Advanced Cost Accounting-munotes

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1 1
PROCESS COSTING
Unit Structure
1.0 Learning Objectives
1.1 Introduction
1.2 Meaning of process costing
1.3 Distinction between job costing and process costing
1.4 Costing Procedure
1.5 Solved illustrations
1.6 Valuation of Work -in-progress
1.7 Questions
1.8 Exercise
1.0 LEARNING OBJECTIVES

After studying this chapter you should able to understand
 the meaning of Process Costing and its importance
 the distinction between job costing and process costing
 the accounting procedure of process costing including normal loss
abnormal loss (or) gain
 the valuation of work -in-progress, using FIFO, LIFO average and
weighted average methods
 the steps involved in inter process transfer
1.1 INTRODUCTION:
Process costing is a form of operations costing which is used where
standardized homogeneous goods are produced. This costing method
is used in industries like chemicals, textiles, steel, rubber, sugar,
shoes, petrol etc. Process costing is also used in the assembly type of
industries also. It is assumed in process costing that the average cost
presents the cost per unit. Cost of production during a particular
period is divided by the number of units produced during that period
to arrive at the cost per unit.
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2 1.2 MEANING OF PROCESS COSTING
Process costing is a method of costing under which all costs are
accumulated for each stage of production or process, and the cost
per unit of product is ascertained at each stage of production by
dividing the cost of each process by the normal output of that
process.
1.2.1 Definition:
CIMA London defines process costing as “that form of operation
costing which applies where standardize goods are produced”
1.2.2 Features of Process Costing:
(a) The production is continuous
(b) The product is homogeneous
(c) The process is standardized
(d) Output of one process become raw material of another process
(e) The output of the last process is transferred to finished stock
(f) Costs are collected process -wise
(g) Both direct and indirect costs are accumulated in each process
(h) If there is a stock of semi -finished goods, it is expressed in terms
of equivalent units
(i) The total cost of each process is divided by the normal output of that
process to find out cost per unit of that process.
1.2.3 Advantages of process costing:
1. Costs are be computed periodically at the end of a particular period
2. It is simple and involves less clerical work that job costing
3. It is easy to allocate the expenses to processes in order to have accurate
costs.
4. Use of standard costing systems in very effective in process
costing situations.
5. Process costing helps in preparation of tender, quotations
6. Since cost data is available for each process, operation and
department, good managerial control is possible.

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3 1.2.4 Limitations:
1. Cost obtained at each process is only historical cost and are not very
useful for effective control.
2. Process costing is based on average cost method, which is not that
suitable for performance analysis, evaluation and managerial control.
3. Work -in-progress is generally done on estimated basis which leads to
inaccuracy in total cost calculations.
4. The computation of average cost is more difficult in those cases wher e
more than one type of products is manufactured and a division of the
cost element is necessary.
5. Where different products arise in the same process and common costs
are prorated to various costs units. Such individual products costs may
be taken as only a pproximation and hence not reliable.
1.3 DISTINCTION BETWEEN JOB COSTING
AND PROCESS COSTING
Job order costing and process costing are two different systems.
Both the systems are used for cost calculation and attachment of
cost to each unit completed, but both the systems are suitable in
different situations. The basic difference between job costing and
process costing are
Basis of
Distinction Job order costing Process costing
1
. Specific
order Performed against
specific orders Production is contentious
2
. Nature Each job many
be different. Product is
Homogeneous
and standardized.
3
. Cost
determination Cost is determined for
each job separately. Costs are compiled for
each process for
department on time basis
i.e. for a given
accounting period.
4
. Cost
calculations Cost is compiled when a
job is completed. Cost is calculated at the
end of the cost period.
5
. Control Proper control is
comparatively difficult
as each product unit is
different and the
production is not
continuous. Proper control is
comparativ ely easier as
the production is
standardized and is
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4 6
. Transfer There is usually not
transfer from one job to
another unless there is
some surplus work. The output of one
process is transferred to
another process as input.
7
. Work -in-
Progr ess There may or may not
be work -in-progress. There is always some
work -in-progress
because of continuous
production.
8
. Suitability Suitable to industries
where production is
intermittent
and customer orders
can be identified in the
value of production. Suitable, where goods
are made for stock and
productions
is continuous.

1.4 COSTING PROCEDURE
For each process an individual process account is prepared.
Each process of production is treated as a distinct cost center.
1.4.1 Items on the Debit side of Process A/c.
Each process account is debited with –
a) Cost of materials used in that process.
b) Cost of labour incurred in that process.
c) Direct expenses incurred in that process.
d) Overheads charged to that process on some pre-determined.
e) Cost of ratification of normal defectives.
f) Cost of abnormal gain (if any arises in that process)
1.4.2 Items on the Credit side:
Each process account is credited with
a) Scrap value of Normal Loss (if any) occurs in that process.
b) Cost of Abnormal Loss (if any occurs in that process)
1.4.3 Cost of Process:
The cost of the output of the process (Total Cost less Sales value of
scrap) is transferred to the next process. The cost of each process is
thus made up to cost brought forward from the previous process and
net cost of material, labour and overhead added in that process after munotes.in

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Process Costing

5 reducing the sales value of scrap. The net cost of the finished process
is transferred to the finished goods account. The net cost is divided
by the number of units produced to determine the average cost per
unit in that process. Spe cimen of Process Account when there are
normal loss and abnormal losses.
Dr. Process I A/c. Cr.

1.4.4 Process Losses:
In many process, some loss is inevitable. Certain production
techniques are of such a nature that some loss is inherent to the
production. Wastages of material, evaporation of material is un
avoidable in some process. But sometimes the Losses are also
occurring due to negligence of Labourer, poor quality raw material,
poor technology etc. These are normally called as avoidable losses.
Basically process losses are classified into two categori es
(a) Normal Loss (b) Abnormal Loss
1. Normal Loss:
Normal loss is an unavoidable loss which occurs due to the inherent
nature of the materials and production process under normal
conditions. It is normally estimated on the basis of past experience
of the in dustry. It may be in the form of normal wastage, normal
scrap, normal spoilage, and normal defectiveness. It may occur at
any time of the process. Particulars Units Rs. Particulars Units Rs.
To Basic Material xxx xx By Normal Loss xx xx
To Direc t Material xx By Abnormal Loss xx xx
To Direct Wages xx By Process II A/c. xx xx
To Direct Expenses xx (output transferred
to
To Production
Overheads xx Next process)
To Cost of
Rectification of
Normal Defects xx By Process I Stock A/c.xx xx

To Abnormal Gains xx
xx xxx xx xx
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6 No of units of normal loss: Input x Expected percentage of Normal
Loss.
The cost of normal loss is a process. If the normal loss units can be
sold as a crap then the sale value is credited with process account. If
some rectification is required before the sale of the normal loss, then
debit that cost in the process account. After adjusting the normal loss
the cos t per unit is calculates with the help of the following formula:
Cost of good unit:
Total cost increased – Sale Value of Scrap Input – Normal Loss units
2. Abnormal Loss:
Any loss caused by unexpected abnormal conditions such as plant
breakdown, substandard m aterial, carelessness, accident etc. such
losses are in excess of pre -determined normal losses. This loss is
basically avoidable. Thus abnormal losses arrive when actual losses
are more than expected losses. The units of abnormal losses in
calculated as under:
Abnormal Losses = Actual Loss – Normal Loss
The value of abnormal loss is done with the help of following
formula:
Value of Abnormal Loss:
Total Cost increase – Scrap Value of normal Loss x Units of abnormal loss Input
units – Normal Loss Units
Abnorm al Process loss should not be allowed to affect the cost of
production as it is caused by abnormal (or) unexpected conditions.
Such loss representing the cost of materials, labour and overhead
charges called abnormal loss account. The sales value of the
abnormal loss is credited to Abnormal Loss Account and the balance
is written off to costing P & L A/c.
Dr. Abnormal Loss A/c. Cr.
Units Rs. Particulars Units Rs.
To Process A/c. xx xx By Bank xx xx
By Costing P & L
A/c. xx xx
xx xxx xx xx

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7 3. Abnormal Gains:
The 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 bet ween the actual output of a
process and that anticipates. This difference may be positive or
negative. If it is negative it is called ad abnormal Loss and if it is
positive it is Abnormal gain i.e. if the actual loss is less than the
normal loss then it is called as abnormal gain. The value of the
abnormal gain calculated in the similar manner of abnormal loss.
The formula used for abnormal gain is:
Abnormal Gain
Total Cost incurred – Scrap Value of Normal Loss x Abnormal Gain Unites Input
units – Normal Lo ss Units
The sales values of abnormal gain units are transferred to Normal
Loss Account since it arrive out of the savings of Normal Loss. The
difference is transferred to Costing P & L A/c. as a Real Gain.
Dr. Abnormal Gain A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Normal Loss
A/c. xx xx By Process A/c. xx xx
To Costing P & L
A/c. xx xx
xx xx xx xx

Check Your Progress:
1. Define the following terms
a. Process costing
b. Normal Loss
c. Abno rmal Loss
2. Give the formulas of following
a) Cost of good / normal unit
b) Value of Abnormal Loss

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8 1000 units @ Rs. 20 per
unit
Rs. 4,200/ -
Rs. 6,000/ -
Rs. 6,000/ -
900 units
5%
Rs. 8/- Input of Raw material

Direct Material
Direct Wages
Production Overheads
Actual output transferred to process II
Normal Loss
Value of Scrap per unit 1.5 SOLVED ILLUSTRATIONS
Illustration 1: (Normal / Abnormal Loss)
Prepare a Process Account, Abnormal Loss Account and Normal
Loss Account from the following informati on.

Solution :
Dr. Process – I A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Raw material @ 20 1000 20000 By Normal Loss
To Direct
Material 4200 (5% on
1000) 50 400
To Direct Wages 6000 By Abnormal
Loss A/c. 50
To Production BY Process – II
A/c.
Overheads 6000 900
1000 36200 (output transferred) 1000 36200

Dr. Abnormal Loss A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process – I A/c. 50 By Bank A/c. 50 400
By Costing P & L
A/c.
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9 Dr. Normal Loss A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process – I A/c. 50 400 BY Bank 50 400


Working Notes:
(1) Cost of abnormal Loss :
= Total Cost increased – Sales value of Scrap x abnormal units
Input units – Normal Loss Units
= 36200 – 400 x 50
1000 – 50

(2) It has been assumed that units of abnormal loss have also been
sold at the same rate i.e. of Normal Scrap
Illustrati on 2: (Normal / Abnormal Loss and Abnormal Gain)
The product of a company passes through 3 distinct process. The
following information is obtained from the accounts for the month
ending January 31, 2008.
Particulars Process – A Process – B Process – C
Direct Material 7800 5940 8886
Direct Wages 6000 9000 12000
Production Overheads 6000 9000 12000

3000 units @ Rs. 3 each were introduced to process – I. There was
no stock of materials or work in progress. The output of each process
passes directly to the next process and finally to finished stock A/c.
The following additional data is obtained :
Process Output Percentage of
Normal Loss to
Input Value of Scrap per
unit (Rs.)
Process – I 2850 5 % 2
Process – II 2520 10 % 4
Process – III 2250 15 % 5

Prepare Process Cost Account, Normal Cost Account and
Abnormal Gain or Loss Account. munotes.in

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10 Solution:
Dr. Process – A A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Units
introduced 3000 9000 By Normal
Loss A/c. 150 300
To Direct
Material 7800 By Process – B
A/c. 2850 28500
To Direct Wages 6000 (Units
transferred
To Production @ Rs. 10/-)
Overheads 6000
3000 28800 3000 28800

Dr. Process – B A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process – I
A/c. 2850 28500 By Normal
Loss A/c. 285 1140
To Direct
Material 5940 By Abnormal
Loss A/c. 45 9000
To Direct Wages 9000 By Process –
C A/c. 2520 50400
To Production
Overheads 9000
2850 52440 2850 52440

Dr. Process – C A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process – II A/c. 2520 50400 By Normal Loss
A/c. 378 1890
To Direct Material A/c 8886 By Finished Stock A/c. 2250 85500
To Direct Wages 12000
To Production
Overheads 12000
To Abnormal Gain A/c. 108 4104
2628 87390 2628 87390 munotes.in

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11
Dr. Abnormal Gain A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Normal Loss A/c. 108 540 By Process – C A/c. 108 4104
To Costing P&L A/c. 3564
108 4104 108 4104

Dr. Normal Loss A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process – A A/c. 150 300 By Bank A/c.
(Sales)
To Process – B A/c. 285 1140 Process – A
A/c. 150 300
To Process – C A/c. 378 1890 Process – B A/c. 285 1140
Process – C
A/c. 270 1350
By Abnormal Gain A/c. 108 540
813 3330 813 3330

1.6 INTER PROCESS PROFI TS:
Normally the output of one process is transferred to another process
at cost but sometimes at a price showing a profit to the transfer
process. The transfer price may be made at a price corresponding to
current wholesale market price or at cost plus an agreed percentage.
The advantage of the method is to find out
Whether the particular process is making profit (or) loss. This will
help the management whether to process the product or to buy the
product from the market. If the transfer price is higher th an the cost
price then the process account will show a profit. The complexity
brought into the accounting arises from the fact that the inter process
profits introduced remain a part of the prices of process stocks,
finished stocks and work -in-progress. Th e balance cannot show the
stock with profit. To avoid the complication a provision must be
created to reduce the stock at actual cost prices. This problem arises
only in respect of stock on hand at the end of the period because
goods sold must have realize d the internal profits. The unrealized munotes.in

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Advanced Cost Accounting
12 profit in the closing stock is eliminated by creating a stock reserve.
The amount of stock reserve is calculated by the following formula.
Stock Reserve = Transfer Value of stock x Profit included in transfer price
Transfer Price
Illustration 3 :
A product passes through three processes before its completion. The
output of each process s charged to the next process at a price
calculated to give a profit of 20% on transfer price. The output of
Process III is transferred to finished stock account on a similar basis.
There was no work -in-progress at the beginning of the years. Stock
in each process has been valued at prime cost of the process. The
following data is available at the end of 31st March, 2009.
Process I Process II Process III Finished
Stock Rs.
Direct Material 20000 30000 10000 --
Direct Wages 30000 20000 40000 --
Stock on 31st March
2009 10000 20000 30000 15000
Sale during the year -- -- -- 180000

From above information prepare:
1. Process Cost Account showing the profit at each stage.
2. Actual realized profit and
3. Stock Valuation as would appear in the balance sheet

Solution:
Dr. Process – I A/c. Cr.
Particulars Total Rs. Cost Rs. Profit
Rs. Particulars Total
Rs. Cost
Rs. Profit
Rs.
To Materi als 20000 20000 -- By Process
IIA/c.
(Transfer) 50000 40000 10000
To Wages 30000 30000 --
Total 50000 50000 --
Les Closing
Stock c/d 10000 10000 -- munotes.in

