Cost Accounting - I Notes | B.Com. (Accountancy) Semester 5 | Mumbai University | munotes

Four of them bear on this paper, and each is named in the chapter it governs: CAS-1 Classification of Cost, CAS-4 on the cost of production and of the provision of services, CAS-6 Material Cost and CAS-7 Employee Cost, with CAS-10 Direct Expenses and CAS-25 Valuation of Inventory beside them.

They are not law. They are issued by the Institute and the Central Government has not notified them, so they bind a cost accountant professionally rather than binding everybody by statute. This book states what each requires, in its own words.

Quick revision

• Cost accounting attaches expenditure to a cost object, so a cost per unit can be found.
• Cost object, cost unit, cost centre - fix all three now.
• Financial accounting is arranged by the nature of expense; cost accounting by what it was spent on.
• The two profits differ for reasons that can be listed, and reconciling them is a topic of this module.
• CAS-1 to CAS-25 are issued by ICAI; six of them touch this paper; they are professional standards, not statute.

Test yourself

1. What can a cost account tell management that a profit and loss account cannot? The cost of each cost object separately - each product, job, batch, process or service - and therefore which of them is profitable, what to quote, and whether an order at a given price is worth accepting.

2. Define cost unit and give one for a transport business. The unit of quantity in which cost is expressed; for transport, the tonne-kilometre or the passenger-kilometre.

3. Is cost accounting confined to manufacturing? No. MU's own concept names the provision of services, and services have cost units of their own.

4. Are the Cost Accounting Standards law? No. They are issued by the Institute of Cost Accountants of India and have not been notified by the Central Government, so they bind professionally rather than by statute.

Answer in one sentence

What is cost accounting? It is the branch of accounting that classifies, records and allocates expenditure to cost objects so as to ascertain the cost of each product, job, process or service and to present that information for managerial planning, control and decision-making, as distinct from financial accounting, which reports the result of the business as a whole.

Three stocks, three different places. Raw material inside direct material, work-in-progress after factory overhead, finished goods after administration overhead. Putting a stock adjustment at the wrong stage is the commonest error in the whole module.

The other bases, briefly

MU's concept is function, but a question can name another basis and the reader should recognise it.

Behaviour matters even here, because an abnormal loss is excluded from cost and charged to profit and loss - which is one of the causes of difference in the reconciliation chapter.

Classification by behaviour, in full

MU sets this as a short note of its own, so the three classes are worth stating properly rather than listing.

The per-unit column is where the marks are. A fixed cost is fixed in total and variable per unit; a variable cost is variable in total and fixed per unit. The statement "fixed cost per unit remains fixed whatever the output" is false, and it is a favourite true-or-false question.

Fixed only within a range. Rent is fixed until a second factory is needed, and then it steps up. A cost that behaves this way is a stepped fixed cost, and it is fixed only within the range of output it was set for.

A semi-variable cost can be split into its fixed and variable parts, and where a question gives the cost at two levels of output the variable part per unit is the change in cost divided by the change in output, the fixed part being the balance.

The cost terms an examiner uses

These are not classes of cost so much as ways of describing one, and MU examines them in the objective questions.

Two of these appear in almost every objective paper. Depreciation is a book cost and not an out-of-pocket cost, and a cost centre may be a person.

Worked example

Classify each and say which stage it enters.

The last two rows are the pair MU sets. Carriage inward is part of the cost of getting material in and belongs to direct material; carriage outward is a cost of delivering to the customer and belongs to selling and distribution.

What it does NOT mean

Direct is not the same as variable. A direct expense can be fixed, and a variable cost can be indirect - power, for instance.

Overhead is not waste. It is the cost that cannot be traced economically, not the cost that need not be incurred.

The stages are cumulative. Factory cost contains prime cost; cost of sales contains everything.

