employees hours
(₹)
Service:
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BMS/BBA(FIA)
A 54,000 2,500 30 3,500

B 60,000 3,000 35 2,500
C 1,27,000 1,500 40 2,000
D 64,000 1,500 50 5,000
Production:
L 1,82,000 1,000 100 2,000
M 77,000 1,000 125 4,000
N 96,000 1,000 75 5,000
The overheads costs of service departments are distributed in the order A, B, C and D on the
following basis:
Department Basis for distribution
A Area (in square meters)
B Number of employees
C Direct labour hours
D Number of employees
Prepare an overhead distribution summary using the information provided below.

Solution:
Since the service departments are providing services to other service departments and the
department providing service is not receiving the service in return from other service
departments, apportionment is to be done to both production and service departments on non
reciprocal basis using step ladder method.
We have to arrange the departments in the descending order of serviceability.
Department A is the most serviceable department as it provides services to the largest number
of departments (production and service). So, the cost of service department A of 45,000 is
apportioned to all the production and other service departments.
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The next most serviceable department is department B. Its cost of 75,000 + 5000 (apportioned
from service department A) will be distributed to the production departments and other service
departments (excluding department A).
Next the cost of service department C (including the apportioned costs of A and B) is
apportioned to all other departments except the service departments A and B.
One thing to note is that in the columns of service departments, steps are formed. That is why
this method is named as ‘step ladder method’.
Items Basis of Service departments Production departments

apportion
ment
A (₹) B (₹) C (₹) D (₹) L (₹) M (₹) N (₹)
Overhead 54,000 60,000 1,27,000 64,000 1,82,000 77,000 96,000
costs
Department Area (in (54000) 18,000 9,000 9,000 6,000 6,000 6,000
A costs meters
square)
Department Number of - (78000) 8,000 10,000 20,000 25,000 15,000
B costs employees
Department Number of - - (1,44,00 45,000 18,000 36,000 45,000
C costs direct 0)
labour
hours
Department Number of - - - (128000) 64,000 16,000 48,000
D costs employees
Total - - - - 2,90,000 1,60,000 2,10,000
Apportionment on reciprocal basis

This method is used when service departments are inter dependent. This method is used when a
service department provides services to other service departments and also receive services
from them in return.
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For example, power department supplies electricity to canteen department and canteen
department in turn provides its services to the power department.
For apportionment of overheads of service department in such a case, the following three
methods can be used.
a. Simultaneous equations method
b. Repeated distribution method
c. Trial and error method
a) Simultaneous equations method
Under this method, the use of algebraic equations is made to first find out the total costs of
service departments and then they are apportioned to production departments. This method is
used when there are two service departments. Let’s say the two service departments are P and
Q. the following equations can be made to find out the total costs of service departments:
P = a+ bQ
Q = a + Bp
a = overheads of service department before re-apportionment
b= share of overheads of one service department to be apportioned to the other service
department
This can further be explained with the help of an example.
Consider a company which has three production departments namely D, E, F and 2 service
department P and Q.
Department Overheads (₹)
D 7,200
E 6,500
F 3,000
P 2,250
Q 4,000
The costs of service departments are apportioned on the basis of the following percentages.
Service D E F P Q
department
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(↓)
P 40 % 40 % 10 % - 10%
Q 20 % 30 % 30% 20% -
Find total overheads of service departments and apportion them to production departments by
preparing a Secondary Distribution Summary.
Solution:
Let us assume that P represents the total overheads of service department P
and
Q denotes the total overheads of service department Q.
P = a+ bQ
Q= a + bP
Therefore, P= 2250 + 20% of Q
and Q = 4000 + 10% of P
We need to solve these equations. On solving them, the value of P =3,112 and Q = 4,311.
So the total cost of service department (its own cost and cost of other service department
apportioned to it) is
Department P = 3,112
Department Q = 4,311
These costs are now to be apportioned to the production department in the specified percentage
provided in the question.
Please note that the 10% costs of service department P are already apportioned to service
department Q. So, only 90% of costs (i.e. 90% of 3,112) of department P are to be apportioned
to various production departments.
Similarly, 20% of the total cost of service department Q are already apportioned to service
department P. So, only 80% of the costs (i.e. 80% of 4,311) of department Q are apportioned to
various production departments.
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Secondary Distribution Summary

Production Departments
D E F
₹ ₹ ₹
Total as per primary 7,200 6,500 3,000
distribution (given in
question)
Department P (₹3,112) 1245 1,245 311
Department Q (₹4,311) 862 1,293 1,293
Total 9,307 9,038 4,604
b) Repeated distribution method

Under this method, the following steps have to be followed to re-apportion the service
departments’ costs to the production departments.
1. The cost of first service department is to all the department according to the percentages
given in the question. This closes the account of first service department.
2. Then the cost of next service department (including the apportioned cost of first service
department) is apportioned to all the department according to the percentages given in the
question. This will close the account of second service department but will open the account
of the first service department again.
3. This procedure has to be done for all the remaining service departments. This will complete
the first cycle of apportionment.
4. Now, the above stated procedure is again repeated starting from the first service department.
The total of cost of service department will consist of costs apportioned from other service
departments. By continuing in this manner, the costs of the service departments keep on
decreasing with each cycle of apportionment.
5. The above stated process continues until the amounts of costs of service departments
become very small.
This method can be used when there are more than two service departments.
Let us take the above example used in simultaneous equation method to understand this method
better.
Solving the example stated earlier using repeated distribution method.
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Since the primary distribution is already provided in the question, we will prepare a secondary
distribution summary.
Secondary Distribution Summary
Items Production departments Service departments
D (₹) E (₹) F (₹) P (₹) Q (₹)
Total 7200 6500 3000 2250 4000
overheads as
per primary
distribution(
given in
question)
Department 900 900 225 (2250) 225
P
Department 845 1267 1268 845 (4225)
Q
Department 338 338 85 (845) 85
P
Department 17 26 25 17 (85)
Q
Department 7 7 2 (17) 1
P
Total 9,307 9,038 4,605 - -
c) Trial and error method

This method is the same as repeated distribution method. Only difference is that under this
method, the cost of first service department is apportioned to other service departments only.
This closes the account of first service department. Then the costs of second service department
including the apportioned cost of first service department are apportion to all the department
including department first service department. This reopens the account of first service
department. Similar exercise is done for all the services departments left.
When one cycle of apportionment is complete, the process is started again starting from the
first service department whose cost now consists of costs apportioned form other departments.
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BMS/BBA(FIA)
This process continues until the costs of service departments become insignificant to be
apportioned.
Using the procedure stated above, the total cost of all service departments will be ascertained.
The total cost of the service department can then be distributed to the production departments
by preparing secondary distribution summary as prepared in simultaneous equation method.
Understanding this method using the figures of example stated above.
Calculation of costs of service department
Service department
P (₹) Q (₹)
Total overheads as per primary distribution 2,250 4,000
(Given in question)
Service department P - 225
Service department Q 845 -
Service department Q 17 -
Total 3112 4311
Now that the total cost of the service departments is known, they can be distributed over the
production departments using secondary distribution summary. It is stated below.
Secondary distribution summary
Production Departments
D E F
₹ ₹ ₹
Total as per primary 7,200 6,500 3,000
distribution (given in
question)
Department P (₹3,112) 1245 1,245 311
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Department Q (₹4,311) 862 1,293 1,293

Total 9,307 9,038 4,604
2.5.3 Absorption of factory overheads

Once the overheads are departmentalised, the total cost of each production department will
consist of the following costs:
• Overheads allocated and apportioned to production departments.
• Overheads of service department re-apportioned to production departments
The process of charging the overheads of individual production departments to the cost units of
the products manufactured in those department or the orders executed in those departments is
known as absorption.
The methods used for calculation of absorption rates may be classified into two categories as
follows:
1. Percentage methods
2. Hourly rate methods
Which particular absorption rate will be used depends on the type of industry and type of firm.
The choice should be proper to ensure proper absorption of overheads.
Percentage methods
1. Percentage of direct material cost
The amount of factory overheads to be absorbed by a cost unit is determined by the percentage
of direct materials consumed in producing it. The rate calculations done by dividing the total
factory overheads by the amount of direct materials consumed in the cost centre or the
department. The formula for the same is as follows:
Overhead rate =
2. Percentage of direct labour cost

The overhead rate under this method is calculated by dividing the production overheads by the
direct labour cost incurred in that production department.
Overhead rate =
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3. Percentage of prime cost

This method is a combination of material cost and labour cost method. This method is based on
the assumption that both labour and material cost give rise to production overheads. Hence both
of them combined together are taken for the calculation of overhead rate.
Overhead rate =
Hourly rate methods

1. Direct labour hour rate
This method involves calculation of rate per unit of labour and not as a percentage of labour
cost. It is calculated by dividing the factory overheads by the number of direct labour hours.
The formula for this is as follows:
Overhead rate =
2. Machine hour rate

This method involves calculation of absorption rate by diving the number of factory overheads
apportioned to the machine by the number of hours used for the period under consideration.
This gives us the overhead cost of operating the machine for one hour. The formula can be seen
as follows:
Overhead Rate =
3. Rate per unit of output

This rate is obtained by dividing the factory overheads by the number of units of the product
manufactured. This is considered the simplest of all the methods discussed.
The formula for its calculation is as follows:
Overhead Rate =
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IN-TEXT QUESTIONS
7. Primary distribution of overheads includes__________________
8. Most scientific method for absorption of factory overheads
9. Factory rent should be apportioned on basis of ______________________
10. Works overheads is the same as factory overheads. True/false?
2.6 ACCOUNTING OF FACTORY OVERHEADS
1.6.1 Actual rate or pre-determined rate

Overheads absorption rate may be calculated on the basis of actual overheads incurred or the
estimated overheads for a period.
Actual rate
It is determined at the end of the period for which it is to be used i.e. it can be computed only
after the overheads are actually incurred. This is because actual overheads are used in
calculation of actual rate and they can be ascertained only after all the work is done and costs
are already incurred for the period. It is also known as Normal Rate.
Actual overhead rate =
The actual overhead has certain drawbacks as follows:

• It leads to delay in cost computation as we have to wait till the accounting period is over to
calculate this rate.
• Cannot be used for cost control purposes.
• Delay in fixation of selling prices for tenders and quotations.
• Difficulty in making comparison of performance of one period with another as actual
overheads incurred fluctuate from year to year due to variations in output and other things.
Predetermined rate
As the name suggests, it is determined before the beginning of the period for which it is being
computed i.e. even before the overheads are actually incurred.
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Pre-determined rate =
Predetermined rate is more useful practically as compared to actual rate. This is because of the
following reasons:
• It enables quick and easy preparation of tenders and quotations.
• Enables fixation of selling prices.
• Allows cost control by facilitating the comparison of actual overheads incurred in a period
with the pre-determined overheads absorbed.
2.6.2 Blanket rate or departmental rate
Blanket rates
When a single overhead rate is calculated for the entire factory, it is termed as blanket rate. It is
also known as plant wise rate or plant wide rate.
Blanket rate =
This rate should be used when the output is uniform. Otherwise, use of this rate will result in
under costing of certain items and over costing of others. Use of this rate also makes it difficult
to exercise control and assess the performance of different departments or cost centres.
Multiple rates
When separate overhead rates are calculated for different departments or cost centres, it is
termed as multiple rates. It is also known as Departmental Rate.
Overhead rate =
It is more practicable and useful to prefer multiple rates over blanket rates. This is because of
the following reasons:
• Multiple rate can be used in big firms whereas blanket rate can be used in small ones.
• It can be used even when a firm produces more than one product which are not uniform
whereas blanket rate can be used only when either a firm produces a single product or
multiple products produced pass through all the departments making incidence of overheads
uniform.
• Performance of individual departments can be assessed easily and exercise of control
becomes easy when multiple rates are used. It becomes difficult to do so in case of blanket
rate.
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2.7 ACCOUNTING OF OFFICE AND ADMINISTRATION

OVERHEADS
There are different views regarding the accounting treatment of office and administration
overheads in cost accounts. The office and administrative overheads are collected in the same
manner as the factory overheads. The different views are discussed below.
2.7.1 Office and administration overheads are distributed/apportioned between
production and selling divisions
The accountants advocating this method believe that an organisation has mainly two functions
to perform. And they are manufacturing and selling. So according to their view, the
administration overheads should be apportioned between manufacturing and selling divisions.
As a result of this the office and administration overheads lose their identity and merge with
production and selling overheads. But it is difficult to find a suitable basis to apportion the
office and admin overheads between manufacturing and selling. So, the method discussed next
is considered better than this.
2.7.2 Office and administration costs are excluded from the cost of production by
charging them to Costing Profit and Loss Account
The advocates of this method believe that the administration overheads are not ideally related
to production function of an organisation and hence they should not be included in the
calculation of cost of production. As a result, these office and administrative overheads are
transferred to the costing profit and loss account. Some accountant oppose this view by saying
that administration function involves formulation of policies and such policies are formulated
for every division of business, be it selling or production. And importance of planning and
policy formulation cannot be undermined especially in today era.
2.7.3 Office and Administration overheads are treated as a separate functional element of
cost
Under this method, office and Administration overheads are treated as a separate functional
element of cost i.e. a separate addition to the function of production and sales. So, the
administrative overheads are treated as a separate charge to the cost of the products just like the
other function of manufacturing and selling and distribution. The treatment of office overheads
under this method is as follows:
Collection
Collection of office overheads is done in the same manner as that of discussed earlier. All the
items of expenses falling under the category of administration overheads like audit fees, office
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rent, legal charges, etc. are allotted standing order numbers (codified) and collected under those
standing order numbers. This process has been explained in detail earlier.
Departmentalisation
Once the office overheads are collected under appropriate heads, they are distributed over
different cost centres or departments. Those which can be directly identified with department
are allocated to them and the remaining overheads are apportioned to various cost
centres/departments. Such departments mat be law department, secretarial department, accounts
department, personnel department, general office etc.
The apportionment is done on some equitable basis just as in the case of factory/production
overheads.
Absorption
Office overheads constitute a small portion of the total cost. So, a single blanket rate is
calculated to absorb these overheads. It is generally calculated on a percentage basis. Various
methods to calculate absorption rate are as follows:
1. Percentage of factory cost
The formula for calculation of rate using this method is as follows:
Administration overhead rate =
2. Percentage of conversion cost

3. Percentage of sales
IN-TEXT QUESTIONS
11. Administration overheads relate to policy formulation. True or false?
12. Office overheads can be absorbed as a percentage of sales. True/false?
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2.8 ACCOUNTING OF SELLING AND DISTRIBUTION

OVERHEADS
The selling and distribution overheads are the costs incurred in making sales and making the
products available to the customers. Their accounting treatment is discussed as under.
The procedure for the collection of selling and distribution overheads is the same as discussed
for factory overheads and administration overheads. Different kinds of selling and distribution
overheads like advertising, freight, packing, salaries, commission, etc. are classified and given
the separate standing order numbers. The overheads are then collected under the suitable
headings or standing order number given to them.
The selling and distribution overheads so collected shall now be distributed to the different
products, sales territories or cost centres on an equitable basis.
Allocation: Those selling and distribution cost as can be directly identified with a cost centre
shall be charged to that department.
Apportionment: But those costs which cannot be traced directly to one particular department
needs to be apportioned between various departments on some suitable basis.
The given table shows which expenses are allocated and which are apportioned along with
basis of apportionment. The table lists only a few examples and is not exhaustive.
Names of expenses Basis of apportionment
Compensation of salesmen Direct allocation
Advertisement and sales promotion Sales value
Credit and collection No. of orders or sales value
Catalogues Direct allocation or space used
Insurance Value of stocks
2.8.3 Overhead absorption

After the above two steps, these overheads are charged to various products or cost units. In
order to achieve this, overheads absorption rate is calculated. There are various method to
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calculate overhead absorption rate for selling and distribution overheads. Some of them are
presented below:
1. Rate per unit of sales
This rate is calculated by adding up all the costs of selling and distributing the product incurred
by the cost centre and dividing them with the number of units of product sold in that cost
centre.
This method is generally used when a firm manufactures one product of uniform type.
For example, if a firm manufactures only one type of radio. During the month of January, the
selling and distribution overheads amounted to ₹1, 00,000 and number of radios sold were
1,000 units.
The overhead absorption rate will be.
Overhead rate = ₹1, 00,000/1000 units
Overhead rate = ₹100 per unit.
2. Percentage of sales value
The formula for calculation of this overhead absorption rate is stated as below.
This method is generally used when a firm manufactures more than one type of product.
3. Percentage of works cost.
Works cost is the same as factory cost. In this method the percentage of selling and distribution
overheads to the factory cost is worked out. The formula for calculation of this rat is as follows:
Example,
Selling and distribution overheads = ₹10,000
Factory cost = ₹80,000
Overhead rate = (10,000 / 80,000) * 100
Overhead rate = 12.5%
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IN-TEXT QUESTIONS
13. Secondary packaging material cost is part of??
14. When one product is produced, which method is used for absorption of selling
overheads?
2.9 TREATMENT OF UNDER ABSORPTION AND OVER

ABSORPTION OF OVERHEADS
When actual rate is used for overhead absorption, the problem of over or under absorption does
not arise. This is because actual overheads incurred during the period are used to calculate the
actual rate. As a result, the actual overheads incurred are exactly equal to the mount of
overheads absorbed/recovered. But when the pre-determined rates are used, due to use of
estimated figures, the amount of overheads absorbed can be either more than, less than or equal
to the actual overheads incurred.
This leads to under absorption or over absorption.
Such under absorption or over absorption is also sometimes called as ‘overhead variance.’
Under absorption of overheads: This happens when the amount of overheads absorbed is less
than the amount of overheads incurred actually. This leads to understatement of the cost as the
overheads incurred are not fully absorbed in the cost of products. Under absorption is also
referred as under recovery.
Under absorption = Absorbed overheads < Actual overheads
Over absorption of overheads: This happens when the amount of overheads absorbed is more
than the amount of overheads actually incurred. This leads to over statement of the cost of
products, jobs, processes, etc. Over absorption is also referred as over recovery.
Over absorption = Absorbed overheads > Actual overheads
Let us understand this with an example:

Assume that the pre-determined overhead rate is calculated as ₹4 per labour hour.
Actual labour hours = 1,000 hours
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Overheads absorbed = Actual labour hours * Pre-determined overhead rate

Overheads absorbed = 1,000 * 4
Overheads absorbed = ₹4,000
Actual overheads incurred = 4,500
Since, Overheads absorbed < Overheads actually incurred, there is under absorption of
overheads.
Under absorption = Actual Overheads – Overheads Absorbed =₹ 4,500 – ₹4,000 = ₹ 500
treatment of under absorption or over absorption
2.9.1 Supplementary rate

When the difference between actual and absorbed overheads (i.e. amount of under or over
absorption) is large (may be because of a serious error in selection of base or estimation of
overheads while calculating pre-determined rate or due to change of circumstances), the
supplementary rate is calculated to adjust the amount of over or under absorption in the cost of
goods manufactured. The adjustment is made in the costs of the following:
• Semi-finished goods (Work in progress)
• Finished goods.
• Goods which are finished and sold (cost of sales)
Supplementary rate is calculated as follows:
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Supplementary rate =
Or
Supplementary rate =
When there is under absorption, it is adjusted by ADDING the amount of under absorption to
the cost of work in progress, finished goods and finished goods sold (cost of sales). This is
because the overheads absorbed are less than what should have been absorbed by these goods
(i.e. actual overheads incurred). In other words, balances of Work in progress A/c (Stock of
Semi-Finished Goods A/c), Stock of Finished Goods A/c and Cost of Sales A/c are increased
by debiting(adding) them with the amount of under absorption. So, in case of under absorption,
the supplementary rate is positive and under absorption I adjusted by a plus rate.
In case of over absorption, it is adjusted by SUBTRACTING its amount from the cost of work
in progress, finished goods and finished goods sold (cost of sales). This is because excess
amount has been absorbed than what should have been (i.e. actual overheads). In other words,
the balances of stock of Semi-Finished Goods A/c, Stock of Finished Goods A/c and Cost of
Sales A/c are decreased by crediting them with the amount of over absorption. So, in case of
over absorption, the supplementary rate is negative and over absorption is adjusted by a minus
rate.
Under Dr. Accounts to be

absorption or or debited or credited
over absorption Cr.
Under absorption Debit Finished goods A/c Units of finished stock * supplementary rate
per unit
WIP A/C Equivalent completed units * supplementary
rate per unit
Cost of sales A/c Units of goods sold * supplementary rate per
unit
Over absorption Credit Finished goods A/c Units of finished stock * supplementary rate
per unit
WIP A/c Equivalent completed units * supplementary
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rate per unit

Cost of Sales A/c Units of goods sold * supplementary rate per
unit
2.9.2 Write off to costing P&L account.

The amount of over absorbed or under absorbed overheads are written off to P & L account in
two situations:
1. When the amount of over or under absorption is insignificant/very small
2. When under/over absorption happened as a result of abnormal factors like defective
planning, idle capacity, etc.
A limitation of this method is that since the amount of under/over absorbed overheads are not
adjusted in the cost of work I progress and finished goods, their stocks remain either over
valued or undervalued and are carried forward to the next accounting period at such values
only.
2.9.3 Carry over to next year.
Sometimes, neither the supplementary rate is calculated nor the overheads are written off to
costing P&L account. Rather the amount of under/over absorbed overheads are carried forward
to the next period by transferring their amount to Overhead Reserve Account. Overhead
Reserve Account is also known as Overhead Suspense Account.
According to some accountants, it is not correct and logical to carry forward the overheads of
one year to the next year for the purposes of absorption.
IN-TEXT QUESTIONS
15. When under absorption is large, we use?
16. When are over absorbed overheads written off to costing P& L?
2.10 CONCEPTS RELATED TO CAPACITY

Licensed capacity
The production capacity for which the appropriate authority has issued a license.
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Installed capacity.
Installed capacity is also known as rated capacity. It is the maximum production capacity of the
plant that can be achieved only under perfect operating conditions. Perfect operating conditions
means no loss of operating time. Since, in practice, this is not possible, installed capacity
cannot be achieved in normal operating circumstances. That is why it is also called theoretical
capacity.
Practical capacity
Practical capacity is the maximum capacity minus the loss of time or output due to certain
unavoidable reasons like repairs and maintenance, Sundays and holidays, stock taking, setting
up time, etc. It is also referred to as available capacity or net capacity.
Actual capacity
It is the capacity which is achieved during a given period of time. It is usually expressed as a
percentage of installed capacity. It ca be known only once the period is over and it can be either
more or less than the practical capacity.
Normal capacity
It is the average capacity utilization of the plant over a long period of time. It is also known as
Average capacity.
Idle capacity
It is the difference between installed capacity and actual capacity when actual capacity is less
than installed capacity. It is that part of the plant capacity which could not be utilized in
production effectively.
Normal idle capacity: it is the difference between installed and practical capacity. (As per CAS-
2 of Institute of Cost Accountants of India)
Abnormal idle capacity: It is the difference between practical and actual capacity. (As per
CAS-2 of Institute of Cost Accountants of India)
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Treatment of costs of idle capacity

• If idle capacity arises as a result of normal factors (i.e. unavoidable reasons), then
overhead supplementary rate is used to recover these idle capacity costs.
• If the idle capacity arises due to abnormal reasons (i.e. avoidable reasons) like defective
planning, etc., the cost are charged to Costing P&L Account.
• If idle capacity is due to seasonal fluctuations, then overhead rates should be inflated and
the cost should be charged to cost of production.
IN-TEXT QUESTIONS
17. Idle capacity is the difference between?
18. Average capacity utilisation of plant over a long period of time is?
2.11 TREATMENT OF SPECIAL ITEMS