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13 Prime Cost 40000 40000 --
To Gross
Profit 10000 -- 10000
(20% on
Transfer Price)
50000 40000 10000
50000 40000 10000
ToStockB/d. 10000 10000 --

Dr. Process – II A/c. Cr.
Particulars Total Rs. Cost Rs. Profit Rs. Particulars Total Rs. Cost Rs. Profit Rs. To Process – I A/c. 50000 40000 10000 By Process -III
A/c. 100000 72000 28000
To Material 30000 30000 -- (Transfer)
To Wages 20000 20000 --
100000 90000 10000
Less :
Closing
Stock C/d. 20000 18000 2000
Prime Cost 80000 72000 8000
To Gross
Profit
(20% on
Transfer Price) 20000 -- 20000
100000 72000 28000 100000 72000 28000
To Stock
B/d. 20000 18000 2000


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14 Process III A/c
Particulars Total
Rs. Cost
Rs. Profit
Rs. Particulars Total
Rs. Cost
Rs. Profit
Rs.
ToprocessII 10000 0 72000 28000 By
Finished 150000 97600 52400
A/c stock A/c
To Material 10000 10000
40000 40000 ------- To Wages
TOTAL
Less.Closing 150000 122000 28000
30000 24400 5600 stock
To Gross
profit 120000 97600 22400
(20%of
transfer 30000 -------- 30000
price)
150000 97600 52400 150000 97600 52400
To Stock b/d 30000 24000 5600
Finished stock A/c
Particulars Total
Rs. Cost
Rs. Profit
Rs. Particulars Total
Rs. Cost
Rs. Profit
Rs.
To process 115000 97600 52400 By Sales 180000 87840 92160
III A/c
(-)Stock 15000 9760 5240
To gross
profit 135000 87840 92160
45000 --- 45000
180000 87840 92160
180000 87840 92160
To Stock
A/c 15000 9760 5240

Calculation of profit on closing stock
Profit included in stock = Profit included in transfer price x Value of stock
Transfer price
Process I = No profit
Process Ii =10000 x20000=2000
100000

Process Iii =28000 x30000=5600
150000

Finished stock= 5240 0x15000=5240
150000
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Process Costing

15 Illustration 4 :
A product process through three process A, B and C. The details of
expenses incurred on the three process during the year 2008 were as
under :
Process A Process B Process C
Units introduced 10000
Cost per unit is Rs. 50/ -
Rs. Rs. Rs.
Sundry Material 6000 9000 3233
Labour 18000 48000 39000
Direct Expenses 3000 11000 18000
Selling price per unit of output 70 100 200
Management expenses during the year were Rs. 80000 and selling
were Rs. 5000. There are not allocable to the processes. Actual
output of the three process were A – 9300 units, B – 5400 units and
C 2100 units. Two -thirds of the output of process A and one half of
the output of process B was passed on to the next process A and
one-half of the output of process B was passed on to the next
process and the balance was sold. The entire output of process C was
sold.
The normal losses of the three process, calculated on the input of
every process was : Process A – 5%, B – 15% and C – 20%. The
loss of process A was sold @ Rs. 3 per unit, that of B @ Rs. 5 per
unit and of process C @ Rs. 10 per unit.
Prepare process A, B and C account and the Profit and Loss Account.
Solution :
Dr. Process A A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
ToUnits Introduced @RS.50 10000 5,00,000 By Normal Loss 500 1,500
By Abnormal loss 200 11063
ToSundry Materials 6,000 By process B 6,200 342958
To Labour 18,000 By output sold 3,100 171479
ToDirect
Expenses 3,000
10000 5,27,000 10000 5,27,000
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16 Dr. Process B A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process A
A/c. 6200 342958 By Normal Lo ss 930 4650
ToSundry Materials 9000 By Process C
A/c. 2700 2,08,165
To Labour 48000 By output sold 2700 2,08,165
To Direct
Expenses 11000
ToAbnormal Gains 100221
A/c. (@ 77.19)
6330 420980 6,330 4,20,980

Dr. Process C A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process B
A/c. 2700 208165 By Normal Loss 540 5400
ToSundry Materials 3233 By Abnormal Loss 60 7305
To Labour 39000 By output sold 2100 255693
To Direct
Expenses 18000 ( @ 12.76)
2700 268398 2700 268398

Dr. Profit & Loss A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process A A/c. 3100 171479 By Sales( @ Rs. 70) 3100 217000
To Process B A/c. 2700 208165 By Sales(@Rs. 100) 2700 270000
To Process C A/c. 2700 265693 BySales(@Rs.2000) 2700 420000
To Management
Expenses A/c. 80000 BY Abnormal Gain A/c. 9372
ToSelling Expenses 50000
To Abnormal
Loss A/c. 17168
To Net Profit 133867
916372 916372 munotes.in

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Process Costing

17 Dr. Abnormal Loss A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process A A/c. 200 11063 By Bank Sales
To Process B A/c. 60 7305 (@ Rs. 30) 200 600
By Bank
(@ Rs. 10) 60 600
By P & L A/c. 17168
260 18368 260 18368

Dr. Abnormal Gain A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Normal Loss
A/c. 130 650 By Process B /c. 130 10022
To Costing P & L
A/c. 9372
130 10022 130 10022

Illustration 5
Mahesh Ltd process a material which passes through three
processes. Figures relating to production for the first 6 months of
2009 are as follows.
Process A Process B Process C
Raw material used 1000 tones @
Rs. 200
Manufacturing Wage s Rs. 40000 Rs. 30000 Rs. 7000
Expenses Rs. 32500 Rs. 10800 Rs. 3710
Scrap sold @ Rs. 50 per tone 50 tones 30 tones 51 tones
Selling price per tone Rs. 320 Rs. 450 Rs. 800
Weight Loss 5% 10% 20%

Management expenses were Rs. 10500, selling expenses Rs. 8000
and interest on borrowed capital Rs. 2000. Two third of process I
and one half of process 2 are passed on to the next process and the
balance are sold.
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18 Prepare Process Account, Process Stock Account and Costing Profit
& Loss A/c.
Solution
Dr. Process No. 1 A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Material @
Rs. 200 1000 200000 By Normal Loss
(sale of Scrap) 50 2500
To Wages 40000 By Weight Loss 50 --
To Expenses 32500 By Process I Stock
A/c.(@300per tone) 900 270000


1000 272500 1000 272500

Dr. Process No. 1 Stock A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process I A/c. 900 270000 By Bank (@ 320) 300 96000
To Costing Profit & Loss A/c. 6000 ByProcessNo.2 A/c. 600 180000

900 276000 900 276000

Dr. Process No. 2 A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process 1
Stock A/c. 600 180000 By Normal Loss (@ Rs. 50) 30 1500
To wages 30000
To Expenses 10800 By Weight Loss 60 --
By Process 2
Stock
A/c(@ Rs. 430) 510 219300
600 220800 600 220800




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19 Dr. Process No. 2 Stock A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process 2 A/c. 510 219300 By Bank
ToCosting P&L
A/c. 5100 (sale @ 450) 255 114750
By Process 3
A/c. 255 109650


510 244400 510 244400

Dr. Process No. 3 A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process 2
Stock A/c. 255 109650 By scrap 51 2550
To wages 7000 By Weight Loss 51 --
To Expenses 3710 By Process 3
stock A/c 153 117810
255 120360 255 120360

Dr. Process No. 3 Stock A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Process 3 A/c. 153 117810 By Bank
To Costing P & L
A/c. 4590 (sale @ 800) 153 122400
153 122400 153 122400

Dr. Costing Profit & Loss A/c. Cr.
Particulars Rs. Particulars Rs.
To Management Expenses 10500 By Process 1 Stock A/c. 6000
To Selling Expenses 8000 By Process 2 Stock A/c. 5100
To Interest on Capital 2000 By Process 3 Stock A/c. 4590
By Net Loss 4810
20500 20500


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20 1.7 VALUATION OF WORK -IN-PROGRESS
1.7.1 Meaning of Work -in-Progress:
Since production is a continuous activity, there may be some
incomplete production at the end of an accounting period. Incomplete
units mean those units on which percentage of completion with
regular to all elements of cost (i.e. material, labour and overhead) is
not 100%. Such incomplete producti on units are known as Work -in-
Progress. Such Work -in-Progress is valued in terms of equivalent or
effective production units.
1.7.2 Meaning of equivalent production units :
This represents the production of a process in terms of complete
units. In other words, i t means converting the incomplete production
into its equivalent of complete units. The term equivalent unit means
a notional quantity of completed units substituted for an actual
quantity of incomplete physical units in progress, when the
aggregate work c ontent of the incomplete units is deemed to be
equivalent to that of the substituted quantity. The principle applies
when operation costs are apportioned between work in progress and
completed units.
Equivalent units of work in progress = Actual no. of units in progress x
Percentage of work completed
Equivalent unit should be calculated separately for each element of
cost (viz. material, labour and overheads) because the percentage of
completion of the different cost component may be different.
1.7.3 Accounting P rocedure:
The following procedure is followed when there is Work -in-
Progress
(1) Find out equivalent production after taking into account of the
process losses, degree of completion of opening and / or closing
stock.
(2) Find out net process cost according to ele ments of costs i.e. material,
labour and overheads.
(3) Ascertain cost per unit of equivalent production of each element of
cost separately by dividing each element of costs by respective
equivalent production units.
(4) Evaluate the cost of output finished and tr ansferred work in progress
The total cost per unit of equivalent units will be equal to the total
cost divided by effective units and cost of work -in- progress will be munotes.in

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21 equal to the equivalent units of work -in- progress multiply by the
cost per unit of effe ctive production. In short the following from
steps an involved.
Step 1 – prepare statement of Equivalent
production Step 2 – Prepare statement of cost per
Equivalent unit Step 3 – Prepare of Evaluation
Step 4 – Prepare process account
The problem on equiv alent production may be divided into four
groups.
I. when there is only closing work -in-progress but without process
losses
II. when there is only closing work -in-progress but with process losses
III. when there is only opening as well as closing work -in- progress
without process losses
IV. when there is opening as well as closing work -in- progress with
process losses
Situation I :
Only closing work -in-progress without process losses :
In this case, the existence of process loss is ignored. Closing work -in-
progress is co nverted into equivalent units on the basis of estimates
on degree of completion of materials, labour and production
overhead. Afterwards, the cost pr equivalent unit is calculated and
the same is used to value the finished output transferred and the
closin g work -in-progress
Situation II:
When there is closing work -in-progress with process loss or gain.
If there are process losses the treatment is same as already discussed
in this chapter. In case of normal loss nothing should be added to
equivalent producti on. If abnormal loss is there, it should be
considered as good units completed during the period. If units
scrapped (normal loss) have any reliable value, the amount should be
deducted from the cost of materials in the cost statement before
dividing by equivalent production units. Abnormal gain will be
deducted to obtain equivalent production.

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Advanced Cost Accounting
22 Situation III:
Opening and closing work -in-progress without process losses.
Since the production is a continuous activity there is possibility of
opening as well as closing work -in-progress. The procedure of
conversion of opening work -in-progress will vary depending on the
method of apportionment of cost followed viz, FIFO, Average cost
Method and LIFO.
Let us discuss the methods of valuation of work -in-progress one by
one.
(a) FIFO Method: The FIFO method of costing is based on the
assumption of that the opening work -in-progress units are the first to be
completed. Equivalent production of opening work -in-progress can be
calculated as follows:
Equivalent Production = Units of Opening WIP x Percentage of work needed to
finish the units
(b) Average Cost Method: This method is useful when price fluctuate
from period to period. The closing valuation of work -in-progress in the
old period is added to the cost of new period and an average rate obtained.
In calculating the equivalent production opening units will not be shown
separately as units of work -in-progress but included in the units completed and
transferred.
(c) Weighted Average Cost Method: In this method no distinction is
made between completed units from opening inventory and completed
units from new production. All units finished during the current
accounting period are treated as if they were started and finished during
that period. The weighted average cost per unit is dete rmined by dividing
the total cost (opening work -in-progress cost + current cost) by equivalent
production.
(d) LIFO Method: In LIFO method the assumption is that the units
entering into the process is the last one first to be completed. The cost of
opening wor k-in-progress is charged to the closing work -in-progress and
thus the closing work -in- progress appears cost of opening work -in-
progress. The completed units are at their current cost.





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Process Costing

23 (1) Format of statement of Equivalent Production :
Input Output Equiv alent Production
Material Labour Overheads Particulars Units Particulars Units
% Units % Units % Units
Opening Stock xx Units
completed xx xx xx xx xx
Units
Introduced xx Normal Loss xx -- -- -- --
Abnormal
Loss xx xx xx xx xx
xx Equival ent
Units xx xx xx xx xx xx Xx

(2) Statement of cost per Equivalent Units :
Element of costing Cost Rs. Equivalent
Units Cost per
Equivalent Units
Rs
Material Cost (Net) Xx Xx Xx
Labour Cost Xx Xx Xx
Overheads Cost Xx xx Xx
xx Xx

(3) Statement of Evaluat ion
Particulars Element of cost Equivalent
Units Cost per
equivalent
units
Rs. Cost
Rs. Total
Cost
Rs.
Units completed Material xx xx xx
Labour xx xx xx
Overheads xx xx xx Xx
Closing WIP Material xx xx xx
Labour xx xx xx
Overheads xx xx xx Xx
Abnormal Loss Material xx xx xx
Labour xx xx xx
Overheads xx xx xx Xx
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Advanced Cost Accounting
24 Illustration 6: (Average Costing)
Prepare a statement of equivalent production, statement of cost,
process account from the following information using average
costing method.
Opening Stock 50000 Units
Material Rs. 25000
Labour Rs. 10000
Overheads Rs. 25000
Units Introduced 2000000 Units
Material Rs. 100000
Wages Rs. 75000
Overheads Rs. 70000
During the period 1,50,000 units were completed and transferred to
Process II.
Closing stock 1,00,000 units. Degree of completion.

