METHODS AND TECHNIQUES OF

COSTING

Dr. Pooja Mathur

 DIFFERENCE BETWEEN METHODS
AND TECHNIQUES OF COSTING
• The difference between costing method and costing techniques
is that that costing techniques uses methods for reducing and
controlling the costs.
• The costing method is used to find out the costs of goods and
services

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 DIFFERENCE BETWEEN METHODS
AND TECHNIQUES OF COSTING
Costing methods
• Costing methods are use calculating and evaluating the
cost for different processes involved in manufacturing of
the goods.
• The costing methods include the costs of process costing,
cost of contract and more.

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 DIFFERENCE BETWEEN METHODS
AND TECHNIQUES OF COSTING
Costing techniques
• The various forms of methods like finding the marginal
cost, activity cost and costing of other processes that
involve the total cost of the jobs
• The costing techniques are methods which are used to
minimize the costs involved in various processes.

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CONTRACT COSTING

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 CONTRACT COSTING
• In contract costing each contract is treated as a cost unit
and costs are ascertained separately for each contract.
• It is suitable for business concerned with building or
engineering projects or structural or construction
contracts.
• Usually, there is a separate account for each contract.
• Also the number of contracts undertaken at a time,
generally, not being very large, the Contract Ledger can
very well be operated as part of the financial books.
 CONTRACT COSTING
• The contract account is debited with all direct and indirect
expenditure incurred in relation to the contract.
• It is credited with the amount of contract price on completion
of the contract.
• The balance represents profit or loss made on the contract
and is transferred to the profit and loss account.
• In case, the contract is not completed at the end of the
accounting period, a reasonable amount of profit, out of the
total profit made so far on the incomplete contract, may be
transferred to profit and loss account.
 MEANING OF THE TERMS USED IN
CONTRACT COSTING
Work-in-Progress: Work-in-progress in contract costing
refers to the contract which is not complete at the reporting
date.
• In Contract Accounts, the value of the work-in-progress
consists of
(i) the cost of work completed, both certified and uncertified;
(ii) the cost of work not yet completed; and
(iii) the amount of estimated/ notional profit.

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 MEANING OF THE TERMS USED IN
CONTRACT COSTING
• In the Balance Sheet (prepared for management), the work-in-
progress is usually shown under two heads, viz., certified and
uncertified.
• The cost of work completed and certified and the profit
credited will appear under the head ‘certified’ work-in-
progress,
• while the completed work not yet certified, cost of material,
employee and other expenses which has not yet reached the
stage of completion are shown under the head “uncertified”
work-in-progress 9
 MEANING OF THE TERMS USED IN
CONTRACT COSTING
Cost of Work Certified or Value of Work Certified: A
contract is a continuous process and to know the cost or
value of the work completed as on a particular date;
assessment of the completion of work is carried out by an
expert (it may be any professional like surveyor, architect,
engineer etc.).
The expert, based on his assessment, certifies the work
completion in terms of percentage of total work

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MEANING OF THE TERMS USED IN
CONTRACT COSTING

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 MEANING OF THE TERMS USED IN
CONTRACT COSTING
• Cost of Work Uncertified: It represents the cost of the
work which has been carried out by the contractor but has
not been certified by the expert. It is always shown at cost
price.

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 MEANING OF THE TERMS USED IN
CONTRACT COSTING
Progress Payment: A Contractor gets payments for work done on a
contract based on work completion.
• Since, a contract takes longer period to complete and requires large
investment in working capital to progress the contract work, hence, it
is desirable by the contractor to have periodic payments from the
contractee against the work done to avoid working capital shortage.
• For this a contactor enters into an agreement with the contractee and
agrees on payment on some reasonable basis, which generally,
includes percentage of work completion as certified by an expert.
Progress payment = Value of work certified – Retention money –
Payment to date
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 MEANING OF THE TERMS USED IN
CONTRACT COSTING
• Retention Money: In a contract, a contractee generally
keeps some amount payable to contractor with himself as
security deposit.
• To have a cushion against any defect or undesirable
work, the contractee upholds some money payable to
contractor. This security money upheld by the contractee
is known as retention money.
Retention Money = Value of work certified – Payment
actually made/ cash paid
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 MEANING OF THE TERMS USED IN
CONTRACT COSTING
• Cash Received: It is ascertained by deducting the
retention money from the value of work certified i.e.