• Interest on capital
Whether to include interest on capital in the cost of cost or not is a matter of huge debate. Some
views are in the favor of its inclusion and others are in the favour of its exclusion. The
arguments and view point for both the schools of thought are presented below.
Arguments for inclusion
• There are different factor of production like land labour capital. Rent is the reward for land,
wags for labour and interest for capital. If rent and wages are include in cost, so should the
interest on capital.
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• Where a firm has to decide about the replacement of manual labour, the interest on capital
need to be included in the cost. This is because unless the interest on the cost of machine is
included in calculation of cost of these two methods, the true comparison is not possible and
correct decision cannot be reached
• If the true cost of maintaining the stocks is to be ascertained, we need to take into account he
interest on capital as proper consideration needs to be given to the capital locked up in the
stocks.
• When the products produced are of different values and the capital invested in them also
varies significantly, inclusion of interest of capital becomes more important.
Arguments for exclusion
• The argument for inclusion of interest on capital on the basis that it is the reward for capital
just like wages is for rent, holds good in economics and not in accounting.
• It is difficult to ascertain the exact amount of capital employed and hence interest cannot be
included. This is because the amount of working capital employed in business keeps on
changing from time and time.
• It is also difficult to ascertain a fair rate of interest to calculate the mount of interest on
capital. This is because the market rate of interest keeps on fluctuating.
• Inclusion of interest in cost implies an inflation of value of work in progress and finished
goods. This leads to inflation of income as well.
• Inclusion of interest on capital in costing creates complications which are unnecessary and
can be avoided.
• Depreciation
Depreciation is the diminution in the value of the fixed assets over a period of time due to wear
and tear. Therefore we can depreciation is a result of two main causes, i.e., lapse of time and
use of the asset. Even if the asset under consideration is not in use, still it will depreciate or
decline in value due to passage of time. All the fixed assets except land decline in their value
over time.
In cost accounts, depreciation is charged to the cost of production. It is directly traced to the
cost object. In case it is not feasible to do so, it shall be charged using one of the two principles
(i) Benefit received (ii) Cause and effect.
There are various methods of charging depreciation. Some of them are listed below:
i. Fixed Instalment method
ii. Reducing balance method
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iii. Machine hour method

iv. Production unit method
v. Revaluation method
vi. Replacement cost method
In order to ensure the ascertainment of true cost of the product, it is really necessary to
determine the proper amount of depreciation to be charged.
• Packing material cost
Packing materials are classifies as: primary packing materials and secondary packing materials.
Primary packaging: If the packaging is necessary to hold a product and to ensure its
convenient use and handling, it is treated as primary packing. For example, butter papers and
wrappers in confectionery industry or foils for tablet strips in pharmaceutical industry. In such
a case, packing material cost is treated as part of direct material cost.
Secondary packaging: Packing costs incurred to store, transport and promote a product come
in this category. For example, cartons containing chocolate and biscuit pack in confectionery
industry or cardboard boxes for holding tablet strips in pharmaceutical industry.
• If the packing is required for the proper transportation, that is, safe delivery of the goods to
the customer, then the packing material cost is treated as a part of the distribution overheads.
• If the packing is a fancy one, in order to attract customers, it considered as a part of the
advertising costs and treated as distribution overheads.
• If the special packaging is done at the request of a customer, it is charged to the specific job
or work order.
• Fringe benefits
These are the payments made to workers or facilities provided to them in addition to the wages
or salary they receive. These fringe benefits include dearness allowance, house rent allowances
and other allowances. They help in boosting the loyalty and morale of the employees towards
the organisation.
Direct workers: If the amount of such fringe benefits is quite large, they are charged to
production as a direct cost in the form of supplementary wage rate. Otherwise, they may be
recovered as a part of factory overheads.
Indirect workers: Incentives provided to indirect workers is treated as part of factory
overheads.
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• Bad debts
There is a lack of unanimity regarding treatment of bad debts. Certain cost accountants are of
the view that bad debts should not be included in the cost accounts at all as they are in the
nature of financial losses. According to another view, since certain amount of bad debts are
bound to happen in a business concern, bad debts up to a certain limit, as determined by the
management, should be charged as selling overheads. But if the amount of bad debts is
exceptionally large, making them abnormal, then they should not be included in cost accounts
and charged to costing P&L account.
• Training expenses
Training is required to guide the new recruits about the job which they are hired. Training
expenses include the costs of running the training department, wages/salaries paid to trainees,
cost arising from low production initially, etc. training expenses of the factory workers is
charged to the cost of production as factory overheads. If the training expenses are incurred on
the training of workers from office and administration division or selling and distribution
division, then the training costs should be charged as office and administration overheads and
selling and distribution overheads respectively. These overheads then can be spread over
different departments depending on the number of workers working in each department.
When a firm is experiencing high labour turnover, the amount of training expenses will be
higher. Such abnormal amounts of training expenses should be charged to costing profit and
loss account.
• Expenses on removal or re-erection of machinery
Sometimes a machinery has to be removed and moved to a new site. This may be because of
changes in the method of production, change in production flow or any alterations in the
factory building or may be due to any other reason not listed here. All the costs incurred in
removing the machine are treated as a part of production overheads. When such expenses is
huge, they may be spread over a period of time like 3 to 5 years. If the removal is because of
some abnormal reasons like faulty planning, etc. then such expenses on removal or re-erection
are transferred to the Costing P & L Account.
It is to be noted that the cost of installation of a new machinery is capitalized with the cost of
machinery itself.
• Carriage and cartage expenses
Such expenses are incurred on the movement and transportation of good and materials
1. If such expenses are incurred on movement of direct materials, it is treated as a part of direct
cost (raw material cost). We need to understand this in detail.
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If such transportation expenses are specifically incurred on the purchases of certain raw
materials, it is charged to direct material cost (raw material cost). But sometimes, multiple
types of raw materials are transported together and it not possible to identify such cartage
expenses with specific raw materials, then such cartage expenses are treated as factory
overheads.
2. If such expenses are incurred on the purchase of indirect materials, then it is treated as
factory overheads.
3. If such expenses are incurred for the distribution of final goods, then such expenses are
treated as a part of distribution overheads.
4. If such expenses have to be incurred due to certain abnormal circumstances like need to shift
the goods somewhere else due to fire or some natural calamity like flood, then such
expenses are charged to costing P&L account.
• Labour welfare expenses
Various facilities like canteen, playgrounds, hospital, etc. provided by employers for their staff
is considered as welfare measures. Expenses incurred on providing such facilities are treated as
overheads costs and apportioned between factory, office and selling and distribution overheads
on the basis of number of people involved.
As regards the canteen expenses, when a canteen runs on no profit-no loss basis, no
expenditure is incurred by the firm. But when the canteen is run on a subsidized basis by the
business concern, it is considered as a welfare measure for the staff. Such expenses when
incurred are treated as overheads. They are then apportioned among various departments using
the criteria of total wages or the number of workers in each department.
• Night shift allowance
Sometimes workers have to work in night as well because the pressure of work is more than
normal. In such a case, compensation given to workers for working in night is known as night
shift allowance. This is treated as a part of production overheads. If the night shift is being done
due to the order of a specific customers, then the cost of night shift allowance is charged to that
particular order.
In case the night shift has to be operated due to some abnormal reasons, the night shift
allowance is charged to costing profit and loss account.
• Research and development expenses
Chartered Institute of Management Accountants (CIMA) defines research costs as “Expenses
of searching for new products or improved products, new/improved methods or new
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application of materials.” CIMA London defines development costs as “Expenses of the

process which begins with the implementation of the decision to produce a new or improved
product or to employ a new or improved method and ends with the commencement of formal
production of that product or by that method.”
Treatment of research and development expenditure in cost accounts depends on different
circumstances as discussed below:
1. If the research and development is related to production, these expenses are treated as
factory overheads. If they are rate to administration, then administration overheads and if
related to market research then selling and distribution overheads.
2. When the amount of expenses is very large and benefit I to be received over a number of
years, they are treated as deferred revenue expenditure and recovered over a period of two to
three years.
3. If the research and development proves unsuccessful, the cost is charged to Costing Profit
and Loss Account.
4. If the cost has been incurred in relation to a specific product or process, it is directly charged
to that product or process.
2.12 SUMMARY
• The costs are divided into direct and indirect costs. The total of all the direct cost is prime
cost. The total of all indirect cost is overheads.
• Overheads can be classified on the basis of different criteria. On the basis of function, they
are – production overheads, office and administrative overheads and selling and distribution
overheads.
• Overheads cannot be traced directly to a cost unit and hence need to distributed on some
suitable basis.
• Stages of overhead distribution involve – collection and classification of overheads, their
allocation and apportionment (re-apportionment also in case of production overheads) to
various cost centres/departments and then their absorption.
• When the overheads are absorbed on the basis of pre-determined rates, there arises the
problem of under absorption or over absorption of overheads.
• The amount of under/over absorbed overheads can be treated by (i) calculation of
supplementary rates and using it to adjust the cost of finished goods, semi-finished goods
(work in progress) and cost of sales. (ii) charging the amount of under/over absorption to
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costing profit and loss account if the amount is small are caused due to abnormal reasons. In
some cases, the amount of over/under absorption is carried forward to the next accounting
period.
• There are certain items of overheads expenses which require special attention. Interest on
capital, depreciation, research and development costs, fringe benefits are some of them.
IN-TEXT QUESTIONS
19. Primary packing cost is part of?
20. Training cost of indirect factory workers is part of production overheads?
2.13 GLOSSARY
• Overheads: Those indirect costs which cannot be identified with a particular cost centre.
They may be related to production, administration or selling and distribution functions.
• Allocation: Allotment of whole items of cost to cost centre.
• Apportionment: Allotment of proportions of items of cost to cost centres.
• Primary distribution: It means the distribution of production overheads to production and
service departments.
• Absorption of overheads: Charging of overhead expenses to units of products
manufactured by the firm.
• Capacity: Ability of a factory to produce with the resources available at its disposal.
• Under absorption of overheads: When the amount of overheads absorbed is less than the
actual overheads incurred.
• Over absorption of overheads: When the amount of overheads absorbed is more than the
actual overheads incurred.
2.14 ANSWERS TO IN-TEXT QUESTIONS
1. False 11. True

2. Indirect material, indirect wages, and 12. True
indirect expenses
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3. True 13. Selling and distribution overheads

4. Distribution overheads 14. Rate per unit of sales
5. Allocation 15. Supplementary rate
6. Recovery of overheads or application of 16. Abnormal factors or small amount
overheads
7. Allocation and apportionment 17. Installed capacity minus Actual capacity
8. Machine Hour Rate 18. Normal Capacity
9. Area occupied by department/cost centre 19. Direct material cost
10.True 20. True
2.15 SELF – ASSESSMENT QUESTIONS
1. What are overheads? Classify them on suitable basis.

2. Discuss the augments in favour and against the inclusion of interest on capital in cost
accounts.
3. Under which situations a blanket overhead rate is used? Explain.
4. Calculate machine hour rate from the information provided below:
i. Cost of machine ₹ 40,000
ii. Machine installation expenses ₹10,000
iii. Working hours of machine per year 2,500 hours
iv. Life of machine 5 years
v. Repair charges 50% of depreciation
vi. Lubricant oil ₹3 per day of 8 hours
vii. Electricity consumed: 15 units per hour @10 paise per unit.
viii. Wages of machine operator ₹10 per day of 8 hours
ix. Consumable stores @ ₹10 per day of 8 hours
5. Consider the following figures from the books of a production company.
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Indirect wages:
Production department:
P ₹ 1900
Q ₹ 600
R ₹ 400
Service department:
A ₹ 3,000
B ₹ 200
Indirect materials
Production departments:
P ₹ 900
Q ₹ 1100
R ₹ 300
Service departments:
A ₹ 1000
B ₹ 650
Assets insurance ₹ 2,000
Rent and rates ₹ 1,400
Power and light ₹ 6,000
Depreciation (per annum) 6% on capital value
Meal charges ₹ 3,300
Additional information is as follows:
Item Production Department Service department
X Y Z P Q
Number of 90 100 30 40 40
workers
Capital value 1,00,000 1,20,000 60,000 40,000 80,000
of assets (₹)
KWh 4,200 4,200 1,500 1,500 600
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Area in 250 300 450 300 100

square
meters
Prepare overhead distribution summary.

6. A factory consisting of three production and two service departments has the following
information extracted for its cost records.
Total overheads:
Production department:
A ₹ 20,000
B ₹ 15,500
C ₹ 14,800
Service department:
F ₹ 8,500
G ₹10,500
The expenses of the service departments are to be charged on the percentage basis as given
below:
A B C F G
F 40% 30% 20% - 10%
G 30% 40% 10% 20% -
Using simultaneous equation method, apportion overheads of service department to production

departments.
2.16 REFERENCES / SUGGESTED READINGS

• Arora, M.N. (2021). Textbook of Cost and Management Accounting. Delhi: Vikas
Publishing House Pvt Ltd.
• Datar, S.M. & Rajan, M.V. (2017). Horngren’s Cost Accounting: A Managerial Emphasis:
Pearson.
• ICAI. Cost and Management Accounting. Delhi: Institute of Chartered Accountants of India.
• Maheshwari, S.N.&S.N. Mittal. (2021). Elements of Cost Accounting. Delhi: Shree Mahavir
Book Depot.
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UNIT-I:
LESSON 3
CLASSIFICATION OF COSTS
Mr. Anil Kumar
Assistant Professor
Ramdayalu Singh College
B.R.A. Bihar University
Email-Id.- srccan@gmail.com
STRUCTURE
3.2 Introduction
3.3 Nature or Element Cost
3.4 Function cost
3.5 Variability, or behaviour cost
3.6 Controllability-based cost
3.7 Normality-based cost
3.8 Managerial decision-making
3.9 Summary
3.10 Glossary
3.13 References
● Understanding of different types of costs: After learning about cost classification, the
student will have a clear understanding of the different types of costs such as direct costs,
indirect costs, fixed costs, and variable costs.
● Ability to differentiate between direct and indirect costs: The student will be able to
identify and differentiate between direct costs, which are directly tied to a specific product
or service, and indirect costs, which are not tied to a specific product or service.
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● Knowledge of fixed and variable costs: The student will have a clear understanding of the
difference between fixed costs, which do not change with production levels, and variable
costs, which vary with production levels.
● Understanding of cost behaviour: The student will be able to analyse the behaviour of
costs in different business situations and understand how costs behave in response to
changes in production levels.
● Improved decision-making: By understanding cost classification, the student will be able
to make more informed decisions about production, pricing, and resource allocation.
● Increased efficiency: The student will be able to use cost classification information to
identify areas of inefficiency and make improvements to increase efficiency and reduce
costs.
● Better product costing: The student will be able to use cost classification information to
accurately calculate the cost of a product, which is crucial for making decisions about
pricing, production levels, and resource allocation.
3.2 INTRODUCTION
Costs are categorised when they are divided into multiple categories based on their traits,
behaviours, or connections to business operations. A thorough understanding of the nature and
behaviour of costs is provided by cost classification, which also serves to design an efficient
cost information system and to make decision-making easier. The important ways of
classification of costs are:
1. By Nature: This involves classifying costs based on the type of expense incurred, such as
direct materials, direct labour, indirect materials, indirect labour, etc.
2. By Function: This involves classifying costs based on the functions of the organization,
such as production, marketing, administration, research, etc.
3. By Behaviour: This involves classifying costs based on their behaviour, whether they are
fixed or variable, direct or indirect, or semi-variable.
4. By Controllability: This involves classifying costs based on management's level of control
over them, such as controllable and non-controllable costs.
5. By Time: This involves classifying costs based on the timing of the expenses, such as
current, capital, sunk, and deferred costs.
6. By Responsibility: This involves classifying costs based on the person or department
responsible for incurring them, such as departmental or personal costs.
7. By Traceability: This involves classifying costs based on their ability to be traced directly
to a product or service, such as direct and indirect costs.
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Each classification of costs serves a different purpose and provides different information for
cost and management accounting. Understanding the different classifications of costs is
essential for effective cost management and decision-making.
3.3 NATURE OR ELEMENT COST

Nature or Element cost refers to the classification of costs based on the type of expense
incurred in the production or sale of a product or service. This classification is important as it
helps to understand the composition of costs and their behaviour in relation to production or
sales volume. The following are the elements of nature or element costs:
Fig 1.1: Element of costs classification into material cost, employee cost and other expenses
Direct Materials Cost: Direct materials are raw materials or components that become a part of
the finished product and can be easily traced to it. Examples of direct materials include the
metal used to make a car or the fabric used to make a shirt.
1. Direct Labour Cost: Direct labour is the cost of the labour required to produce a product or
provide a service. It includes the wages, salaries, and benefits of the workers who are
directly involved in the production process. Examples of direct labour include the workers
who assemble a car or sew a shirt.
2. Direct Expenses: Direct expenses are costs that are directly incurred in the production of a
product or the provision of a service. They are expenses that can be easily traced to a
specific product or service. Examples of direct expenses include the cost of gasoline used to
transport raw materials or the cost of delivery charges for finished goods.
3. Indirect Materials Cost: Indirect materials are materials that are used in the production
process but are not directly identifiable with a specific product or service. Examples of
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indirect materials include office supplies, such as paper and ink, used in the production
process.
4. Indirect Labour Cost: Indirect labour is the cost of the labour required to support the
production process, but which is not directly involved in the production of a product or
provision of a service. Examples of indirect labour include the wages and salaries of
supervisors, maintenance workers, and administrative staff.
5. Indirect Expenses: Indirect expenses are costs that cannot be easily traced to a specific
product or service. They are indirect overhead costs that are incurred in the production
process but are not directly tied to the production of a specific product or service. Examples
of indirect expenses include rent, property taxes, and insurance for the factory.
IN-TEXT QUESTIONS
1. Distinction between direct cost and indirect cost is an example of

______classification
a) By Element
b) By Function
c) By Controllability
d) By Variability
Fig 3.2: Overheads cost classification.
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6. Overhead: Overhead refers to indirect costs that are not directly tied to the production of a
product or the provision of a service. Overhead costs are indirect expenses that are incurred
in the production process but cannot be easily traced to a specific product or service.
a. Production Overhead: Production overhead refers to indirect costs that are incurred in the
production process, such as utilities, rent, property taxes, insurance, maintenance, and
indirect materials and labour. Examples of production overhead costs include the cost of
electricity and water used in the production process and the cost of cleaning and maintaining
the factory.
b. Administrative Overhead: Administrative overhead refers to indirect costs that are
incurred in the administration of a business, such as salaries and benefits for administrative
staff, rent and utilities for office space, and office supplies. Examples of administrative
overhead costs include the salaries and benefits of the company's human resources and
accounting staff, and the cost of office supplies such as paper and ink.
c. Selling Overhead: Selling overhead refers to indirect costs that are incurred in the sales
process, such as advertising, sales commissions, and delivery charges. Examples of selling
overhead costs include the cost of advertising in a magazine or on television, and the cost of
delivering finished goods to customers.
d. Distribution Overhead: Distribution overhead refers to indirect costs that are incurred in
the distribution of a product, such as transportation and handling costs. Examples of
distribution overhead costs include the cost of shipping finished goods to customers and the
cost of storing finished goods in a warehouse.
Classifying costs based on their nature or element provides important information for cost and
management accounting, as it helps management understand the structure of costs and make
informed decisions about cost control and reduction.
3.4 FUNCTION COST
Function cost classification in cost accounting involves grouping costs based on the function of
the organization, such as production, marketing, administration, research, etc. Some common
examples of function costs include:
1. Direct Material Cost
2. Direct Employee (Labour) Cost
3. Direct Expenses
4. Production / Manufacturing overheads
5. Administration Overheads
6. Selling overheads:
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7. Distribution Overheads:
8. Research and Development Costs:
It is important to note that the calculation of prime cost, factory cost, cost of goods sold, and
cost of sales may vary depending on the specific business and the nature of its activities.
Direct Material Cost

+ Direct Employee (Labour) Cost
+ Direct Expenses
Prime Cost
+ Production/Manufacturing Overheads
Factory Cost or Works Cost
+ Administration Overheads
Cost of Goods Sold
+ Selling Overheads and Distribution Overheads
Cost of Sales
Fig 3.2: Calculation of prime cost, factory cost or work cost, cost of goods sold, and cost of sales.
IN-TEXT QUESTIONS
2. Which of the following is an example of functional classification of cost:

a) Semi-variable Costs
b) Fixed Cost
c) Administrative Overheads
d) Indirect Overheads.
3.5 VARIABILITY OR BEHAVIOUR COST
Variability, or behaviour cost, refers to the different patterns in which costs change in response
to changes in production or sales activities. In cost accounting, there are three main types of
costs: fixed costs, variable costs, and semi-variable costs (mixed costs).
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1. Fixed Costs: Fixed costs are costs that do not change in total as a company's level of activity
changes. They are fixed expenses that a company must pay regardless of its level of
production. Examples of fixed costs include rent, property taxes, insurance, and salaries of
executives.
2. Variable Costs: Variable costs are costs that change in direct proportion to the company's
level of activity or output. They increase or decrease with changes in the level of production.
Examples of variable costs include raw materials, direct labour, and commissions.
3. Mixed Costs: Mixed costs are costs that contain both fixed and variable components. The
total amount of the cost changes as the level of activity changes, but the proportion of the
fixed and variable components remains constant. Examples of mixed costs include utilities,
such as electricity and water, which have a fixed component for the connection and a
variable component based on usage.
It's important to understand the cost behaviour of a company's costs because this information
can be used to make informed decisions about pricing, production, and cost control. Knowing
the fixed, variable, and mixed costs associated with a particular product or service can help a
company determine the best pricing strategy and make decisions about cost control that will
maximize profits.
IN-TEXT QUESTIONS
3. Taxi provider charges minimum Rs. 40 thereafter Rs.12 per kilometre of

distance travelled the behaviour of conveyance cost is:
a) Fixed Cost
b) Semi-variable Cost
c) Variable Cost
d) Administrative Cost.
Methods of segregating semi-variable costs into fixed and variable costs

These costs can be difficult to analyse as they do not neatly fit into either category. To
segregate semi-variable costs into fixed and variable components, there are several methods
that can be used:
1. Graphical Method: This method involves plotting the semi-variable cost against the level
of activity on a graph. The fixed component is estimated by drawing a line of best fit
through the data points, and the variable component is calculated as the difference between
the semi-variable cost and the estimated fixed component.
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Steps to segregate semi-variable costs using the graphical method:

a. Plot the semi-variable cost against the activity level.
b. Draw a line of best fit through the data points.
c. Identify the y-intercept, which represents the fixed component of the cost.
d. For each activity level, calculate the variable component as the difference between the semi-
variable cost and the fixed cost.
2. High-Low Method: This method uses the highest and lowest levels of activity to determine
the fixed and variable components of the semi-variable cost. The fixed component is
calculated as the difference between the high-level total cost and the variable cost per unit
multiplied by the high-level activity. The variable cost per unit is calculated as the difference
between the high-level total cost and the low-level total cost divided by the difference in
activity levels.
Steps to segregate semi-variable costs using the high-low method:
a. Identify the highest and lowest levels of activity during a given period.
b. Calculate the total cost at the high level of activity.
c. Calculate the total cost at the low level of activity.
d. Calculate the variable cost per unit by dividing the difference between the high and low total
costs by the difference in activity levels.
e. Calculate the fixed cost by subtracting the variable cost per unit multiplied by the high level
of activity from the high-level total cost.
3. Analytical Method: This method involves using statistical techniques, such as regression
analysis, to determine the fixed and variable components of the semi-variable cost. The
regression equation is used to estimate the fixed and variable components of the cost, based
on the relationship between the cost and the activity level.
Steps to segregate semi-variable costs using the analytical method:
a. Identify the semi-variable cost and the activity level that affects it.
b. Develop a mathematical expression to represent the relationship between the semi-variable
cost and the activity level.
c. Use regression analysis to estimate the fixed and variable components of the cost.
d. The estimated fixed component represents the fixed cost, and the estimated variable
component represents the variable cost.
4. Comparison by Period or Level of Activity Method: This method involves comparing
the semi-variable cost for different periods or levels of activity to determine the fixed and
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variable components. The fixed component is estimated by comparing the cost for periods or
levels of activity where the variable component is relatively constant, and the variable
component is calculated as the difference between the semi-variable cost and the estimated
fixed component.
Steps to segregate semi-variable costs using the comparison by period or level of activity
method:
b. Collect data for several periods or levels of activity.
c. Calculate the semi-variable cost for each period or level of activity.
d. Compare the semi-variable cost across periods or levels of activity to determine the fixed
and variable components of the cost.
e. The portion of the semi-variable cost that does not change across periods or levels of activity
represents the fixed component, while the portion that changes represent the variable
component.
5. Least Squares Method: This method involves using regression analysis and the concept of
least squares to determine the fixed and variable components of the semi-variable cost. The
regression equation is used to estimate the fixed and variable components of the cost, and
the least squares method is used to determine the best-fit regression line through the data
points.
Steps to segregate semi-variable costs using the least squares method:
b. Collect data for several periods or levels of activity.
c. Calculate the semi-variable cost for each period or level of activity.
d. Develop a mathematical expression to represent the relationship between the semi-variable
cost and the activity level.
e. Use least squares regression analysis to estimate the fixed and variable components of the
cost.
f. The estimated fixed component represents the fixed cost and the estimated variable
component represents the variable cost.
Regardless of the method used, it is important to validate the results and consider the specific
nature of the cost being analysed, as well as the reliability of the data and the level of accuracy
desired, when choosing the best approach for segregating semi-variable costs into fixed and
variable components.
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3.6 CONTROLALABILITY-BASED COST
Controllability-based cost classification is a method of classifying costs based on whether they

can be controlled or influenced by a specific manager or department. In this method, costs are
divided into two categories: controllable and uncontrollable costs.
1. Controllable Costs: Controllable costs are those that can be directly influenced or
controlled by a specific manager or department. An example of a controllable cost is the cost
of direct labour, as the manager can control the amount of direct labour used in production.
2. Uncontrollable Costs: Uncontrollable costs are costs that cannot be directly influenced or
controlled by a specific manager or department. An example of an uncontrollable cost is rent
for a building, as the manager does not have control over the cost of the rent.
Difference between controllable and uncontrollable costs
The difference between controllable and uncontrollable costs is that controllable costs can be
directly influenced or controlled by a manager, while uncontrollable costs cannot be influenced
or controlled. This distinction is important for managers in terms of cost control and
management, as it helps them to focus on controlling costs that are within their sphere of
influence and not waste time and resources trying to control uncontrollable costs.
In conclusion, controllability-based cost classification is a useful tool for managers to identify
and prioritize costs that can be influenced and controlled, leading to better cost control and
decision-making.
3.7 NORMALITY-BASED COST
Normality based cost classification is a method of classifying costs based on whether they are
normal or abnormal. In this method, costs are divided into two categories: normal costs and
abnormal costs.
1. Normal Costs: Normal costs are costs that are considered normal or expected based on past
experience or current market conditions. An example of a normal cost is the cost of raw
materials for a manufacturing company, as the cost of raw materials is expected to be stable
and consistent over time.
2. Abnormal Costs: Abnormal costs are costs that are considered unusual or unexpected based
on past experience or current market conditions. An example of an abnormal cost is an
unexpected increase in the cost of raw materials due to a sudden shortage in the market.
The difference between normal and abnormal costs is that normal costs are expected and
consistent, while abnormal costs are unexpected and inconsistent. This distinction is important
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for managers in terms of cost control and management, as it helps them identify and address
unexpected or unusual costs that may impact the financial performance of the company.
3.8 MANAGERIAL DECISION-MAKING COST