Material 100 %
Labour 50 %
Overheads
Solution : 40 %
Input Output Equivalent Production
Material Labour Overheads Particulars Units Particula rs Units
% Units % Units % Units
Opening Units
Stock 50,000 Produced 150000 100 150000 100 1500 00 100 150000
Introduced 200,000 Closing
Stock 100000 100 100000 50 50000 40 40000

250000 250000 250000 200000 190000 munotes.in

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Process Costing

25 Statement of Cost :
Element Opening cost Rs. Current cost Rs. Total Cost
Rs. Equivalent
units Cost per
unit
Material 25,000 1,00,000 1,25,000 2,50,000 0.500
Labour 10,000 75,000 85,000 2,00,000 0.425
Overheads 25,000 70,000 95,000 1,90,000 0.500
60,000 2,45,000 3,05,000 1.425

Statement of Apportionment of Cost
Particulars Units Cost per unit Cost Total cost
1. Units introduced &
transferred 1,50,000 1.425 213750
2. Closing work -in-progress
Material 1,00,000 0.500 50,000
Labour 50,000 0.425 21,250
Overheads 40,000 0.500 20,000 91,250
3,05,000

Dr. Process I A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Opening
Stock 50,000 60,000 By Units
completed
To Materials 2,00,000 1,00,000 & transfer 50,000 2,13,750
To Labour 75,000 By Closing Stock 50,000 91,250
To Overheads 70,000
2,50,000 3,05,000 2,50,000 3,05,000


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Advanced Cost Accounting
26 Illustration 7: (FIFO Method)
From the following information relating to KKN Company Ltd.
Prepare Process Cost Account for Process III for the year 2008.
Opening Stock IN Proces s III 5000
units of Rs. 36,000
Transfer from Process II 2,13,000
units of Rs. 8,27,000
Direct Material added in Process III Rs. 4,01,800
Direct Wages Rs. 1,98,100
Production Overhead Rs. 99,050
Units Scrap 11,000 units
Transferred to Process IV 1,89,000
units
Closing Stock 18,000 units


There was a normal loss of 5% production and unit scraped were
sold at Rs. 1.50







Degree of Completion :
Opening
Closing
Scrap
Stock Stock
Material 70 % 80 % 100 %
Labour 50 % 60 % 80 %
Overhead 50 % 60 % 80 % munotes.in

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Process Costing

27 Solution :
Input Output Equivalent Production
Material Labour Overheads Particular s Units Particulars Units
% Units % Units % Units
Opening Normal
Stock 5,000 Loss 10000
Process II Op. Stock
Transfer 213,000 Processed 5000 - - 30 1500 50 2500
Introduces &
Completed 184000 100 184000 100 184000 100 184000
Abnormal
Loss 1000 100 1000 100 1000 80 800
Closing
Stock 18000 100 18000 80 14400 60 10800
218000 218000 203000 200900 19810 0

Note : Units Produced: Opening stock + units introduced – closing stock
: 5000 +213000 – 18000 = 200000
Normal Loss : 5 % of 200000 = 10000 units
Statement of Cost
Particulars Cost Rs. Equivalent
Units Rs. Cost PerUnit Rs.
Material – I
Transfer
process from Previous 8,27,000
Less –
(normal) Value of scrap 15,000 8,12,000 2,03,000 4.00
Material – II
Added+ in the process 4,01,800 2,00,900 2.00
Direct Wages 1,98,100 1,98,100 1.00
Overheads 99,050 1,98,100 0.50
7.50



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Advanced Cost Accounting
28 Stateme nt of Apportionment of Cost
Particulars Elements Equivalent
Units Cost Per Unit
Rs. Cost Rs. Total cost Rs. Op. Stock
Processed Material I -- --
Material II 1,500 2.00 3,000
Wages 2,500 1.00 2,500
Overheads 2,500 0.50 1,250 6,750
Units introduc ed and Material I 1,84,000 4.00 7,36,000
Completed Material II 1,84,000 2.00 3,68,000
Wages 1,84,000 1.00 1,84,000
Overheads 1,84,000 0.50 92,000 13,80,000
Closing stock Material I 18,000 4.00 72,000 13,86,750
Material II 14,400 2.00 28,800
Wages 10,800 1.00 10,800
Overheads 10,800 0.50 5,400 1,17,000
Abnormal loss Material I 1,000 4.00 4,000
Material II 1,000 2.00 2,000
Wages 800 1.00 800
Overheads 800 0.50 400 7,200
TOTAL 15,10,950

Dr. Process III A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Balance b/d. 5,000 36,000 By Normal
Loss 10,000 15,000
To Process II A/c. 2,13,000 8,27,000 By Process IV
A/c. 1,89,000 14,22,750
To Materials 4,01,800 By Abnormal
Loss 1,000 7,200
To Wages 1,98,100 By Closing
Stock 18,000 1,17,000
To
Overheads 99,050
2,18,000 15,61,950 2,18,000 15,61,950 munotes.in

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Process Costing

29 Note :
Cost of goods transferred to Process IV :
Value of Opening Stock 36,000
Cost incurred in this process for Opening Stock 6,750
Cost incurred for the units introduc ed & Processed 13,80,000
Total 14,22,750

Illustration 8
The following information is given in respect of Process costing 10 :
3 for the month of January 2009.
Opening stock – 2,000 units made up of
Rs.
Direct Material – I 12,350
Direct Material – II 13,200
Direct Labour 17,500
Overheads 11,000
Transferred from Process 2 – 20,000 units @ Rs. 6 per unit.
Transferred to Process 4 – 17,000 units
Expenditure incurred in process – 3
Rs.
Direct Material 30,000
Direct Labour 60,000
Overheads 60,000
Scrap:1,000 units -Direct Materials 100%,Direct Labour 60%,
Overheads 40%.
Normal Loss 10 % of Production. Scrapped units realized Rs. 4/- per
unit
Closing stock : 4,000 units – Degree of completion. Direct Materials
80 %, Direct Labour 60 % and Overheads 40 %.
Prepare Process 3 Account using average price method along with
necessary supporting statements.
[C. A. – Inter, May 2001] munotes.in

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Advanced Cost Accounting
30 Solution :
Statement of Equivalent Production (weighted Average cost
Material)
Material – II Labour Overheads Particulars Total
Units Material – I
% Units % Units % Units
Units Completely
Processed 17000 100 17000 100 17000 100 17000 100 17000 Normal Loss 1800 --
10% of (2000 +
20000 – 4000)
Abnormal Gain 800 100 800 100 800 100 800 100 800
Closing Stock 4000 100 4000 80 3200 60 2400 40 1600
22000 20200 19400 18600 17800

Statement of Cost
Particulars Cost Rs. Equivalent
Units Rate / Equivalent Units
Rs.
Material – I :
Opening balance 2000 units 12,350
Cost of 20000 units @ Rs. 6
Per unit 1,20,000
1,25,150 20,200 6.1955
Material – II :
Opening Stock 13,200
In Process II 30,000
43,200 19,400 2.2268
Labour :
Opening Labour 17,500
In Process II 60,000
77,500 18,600 4.1667
Overheads :
Openi ng Stocks 11,000
In Process II 60,000
71,000 17,800 3.9888
Total cost per unit 16.5778

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Process Costing

31 Valuation of Equivalent Unit
Rs.
Finished goods
Abnormal Units
Workinprogress
Material I Material
II
Labour Overheads (17000 units x Rs. 16.5778)
(800 units x Rs. 16.5778)

(4000 units x Rs. 6.1955)
(3200 units x Rs. 2.2268)
(2400 units x Rs. 4.1667)
(1600 units x Rs. 3.9888)

24,782
7,126
10,000
6,382 2,81,822
13,262



48,290

Dr. Process III A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Opening
WIP 2,000 57,050 By Normal Loss 1,800 7,200
To Process 2 20,000 1,20,000 By Finished Goods
To Direct Units 17,000 2,81,822
Material II 30,000 By Closing Balance 4,000 48,290
To Direct
Labour 60,000
To Overheads 60,000
To Abnormal
Gain 800 13,262
22,800 3,37,312 22,800 3,37,312

Illustration.9
The finished product of a factory pass through two processes .The
entire material being placed in process at the beginning of the first
process. From the following production and last da ta relating to the
first process, work out the value of the closing inventory and the
value of the materials transferred to the second process.



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Advanced Cost Accounting
32 Process I Rs.
Opening inventory 10,000
Material 27,500
Labour 50,000
Manufacturing Overheads 40,000
Opening inventory (25 percent complete) 4,000
Put into Process 12,000
Transferred to II Process 10,000
Closing inventory (20 percent completed) 5,000
Spoilage during process 1,000

Solution : [I.C.W.A., Final]
Process I A/c
Particulars Kg. Amount Rs. Particulars Kg. Amount Rs. Opening Inventory 4,000 10,000 Transferred to Process II 10,000 1,15,750
Material 12,000 27,500 Normal Loss 1,000 --
Labour 50,000 Closing
Inventory 5,000 11,750
Manufacturing
Overheads 40,000
16,000 1,27,500 16,000 1,27,500

Working Note :
Statement of Equivalent Production Units
Material Labour Overheads Particulars Output Kg. Qty. % Qty. % Qty. %
Opening Stock
Processed 4,000 3,000 75 3,000 75 3,000 75
Completely Processed 6,000 6,000 100 6,000 100 6,000 100 Normal Loss 1,000 -- -- -- -- -- --
Closing Inventory 5,000 1,000 20 1,000 20 1,000 20
16,000 10,000 10,000 10,000




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Process Costing

33 Statement of Element of Cost on the basis of Equivalent Production
Particulars Cost Rs. Equivalent
Units Cost per Unit Rs.
Material 27,500 10,000 2.75
Labour 50,000 10,000 5.00
Overheads 40,000 10,000 4.00
Total 11.75

Statement of Apportionment of Cost
Particulars Elements Equivalent
Units Cost Per
Unit Rs. Cost Rs. Total costRs.
Op. Stock
Processed Material 3,000 2.75 8,250
Labour 3,000 5.00 15,000
Overheads 3,000 4.00 12,000 35,250
Completely
Processed Material 6,000 2.75 16,500
Labour 6,000 5.00 30,000
Overheads 6,000 4.00 24,000 70,500
Closing
Inventory Material 1,000 2.75 2,750
Labour 1,000 5.00 5,000
Overheads 1,000 4.00 4,000 11,750
TOTAL 1,17,500

Value of goods transferred to next process
Rs. Units
Value of opening stock (given) 10,000
Additional cost on opening stock 35,250 4,000
Value of completely processed units 70,500 6,000
1,15,750 10,000


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Advanced Cost Accounting
34 Illustration 10
ABC Limited manufactures a product ‘2X’ by using the process
normally R. T. for the month of May 2009, the following data is
available.
Process R. T.
Material Introduced 16,000 units
Transfer to next process 14,000 units
Work -in-Process 4,000 units
At the beginning of the month (4/5 completed) 3,000 units At the end
of the month (2/3 completed)
Cost records:
Work -n-Process at the beginning of the month
Material Rs. 30,000
Conversioncost Rs. 29,200
Cost during the month Materials Rs. 1,20,000
Conversion cost Rs. 1,60,800
Normal spoiled units are 10% of goods finished output transfer red to
next process.
Defects in these units are identified in their finished state.
Materials for the product is put in the process at the beginning of the
cycle of operation, whereas labour and other indirect cost flow
evenly over the year. It has no real izable value for spoiled units.
Required :
(1) Statement of equivalent production (average cost method)
(2) Statement of cost and distribution of cost
(3) Process accounts
[C.A. PCE. Nov. 2007]



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Process Costing

35 Solution :
Statement of Equivalent Production (average cost method)
Equivalent Production
Materials Conversion cost Input units Particulars Output
Units
% completed Equivalent
Units %
Complet ed Equivalent Units 4000 Opening WIP -- --
16000 Introduced and 14,400 100 14,400 100 14,400
Completed to
next
Normal spoilage 1,440 100 1,440 100 1,440
Abnormal spoilage 1,160 100 1,160 100 1,160
Closing WIP 3,000 100 3,000 66.67 2,000
20000 20000 20000 19000

Statement showing cost of each element
Particulars Materials Conversion
cost
Opening 30,000 29,200
Cost in process 1,20,000 1,60,800
Total (a) 1,50,000 1,90,000
Equivalent Units (b) 20,000 19,000
Cost per unit (a ÷ b) 7.50 10.00

Statement showing distribution of cost
Particulars Equivalent
Units Cost per
unit (Rs.)
Units completed
Mater ials 14,400 7.50 1,08,000
Conversion cost 14,400 10.00 1,44,000 2,52,000 Normal spoilage 1,440 17.50 25,200
(10 %)
Closing stock :
Material 3,000 7.50 22,500
Conversion cost 2,000 10.00 20,000 42,500
Abnormal Stock:
Material 1,160 7.50 8,700
Conversion Stock 1,160 10.00 11,600 20,300

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Advanced Cost Accounting
36 Dr. Process A/c. Cr.

Illustration.11
GH & Co. manufactures a product. The process costing is followed
and work -in-progress stocks at the end of each month are valued at
FIFO basis.
At the beg inning of the month of June, the inventory of work - in-
progress showed 400 units, 40% complete, valued as follows:
Rs.
Material 3,600
Labour 3,400
Overheads 1,000
Total 8,000
In the month of June, materials were purchased for Rs. 75,000.
Wages and overheads in the month amounted to Rs. 79,800 and Rs.
21,280 respectively. Actual issue of material to production was Rs.
68,500. Finished stock in the month was 2500 units. There was no
loss in process.
All the end of the month, the work -in-process inventor y was 500
units, 60 percent complete as to labour and overheads and 80 %
complete as to materials.
Prepare a Process Account for recording the month’s transactions
and prepare a Process Cost Sheet showing total and units costs
[I.C.W.A., Final]

Particulars Rs. Particulars Rs.
To Opening WIP 59,200 By Profit and Loss
A/c.
To Material 1,20,000 (abnormal) 20,300
Introduced
To Conversion cost 1,60,800 By Transf er to Next 2,77,200
Incurred Process
By Closing WIP 42,500
340000 3,40,000
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Process Costing

37 Solution:
Dr. Process A/c. Cr.
Particulars Units Rs. Particulars Units Rs.
To Opening 400 8,000 BY Transfer to
Stock
To Material 2,600 68,500 Finished stock 2,500 1,56,094
To Labour 79,800 By Work -in-
To Overheads 21,280 Progress 500 21,486
3000 1,77,580 3000 1,77,580

Working Note :
Statement of Equivalent Production (Units)
Material Labour Overhead Input Particulars Outp ut
Qty. % Qty. % Qty. %
400 400 240 60 240 60 240 60

2600
2,100
2,100
100
2,100
100
2,100
100
500 400 80 300 60 300 60
3000 Opening Stock
Completely
Processed Work -
in- Progress
3,000 2,740 2,640 2,640

Working Note :
(1) For opening stock also equivalent production has been calculated as
it was partly complete and it has to be converted into finished
product in this period. They were completed 60 % in this period.
(2) Total units produced in a month are 2,50 units. Out of this 400 units
of opening stock has been deducted because they have been par tly
processed in this particular month and we have already calculated
equivalent units of opening stock. Only, 2,100 units have been
introduced and completed in the particular period.
(3) For closing stock also equivalent production in terms of total units
completed has been calculated.
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Advanced Cost Accounting
38 Statement of Element of cost on the basis of Equivalent Units
Cost Rs. Equivalent
Units Cost per unit Rs. Material 68,500 2.740 25.000
Labour 79,800 2.640 30.2273
Overheads 21,280 2.640 8.0606