Quick revision

• Elements: material, labour, expenses, each direct or indirect.
• Prime cost = direct material + direct labour + direct expenses.
• Factory cost = prime cost + factory overhead, adjusted for work-in-progress.
• Cost of production = factory cost + administration overhead.
• Cost of goods sold = cost of production adjusted for finished goods.
• Cost of sales = cost of goods sold + selling and distribution overhead.
• Profit = sales less cost of sales.
• Three stocks at three different stages: raw material, work-in-progress, finished goods.
• CAS-1 Classification of Cost requires a consistent, stated basis of classification.

Test yourself

1. Define prime cost. The aggregate of direct material, direct labour and direct expenses.

2. At which stage is work-in-progress adjusted? After factory overhead has been added, in arriving at factory cost, because factory cost is the cost of production completed.

3. Under which heading does carriage outward fall, and carriage inward? Carriage outward is selling and distribution overhead; carriage inward is part of direct material cost.

4. Is a direct cost always variable? No. Traceability and behaviour are different bases; a direct expense may be fixed.

5. What does CAS-1 require? That costs be classified on a consistent and stated basis so that cost statements are comparable, setting out the bases of classification and the elements of cost.

Answer in one sentence

How is cost classified by function? Into four cumulative stages: prime cost, being direct material, direct labour and direct expenses; factory cost, being prime cost plus factory overhead adjusted for work-in-progress; cost of production, being factory cost plus administration overhead; and cost of sales, being the cost of goods sold after adjusting finished goods stock plus selling and distribution overhead.

What it does NOT mean

Cost accounting is not less rigorous. Its freedom of form is not a freedom of arithmetic, and its figures come from the same records.

They are not two sets of books. In most firms they are one ledger looked at two ways, or two ledgers reconciled - which is why reconciliation is a topic at all.

"Voluntary" is not "unregulated". Where the Central Government prescribes cost records and cost audit for an industry, they are compulsory for it.

Financial accounting is not only annual. It is usually annual for reporting; the contrast is with cost accounting's continuous, job-by-job rhythm.

Quick revision

• Purpose: result of the business, against cost of each object.
• Audience: external, against internal.
• Compulsion: statutory, against voluntary but prescribed for some industries.
• Form: Schedule III, against whatever is useful.
• Classification: by nature, against by function and traceability.
• Period: annual, against continuous.
• Measure: money, against money and quantity.
• Stock: lower of cost and net realisable value, against cost.
• Abnormal items: included, against excluded from cost.
• Those last four rows are the causes of difference the reconciliation topic works with.

Test yourself

1. Give four points of difference between cost and financial accounting. Purpose - the result of the business against the cost of each object; audience - external against internal; classification - by nature of expense against by function and traceability; and stock valuation - the lower of cost and net realisable value against cost.

2. Why does cost accounting exclude abnormal losses? Because including them would make the product appear to cost more for a reason unconnected with making it, and the cost per unit would then be useless for pricing and control. They are charged to profit and loss instead.

3. Is cost accounting compulsory? Not generally. It is voluntary except where the Central Government prescribes the maintenance of cost records and cost audit for a particular class of companies.

4. Name the four causes of difference between the cost profit and the financial profit. Different stock valuation; abnormal items excluded from cost; purely financial items appearing in the financial accounts only; and over- or under-absorption of overhead.

Answer in one sentence

Distinguish cost accounting from financial accounting. Financial accounting records and reports the result and position of the business as a whole to external users, in a form prescribed by statute, classifying expenditure by its nature and valuing stock at the lower of cost and net realisable value; whereas cost accounting ascertains the cost of each product, job, process or service for internal management in whatever form is useful, classifying expenditure by function and traceability, measuring in quantity as well as money, valuing stock at cost, and excluding abnormal items from cost altogether.

They are the reconciliation list. Every one of them explains part of the difference between the cost profit and the financial profit.

Sale of scrap

Scrap is the residue of production that has a small recoverable value - metal turnings, offcuts, sweepings. It is not a defective product; it is what is left over when a good one has been made.