Costs used in managerial decision-making are a range of costs that are considered when making
decisions in a business setting. Some of the common costs used in managerial decision-making
include:
1. Predetermined Costs: This cost is estimated before the actual production takes place and
is used as a basis for cost control. Example: In a manufacturing company, the
predetermined cost of producing 100 units of a product may be Rs.10,000.
2. Standard Costs: This is the cost that a company expects to incur for producing a specific
quantity of a product. Example: The standard cost of producing 100 units of a product may
be Rs.9,500.
3. Marginal Costs: This is the change in total cost that results from producing one more unit
of a product. Example: If the cost of producing 100 units of a product is Rs.9,000 and the
cost of producing 101 units is Rs.9,100, the marginal cost is Rs.100.
4. Estimated Costs: This is a rough estimate of the cost of producing a product, based on the
information available at a given time. Example: If a company wants to estimate the cost of
producing 100 units of a new product, it may use an estimated cost of Rs.10,000.
5. Differential Costs: This is the difference in total cost between two alternatives. Example:
If a company is considering two alternative methods of producing a product, the
differential cost is the difference in cost between the two methods.
6. Sunk Costs: Sunk costs are costs that have already been incurred and cannot be recovered,
regardless of the decision that is made. Sunk costs are irrelevant costs because they are not
directly tied to a specific decision and will not impact the outcome of the decision. For
example, if a company has already purchased a factory building and equipment, the cost of
the building and equipment would be considered a sunk cost. Regardless of the decision to
continue or shut down operations, the cost of the building and equipment has already been
incurred and cannot be recovered.
7. Discretionary Costs: This is a cost that can be changed by management. Example: If a
company decides to increase its advertising budget, this is a discretionary cost.
8. Period Costs: Period costs are costs that are not related to the production of goods and are
expensed in the period in which they are incurred. These costs include selling and
administrative expenses, such as advertising, salaries, and rent. Period costs are not
assigned to specific products, but rather are treated as a general expense for the business.
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For example, the cost of an advertisement campaign or the salary of a salesperson would
be considered a period cost.
9. Engineered Costs: This is a cost that is calculated using engineering data and techniques.
Example: If a company wants to estimate the cost of constructing a building, it may use an
engineered cost estimate.
10. Explicit Costs: This is a cost that is directly incurred as a result of a decision. Example: If
a company buys raw materials to produce a product, the cost of the raw materials is an
explicit cost.
11. Implicit Costs: This is a cost that is not directly incurred as a result of a decision, but is
still relevant to the decision. Example: If a company decides to use its own truck to
transport goods, the cost of fuel and maintenance is an implicit cost.
12. Imputed Costs: This is a cost that is not actually incurred, but is assigned a value for the
purpose of decision-making. Example: If a company decides to use its own truck to
transport goods, the cost of using a rented truck may be imputed.
13. Capitalized costs: This refers to the cost incurred when a company purchases a long-term
asset, such as a building, machinery or a patent, which will generate future revenue. It is
recorded on the balance sheet as a fixed asset and amortized over the expected life of the
asset. For example, the cost of building a factory is a capitalized cost.
14. Product costs: Product costs are costs incurred in the production of goods. They are also
referred to as "inventoriable costs" or "manufacturing costs". These costs include direct
materials, direct labour, and manufacturing overhead. Product costs are considered to be
part of the cost of goods sold, and they are assigned to the finished products that are being
manufactured. For example, if a company is producing laptops, the direct materials used in
production (such as the plastic casing, circuit boards, and keyboard) and the direct labour
required to assemble the laptops are considered product costs.
15. Opportunity costs: These are the costs of the next best alternative use of resources. For
example, if a company invests in one project, the opportunity cost is the return it could
have received from the next best investment.
16. Out of pocket costs: These are the costs that a company incurs that are paid in cash and
are not recoverable. For example, the cost of buying raw materials to manufacture a
product is an out of pocket cost.
17. Shut-Down Costs: Shut-down costs are costs that are incurred when a business
temporarily ceases operations, either partially or completely. These costs can include
costs associated with shutting down and restarting production, such as severance pay for
employees and the cost of storing raw materials. Shut-down costs are relevant costs
because they are directly tied to a specific decision and will impact the outcome of the
decision to shut down operations. For example, if a manufacturing company is
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considering shutting down operations due to a temporary decrease in demand, the cost of
paying severance to employees and storing raw materials would be considered shut-down
costs.
18. Absolute costs: These are the costs that are incurred regardless of the level of production.
For example, rent, insurance, and property taxes are absolute costs.
19. Relevant Costs: Relevant costs are future costs that will differ among the alternatives
being considered in a decision. These costs are directly tied to a specific decision and are
therefore important in the decision-making process. Relevant costs include incremental
costs (the difference in costs between two alternatives) and opportunity costs (the benefits
that must be given up to pursue one alternative over another). Examples of relevant costs
include the cost of materials for a new product, the cost of hiring additional staff for a new
project, and the cost of lost sales if a product is discontinued.
20. Irrelevant Costs: Irrelevant costs are costs that will not change regardless of the decision
being made. These costs are not directly tied to a specific decision and are therefore not
important in the decision-making process. Irrelevant costs include sunk costs (costs that
have already been incurred and cannot be recovered), and non-differential costs (costs that
are the same for all alternatives). Examples of irrelevant costs include the cost of a
machine that has already been purchased, the cost of advertising that has already been
completed, and the cost of research and development that has already been done.
21. Expired Costs: Expired costs refers to costs that have been incurred in the past, but no
longer have any effect on the current period. These costs are considered "expired" or
"expired" because they are no longer relevant to the current financial situation of a
company. Examples of expired costs include depreciation on assets, amortization of
intangible assets, and provisions for bad debts. These costs are recorded in the company's
financial statements and may be used for tax purposes, but they do not have a direct impact
on the company's current financial performance.
22. Unexpired Costs: Unexpired costs refer to costs that are still relevant and have not yet
been consumed or used in the production process. These costs are expected to be incurred
in the future as part of the normal course of business operations. Examples of unexpired
costs include prepaid expenses, unused supplies, and advance payments for services. These
costs are still assets on the balance sheet and will be recorded as expenses when they are
used or consumed. Unexpired costs are a reflection of the company's ongoing financial
obligations and are essential in determining the company's financial health.
23. Avoidable Costs: Avoidable costs are costs that can be eliminated or reduced without
affecting the overall operations of a business. These costs are usually discretionary in
nature and can be changed by management action. For example, if a company decides to
cut back on its advertising budget, the costs associated with the advertising are considered
avoidable costs.
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24. Unavoidable costs: Unavoidable costs, on the other hand, are costs that cannot be
eliminated or reduced without affecting the company's ability to produce its goods or
services. These costs are often fixed in nature and are essential to the operation of the
business. For example, the cost of raw materials, utilities, rent, and salaries are considered
unavoidable costs.
IN-TEXT QUESTIONS
4. The cost which is to be incurred even when a business unit is closed is a
a) Imputed cost.
b) Historical cost.
c) Sunk cost.
d) Shutdown cost.
In conclusion, the cost used in managerial decision-making is dependent on the decision to be

made and the type of cost incurred. Companies need to consider the different types of costs in
order to make informed decisions that will increase profits and minimize costs.
3.9 SUMMARY
Cost classification is an important aspect of cost accounting that involves grouping costs into
categories based on their behaviour and relationship to specific products or services. The
classification of costs is crucial for making informed decisions about production, pricing, and
resource allocation.
Fixed costs are those costs that do not change with changes in production levels. For example,
rent, property taxes, and salaries of administrative staff. Variable costs, on the other hand, vary
with changes in production levels. For example, the cost of raw materials and direct labour.
Mixed costs are costs that contain both fixed and variable elements.
Product costs are those costs that are directly tied to a specific product or service, such as direct
materials and direct labour. Period costs are indirect costs that are not tied to a specific product
or service, such as advertising, rent, and office supplies. Direct costs are those costs that can be
traced directly to a specific product or service, while indirect costs cannot be traced directly to
a specific product or service.
Relevant costs are those costs that are relevant to a specific decision, while irrelevant costs are
those costs that are not relevant to a specific decision. Shut-down costs are the costs that are
incurred when a company shuts down its operations, while sunk costs are costs that cannot be
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recovered or recovered only partially. Controllable costs are those costs that can be controlled
or influenced by management, while uncontrollable costs are those costs that cannot be
controlled or influenced by management.
Avoidable costs are those costs that can be avoided or eliminated, while unavoidable costs are
those costs that cannot be avoided or eliminated. Imputed costs, also known as hypothetical or
implicit costs, are costs that are not incurred in a monetary sense but are incurred in an
opportunity sense. Out-of-pocket costs are the costs that are incurred directly and immediately,
such as the cost of raw materials. Opportunity costs are the costs that are incurred when an
opportunity is foregone in order to pursue another opportunity.
Expired costs are costs that have already been incurred and cannot be recovered, while
unexpired costs are costs that have not yet been incurred. Understanding the different types of
costs is crucial for making informed decisions about production, pricing, and resource
allocation.
In conclusion, the classification of costs is a crucial aspect of cost accounting that involves
grouping costs into categories based on their behaviour and relationship to specific products or
services. Understanding the different types of costs, such as fixed, variable, mixed, product,
and period costs, direct and indirect costs, relevant and irrelevant costs, shut-down and sunk
costs, controllable and uncontrollable costs, avoidable and unavoidable costs, imputed,
hypothetical, implicit costs, out-of-pocket costs, opportunity costs, expired, and unexpired
costs, is crucial for making informed decisions about production, pricing, and resource
allocation.
3.9 GLOSSARY
1. Fixed Costs: Costs that do not change with production levels. Examples include rent,
property taxes, and insurance.
2. Variable Costs: Costs that vary with production levels. Examples include raw materials,
labour, and shipping costs.
3. Mixed Costs: Costs that have both a fixed and variable component. Examples include
utility bills and salary expenses.
4. Product Costs: Costs incurred in the production of a product. These are also known as
inventoriable costs.
5. Period Costs: Costs incurred in the course of conducting business, but not related to the
production of a specific product. Examples include marketing expenses and administrative
costs.
6. Direct Costs: Costs that are directly tied to a specific product or service. Examples include
raw materials and direct labour.
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7. Indirect Costs: Costs that are not tied to a specific product or service. Examples include
rent and utilities.
8. Relevant Costs: Costs that will change in the future as a result of a decision. These costs
are important in decision making.
9. Irrelevant Costs: Costs that will not change in the future as a result of a decision. These
costs are not important in decision making.
10. Shut-down Costs: Costs associated with shutting down a business or a portion of a
business. Examples include severance pay and inventory write-downs.
11. Sunk Costs: Costs that have already been incurred and cannot be recovered. Examples
include investments in research and development.
12. Controllable Costs: Costs that can be managed or reduced through changes in business
practices. Examples include marketing expenses and overtime costs.
13. Uncontrollable Costs: Costs that cannot be managed or reduced through changes in
business practices. Examples include property taxes and insurance.
14. Avoidable Costs: Costs that can be eliminated through changes in business practices.
Examples include overtime pay and unnecessary travel expenses.
15. Unavoidable Costs: Costs that cannot be eliminated through changes in business practices.
Examples include rent and insurance.
16. Imputed/Hypothetical/Implicit Costs: Costs that are not incurred as cash expenses but
represent an opportunity cost. Examples include the value of an owner's time.
17. Out-of-pocket Costs: Costs that are incurred as cash expenses. Examples include raw
materials and labour costs.
18. Opportunity Costs: The benefits foregone by choosing one option over another. Examples
include the opportunity cost of investing in one project over another.
19. Expired Costs: Costs that have reached the end of their useful life. Examples include
depreciated assets.
20. Unexpired Costs: Costs that have not reached the end of their useful life. Examples
include investments in property and equipment.
1. a 4. d
2. c
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3. b
10. What is the difference between direct and indirect costs?

11. Can you explain the difference between variable costs and fixed costs?
12. What is the difference between product costs and period costs?
13. What is an example of a sunk cost?
14. What are semi-variable costs and how do they differ from variable and fixed costs?
15. What is an opportunity cost and how does it affect cost and management accounting
decisions?
16. What are avoidable costs and what are some examples of avoidable costs that a company
may have?
17. Can you explain the difference between sunk costs, unavoidable costs, and avoidable
costs?
18. What is the role of cost classification in cost and management accounting?
19. How does a company use cost classification information to make informed decisions about
resource allocation and prioritizing expenses?.
3.12 REFERENCES
• Horngren, C. T., Datar, S. M., & Rajan, M. (2017). Cost Accounting: A Managerial
Emphasis (16th ed.). Pearson.
• Drury, C. (2017). Management and Cost Accounting (9th ed.). Cengage Learning.
• Shank, J. K. (2017). Management Accounting (2nd ed.). Routledge.
• Kinney, W. R., Raiborn, C. A., & Hansen, D. R. (2015). Cost Management: A Strategic
Emphasis (7th ed.). McGraw-Hill Education.
• John, J. (2015). Cost Management: Strategies for Business Decisions (5th ed.). McGraw-
Hill Education.
• ICAI. (n.d.). In ICAI. Retrieved February 7, 2023, from https://www.icai.org
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• "Cost Accounting: A Managerial Emphasis" by Charles T. Horngren, Srikant M. Datar, and
George Foster
• "Cost and Management Accounting" by Colin Drury
• "Cost Accounting: Principles and Practice" by M.N. Arora
• "Cost Accounting: An Introduction to Managerial Accounting" by Eric W. Noreen and Peter
C. Brewer
• "Managerial Accounting" by Ray H. Garrison and Eric W. Noreen
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UNIT-II
LESSON 4
COST-VOLUME PROFIT ANALYSIS
CA. VISHAL GOEL
(CA, CFA, PGDBA, M. Com, CS, UGC-NET)
Adjunct Faculty- AMITY University
Ex- Associate Professor- IILM University
Email-Id: cavishalgoel7@gmail.com
STRUCTURE
4.2 Introduction
4.7 Cost-Volume-Profit analysis
4.8 Break Even Analysis
4.10 Summary
4.11 Glossary
4.14 References

After reading this lesson student should be able to understand:
● Concepts of marginal costing.
● Advantages & limitations of marginal costing.
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● Difference between absorption and marginal costing,

● Break-even analysis and its uses for decision making.
● Concept of CVP analysis and its practical application in various decision-making
process like make or buy decisions, selection of a suitable product mix, effect of change
in price, Shutdown or continue, maintaining a desired level of profit.
4.2 INTRODUCTION
Cost Volume Profit Analysis: As the name suggests, cost volume profit (CVP) analysis is the
analysis of three variables cost, volume and profit. Cost-Volume-Profit (CVP) Analysis can be
described as an analysis of reciprocal effect of changes in cost, volume and profitability on
each other. CVP analysis explores the relationship between costs, revenue (Sales), actual
production and sales activity levels and the resulting profit. It aims at measuring changes in
cost and volume due to change in any one or more component of costs. Profit depends upon a
large number of factors, the most important of which are the cost of manufacture product or
delivering a service and the volume of sales . Both these factors are interdependent-volume of
sales depends upon the volume production, which in turn is related to costs.

Marginal costing is the process of ascertaining marginal (additional) costs and the effect of
changes in volume of output on profit
This is done by differentiating between fixed costs and variable costs. Several other terms are
used synonymously in place of marginal costing like direct costing, variable costing, and
incremental costing.
Marginal costing can also be defined as a process whereby each costs element is analysed and
is classified into fixed cost and variable cost and with after this division managerial decisions
are taken to be more effective. Variable costs are the one which vary with volume of
production or output, whereas fixed costs are the ones which remains unchanged irrespective of
changes in the volume of production or output.
In other words, per unit variable cost remains same at different levels of output and total
variable cost changes in direct proportion with the number of units. On the other hand, total
fixed cost remains same for all levels of output, while per unit fixed cost keep changing with
change in number of units, more the number of units produced lesser will be the per unit fixed
cost.
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1. It Helps in determining the volume of production:-
Marginal costing helps in determining the level of output which is most profitable for a running
concern. The production capacity, therefore, can be utilized to the maximum possible extent.
2. Maximisation of Profit:
It helps, in determining the most profitable relationship between cost, price and volume in the
business, which helps the management in fixing appropriate selling price for its products thus,
maximization of profit can be achieved.
3. Helps in selecting optimum production mix: -
The techniques of Marginal costing helps in determining the most profitable production mix by
comparing the profitability of different products. With analysis of data it can help in deleting
the less profitable products from the portfolio of products and adding new more profitable new
products thereby creating an optimum product mix products.
4. Helps in deciding whether to Make or Buy:-
The decision whether a particular product should be manufactured in the factory or to be
bought from outside supplier can be taken. In case the purchase price is lower than the marginal
cost of production, it will be advisable to purchase the product from outside rather than
manufacturing it in the factory.
5. Help in deciding method of manufacturing: -
In case a product can be manufactured by two or more alternative methods, ascertaining the
marginal cost of manufacturing the product by each method will be helpful in deciding as to
which method should be adopted for maximum cost saving.
6. Helps in deciding whether to shut down or continue:-
In the periods when company is suffering losses due to lower demand for its products Marginal
costing helps in deciding in whether the production in the plant should be temporarily
suspended or continued.
There are numerous other managerial decisions in which marginal costing will be very helpful
by providing the relevant data.
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1. Artificial Classification: -
Marginal costing assumes that all expense can be classified into fixed and variable expenses.
But in real life scenario it is difficult to analyse and classify all costs into fixed and variable
elements. Some elements of costs are partly fixed and partly variable and their separation is
mostly based on assumption and not on facts. In reality all costs are variable in the long run.
2. Faculty Decision: -
In marginal costing most decisions are taken based on variable costs that’s why it is also
sometimes referred as variable costing but if fixed costs are completely ignored, decisions
taken by management can be deceptive in certain circumstances. For e.g. With the introduction
of costly automatic machine, the importance of fixed costs in increasing day by day.
3. Marginal costing ignores time factor and investment: -
The marginal cost of two jobs may be the same but the time taken for their completion and the
cost of machines used may differ. The true cost of a job which takes longer time and uses
costlier machine would be higher. This fact is not covered by marginal costing.
4. Controllability of Fixed cost: -
In Marginal costing the importance of controlling fixed costs in completely ignored. No doubt,
fixed costs can also be controlled in short term but by placing them in a separate category and
by accepting them as fixed and completely non controllable, the importance of controllability
of fixed cost is undermined.
5. Difficult to apply: -
The technique of marginal costing is difficult to apply in industries such as ship building, and
other construction based industries where due to long operating cycle the value of work in
progress is generally high in relation to turnover.
6. Stock is understated: -
Under marginal costing stocks and work in progress are valued at variable cost only so their
value is bound to be understated.
7. No Basis for Cost control or reduction: -
Marginal costing does not provide any standard for the evaluation of performance. A system of
budgetary control and standard costing provides more effective tools and basis for cost control
than the one provided by marginal costing.
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Absorption costing: -
The process of charging all costs, both variable and fixed, to operations, products or process is
known as absorption costing. So in other words absorption costing is a method of costing in
which all direct costs and appropriate overheads are absorbed/charged in cost of the product or
services for finding out the total cost of production.
STOCK VALUATION under Absorption costing Vs Marginal Costing
Inventories are over-stated in absorption costing as it includes one extra cost element in
inventory value than under marginal costing, i.e., the fixed manufacturing cost.
Inventory value under absorption costing
= Direct material+ Direct labour +variable manufacturing costs+ Fixed manufacturing costs
Inventory value under marginal costing
= Direct material+ Direct labour +variable manufacturing costs
From the Discussion so far one can easily understand that there are some basic differences in
basic premise on which cost are ascertained in absorption costing and marginal costing. The
main difference is in treatment of fixed cost among the two. While in absorption costing it is
treated in same manner as variable cost and form part of total cost based on which stock is
valued but on the other hand in marginal costing only variable costs are considered in decision
making and valuing the stock.
Following are various points of difference between Absorption costing and Marginal Costing
Basis of Difference Absorption costing Marginal costing
Classification of Costs are not classified into Costs have to be classified into fixed
Costs variable and fixed. costs and variable costs. To establish
cost-volume-profit relationship.
Treatment of Fixed Fixed production overheads Fixed production costs are regarded as
Production are charged to the product. period cost and are charged to revenue
overheads It is included in cost per along with the selling and administration
unit. expenses, i.e., they are not included in
cost per unit.
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Calculation of Profit is the difference Under marginal costing first contribution

Profit between sales and cost of is ascertained by subtracting variable
goods sold. cost from total revenue. After that we
deduct therefrom the total fixed
expenses to calculate profit.
Effect of valuation If inventories increase If inventories increase during a period,

of inventory on during a period, this method this method generally reports less profit
Profit will reveal more profit than than absorption costing but when
marginal costing. When inventories decrease this method reports
inventories decrease, less more profit. As closing stock is valued at
profits are reported because lower cost as compared to absorption
under this method closing costing
stock is valued at higher
figures as it includes
absorbed fixed cost also.
Over/under Arbitrary apportionment of Since fixed costs are excluded, there is
absorption of fixed costs may result in no question of arbitrary apportionment
Overheads under or over absorption of of fixed overheads and thus no under or
overheads. over absorption of overheads.
Let’s understand with the help of an example how profit is calculated under absorption costing
and Marginal costing. Before that understand the format for income statement under both
methods.
Income Statement under Absorption Costing
Particulars Amount
Rs.
Sales (A) XXX
Variable (Direct Material Cost) X
Variable (Direct Labour Cost) X
Variable (Direct Expenses) X
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Variable Factory Overhead X

Fixed Factory Overhead absorbed X
(Units produced x standard rate per unit)
Total manufacturing cost of Quantity Produced XXX
Add: - Opening FG X
Less: - Closing FG X
Total manufacturing cost of Quantity Sold XXX
Add: - Variable Office & Admin Overhead X
Fixed Office and Admin Overhead X
Variable Selling & Distribution Overhead X
Fixed Selling & Distribution Overhead X
Add: - Under absorbed Overhead(Actual Overhead incurred – Overhead absorbed) X
Less: - Over absorbed Overhead (Overhead absorbed – Actual Overhead incurred) X
Total Cost of Sales (B) XXX
Profit (A-B) XXX
Income Statement Under Marginal Costing

Particulars Amount Rs.
Sales XXX
Less Variable Cost
Direct Material Cost X
Direct Labour Cost X
Direct Exp. X
Variable Factory Overhead X
Variable Office & Admin Overhead X
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Variable Selling & Dist. Overhead X

Contribution XXX
Less Fixed Cost
Fixed Factory Overhead X
Fixed Office & Admin Overhead X
Fixed Selling & Dist. Overhead X
Profit XXX
Example 1 VGA Ltd. Produces a single product and normal level of production is 18000 units.
Information for last accounting year is provided below:
Production 20000 units sales 16000 units
Particulars Rs
Selling Price per unit 30
Production cost:
Direct material cost per unit 7
Direct labour cost per unit 6
Variable Overheads per unit 4
Fixed Overhead incurred 54,000
Variable Selling and administration overheads per unit 4.5
Fixed Selling and administration overheads 25,000
There was no opening stock of finished goods.
Income statement under Absorption costing method
Particulars Amount Amount
(Rs.) (Rs.)
Sales (A) 4,80,000
Production cost:
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Direct material cost (20000*7) 1,40,000

Direct labour cost (20000*6) 1,20,000
Variable Overheads (20000*4) 80,000
Fixed Overhead incurred 60,000 4,00,000
Add: Opening stock Nil
Less: Closing stock (4000*20) (80,000)
Total Production cost 3,20,000
Less: over absorbed overheads (2000*3) (6,000)
Adjusted Production Cost 3,14,000
Variable Selling and administration overheads (16000*4.5) 72,000
Fixed Selling and administration overheads 25,000 97,000
Total Cost of Sales (B) 4,11,000
Profit (A-B) 69,000
Fixed production overheads given are Rs. 54,000 for budgeted 18000 units so it comes down
to Rs.3 per unit (54000/18000)
Fixed production overheads absorbed for current production of 20,000 units is Rs. 60,000
(20000*3)
Therefore, over absorbed fixed production overheads 6000 (60000-54000)
Income statement under Marginal costing

Particulars Amount Amount
Rs. Rs.
Sales 4,80,000
Less Variable Cost
Direct Material Cost 1,40,000
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Direct Labour Cost 1,20,000

Variable Factory Overhead 80,000
Total Variable cost of production 3,40,000
Add Opening Stock Nil
Less: Closing Stock (4000*17) (68,000)
2,72,000
Add: Variable Selling and Administration overheads 72,000 3,44,000
Contribution 1,36,000
Less Fixed Cost
Fixed Production Overhead 54,000
Fixed Selling & Admin Overhead 25,000 79,000
Profit 57,000
So, it can be observed that there is a difference of Rs. 12,000 Between profits under two
method, this is the same amount as difference between value of closing stock. Since closing
stock under Absorption is valued at Rs. 80,000 (Full Cost of production) while in Marginal
costing it is valued at Rs. 68,000 (Variable cost of Production)
4.7 Cost-Volume-Profit Analysis

Cost-Volume-Profit (CVP) analysis is the systematic study of relationship between cost of the
product, volume of activity and the resultant profit. Since all these three factors are interrelated
so it’s very important to study their relationship and how a change in one can affect the other as
well. For e.g. Cost of the product will provide the base on which selling price will be
determined and accordingly profit will be calculated. If we change selling price, it might impact
volume of sales and volume of production and thereby will impact the cost.
So CVP analysis is very important technique used in managerial decision making and
achieving the desired results.
Assumptions in CVP Analysis:
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1. Any Changes in the levels of revenues (Sales) and costs arise only because of changes in the
number units produced and sold – for example, the number of Cars produced and sold by
Maruti Suzuki or the number of Passengers travelling in a bus.
2. Total costs can always be separated into two elements or parts i.e. a fixed element which
does not change with the level of output and a variable element which changes with level of
output.
3. Selling price per unit, variable cost per unit, and total fixed costs are known and constant.
(Mind it, Total sales and total variable cost will keep changing with level of output).
4. It is assumed that company is either selling a single product or that the proportion of
different products will remain constant as the level of total units sold changes i.e., sales mix
remains constant.
Before we proceed further let us briefly discuss various concepts & symbols used in marginal
costing and CVP analysis
Comparison of TFC and TVC
Units 500 800 1000

Produced
Per Unit Total Per Unit Total Per Unit Total
Amount Amount Amount
Raw 1.20 600 1.20 960 1.20 1,200

Material
Wages 3.00 1,500 3.00 2,400 3.00 3,000
Factory 20 10,000 12.50 10,000 10 10,000

Rent
a) Total Fixed Cost (TFC):

Total Fixed Cost remains constant in total amount and changes per unit. FC/unit decreases with
increase in the output level and vice-versa. Example: Rent of a premise
b) Total Variable Cost (TVC):
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Total Variable Cost per unit remains same at all levels of output but changes in total amount
with the change in output level. TVC in total amount increases with output level and vice-
versa. TVC will be zero (0) at zero level of activity. Example: Wages per unit paid to labour,
Raw Material Cost
Total Fixed cost (FC):

It remains constant or same for all levels of output.
Total variable cost (VC):
It will be 0 at zero level of activity and increases proportionately with the volume of activity.
Total cost (TC):
It is a combination of Fixed cost and variable cost so it will start from the level of fixed cost
and keep increasing following the variable cost.
Total Sales (S): It represents the total amount received as revenue by selling the goods
produced
Profit (P): It represents the difference between Total sales and Total Cost.
Basic equation:
Total sales = Total Fixed Cost + Total variable Cost + Total Profit
TS = FC +VC + P
Contribution (C): When only Variable cost is subtracted from Sales the resultant figure is
called Contribution. Since in Marginal costing it is assumed that fixed cost will remain same at
least in short run for all levels of production activity. So, contribution is an important concept
to help in decision making in marginal costing.
Contribution =Total Sales – Total Variable Cost
OR Contribution=Fixed Cost + Profit

Standard Marginal Cost statement (Simplified)
Particulars Amount (Rs.)
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Sales (S) XXX
Less Variable cost (VC) XXX
Contribution (C) XXX
Less Fixed Cost (FC) XXX
Profit (P) XXX
Concepts Used in Marginal costing for Decision Making

1. Profit Volume (P/V) Ratio:
This ratio helps in knowing the profitability of the operations of a business. It establishes the
relationship between Contribution and sales. Since Fixed cost do not change with the level of
output so any increase in contribution will leads to increase in profit.
So, Profitability of the different Goods produced by a company can be ascertained by
comparing their P/V ratio. Higher the P/V ratio higher the profit of that particular product and
vice-versa. P/V ratio is also known as Contribution Margin Ratio or Contribution to Sales
Ratio.
P/V Ratio = Contribution X 100
Sales
Or Contribution per unit X 100

Sales per unit
Or change in contribution X 100

Change in sales
Or change in profit X 100

Change in sales
Let us see how all of these formulas will give same result for a given set of information.
Example 2 Khushi Enterprises shares with you their cost data for 2 years
Particulars Year 1 Year 2 Change
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Production 5000 units 8000 units 3000 units
Sales @5 per unit 25000 40000 15000
Variable cost @ 3 per Unit 15000 24000 9000
Contribution @2 per unit 10000 16000 6000
Fixed cost 4000 4000 0
Profit 6000 12000 6000
Let’s check P/V ratio with all Formulas mentioned above

P/V Ratio = Contribution X 100 For Year 1 (10000/25000)*100 = 40%
Sales
Or Contribution per unit X 100 For year 1 (2/5)*100 = 40%

Sales per unit
Or Change in contribution X 100 (6000/15000)*100 = 40 %

Change in sales
Or Change in profit X 100 (6000/15000)*100 = 40%

Change in sales
So That’s the benefit of this formula that as per given information we can use any of its version
still getting same answer.
4.8 Break Even analysis
Though many believes that there is no difference in CVP analysis and Break even analysis and
they refer to same concept others believe that CVP is a broader term and include Break even
analysis But if we carefully observe concepts used in them we can say that Break-even analysis
is a actually a method to apply the CVP analysis in decision making process by including many
more related concepts into it.
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2. Break-even point:
Break-even point is production and sales level where there will be no profit and loss i.e. total
cost (TC) is equal to total sales revenue (S)
or Sales = Total Fixed Cost + Total Variable cost & Profit = 0
Break-even Point can be calculated both in units and Rs. When calculated in Terms of Rs. It is
also referred as Break-even sales.
Let us calculate Break-even point For the given set of data we used in CVP analysis above
Particulars Year 1 Year 2 Change
Production 5000 units 8000 units 3000 units
Sales @5 per unit 25000 40000 15000
Variable cost @ 3 per Unit 15000 24000 9000
Contribution @2 per unit 10000 16000 6000
Fixed cost 4000 4000 0
Profit 6000 12000 6000
Break-even point (in units) = BEP = Fixed costs

Contribution per unit
So, For given set of values Break Even Point = (4000/2) = 2000 units
We can Cross check this by simple calculations
Suppose we produce 2000 units and selling price is 5 per unit so total sales 10000
Variable cost @ 3 per unit will be (2000 *3) = 6000 so contribution will be 4000 and fixed
cost given is 4000 so profit will be 0
3. Breakeven Point (in Rs.) = BES = Fixed cost X Sales per unit
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Or BEP in units * Selling Price per unit or Fixed Cost

P/v ratio
In our example BES = 2000 * 5 = 10000 Rs. Or 4000/40% = 10000 Rs.