Cash received = Value of work certified – Retention

money

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 MEANING OF THE TERMS USED IN
CONTRACT COSTING
• Notional Profit: It represents the difference between the
value of work certified and cost of work certified. It is
determined:
Notional profit = Value of work certified – (Cost of work
to date – Cost of work not yet certified)
• Estimated Profit: It is the excess of the contract price
over the estimated total cost of the contract.

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 COST PLUS CONTRACT

• Cost- plus contract is a contract where the value of the

contract is determined by adding an agreed percentage of
profit to the total cost.
• These types of contracts are entered into when it is not
possible to estimate the contract cost with reasonable
accuracy due to unstable condition of factors that affect
the cost of material, employees, etc.

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 ESCALATION CLAUSE IN A CONTRACT

• Escalation clause in a contract empowers a contractor to

revise the price of the contract in case of increase in the
prices of inputs due to some macro- economic or other
agreed reasons.
• As per this clause, the contractor increases the contract
price if the cost of materials, employees and other
expenses increase beyond a certain limit.

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PROCESS COSTING (TREATMENT OF
ABNORMAL LOSS/ GAIN)
 PROCESS COSTING
• Process costing is that aspect of operation costing which is
used to ascertain the cost of the product at each process or
stage of manufacture.
• This method of accounting used in industries where the
process of manufacture is divided into two or more
processes.
• The objective is to find out the total cost of the process and
the unit cost of the process for each and every process.
• Usually the industries where process costing used are
textile, oil industries, cement, pharmaceutical etc.
 NORMAL PROCESS LOSS

• It is the loss which is unavoidable on account of

inherent nature of production process.
• Such loss can be estimated in advance on the
basis of past experience or available data.
 NORMAL PROCESS LOSS
• The normal process loss is recorded only in terms
of quantity and the cost per unit of usable
production is increased accordingly.
• Where scrap possesses some value as a waste
product or as raw material for an earlier process,
the value thereof is credited to the process
account.
• This reduces the cost of normal output; process
loss is shared by usable units.
 ABNORMAL PROCESS LOSS
• Any loss caused by unexpected or abnormal conditions
such as plants breakdown, sub-standard materials,
carelessness, accident etc., or loss in excess of the
margin anticipated for normal process loss should be
regarded as abnormal process loss.
COST PER UNITS OF COMPLETED AND
ABNORMAL GAIN /LOSS

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ABNORMAL PROCESS LOSS

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 ABNORMAL GAIN
• We know that margin allowed for normal loss is an
estimate, (i.e., on the basis of expectation in process
industries in normal conditions) and slight differences are
bound to occur between the actual output of a process
and that anticipated.
• These differences will not always represent increased
loss, on occasions the actual loss will be less than that
expected.

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 ABNORMAL GAIN
• Thus, when actual loss in a process is smaller than that
was expected, an abnormal gain results.
• The value of the gain will be calculated in similar manner
to an abnormal loss.
• The Abnormal Gain Account is to be debited for the loss
of income on account of less quantity of sale of scrap
available as a result of abnormal gain and Normal
Process Loss Account credited accordingly.
• The balance is transferred to Costing Profit and Loss
Account as abnormal gain.
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MARGINAL COSTING
 MARGINAL COSTING

• Marginal Costing is a technique of cost and management

accounting which is used to analyse relationship between
cost, volume and profit.
 MARGINAL COST
• Marginal cost as understood in economics is the
incremental cost of production which arises due to one-
unit increase in the production quantity.
• Variable costs have direct relationship with volume of
output and fixed costs remains constant irrespective of
volume of production.
• Hence, marginal cost is measured by the total variable
cost attributable to one unit.
 MARGINAL COSTING
• It is a costing system where products or services and
inventories are valued at variable costs only.
• It does not take consideration of fixed costs. This system
of costing is also known as direct costing as only direct
costs forms the part of product and inventory cost.
• Costs are classified on the basis of behavior of cost (i.e.
fixed and variable) rather functions.
 DIRECT COSTING