Statement of Apportionment of Cost
Particulars Equivalent
Units Cost
Per Unit
Rs. Details Rs. Total Rs.
Op. Stock Material 240 25.0000 6,000
Processed
Labour 240 30.2273 7,255
Overheads 240 8.0606 1,935 15,190
Completely Material 2,100 25.0000 52,500
Processed
Labour 2,100 30.2273 63,477
Overheads 2,100 8.0606 16,927 1,32,904
Work -in- Material 400 25.0000 10,000
Process
Labour 300 30.2273 9,068
Overheads 300 8.0606 2,418 21,486
TOTAL 1,69,580

Total Cost of 2500 units
Rs.
Cost of opening stock 8,000
Additional cost of opening stock processed 15,190
Cost of completely processed 1,32,904
1,56,094

Illustration 12
The following data is available in respect of Process I for
February 1990.
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Process Costing

39 (1) Opening stock of work -in-process 800 units at a total cost of Rs.
4,000.
(2) Degree of completion of opening work in process
Materials 100 %
Labour 60 %
Overheads 60 %
(3) Input of materials at a total cost of Rs. 36,800 for 9,200 units
(4) Direct wages incurred Rs. 16,7540
(5) Production overheads Rs. 8,370
(6) Units scr apped 1,200 units. The stage of completion of these units
was
Materials 100 %
Labour 80 %
Overheads 80 %
(7) Closing work -in-process : 900 units. The stage of completion of
these units was :
Materials 100 %
Labour 70 %
Overheads 70 %
(8) 7,900 units were complete d and transferred to the next process.
(9) Normal Loss is 80 % of the total input (opening stock plus units put
in)
(10) Scrap value is Rs. 4 per unit
You are required to :
(a) Compute equivalent production
(b) Calculate the cost per equivalent unit for each element
(c) Calcu late the cost of abnormal loss (or gain), closing work in process
and the units transferred to the next process using the FIFO method.
(d) Show the Process Account for February 1990
[C.A., Inter]
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Advanced Cost Accounting
40 (a) Statement of Equivalent Production (FIFO Method)
input Output Equivalent
Material Labour &
Overheads Particulars
units Particulars
Units
Units % Units %
Op. Stock Units
of completed
W.I.P. 800 Work on Op. 800 -- 320 40
stock
Units New units 7100 7100 100 7,100 100
9,200 Closing stock 900 900 100 630 70
Introduced
Normal Loss 800 -- --
Abnormal 400 400 100 320 100
Loss
10,000 10,000 8,400 8,370

(b) Statement of cost per equivalent units for each element
Particulars Cost Rs. Equivalent Unit Cost Per Unit
Material 36,800
Less : Scrap realization
(800 units @ Rs. 4) 3,200
Labour
Overheads

33,600
16,740
8,370

8,400
8,370
8,370

4.00
2.00
1.00
I Statement showing cost of abnormal loss, closing WIP and units
transferred to the next process :
Particulars Cost per unitRs. Equivalent
unit Total cost Rs. Abnormal Loss
Materials 4.00 400 1,600
Labour 2.00 320 640
Overheads 1.00 320 320
2,560
Closing WIP
Material 4.00 900 3,600
Labour 2.00 630 1,260
Overheads 1.00 630 630
7900 units transfe rred to next 5,490
Process
(i) Cost of opening WIP (80 units) 4,000
(ii) Cost incurred on opening WIP
Material -- --
Labour 2.00 320 640
Overheads 1.00 320 320
960 munotes.in

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Process Costing

41
(iii) Cost of completing 7100 units
Material 4.00 7100 28400
Labour 2.00 7100 14200
Overheads 1.00 7100 7100
49700
Total (I + ii + iii) 54600

Dr. Process A/c. for February 1990 Cr.
Particulars Units Rs. Particulars Units Rs.
To Opening 800 4000 By Finished 7900 54660
WIP Goods
To Materials 9200 36800 By Closing WIP 900 5490
To Labour -- 16740 By Normal Loss 800 3200
To Overheads -- 8370 By Abnormal 400 2560
Loss
10000 65910 10000 65910

1.8 EXERCISE

1.8.1 Objective type:
Answer in Brief
1. State any four features of process costing.
2. Define process costing,
3. What do you mean by normal loss? How is it treated in process
cost accounts?
4. What do you mean by abnormal loss? How is it treated in process
cost accounts?
5. Distinguish between normal loss and abnormal loss.
6. What do you mean by abnormal effecti ve? How is it treated in
process cost accounts?
7. What do you mean by inter process profit? What purpose does it
serve?
8. What do you mean be equivalent production? munotes.in

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Advanced Cost Accounting
42 9. Name any four industries in which process costing is applicable?
10. Enumerate any two advantages of process costing.
11. Enumerate any two disadvantages of process costing.
12. What do you meant by equivalent units?
Multiple Choice Questions
1. The type of spoilage that should not affect the cost of inventories is
(a) Abnormal spoilage (c) Seasonal spoilage
(b) Normal spoilage (d) Indirect spoilage
2. Materials may not be put into process
(a) At the beginning of an operation
(b) Continuously
(c) At the end of the operation
(d) In the shipping department.
3. Process cost method is especially suitable for
(a)Custom production (c) FIFO
(b) Stand ard costs (d) LIFO
4. In process costing, costs follow
(a) Price rise (c) Product flow
(b) Price declines (d) Finished goods
5. When average costing is used, the opening inventory costs are
(a) Kept separate from the costs for the new period
(b) Added to the costs of the new period
(c) Subtracted from the new costs
(d) Averaged with other costs to arrive at total cost.
6. A disadvantage of FIFO costing is that
(a) The first units produced cannot be distinguished from later
production.
(b) Several units costs are used at the same time.
(c) The units have to be kept separate
(d) The shipping costs are higher munotes.in

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Process Costing

43
7. Which of the following method of costing can be used in a large
oil refinery?
(a) Process costing (c) Unit costing
(b) Operating costing (d) Job costing

8. Which of the following paid is odd :
(a) Construction -Contra ct costing
(b) Ship-building -Job costing
(c) Brick manufacturing – Process costing
(d) Transport undertaking – Operating costing
9. A product which has practically no sales or utility value is
(a) Waste (c) Spoilage
(b) Scrap (d) Defectives
10. Trimmings in timber industry should be treated as a :
(a) Waste (c) Spoilage
(b) Scrap (d) Defectives
11. The type of process loss that should not affect the cost of
inventory is
(a) Abnormal loss (c) Seasonal loss
(b) normal loss (d) standard loss
12. The stage where joint products are separated from each other is
known as
(a) break -even point (b) angle of incidence
(c) split-off point
13. Fifty units are put in a process at a total cost of Rs. 90. Wastage is
normally 10% without any scrap value. If output is 40 units the amount of
abnormal loss would be
(a) Rs. 80 (c) Rs. 10
(b) Rs. 8 (d) Rs. 9
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44 14. Abnormal loss is charged to
(a) process account (b) costing profit and loss account
(c) Normal loss account
(Answers: 1(a), 2 (d), 3 (b), 4(c), 5(a), 6(b), 7(a), 8(c), 9(a),
10(b).)11 (a), 12(c), 13 (c), 14(b) )
1.8.2 Short notes
1. Write a short note-Inter process profits.(Apr -08)
2. Write a Short Note -Treatment of losses in Process.(Apr 07)
3. Write a short Note -Equivalent Production. (Apr -07)
4. Describe the main features of process costing.
5. Explain the features of process costing
6. How would you treat abnormal gain?
1.8.3. Long questions
1. What do you mean by inter -process profits in process cost accounts.
2. Explain the methods to be adopted in the treatment of joint products
and by-products in process account.
3. What do you understand by `Normal’ and `Abnorma l’ Wastage
during the process of manufacture?
4. Describe briefly the method known as Process Costing, stating four
types of manufactures which would be suitable for its application. A
description of the method of dealing with by - products is not
required.
5. Explain the concept of Equivalent Production. Discuss the two
methods of its valuation.
1.8.4 Practical Problems Illustration 1:
During a particular period 2,000 units at a cost of ` 60,000 were
introduced into Process ‘A’ (at the beginning). The normal loss was
estimated at 5% of the input. At the end, 1,400 units were produced
and transferred to the Process ‘B’, 460 units being partially
completed and 140 units scrapped. The partially completed units had
reached the following state of production:
Materials 100% complete
Labour 50% complete
Overheads 50% complete
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45 Additional costs incurred during the process were: Materials Rs.
17,000
Labour Rs.33, 400
Overheads Rs. 16,700
The units scrapped realised Rs.10 per unit. Prepare Process ‘A’ A/c
with all relevant statements.
(Ans.: Equivalent Units, Material: 1,900, Labour: 1670, Overheads: 1,670
Transfer to Process B 1,400 units @Rs. 70 p.u.)
(M.Com. Mar. 2002)
Illustration 2 :
XYZ Ltd. is engaged in process industry. During the month August
2000, 2000 Units were intro duced in process ‘X’. The normal loss
was estimated at 5% of input. At the end of the month 1,400 units
had been produced and transferred to process ‘Y’. 460 units were
incomplete and 140 units, after passing through fully the entire
process had to be scra pped. The incomplete units had reached the
following state of completion:
Materials 75% Completed
Labour 50% Completed
Overheads 50% Completed
Following are the further information on the process ‘X’ :
Cost of the 2000 units Rs. 58,000
Additional Direct materials Rs. 14,400 Direct
Labour Rs. 33,400
Direct Overheads Rs. 16,700
Units scrapped realised Rs. 10 each
Prepare statement of equivalent production, statement of cost,
statement of evaluation and process ‘X’ account.
(M.Com. Mar. 2005)
Ans. (Equivalent Units, Material: 1,785, Labour: 1,670, Overheads: 1,670)
Illustration 3 : (FIFO)
The following information is available for Process IV of
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46 Opening Stock: 4,800 units @ Rs.16,500
Degree of Completion: M aterial 70%
Labour 60%
Overheads 60% Transfer from Process III: 30,600 units @ Rs. 30,600
Transfer to Process V: 27,600 units
Direct Material introduced in Process IV: Rs. 13,440 Direct Labour
introduced in Process IV: Rs. 39,420 Production overheads incurred
Rs. 52,560
Units scrapped: 2,400
Degree of completion: Material 100%
Labour 70%
Overheads 70%
Closing stock 5400 units
Degree of completion:
Material
60%
Labour 40%
Overheads 40%

There was a normal loss of 10% of production in the process.
Unites scrapped were realised at Re. 1 per unit. From the above
information prepare:
1) Statement of equivalent production
2) Cost of equivalent unit for each element of the cost, the loss, the
work -in-process, etc.
3) Process account using FIFO method.
(M.Com. Oct. 2005)
Ans. (Equivalent Units, Material I: 27,600, Material II: 26,880, Labour: 26,460,
Overheads: 26,460)
Illustration 4 : (FIFO)
The following data pertains to Process I for March 2003 of Beta
Limited :

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47 Particulars Units Rs.
Opening Work -in-Progress … … … … . 1,500 15,000
Degree of completion :
Materials 100%; Labour and
overheads 33⅓%
Input of Materials … … … … . 18,500 52,000
Direct Labour … … … … . 14,000
Overheads … … … … . 28,000
Closing Work -in-Progress … … … … . 5,000

Degree of Completion Materials 90% and Labour and Overheads
30%.
Normal Process Loss is 10% of total input (opening work in
progress units + units put in).
Scrap value 2.00 per unit.
Units transferred to the next process 15,000 units. You are required
to:
1) Compute equivalent units of production.
2) Compute cost per equivalent unit for each cost eleme nt i.e.,
materials, labour and overheads.
3) Compute the cost of finished output and closing work -in- progress.
4) Prepare the process and other Account.
Assume:
i) FIFO Method is used by the Company.
ii) The cost of opening work -in-progress is fully transferred to the next
process.
(M.Com. Mar.2006)
Ans. (Equivalent Units, Material: 16000, Labour:14,000, Overheads: 14,000)
Illustration 5: (Weighted Average)
From the following details prepare Statement at Equivalent
Production, statement of Cost and find the value of: (a) Output
transferred and (b) Closing work in progress
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48 Opening work in progress (units) 2,000
Materials (100% Complete) 7,500
Labour (60 % Complete) 3,000
Overheads (60% Complete) 1,500
Units introduced into this process 8,000
There are 2,000 units in process at the end and the stage of
completion is estimated to be :
Materials 100%
Labour 50%
Overheads 50%
8,000 units are transferred to next process. The process costs for the
period are:
Materials Rs. 1, 00,000
Labour Rs.78,000
Overheads Rs. 39,000
(M.Com. Oct. 2006)
Ans. (Equivalent Units, Material:10,000, Labour: 9,000, Overheads: 9,000)
Illustration 6 : (Average)
Shete and Shete Pvt. Ltd. gives the following particulars relating to
process ‘P’ in its plants for the month of January 2007 :
Particulars Rs. Rs.
Work -in-Progress (500 units)
01-01-2007
Material (100%) … … … … 12,000 -
Degree of Completion Labour (50%) … … … … 7,200 -
Overheads (50%) … … … … 16,000 35,200
Units introduced during the Month
January, 2007 – Units – 19,500 … … … … - -
Processing Cost incurred during the
Month
January, 2007 Materials … … … … 4,65,500 -
Labour … … … … 1,80,000 -
Overheads … … … … 2,64,800 9,10,300
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49
Particulars Units
Output transferred to Process Q … … … … 18,200
Units Scrapped (Degree of Completion Material 100%, 1,400
Labour 80% and Overheads 80%) … … … … 400
Work -in-Progress (Closing Balance) … … … …
(Degree of Completion -Materials 100%, Labour and Overheads
50%)

Normal loss in processing is 5% of total input a nd scrapped units
fetch 2.50 each. Prepare the following statements for Process ‘P’
for January, 2007 :
a) Statement of Equivalent Production
b) Statement of Cost and Statement of Evaluation
c) Process ‘P’ A/c
d) Abnormal Loss A/c Use Average Method
(Mar. 07, adapted )
Ans. (Equivalent Units, Material: 19,000, Labour: 18,720, Overheads: 18,720)
Illustration 26 : (FIFO – No Losses)
Avdoot Ltd., a manufacturer of a specialized product, is have a
process costing system. The stock of work -in-progress at the end of
each mont h is valued on First in First Out (FIFO) basis. At the
beginning of January 2008 the stock of work -in-progress was 2000
units (40% completed) which was valued as :
Material Rs. 18,000
Labour Rs. 17,000
Overheads Rs. 5,300
During the month of January 2008 , actual issue of materials for the
production purpose was Rs. 3,42,500. wages and overheads in
the month of January, 2008 amounted to Rs. 4,02,600 and Rs.
1,12,200 respectively. Finished production taken into the stock in the
month was 12 ,500 units. There was no loss in the process. At the end
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50 2500 units (60% complete as to Labour and Overheads and 80%
complete as to materials). Prepare the following statements for
January, 2008.
a) No. of units introduced in the process b) Statement of Equivalent Production
c) Statement of Cost d) Statement of Evaluation e) Process Account.
(Apr. 08, adapted) (Equivalent Units, Material: 13,700, Labour:
13,200, Overheads: 13,200)
Illustr ation 27 : (FIFO – Process A/c with Abnormal Loss)
From the following information prepare Process account as per
FIFO assumption:
Opening stock Degree of completion
80 units @ Rs. 6 per unit Rs. 4,800
Material 60%
Labour 40%
Overheads 40%
Transfer from previous process : 12,000 units costing Rs. 16,350
Transfer to next process : 9,700; Units scrapped 1,300 units Normal
loss 10%; Closing stock : 1,800 units
Degree of completion
For units scrapped : For closing stock :
Material 100% Material 60%
Labour 50% Labour 50%
Overheads 50% Overheads 50%
Scrap realised Re. 1.00 per unit
Other information Rs.
Material 10,500
Labour 20,760
Overheads 16,470
(M.Com, Oct. 2008, adapted) (Ans. Equivalent Units, Material I: 10,900, Material
II: 10,500, Labour: 10,380, Overheads: 10,380)