Normal scrap is credited to cost, because the material was bought and part of it was always going to become scrap. Where it is credited depends on what the question tells you:

The safe rule in an examination: unless the question identifies the scrap with a material or a job, deduct the sale of scrap in arriving at factory cost, and say in a working note that you have done so.

Do not add it to sales. Scrap is not the product, and treating its sale as revenue overstates both sales and cost.

Primary and secondary packing

Primary packing is part of production; secondary packing is part of selling.

The test is whether the product exists without it. Toothpaste with no tube is not a product; toothpaste in a tube without a carton still is.

Profit on cost, and profit on sales

These are different percentages of different bases, and mixing them is a standard trap.

On sales, the denominator is not the cost. If profit is 10 per cent of sales, then cost of sales is the other 90 per cent, so the profit is ten ninetieths of the cost, not a tenth of it.

Cost of sales is Rs 4,50,000.

Check the second line: Rs 50,000 on sales of Rs 5,00,000 is exactly a tenth. Taking a tenth of the cost instead would have given Rs 45,000, and the answer would have been wrong by Rs 5,000 with nothing on the page to show it.

Cost per unit

Where the question gives the number of units, each stage can be divided by the units to give a cost per unit at that stage. A cost sheet with a units column beside the amount column is a fuller answer and costs nothing to produce.

Divide by the right quantity. Cost of production is divided by units produced; cost of sales by units sold. Where the two differ - and they differ whenever finished goods stock moves - using one figure for both is wrong.

What it does NOT mean

It is not a profit and loss account. No financial item enters it.

The stages are not optional. A cost sheet that jumps from prime cost to cost of sales has lost the marks for the two stages in between, even if the final figure is right.

Profit is a balancing figure only when sales are given. Where the question gives a percentage on cost or on sales, it is computed, not balanced.

Quick revision

• Four stages: prime cost, factory cost, cost of production, cost of sales.
• Raw material stock inside direct material; work-in-progress at factory cost; finished goods after cost of production.
• Carriage inward at the top, carriage outward at the bottom.
• No financial item enters: interest, dividend, tax, donation, abnormal loss, appropriations.
• Cost of production per unit uses units produced; cost of sales per unit uses units sold.

Test yourself

1. Where is work-in-progress adjusted, and why? At factory cost, after factory overhead has been added, because factory cost is the cost of production completed and partly finished units have already absorbed overhead.

2. How is raw material consumed computed? Opening stock of raw material plus purchases plus carriage inward and duty, less closing stock of raw material.

3. Where do carriage inward and carriage outward go? Carriage inward into direct material at the top of the sheet; carriage outward into selling and distribution overhead at the bottom.

4. Name four items that never appear in a cost sheet. Interest paid or received, dividend received, profit or loss on the sale of an asset, income-tax, donations, abnormal losses and appropriations of profit.

5. By what quantity is the cost of sales per unit computed? By units sold, not units produced.

Answer in one sentence

Set out the stages of a cost sheet. Raw material consumed, being opening stock plus purchases and carriage inward less closing stock, plus direct wages and direct expenses gives prime cost; plus factory overhead and adjusted for opening and closing work-in-progress gives factory cost; plus administration overhead gives cost of production; adjusted for opening and closing finished goods gives cost of goods sold; plus selling and distribution overhead gives cost of sales; and sales less cost of sales is profit.

The six checks to run on your own answer

Did the three stocks go to three different places? Raw material inside direct material, work-in-progress at factory cost, finished goods after cost of production. This question moves all three so that a misplacement shows.

Did you put carriage inward at the top? It is Rs 46,000 of direct material cost, not an overhead.

Did you treat the machine hire as a DIRECT expense? It was hired for one order, so it is traceable to that order and belongs in prime cost. Put into factory overhead it would give the same cost of sales but the wrong prime cost, and prime cost is a marked line.

Did you exclude the interest? Rs 74,000 is a financial charge and enters no stage.

Did you exclude the abnormal loss? Rs 55,000 by fire is abnormal, and cost accounting excludes abnormal losses so that the product does not appear dearer for a reason unconnected with making it.