Let’s see few other related concepts which further help in decision making
Break Even Point With Desired Profits: BEP with DP (in units)
Since no business entity would like to settle at Break-even point , their main objective of
existence is to earn profit for shareholders or owners, so it makes sense to calculate particular
level of units to be produced and sold to earn desired profits.
4. BEP with DP (in units) = Fixed cost + Desired profit
And following the same concept which we discussed for BEP in Rs. , BEP with desired profit
in Rs can also be calculated in similar manner
5. BEP with DP (In Rs) = BES with DP = Fixed cost + Desired profit x Sales per unit
Or BEP with DP in units * Selling Price per unit
Or Fixed Cost + Desired Profit

P/V ratio
Let us assume in our example shareholders have given a target of Rs. 24000 Profit to be earned
So BEP With DP in Units = (4000 + 24000)/2 = 14000 units
BEP with DP in Rs. = 14000 *5 = Rs.70000 or (4000 + 24000)/40% = Rs. 70000
This can be verified with following calculations
Production 14000 units
Sales @5 per Unit 70000
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Variable cost Per unit @3 per unit 42000
Contribution @2 Per unit 28000
Fixed Cost 4000
Profit 24000
So, it can be clearly observed that by producing and selling 14000 units The revenue will be
Rs. 70000 and a profit of Rs 24,000 is expected be achieved.
Margin Of Safety (MOS):

Margin of safety is the difference between actual sales and Break even sales It can be expressed
in absolute terms or as a % of Actual sales
6. MOS (Absolute) = Actual Sales – Break Even Sales
MOS Can also be calculated with following Formula
MOS = Profit/P/V ratio
7. MOS (%) = MOS/ Actual sales
So, in our example If We calculate Margin of Safety for 2nd year it is
MOS (Absolute) Actual Sales- BES = 40000-10000 = Rs 30000
MOS = 12000/40% = Rs.30000
MOS (%) = MOS/Actual Sales = 30000/40000 = 0.75 or 75%
8. Angle of Incidence
The angle which the Total Sales Line makes with the Total Cost Line is known as the Angle of
Incidence.
The angle indicates the profit-earning capacity of the company over the break-even point.
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A large angle of incidence indicates a high margin of profit, and a mall angle of incidence
indicates earning of low margin of profit.
Figure 4.1
Let us see with few more examples that with the minimal information given how we can
calculate all these components which will help in decision making process to a great extent
Example 3 Homemakers Pvt Ltd. Gives you following data
Particulars Amount in Rs.
Sales 500000 units 15,00,000
Fixed Cost 4,50,000
Profit 3,00,000
You need to find BEP, MOS
Solution:
Since All marginal costing concepts revolve around contribution and P/V ratio lets first
calculate that
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Contribution = Fixed Cost + Profit

= 4,50,000 + 3,00,000 = 7,50,000
P/V Ratio = (Contribution/Sales) *100
= (7,50,000/15,00,000) *100 = 50%
BEP in Rs (In Sales) = Fixed Cost / P/V ratio
= 4,50,000/50% = 9,00,000
BEP in Units = BEP in sales/ Selling Price per unit
= 9,00,000/3 = 3,00,000 units
(note: Selling price per unit = sales/ no of units = 15,00,000/5,00,000 = 3 per unit)
Margin of Safety (in Rs.) = Actual sales – Break even sales

= 15,00,000 - 9,00,000 = Rs. 600000
Margin Of safety (in %) = MOS/ Actual Sales
= 6,00,000/15,00,000 = .0.4 or 40%
Example 4 Mrs Anju is running a business named “AHAAR” for supplying packed foods to
nearby offices. She supplied you the following information and ask for answers to few
questions.
Particulars Year 1 Year 2
Sales 20,00,000 30,00,000
Profit 2,00,000 4,00,000
Answer the following:

1. P/V ratio
2. Variable cost for year 1
3. Fixed Cost
4. BEP
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5. Sales to earn a Profit of Rs 6,00,000

6. Profit When sales are 50,00,000
7. MOS for a Profit of 6,00,000
Solution:
1. P/V ratio = (Change in Profit/ Change in Sales) *100
= (2,00,000/10,00,000) *100 = 20%
2. Variable cost in 1st year = Sales - Contribution
Contribution in year 1 = Sales *P/V ratio
= 20,00,000* 20% = 4,00,000
Therefore, Variable cost = 20,00,000 - 4,00,000 = 16,00,000

3. Fixed Cost = Contribution – Profit
= 4,00,000 – 2,00,000 = Rs 2,00,000
4. BEP = FC/ P/V ratio
= 2,00,000/20 % = 10,00,000
5. Sales to earn a profit of 6,00,000
BEP with DP = (FC +DP)/ P/V ratio
= (2,00,000 + 6,00,000)/20%
= Rs. 40,00,000
6. Profit when sales are 50,00,000
Contribution = Sales * P/V ratio
= 50,00,000*20%
= 10,00,000
Profit = Contribution – fixed cost
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= 10,00,000 – 2,00,000 = Rs. 8,00,000

7. MOS for a profit of 6,00,000
MOS = Profit/ P/V ratio
= 6,00,000/20%
= 30,00,000

In every organisation Management uses CVP analysis for making various decisions. In this
section, we will learn how CVP analysis is applied for short-term decision making. Some of the
Decision problems faced are as follows:
1. Problem of Limiting Factor (Key Factor)
2. Processing of Special Order
3. Local vs Export sale
4. Make or Buy/ In-house-processing vs Outsourcing
5. Shutdown or continue decision etc.
1. Limiting Factor (Key Factor)
In real life, there may be several factors which may put a limit on the number of units to be
produced even if the products give a high contribution. These factors limit the volume of output
at a particular point of time or over a period. these are called key factors, scarce factors,
limiting factors.
The limiting factors may be, raw material available, labour hours available ,Machine hours
available, availability of capital etc. For e.g., for a factory in a remote location, labour may be a
key factor or the factory in a location with limited power supply may have limited machine
hours for production. Contribution per unit of key factor should be considered and that
particular course of action should be adopted which gives the highest contribution per unit of
key factor.
Example 5
You are given the following information in respect of products X and Y of Altitude. Ltd.
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Product X Product Y
Selling price 37 49
Direct material 10 5
Labour hours (2 Rs per hour) 5 hours 10 hours
Variable overheads 20% of Direct wages
Show which product is more profitable during labour shortage. Also, if Labour hours available
are 25000 hours and demand for X and Y is 2000 and 3000 units respectively
Solution:
Particulars Product X Product Y
Selling price per unit in 37 49
Direct Material per unit in 10 5
Labour cost per unit (Hrs *2 per hour) 10 20
Variable overhead (20% of Labour Cost) 2 4
Total Variable Cost per unit 22 29
Contribution per unit 15 20
Since Labour is in shortage so it will be treated as Key factor and the product which is
generating higher contribution per unit of labour hour will be produced first.
Contribution per Unit 15 20
Number of Hrs required per unit 5 10
Contribution per labour hour: 3 2
So You can see that though contribution per unit is higher for Y but contribution per labour
hour for product X is higher so product X is more profitable in the case labour hours are limited
So we will first use labour hours for producing X to maximum possible extent i.e. 2000 units in
our case as demand is only for 2000 pieces remaining labour hours will be used for Y
Total labour hours available 25000
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Labour hours for X (2000*5) 10000

Remaining labour hours 15000
Maximum Production of Y possible is 15000/10(labour hr per unit for Y)
So only 1500 units of Y can be produced with remaining labour hour
Now we can calculate Total Contribution by multiplying the unit produced with the per unit
contribution.
X (2000*15) = 30000
Y (1500*20) = 30000
Total = 60000
2. Processing of Special Order/ Accepting export order
Sometimes company is faced with a situation that it receives an order to supply goods below its
normal selling price. In that case if company has additional idle capacity, only additional cost
in producing and processing such order shall be compared with additional revenue to be
generated. In simple words Only Marginal cost to be considered and if it is less than the price
offered by exported or new local customer than it can be accepted, if it’s not going to impact
current selling price of local market.
Example 6
Anjana Industries manufacture and sell toys and has following cost structure for each unit of
Product
Particulars Amount
Rs. `
Materials 10.00
Labour 8.00
Variable expenses 10.00
Fixed expenses 17.00
Total cost 45.00
Per Unit Selling Price of the product is Rs 52.00.
The company’s normal capacity is 1,00,000 units. The figures given above are for
70,000 units. The company has received an offer for 20,000 units @ Rs. 40 per unit
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from a customer in USA.
Advice the manufacturer on whether the order should be accepted. Also give your
advice if the order is from a local merchant.
Solution:
Marginal cost for additional 20,000 units
Per unit For 20,000

units
` `
Material 10.00 2,00,000
Labour 8.00 1,60,000
Variable expenses 10.00 2,00,000
Marginal cost/ variable cost 28.00 5,60,000
Additional revenue to be realised 40 8,00,000
Marginal cost 5,60,000
Net additional contribution) 2,40,000
The offer should be accepted because it gives an additional contribution of Rs.

2,40,000. The total profit will also increase by Rs 2,40,000 because fixed expenses
have already been recovered from the local market.
As regarding answer to 2nd part of question, the order from the local customer should
not be accepted at Rs. 40 per unit or at any rate below the normal price i.e., Rs. 52
because it will result in the general reduction of selling prices of the product.
Note: If circumstances are such that acceptance of the additional order is

beyond the present capacity of the organization than in that case, some fixed
expenses may also go up substantially. If there is an increase in fixed expenses,
the increase should also be considered by including it in the total additional cost
and then it shall be compared with the additional revenue.
3. Make or Buy decision
Sometimes company is faced with a decision whether to buy a component or part,

required for its product from outside supplier or manufacture it on its own.
In such cases, Marginal cost of Producing that item internally shall be compared with Purchase
price to come to a conclusion.
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SAANVI Automobile Ltd manufactures 20,000 units of Part UVW each year. At current level of
activity, the cost per unit follows:
Direct materials Rs. 4.80
Direct labour Rs. 7.00
Variable manufacturing overhead Rs. 3.20
Fixed manufacturing overhead Rs. 10.00
Total cost per part UVW Rs.25
An outside supplier has offered to sell 20,000 units of Part UVW each for Rs. 22 per part. And
You Are Required to advice which option is better
Solution:
Total Marginal Cost of Producing the Part in Factory
Direct materials Rs. 4.80
Direct labour Rs. 7.00
Variable manufacturing overhead Rs. 3.20
Total Marginal cost of manufacturing Rs. 15
Total cost of purchase Rs 22
It is advisable to manufacture in our own factory as cost saved by not manufacturing is less than the
purchase price. It is assumed that Fixed cost will still need to be incurred.
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IN-TEXT QUESTIONS
Following information is available of Anvi enterprises for year ended June 2022
Fixed cost Rs. 3,00,000
Variable cost Rs. 12 per unit
Selling price Rs. 15 per unit
Output level 1,50,000 units
1. P/V Ratio is
a) 80% b) 20% c) 100% d) 33.3%
2. BEP in Units
a) 200000 b) 100000 c) 600000 d) 300000
3. BEP in Rs.
a) 10,00,000 b) 12,00,000 c) 15,00,000 d) 20,00,000
4. Sales Required To earn Profit of Rs. 6,00,000

a)30,00,000 b) 45,00,000 c) 60,00,000 d) 20,00,000
4.10 SUMMARY
Advantages of Marginal Costing
1. It Helps in determining the volume of production: -
2. Maximisation of Profit:
3. Helps in selecting optimum production mix: -
4. Helps in deciding whether to Make or Buy: -
5. Help in deciding method of manufacturing: -
6. Helps in deciding whether to shut down or continue: -
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Limitations of Marginal Costing

1. Artificial Classification: -
2. Faculty Decision: -
3. Marginal costing ignores time factor and investment: -
4. Controllability of Fixed cost: -
5. Difficult to apply: -
6. Stock is understated: -
7. No Basis for Cost control or reduction: -
Marginal Costing Vs Absorption Costing
The main difference is in treatment of fixed cost among the two. While in absorption costing it
is treated in same manner as variable cost and form part of total cost based on which stock is
valued but on the other hand in marginal costing only variable costs are considered in decision
making and valuing the stock.
product, volume of activity and the resultant profit. Since all these three factors are interrelated
so it’s very important to study their relationship and how a change in one can affect the other as
well.
Decision Making Problems
In this section, we have learned how the concepts of marginal costing and CVP is applied for
analysis of identified options for short-term decision making. Some of the Decision problems
faced are as follows:
1. Problem of Limiting Factor (Key Factor)
2. Processing of Special Order
3. Local vs Export sale
4. Make or Buy/ In-house-processing vs Outsourcing
5. Shutdown or continue decision etc.
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1. Two competing companies HERO Ltd. And ZERO Ltd. Sell the same type of product in
the same market. Their forecasted profit and loss accounts for the year ending December 2022
are as follows:
2.
Particulars Hero Ltd. Zero Ltd.

Sales Rs.5,00,000 Rs. 5,00,000
Less: Variable Costs Rs.4,00,000 Rs.3,00,000
Less: Fixed Costs Rs.50,000 Rs.50,000
Forecasted Profit Rs.50,000 Rs.50,000
You are required to state which company is likely to earn greater profits in conditions of:
a) Low demand
b) High demand
3. Two manufacturing companies which have the following operating decides to merge:
Particulars Company A Company B

Capacity Utilization (%) 90 60
Sales (Rs. in lacs) 540 300
Variable Costs (Rs. in lacs) 396 225
Fixed Assets (Rs. in lacs) 80 50
Assuming that the proposal is implemented, calculate:
a) Break-even sales of the merged plant and the capacity utilization at that stage
b) Profitability of the merged plant at 80% capacity utilization
c) Turnover of the merged plant to earn a profit of Rs.75 lacs
d) When the merged plant is working at a capacity to earn a profit of Rs.75 lacs, what
percentage increase in selling price is required to sustain an increase of 5% in fixed
overheads
4. Croma manufactures and sells four types of products under the brand names A, B, C and D.
The sales mix in value comprises of 33-1/3%, 41-2/3%, 16-2/3% and 8-1/3% of A, B, C and
D respectively. The total budgeted sales are Rs.60,000 per month.
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Operating costs of the company are as follows:
Product % of sale price

A 60%
B 68%
C 80%
D 40%
Fixed Cost is Rs.14,700 per month.
The company proposes to change the sales mix for the next month as follows and it is estimated
that total sales would be maintained at the same level as the current month:
Product Sales mix

A 25%
B 40%
C 30%
D 5%
You are required to calculate:

a) Break-even point for the products on an overall basis for the current month.
b) Break-even point for the products on an overall basis for the next month assuming that
the proposal is implemented
4.12 GLOSSARY
Relevant costs are the costs which would be impacted by managerial decisions. They are the
future cost whose magnitude will be effected by a decision.
Irrelevant costs are those which would not be effected by the decision.
Differential Costs The difference in total costs between two alternatives is termed as.
Opportunity Cost This cost means the value of benefit sacrificed in favour of an alternative
course of action.
Costing Systems are the systematic allocation of cost to products by following one or the other
available and suitable technique.
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Absorption costing The process of charging all costs, both variable and fixed, to operations,
products or process is known as absorption costing.
product, volume of activity and the resultant profit.
Break-even analysis is a actually a method to apply the CVP analysis in decision making
process by including many more related concepts into it.
All Formulas at a Glance

1. Basic Cost equation:
Total sales = Total Fixed Cost + Total variable Cost + Total Profit
TS = FC +VC + P
2. Contribution =Total Sales – Total Variable Cost
OR Contribution=Fixed Cost + Profit

3. P/V Ratio = Contribution X 100
Sales
Or Contribution per unit X 100

Sales per unit
Or change in contribution X 100

Change in sales
Or change in profit X 100

Change in sales
4. Break-even point (in units) = BEP = Fixed costs

5. Break-even Point (in Rs.) = BES = Fixed cost X Sales per unit
Or BEP in units * Selling Price per unit or Fixed Cost

P/v ratio
6. BEP with DP (in units) = Fixed cost + Desired profit
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7. BEP with DP (In Rs) = BES with DP = Fixed cost + Desired profit x Sales per unit
Or BEP with DP in units * Selling Price per unit
Or Fixed Cost + Desired Profit

P/V ratio
8. MOS (Absolute) = Actual Sales – Break Even Sales
MOS Can also be calculated with following Formula
MOS = Profit/P/V ratio
9. MOS (%) = (MOS/ Actual sales)*100
4.13 Answers to in-text Questions
1. b)20% 3. c) 15,00,000
2. b) 1,00,000 4. b) 45,00,000
Q1 What are various Cost concepts involved in managerial decision making?

Q2 What is Marginal Costing? How is it Different from Absorption Costing?
Q3 What is CVP analysis and what are is uses?
Q4 What are Advantages of Marginal Costing?
4.15 REFERENCES
• Study Material of Institute of Chartered Accountants of India
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• Study Material of Institute of Cost and management Accountant of India

• S.N. Maheshwari , Suneel Maheshwari , Sharad K. Maheshwari - A Textbook Of
Accounting For Management, Vikas Publishing House Pvt. Limited
• Asish K Bhattacharyya- Principles and Practice of Cost Accounting ,PHI learning

Private Limited
• R.S.N. Pillai, V. Bagavathi -Management Accounting , S. Chand and Company

Limited.
• M.Y. Khan P.K. Jain - Management Accounting: Text, Problems and Cases , Mc Graw
Hill Education
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LESSON 5
RELEVANT COSTS AND DECISION MAKING
Priya Dahiya
Assistant Professor
Jesus and Mary College
University of Delhi
Email-Id: priyadahiya102@gmail.com
&
Rinki Dahiya
Assistant Professor
Department of Economics
Shaheed Bhagat Singh College
University of Delhi
Email-Id: rinkydahiy95@gmail.com
STRUCTURE
5.2 Introduction
5.3 Relevant Costs and Decision Making
5.4 Key Factor
5.5 Product Profitability
5.6 Dropping a product line
5.7 Make or Buy
5.8 Export Order
5.9 Shut down vs. Continue operations.
5.10 Summary
5.11 Glossary
5.14 References
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At the end of studying the course material, the learner will be able to:
● Understanding the definition of marginal cost and the methods used in marginal costing
● Distinguish between marginal cost and differential cost.
● Describe cost analysis and relevant cost.
● To have an insight into the decision-making tools, the steps involved, and the associated
costs.
● After carefully evaluating all the information at your disposal, advise management on the
best course of action.
● To increase awareness of decision-involving-alternative-choices, which is crucial for society
or a country as a whole as well as for individual organisations.
5.2 INTRODUCTION
The use of marginal costing is crucial for cost management, business decision-making, and the
resolution of numerous business issues. It is known as a variable costing technique as well. The
overall cost of a company is typically split into two categories: fixed costs and variable costs.
Due to the fact that fixed costs do not fluctuate with changes in output up to a certain point,
they are often referred to as period costs. Variable costs, on the other hand, are directly related
to changes in production and are therefore referred to as product costs. This variable cost is
known as the marginal cost, which is based on the idea that fixed costs are unpredictable and
should not be taken into account when determining the cost of manufacturing.
A method of calculating marginal cost that takes into account how cost and profit fluctuate as
volume changes is known as marginal costing. The variable cost is taken into account while
making the decision.
If a firm produced 100 units at a variable cost of Rs. 10 per unit and a fixed cost of Rs. 5000
then the overall cost, would be Rs. 1000 + Rs. 5000 = Rs. 6000. However, if the company
produced an additional unit, only the variable cost would vary; the fixed cost would remain the
same. Now the entire cost is Rs 1010 Plus Rs 5000, which is Rs 6010. Therefore, the selection
will be made based on variable costs. This method is referred to as marginal costing, and the
additional cost of producing one unit, or Rs. 10, is referred to as the marginal cost.
Differentiating between "Differential cost" and "Marginal cost"
The term "marginal cost" refers to the increase or decrease in overall costs that results from a
relatively minor change in output, such as a unit of output.
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Variable costs are the equivalent of marginal costs in cost accounting. The term "differential
cost" refers to the variation (increase or decrease) in the overall cost (variable as well as fixed)
brought on by changes in the intensity of the activity, the use of technology, the production
process, or the production technique.
In other words, it is the cost of a single unit of a good or service that might have been avoided
if it hadn't been made or offered.
The primary difference between marginal cost and differential is the shift in fixed costs that
occurs when production volume changes by one unit of production. In the case of differential
costing, both costs—variable and fixed—change as a result of changes in the level of activity,
whereas under marginal costing, only variable costs are affected by these changes.
Making managerial decisions using incremental cost strategies
It is a method for creating ad-hoc information where only the variations in costs and profits
between potential courses of action are taken into account. This method can be used in
circumstances when operating cost change.
To compare incremental costs and incremental revenues is a necessary prerequisite before
employing the incremental cost technique to make managerial decisions. The idea should be
approved as long as the incremental revenue exceeds the incremental costs.
Making managerial decisions using incremental cost strategies The following are some key
instances where managerial decision-making could benefit from the application of incremental
cost analysis: the launch of a new product, discontinuing a product, stopping operations, or
shutting down a division of the company; if a product needs to be processed any further;
acceptance of a second order from a particular customer at a discounted rate; Make or purchase
choices; submitting a bid; Choosing to buy or lease; decisions on replacing equipment.
5.3 RELEVANT COST AND DECISION MAKING
The act of making decisions by selecting the best option from a variety of alternatives is known
as decision-making. It is a technique for identifying the numerous problem-solving possibilities
and picking the optimal one. It is a method that improves the profitability and thoughtfulness of
decisions. The management uses the marginal costing technique to come at logical conclusions.
For instance, choosing the best sales or product mix, deciding whether to manufacture or
purchase any certain product, etc.
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However, because the environment is constantly changing, no choice is ever useful. Making
decisions is a continual and iterative process. Top management has a responsibility to make
wise decisions in unclear or risky circumstances that call for knowledge, skills, and experience.
Cost Related with Decision Making
The division of the total costs into pertinent types is called cost analysis. It is crucial for
decision-making as well as cost management.
Costs are categorized for decision-making and control purposes based on their applicability to
the various decision- and control-related functions.
Relevant Cost: Relevant cost are those anticipated future expenses that are crucial to a choice.
The following are the two main components:
• Future expenses must be anticipated.
• The alternate course of action must differ from them.
These are costs that will arise in the future and may be impacted by management decisions
changing. Variable costs, which may be additional or avoidable, are the relevant costs. If a cost
varies while comparing many alternatives, that specific cost will be considered important.
Assume a company purchased machinery costing Rs 10,000 and now its book value remains Rs
1,000. The equipment has become outdated but can still be modified at a cost of Rs 500 and
sold for Rs 2000. Both Rs. 2000 and Rs. 500 will be pertinent costs in this case.
Costs that fluctuate in relation to a particular decision are considered relevant costs. Sunk
expenses have no application. Future expenses could or might not be important. Future
expenses are irrelevant if they will be incurred regardless of the choice that is made. Future
expenses that are unimportant are committed costs. Even if the costs in the future are not
committed, they are irrelevant if we expect to suffer them regardless of the choice we choose.
Differential cost is the difference between the overall cost before and after a management
decision. Costs might be increased or decreased. It is a crucial concept for making decisions.
When a decision is made to choose one alternative over another, the total cost may increase;
this is known as an incremental differential cost. In contrast, if overall costs drop by choosing
one option over another, this is known as a decremental differential cost.
Costs could go up or down as a result of changes in manufacturing methods, production
volume, and production mix, among other things. Differential costs are the increase or decrease
in total expenses at one level of activity relative to another. The alternative course of action
might be necessary due to a change in sales volume, an alternative method of production, a
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change in the product/sales mix, decisions about whether to buy or not, whether to accept or
reject an offer, the addition of a new product, market research, the decision to discontinue a
product line, etc.
For instance, if the cost of sales at the current level of activity (50 percent capacity) is Rs.
1,00,000 and the predicted cost of sales at 60 percent capacity is Rs. 1,20,000, the differential
cost will be Rs. 1,00,000 – Rs. 1,20,000 = Rs. 20,000.
Opportunity Cost: An opportunity cost is a benefit given up while selecting one course of
action over another. Profits that are sacrificed when picking an alternative are referred to as
opportunity costs. If a resource were put to its next best use, a net return would be possible. It
comes from "the way not taken," and is "what we give up."
The profit lost while choosing one option over another is known as the opportunity cost.
Opportunity costs are important for many decisions, but they can be challenging to detect and
measure. Moreover, they are rarely recorded in the accounting system of a firm.
When comparing alternatives, the opportunity cost—the worth of the opportunity lost—is taken
into account. When one or more of the inputs needed by one or more alternative courses of
action are already accessible, it helps management determine profitability.
For instance, a manufacturer can create either a table or a chair. One chair is worth Rs. 500, and
a table is worth Rs. 700. Due to a lack of resources, the manufacturer decides to build chairs
rather than tables. Opportunity cost is the worth of the table that was given up in favour of the
chair (Rs. 700).
Shut down Cost: This fixed cost is incurred when a division, department, or company is
shutting down. Since variable costs are not incurred if manufacturing is not completed.
However, some business-related fixed costs that cannot be avoided, such as salaries and
depreciation, are referred to as shut-down costs.
Depending on the nature of the industry, certain fixed expenses can be avoided when a
company suspends its production operations, while other permanent expenses may be added.
The company will cut some discretionary fixed expenditures and some variable costs of
production by ceasing manufacture. The term "shut-down cost" refers to this specific
discretionary expense.
Imputed Cost: Expenses that are allegedly incurred but are not paid for in cash are known as
imputed costs. Imputed costs, commonly referred to as hidden costs or implicit costs, are the
costs associated with the production elements that a company owns and employs. Because the
company does not separately disclose it on its financial accounts, it is referred to as a "imputed"
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expense. Even if implicit costs may not include a monetary outlay, they nonetheless count as
production costs. For instance, interest on capital that is required for management decisions but
is not really paid.
Out-of-Pocket Costs: Out-of-pocket expenses are those that call for a cash payment. It is a
payment made directly out of pocket that may or may not be later repaid by another party.
Costs that must be paid for out-of-pocket include those for materials, labour, costs, etc. Out-of-
pocket costs do not include costs that are not paid in cash as depreciation.
For instance, out-of-pocket expenses for a journey when using a car include gas, parking fees,
and tolls. Interest, car insurance, and oil changes are not because the initial outlay pays for
costs accumulated over a longer period of time.
On the other hand, not all non-cash charges, such depreciation and amortisation, are regarded
as out-of-pocket expenses. Furthermore, substantial expenses like those for fixed assets or
planned expenses like those for supplier invoices submitted on time are not regarded as out-of-
pocket costs.
Sunk Cost: Sunk cost is the expense incurred as a result of a post-choice that cannot be
changed by another decision made at a later time. It is an expense that cannot be recovered
once it has been made. Since these expenses have already been incurred, they are not important
for management choices. Sunk costs, such as investments in fixed assets, refer to decisions that
have costs connected with them that are not recoverable. Similarly, the book value of the
existing plant should be treated as sunk cost if the decision to replace it must be made since it is
unrelated to the replacement decision.
Therefore, sunk cost refers to expenditure that has already occurred and is not recoupable under
the circumstances. Sunk costs are hence irrelevant costs for decisions that will have an impact
in the future. For instance, if you have a non-refundable concert ticket and are feeling under the
weather, you could still go anyway since you do not want to waste the ticket. But, the money
used to purchase the ticket has already been spent, so whether it cost Rs.500 or Rs.1000 is
completely unimportant. The only factor that matters is whether you would enjoy the event
more if you went or stayed home on the night of the show.
Escapable Cost: An avoidable expense, also known as an escapable expense, is a cost that
won't materialise as a result of the closure of a department, the suspension of an activity, or the
discontinuation of a good. In other words, it's a cost that can be reduced by stopping certain
processes. When considering firm downsizing, ending goods, or moving activities,
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management must look into avoidable costs because they are costs that the business can avoid
if specific actions are made.
Therefore, the costs that can be avoided during the production process are referred to as
escapable those, whereas costs that cannot be avoided are referred to as unavoidable costs. For
instance, management may think about consolidating or shutting down a department if a factory
is operating poorly and consistently losing money every quarter. You must consider the savings
that will result from closing a department or branch before making the dramatic decision.
5.4 KEY FACTOR
A restricting or discouraging impact on sales volume, production, labour, materials, and other
variables is known as a key factor. Often, the limiting factor varies from one to another.
Businesses must consider a variety of constraints while planning their activities: Limited
demand, a shortage of competent workers and other manufacturing resources, and a scarcity of
money (sometimes known as "capital rationing"). Like, a company may not be able to
manufacture as many units as it would want to owing to a labour shortage this month brought
on by illness.
Men (employees), Materials (raw materials or supplies), Machines (capacity), or Money
(availability of fund or budget) may be the limiting factors from the supply side, while the
demand for the product, as well as other factors like its nature, regulatory and environmental
requirements, etc., may be the limiting factor from the demand side. The management's goal
while making decisions is to utilise essential resources as fully as feasible.
Key factor analysis is a technique for making quick decisions when there is only one limiting
factor. It is preferable to utilise linear programming when there are two or more scarce
resources.
For instance,
• Sales volume: The production of the required number of articles is the limiting constraint.
• Production volume is limited by a lack of sufficient raw resources, manpower, the inability
to market the goods produced, and other variables.
In light of the contribution, the limiting variables are examined. The limiting factor has an
inverse connection with contribution volume. The contribution is taken into consideration as a
criterion to rank them one after another in order to evaluate the value of business ideas among
the limiting considerations.
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The goal of questions is typically to maximise profit. The strategy should be to maximise the
contribution made because fixed expenses aren't impacted by production choices in the short
term.
Key factor analysis is the most effective method for resolving issues where there is just one
limiting factor.
Step 1: Identify the scarce resource.
Step 2: To figure out how much each product contributes each unit.
Step 3: Determine how much of the contribution per unit of the scarce resource for each
product.
Step 4: Sort or rank the items according to their contribution to the scarce resource per unit of
production.
Step 5: Use this rating to distribute or allocate the resources.
Example- Which product would you suggest being produced in a factory based on the
information below, with time being the key?
Particulars Product A (per unit in Rs. ) Product B (per unit in Rs.)
Direct Labour @ Rs. 2 per 6 8
hour
Variable overheads @ Rs. 4 12 16
per hour
Selling Price 200 250