• Direct costing and Marginal Costing is used

synonymously at various places and it is so also.
• Some costs are variable at batch level but fixed for
unit level and likewise variable at production line
level but fixed for batches and units

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 DIFFERENTIAL AND INCREMENTAL COST
• Differential cost is difference between the costs of two
different production levels.
– It is a relative representation of costs for two different levels either
increase or decrease in cost.
• Incremental cost is the increase in the costs due change in
the volume or process of production activities.
– Incremental costs are sometime compared with marginal cost but
in reality there is a thin line difference between the two.
– Marginal cost is the change in the total cost due to production of
one extra unit while incremental cost can be both for increase in
one unit or in total volume.
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DETRMINATION OF COST AND PROFIT
UNDER MARGINAL COSTING

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  Amount Amount (`)
(`)
Revenue (A)   xxx
Product Cost:    
xxx  
- Direct Materials xxx  
- Direct employee (labor) xxx  
- Direct expenses xxx  
xxx  
- Variable manufacturing overheads
xxx
Product (Inventoriable) Costs: (B)
Product Contribution Margin {A – B}   xxx
- Variable Administration overheads
xxx  
- Variable Selling & Distribution overheads xxx xxx
Contribution Margin: (C)
Period Cost: (D)   xxx
   
Fixed Manufacturing expenses
xxx  
Fixed non-manufacturing expenses xxx
xxx

Profit/ (loss) {C – D}   xxx

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 BREAK-EVEN ANALYSIS AND
CALCULATION OF SALES FOR DESIRED
PROFIT
 BREAK-EVEN ANALYSIS/COST-VOLUME
PROFIT ANALYSIS
• A fixed cost is one that is independent of the level of
sales; rather, it is related to the passage of time.
• Examples of fixed costs include rent, salaries and
insurance.
• A variable cost is one that is directly related to the level of
sales, such as cost of goods sold and commissions.

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 BREAK-EVEN ANALYSIS/COST-VOLUME
PROFIT ANALYSIS
• This categorisation of costs into “variable” and “fixed”
elements and their relationship with sales and profits has
been developed as “break-even analysis”. This break
even analysis is also known as Cost–volume– profit
(CVP) analysis.
• Cost–volume–profit (CVP) analysis is defined in CIMA’s
Official Terminology as ‘the study of the effects on future
profit of changes in fixed cost, variable cost, sales price,
quantity and mix’.
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 FACTORS AFFECTING COST

• Volume of production;
• Product-mix;
• Internal efficiency;
• Methods of production; and
• Size of plant; etc.

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 FACTORS AFFECTING COST-
VOLUME-PROFIT
• Volume of sales;
• Selling price;
• Product mix of sales;
• Variable costs per unit; and
• Total fixed costs.

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 USES OF COST-VOLUME-PROFIT
ANALYSIS
• C.V.P. analysis helps in forecasting costs and profits as a
result of change in volume.
• It helps fixing a sales volume level
• It assists determination of effect of change in volume
• C.V.P. analysis helps in determining relative profitability of
each product, line, project or profit plan.
• Through cost volume-profit analysis inter-firm comparison
of profitability can be done intelligently.

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 USES OF COST-VOLUME-PROFIT
ANALYSIS
• It helps in determining cash requirements at a desired
volume of output, with the help of cash breakeven charts.
• Break-even analysis emphasises the importance of
capacity utilisation for achieving economy.
• From break-even analysis during severe recession, the
comparative effects of a shut down or continued operation
at a loss is indicated.

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 USES OF COST-VOLUME-PROFIT
ANALYSIS
• The effect on total cost of a change in the fixed over-head
is more clearly demonstrated through break-even analysis
and cost- volume-profit charts.
• The conditions of a business such as profit potentialities,
requirements of capital, financial stability and incidence of
fixed and variable costs can be gauged from a study of
the position of the breakeven point and the angle of
incidence in the break-even chart.