Does the arithmetic close? Cost of sales of Rs 48,68,000 plus profit of Rs 7,32,000 is Rs 56,00,000, the sales figure given. If it does not, the error is above.

In short

• Work downward, labelling all four stages.
• Three stocks, three places. Raw material, work-in-progress, finished goods.
• Carriage inward is direct material; carriage outward is selling and distribution.
• An expense hired for one order is a direct expense.
• Interest, abnormal losses and every financial item stay out, and say so in a note.
• Check by adding cost of sales to profit and matching sales.

Answer in one sentence

How is a cost sheet prepared? By computing raw material consumed from opening stock, purchases and carriage inward less closing stock, adding direct wages and direct expenses to reach prime cost, adding factory overhead and adjusting opening and closing work-in-progress to reach factory cost, adding administration overhead to reach cost of production, adjusting opening and closing finished goods to reach cost of goods sold, adding selling and distribution overhead to reach cost of sales, and deducting that from sales to reach profit, every purely financial and abnormal item being excluded.

Step 1: the cost unit.

The return journey is empty and earns nothing, so it produces no tonne-kilometres. The lorry runs 500 kilometres a trip, but only 250 of them carry a load.

Step 2: the cost statement.

Cost per tonne-kilometre is Rs 14,40,000 divided by 1,20,000 tonne-kilometres, which is Rs 12.00.

Three things to check.

The empty return is excluded from tonne-kilometres. Including it would give 2,40,000 units and halve the cost to Rs 6, which is the error the question is set to catch. The cost of the return journey is still in the statement - the diesel was burnt - but it produced no output.

Depreciation is fixed here because the question says it is charged on a time basis. Had it been per kilometre, it would have moved to running charges, and the total would be unchanged but the analysis wrong.

Repairs are shown separately as semi-variable, because the format has three classes and a marker looks for all three.

What it does NOT mean

There are no stock adjustments. A service cannot be stored.

A composite unit is not optional. Cost per kilometre alone would treat a full lorry and an empty one as the same.

Fixed does not mean unavoidable. It means it does not vary with the level of activity in the period.

Quick revision

• A service has no stock and no work-in-progress, so the cost sheet's stage adjustments do not apply.
• Choose and state the cost unit first. Composite units multiply two measures: tonne-kilometre, passenger-kilometre, patient-day, room-day.
• Three classes: fixed or standing, variable or running, semi-variable or maintenance.
• Depreciation is fixed on a time basis and variable on a mileage basis - read which the question gives.
• Cost per unit = total cost divided by the cost units actually produced, and an empty return journey produces none.
• CAS-4 covers the provision of services as well as the production of goods.

Test yourself

1. Why does a service cost statement have no stock adjustments? Because a service cannot be stored: there is no closing stock of finished units and no work-in-progress to carry forward.

2. Give the cost unit for goods transport, a hospital and a hotel. The tonne-kilometre, the patient-day and the room-day or occupied bed-day.

3. A lorry carries a load out and returns empty. Which journey produces cost units? Only the loaded journey. The return costs money and produces no tonne-kilometres, so its cost is included in the statement and its distance is excluded from the units.

4. Under which class does depreciation fall? Fixed where it is charged on a time basis and variable where it is charged per kilometre run; the question decides.

Answer in one sentence

How is a cost statement for a service prepared? By choosing and stating an appropriate cost unit, often a composite one such as the tonne-kilometre or patient-day, classifying the costs of the period into fixed or standing, variable or running, and semi-variable or maintenance charges, totalling them without any stock or work-in-progress adjustment, and dividing that total by the number of cost units actually produced.

Reason it out rather than remembering it. If cost accounting charged too much cost, it reported too little profit; to get to the financial profit, add the excess back.

The direction of every adjustment

Starting from the cost profit and working to the financial profit:

The two stock rows are opposite, and that is not arbitrary. A higher opening stock is a higher cost, which lowered the cost profit, so it is added back. A higher closing stock is a lower cost, which raised the cost profit, so it is deducted.