Standard Hour to 3 Hours 4 Hours
manufacture
Solution- The manufacturer selects the product based on its potential to provide a higher
contribution. The status of the company improves with more contribution.
Particular Product A (per unit in Rs. ) Product A (per unit in Rs. )
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Less: Direct Material 30 20

Direct Labour 6 8
Variable overheads 12 16
Contribution 152 206
Standard Hour to 3 Hours 4 Hours
manufacture
Contribution per hour per 152 / 3 Hours = Rs. 50.66 206 / 4 Hours = Rs. 51.5
product
(Contribution / Standard
Hour to manufacture)
The following computation clearly shows that the firm has a higher contribution margin per
hour for Product B than for Product A, indicating that Product B is superior to Product A.
Therefore, managers have to take various timely decisions out of various alternatives. Marginal
costing is a technique to take effective decision such as profit planning, deciding optimum
product policy, make or buy decision of a product, etc. Following are some important
management problems regarding which management has to take decision:
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IN-TEXT QUESTIONS
1. State whether the following are True or False:
a) Sunk expenses might occasionally be important when making decisions.
b) When deciding whether to replace a machine with another equipment,
consideration should be given to the book value of the machine as
represented on the balance sheet.
c) Sunk costs are fixed costs that do not vary between alternatives.
d) Fixed costs have no impact on a decision.
e) A decision regarding whether to accept or reject a special offer for a
company's goods often depends on the depreciation expense on current
factory equipment.
f) Avoidable costs are important while making decisions.
2. Opportunity costs:
A) Important for making decisions. B) the exact same costs as in the past.
C) Equal to variable expenses. D) are not considered when making
decisions.
3. The following is the opportunity cost of producing a component part at a
factory without surplus capacity:
A) The component's variable production cost.
B) The component's fixed production cost.
C) The component's overall production cost.
D) The net benefit lost from the best possible alternative use of the needed
capacity.
4. A business should focus on the items that have:
A) The largest unit contribution margins when manufacturing is limited.
B) The ratios with the highest contribution margins.
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5.5 PRODUCT PROFITABILTY
In the event that a company produces multiple products, the issue of the product mix that
maximises profitability will arise. Due to a lack of resources or capabilities, the company must
deal with this issue. A company should use a combination of sales that results in higher profit
or maximum contribution. The key or limiting component should also be taken into account
while choosing the profitable blend.
For example- The following describes a company's sales/production mix:
1. The company produce 500 units each of Product A and Product B.
2. 1500 units of product C.
3. 300 units each of product B and C, and 500 units of product A.
Particulars Product A (Rs.) Product B (Rs.) Product C (Rs.)
Direct Material 5 5 6
Direct Labour 3 5 4
Variable Cost 4 4 3
Fixed Cost 1500 1500 1500
Selling Price 20 30 25
Determine the profitable product mix.

Solution- First of all let us calculate the contribution per unit. Formula to calculate
Contribution per unit = Selling Price – (Direct material + Direct Labour + Variable cost)
Contribution per unit Product A = 20 – (5+3+4) = Rs. 8 per unit
Contribution per unit Product B = 30 – (5+5+4) = Rs. 16 per unit
Contribution per unit Product C = 25 – (6+4+3) = Rs. 12 per unit
Then, evaluate different alternative one by one:
Alternative 1: The company produce 500 units each of Product A and Product B.
Total Contribution = (Contribution per unit Product A x No. of units of Product A) +
(Contribution per unit Product B x No. of units of Product B)
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= (Rs.8 per unit x 500 units) + (Rs. 16 per unit x 500 units)
= Rs. 4000 + Rs. 8000 = Rs. 12,000
Profit = Total Contribution – Fixed cost
= 12,000 – 1500
= Rs. 10500
Alternative 2: 1500 units of Product C.
Total Contribution = (Contribution per unit Product C x No. of units of Product C)
= (Rs.12 per unit x 1500 units)
= Rs. 18000
= 18,000 – 1500
= Rs. 16500
Alternative 3: 300 units each of product B and C, and 500 units of product A.
(Contribution per unit Product B x No. of units of Product B) +
(Contribution per unit Product C x No. of units of Product C)
= (Rs.8 per unit x 500 units) + (Rs. 16 per unit x 300 units) +
(Rs. 12 per unit x 300 units)
= Rs. 4000 + Rs. 4800 + Rs. 3600 = Rs. 12,400
= 12,400 – 1500
= Rs. 10900
Conclusion: As a result of its larger profit of Rs. 16500, product mix 2 is more profitable than
the other product mixes.
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5.6 DROPPING A PRODUCT LINE
When a company produces multiple products and needs to stop one of them, management
should make a decision based on the product's contribution, the impact on sales of other
products, the plant's capacity, etc. Using the marginal costing technique, management can
decide whether to add or remove a product or product line. The product that contributes the
least should be discontinued.
Since the goal of every corporate organisation is to maximise profits, the company can think
about the efficiencies of doing away with unproductive items and replacing them with more
lucrative ones (s).
In such circumstances, the company may have two options, as follows:
(a) To discontinue the unprofitable product and not use the available capacity.
(b) To stop producing the unprofitable product and use the available resources to start
producing a more lucrative product.
For choosing whether to add or remove a product line the contribution technique is used for this
purpose, accounting for the following elements:
• Contribution from a product that isn't viable (i.e., Sale Revenue Less Variable Costs)
• Specific unprofitable product fixed costs that can now be avoided or minimised.
• Contribution from a different profitable product that would be produced using all available
capacity.
The following considerations should be made into account whenever a decision is made on
whether or not the capacity will be increased.
• Additional fixed costs will be incurred.

• Possibility of a drop in selling price as a result of increased output.
• Whether there is enough demand to accommodate the extra production.
• The cost schedule will be developed based on the aforementioned points.
• The division of fixed expenses and the marginal contribution cost must be considered
while considering whether to shrink the firm.
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Example: XYZ Ltd. manufactures three products:

A — 500 units @ Selling price Rs. 25 Per unit.
B — 400 units @ Selling price Rs. 30 Per unit.
C — 300 units @ Selling price Rs. 28 Per unit.
The company decides to stop producing one product, which will result in a 50% increase in the
production of other products. The other details are as follow:
Particulars Product A (Rs.) Product B (Rs.) Product C (Rs.)
Direct Labour 4 7 6
Variable cost 6 5 4
Fixed cost 8 7 9
You must determine which product needs to be discontinued.

Solution: First of all, let us calculate the contribution per unit. Formula to calculate
Contribution per unit = Selling Price – (Direct material + Direct Labour + Variable cost)
Contribution per unit Product A = 25 – (5+4+6) = Rs. 10 per unit
Contribution per unit Product B = 30 – (6+7+5) = Rs. 12 per unit
Contribution per unit Product C = 28 – (7+6+4) = Rs. 11 per unit
Situation 1: Now let us suppose that production of products B and C will each be boosted by
50% if product A is discontinued. 600 units of B and 450 units of C would be produced,
respectively.
Total Contribution = (Contribution per unit Product B x No. of units of Product B) +
= Rs. 7200 + Rs. 4950 = Rs. 12,150
Total Fixed Cost= (Fixed Cost per unit Product B x No. of units of Product B) +
(Fixed cost per unit Product C x No. of units of Product C)
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= (Rs.7 x 600) + (Rs. 9 x 450)

= Rs. 4200 + Rs. 4050
= Rs. 8250
= 12,150 – 8250
= Rs. 3900
Situation 2: Now let us suppose that production of products A and C will each be boosted by
50% if product B is discontinued. 750 units of A and 450 units of C would be produced,
respectively.
= Rs. 7500 + Rs. 4950 = Rs. 12,450
Total Fixed Cost= (Fixed Cost per unit Product A x No. of units of Product A) +
(Fixed cost per unit Product C x No. of units of Product C)
= (Rs.8 x 750) + (Rs. 9 x 450)
= Rs. 6000 + Rs. 4050
= Rs.10050
= 12,450 – 10,050
= Rs. 2400
Situation 3: Now let us suppose that production of products A and B will each be boosted by
50% if product C is discontinued. 750 units of A and 600 units of B would be produced,
respectively.
(Contribution per unit Product B x No. of units of Product B)
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= Rs. 7500 + Rs. 7200 = Rs. 14,700

Total Fixed Cost= (Fixed Cost per unit Product A x No. of units of Product A) +
(Fixed cost per unit Product B x No. of units of Product B)
= (Rs.8 x 750) + (Rs. 7 x 600)
= Rs. 6000 + Rs. 4200
= Rs.10200
= 14,700 – 10,200
= Rs. 4500
Conclusion: If product C is discontinued, production of products A and B will each be boosted
by 50%. As a result of its larger profit of Rs. 4500, this product mix is more profitable than the
other product mixes.
5.7 MAKE OR BUY
A company must decide whether to buy a product or make it on its own. If a company creates a
product or a component of a product, it will have some fixed or variable costs. If the company
gets the product from the market, it will need to choose the supplier by looking at the seller's
financial stability, consistency of supply, and reliability. After weighing the advantages and
disadvantages of the two possibilities, a decision should be made. It is wise to buy the product
from the market rather than having the company manufacture it if the cost of buying is less than
the marginal cost of producing.
The relevant factors to take into account when deciding whether to make or buy are -Relations
at work, cost of production and acquisition, Quality of goods supplied by supplier, labour force
readily available to produce the commodity, Potential utilisation of facilities and capacity
connected to the purchase rather than production, cost of layoffs of employees and whether it is
possible to add capacity or increase the current capacity.
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For Example- The following are the costs involved in producing a product:
Particulars Rs.
Direct Material 9
Direct Labour 7
Variable cost 6
Fixed cost 3
Total Cost 25
A business discovers that although producing a product internally costs Rs. 25, purchasing it
from the market costs Rs. 20 per unit with consistent supply. Give the business your
recommendations on whether to produce or purchase the goods.
Solution- The choice should be made using marginal cost, leaving away the fixed cost that must
be incurred even if you make the product or buy it from outside.
Marginal cost of product manufactured:
Direct Material 9
Direct Labour 7
Variable cost 6
Total 22
Therefore, it is wise to buy the product from outside because purchasing it from the market
costs Rs. 20 per unit which is Rs. 7, is lower than the cost of manufacturing the product which
is Rs. 22 per unit.
5.8 EXPORT ORDER
To capitalize through large scale production, a company must accept the additional order of
production if its plant capacity is still underutilised. Because there are no additional fixed costs
associated with such orders, a company should opt to accept them at a lower price than the
market. If total profits increase as a result of the order's acceptance, the company should decide
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to accept the new order. The company may use its excess capacity to satisfy demand coming
from either new domestic or international markets.
When a company has excess capacity, it might consider using it to fill export orders at a
discount from what is going on in the local market. The choice is only made if the local sale is
profitable i.e., in cases where local sales have already covered fixed costs. It is advantageous to
enter the export market in these circumstances if the export price is higher than the marginal
cost. Any price decrease made in the local market to make up for excess capacity may have an
impact on regular local sales.
For Example: ABC Ltd Company sells 10,000 units per month at a cost of Rs. 50 per unit while
operating at 50% capacity. The product's price per unit is listed below:
Direct Material Rs. 20
Direct Labour Rs. 10
Variable Cost Rs. 5
Total Cost Rs. 35
The fixed cost incurred by the company are Rs. 50000. Now, the company received an order of
10000 units from foreign market at a price of Rs. 40 per unit. In the case that the company
accepts the order, fixed cost will rise by 10%. Indicate whether or not the business should
accept the order.
Solution- The company is currently operating at 50% capacity, but in order to create an
additional 10,000 units, it will need to operate at 100% capacity.
Comparative profitability statement
Particulars Present Proposed Total

(At capacity 10000 (Additional
Units) order 10000
units)
Rs.
Rs.
Selling Price per unit 50 40
Sales 500000 400000 900000
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Less- Direct Material 200000 200000 400000

Direct Labour 100000 100000 200000
Variable Cost 50000 50000 100000
Contribution 150000 50000 200000
Less- Fixed Cost 50000 5000 55000
Profit 100000 45000 145000
The order should be accepted by the firm because doing so will improve overall profitability.
5.9 SHUT DOWN VS. CONTINUE OPERATIONS
When a corporation decides to shut down, it signifies that production will stop temporarily.
That indicates that the company will restart production in the future. Reasons of shut down
production include- decline in demand; financial difficulty; high tax rates and technological
change; inadequate raw material availability a market downturn and mismanagement.
In general, all businesses should have greater revenue than total cost (Revenue > Total Cost) in
order to remain in operation. But in the short run, all businesses disregard fixed costs; as a
result, Revenue must be equal to or higher than variable cost.
If the items are helping to pay for fixed costs, or if the selling price is higher than the marginal
cost then it is preferable to continue because the losses are kept to a minimum.
Shut Down Point determines whether to shut down. The shutdown point describes the precise
point at which a company's revenue and variable costs are equal. labour costs, supplies for
production, and other varying costs. It describes the precise point at which a company's revenue
and variable costs are equal. A corporation is said to be operating at a shutdown point when
there is no advantage to continuing such operations. in order to decide to temporarily or, in
certain situations, permanently shut down.
Depending on the nature of the industry, certain fixed expenses can be avoided by pausing
production while other fixed expenses may go up.
The contribution must be more than the difference between fixed expenses incurred during
normal operation and fixed expenses incurred during plant shutdown before a decision can be
made. The formula below can be used to determine the shutdown point.
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Shutdown point is calculated as Total Fixed Cost – Shutdown Cost = Contribution per unit
1. A short-run criterion
Depending on the company, the short-run is for a finite amount of time, such as quarterly, half-
yearly, or yearly. For choosing whether to stop or continue in short run, only variable cost is
taken into account during the short-term outage. In other words, we analyse whether or not the
business can cover its variable costs for the short period during which sales occur. Otherwise,
the Firm must close.
As an illustration, suppose a company's income is Rs. 500 and its variable cost is Rs. 400. then
the contribution will be Rs. 100. There is no need to turn the product off in this case. However,
the corporation must discontinue that product if the variable cost exceeds the sales.
2. Long-term criterion
Depending on the sort of business, the long run may be annually or more frequently than
annually. Both fixed and variable costs are taken into account when considering a long-term
shutdown. As an illustration, let's say a corporation sells for Rs. 500, with Rs. 450 in variable
costs and Rs. 100 in fixed costs. Then a loss of Rs. 50 occurs.
That suggests that while the business won't last in the long run, it will likely survive in the short
term.
Marginal costs are useful when a department or product is being discontinued. The marginal
costing technique demonstrates how each product affects the profit at fixed costs. If a
department or product makes the smallest contribution, it may be closed or its production may
be stopped. It implies that just the product with the highest level of contribution should be used,
and the rest should be discarded.
5.10 SUMMARY
Making decisions entails selecting one option over another. Making decisions requires careful
consideration of a wide range of quantitative and qualitative elements. Cost is a fairly elusive
concept; depending on the context, it can mean multiple things.
Choosing the optimal course of action is fundamentally a process of weighing the pros and
cons of each possibility in light of the information at hand. There is no decision to be made if
there is no alternative to the existing course of action. Nonetheless, it is uncommon for there to
be no alternatives for any course of action. In making personal decisions, elements besides
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income and expenses, such qualitative factors, may be more significant than cost. But in
business, decisions are typically made by figuring out which option will bring in the greatest
money or incur the fewest expenses.
A cost accountant and management accountant thoroughly analyses each circumstance to
determine the type of cost concepts to use and plays a crucial role in decision-making by
providing management with accurate and pertinent data. Prediction is a component of decision-
making that cannot alter the past but is predicted to have an impact on the future.
Marginal costing is a technique that is frequently used in managerial decision-making. The
following are some examples of how marginal costing is used in routine decision-making-
Product Profitability; Dropping a product line; Make or Buy; Export Order and Shut down vs.
Continue operations.
5.11 GLOSSARY
Sunk costs: Expenses that have already been incurred. Sunk costs cannot be adjusted, hence
they are meaningless for decisions.
Escapable Cost: Costs that can be avoided during the production process are referred to as
escapable those, whereas costs that cannot be avoided are referred to as unavoidable costs.
Imputed Cost: Expenses that are allegedly incurred but are not paid for in cash are known as
imputed costs.
Key Factor: Anything which restricts an entity's action is a limiting factor. It is essential in
determining the volume of sales and output.
Opportunity cost: The revenue lost as a result of choosing one option over another.
Out of pocket Cost: Out-of-pocket expenses are those that call for a cash payment.
Relevant Cost: A cost is considered relevant if it would change if a different course of action
were chosen. Differential costs are another name for relevant costs.
Historical Cost: The expense has already been incurred and has no impact on the choice. For
instance, the book value of machinery.
Committed Cost: The agreed-upon costs known as committed costs are those that, in most
cases, cannot be changed. There is a sunk cost as well. Examples include the cost of materials
at the agreed upon rate, the cost of staff salaries, etc.
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1. (a) False 2. (a)

(b) False 3. (d)
(c) False 4. (C)
(d) False
(e) True
20. What exactly do you mean by differential costing? What distinguishes it from managerial
costing?
21. What are relevant costs and irrelevant costs, in your opinion?
22. Describe differential cost in detail.
23. Distinguish between:
(a) Relevant cost and Irrelevant cost
(b) Out of pocket cost and Imputed cost
(c) Avoidable cost and unavoidable cost
24. 5,000 pieces are being produced by Star Company Ltd, and their cost information is as
follows:
Variable cost: Rs. 20 per unit
Fixed costs: Rs. 10
Total cost: Rs. 30
The same product is available from a manufacturer for Rs. 25 per unit. According to the
examination of the cost data, fixed overhead costs of Rs. 20,000 will be spent regardless of
production. You are asked to recommend whether Star Ltd. should produce or purchase the
article.
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25. Which product would you suggest being produced in a factory based on the information
below, with time being the key?
Particulars Product A (per unit Product B (per unit
in Rs. ) in Rs.)
Direct Labour @ Rs. 5 per hour 10 15
Variable overheads @ Rs. 3 per hour 06 09

Standard Hour to manufacture 2 Hours 3 Hours
26. The following describes a company's sales/production mix. Determine the profitable
product mix.
(a) The company produce 550 units each of Product X and Product Y.
(b) 1600 units of product Z.
(c) 380 units each of product Y and Z, and 320 units of product X.
Particulars Product X (Rs.) Product Y (Rs.) Product Z (Rs.)

Direct Labour 13 15 14
Variable Cost 14 14 13
Fixed Cost 2550 2550 2550
Selling Price 220 280 250
5.14 REFERENCES
• Arora, M. N. Cost and Management Accounting-Principles and Practice. Vikas Publishing

House, New Delhi.
• Datar, S. M. & Rajan, M. V. (2018). Horngren's Cost Accounting: A Managerial Emphasis,
Global Edition. Pearson Education Limited: London.
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• Jain, S.P., and K. L. Narang. Cost Accounting: Principles and Methods. Kalyani Publishers,
Jalandhar.
• Kishore, Ravi M. Strategic Management – Text & Cases. Taxmann Publications Pvt. Ltd.
New Delhi.
• Lal, Jawahar & Seema Srivastava. Cost Accounting. McGraw Hill Publishing Co., New
Delhi.
• Maheshwari, S. N., & S. N. Mittal. Cost Accounting. Theory and Problems. Shri Mahabir
Book Depot, New Delhi.
• Davidson, Maher, Stickney, Weil. (1991). Managerial Accounting, Holt-Sounders

International Editions, New York.
• J. Lewis Brown, Leslie R. Howard (1986). Managerial Accounting and Finance, Machonald
& Evans Ltd., London.
• Jauch, Lawrence R. & Glueck, William. Business Policy & Strategic Management.
McGraw-Hill.
• Nigam and Sharma. (1999). Advanced Cost Accounting, Himalaya Publishing House,
Bombay.
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LESSON 6
BUDGETS AND BUDGETARY CONTROL

Ms. Shalu Garg
Assistant Professor
shalugarg11901@gmail.com
STRUCTURE

6.2 Introduction
6.3 Meaning of Budget and Steps in Budgetary Control
6.3.1 Meaning of Budget
6.3.2 Objectives and Functions of Budgeting
6.3.3 Advantages of Budgeting
6.3.4 Disadvantages of Budgeting
6.3.5 Steps in Budgetary Control
6.4 Types of Budgets
6.4.1 Sales Budget
6.4.2 Production Budget
6.4.3 Raw Material Consumption Budget
6.4.4 Raw Material Purchase Budget
6.4.5 Overheads Budget
6.4.6 Cash Budget
6.4.7 Master Budget
6 .4.8 Fixed and Flexible Budget
6.5 Zero-Based Budgeting
6.6 Summary
6.7 Glossary
6.8 Answers to In-text Questions
6.10 References
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The objective of learning budgets and budgetary control would be to know the basic meaning
of budget and how can we control the budgets. What measures can be taken to control the
budget which is going above expectations. After reading the lesson, learners will be able to:
• Define what is Budget.

• Understand the basic objectives and functions of the Budget.
• Understand the advantages and disadvantages of the Budget.
• Explain the steps which have to be taken in Budgetary control.
• Know the various types of Budgets.
• Differentiate between Fixed and Flexible Budgeting.
• Explain the concept of Zero-Based Budgeting.
6.2 INTRODUCTION
In the previous chapter, we have learned about the Cost Volume Profit analysis, and Break-
even analysis. We also learned how some factor serves as key factor and influences our
decision making and also impacts the profitability of the business.
In this chapter, we will be going to learn the meaning of budget, various types of budgets, and
how to control those budgets.
Budgets are not a fancy tool in fact this tool is used in our day-to-day life. We use it almost
daily in our routine. Let us suppose you are going on a trip with your parents or the family, the
very first thing which comes to your mind is the place which you want to visit then the
expenses which will be used for the trip like traveling, accommodation. So, when we prepare a
rough estimate, we are preparing the budget. Even housewives also make budgets when they
plan their monthly expenditures that it would be a certain amount.
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Fig 6.1: Image Source: https://www.thebalance.com/how-to-make-a-budget-1289587
6.3 MEANING OF BUDGET AND STEPS IN BUDGETARY
6.3.1 Meaning of Budget:

A Budget is a
• Financial Statement
• In Quantitative terms
• Prepared for a defined period of time
• For achieving some objective
• Includes income and expenditure
So in simple words, I can say that when we need to plan our finances or money we prepare a
budget so that we can make better use of our financial resources(money). A budget is a
blueprint on which every organization has to work so as to achieve the goals and objectives of
the organization. It helps in communicating all the employees about the strategies and the long-
term policies of the organization.
It also serves as a control tool the management. With the help of the budget, management can
easily evaluate the performance of the employees and the business. It is not a substitute for
management but a tool that aids management.
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ACTIVITY
Suppose you are going on a trip, prepare a small Budget including all the
estimated expenditures. Keep certain points in mind while preparing the budget:
1. It is in financial terms
2. It only involves quantitative aspect
3. It has certain defined period of time
6.3.2 Objectives and Functions of Budgeting:

For a successful budget, the budget needs to fulfil certain objectives and functions. Those
objectives and functions are given below:
a) Helps in Planning- Preparing the budget requires planning as in every other field in the
business requires planning. In business, there are some defined goals and objectives set by
the management. In order to achieve those objectives business prepares some strategies
and long-term policies, on the basis of these objectives and strategies budgets are prepared.
b) Helps improve Coordination- When the business has defined objectives and strategies
everyone knows what the goals of the organization are. So, when the budgets are prepared
everyone has a clear picture in their mind that what is expected from them. All the work is
aligned to those budgets, and it brings coordination among all the departments and the
employees.
c) Helps in improving Communication- In the process of preparing of budget, we should
involve all the employees so that they can also give their opinion in the budget making. It
is important to involve employees because ultimately, they have to do the work with the
help of the managers. It will also improve communication between the higher authorities
and the employees, and they will feel dedicated to the work to which they also have
contributed.
d) Helps in Control- The budget acts as a great tool for control purposes. When we have
involved the employees also in the process of preparing the budget then we can easily
make them accountable for the deviations in the budgeted or planned or estimated activity
and the actual activity.
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e) Helps in Performance Evaluation- When we compare the budgeted or estimated or planned

activity with the actual activity, we can easily be able to find out the deviations. And we
can also evaluate the performance of the employees whether they have achieved the goals
of the business or not.
6.3.3 Advantages of Budgeting:
The budget helps in achieving so many objectives and also helps in the efficient use of
resources like finance, material, etc. Apart from these advantages, there are many more
advantages of budgeting. The following advantages are:
a) Provides motivation to management- Budgeting helps the manager in making quicker
decisions. It also motivates the manager in finding out the deviations and taking
precautionary measures towards any deviation found in the early stages.
b) Plan for spending- Budgeting helps in providing the correct means of using the resources.
It helps in the optimum utilization of the resources and the funds available to the business.
c) Tool for evaluation- With the help of budgeting, management can easily evaluate the
success of the budgets. It can also find out the level of attainment of the goals and the
objectives.
d) Finding deviations- The budget compares the estimated activity or the planned activity
with the actual level of activity and if there is some difference between the two that is
known as deviation. So, with the help of budgeting, management can easily find how much
deviation is there from the standard or the yardstick.
e) Develops attitude of Cost Consciousness- With the introduction of a budgeting system in
the organization, an environment of cost consciousness develops. With budgeting,
everyone in the organization knows what the goals and objectives of the business are. It
also leads to efficient utilization of resources.
f) Provides a standard- Budgeting provides a yardstick on which the performance of the
employees, the management, and the business is evaluated. With budgets, we can easily
compare the budgeted activity and the planned activity and find out the deviations.
6.3.4 Disadvantages of Budgeting:
Despite of being so many advantages of budgeting, there are some limitations too. The
following are the limitations or disadvantages of budgeting:
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a) Not an Exact Science- Budgeting depends on estimation. It is subjective in nature and one
who is making the budget uses his judgment accordingly. So, it is not an exact science
where everything is accurate in nature.
b) Requires Cooperation from all- The success of the budgeting depends on the coordination
and cooperation between all the departments, management, and employees. When everyone
in the organization put their all effort then only the organization will be able to achieve its
goals and objectives.
c) Not the substitute for Management- Budget only acts as a tool for controlling purposes but it
can’t take the place of management altogether. It can help in fulfilling the goals and
objectives of the business by fulfilling all the managerial functions.
d) Time Consuming Process- The activity of preparing a budget is in itself a tedious task. It
takes lots of effort and lots of time to prepare a budget that will be going to attain the goals
and objectives of the business.
e) Budget Slack by employees- The term budget slack means when management puts lots of
pressure on the lower-level employees for achieving the results then there are chances that
those employees can provide inaccurate future costs and revenue to the top-level
management.
f) Sub-optimal profits for the company- At the end of the period of the budget when lover level
employees found the expenses which taken place are way less than those planned then they
have an urge to spend more excessively which will result in the reduction of the profits for
the company.
6.3.5 Steps in Budgetary Control:
The following steps need to be followed:
a) Set Standards- We have to make a plan for which we need to prepare the budget. We
should have a target which we need to achieve through the budget. For example, we have set
a standard that the expenditure for the trip would be Rs.50,000.
b) Measurement of Actuals- In the next step, we will record the actual performance, which
means what we have achieved in the actual situation. For example, the actual expenses for
the trip came out to be Rs.60,000.
c) Compare- Now, we will compare the actual situation with the planned one.
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d) Find Deviation- In the next step, when we have compared the actual with the standard, we
will find out the deviation(difference) between the two. For example, Actual deviates by
Rs.10,000 from the standard or the planned.
e) Remedial Action- In last step we have to take corrective action if there are deviations.
IN-TEXT QUESTIONS
5. Budget is a Qualitative statement or a Quantitative statement?
6. The Budget involves non-financial aspects. True/ False
7. Do we also use budget in our day to day routine? Yes/No
8. Budget is prepared for a _______ period of time.
9. The first step in Budgetary control is to______.
6.4 TYPES OF BUDGETS
The budgets are the end product which comes out of planning. In business we prepare different
types of budgets. We are going to study few budgets out of them in our coming sections.
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6.4.1 Sales Budget