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STATEMENT/RELATIONSHIP OF EBIT
AND EPS
Total Sales
Less: Variable Cost
Contribution
less: Fixed Cost
EBIT (Operating Profit)
Less: Interest
EBT
Less: Taxes
EAT
Less: Preference Dividend
Equity Earnings
 CONTRIBUTION

• Contribution is the difference between selling price and

variable cost of sales.
• It is visualised as some sort of a fund or pool, out of which
all fixed costs, irrespective of their nature are to be met,
and to each product has to contribute its share.
• The excess of contribution over fixed costs is the profit. If
the total contribution does not meet the entire fixed cost,
there will be loss.

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 CONTRIBUTION

• Selling price containing profit:

– Contribution = Fixed cost + Profit
• Selling price at cost:
– Contribution = Fixed cost
• Selling price at loss:
– Contribution = Fixed cost − Loss

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 MARGINAL COST EQUATION

• Sales-Cost= Profit
Or
• Sales- (Fixed cost + Variable cost)= Profit
Or
• Sales- Variable cost= Fixed cost + Profit
S- V= F + P

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 PROFIT-VOLUME RATIO

• The ratio or percentage of contribution margin to sales is

known as P/V ratio.
• This ratio is also known as marginal income ratio,
contribution to sales ratio, or variable profit ratio.
• P/V ratio, usually expressed as a percentage, is the rate
at which profit increases with the increase in volume.

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PROFIT-VOLUME RATIO

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 PROFIT-VOLUME RATIO
Higher the P/V ratio more will be the profit and lower the
P/V ratio, lesser will be the profit. P/V ratio can be improved
by:
• Increasing the selling price per unit.
• Reducing direct and variable costs by effectively utilising,
men, machines and materials.
• Switching the production to more profitable products
showing a higher P/V ratio.

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 MARGIN OF SAFETY
• Margin of safety is the difference between the actual sales and
sales at break-even point. Sales beyond break-even volume brings
in profits.

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 MARGIN OF SAFETY
• A high margin of safety shows that break-even point is
much below the actual sales, so that even if there is a fall
in sales, there will still be a point.
• A low margin of safety is accompanied by high fixed
costs, so action is called for reducing the fixed costs or
increasing sales volume.

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 MARGIN OF SAFETY
The margin of safety may be improved by taking the
following steps:
• Lowering fixed costs.
• Lowering variable costs so as to improve marginal
contribution.
• Increasing volume of sales, if there is unused capacity.
• Increasing the selling price, if market conditions permit,
and
• Changing the product mix as to improve contribution
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BREAK EVEN POINTS

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LIMITING OR KEY FACTOR, MAKE OR
BUY DECISION
 LIMITING OR KEY FACTOR

• The product giving the greatest contribution will be the

most profitable.
• To maximise profit, resources should be mobilised
towards that product which gives the maximum
contribution.
• 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.

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 LIMITING OR KEY FACTOR

• These factors are equally important for arriving at

managerial decisions because 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, principal budget factors or governing factors.

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 LIMITING OR KEY FACTOR

• The limiting factors may be sale, raw material, labour,

plant capacity and availability of capital e.g., for a concern
established in a relatively new town, labour may be a key
factor or the concern may find it difficult to acquire an
unlimited quantity of raw material because of scarcity or
the quota system, etc.
• In the later case material will be the key factor.

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 LIMITING OR KEY FACTOR

• The extent of influence of these factors should be

carefully examined before arriving at a particular decision.
• Contribution per unit of key factor should be considered
and that course of action should be adopted which gives
the highest contribution per unit of key factor.

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 MAKE OR BUY DECISION

• When the management is confronted with the problem

whether it would be economical to purchase a component
or a product from outside sources, or to manufacture it
internally, marginal cost analysis renders useful
assistance in the matter.
• Under such circumstances, a misleading decision would
be taken on the basis of the total cost analysis.
 MAKE OR BUY DECISION

• In case the proposal is to buy from outside then, what is

already being made, and the price quoted by the outsider
should be lower than the marginal cost.
• If the proposal is to make something what is being
purchased outside, the cost of making should include all
additional costs like depreciation on new plant, interest on
capital involved and that cost should be compared with
the purchase price.