Working the other way round, every sign reverses. Starting from the financial profit, add what was deducted and deduct what was added. MU sets it in both directions.

What it does NOT mean

Neither profit is wrong. Each is right for its purpose. The reconciliation explains the gap; it does not correct an error.

Abnormal loss is not simply omitted. It is excluded from cost and charged in the financial accounts, which is why it appears in the reconciliation.

Over-absorption is not a profit. It is a charging difference, and the reconciliation removes it.

This book does not teach absorption rates. How a rate is set and applied is Module I of Cost Accounting II, in Semester VI. What is needed here is only the direction of the adjustment.

Quick revision

• Group 1: financial accounts only - interest, dividend, donation, income-tax, profit or loss on sale of an asset, abnormal losses, appropriations.
• Group 2: cost accounts only - notional rent, interest on own capital, proprietor's salary.
• Group 3: valued differently - stock and depreciation.
• Group 4: overhead over- or under-absorbed.
• From cost profit to financial profit: add financial income and over-absorption; deduct financial expenses and under-absorption; add a higher opening stock and deduct a higher closing stock, both as valued in the cost accounts.
• Reverse every sign when going the other way.

Test yourself

1. Name the four groups of causes of difference. Items appearing in the financial accounts only; items appearing in the cost accounts only; items valued differently in each; and overhead over- or under-absorbed.

2. Is an abnormal loss by fire added or deducted, starting from the cost profit? Deducted. It is an expense in the financial accounts only, and cost accounting excludes abnormal losses.

3. Overhead was under-absorbed by Rs 40,000. What is the adjustment? Deduct Rs 40,000. Too little cost was charged, so the cost profit is too high by that amount.

4. Closing stock is valued higher in the cost accounts than in the financial accounts. Why is it deducted? Because a higher closing stock reduces the cost charged, which raised the cost profit; deducting the excess brings it back to the financial figure.

5. What is notional rent, and why does it appear? A charge made in the cost accounts for premises the firm owns, so that its cost is comparable with a firm that rents. It is not a transaction, so the financial accounts do not record it and it must be added back.

Answer in one sentence

Why do the cost and financial profits differ? Because purely financial items such as interest, dividend, donations, income-tax, abnormal losses and appropriations are recorded in the financial accounts only; notional charges such as rent on owned premises and interest on the proprietor's capital are made in the cost accounts only; stock and depreciation may be valued differently in each; and overhead is charged to production at a predetermined rate, so that it is over- or under-absorbed against what was actually incurred.

Statement 2: the same figures, the other way round

Every sign has reversed and nothing else has changed. That is the whole of the second direction, and it is worth saying in one line in the answer: the items and the amounts are identical, only the column each sits in has swapped.

The five checks to run on your own answer

Did you state the direction in the heading? The examiner reads it before the figures.

Are the two stock rows on opposite sides? Opening overvalued is an addition; closing overvalued is a deduction. A candidate who puts both on the same side has misunderstood the mechanism, and the error is worth two marks.

Are the two absorption rows on opposite sides? Over-absorbed is an addition; under-absorbed is a deduction. The two overheads here are deliberately one of each.

Did every financial income go up and every financial expense go down? Interest and dividend received up; interest paid, donation and loss on sale down.

Does the reverse statement return to the starting figure? Rs 4,16,000 plus Rs 1,70,000 less Rs 1,00,000 is Rs 4,86,000. If it does not, one of the signs in Statement 1 is wrong, and this is the cheapest way to find it.

In short

• Sort into the four groups first, then compute.
• Financial income adds, financial expense deducts.
• Over-absorbed adds, under-absorbed deducts.
• Opening stock higher in cost accounts adds; closing stock higher deducts.
• Going the other way, every sign reverses and nothing else changes.
• Reconcile back to your starting figure as a check.