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51 2
COST ALLOCATION
Unit Structure
2.0 Introduction
2.1 Types of cost
2.2 Cost driver
2.3 Methods of allocation of cost
2.4 Step Down Method
2.5 Reciprocal Method of cost allocation
2.6 Activity Based costing
2.7 Difference between Traditional Cost System and ABC system
2.8 Illustrations
2.0 INTRODUCTION
Cost Allocation or cost assignment is the process of identifying and
assigning costs to the various cost objects. These cost objects could be
those for which the company needs to find out the cost separately. A few
examples of cost objects can be a product, customer, project, department,
and so on. The need for cost allocation arises because some costs are not
directly attributable to the particular cost object. In other words, these
costs are incurred for various objects, and then the sum i s split and
allocated to multiple cost objects. These costs are generally indirect. Since
these costs are not directly traceable, an accountant uses their due
diligence to allocate these costs in the best possible way. It results in an
allocation that coul d be partially arbitrary, and thus, many refer cost
allocation exercise as the spreading of a cost. Cost allocation is the process
of identifying, accumulating, and assigning costs to costs objects such as
departments, products, programs, or a branch of a company. It involves
identifying the cost objects in a company, identifying the costs incurred by
the cost objects, and then assigning the costs to the cost objects based on
specific criteria.
When costs are allocated in the right way, the business is able to trace the
specific cost objects that are making profits or losses for the company. If
costs are allocated to the wrong cost objects, the company may be
assigning resources to cost objects that do not yield as much profits as
expected.
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52 2.1 TYPES OF COSTS
There are several types of costs that an organization must define before
allocating costs to their specific cost objects. These costs include:
1. Direct cost
Direct costs are costs that can be attributed to a specific product or service,
and they do not need t o be allocated to the specific cost object. It is
because the organization knows what expenses go to the specific
departments that generate profits and the costs incurred in producing
specific products or services. For example, the salaries paid to factory
workers assigned to a specific division is known than does not need to be
allocated again to that division.
2. Indirect Cost
Indirect costs are costs that are not directly related to a specific cost object
like a function, product, or department. They are co sts that are needed for
the sake of the company’s operations and health. Some common examples
of indirect costs include security costs, administration costs, etc. The costs
are first identified, pooled, and then allocated to specific cost objects
within th e organization.
Indirect costs can be divided into fixed and variable costs. Fixed costs are
costs that are fixed for a specific product or department. An example of a
fixed cost is the remuneration of a project supervisor assigned to a specific
division. The other category of indirect cost is variable costs, which vary
with the level of output. Indirect costs increase or decrease with changes
in the level of output.
3. Overhead costs
Overhead costs are indirect costs that are not part of manufacturing cost s.
They are not related to the labor or material costs that are incurred in the
production of goods or services. They support the production or selling
processes of the goods or services. Overhead costs are charged to the
expense account, and they must be continually paid regardless of whether
the company is selling goods or not .Some common examples of overhead
costs are rental expenses, utilities, insurance, postage and printing,
administrative and legal expenses and research and development costs.
2.2 CO ST DRIVER
A cost driver triggers a change in the cost of an activity. The concept
is most commonly used to assign overhead costs to the number of
produced units. It can also be used in activity -based costing analysis to
determine the causes of overhead, wh ich can be used to minimize
overhead costs. A large number of cost drivers may be used within an
activity -based costing system. If a business is only concerned with
following the minimum accounting requirements to allocate overhead
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53 activity that is the root cause of why a cost occurs. It must be applicable
and relevant to the event that is incurring a cost. A cost driver assists with
allocation expenses in a systematic manner that results in more accurate
calculations of the true costs of producing specific products.
Cost pool: It is an aggregate of all the costs associated with performing a
particular business activity.
An activity cost driver refers to actions that cause variable c ost to
increase or decrease for a business. Therefore, identifying what
product/service is causing particular costs can help the business to become
more profitable by better understanding the specific activities that are
driving the costs. Allocating cost drivers appropriately is important in
accurately determining the cost of producing a good or service, as well
as making financial projections.
Activity cost drivers are specific activities that cause variable expenses to
be incurred. One variable expense can comprise more than a single
activity cost driver. For example, machine hours and labor hours can be
activity cost drivers in the manufacturing of a product.
All variable expenses can be broken down and looked at by one or several
activity cost drivers, which can also be influenced by several factors. For
example, if the minimum wage increases, it can cause the cost of
producing a produc t to also increase.
Examples of Activity Cost Drivers
 Direct labour hours
 Machine setups required
 Number of customer contacts
 Number of customer change orders
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54 2.3 METHODS OF ALLOCATING COST
Direct method of cost allocation
The direct method is conside red the most simple method of allocating the
cost of service departments to operating departments . In the direct
method, interactions between service departments are ignored and costs
are allocated just to operating departments. Under this method, the costs
incurred by service departments a re not allocated to each other; rather,
they are directly allocated to operating departments using some
appropriate allocation base. In other words, we can say that the direct
method of departmental cost allocation ignores the service provided by
a service department to itself and to other service departments.
A firm generates various expenses that can be assigned to a specific “cost
item” — such as a commodity, program, function, or service. These costs
include anything from mop floors to functional equipm ent. You should,
however, generate enough income to pay such corporation overhead
expenditures. This means that revenue must surpass total costs. The direct
allocation technique is one of numerous cost allocation strategies used to
allocate indirect costs to activities. It is one of the most often used
technique The direct technique is the easiest in terms of cost allocation,
even though it has several shortcomings. Nevertheless, because of its
simplicity of using it, it became one of the most widely applie d cost
allocation techniques in recent years. In a nutshell, it assumes that service
departments do not give facilities or services to each other, and it merely
distributes the service departments’ costs in the company’s manufacturing
departments.
The direct approach of transferring service department costs to the
operational department is the simplest way of allocating costs between
divisions. As a result of this technique, the expenses involved by service
departments are not assigned to one another. Still, they are instead allotted
straight to operational departments using a suitable rate of allocation.
The direct approach assigns the expenses of all the support departments to
every other manufacturing unit calculated based on the rates of each
operationa l department rates. Services that other support departments
receive are not considered in this method of cost allocation. With the help
of this approach, it is possible to completely charge operational
departments with the overhead expenditures for which they are
accountable. Firms that use the direct method completely transfer excess
costs from service departments to inventories, even though there may be
cross -costs across service departments, because of the nature of the
business.
For instance, the cleani ng crew offers services to sanitize all business
buildings. In contrast, the maintenance department oversees the firm’s
machinery, and the information technology department oversees
maintaining the organization’s computer networks. Assume that a service
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55 Department 2. Such services will be excluded from consideration
throughout the cost allocation procedure. Because such services are not
assigned to certain other service divisions, many cost auditors think that
the direct approach is not as precise as other methods.
Advantages and disadvantages
Many organizations use direct method for allocating departmental costs
because it is very simple and easy to employ.
The major disadvantage of direct me thod is that it ignores
interdepartmental services and can therefore lead to distorted products and
services cost. Moreover, it is commonly considered a less accurate method
when compared with other methods available for departmental cost
allocation.
There is, however, a disadvantage to using this approach. Direct allocation
does not enable companies to shift expenditures from one support
department to another support department and vice versa. Depending on
the nature of your company, this is a possibility. Assume that there is an
HR and maintenance department. Allowing for the possibility that almost
all the HR and maintenance department support expenditures are assigned
to an operational unit through direct allocation. As a result, HR and
maintenance depa rtment expenses are completely depleted.
Q.1) The Murphy Company has two service departments and two
operating departments as shown below:

The two service departments provide service to each other as well as to
operating departments. The department A’s cost is allocated on the basis
of employee hours and department B’s cost is allocated on the basis of
square feet occupied.
Required : Allocate the cost of service departments to operating
departments using direct method of cost allocation.



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56 Solution

Departme nt A’s cost has been allocated on the basis of employee hours:
9,000 hours + 15,000 hours = 24,000 hours.
Allocated to department X: $180,000 × (9/24) = $67,500
Allocated to department Y: $180,000 × (15/24) = $112,500
Department B’s cost has been allocated on the basis of spaces occupied:
3,000 square feet + 22,000 square feet = 25,000 square feet.
Allocated to department X: $45,000 × (3/25) = $5,400
Allocated to department Y: $45,000 × (22/25) = $39,600
On the other hand, the human resources department assists the
maintenance department throughout the same time frame. It goes without
saying that the maintenance department should bear a portion of the costs
of human resources. However, the expenditures of the maintenance
department have already been transf erred in whole to another operating
unit.
2.4 STEP DOWN METHOD:
In the step down method, one service department’s costs are allocated to
another service department as well as operating departments that use it.
Any amount of the allocation base attributabl e to the service department
whose cost has already been allocated is ignored. Each service department
assigns its own costs to operating departments plus the costs that have
been allocated to it from other service departments.
The step technique of distrib uting service department expenses is the
second way of allocating costs. As part of a sequential process, service
expenses are allocated to operational departments and other service
departments by using this approach. The following are the critical phases
in the allocation process:
1. Service departments that offer services to the greatest number of other
service departments or that have the greatest proportion of their expenses
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57 expense s to certain other service departments. It also distributes the
remainder of its expenses across the operational divisions.
2. The service department that offers services to the second -
highest number of other services departments or has the second -
highest proportion of its expenses absorbed by other service departments,
oversees allocating its expenses towards the other service departments. At
this point, all the company’s other expenses have been assigned to the
operational divisions.
3. Till the service departm ent offering services to the fewest amount of
other service departments or having the lowest proportion of its expenses
absorbed by the other service departments is assigned its expenses, the
procedure is repeated. The procedure comes to an end when all th e
allotment has been accomplished.
Advantages
This technique is easy and uncomplicated to execute and can be finished
quickly. Due to the higher level of convenience, supervisors willing and
eager to reduce the time spent on record keeping and forming acco unting
reports are far more likely to select it, even though the precision offered is
not the highest in this cost allocation.
Q.1) The TCS Company uses the step method for allocating the costs of its
service departments to operating departments. The compa ny has two
service departments and two operating departments. The selected
information for the four departments is given below:

The company uses employee hours as the base for allocating the cost of
department A and space occupied for allocating the cost of department B.
Required: Allocate the cost of service departments to operating
departments using step down method.




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58 Solution

Allocation of department A’s cost:
Allocation ratio:
Department B: 3,000/(3000 + 9000 + 15,000 ) = 3,000/27000 or 3/27
Department X: 9,000/(3000 + 9000 + 15,000 ) = 9,000/27000 or 9/27
Department Y: 15,000/(3000 + 9000 + 15,000 ) = 15,000/27000 or 15/27
Allocated to department B: $180,000 × (3/27) = $20,000
Allocated to department X: $180,000 × (9/27) = $60,000
Allocated to department Y: $180,000 × (15/27) = $100,000
Allocation of department B’s cost:
Allocation ratio:
Department X: 3,000/(3,000 + 22,000) = 3,000/25,000 or 3/25
Department Y: 22,000/(3,000 + 22,000) = 22,000/25,000 or 22/25
Total cost of department B: $45,000 + $20,000 = $65,000
Allocated to department X: $65,000 × (3/25) = $7,800
Allocated to department Y: $65,000 × (22/25) = $57,200
Q.2) The Religare Company provides the following selected data about its
three service and two operating departments:

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59 The order and bases for allocating service department costs is given
below:
1. Department A; allocation base is “number of employees”.
2. Department B; alloc ation base is “space occupied”.
3. Department C; allocation base is “hours of time”.
Required: Allocate the cost of service departments to operating
departments using step down method of cost allocation.
Solution

2.5 RECIPROCAL METHOD OF COST ALLOCATION
Reciprocal method is a method of allocating service department costs to
other departments that gives full recognition to interdepartmental services
.Although it is the most accurate, it is also the most complicated. In the
reciprocal method, the relationship between the service departments is
recognized. This means service department costs are allocated to and
from the other service departments. The reciprocal method gives full
recognition to interdepartmental services. Under the step method, only
partial recognitio n of interdepartmental services is possible. The step
method always allocates costs forward never backward. The reciprocal
method, by contrast, allocates service department costs in both directions.
The reciprocal allocation requires the use of simultaneou s equations. Other
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60 allocation method, matrix allocation method and double distribution
method.
Under this method the true cost of the service departments are computed
first with the help of simultaneous equations and these are then distributed
to producing departments on the basis of given percentage or ratio.
Remember that true cost of the service department means the cost of the
service department which includes original cost of the department plus the
share of the other service department. The main advantage of this method
is to have an accurate distribution in a single step in the distribution
summary.
Use of Reciprocal Method
This method is rarely used in practice for two reasons. First, the
computations are relatively complex. Although the complexity issue could
be overcome by use of computers, there is no evidence that computers
have made the reciprocal method more popular. Second, the step method
usually provides results that are a reasonable approximation of the results
that the reciprocal method would provide. Thus, companies have little
motivation to use the more complex reciprocal method.
Q.1) A company has two service and two producing departments. The two
service departments serve not only to producing departments but also to
each other. The departmental estimates for the next year are as follows. Producing departments:
A
B
Service departments:

X
Y 50,000
40,000

10,000
8,800 The service departments costs are to be distribut ed as under:
Cost of X : 50% to A, 40% to B, and 10% to Y
Cost of Y : 40% to A, 40% to B, and 20% to X Required:
Transfer the service departments costs to each other and to producing
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61 Solution:
Now we solve the given illustration first using the simultaneous equation
method as follows: Original costs of service departments:
X = Rs.10,000
Y = Rs. 8,800
After getting the share from distribution of service departments:
X = Rs. 10,000 + 20% Y
Y = Rs. 8,800 + 10% X
By putting the value of Y in equat ion (1)
X = Rs. 10,000 + 20%(Rs.8,800 + 10%X)
X = Rs. 10,000 + 1760 + 0.2X
X – 0.02X = Rs. 10,000 + Rs.1,760
0.98X = Rs. 11,760
X = 11760 / 0.98
= Rs. 12,000
By putting the value of X in equation (2)
Y = Rs. 8,800 + 10%(Rs. 12000)
Y = Rs. 8,800 + Rs. Rs. 1 ,200
= Rs. 10,000 Distribution Summary Department Producing Service Original
costs
Distribution
of service
department
costs:
X
Y
Total
departmental
overheads A
Rs
50,000
6,000
4,000
—— -
60,000
===== B
Rs
40,000
4,800
4,000
——
48,800
===== X
Rs
10,000
(12,000)
2,000
—— -
Nil
===== Y
Rs
8,8001,200
(10,000)
—— -
Nil
=====

2.6 ACTIVITY BASED COSTING
Activity based costing (ABC) assigns manufacturing overhead costs to
products in a more logical manner than the traditional approach of simply
allocating costs on the basis of machine hours. Activity based costing first
assigns costs to the activities that are the real cause of the overhead. It then
assigns the cost of those activities only to the products that are actually
demanding the activities. A B C w o r k s b e s t in complex environments,
where there are many machines and products, and tangled processes
that are not easy to sort out. Conversely, it is of less use in a
streamlined environment where production processes are abbreviated,
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62 Activity based costing is basically a change in accent. People perform
activities and activities use resources. Thus, by controlling activities the
manager is making sure that costs are controlled at their source. A wise
manager will not focus on how to estimate product costs, but will focus
more on why the costs were there in the first place. When intending an
activity based costing system this should be utilized as a departure point.
Advantages of Activity Based Costing System
 The first and most sign ificant benefit is the accuracy in the procedure
of costing with regards to the product line, the consumers of the
product, the stock -keeping units employed by the administration and
the channel and group which streamline the flow of the product from
the m aker to the consumer.
 This system better helps in the procedure of understanding the concept
of overhead costs i.e. the distribution of common business resources as
they are utilized by particular product lines and their association to
particular cost driv er.
 The system is simple to interpret and understand is it is available,
useable and specifically implement capable across all norms of
business set -ups.
 This procedure consumes unitary cost, or marginal cost as the
calculation base in comparison to the co nventional cost accounting
techniques which employ total cost.
 This system is specifically useful in recognizing and ear -marking some
of the matters business activities which are a stress or burden on the
business i.e. wasteful or non value adding services ..
 This procedure permits firms to implement costing policies across
another diagonal of the company as business procedures, supply chains
and value addition channels are capably and optimally analyzed in this
procedure.
 This system mimics the actual busin ess procedure as the appropriation
of common pool resources takes place in the same way as common
resources are utilized in the business.
 Disadvantages of Activity Based Costing System
 Data collection procedure for this system is very time consuming.
 The c apital expense on the activity based system and its subsequent
running costs can be a road block for companies.
 The system is very apparent which some managers would not
authorize of as they would like to keep some things out of the view of
the owners of t he firm.
 ABC Costing System is very costly to implement and maintain in a
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63 activity measures must be collected, checked, and entered into the
system.
 ABC costing systems produces the reports th at are different from
the profit and loss reports produced through traditional costing
systems.
 As most of the companies are using , traditional costing systems, so
because of the difference in the costing basis the costing and financial
reports of the tw o companies of the same industry could not be
compared for performance evaluation purposes.
 Adaptability of ABC Costing System is not suitable for all kind of
companies because small companies have not many resources to ad
 Data Produced through ABC Costing System can easily misinterpret
and can lead towards wrong decisions. So manager should use the data
produced through ABC Costing System with extreme care and should
assign the costs that are relevant to the products, customers and should
not consider the other cost objects that are irrelevant.
 ABC costing system does not comply with the GAAP and a company
has to produce its reports for internal and external purposes by using
traditional and ABC costing system both at a time.
 In ABC costing system costs are allocated on the base of cost drivers
and activities undertaken to manufacture the product, definitely, it
provides the accurate and proper allocation of the costs to the products
but there is a danger of over or under costing of the products when
irrelev ant cost drivers or activities are assigned to the products or
services produced.
Steps in ABC
 Identify which activities are necessary to create a product
 Separate each activity into its own cost pool
 Assign activity cost drivers to each cost pool
 Divide the total overhead in each cost pool by the total cost drivers
to get your cost driver rate
 Compute how many hours, parts, units, etc. that the activity used and
multiply it by the cost driver rate to find total cost
 Calculate Cost per Unit by dividing the Total Cost by Total Units
produced.

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64 Uses of ABC
 Identification of necessary activities: The ABC system shows how
overhead is used, which helps to determine whether certain activities
are necessary for production.
 Focus on Value adding activities: The Act ivity Based Costing helps the
management on focusing the forces on value adding activities and
eliminate non -value adding activities.
 Ensuring profit margin: The specific allocation of costs also helps to set
prices that produce a healthy small business pr ofit margin.
 Product pricing: With an ABC system, the business can assign costs to
each activity in the production process, allowing it to more accurately set
a price that accounts for how much it costs to create a product.
 Measures to improve productivity : The accurate cost information helps
the management to adopt productivity improvement approaches like
Total Quality Management (TQM), Business Process Re -engineering
(BPR) etc.
 Help in deciding Make or Buy: The management can take make or buy
decisions by considering the cost of manufacture of a product or sub
contract the same with an outside agency through Activity Based
Costing analysis.
2.7 DIFFERENCE BETWEEN TRADITIONAL COST
SYSTEM AND ABC SYSTEM
Basis Traditional ABC
1. Cost pools One or limited num ber Many
2. Applied Rate Volume based Activity Based
3. Applied for Labour Intensive Capital Intensive
4. Benefits Simple, Inexpensive Accurate product
costing, identification ofnecessary activities etc
5. Cost assignments Primary and secondary distribution of
Overhead and then allocation of Overhead as per the suitable rate Allocation of cost pool
based on cost drivers
then allocation of costs to
product or service based
on the drivers used by
the particular product or service
6. Focus Departments or
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65
2.8 PRACTICAL SUM
Problems involving calculations of Total cost and CPU under both
Traditional and ABC methods.
Question:
Amrit Company produces 3 products A, B and C. The company follows
Activity Based Costing system. Information related to various costs of
these products for the last year:
Particulars A B C
Production and Sales (Units) 15000 12000 18000
Selling Price p.u. (Rs.) 7.5 12 13
Raw Material Usage (kg) p.u. 2 3 4
Direct labour hours p.u. 0.1 0.15 0.2
Machine Hours p.u. 0.5 0.7 0.9 No. of Production runs p.a. 16 12 8 No. of purchase orders p.a. 24 28 42 No. of deliveries to retailers p.a. 48 60 32

The price of Raw materials remained constant through out the year at
Rs.1.2 per kg and the labour cost was Rs.14.8 per hour. The annual
Overhead costs are as follows:
Overheads Rs
Machine set up costs 26550
Machine running costs 66400
Procurement Costs 48000
Delivery costs 54320




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66
Solution: Traditional Method
a) Calculation of Total Overhe ad
Overheads Rs
Machine set up costs 26550
Machine running costs 66400
Procurement Costs 48000
Delivery costs 54320
Total 195270

b) Calculation of Overhead Absorption rate
Particulars A B C Total
Production Volumes 15000 12000 18000
Labour hours p.u. 0.1 0.15 0.2
Total Labour hours 1500 1800 3600 6900

Overhead absorption rate = 195270/6900 = Rs.28.30 per hour.
c) Calculation of Cost p.u.
Particulars A B C
Raw material cost (Usage * Rs.1.20) 2.4 3.6 4.8
Direct Labour Cost (Labour hours * Rs.14.80) 1.48 2.22 2.96
Overhead (Labour hours * Rs.28.30) 2.83 4.25 5.66
CPU 6.71 10.07 13.42





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67 ABC Method
a) Calculation of Overhead Absorption rate
Cost Pool Rs. Cost
Driver Rate of OH per
activity (Rs.)
Machine
costs set
up 26550 No. of
Production
runs p.a. (16+12+8) = 36 runs 26550/36=
737.50 per run
Machine
costs
running 66400 No. of
Machine
Hours p.a. (7500+8400+16200)#
= 32100 hours 66400/32100 =
2.0685 per hour
Procureme
nt Costs 48000 No. of
purchase
orders p.a. (24+28+42)
orders = 94 48000/94=
510.6383per
order
Delivery
costs 54320 No. of
deliveries
to retailers
p.a. (48+30+62)
deliveries = 140 54320/140=
388 per
delivery

# Total Machine hours p.a. = Machine hours p.u. * Total units produced A
= 0.5*15000 = 7500
B = 0.7*12000 = 8400 C = 0.9*18000 = 16200
b) Calculation of Cost p.u.
Particulars A B C
Material Cost 2.4 3.6 4.8
Labour Cost 1.48 2.22 1.96
Overhead: ##
Machine set up (737.50*16)/15000 = (737.50*12)/12000 = (737.5*8)/18000 = Costs 0.7867 0.7375 0.3278
Machine running (2.0685*7 500)/15000 (2.0685*8400)/12000 (2.0685*16200)/18000
Costs = 1.034 = 1.4479 = 1.8616
Procurement (510.6383*24)/15000 (510.6383*28)/12000 (510.6383*42)/18000
Costs = 0.817 = 1.1915 = 1.1915
Delivery costs (388*48)/15000 = (388*30)/12000 = (388*62)/18000 = 1.2416 0.97 1.3364
Total CPU 7.7593 10.1669 11.4773

## Overheads p.u. for products A, B and C
= (Overhead absorption rate* No. of cost drivers used by the individual
products p.a.)/ No. of units produced
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68 3
RESPONSIBILITY ACCOUNTING
Unit Structure
3.0 Introduction
3.1 Objectives of responsibility accounting
3.2 Assumptions and Requisites of responsibility accounting
3.3 Types of cost centres
3.4 Concept of controllability
3.5 Residual income
3.6 Segment pe rformance
3.7 Illustrations
3.8 Controllable cost
3.9 Exercise
3.0 INTRODUCTION
Responsibility accounting is a kind of management accounting that is
accountable for all the management, budgeting, and internal accounting of
a company. The primary objective of this accounting is to support all the
Planning, costing, and responsibility centers of a company.
The accounting generally includes the preparation of a monthly and annual
budget for an individual responsibility center. It also accounts for the cost
and revenue of a company, where reports are accumulated monthly or
annually and reported to the concerned manager for the feedback.
Responsibility accounting mainly focuses on responsibilities centers.
For instance, if Mr X, the manager of a unit, plans the b udget of his
department, he is responsible for keeping the budget under control. Mr X
will have all the required information about the cost of his department. In
case, if the expenditure is more than the allocated budget than Mr X will
try to find the erro r and take necessary action and measures to correct it.
Mr X will be personally accountable for the performance of his unit.
Features of Responsibility accounting
 The main feature of responsibility accounting is to define the cost
centers at the initial st age which we earlier referred to as responsibility
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69  For each center, there should be a fixed target which the department
has to achieve in the defined deadline, so setting targets for the center
is very crucial.
 Then, we must track the performance of each responsibility center and
also compare the actual performance with the target performance.
 The variance between the actual performance and target performance
is analyzed and post that the responsibility of each center should be
fixed.
 Then correcti ve action has to be taken by the management and it
should be individually communicated to the concerned person taking
care of the responsibility center.
3.1 OBJECTIVES
 Know how cost and management accounting will be used for
managerial planning and contr ol.
 Appreciate the structure and process in designing responsibility
accounting system;
 Understand the concept of responsibility centres;
 Familiar with different methods of evaluating the performance of
different segments of an organisation; and
 Identify the benefits, and essentials of success of measuring and
reporting of costs by managerial levels of responsibility.
2.2 ASSUMPTIONS AND REQUISITES
(1) The areas of responsibility are defined for which managers should be
held responsible.
(2) Managers are o nly charged with the items and responsibility over
which they can exercise a significant degree of direct control.
(3) Managers should actively participate in establishing the goals or
budgets against which their performance is measured.
(4) Goals defined for each area of responsibility should be attainable with
efficient and effective performance.
(5) Control (performance) reports should contain significant information
related to each area of responsibility.
(6) Responsibility centre managers should try to accomplish the budgets
and objectives established for their respective areas of responsibility.

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70 Requisites
The following are must for efficient implementation of responsibility
accounting:
1) A company must have a clearly defined organizational structure that is
understandable to all without any ambiguity.
2) There should be clear measures and standards for the evaluation of
performance.
3) A manager who is accountable for a responsibility center must know
all the evaluation parameters with utmost clarity in advance.
4) All those accountability and evaluation parameters should be
controllable at the level of the manager.
5) Uncontrollable factors need to be addressed separately.
3.3 TYPES OF COST CENTERS:
Cost center
It is a unit in a company that has control ov er the cost only, such as the
production department. The cost center does not exercise control over
other functions, such as revenues or investments. A point to note is that a
manager responsible for any cost center is only responsible for the
controllable costs, and not uncontrollable costs.
Revenue center
This unit is only responsible for generating revenues, and not any other
business function. The sales and marketing department are an example of
a revenue center
Profit centre
It is accountable for both costs and revenues. One example of this is the
factory, whose cost is the raw material, and revenue is the products it
transfers to other departments. Also, branches of a company in different
regions are responsible for both costs and revenues.
Investment centre
It has control over costs, revenues, and investments. Or, we can say the
person is responsible for investing the assets of a company most
efficiently. Such a cost center works as a separate entity, such as a
corporate headquarters. A company measures the performance of an
investment center by using ratios, such as ROI (return on investment),
economic value -added, and more.