Before understanding the meaning of Sales Budget, let us understand the meaning of the word
Sales. So, sales are nothing but the number of units which are bought by our customers or our
target audience for their use. For these customers, we produce our products.
Now that we have understood the meaning of the word sales let’s understand the meaning of
Sales Budget. So sales budget involves planning or estimating the number of units that we will
sell in the coming future to our customers or to our target audience. In other words, the number
of units which will be sold in the future is written in the form of a financial statement in
quantitative terms.
The sales budget is the base for most of the budgets in the business. For example, the
production budget is dependent on the sales budget, how much sales we are getting will tell us
how much we have to produce. The sales budget is required to evaluate the performance of the
business. It also helps in finding out the amount of revenue which a business can earn.
The Budgets which depend on the sales budget are-
• Production budget
• Inventory(stock) budget
• Personnel(staff or employees) budget
• Administration budget
• Selling and Distribution budget
+
EXAMPLE OF SALES BUDGET –
XYZ Co. Ltd.
Sales Budget for the year ending December 31, 2021
Particulars Product A Product B Total
Budgeted 50,000 70,000 1,20,000

Sales unit
Budgeted 50 70
Sales price
Total 25,00,000 49,00,000 74,00,000
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6.4.2 Production Budget

Before understanding the meaning of Production Budget, let us understand the meaning of the
word Production. So, production is nothing but the number of units which we produce for sale
purposes in the factory. It means when we convert given raw material into finished goods
which are in a condition to sell.
Now that we have understood the meaning of the word production let’s understand the meaning
of Production Budget. So production budget involves planning or estimating the number of
units that we will produce in the coming future for selling purposes to our customers or to our
target audience.
After we have prepared the sales budget that means we have estimated our sales then we
prepare our production budget according to the sales budget prepared. The production budget
tells us the number of physical units which need to be produced to fulfil the sales planned by
the sales budget.
The production budget helps in managing the production and the stock of the inventory. It helps
the organization in knowing the demand of the product so that organization does not do
overproduction and has sufficient units of the finished goods for fulfilling the demand. We
make certain adjustments for the inventory in the sales budget to come out for the production
budget. The adjustments are:
Units to be produced= Budgeted Sales (+) Desired Closing Stock (-) Opening Stock
EXAMPLE OF PRODUCTION BUDGET –
XYZ Co. Ltd.
Production Budget for the month of December 31, 2021
Particulars Product A Product B
Budgeted Sales 50,000 60,000
Add: Desired 10,000 20,000

Closing Stock
Less: Opening 20,000 30,000

Stock
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Units to be 40,000 50,000

produced
6.4.3 Raw Material Consumption Budget

Let’s understand the meaning of the term Raw Material. So raw material is the direct material
that is consumed during the process of production. It is the basic material that is used in the
manufacturing process. It is an unprocessed material that is processed to make a finished which
is ready for use. It is also known as an intermediate good which will be used in the preparation
of the final good.
Now Raw Material Consumed means how much material is used in the process of making the
final product or the finished good. It represents the quantity of raw material which will become
part of the final good. For example, we have milk which will be used in the making of a mithai
(sweet dish). So here in the example milk is a raw material or is an intermediate good that will
be used in the making of the final good which here is the mithai.
Raw Material Consumption Budget means estimating or planning the number of units that will
be used in the preparation of finished goods. After we have prepared the production budget that
means we have estimated the number of units which will be produced so now we can easily
estimate the amount of raw material which will get consumed during the conversion to finished
goods. Now we can prepare our raw material consumption budget according to the production
budget prepared. Correct estimation of the production budget helps in better utilization of the
direct material. It calculates how much material will be used to fulfil the demand of the
production budget.
EXAMPLE OF RAW MATERIAL CONSUMPTION BUDGET –
XYZ Co. Ltd.
Raw Material Consumption Budget for the month of December 31, 2021
Budgeted 10,000 20,000

Production units
Material *4 *5
Requirement:
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Product A- 4 kg
per unit
Product B- 5 kg
per unit
Material Used 40,000 1,00,000
Cost per kg Rs. 2 Rs. 1
Cost of material Rs. 80,000 Rs. 1,00,000

used
6.4.4 Raw Material Purchase Budget

We have already understood the meaning of Raw Material so now we can understand the
meaning of Purchase of Raw Material. So, the purchase of raw material means how much
amount we will be needing to buy the quantity of raw material to produce the number of
finished products which we have found from the raw material consumption budget already. It
specifies the amount of the raw material which we need to buy that raw material.
Suppose we found out from the raw material consumption budget that to make 1 kg of
mithai(final good) we need 2 packets of milk(raw material) so now we know how much raw
material we will be purchasing and what amount it will cost us to purchase the given quantity
of raw material.
Raw Material Purchase Budget means estimating or planning the amount of money that we will
require to buy the quantity of raw material which will be consumed in the process of making
the finished goods. It specifies the finance which we need for making purchases of the raw
material or the intermediate goods. Correctly estimating the usage of the raw material will help
in purchasing the raw material in the correct quantity and which will also save the finances of
the business. Keeping more inventory will cost the company in the form of holding cost and
also some raw material will get wasted or destroyed.
EXAMPLE OF RAW MATERIAL PURCHASE BUDGET –
XYZ Co. Ltd.
Raw Material Purchase Budget for the month of December 31, 2021
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Cost of material 80,000 1,00,000

used
Add: Budgeted + 40,000 + 50,000

closing stock
Total 1,20,000 1,50,000

Requirement
Less: Opening - 20,000 - 40,000

stock
Purchase of 1,00,000 1,10,000

material
Cost per kg Rs. 2 Rs. 1
Cost of purchase Rs. 2,00,000 Rs. 1,10,000
6.4.5 Overheads Budget

Let’s understand the meaning of the term Overheads first. Overheads are nothing but all the
indirect expenses. Now the question arises is what the meaning of indirect expenses is. Direct
expenses are those expenses that can easily be allocated to the number of units produced. For
example, all the direct materials like raw materials, all the direct labour expenses like the
labour which is involved in the manufacturing of the finished goods, and the direct expenses.
The indirect expenses include all the indirect material involved like machinery oil which is
used in the machinery and indirect labour involved like the salary of the gatekeeper or the
guard. All these will be counted as indirect expenses and all these indirect expenses are known
as Overheads.
Now when we have understood the meaning of the term overheads, we can easily understand
the meaning of Overheads Budget. Overhead budget involves planning or estimating the
amount of expenditure which we will be incurred in the manufacturing of the goods. Not only
do direct expenses occur in the manufacturing of the goods but also indirect expenses are also
involved in the manufacturing of the goods. The overheads budget gives the management an
idea of all the future expenditures of the business. It helps the management in taking
precautionary measures about the increasing expenditure as compared to the revenue which the
business is going to earn in the future.
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There can be two types of overheads-

• Variable Overheads (example- electricity bill of the factory or office)
• Fixed overheads (example- salary of employees who are not directly involved in the
manufacturing process)
EXAMPLE OF OVERHEADS BUDGET –
XYZ Co. Ltd.
Overheads Budget for the month of December 31, 2021
Variable Overheads
Units 50,000 40,000
Rate 10 5
Total Variable 5,00,000 2,00,000

Overheads
Fixed Overheads
Rent 10,000 20,000
Depreciation 15,000 30,000
Total Fixed 25,000 50,000

Overheads
Total Overhead 5,25,000 2,50,000

Expenses
6.4.6 Cash Budget

Before learning the meaning of cash budget, let us understand the meaning of the word Cash.
Cash includes all the cash in the form of money and the coins and also cash equivalents. Now
let’s understand the meaning of Cash Flows. Cash Flows means the amount of money that is
going out from the business in the form of money spent on expenses or the money coming into
the business in the form of the sales that the business has made.
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When we have understood the meaning of cash and cash flows now, we can learn the meaning
of cash budget. A cash Budget is the planning or the estimation of the cash and the cash flows
which will arise during the operation of the business. In simple terms, the cash budget is the
inflow and the outflow of the cash of the business.
EXAMPLE OF CASH BUDGET –
XYZ Co. Ltd.
Cash Budget for the month of December 31, 2021
Cash Sales 80,000 1,00,000
Collection from + 40,000 + 50,000

Debtors
Total Cash Inflow 1,20,000 1,50,000
Cash Purchases 20,000 30,000
Wages + 5,000 + 8,000
Rent + 4,000 + 2,000
Other expenses + 11,000 + 10,000
Total Cash 40,000 50,000

Outflows
Cash Flows (Cash 80,000 1,00,000

Inflows- Cash
Outflows)
6.4.7 Master Budget

After all the budgets are prepared business prepares a Master Budget for the management. So,
the master budget is nothing but the aggregation of all the budgets. It is the sum total of all the
budgets. When all the budgets are combined it is called a master budget.
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In other words, a master budget is the summarised statement given to the management so that
they can have a quick look at all the budgets in a summarised manner. The master budget is
prepared for making instant decisions and for saving the time of the top authorities so that they
don’t have to go through each and every budget. They can have every detail which is important
for decision-making in the master budget only.
Master budget means what the company plans to earn overall and what the company plans to
spend overall in an accounting period. A master plan also acts as a directional tool. It means it
helps the management in giving the right directions to all the employees on which aspect they
need to work on.
It is a strategic plan which helps the management in the formulation of strategies and long-term
policies. It also serves as a tool for control purposes. Management can see from the master
budget what the expected or planned activities are and what would have been achieved in the
actual situation. The amount of deviation could be found, and then corrective action can be
taken.
6.4.8 Fixed and Flexible Budget
FIXED BUDGET- As the name suggests, a fixed budget is a budget that does change or
remains fixed irrespective of the amount of change in the level of activity or the level of output.
It is a financial plan which does not get modified with the variations in the actual activity. It is
also known as static because it does not fluctuates.
It is a financial plan which is based on a single level of activity. It has an assumption that the
company will work on one single activity and one single target, and it will try to achieve that
single target. In real-life situations fixed budget is not very much applicable because of its
nature of functioning, it is rigid in nature.
FLEXIBLE BUDGET- As the name suggests, a flexible budget is a budget that changes with
the change in the level of activity. The flexible budget adjusts itself with the level of activity or
the level of output. It is also known as a variable budget because it keeps on fluctuating. It is a
financial plan of the estimated revenues and expenses. A flexible budget considers the
classification of cost into fixed, variable, and semi-variable.
It is a budget that is prepared for a range of activities. It means it is prepared for more than one
activity. It has so many alternative names due to its functioning, some of them are dynamic
budget, sliding scale budget, step budget, expenses formula budget, and expenses control the
budget. In real-life situations, a flexible budget is used in most of situations as compared to a
fixed budget. The reason behind the usage of a flexible budget is that our business is also
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dynamic and keeps on changing. So, with the changing nature of business if the budget would
not change then the business would definitely fail.
EXAMPLE of Fixed Budget:
Practical Example- Using the following information, prepare a flexible budget for the
production of 80% and 100% activity.
Production at 50% Capacity 5,000 Units
Raw Materials Rs.80 per unit
Direct Labour Rs.50 per unit
Direct Expenses Rs.15 per unit
Factory Expenses Rs.50,000 (50) (Fixed)
Administration Expenses Rs.60,000 (Variable)
Solution for the practical example-
Flexible Budget at a Capacity of
Capacity of 50% 80% 100%

Output Units 5,000 8,000 10,000
Rs. Rs. Rs.
Raw Materials 4,00,000 6,40,000 8,00,000
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Labour 2,50,000 40,000 50,000
Direct Expenses 75,000 1,20,000 1,50,000
Prime Cost 7,25,000 11,60,000 14,50,000
Factory Expenses 50% Fixed

25,000 40,000 50,000
(50,000)
Factory Cost 7,75,000 12,25,000 15,25,000
Admin Expenses 40% Fixed

24,000 24,000 24,000
(60,000)
Variable 60% 36,000 57,600 72,000
Total Cost 8,35,000 13,06,000 16,21,000
Difference between Fixed Budget and Flexible Budget-
S. BASIS FIXED BUDGET FLEXIBLE BUDGET

No.
1. Activity level A fixed Budget is based on Flexible Budget works on different

always one single activity. levels of activity rather than on a
range of activities.
2. Nature of the A fixed Budget is static in A flexible Budget is dynamic in

budget nature. Due to its nature, it nature. Due to its nature, it changes
does not change and is rigid. with the level of activity and is
It does not change with the flexible. It does changes with the
level of output achieved. level of output achieved.
3. Difficulty in When we compare the actual When we compare the actual level of
comparing. level of output and the output and the budgeted level of
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budgeted level of output, it output, it does give us a true picture

does not give us a true picture if the level of output got changed.
if the level of output got
changed.
4. Working A fixed budget assumes that A flexible budget assumes that the
conditions of the business conditions business conditions keep on
the business remain the same and does not changing and takes this fact into
consider this fact. consideration.
5. Differentiation The fixed budget does not The flexible budget considers the
in cost consider the differentiation in differentiation in the cost between
the cost between fixed cost, fixed cost, variable cost, and semi-
variable cost, and semi- variable cost.
variable cost.
6. Cost Under a fixed budget where But in a flexible budget where the
ascertainment the business working budget changes with the volume of
conditions keep on changing output, finding out the cost becomes
then finding costs correctly is an easy task.
a difficult task.
7. Tool for A fixed budget is an A flexible budget is an effective tool

controlling ineffective tool for for controlling purposes because of
cost controlling purposes because its applicability.
of its limited application.
8. Price fixing. Under a fixed budget due to Under a flexible budget due to
not being able to correctly correct cost ascertainment, price
ascertain cost, price fixation fixation becomes an easy job.
becomes a difficult job.
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IN-TEXT QUESTIONS
7. Production Budget is based on the sales budget. True / False

8. The budget which identifies the quantity of raw material which will be
consumed during the process of making finished goods is known as
_______________.
9. The Raw material consumption budget and Raw material purchase budget is
one and the same thing. Yes/No
10. _______ budget involves the inflow and outflow of cash.
11. A budget which is a summary of all the budgets is known as ____________.
6.5 ZERO-BASEDBUDGETING
Zero- Based Budgeting is a special type of budgeting. It means we start preparing the budget
from zero as the name suggests. In simple words we can say that we start the preparation of the
budget from the scratch, that means from the very beginning.
Zero-based budgeting came in the 1960s. The concept was given by Peter Pyhrr, who wrote a
Harvard Business Review article about it. And after that, the concept gained huge success and
many organizations started using it.
Even our government promoted this concept in its seventh five-year plan as a system for
determining the budget for the expenditure.
The reason behind the success of the zero-based budgeting concept as it allows the organization
to know the number of cash flows, they have and saves the organization from spending what
they don’t have. It helps in cutting down the cost for the organization.
Traditional Budgets are prepared on the basis of the previous performance and the cost of the
previous accounting period. But this is not the case in Zero-Based Budgeting, here we don’t
take anything from the previous accounting period.
Majorly in zero-based budgeting, we focus on the goals and the objectives which we need to
attain and rest the procedure of preparing the budget is the same as we prepare our normal
budgets.
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TRADITIONAL BUDGETING ZERO-BASED BUDGETING
It takes into consideration the previous It does not take into consideration the
accounting period’s data to make the new previous accounting period’s data for
budget. making the new budget, rather it starts from
scratch.
It has a major focus on money. It has a major focus on the attainment of

goals and objectives.
It does not consider different approaches. It takes different approaches to achieve

similar results.
Advantages of Zero-Based Budgeting:

a) Efficient Allocation of Resources- Budgeting requires allocating the resources optimally so
that their best use can be made, and goals and objectives of the business can be achieved.
b) Eliminates wastage- Zero-based budgeting helps in identification of then activities which are
waste and obsolete. After identification of the useless activities it tend to eliminate them.
c) Encourage new ideas- Zero-based budgeting is in itself a new idea and hence it promotes
and encourages activities which will increase the profit potential of the business.
d) Encourages questioning attitude- This method of budgeting improves the questioning
attitude of the employees rather than accepting everything passively.
e) Increased staff involvement- When we involve our employees in the process of preparation
of budget, it motivates them and encourage them to do better.
f) Improves communication- It helps in improving the communication between the employees
and the management as they are involved in the process of preparing budget.
g) Improves coordination- When employees are highly motivated, they will work together
which will bring coordination in their work and cooperation among the business.
Disadvantages of Zero-Based Budgeting:
a) Very high cost involved- In zero-based budgeting we have to prepare lots of decision
packages which costs the organization way too much.
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b) Time-consuming- We already know that preparing a budget takes lots of time and effort. It
is a tedious task that requires observation to estimate things which is a time-consuming
activity.
c) Additional paperwork is required- A lot of additional paperwork arises due to making
various types of decision packages.
d) Opposition from the managers- It is a human nature that we tend to oppose the changes.
Similar is the case in the introduction of zero-based budgeting also, managers tend to oppose
new ideas.
e) Can result in departmental conflict- When the resources are distributed, it is distributed
according to the decision package, and it is subjective in nature which may lead to conflicts
in various departments.
IN-TEXT QUESTIONS
11. Zero based Budgeting means starting from the _____.
12. Zero based Budgeting takes into consideration previous accounting period’s
data. True/False
13. Zero based Budgeting is a time-consuming process. Yes/No
14. Traditional Budgeting takes into consideration previous accounting period’s
data. True/False
15. The major focus of Zero-based Budgeting is on ____ and ___________.
16. Following tools can be used to create interest among the learners:
a) Jargons b) complex language
c) Pictures d) repetitive sentences
6.6 SUMMARY
In a summarised manner, a budget is a financial statement that is made with estimations. And if
there are some deviations between the planned level of activity and the activity actually
attained these are known as deviations and corrective measures can be taken against them. The
budget acts as a controlling tool and helps in achieving the goals and objectives of the
organization. There are different types of budgets like sales budget, production budget, raw
material consumption budget, raw material purchase budget, cash budget, master budget, fixed
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budget, and flexible budget. Also, there is a concept of zero-based budgeting which means no
previous accounting period’s data is used and the budget is prepared from the scratch.
1. Bhushan Steel Limited manufactures a single product for which market demand exists for
additional quantity. Present sales of Rs.60,000 per month utilises only 60% capacity of the
plant. Marketing Manager assures that with the reduction of 10% in the price he would be
able to increase the sale by about 25% to 30%.
The following data are available:
Selling Price Rs.10 per unit
Variable Cost Rs.3 per unit
Semi-variable Cost Rs.6,000 fixed + 50 paise per unit
Fixed Cost Rs.20,000 at present level estimated to be
Rs.24,000 at 80% Output
You are required to prepare the following statements:
a) The operating profits at 60%, 70% and 80% levels at current selling price, and
b) The operating profits at proposed selling price at the above levels
2. A factory is currently running at 50% capacity and produces 5,000 units at a cost of Rs.90/-
per unit as per details below:
Material Rs.50
Labour Rs.15
Factory Overheads Rs.15 (Rs.6 fixed)
Administrative Overheads Rs. 10 (Rs.5 fixed)
The current selling price Rs.100 per unit.

At 60% working, material cost per unit increases by 2% and selling price per unit falls by 2%
At 80% working, material cost per unit increases by 5% and selling price per unit falls by 5%
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Estimate profits of the factory at 60% and 80% working and offer your comments.
5. Based on the following information, prepare a Cash Budget for the three months ending 30th
June 2022
Month Sales Materials Wages Overheads
February Rs.14,000 Rs.9,600 Rs.3,000 Rs.1,700
March Rs.15,000 Rs.9,000 Rs.3,000 Rs.1,900
April Rs.16,000 Rs.9,200 Rs.3,200 Rs.2,000
May Rs.17,000 Rs.10,000 Rs.3,600 Rs.2,200
June Rs.18,000 Rs.10,400 Rs.4,000 Rs.2,300
Credit Terms are:
• Sales / Debtor – 10% sales are on cash, 50% of the credit sales are collected next month and
the balance in the following month.
• Creditors: Materials 2 months, Wages ¼ month, Overheads ½ month
• Cash and Bank Balance on 1st April 2022 is expected to be Rs.6,000
• Other relevant information is:
• Plant & Machinery will be installed in February 2022 at a cost of Rs.96,000. The monthly
instalments of Rs.2,000 is payable from April onwards.
• Dividend @ 5% on Preference Share Capital of Rs.2,00,000 will be paid on 1st June.
• Advance to be received for sale of vehicles Rs.9,000 in June
• Dividends from investments amounting to Rs.1,000 are expected to be received in June.
• Income Tax (advance) to be paid in June is Rs.2,000
6.8 GLOSSARY
Deviation: It shows the amount of difference between the two things.

Remedial Action: The corrective action which needs to be taken in the case of deviation.
Attain: To attain anything is to achieve something.
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Target Audience: A group of people who will become our potential customers.
Allocation of expenses: It means assigning a particular expense to a particular unit.
Aggregation: It is the sum total of all.
Ascertainment: It means to find out something.
1. Quantitative Statement 9. Cash budget

2. False 10. Master budget
3. Yes 11. Scratch or zero
4. Defined 12. False
5. Set Standards 13. Yes
6. True 14. True
7. Raw material consumption budget 15. Goals and Objectives
8. No
1. Explain the meaning of Budget and the steps which need to be taken during budgetary
control.
2. What do you understand by Zero Based Budgeting? How is it different from traditional
budgeting? Write in brief its advantages and limitations.
6.11 REFERENCES
• Tips on Preparing a Direct Materials Purchases Budget. (2019, June 28). The Balance
Small Business. https://www.thebalancesmb.com/how-to-prepare-a-direct-materials-
purchases-budget-
• 93023#:%7E:text=What%20Is%20a%20Direct%20Materials,production%20%E2%80%94
%20usually%20monthly%20or%20quarterly.
• Tamplin, T. B. (2022, July 22). Flexible Budget Practical Problems & Solutions |
Explanation & Discussion. Finance Strategists.
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https://learn.financestrategists.com/explanation/management-accounting/flexible-budget-
practical-problems-and-solutions/
• O. (2022, August 7). Difference Between Fixed Budget and Flexible Budget. Otosection.
https://www.otosection.com/difference-between-fixed-budget-and-flexible-budget/
• Arora, M. N. (2016). COST AND MANAGEMENT ACCOUNTING. Penguin Random

House.
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LESSON 7
STANDARD COST
CA Madhu Totla
Assistant Professor
SSCBS, University of Delhi
Email-Id: madhumaheshwari@sscbsdu.ac.in
STRUCTURE

7.2 Introduction
7.3 Objectives of Standard Costing
7.4 Setting up of standards
7.5 Difference between Standards Costs and Estimated Costs
7.6 Difference between Standard Costing and Budgetary Control
7.7 Advantages of Standard Costing
7.8 Limitations of Standard Costing
7.9 Variance Analysis
7.10 Material Cost Variances
7.11 Labour Cost Variances
7.12 Summary
● Understanding the concept of standard cost along with its advantages and limitations
● Understanding of the process of setting up standards for different components of cost
● Understanding the difference between standard cost and estimated cost.
● Understanding how is standard costing different from budgetary control as a technique of

cost control.
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● Understanding the concept of variance Analysis
● Computation of material cost variance and its further classification into material price
variance and material usage variance. Material mix variance and yield variance
● Understanding the concept and computation of labour cost variance and its further
classification into rate and efficiency variance. Idle time variance, mix variance and yield
variances
7.2 INTRODUCTION
Standard costing is an important aspect of cost and management accounting Historically it has
been associated with manufacturing organisations and overcomes the limitations of historical
costing. It is a specialised technique used to control cost and tells us “What the cost should be.”
And can be used simultaneously with other costing systems like marginal costing or process
costing.
Standard Costing is the process of coming up with standard costs for some or all of the
company’s activities and these costs are used as an close approximation of actual costs. This
brings efficiency to accounting and saves a lot of time and money.
According to CIMA London, Standard costing is defined as “the preparation of the standard
costs and applying them to measure the variations from actual costs and analysing variances
with a view to maintain efficiency”.
Standard costing provides us with standard costs which are compared with the actual costs
periodically for computing variances and their further analysis helps in taking corrective action.
Standard Cost is basically a norm or a criterion which is being used as a yardstick to measure
the efficiency of various cost centres.
According to CIMA London, “Standard cost is the predetermined cost based on technic
estimates for materials labour and overhead for a selected period of time for a prescribed set of
working conditions”.
Standard cost provides us with what the cost should be and is forward-looking. Standard
costing system is suitable for those industries where the processes can be the standardised and
sufficient volume is being produced.
7.3 OBJECTIVES OF STANDARD COSTING
The application of standard costing paves the way for organised and methodical
accomplishments of organisational objectives. It is a system that may be implemented with any
of the available costing methods such as direct costing, job costing, absorption costing and so
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on. Standard costing helps in evaluating the performances and enhancing competencies. The
principal objectives of standard costing are as follows:
• Measuring performance and motivating efficiency: This costing system helps in
evaluating the performance while simultaneously throwing light on the differences between
desired performance and attained performance. These standards act as challenges and
motivate to achieve the targets and thus lead to efficiency.
• Cost control: Standard costing is a technique of cost control where the predetermined costs
are compared with actual costs and the differences (termed as variances) are analysed to
achieve effective cost control. Both the favourable and the unfavourable variances need to
be analysed and rectification measures to be taken. The unfavourable variances are an
indication of inefficiency whereas favourable variances may result from loose standards
being set or substandard resources being used.
• Simplification of costing procedure: Standard cost is determined separately for each
product or process and is usually done by experts in consultation with the technical and
production team along with the management. This process ensures a smooth and simplified
costing procedure.
• Determination of sale price: The price of any product is determined either based on
standard cost or the real cost incurred. It is usually seen that the actual cost changes a lot for
different reasons and keeping the actual cost as a base for determining the sale price will
lead to a lot of fluctuations in the sale price therefore standard cost is being taken as a basis
to determine the sale price.
• Management by exception: Variance reports are being used by top management for control
and the exceptional variances get their attention for suitable control functions.
7.4 SETTING UP OF STANDARDS
The process of setting the costs of each of its elements on a scientific foundation is referred to
as the setting up of standards. The efficiency of standard costing is dependent on the
establishment of its exact and precise standards. The standards set need to be reliable and
realistic. Therefore, standards should be set off with utmost care.
Material quantity standards: This standard explains the quantity of material to be used for the
production of one unit of output. It is set considering the spoilage, input-output ratio, quality
specifications of material and technology used in production.
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Material price standards: This standard is based on the forecast of average prices of material
to be used in production during the future time period. Price standards for materials are
developed on the basis of the prices mentioned in long-term contracts and the purchase price of
recent orders also considering the discounts and other charges which need to be incurred for the
material.
Labour time standards: This standard is all about scientifically determining the labour time
for output based on time and motion studies which include determining the time for all sorts of
sub-movements necessary for the production
Labour rate standards: It is usually the result of labour contracts of the organisation and the
wage policy.
7.5 DIFFERENCES BETWEEN STANDARD COST AND