Answer in one sentence

How is a reconciliation statement prepared? By starting from the profit shown by one set of books, adding the incomes recorded in the financial accounts only, the overhead over-absorbed in the cost accounts and any opening stock valued higher there, deducting the expenses recorded in the financial accounts only, the overhead under-absorbed and any closing stock valued higher in the cost accounts, and so arriving at the profit shown by the other set, every sign reversing if the statement is begun from the other end.

Note. Income-tax of Rs 1,20,000 and dividend received of Rs 18,000 are purely financial items and are excluded from the cost sheet. Both appear in Question 2.

Three marks most often lost. Putting royalty on units produced into factory overhead: it varies with production and is traceable to it, so it is a direct expense and belongs in prime cost. Bringing income-tax or the dividend into the sheet. And adjusting work-in-progress before factory overhead rather than after it.

Question 2

Three things to check.

Over-absorbed is an addition. Too much cost was charged, so the cost profit was understated by Rs 26,000.

Closing stock overvalued in the cost accounts is a deduction. A higher closing stock reduced the cost charged and so raised the cost profit.

Goodwill written off is a financial expense. It is not a cost of making anything, so cost accounting never saw it.

Question 3

(a) After factory overhead has been added, in arriving at factory cost. Factory cost is the cost of production completed, and partly finished units have already absorbed some factory overhead, so the adjustment cannot come earlier.

(b) 300 kilometres. The empty return produces no tonne-kilometres. Its cost is still included in the cost statement, because the diesel was burnt, but it produced no output to divide by.

(c) Added. Over-absorption means more cost was charged to production than was incurred, so the cost profit is too low by that amount.

(d) Notional rent on premises the firm owns, notional interest on the proprietor's own capital, and a notional salary for a proprietor who works in the business. They are charged so the cost is comparable with a firm that rents and borrows, and they are not transactions, so the financial accounts do not record them.

In short

• Label all four stages; a stage not shown is a mark not earned.
• Royalty on units produced is a direct expense, not factory overhead.
• Three stocks, three places.
• Check the sheet with cost of sales plus profit equals sales before going on.
• In the reconciliation, sort into the four groups first, then compute.
• Over-absorbed adds; closing stock overvalued in cost accounts deducts.

Worked example

Compute the material cost of a consignment. The invoice shows: list price Rs 6,00,000; trade discount 5 per cent; goods and services tax Rs 1,08,000, wholly recoverable as input tax credit; freight inward Rs 24,000; insurance in transit Rs 6,000; unloading and handling into store Rs 9,000. A cash discount of Rs 11,000 was taken for early payment, and Rs 4,000 of demurrage was paid at the port.

Four items were kept out and each for its own reason.

The goods and services tax of Rs 1,08,000 is recoverable as input tax credit, so it never falls on the product.

The cash discount of Rs 11,000 is a financial gain for paying early, not a reduction in the price of the goods. Trade discount comes off; cash discount does not.

The demurrage of Rs 4,000 is a penalty for delay. It is abnormal and is charged to profit and loss.

What it does NOT mean

Not every tax is excluded. Only the recoverable part.

Cash discount is not trade discount.

Indirect material is not unimportant material. It is material not economically traceable.

Normal loss is part of cost; abnormal loss is not. Normal loss is absorbed by the good units, which raises their cost per unit; abnormal loss goes to profit and loss.

Quick revision

• CAS-6 Material Cost: material is valued at the cost of purchase, being the price plus every cost of bringing it to its present location and condition, net of recoverable taxes.
• Include: non-recoverable duties, freight inward, insurance in transit, handling, non-returnable containers, normal loss.
• Exclude: recoverable tax, trade discount (deducted), abnormal loss, demurrage and penalties, interest.
• Cash discount is NOT deducted; trade discount is.
• Direct material enters prime cost; indirect material enters factory overhead, and the line is economic.
• Control balances the cost of holding too much against the cost of holding too little.

Test yourself

1. What does CAS-6 require material cost to be? The cost of purchase, comprising the price and all costs of bringing the material to its present location and condition, net of taxes and duties recoverable from the authorities.