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71 3.4 CONCEPT OF CONTROLLABILITY
Responsibility accou nting is closely related with the goal of
controllability. Controllability is the degree of influence that a specific
manager has over costs, revenues, or other items in question. Accordingly,
in responsibility accounting those elements in a certain area o f activity are
identified which are controllable and then a person is given the
responsibility for managing such elements.
Responsibility accounting implies that individuals in an organisation can
not be responsible for those items which they can not contr ol. They should
also not claim any authority over those revenues which are not the result
of their actions and performances. For instance, a foreman in a production
department can be held responsible only for direct material and direct
labour costs, becaus e these are the costs which are controllable by him.
On the other hand, divisional manager of the production division can be
held accountable for all direct and indirect costs incurred in his division.
Generally, those decision makers who are placed higher in the authority
hierarchy, are held responsible for a greater number of activities and
financial elements. In the long run, however, all costs are control lable by
someone in the organisation.
There are various criteria to measure divisional performance such as profit
on turnover, sales per employee and sales growth etc.
The most popular criteria are:
Return on Investment (ROI)
Residual Income (RI)
Return on investment
Divisional operating profit is generally, used as a common measure of
performance. But divisional profit by itself does not provide a basis for
measuring a division performance in generating a return on the funds
invested in the division. For example, Division A and Division B had an
operating profit of Rs.1,00,000 and Rs.80,000 respectively d oes not
necessarily mean that Division A was more successful than Division B.
The difference in profit levels may be due to the difference in the size of
the divisions. Therefore, a suitable measure may be used to scale the profit
for the amount of capital invested in the division. One common method is
Return on Investment (ROI) which will be calculated as follows :



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72 Profit
Return on Investment = ——————— x 100
Capital employed

Profit sales
ROI = ——— x ———————
Sales Capital employed

Q.1) Peacock Company Ltd. has six segments for which the following
information is available for the year 31st March, 2005:
I
(Rs. in Lakhs) II
(Rs. in
Lakhs) III
(Rs. in
Lakhs) IV
(Rs. in
Lakhs) V
(Rs. in Lakhs) VI
(Rs. in Lakhs)
Capital
employed
1500
1200
3000
2400
4500
6000
Sales 3000 3000 6000 3600 18000 12000 Net profit 150 300 150 720 450 1200
You are required to measure the performance of different segments.
Solution
The return on investment can be analysed as follows:
Segments
I II III IV V VI
Profit/ Sales
(Profit ÷ Sales
x 100)

5%

10%

2.5%

20%

2.5%

10%
Turnover ofcapita l (Sales
÷ Capital
Employed)
2
2.5
2
1.5
4
2
ROI (Profit ÷
Capital
Employed
x 100)
10%
25%
5%
30%
10%
20%
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73 The above analysis gives the following conclusions regarding the
performance of different segments:
1) The manager of segment I is not sho wing a satisfactory level of ROI
even though his turnover of capital is not too bad. He must be
motivated to increase his profit sales ratio.
2) Segment II is performing well as profit, sales ratio and turnover of
capital, are relatively good.
3) The performance of segment III is not satisfactory as its profit margin
and capital turnover is Poor.
4) The performance of segment IV is good as its profit margin is high
with a reasonable capital turnover.
5) In respect of segment VI, the manager should be motivated to
incre ase its profit margin but maintains a very good turnover of capital.
6) The manger of segment VI is performing well comparing to other
segments, as it maintains a good ROI, fairly good capital turnover and
reasonably good profit margin.
The segments which show a low capital turnover should be investigated
and remedial action should be initiated particularly in segments IV, I
and III.
3.5 RESIDUAL INCOME
Residual income is the profit remaining after deduction of the cost of
capital on invest ment. It is the excess of net earnings over the cost of
capital. Any income earned above the cost of capital is profit to the firm.
The cost of capital charged to each division will be the same rate that is
applicable to the organization as a whole. The mo re the income earned
above the cost of capital, the better off the firm will be.
The Residual Income may be calculated as follows:
RI = Profit – (Capital Charge x Investment Centre Asset)
Where, capital is the minimum acceptable rate of return on investmen t.
This method is used as a substitute for or along with ROI as means of
evaluating managerial performance and motivates the managers to act to
the aims of goal congruence. The firm is interested to maximise its
income above the cost of capital. If the div isional managers are measured
only through ROI, they will not necessarily maximise RI. If managers are
encouraged to maximise RI, they will accept all projects above the
minimum acceptable rate of return. That is why most managers recognise
the weakness of ROI and take into account when ROI is lowered by a
new investment.
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74 Q.1) A division of a company earns a profit of Rs.1,00,000 for an
investment of Rs.4,00,000. There is an opportunity to make an additional
investment of Rs.2,00,000 which earns an annua l income of Rs.40,000.
You are required to calculate residual income if the company requires a
minimum return of 15 per cent on its investment and comment.
Solution
Before the additional Investment:
RI = Rs.1,00,000 – (15% of Rs.4,00,000)
= Rs.1,00,000 – Rs.60,000
= Rs.40,000
RI from additional Investment
RI = Rs.40,000 – (15% of 2,00,000)
= Rs.40,000 – Rs.30,000
= Rs. 10,000
Total Residual Income on an investment of Rs.6,00,000 is Rs.50,000. The
additional investment increases residual income and is improv ing the
measure of performance.
Q.2) Sunrise Company has three divisions A, B and C. The investment in
these divisions amounted to Rs.2,00,000, Rs.6,00,000 and Rs.4,00,000
respectively. The profits in these divisions were Rs.50,000, Rs.60,000 and
Rs.80,000 respectively. The cost of capital is 10 per cent. From the above
data, comment the performance of the three divisions.
Solution
Divisions
A B C
Profit Investment
ROI
( Profit
) x 100 Investment

RI = Profit – Cost of capital: Rs. 50,000
Rs. 2,00,000

25%
(50,00 0 x 100
) ————
2,00,000

Rs. 30,000
(50,000 –20,000) Rs. 60,000 Rs.6,00,000
10%
(60,00 0 x 100
) ————
6,00,000
NIL
(60,000 –10% of 6,00,000) Rs. 80,000
Rs. 4,00,000
20%
(80,00 0 x 100
) ————
4,00,000

Rs.40,000 (80,000–10% of 4,00,000)
In terms of profit division C has done best performance. If evaluation is
done on the basis of ROI criteria division A is the best performer. If
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75 3.6 SEGMENT PERFORMANCE
A segment or division may be either a profit centre having responsibility
for both revenues and operating costs, or an investment centre, having
responsibility for assets in addition to revenues and operating costs.
The manager of each segment are free to take decisions regarding the
performance of their centres. When an orgainzation grows it is inevitable
to create divisions or segments to control operations of different divisions.
This requires accounting information which discloses not only the
objectives and performances of divisions but also whether or not each
division is performing in the interest of the organization as a whole. This
section illustrates how segment data should be presented so that
meaningful decisions regarding segment performance can be taken.
A manager’s performance is evaluated generally on the basis of
comparison of costs incurred with costs budgeted. It is therefore,
important to allocate appropriate costs to the respective segments. While
allocating the costs, the costs relating to general administration or head
office should not be charged to any segment as these costs remain constant
irrespective of the volume of sales by each department. Letus see the
following illustration:
1) A simplified representation of organization of Digital Co. Ltd. is
presented below:
President

Vice President Marketing Vice President Manufacturing

Sales Advertising Credit Production Production
Manager Manager Manager Manager Engineer

Sewing Department

Cutting Department
The company manufacturers cloth potholders in a simple process of
cutting the potholders in various shapes and then sewing the contrasting
pieces together to form the finished potholder.




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76 The accounting system reports the following data for the year 2004 -05:
Budgeted Actual
Rs. Rs.
Bad debt losses 500 300
Cloth used 3,100 3,400
Advertising 400 400
Credit reports 120 105
Sales representatives’ travel exp. 900 1,020
Sales commissions 700 700
Cutting labour 600 660
Thread 50 45
Sewing labour 1,700 1,840
Cutting utilites 80 70
Credit department salaries 800 800
Sewing utilities 90 95
Vice -President, Marketing office exp. 2,000 2,140
Production engineering expense 1,300 1,220
Sales management office expenses 1,600 1,570
Production manager’s office exp. 1,800 1,700
Vice -President, manufacturing office expenses 2,100 2,010
Using the data given, prepare responsibility accounting reports for the two
vice-presidents.
Solution
Responsibility accounting tailors reports to each level of management to
include those items which t hey can control and for which they are
responsible. The items for which they are responsible are generally
determined by the organization structure as reflected in the organization
chart. Responsibility report highlights variances to assist in the process of
management by exception. Reports for higher -level managers are in
summary form in order to avoid flooding them with more detail than is
needed.
With these general ideas in mind, one can turn to the responsibility reports
required by the problem. Each re port is assumed to contain a one -line
summary of the expenses of the subordinate departments. From the
organization chart, the contents of the reports will, therefore, be as follows:

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77 Vice-president, marketing : Sales expense + advertising
expense + credi t expense
Sales expense : Sales representatives’ travel
expense + sales commissions +
sales management office
Advertising expense : Advertising
Credit expense : Credit reports + credit department
salaries + bad debt losses
Vice-president, manufacturing : Production expense + production
engineering expense + production
manager’s office expenses
Production Manager : Sewing department + cutting
department, i.e. thread + sewing
labour + sewing utilities + cloth
used + cutting labour + cutting
utilities
Notice that these reports do not contain the expenses of the vice-
president’s offices. Although sometimes included, they are not here on the
ground that the vice presidents cannot control their own salaries, the major
component of these categories. If they are excluded on these reports, they
would be included as an item on the president’s report, where they are
controllable.
Since the lower level reports are summarized in the higher -level reports, it
is usually easier to begin with the lower -level reports.
i) Produ ction Manager
Controllable expense report: Budgeted
Rs. Actual
Rs. Variance
Rs.
Sewing department 1,840 1,980 140U
Cutting department 3,780 4,130 350U
Total 5,620 6,110 490U
ii) Vice -President, Manufacturing Controllable expense report:
Production depa rtments
5,620
6,110
490U
Production manager’s expenses 1,800 1,700 100F
Production engineer’s expenses 1,300 1,220 80F
Total 8,720 9,030 310U
iii) Vice -President, Marketing
Controllable expenses summary:
Sales manager’s expense 3,200 3,290 90U
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78 Advertising expense 400 400 -
Credit expense 1,420 1,205 215F

Total 5,020 4,895
125F


Responsibility Accounting
Standard Costing Probably the most significant variances are in the
production departments, with an average unfavourable variance of 8.7
percent ( 490 x 100 ) of the budgeted amount and the credit department,
with a 5620
favourable variance of 15.1 percent ( 215 x 100 ) of the budgeted amount.
The credit 1420
department variance results primarily from a b etter than normal bad debt
loss experience. The production department’s variance should be
investigated if 8.7 percent appears large relative to past experience.
Illustration 2
Kelly Services Ltd. has five plants ---A,B,C,D and E. Each plant has a
forming, cleaning and packing department. Each level of management at
the company has responsibility over costs incurred at its level. The budget
for the year ended March, 2005 has been set up as follows:


Plant Budgeted Cost (Rs.)
A 1,35,000
B 1,22,500
C 1,08,40 0
D 1,35,000
E 1,35,000
Budgeted information for Plant C is as
follows:
Rs.
Plant manager’s office 2,350
Forming department 30,000
Cleaning department 55,450
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79 Budgeted information for Plant C forming department is as follows:
Rs.
Direct material 8,333
Direct labour 15,000
Factory overhead 6,667
The following additional budgeted costs available:
Rs.
President’s Office 16,250
Vice President ---Marketing 20,000
Vice President ---Manufacturing office 4,167
The following actual costs were incurred during the year:
Plant Budgeted Cost Rs.
A 1,27,650
B 1,24,300
C 1,08,475
D 1,31,100
E 1,36,800
Actual costs for Plant C Forming department were as follows:
Rs.Responsibility Accounting
Direct materials 333 Under budget
Direct labour 4,000 Under budget
Factory overhead 333 Over budget

Actual cost for Plant C plant manager were:
Rs.
Plant manager’s office 2,475
Cleaning department 57,500
Packing department 22,500
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80 Actual costs for the president’s level were:
Rs.
President’s Office 16,375
Vice president ---marketing 29,800
Vice -president ---manufacturing 6,33,315
Prepare a responsibility report for the year showing the details of the
budgeted, actual and variance amounts for levels 1 through 4 for the
following areas:
Level 1 -Forming department ---Plant C Level 2 -Plant manager ---Plant C
Level 3 -Vice president -manufacturing Level 4-President.
Solution
Kelly Services
Responsibi lity Report for the Year ended March 2005
BudgetedActualVariance
Level 4-President:
Rs. Rs. Rs.
President’s Office 16,250 16,375 125
Vice -president ---marketing 20,000 29,800
9,800
Vice -president ---manufacturing 6,40,000 6,33,315
(6,752)
Total Controllable costs 6,76,250 6,79,490
3,173 79
Standard Costing Level3 -Vice
President ---
Manufacturing
Vice-president ---
manufacturing office:
4,990*
823
Plant A 1,27,650 (7,350)
Plant B 1,24,300 1,800
Plant C 1,08,475 75
Plant D 1,31,100 (3,900) munotes.in

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Plant E 1,36,800 1,800
Total Controllable
Costs 6,33,315 (6752)
Level 2 - Plant
Manager ---Plant C:
Plant manager’s office


2,475


125 Forming department 26,000 (4,000) Cleaning department 57,500 2,050 Packing department 22,500 1,900 Total controllable costs 1,08,475 75
Level 1-Forming
Department -Plant C:
Direct material

8,000

(333) Direct labour 11,000 (4,000) Factory overhad 7,000 333 Total controllable costs 26,000 4,000
* The difference in t he actual total controllable cost arrived and the figure
as given in the illustration is to be treated as the actual cost of
manufacturing office of vice president.
( ) Variance favourable (Figures within parentheses indicate favourable
variance
3.8 CONTRO LLABLE COST
Controllable cost are costs which can be controlled. Such costs are
controllable in the short run and the discretion lies with the managers or
production supervisors whether to incur them or not.
Also, the “controllable” factor is relative an d depends upon the
hierarchy and level of management taking the decision. For instance,
consider the case of yarn purchase in a cotton mill. Now since the yarn is a
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82 authorized to negotiate vendor contracts best suited to organization needs.
However, the production supervisor charged with the running of day to
day operations has no say in yarn prices. Direct materia l cost is
consequently a controllable cost for the management but an uncontrollable
cost for the supervisor.
Controllable costs can also be referred to as variable costs as is commonly
used in the accounting parlance. In short, controllable costs are like ly
direct costs related to the level of production or core services of a
business.
If an item of expense directly impacts the manufacturing process it a
controllable cost. Secondly, the controllable cost is incurred in direct
proportion to the production volume.
Controllable cost constitutes the bulk of production costs. As a result, it
has a direct impact on profitability margins. For this reason, it is also
intuitive that such costs remain controllable. The management would
always like to control or ta ilor these costs in order to ensure they are in
line with the profit forecasts and budgetary requirements. To sum up,
direct materials, direct labour & factory overheads are prime examples of
controllable costs.
3.9 EXERCISE
Q.1)Fill in the blanks
1) ___________ is a controllable cost
2) ___________ is also called as variable cost
3) A segment or division may be a ___________.
4) __________ is the profit remaining after deduction o f the cost of capital
on investment
(5)_______ is only responsible for generating revenues, and not any other
business function
(1) Material, 2) Controllable cost , 3) Profit centre 4) Residual income
5) Revenue centre
Q.2)Short notes
1) Controllable cost
2) Segment reporting
3) Responsibility centres