ESTIMATED COST
Standard Costs and estimated costs are the predetermined costs which vary in their objectives.
The differences between the two are:
Standard Cost Estimated Cost
It gives an estimate of what the cost would be
It aims at what the cost should be
These costs are developed scientifically. These costs are based on past averages and
future anticipations.
Standard costs are used only with the
standard costing system. These costs are used in any organisation
working with a historical costing system
The objective is to control costs.
These costs are usually entered in the The objective is to provide a basis for price
accounting system and used in variance fixation.
computation and analysis. These costs do not enter the accounting system.
7.6 DIFFERENCES BETWEEN STANDARD COSTING AND

BUDGETARY CONTROL
Both Standard costing and budgetary control are cost-control techniques involving the
comparison of predetermined costs with the actuals and further followed with corrective action.
However, the two techniques differ from each other in many aspects:
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Standard Costing Budgetary Control

Standard costing is based on scientific It is based on past performance and future
calculations. anticipations.
The standard costing system is mainly used Budgetary control is used in various
by the manufacturing division. departments like production, sales, finance
etc.
It is used to measure efficiency. It is used for forecasting.
Its main objective is the ascertainment of It’s mainly concerned with the profitability
costs and cost control. of the business.
Standard costing is a projection of cost It’s a projection of financial accounts.

accounts.
It is intensive in the application and requires It is extensive in the application and does
a detailed analysis of variances. not call for rigorous analysis of deviations.
7.7 ADVANTAGES OF STANDARD COSTING
Standard costing system if implemented properly yields many advantages to the organisation.
However, the magnitude and nature of the advantages will vary from organisation to
organisation. The most possible ones are:
• Cost Control: This is the most important and significant advantage of the standard costing
system. Comparison of actual performance with the pre-determined standards helps in
finding out variances and further analysis of variances and corrective action taken leads to
cost control.
• Fixing of responsibility: Determination and analysis of variances help in fixing the
responsibility of the cost centre or the particular individual.
• Improvement in quality: Under standard costing the focus is on quality and cost-
effectiveness together and improvement of quality gets the right amount of attention.
• Determination of product cost: In the majority of the time, organisations start advertising
prices in the market much before the product is actually manufactured. Standard costing is
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used to set prices in such cases as the manufacturer is unaware of the actual cost of
production.
• Provides motivation: Standard costing provides incentives and motivation to employees to
work towards achieving the standards and thus increases productivity.
• Management by exception: Highlighted variance reporting to the management helps
management to focus only on exceptional variances and take corrective action.
• Easy and economic: With the use of standard costing accounting becomes comparatively
easier and results in savings in the cost.
7.8 LIMITATIONS OF STANDARD COSTING
Standard costing is a useful tool for the management of an organisation. However, it suffers
from certain limitations which need to be kept in mind while using a standard costing system.
• Challenge in establishing standards: It is hard to set standards and management while
establishing standards should pay attention to data and other information from the past. If
the right standards are not set, then all future analysis and their interpretation would be
futile.
• Costly affair: Determination of standard costs and establishment of the standard costing
system involves a huge amount of cost to be incurred and therefore small organisations
cannot afford it.
• Inappropriate for some businesses; It works for those businesses where standardisation
can be done and therefore certain businesses where standardisation is not possible, standard
costing is inappropriate for them.
• Revision of standards: Setting up standards once does not mean that the job is done
forever. It requires updation from time to time to meet the changing requirements.
• May need the help of experts: Standard costing requires help and advice of experts and
specialists and therefore it can be used only by those organisations which can afford to hire
the experts.
7.9 VARIANCE ANALYSIS
The difference in the actual and standard cost or the deviation from the standard performance is
known as Variance. The primary purpose of variance computing and analysing variance is to
enable the management to find out reasons for deviation from the budgeted profit. In other
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words, variance analysis helps the management to know the responsibility centres which can be
held accountable for various variances.
According to CIMA London, “Variance Analysis is the process of computing the amount of
variance and isolating the causes of variance between actual and standard.”
For achieving the objective of the standard costing, a report on variance analysis is prepared to
show the actual cost, standard cost, and the variances (along with the causes) and submitted to
the management for further action. The report is prepared to indicate the direction (favourable
or unfavourable), nature (controllable or uncontrollable) and the quantum of variance. The
variances may be cost variances or sales variances.
In the case of cost variances, when the actual cost is less than the standard cost, the variance is
favourable and vice versa. Both favourable and unfavourable variances need analysis.
Favourable variance not always implies efficiency. It may be due to certain favourable external
factors, or the standards are loosely set. In the same way, an unfavourable variance does not
always mean inefficiency. Controllable variances are those variances which can be or are
within the influence of a particular responsibility centre or a particular individual.
Uncontrollable variances are to be disposed of by apportioning to the unit of the finished good
and work in progress.
The analysis of variance is significant to management to pinpoint responsibilities and identify
possible causes. The magnitude and the frequency of variance will determine the quantum of
attention required by the management.
Cost variances can be subclassified into four categories based on the elements of cost:
• Material cost variance
• Labour cost variance
• Variable overhead cost variance
• Fixed overhead cost variance
7.10 MATERIAL COST VARIANCES
Material cost variance is the difference between the actual cost of material used for production
and the standard cost of materials allowed (as per the laid standards) for the actual output
achieved. This variance may arise due to differences in the quantity of material used or the
difference in prices or both.
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Where,
MCV= Material Cost Variance
SQ = Standard quantity of material required for actual output
SP = Standard Price per kg of material
AQ = Actual quantity of material used
AP = Actual price per kilogram of material
Material Cost Variance
Material Usage Material Price

Variance Variance
Material Mix Material Yield

Variance Variance
Material cost variance is further subdivided into two: material price variance and material
usage variance.
Material Price Variance: This variance measures that portion of the material cost variance
which is because of the difference in the standard price set and the actual price paid for the
purchase of the actual quantity.
Where,
MPV= Material Price Variance
AP = Actual price per kilogram of material
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Material price variance may arise due to either some inefficient buying or changes in the
market price which is uncontrollable. It may also arise due to certain emergency purchases or
change in quantity purchase impacting the discounts availed.
Material Usage Variance: This variance measures that portion of the material cost variance
which is because of the difference between the actual quantity of material used in the
production and the quantity of material that should have been used as per the standard set. The
material usage variance is the standard price multiplied by the difference between the actual
quantity of material used and the standard quantity allowed for actual production.
or
Where,
MUV= Material Usage Variance
Material usage variance is calculated using the standard price rather than the actual price. This
helps in removing the effect of price changes or in other words the efficiency of the purchase
department is segregated. Material usage variance may be the result of the use of inferior
quality material purchased and used, improper mix of raw materials, mishandling of material or
excessive wastage during the production process.
Material usage variance can be further subdivided into material mix variance and material yield
variance.
Material Mix Variance: This variance is due to the difference in standard composition and the
actual composition of materials used in production. It will arise only when there is a mix of
different materials used in the production process and their standard prices are different.
Where,
MMV= Material Mix Variance
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RSQ = Revised standard quantity (total actual quantity of raw material used in the standard
ratio)
Material Yield Variance: It is that portion of the material usage variance which is due to the
difference between the standard yield set and the actual yield achieved. This variance is based
on productivity, and it arises if the actual loss of material is different from the standard loss of
material being specified.
Where,
MYV= Material Yield Variance
SP = Standard Price per unit of output
AY = Actual output
SY = Standard Yield from actual input
This variance arises because of failure to keep the input-output ratio and follow the standard
procedure. Difference in yield may arise due to use of inferior quality material being used as
input.
Material yield variance is equal to material sub usage variance, which is being calculated as:
Example 7.1
X Ltd.is a garment manufacturing company using standard costing system. It furnishes
following information about manufacturing of shirts. Compute all material cost variances.
Standard price of fabric per metre ₹ 50
Actual price of fabric per metre ₹ 40
Standard quantity of fabric required to produce one unit 1.5m
of output
Actual quantity of fabric used to produce one unit of 2m
output
Actual output (number of shirts stitched) 10,000 units
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Solution :
Given,
SP = ₹ 5
AP =₹ 4
SQ = Standard quantity of material required for actual output = 1.5m 10,000 = 15,000 m
AQ = Actual quantity of material used for actual output = 2m = 20,000 m
Material Price Variance
Material Usage Variance
Verification: MCV= MPV+ MUV

5000 (A) = 20000 (F) + 25000 (A)
Material mix variance is not computed as only one type of raw material is used. The material
usage variance is entirely due to difference in productivity and therefore material yield variance
is same as material usage variance in the given case.
Example 7.2
X chemical ltd. manufactures chemical X using three kinds of raw material A, B and C. The
company uses standard costing system and furnishes following information about
manufacturing of chemical X. Compute all material cost variances.
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Standard price of raw material A ₹ 100 per kg

Standard price of raw material B ₹ 50 per kg
Standard price of raw material C ₹ 60 per kg
Actual price of raw material A ₹ 90 per kg
Actual price of raw material B ₹ 60 per kg
Actual price of raw material C ₹ 70 per kg
Standard quantity of raw material A to produce 1 tonne 300 kg
of chemical X
Standard quantity of raw material B to produce 1 tonne 400 kg
of chemical X
Standard quantity of raw material C to produce 1 tonne 500 kg
of chemical X
Actual quantity of raw material A used to produce 3,50,000 kg
chemical X
Actual quantity of raw material B used to produce 4,20,000 kg
chemical X
Actual quantity of raw material C used to produce 5,30,000 kg
chemical X
Actual output of chemical X 1000 tonnes
Solution:
Given,
SP of A = ₹100, B = ₹50, C= ₹60
AP of A=₹ 90, B = ₹60, C = ₹70
A= 300 1,000 = 3,00,000 kg
B= 400 1,000 = 4,00,000 kg
C= 500 1,000 = 5,00,000 kg
AQ = Actual quantity of material used for actual output
A= 3,50,000 kg
B= 4,20,000 kg
C= 5,30,000 kg
RSQ = Revised standard quantity based on actual quantity of material used in standard ratio
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A= =3,25,000 kg
B= =4,33,333 kg
C= = 5,41,667 kg
Standard Yield for actual input = 1300000 =1083.33 tonnes
Standard cost per unit of output = (300
Material A = 1500000 (A)
Material B = 5200000 (A)
Material C = 1500000 (A)
MCV=13800000 (A)
Material Price Variance
Material A = 3500000 (F)
MPV= 6000000 (A)
Material Usage Variance
MUV= 7800000 (A)
Material Mix Variance
Material B = 666650 (F)
Material C = 700020 (F)
MMV=11,33,330 (A)
Material Sub Usage Variance
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MSuV=66,66,670 (A)
Material Yield Variance
(1000-1083.34) 80000 = 6666670 (A)
Material Yield Variance = Material Sub Usage Variance
7.11 MATERIAL COST VARIANCES
Labour Cost Variance is the difference between the standard cost of labour for actual output
and the actual labour cost incurred. Difference in the standard wage rates and actual wage rates
along with the difference in actual time taken over the standard time allowed are the major
causes of labour cost variance in any organisation. The way of calculation of labour cost
variances is same as that of material cost variances with small variation in their names as to
exhibit better information content of these variances. It is computed as:
Where,
LCV= Labour Cost Variance
ST = Standard time for actual output
SR = Standard rate per hour of labour
ATp = Actual time paid
ATw = Actual time worked
AR = Actual rate per hour
Labour cost variance can be segregated into labour rate variance and labour efficiency variance.
The part of the labour cost variance which measures deviation from the price is known as
labour rate variance and for the quantity is known as labour efficiency variance.
Labour Rate Variance: The variance which arises because of the deviation between the
standard rate set per hour and actual rate per hour paid to the labour for the production of actual
output. This variance focuses only on the rate deviation and may arise due to wrong type of
labour being used for production, or a general rise in wages or overtime allowance being paid
for some urgency, or new workers employed not being paid full. Usually, a major portion of
this variance is uncontrollable by the management.
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It is computed as:
Labour Efficiency (Time) Variance: The portion of the labour cost variance which arises
because of the deviation between the standard hours allowed for actual output and actual hours
paid to the labour for the production of actual output. This variance is the quantity variance for
labour cost and depicts efficiency if the actual hour of labour is less than the standard hours set
to manufacture the product. Similarly, if the actual hours of labour are more than the standard
hours set to manufacture the product, the variance denotes inefficiency.
Labour efficiency variance may arise due to poor working conditions, sub-standard raw
material used, relaxed supervision, improper training of worker used in production, use of some
new technology which requires adaptation time for worker, inefficient workers, defective plant
and machinery. This variance is also known as labour time variance.
Labour efficiency variance can be subdivided into labour mix variance, idle time variance and
labour revised efficiency variance (or labour yield variance).
Labour Mix Variance: This variance is due to the difference in type of labour allowed to be
used and the actual type of labour used in production. It will arise only when there is a mix of
different types of labour used in the production process and their standard prices are different.
It is also known as gang composition variance.
Where,
LMV= Labour Mix Variance
ATw = Actual hours worked
RST = Revised standard time (total actual hours of labour used in the standard ratio)
Labour Idle Time Variance: As the name suggests this variance arises due to idle time of the
labour which has to be paid. It is segregated to show the effect of abnormal causes hampering
the production process. For example- power failure, insufficient supply of raw material,
breakdown of plant and machinery. Few management accountants treat idle time variance as a
part of labour cost variance and not as a part of labour efficiency variance. It is calculated as:
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Where,
ITV = Idle Time Variance
Idle Time = Actual hours paid - Actual hours worked
Idle time is a waste of time and is a loss. This this variance will always be unfavourable.
Labour Revised Efficiency Variance: It is the residual portion of the labour efficiency
variance which is not being explained by labour mix variance and idle time variance. This
variance is similar to material sub usage variance. It is calculated as:
Labour Yield Variance: It is always equal to labour revised efficiency variance and arises
due to the difference between the standard yield set for actual hours of input and the actual
yield achieved. This variance is based on productivity and is similar in concept to material yield
variance. It is calculated as:
Where,
LYV = Labour Yield Variance
AY = Actual yield
SY = Standard Yield from actual input
SC = Standard labour cost per unit of output
Example 7.3
X Ltd.is a cement manufacturing company using standard costing system. It furnishes
following information about manufacturing of cement in tonnes. Compute all labour cost
variances.
Standard rate of labour per hour ₹ 50
Actual rate of labour per hour ₹ 45
Standard hours required to produce one tonne of cement 15
Actual hours 15300 hours
Actual output 1000 tonnes
Solution:
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Given,
SR = ₹ 50
AR =₹ 45
ST = Standard hours of labour required for actual output = 15 1000 = 15000 hours
AT = Actual hours of labour = 15300hours
Labour Cost Variance
Labour Rate Variance
LR
Labour Efficiency Variance
Verification: LCV= LRV+ LEV

61500 (F) = 76500 (F) + 15000 (A)
Labour mix variance, labour revised efficiency variance and Idle time variance are not
computed as only one type of labour used and no information about idle time is given.
Example 7.4
X Ltd.is a steel pipe manufacturing company using standard costing system. It furnishes
following information about manufacturing of steel pipes for work scheduled to be completed
in 30 hours in a week. Compute all labour cost variances and verify them.
Unskilled Semi-skilled Skilled

Standard number of 9 15 26
workers in one
group
Actual number of 8 18 24
workers employed
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Standard wage rate 100 200 400

per week
Actual wage rate per 120 180 400
week
During the week, the gang produced 1600 standard labour hours.
Solution:
Type of Standard Actual
workers
Hours Rate Amount Hours Rate Amount
Skilled 780 400 312000 720 400 288000
Semi- 450 200 90000 540 180 97200
skilled
Unskilled 270 100 27000 240 120 28800
1500 429000 1500 414000
Standard cost of actual output
Labour Cost Variance
Labour Rate Variance
Skilled 720 = 0
Semi-skilled 540 = 10800 (F)
Unskilled 240 = 4800 (A)
LRV = 6000 (F)
Labour Efficiency Variance
Skilled 400 = 44800 (F)
Semi-skilled 200 = 12000 (A)
Unskilled 100 = 4800 (F)
LEV = 37600 (F)
ST= Standard hours for actual output
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Skilled
Semi-skilled
Unskilled
Labour Mix Variance

Skilled 400 = 24000 (F)
Semi-skilled 200 = 18000 (A)
Unskilled 100 = 3000 (F)
LEV = 9000 (F)
Labour Yield Variance
= 28600(F)
SC= Standard rate per hour of work =
Verification: LCV= LRV+ LEV

43600 (F) = 6000 (F) + 37600 (F)
LEV = LMV+LYV
37600(F) = 9000(F) + 28600 (F)
IN-TEXT QUESTIONS
1. Please indicate if the following statements are correct or incorrect
a) Idle time variance is always unfavourable.
b) Gang composition variance is a sub variance of labour time variance
c) Standard costs are scientifically determined.
d) Material price variance arises due to excess amount of raw material consumed
in production.
e) Material sub usage variance is always equal to material mix variance.
f) When standard cost is higher than the actual cost the variance is unfavourable.
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IN-TEXT QUESTIONS
2. Fill in the blanks:
a) Difference between actual cost and standard cost is known as …………
b) ………. is the variance which arises when more than two materials are used in
production.
c) …………….. is always unfavourable.
d) Excess of actual cost over standard cost is known as…… variance.
e) MCV = MPV +……...
f) MUV = …….+ MYV
7.12 SUMMARY
• Standard costing is a technique used for cost control. It is based on setting up of standards,
comparison of actuals with standards and analysis of variances and corrective action.
• The main objective of standard costing is measuring performance, cost control and
management by exception.
• It helps in cost control and performance evaluation but also suffers from limitation of being
costly and not being beneficial for small organisations. It also requires updation of standards
and advice of experts.
• Standard cost is different from estimated cost as the former is scientifically set and the later
is based on past performance and future expectation.
• Variances are calculated for each element of cost and analysed on the basis of control and
magnitude.
• Material cost variance is classified into material price variance and material usage variance.
Material usage variance is further subdivided into material mix variance and material yield
variance.
• Labour cost variance measures deviation of actual labour cost from the standard and is
classified into labour efficiency variance and labour rate variance. Labour efficiency
variance is further classified into labour mix variance, labour yield variance and idle time
variance.
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1. (a) correct 2.(a) Variance

(b) correct (b) Material Mix Variance
(c) correct (c) Idle Time Variance
(d) incorrect (d) unfavourable
(e) incorrect (e) MUV
(f) incorrect (f) MMV
1. Explain the concept of standard cost.

2. Explain the differences between standard cost and estimated cost.
3. Distinguish between standard costing and budgetary control.
4. Explain the advantages and limitations of standard costing.
5. What is the significance of term variance?
6. Write short notes on
a. Material Price Variance
b. Labour Efficiency Variance
c. Labour Rate Variance
d. Material Mix Variance
7. X Ltd. a manufacturing concern, which has adopted standard costing, furnished the
following information:
Standard Material for 700 kg finished product: 1000 kg. Price of materials: Rs 10 per kg.
Actual Output: 280,000 kg. Material used: 3,80,000 kg. Cost of material: Rs. 4,52,000.
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Calculate: (a) Material Usage Variance (b) Material Price Variance (c) Material Cost Variance
8. Calculate Labour cost variance from the information:
Standard production : 800 units Standard Hours : 4000 hours
Wage rate per hour : Rs. 20
Actual production: 850 units Actual time taken : 4500 hours Actual wage rate paid :
Rs. 2.10 per hour
9. The standard cost of a certain chemical mixture is as under:
40% of Material A at Rs.20 per tonne
60% of Material B at Rs.30 per tonne
A standard loss of 10% is expected in production. The following actual cost data is given for
the period.
180 tonnes of Material A at a cost of Rs.18 per tonne
220 tonnes of Material B at a cost of Rs.34 per tonne
The weight produced is 364 tonnes.
Calculate Material Variance.
10. Following information is given regarding standard composition and standard rates of
workers:
Standard Composition Standard hourly rate
10 Men Re. 0.625
5 Women Re. 0.400
5 Boys Re. 0.350
According to given specifications, a week consists of 40 hours and standard output for a week
is 1,000 units.
In a particular week, gang consisted of 13 men, 4 women and 3 boys and actual wages were
paid as follows:
• Men @ Re.0.60 per hour

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• Women @ Re. 0.425 per hour
• Boys @ Re. 0.325 per hour

11. Two hours were lost in the week due to abnormal idle time. Actual production was 960
units in the week. Calculate Labour Variances
Latest edition of the following textbooks to be used.

• Arora, M.N. A Textbook of Cost and Management Accounting, Vikas Publishing House
Pvt. Ltd.
• Maheshwari, S.N. and Mittal,S.N. Cost Accounting: Theory and Problems, Shree Mahavir
Book Depot
• Datar, S.M. & Rajan, M.V., Horngren's Cost Accounting: A Managerial Emphasis, Pearson.
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UNIT-: IV
LESSON 8
CONTEMPORARY ISSUES IN COST ACCOUNTING AND
MANAGEMENT ACCOUNTING.
Dr. Saumya Jain
Assistant Professor
Shaheed Sukhdev College of Business Studies
saumyajain@sscbs.du.ac.in
STRUCTURE

8.2 Introduction
8.3 Activity Based Costing
8.4 Target Costing
8.5 Life Cycle Costing
8.6 Quality Costing
8.7 Summary
8.8 Glossary
8.11 References
To help students understand about an alternate way of indirect cost allotment

● To help students understand the concept of Market Based pricing
● To enable students to take into account life cycle costs in pricing decisions
● To help students understand the implications of quality on costing
8.2 INTRODUCTIONS
In the previous lessons, the main components of cost and management accounting like
Budgeting and Standard costing were described. These focused on comparing actual costs
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against pre-determined costs, identifying the variances and taking correcting action. These tools
can be described as cost control tools where the focus is on maintaining the status quo.
Nowadays, companies need not only control costs but reduce them and bring about continuous
improvements in quality and productivity. Cost management refers to planning and controlling
costs to ensure customer satisfaction and long-term competitiveness of the business. In the
words of Horngren, cost management is used “to describe the approaches and activities of
managers in the short term and long term planning and control decisions that increase value for
customers and lower costs of products and services ”. Information provided by cost and
management accounting systems help the managers in cost based strategic planning and
improvement of profitability. Cost Management has a broader focus than cost and management
accounting. It involves effective forecasting and linkage of cost with revenues and profit
planning. In this lesson, some of major cost management approaches used in management
decision making are discussed.
8.3 ACTIVITY BASED COSTING
Under the traditional costing system, overheads or indirect costs are assigned to products using
a single absorption rate. Traditional cost accounting may lead to inaccurate determination of
product costs by allocating overhead costs to different cost objects uniformly when in fact
individual cost objects use the resources that lead to overhead costs in different ways leading to
undercosting or overcosting. This may lead inaccurate management decisions especially
relating to pricing. With increase in product range, rise of indirect costs, intense competition
and customization, it is imperative to refine cost systems. Activity Based Costing is a new and
scientific method of costing developed by Robin Cooper and Robert Kaplan (1988) as an
alternative to traditional costing. Activity based costing is one such approach which identifies
total activity costs and objectively assigns these costs to products by identifying the extent to
which each product uses that activity. Cooper and Kaplan (1988) describe ABC as “systems
that calculate the costs of individual activities and assign costs to cost objects such as products
and services on the basis of activities undertaken to produce each product or service”. The
Chartered Institute of Management Accountants (CIMA), London defines ABC as “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..” ABC
is thus a modern tool of overhead assignment which considers activities as consumers of
resources and products as consumers of activities.
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8.3.1 Steps in Activity Based Costing

1. Identify the Cost Objects: The first step in ABC is to identify the unit of production or
distribution (cost object) for which total cost and per unit cost is to be measured. CIMA
defines Cost Object as a “product, service, centre, activity, customer or distribution channel
in relation to which costs are ascertained”. Cost object is any item for which a separate
measurement is required.
2. Determine the direct costs of cost object: Direct costs comprise of direct material, direct
labour and direct manufacturing expenses which can be easily traced to cost objects such as
products.
3. Identify the main activities: This step involves evaluation of various tasks performed in the
organization and grouping them into “activities”. An activity is a task or combination of
tasks that has a specific purpose in the production and distribution process such as machine
set ups, inspections, purchase orders, designing products etc. The number of activities
should neither be too low or too high. A guide to combining activities is to identify which
activities have common cost drivers. Cost driver is the cause or trigger of the cost of an
activity. For example: Setting up machines, operating the machines and maintaining them
can be grouped into a single activity as they have the same cost driver i.e., machine-hours.
4. Create Activity Cost Pools: Activity Cost pools refer to groups of costs that have the same
cost driver. For example: Product Design pool includes all costs (research, prototype
development, engineers’ fees) that increase as the cost driver i.e., number of products
increase.
Table.8.1: Illustrative list of cost pools and cost drivers
Cost Pools Cost Drivers