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83 4
TRANSFER PRICING
Unit Structure
4.0 Introduction
4.1 Objectives
4.2 Advantages and Disadvantages
4.3 Cost based transfer pricing
4.4 Negotiated Transfer Pricing
4.5 Target Costing
4.6 Comparision between Target costing and Cost plus pricing
4.7 Inflatio n accounting
4.8 Illustrations
4.0 INTRODUCTION
Transfer pricing is the setting of the price for goods and services sold
between controlled (or related) legal entities within an enterprise. For
example, if a subsidiary company sells goods to a parent compa ny, the
cost of those goods paid by the parent to the subsidiary is the transfer
price. Legal entities considered under the control of a single corporation
include branches and companies that are wholly or majority owned
ultimately by the parent corporatio n. Certain jurisdictions consider entities
to be under common control if they share family members on their boards
of directors. Transfer pricing can be used as a profit allocation method to
attribute a multinational corporation's net profit (or loss) befo re tax to
countries where it does business. Transfer pricing results in the setting of
prices among divisions within an enterprise. Transfer pricing accounting
occurs when goods or services are exchanged between divisions of the
same company.A transfer pric e is based on market prices in charging
another division, subsidiary, or holding company for services
rendered.Companies use transfer pricing to reduce the overall tax burden
of the parent company.
4.1 OBJECTIVES
 True and fair reporting of financial statements
 Better estimation of profits generated by entities from associated
transfers
 Avoidance of double taxation and avoiding tax evasion by entities
 Promoting competitiveness among the associated enterprises.
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84 4.2 ADVANTAGES AND DISADVANTAGES
 The critical importanc e of Transfer Pricing provisions is that there will
be an equal and fair distribution of resources between associated
entities leading to nondiscriminatory trade transactions.
 This provides opportunities for associated enterprises to transact
business betw een them as the transactions are valued at market price,
this will enhance the scope of business and have a positive impact on
the group company as a whole due to internal profits generated by these
associated entities,
 Also, it is useful for the tax auth orities to determine the actual value of
such transactions and to estimate the profits derived from such
transactions taking place between associate entities. Without transfer
pricing provision, there would be a reduction or avoidance of tax by
misleading authorities and transferring or reporting profits based on the
limitation presents in tax provisions.
 It is used not only by multi -company organizations but also by entities
that satisfy the conditions of associated enterprises.
Disadvantages
 This would re quire additional administrative cost and a time -consuming
process.
 There are few limitations in the determination of arms -length price as
two products cannot be compared due to the homogenous nature of
such commodities or services.
4.3 COST BASED TRANSFER PRICING:
When external markets do not exist or are not available to the company or
when information about external market prices is not readily available,
companies may decide to use some forms of cost -based transfer pricing
system.Cost -based transfer pric es may be in different forms such as
variable cost, actual full cost, full cost plus profit margin, standard full
cost.
(a) Variable Cost:
Variable cost -based pricing approach is useful when the selling division is
operating below capacity. The manager of the selling division will
generally not like this transfer price because it yields no profit to that
division. In this pricing system, only variable production costs are
transferred. These costs are direct materials, direct labour and variable
factory over head.
Variable cost has the major advantage of encouraging maximum profits
for the entire firm. By passing only variable costs alone to the next
division, production and pricing decisions are based on cost - volume -
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85 selling division is left holding all its fixed costs and operating expenses.
That division is now a loss division, no where near a profit centre.
(b) Actual Full Cost:
In actual full cost approach, transfer price is based o n the total product
cost per unit which will include direct materials, direct labour and factory
overhead. When full cost is used for transfer pricing, the selling division
can not realise a profit on the goods transferred. This may be disincentive
to the selling division. Further, full cost transfer pricing can provide
perverse incentives and distort performance measures. A full cost transfer
price would have shutdown the chances of any negotiation between
divisions about selling at transfer prices.
(c) Full Cost Plus Profit Margin:
Full cost plus mark up (or profit margin) overcomes the weaknesses of full
cost basis transfer pricing system. The full cost plus price include the
allowed cost of the item plus a mark up or other profit allowance. With
such a s ystem, the selling division obtains a profit contribution on units
transferred and hence, benefits if performance is measured on the basis of
divisional operating profits. However, the manager of the buying division
would naturally object that his costs (a nd hence reported performance) are
adversely affected.
The basic question in full cost plus mark up is ‘what should be the
percentage of mark up.’ It can be suggested that the mark up percentage
should cover operating expenses and provide a target return o n sales or
assets.
(d) Standard Costs:
In actual cost approaches, there is a problem of measuring cost. Actual
cost does not provide any incentive to the selling division to control cost.
All product costs are transferred to the buying division. While tran sferring
actual costs any variances or inefficiencies in the selling division are
passed along to the buying division.
The problem of isolating the variances that have been transferred to
subsequent buyer division becomes extremely complex. To promote
responsibility in the selling division and to isolate variances within
divisions, standard costs are usually used as a basis for transfer pricing in
cost-based systems.
Whether transferring at differential costs or full costs, standard costs,
where available, are often used as the basis for the transfer. This
encourages efficiency in the selling division because inefficiencies are not
passed onto the buying division. Otherwise, the selling division can
transfer cost inefficiencies to the buying division. Use of standard cost
reduces risk to the buyer. The buyer knows that standard costs will be
transferred and avoids being charged with suppliers’ cost overruns
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86 4.4 NEGOTIATED TRANSFER PRICING:
Negotiated prices are generally preferred as a middle solution betwee n
market prices and cost - based prices. Under negotiated prices, the
managers involved act much the same as the managers of independent
companies. Negotiation strategies may be similar to those employed when
trading with outside markets. If both divisions are free to deal either with
each other or in the external market, the negotiated price will likely be
close to the external market price. If all of a selling division’s output can
not be sold in the external market (that is, a portion must be sold to the
buying division), the negoti ated price will likely be less than the market
price and the total margin will be shared by the divisions.
Negotiated price avoids mistrusts, bad feelings and undesirable bargaining
interests among divisional managers. Also, it provides an opportunity to
achieve the objectives of goal congruence, autonomy and accurate
performance evaluation. The overall company is beneficiary if selling and
buying divisions can agree upon some mutually transfer prices. Negotiated
transfer price is considered as a vital integrating tool among divisions of a
company which is necessary to achieve goal congruence.
If negotiations help ensure goal congruence, top management has little
temptation to intervene between divisions. The agreed prices also c an be
used for performance measurement without creating any friction. The use
of negotiated prices is consistent with the concept of decen tralised
decision -making in the divisionalised firms.
However, negotiated prices have the following disadvantages:
(1) A great deal of management effort, time and resources can be
consumed in the negotiating process.
(2) The final emerging negotiated price may depend more on the
divisional manager’s ability and skill to negotiate than on the other
factors. Thus, performa nce measures will be distorted leading to
incorrect evaluation of divisional performance.
(3) One divisional manager having some private information may take
advantage of another divisional manager.
(4) It is time -consuming for the managers involved.
(5) It leads to conflicts between divisions.
(6) It may lead to a suboptimal level of output if the negotiated price is
above the opportunity cost of supplying the transferred goods.
4.5 TARGET COSTING
Target costing is a structural approach to determine the cost at which
a proposed product with specified function and quality must be
produced, to generate a desired level of profitability at its anticipated
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87 In other words, Target Costing is a cost management tool for
producing overall cost of produ ct over its entire life cycle with the
help of the function engineering and research and development.
Target cost is called estimated cost of the product that helps a
manufacturing unit to remain.It competes in the market in the long
run. Target costing is a cost management technique. Target cost is the
difference between target sales minus target margin. It is, thus, the
difference between estimated selling price of a proposed product with
specified functionality and quality and the target margin.
The features of target costing are as follows:
1. It is viewed as an integral part of the design and introduction of new
products.
2. A target selling price is determined using various sales forecasting
techniques.
3. The target selling price is the establishment of target production
volumes, given the relationship between price and volume.
4. Target costing process is to determine, cost reduction targets.
5. A fair degree of judgement is needed where the allowable cost and the
target cost differ.
Characteristics of Target Costing
The main characteristics of target costing system are as under:
(1) Identification of Opportunities –
With the help of value engineering and value analysis, opportunities, for
cost reduction can be identified easily. Value engineering in volves
searching the opportunities to modify the design for reducing the cost
without reducing the quality of the product.
Similarly, value analysis involves rejecting non -value adding activities
which may minimise the cost without reducing quality of the product.
Thus current cost is reduced to the level of target cost. It is presumed that
when production commences, the total cost will meet the target and profit
also.
(2) Target Cost –
Target cost is decided by deducting target income from the target price .
(3) Integral Part of Design –
Target costing is known as an integral part of the design and introduction
of new products.

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88 (4)Target Price –
It is the estimated market price of the product. It is a target price which is
determined by using various sale s forecasting techniques in which
consideration is made for design specifications of the product and
competitive market conditions.
(5) Cost Reduction Target –
Cost reduction target is fixed, which requires estimation of current cost of
the new product. I t is based on existing technologies and its various
components. The excess of current cost over target cost indicates the cost
reduction.
Objectives
1. To lower the costs of new products so that the required profit level can
be ensured.
2. The new products meet the levels of quality, delivery timing and price
required by the market.
3. To motivate all company employees to achieve the target profit during
new product development by making target costing a company wide
profit management activity.
4.6 COMPARIS ION BETWEEN TARGET COSTING AND COST
PLUS PRICING
Target costing and cost -plus pricing are two different things. In product
development, target costing is a management technique used to determine
the cost of manufacturing a product, while cost -plus pricing is a system
used to determine the selling price of the product. Cost -plus pricing starts
with an estimate of the costs incurred to build a product, and a certain
profit percentage is added to establish the price . ... Target
costing integrates the product d esign, desired price , desired profit, and
desired cost into one process beginning at the product development stage.
1.7) Inflation Accounting.
Inflation accounting refers to the adjustment of the financial statements
during inflationary periods. This speci al accounting technique is only used
in inflationary periods where the general level of prices is usually high for
three consecutive quarters.
It involves the recording of the income and expenditure of the business at
the current prices and reinstating all the three statements of the company
and analyze the cost and the trend of the current company.
There are various kinds of techniques that are involved in inflation
accounting and there are various methods attached to it.
 Current Purchasing Power Method: This technique involves the
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89 involves recalculating the historical financial figures of the company at
the current purchasing power which is done by applying a certain
conversion factor.
 Current Cost Accounting: Under this method, the cost categories and
the various cost items and the items in the balance sheet are shown at
the current cost rather than the historical cost and the profit is
determined on the actual cost period and not on t he basis of the sales.
 Current Value: Under this method, all assets and liabilities are
measured and are reinstated at their current cost structure.
 Replacement Cost Accounting: The cost of replacing is the
parameter under which all the assets and the lia bilities on the balance
sheet are recorded.
Advantages of Inflation Accounting
The following are the advantage of Inflation Accounting:
 It reflects the current and not the historical cost of the balance sheet.
 It is highly effective in times of general inf lation or hyperinflation.
 Depreciation of the business is valued and cost on the current price and
not on the historical or the carrying value of the asset which is the
correct method.
 Profit and loss will reflect the true condition of the company.
 Financi al ratios based on figures, adjusted to the current value, are
more meaningful.
Disadvantages of Inflation Accounting
The following are the disadvantage of Inflation Accounting:
 Changing in price is a never -ending process hence it becomes difficult
every t ime to reinstate the figures of the company and present the
financial statements.
 Inflation accounting is a complicated process and it involves too much
calculation and the data gathering process.
 In times of deflation, the depreciation cost will be on a l ower side
hence it does not reflect the true picture.
4.8 ILLUSTRATIONS
Q1)A firm had Rs 2,00,000 as cash at bank on April 1, 2011. The
consumer price index on that date was 200. During the year ended
31st March, 2012 the receipts and payments were stated below: munotes.in

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90

Solution:
Statement showing Profit/Loss on Cash during the year ended 31st
March, 2012:

The balance according to Constant Rupees should have been Rs 1,16,667
whereas the actual balance is only Rs 85,000. Therefore, as a result of
changes in prices, there has been a loss of Rs 31,667.
Q.2)B elow is given a simplified balance sheet and statement of profit
and loss of a company in existence for about 10 years:
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91

Depreciation charge comes to Rs 124 lakhs.
The following facts are established:
(1) The price indices of tangible assets had climbed to 200 in the
beginning of 2011 -2012 and to 2 25 by the end of the year with the prices
ten years ago being 100; the price increase in 2010 -2011 was only 6%. Till
the end of 2010 -2011 the company had not made any substantial additions
to the tangible assets. The company considers the life of the tangi ble assets
to be 20 years and would prefer the straight line basis of depreciation.
(2) Prices of materials rose by 54% and of finished goods by 35% during
2011 -2012; rates relating to manufacturing costs increased by 20%.
(3) The value of finished goods s tock in the beginning and at the end of
the year was respectively Rs 158 lakhs and Rs 203 lakhs.
Prepare the current cost accounting balance sheet as at 31st March, 2012
and statement of profit and loss for the year 2011 -2012 on that basis.
Solution:
The following assumptions are made:
(a) Material stocks are valued on FIFO basis.
(b) Loans and advance are against supplies of materials and stores, so also
current liabilities. :




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92 The various adjustments required under CCA are worked out below
(to the near est lakh of rupee):


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94


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95 Some observations:
The accounts given above are naturally much too simple compared to the
actual situation but, nevertheless, they are based on reality. The following
observations on these accounts may be pertinen t:
(i) The additional depreciation for the current year is only Rs 8 lakh; this
low figure is because the depreciation actually charged in the accounts is
much higher than that warranted on straight line basis with a life of 20
years. Generally, in industr ial concerns the adjustment required for
depreciation will be heavy.COSA in the above case is very large. This is
because there was a very big increase in the prices of materials — 54%.
Normally, the adjustment may not be large. Still the point that emerge s is
that if prices rise rapidly and if there is big time lag between purchase and
consumption, the adjustment in respect of cost of sales will be material.
Trading concerns cannot naturally ignore COSA.The gearing adjustment
has reduced the debit to the P rofit and Loss Account by Rs 130 lakhs.
Indian companies normally resort to loans in a big way and, hence, for
Indian companies this adjustment will be generally substantial. In the case
under discussion, interest payment was only Rs 108 lakhs, showing tha t
due to rise in prices, there was a saving of Rs 22 lakhs because of the fixed
nature of monetary obligations.
On 31st March, 2002, when the general price index was say 100, Forward
Ltd. purchased fixed assets of Rs one crore. It had also permanent workin g
capital of Rs 40 lakh. The entire amount required for purchase and
permanent working capital was financed by 10% redeemable preference
share capital. Forward Ltd. wants to maintain its physical capital.
On 31st March, 2012, the company had reserves of Rs 1.75 crore. The
general price index on this day was 200. The written down value of fixed
assets was Rs 10 lakh and they were sold for Rs 1.5 crore. The proceeds
were utilised for redemption of preference shares.
On the same day (31st March, 2012) the comp any purchased a new
factory for Rs 10 crore. The ratio of permanent working capital to cost of
assets is to be maintained at 0.4 : 1.
The company raised the additional funds required by issue of equity
shares.
Based on the above information (a) Quantify th e amount of equity capital
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