Order Processing Number of orders
Number of customers
Number of customer visits
Machine set up Number of machine hours
Number of set-ups
Maintenance Number of machine hours
Number of breakdowns
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Number of defects
Distribution Number of orders shipped
Volume of orders shipped
Number of vehicles
Customer Service Number of complaints
Time spent on complaint resolution
5. Determination of absorption rate: All activity cost pools are absorbed using respective cost
drivers as the base. Absorption rate can be calculated by dividing the total cost of activity by
the cost drivers.
6. Charging activity costs to products: The cost of activities are allocated to individual
products using the absorption rate calculated above on the basis of demand of cost drivers by
each product. For example: If the machine set up related costs are Rs.50,000 and total
number of times the machine was set up is 100, the absorption rate is Rs. 500. If Product A
requires 20 set ups (number of machines set ups being the cost driver), Product A will be
charged with Rs. 10,000 out of the total set up costs of Rs.50,000.
8.3.2 Benefits of Activity Based Costing
Activity Based costing offers the following advantages as compared to traditional costing
approach:
1. Accurate cost determination: ABC leads to accurate and precise cost determination through
proper matching of overheads to products through cost drivers.
2. Detailed cost information for decision making: ABC provides segregated cost information
for better decision making especially relating to pricing, profit planning, product lines etc.
3. Cost Control: Managers are able to exercise cost control effectively by identifying value
added and non-value-added activities.
4. Budgeting and Performance Evaluation: Detailed breakdown of cost and identification of
cost drivers leads to realistic budgeting and comparison of actual performance with
budgeted performance.
8.3.3 Limitations of Activity Based Costing
ABC provides superior information for strategic decisions; however, its benefits must be
weighed against the following potential limitations:
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1. Detailed measurements: ABC requires detailed analysis of tasks and grouping them into
activities, calculations relating to cost drivers for each activity, tracing of cost drivers to
products and assignment of costs to products. This is a continuous exercise requiring time,
cost and effort.
2. Difficulty in identification: Sometimes it is difficult to identify the cost driver for each
activity and managers may be forced to arbitrarily select allocation base which may lead to
inaccurate cost assignment.
3. Non-suitability for small organizations: Due to the complexity of ABC systems, it not
suitable for small organizations which may find traditional costing system more feasible.
Activity Based Costing furnishes information that can be used for management decision
making both at strategic and operational level. Data generated by ABC leads to accurate
pricing, product redesigning and overall cost control. Many companies like Ford, Chrysler,
Coco-Cola, UPS, Safety Kleen, Hewlett-Packard, IBM etc have implemented ABC to increase
their understanding of process costs, eliminate unnecessary activities and improve profitability.
A detailed cost benefit analysis is necessary before installing ABC system especially for small
and mid-sized companies. Even though the application of ABC originated in manufacturing
companies since overheads are an inherent part of their production cost, this concept has found
usefulness in service industries as well because of its ability to accurately assign indirect costs
to cost objects and provide data for strategic decisions.
IN-TEXT QUESTIONS
1. The basis of assignment of indirect costs in ABC is:
a) Cost objects
b) Overheads
c) Direct materials
d) Cost Drivers
2. An appropriate absorption basis for maintenance cost would be
a) Area of factory b) Number of employees
c) Machine hours d) Number of orders
8.4 TARGET COSTING
Target costing is a pricing method used by companies. It is defined as "a cost management tool
for decreasing the complete cost of a product over its whole life-cycle with the help of
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production, engineering, research and design". Target Costing is defined as “a disciplined

process for determining and achieving a full-stream cost at which a proposed product
with specified functionality, performance, and quality must be produced in order to
generate the desired profitability at the product’s anticipated selling price over a specified
period of time in the future."
There are two approaches to pricing: The conventional approach which is Cost Based Pricing
or Cost Plus Pricing and Market based Pricing approach which is Target Costing.
Under the cost-based pricing approach, companies add a desired profit margin to their costs and
arrive at the estimated selling price. These companies first consider their costs and then look at
the market. If the estimated selling price is too high, they try to reduce the costs to attain the
desired profit margin. This type of costing approach works well in less competitive markets as
companies have freedom to dictate the price.
Under the market-based pricing approach, companies set a target price based on competition
and customers and then deduct a target profit margin to arrive at the target cost. These
companies first consider the markets and then look at the costs. Target costing is based on
thorough research of customers’ needs, prices that they are willing to pay, competitors’ prices
and then focusing on product development and design to meet the customer requirements
within the confines of target cost and prices. This type of costing is mostly used in competitive
markets like FMCG (Fast Moving Consumer Goods), travel, hospitality, healthcare, telecom
where companies must match the prices set by the competitors. The focus of target costing is
on cost management whereas that of cost-based pricing is cost reduction. As per CIMA, a
target cost is “a product cost estimate derived from a competitive market price”. Target costing
has its origin in Japan in the late 1960s and is considered as the reason behind unique
competitiveness of Japanese companies in the 1980s. Sakurai (1989) writes that “…target
costing can be defined as a cost management tool for reducing the overall cost of a product
over its entire life cycle with the help of production, engineering, R&D, marketing and
accounting departments.” Target costing is a structured approach to product development
where companies work backwards by first understanding customer requirements and
competitors’ potential reaction and then focus on value engineering from the design stage to
achieve the targeted selling price while retaining the products quality and specification as per
the market requirements. One of the famous examples of target costing in the Indian context is
Tata Nano. Tata Nano’s target price was fixed at around Rs. One Lakh by the then chairman of
the Tata conglomerate, Mr. Ratan Tata as he wanted to provide an affordable and safe vehicle
for Indian families, fulfilling their dream of owning a four-wheeler. The company was able to
achieve this ambitious dream through clear understanding of target customers’ requirements,
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innovation in product design, distributed manufacturing and assembly and collaboration with
suppliers and vendors. This is a perfect example of how target costing helped Tata Motors
delivers on its Chairman’s vision of “people’s car” without compromising on the desired
performance and safety features.
8.4.1 Steps in Implementing Target Costing
1. Market Research and Selecting a Target Price: The starting point of target costing is
understanding what features of product are valued by the customers and how much they are
willing to pay for it. Customer feedback, prices of the competing products, market size and
estimated demand are analysed before the product specifications and design are finalised.
These inputs become the basis of determination of target selling price.
2. Determine target cost per unit: The next step is to arrive at the target cost per unit by
deducting the target profit per unit from the target selling price. The target cost should take
into account the total costs that the firm must recover to remain profitable in the long run.
3. Attain Target Cost: Once the target cost is established, the next step is to achieve it through
Value Engineering. Value engineering is a systematic study of value chain by a cross
functional team of experts to identify opportunities for reducing cost while retaining the
utility of the product. The avenues for cost reduction may involve product design, materials,
production technology, plant location etc. While implementing value engineering, the team
tries to identify value added and non-value-added cost. Value added costs are those which
are necessary to maintain the specific functionality of the product for the customers and if
removed, would reduce the actual value or utility of the product. For example: Direct
material and labour are value added costs. Non-value added costs are those which if
removed would not affect the basic utility of the product. Cost of reworking, rejects, product
recalls are examples of non-value added costs. In some cases, it is not easy to distinguish
between value added and non-value added costs. The distinction also depends on the
targeted market segment. Target costing is generally focused on basic product value and
incorporating design and process changes for features that all customers desire and are
willing to pay for. Costs need to be managed before they are locked in i.e., committed to be
incurred in future because of decisions taken in the present. For example: Once the product
design is finalized, there is not scope for cost reduction in the materials requirement per unit.
Thus, to summarise, attainment of target cost consists of identifying the perceived value of
the product for the specific target customer, assigning cross functional team to study all
aspects of value chain and identify value added and non-value added costs and finally,
managing costs before they are locked in.
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8.4.2 Benefits of Target Costing

1. Cost Minimisation: Target costing involves determination of maximum costs and entails
efforts to meet that cost at all stages of value chain while meeting customers’ needs and
wants. It also eliminates defects, wastages and costly revisions after production.
2. Market orientation: Under Target costing, products are driven by market rather than
business capabilities. Target costing begins with thorough research of customers’
requirements, defining product features, deciding the price they would be willing to pay and
then trying to achieve the target margins through continuous cost reduction.
3. Profitability: Target costing involves active simultaneous focus on costs and prices leading
to improved profitability.
4. Innovation: As management looks for alternative ways to attain target cost, it gives rise to
innovation which may also lead to a product differentiation and competitive edge to the
company.
8.4.3 Limitations of Target Costing
1. Burden on employees: In a bid to continuously reduce the costs, employees may be unduly
burdened and may also be penalized for failing to meet the targets.
2. Conflicts in the organization: Even though all the departments are equally involved in value
engineering, there is greater burden on the manufacturing department which may lead to
organisational conflicts. Also, problems of co-ordination may arise when there are multiple
experts on the team.
3. Compromise on Quality: It is possible that managers may resort to use of cheaper
substitutes to attain the target costs which may do more harm than good in the long run.
4. Inaccurate estimations: Since, target price is the basis for the entire process, failing to
estimate it with reasonable accuracy may lead to failure of the entire project.
In order to address these limitations, it is important that:
(1) There should be strong top management leadership and employee participation in
implementing target costing system.
(2) Team orientation and commitment among employees
(3) Realistic performance standards
(4) Specific cost goals for all departments rather than overall goal for the entire team.
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IN-TEXT QUESTIONS
3. Target Cost is:
a) Prime Cost
b) Selling price minus predetermined profit margin
c) Target Price less Target Profit
d) Works Cost
4. Target Costing has its origin in which country?
a) Japan b) India
c) USA d) None of these
8.5 LIFE CYCLE COSTING
When making budgets and establishing pricing, managers sometimes consider the cost of the
product over its entire life cycle spanning from research and development to the stage where
support and service for the product is withdrawn. Life cycle costing (LCC), also referred to as
Whole Life Costing tracks the costs and revenues of a cost object i.e. project, product or asset
right from its procurement, operation, maintenance till disposal. The difference between
traditional costing and life cycle costing is that traditional focuses primarily on the
manufacturing stage whereas life cycle costing involves reporting on the costs and revenues
multiple calendar periods throughout the life cycle of the cost object i.e. pre manufacturing,
manufacturing and post-manufacturing. Traditional costing reports on the income in one
calendar period whereas LCC reports on income over multiple calendar periods.
Life cycle costing provides an overall long-term picture of product cost and the amount the
firm must recover throughout the product’s life cycle for long term profitability. The costs are
discounted for uniform evaluation and life cycle revenues can be compared with the life cycle
costs to determine overall profitability. Each stage of product’s life cycle offers different threats
and opportunities and strategies should be framed accordingly in advance. Life cycle costing
can also be basis for evaluation of new projects/assets and effective decisions. LCC should also
focus on the environmental costs and sustainability investments as greater regulations relating
to environmental impact of industries come into force. Life cycle cost Analysis (LCCA) can
also be used by consumers while choosing between different assets especially those which
require regular maintenance such as automobiles, home appliances etc. This is also referred to
as Customer Life Cycle Costing.
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1.5.1 Stages of Product Life Cycle

1. Market research: This stage involves understanding of target market’s needs and wants,
existing products and how much the market would be willing to pay for the product.
2. Product features: This stage involves identification of basic product features related to
functionality, durability, performance, maintenance cost etc.
3. Design and Development: This stage involves drawing the product, processes, running,
testing and redesigning. The product goes through many iterations before the design is
finalized and prototype is market ready.
4. Market testing: The product is introduced on a small scale to gauge market reaction.
5. Production: Once the product passes the market test, it is produced on a mass scale.
6. Sales and Distribution: Finished products are shipped to the final consumers
7. Customer Support
8. Phasing Out: In this phase, further production is stopped and customer support for existing
products is also rolled back.
Product Life Cycle Costing involves taking into account all the costs that would be incurred in
the above-mentioned stages and incorporating those in budgets and pricing so that income
generated throughout the product life cycle is sufficient to cover the life cycle costs.
1.5.2 Benefits of Life Cycle Costing
1. Life Cycle Costing forces managers to see the long-term consequences of their decisions and
make decisions relating to design, pricing, life cycle wisely.
2. Life Cycle Costing is a pro-active rather than reactive approach to maximise total operating
income over the life cycle of product. Prices can be lowered during the introduction stage
and increased during the growth stage to maximise life time revenue.
3. It generates cost consciousness in the organization as all costs from “cradle to grave” are
analysed beforehand and cost reduction efforts can be initiated early on.
4. Life Cycle Costing leads to more accurate determination of cost per unit.
1.5.3 Limitations of Life Cycle Costing
1. This method relies heavily on estimations and if market projections are wrong, the entire
costing and pricing will fail.
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2. In a dynamic market, Life Cycle Costing may not be feasible as uncertainties render long
range planning futile.
8.6 QUALITY COSTING
In the modern competitive era, many major companies like Apple, Samsung, Toyota, Philips,
Ford are using quality as a strategic tool to distinguish their products from competitors and
maximise customer satisfaction. There are varied definitions of quality. One of the most widely
accepted definition for quality is Dr. Juran’s “fitness for use” approach which implies that the
product should be suitable for those who will use it. Quality refers to the “sum total of features
and characteristics of a product that bear on its ability to satisfy stated or implied needs and
wants”. Companies try to balance the costs of providing quality product against superior
performance which the customers will value and then gradually gaining expertise and cost
competitiveness over it. Quality cost or cost of quality (COQ) refers to the total cost a
company incurs in preventing quality deficiencies and providing quality product. Quality costs
are grouped into four categories:
1. Prevention costs: Prevention costs are incurred to prevent products from falling outside the
acceptable performance standards. Example of these costs would be materials research,
design and process innovations, training of employees etc.
2. Appraisal costs: Appraisal costs are incurred to determine which products do not fall within
the performance standards so that timely action can be taken. These include random
sampling, inspection, surveying, testing etc.
3. Cost of Internal Failure: Costs incurred on rectifying the defective products before they are
delivered to the customers are referred to as Internal Failure costs. These include reworking
on the defectives, machine maintenance, additional materials etc.
4. Cost of External Failure: Costs incurred on rectifying the defective products after they are
delivered to the customers are referred to as External Failure costs. These include warranty
costs, product recalls, customer service, product liability claims etc. There are also non-
financial aspects of external failure as it hampers the image of the company.
Quality costing involves keeping an account of the above costs so that resulting benefits can be
compared against it. Quality cost is the sum of the above four types of costs. As the company
invests more in prevention and appraisal costs (sometimes referred to as Conformance costs),
the costs of internal and external failure ( Non-conformance) should decline. Apart from these
four, one more cost can be included which is revenue foregone because firm was not able to
keep up with the quality standards. Even though these costs cannot be measured directly, they
need to be included on estimated basis. Quality costing helps managers in identifying and
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removing costs of internal and external failure and analyse how poor quality affects overall
revenue and profits.
The above discussion relates to financial measures of quality. There are also non-financial
measures that managers can track to measure their performance on quality aspect which relates
to customer satisfaction. Some of these measures are:
1. Number of complaints received
2. Number of repeat orders
3. Customer feedback
4. Number of order cancellations
5. Market share
6. Social media following
Companies keep track of these measures to gauge level of customer satisfaction. High customer
satisfaction leads to higher market shares, brand loyalty and low-quality costs.
1.6.1 Tools for Quality Control
1. Control Charts: Control charts are a formal tool of statistical quality control where samples
are measured for deviations within acceptable limits. Each observation is plotted on a chart
which contains the average measure (For example: average diameter of tubes), upper control
limit and lower control limit. The upper and lower control limits represent acceptable level
of departures from average. If a large number of sample observations fall outside the limits,
the process is deemed out of control and requires investigation. The following figure
represents a control chart for a process under control.
Figure 8.1: Control Chart for Process under control
2. Pareto Diagrams: Pareto Diagrams are a tool of quality control which plot the type of
defects observed against frequency of occurrence in descending order. It represents the
sources of defects and most commonly occurring defects. Generally, one or two defects
account for majority of customer complaints which can be identified easily using this chart.
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Figure 8.2: Pareto Diagram
3. Cause and Effect/Fish-Bone Diagrams: The major defects identified through Pareto
Diagrams can be further analysed through Cause and Effect Diagram which represents the
bone structure of a fish wherein the head of the bone is the Problem and the body/skeleton
represents underlying causes of the problem. The arrows leading upto the head/problem
represent broad causes and smaller arrows represent primary and secondary causes. For
example: In the ‘people’ cause, the small arrows can be improper training (Primary Cause)
and Frequent changes in trainer (Secondary Cause)
Figure 8.3: Generic Cause and Effect Diagram
Apart from these, there are other tools of quality control are Check lists, Scatter Plots, Flow
Charts etc. The ultimate goal of using these tools is to minimize variations in the process and
improve quality.
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IN-TEXT QUESTIONS
1. Which of the following is not included in Life Cycle costs?
a) Design costs
b) Development costs
c) Selling costs
d) None of these
2. Which of the following quality cost is not an out of pocket cost:
a) Appraisal Cost b) Cost of opportunity lost
c) Prevention cost d) Cost of Internal Failure
8.7 SUMMARY
Solved Example 1 (Activity Based Costing):

Fine Cocoa Ltd. makes two types of chocolates: Regular chocolate and luxury gourmet
chocolates. Regular chocolates are distributed to 10 local distributers in 2,50,000 cartons and
gourmet chocolates are distributed to 25 premium distributers in 1,50,000 cartons. The
company incurs a sum Rs. 30,05,000 in distribution costs. Under the existing costing system,
the distribution costs are charged on the basis of number of cartons shipped. The following
break up of distribution costs is given:
Marketing costs: Rs. 12000 per distributor
Order processing costs: Rs. 500 per order (Regular chocolates are ordered 12 times on an
average per annum and Premium chocolates have on an average 10 orders per annum)
Delivery costs: Rs. 6 per carton
Required:
1) Calculate the distribution cost per carton of both types of chocolates as per Fine Cocoa’s
existing costing system.
2) If Fine Cocoa implements Activity based costing, calculate distribution cost per carton of
both types of chocolates.
3) Explain the reasons for differences between the two costing systems and which system is
able to provide accurate product costs.
Solution:
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Total Distribution Cost: Rs. 30,05,000
1) Distribution cost per carton under existing costing system
per carton
Total Distribution Regular Chocolate Premium Chocolate Total
costs
Rs. 12.5 X No. of 2,50,000 X = Rs. 1,50,000 X = Rs. Rs.

cartons 1878125 1126875 30,05,000
2) Distribution cost per carton under Activity Based Costing

Marketing costs Regular Chocolate Premium Chocolate
Rs. 12000 X No. of 12000 X 10 = Rs. 12000 X 25 = Rs.

distributors 1,20,000 3,00,000
Order Processing
costs
Rs 500 X Average 500 X 12 X 10 = Rs. 500 X 10 X 25 = Rs.
No. of orders p.a. X 60,000 1,25,000
No. of distributors
Delivery costs
Rs 6 X No. of cartons 6 X 2,50,000 = Rs. 6 X 1,50,000 = Rs.
15,00,000 9,00,000
Total Distribution Rs. 1680000 Rs. 13,25,000

costs
Cost per carton Rs. 6.72 Rs. 8.83
3) Under the existing (traditional) costing system, total distribution cost allocated to premium
chocolates is less than regular chocolates. Both the products are allocated distributions costs
at the same rate per carton though premium chocolate uses more resources as compared to
regular chocolates. The marketing costs are the same for both types of distributors whereas
premium chocolate distributors are more in number so it should bear greater proportion of
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marketing costs. Also, premium chocolate should bear more order processing costs as it has
more number of distributors. The traditional costing system is undercosting distribution
costs per carton for premium chocolates and overcosting distribution costs per carton for
regular chocolates. Thus, ABC is helpful accurate determination of product costs in this case
based on cause and effect relationship.
Solved Example 2 (Activity Based Costing): Insignia Tiles Co. produces two types of tiles:
Gloss and Matte. The company uses traditional costing system to allocate overheads on the
basis of machine hours. The present cost structure is given below:
Matte Glossy
Units sold 4000 2500
Selling price 250 400
Direct material cost p.u 125 175
Direct labour cost p.u 75 85
Production runs 40 60
Machine set ups 45 65
Number of inspections 150 100
Machine hours 550 450
The company is considering implementing Activity based Costing and has identified the
following indirect costs:
Machine Set up Rs. 40,000
Production Scheduling Rs.1,00,000
Inspection Rs. 25000
Maintenance Rs. 75000
Marketing Costs Rs. 80,000
Required:
a) Calculate the cost of both type of tiles under traditional costing system
b) Calculate the cost of both type of tiles under Activity Based Costing system
Solution:
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a) Total Indirect Costs: Rs. 3,20,000 (Rs. 40,000 + 1,00,000 +25000 +75000+80000)
Total machine hours: 1000 (550 + 450)
Indirect cost per machine hour = 3,20,000/1000
= Rs. 320 per machine hour
Calculation of Cost per unit under Traditional Costing System
Traditional Costing System Matte (Rs.) Glossy (Rs.)
Direct material cost 500000 437500

Direct labour cost 300000 212500
Indirect cost 176000 144000
Total costs 976000 794000
Units 4000 2500
Cost per unit 244 317.6
b) Calculation of cost driver rates under Activity Based Costing

Quantity of Cost Absorption
Activity Amount Cost Driver Driver Rate
Machine Set up 40000 Machine set ups 110 363.64
Production Scheduling 100000 Production runs 100 1000
Number of
Inspection 25000 inspections 250 100
Maintenance 75000 Machine hours 1000 75
Marketing Costs 80000 Units sold 6500 12.31
Activity Based Costing Matte (Rs.) Glossy (Rs.)

Direct material cost 500000.00 437500.00
Direct labour cost 300000.00 212500.00
Indirect Costs:
Machine Set up 16363.64 23636.36
Production Scheduling 40000.00 60000.00
Inspection 15000.00 10000.00
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Maintenance 41250.00 33750.00

Marketing Costs 49230.77 30769.23
Total costs 961844.41 808155.59
Units 4000.00 2500.00
Cost per unit 240.46 323.26
Solved Example 3 (Quality Costing): MeeMaw Go company produces strollers for kids from
ages zero to three years old. The company wishes to analyse its quality costs because of a
recent safety incident involving its competitor’s products. The company has determined from
past data that its only problem area is the grip of the seat belt buckle. The companies’
inspection cost per stroller is Rs. 45 and repair cost is Rs. 10 per stroller. Out of the 1,00,000
strollers produced last year, 4% were found to be defective and repaired. Another 0.5% failed
detection and were sold. The defective strollers that are sold are shipped back to the company
and repaired. Shipping costs are Rs. 60 per stroller and repair costs are the same. The company
estimated the loss in sales due to damage in reputation is about 1% and the contribution margin
per stroller is Rs. 675. You are required to calculate the total and individual cost of quality.
Solution:
Appraisal costs (Cost of Inspection) = Rs. 45 X 1,00,000 = Rs. 45,00,000
Internal Failure Costs (Repair costs) = Rs. 10 X 1,00,000 X 0.04 = Rs. 40,000
External Failure Costs (Shipping costs + Repair costs) = Rs. 60 X 500 + Rs. 10 X 500 = Rs.
35000
Opportunity cost (loss in sales) = 0.01 X 100000 X Rs 675 = Rs. 6,75,000
Total quality costs = Rs. 45,00,000 + Rs. 40,000 + Rs. 35000 + Rs. 6,75,000 = Rs. 52,50,000
8.8 GLOSSARY
In this lesson, some of the modern management techniques for costing and pricing are
discussed in detail. These tools enable a company to measure its costs accurately, estimate
prices that the market would be willing to accept and build a quality product that would
improve customer satisfaction and consequentially company profitability. Companies can use
these techniques in conjunction with each other to reap greater benefits. For example: The
target costs could be arrived at using the life cycle costing approach. Similarly, for accurate
costing, companies can use the Activity Based Costing system to assign indirect costs to
different products in a reliable manner. With increasing competition, changing consumer
preferences, increased accountability to different stakeholders and consumer awareness, it is
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imperative that companies use new and improved cost management techniques for continuous
cost reduction and quality improvement without compromising on customer satisfaction.

• Activity: An activity is a task or combination of tasks that has a specific purpose in the
production and distribution process
• Appraisal costs: Appraisal costs are those costs which are incurred to determine which
products do not fall within the performance standards so that timely action can be taken
• Cause and effect diagram: Cause and Effect Diagrams are a tool of problem analysis which
represents the bone structure of a fish wherein the head of the bone is the problem and the
body/skeleton represents underlying causes of the problem.
• Control chart: Control charts are a formal tool of statistical quality control where samples
are measured for deviations within acceptable limits
• Cost of quality: Cost of quality (COQ) refer to the total cost a company incurs in preventing
quality deficiencies and providing quality product
• Pareto Diagram: Pareto Diagrams are a tool of quality control which plot the type of defects
observed against frequency of occurrence in descending order.
• Prevention costs: Prevention costs are incurred to prevent products from falling outside the
acceptable performance standards.
• Value engineering: Value engineering is a systematic study of value chain by a cross
functional team of experts to identify opportunities for reducing cost while retaining the
utility of the product.
8.10 SELF-ASSESSENT QUESTIONS
1. (d) Cost Drivers 4. (a) Japan

2. (c) Machine hours 5. d) None of these
6. (b) Cost of opportunity lost
3. (c) Target Price less Target Profit
8.11 REFERENCES
27. “The costs of installing Activity Based Costing system outweigh its potential benefits”.
Comment.
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28. What are the factors influencing pricing apart from cost and market conditions?
29. Explain the components of Quality Costs.
30. Discuss the advantages and limitations of Life Cycle Costing
31. What are the conditions that indicate that the company should go for Market Based /Target
Pricing?
32. Discuss the behavioural implications of installing Quality Costing in an organisation.
33. Activity Based Costing Systems are suitable only for manufacturing organisations.
Comment.
• Arora, M. N. (2020). A textbook of Cost and Management Accounting. Vikas Publishing House Pvt
Ltd.
• Cooper, R. and Kaplan, R.S. (1988) , Measure Costs Right: Make the Right Decisions. Harvard
Business Review, 66, 96-103.
• Horngren, Datar, S., & Rajan, M. (2020). Cost Accounting : A managerial Emphasis. Pearson.
• Sakurai (1989), Target Costing and How to Use It. Journal of Cost Management for the
Manufacturing Industry, Pp 39-50
• The Chartered Institute of Management Accountants, London. (2005). CIMA Official Terminology.
CIMA Publishing.
• Cooper, R. and Kaplan, R.S. (1988). How cost Accounting distorts Product Costs. Management
Accounting, 69Feil, P., Yook, K., & Kim, W. (2004). Japanese Target Costing : A Historical
perspective. nternational Journal of Strategic Cost Management.
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Cost and Management Accounting SLM (BMS&BBAFIA)

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Department of Distance and

Bachelor of Business Administration

Bachelor of Management Studies

As per the UGCF - 2022 and National Education Policy 2020

© Department of Distance and Continuing Education

© Department of Distance & Continuing Education, Campus of Open Learning,

Lesson 1: Introduction to Cost and Management accounting………………………………...01

1.1 Learning Objectives

Lesson 3: Classification of Costs…………………………………………………………………..78

3.1 Learning Objectives

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3.6 Controllability-based cost

Lesson 4: Cost Volume Pofit Analysis………………………………………………………………96

4.1 Learning Objectives

Lesson 5: Relevant costs and Decision Making……………………………………………….128

5.1 Learning Objectives

Lesson 6: Budgets and Budgetary Control……………………………………………………152

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6.4 Types of Budgets

Lesson 7: Standard Costing………………………………………………………………….177

7.1 Learning Objectives

8.1 Learning Objectives

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1.1 LEARNING OBJECTIVES

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● Develop an understanding of the difference between cost accounting and management

● Describe the roles of cost accounting and management accounting.

● List and explain the components of cost.

1.3 MEANING, NATURE AND SCOPE OF COST ACCOUNTING

A financial analyst must apply several management accounting methodologies in order to

© Department of Distance & Continuing Education, Campus of Open Learning,

© Department of Distance & Continuing Education, Campus of Open Learning,

© Department of Distance & Continuing Education, Campus of Open Learning,

© Department of Distance & Continuing Education, Campus of Open Learning,

1.4 MEANING, NATURE AND SCOPE OF MANAGEMENT

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© Department of Distance & Continuing Education, Campus of Open Learning,

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The management accounting temperament is wholly preoccupied with predicting. To determine

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1.5 Comparison between Cost Accounting & Management Accounting

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© Department of Distance & Continuing Education, Campus of Open Learning,

regulating, and minimizing use of financial accounting and

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© Department of Distance & Continuing Education, Campus of Open Learning,

1.6 Cost Control, Cost Reduction & Cost Management

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© Department of Distance & Continuing Education, Campus of Open Learning,

to raise the bar and modifies all norms.

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© Department of Distance & Continuing Education, Campus of Open Learning,

1.7 Components of Total Cost & Preparation of Cost Sheet

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© Department of Distance & Continuing Education, Campus of Open Learning,

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