2. Is cash discount deducted in arriving at material cost? No. Trade discount is deducted as a reduction in price; cash discount is a financial item for early payment.

3. How is goods and services tax treated? Excluded where it is recoverable as input tax credit; included in cost where it is not recoverable.

4. Distinguish direct from indirect material. Direct material is traceable to the cost object economically and enters prime cost; indirect material cannot be so traced, or is not worth tracing, and enters factory overhead.

5. Give two costs of holding too much stock and two of holding too little. Too much: capital locked up, storage and insurance, obsolescence, risk of price fall. Too little: production stoppages, emergency purchases at worse prices, loss of goodwill, loss of quantity discounts.

Answer in one sentence

What is material cost? Under CAS-6 it is the cost of purchase of materials, comprising the purchase price after trade discount together with non-recoverable duties and taxes, freight inward, insurance in transit, handling and other costs of bringing them to their present location and condition, and normal loss, but excluding recoverable taxes, cash discount, abnormal losses, penalties and finance charges.

What it does NOT mean

A purchase requisition is not a purchase order.

A bin card is not a duplicate of the stores ledger. One is quantity at the bin, the other quantity and value in the books, and they are deliberately kept by different people.

The material requisition is not a request to buy. It draws on stock already held.

Quick revision

• Purchase requisition (internal, asks to buy) then purchase order (external, a contract) then goods received note then inspection note then bin card and stores ledger then material requisition (issues to a job).
• Material return note credits unused material back; material transfer note moves cost between jobs.
• Bin card: storekeeper, at the bin, quantity only.
• Stores ledger: costing office, quantity and value.
• The separation of who requests, who orders, who receives and who records is the control.

Test yourself

1. Distinguish a purchase requisition from a purchase order. A purchase requisition is an internal document by which a department or the storekeeper asks the purchase department to buy; a purchase order is an external document instructing the supplier to supply, and it is a contract.

2. Who keeps the bin card and who keeps the stores ledger, and what does each record? The storekeeper keeps the bin card at the bin and records quantity only; the costing office keeps the stores ledger and records both quantity and value.

3. What document charges material to a job? The material requisition, or stores requisition.

4. What is a material transfer note for? To record material moved from one job to another, so that the cost follows the material without it going back through the store.

Answer in one sentence

Describe the purchase procedure and its documents. A department or the storekeeper raises a purchase requisition; the purchase department invites quotations and places a purchase order; the receiving department raises a goods received note and inspection follows; the storekeeper enters the bin card and the costing office the stores ledger; and production draws material on a material requisition, with a material return note for what comes back and a material transfer note for what passes between jobs, the separation of these duties being the control the system exists to provide.

Material turnover ratio, and finding the slow movers

ABC analysis sorts material by value; the material turnover ratio sorts it by movement, and a firm needs both. An item can be cheap and still be dead money if nobody draws it.

Material turnover ratio = cost of material consumed divided by average stock held.

Cost of material consumed = opening stock plus purchases less closing stock. Average stock = half of opening plus closing stock.

Days of stock held = 365 divided by the ratio. It is the same fact stated in a way a storekeeper can act on.

A high ratio means fast movement. A low ratio means the item sits, and the money in it is doing nothing while it deteriorates, goes out of fashion or is superseded.

Worked example

For the year, material X had opening stock Rs 1,60,000, closing stock Rs 90,000 and purchases Rs 10,00,000; material Y had opening stock Rs 2,80,000, closing stock Rs 1,20,000 and purchases Rs 5,00,000. Compute the turnover ratio and the days of stock held for each, and say which is slow moving.

Material Y is the slow mover. It turns over 3.3 times a year against X's 8.56, and sits in the store for 111 days against 43. Y is the item to question: is the reorder quantity too large, is the level set too high, has demand fallen away?

Look at the stock figures alone and you get it backwards. Y's average stock is the larger of the two in rupees, which tempts a reader to call it the important item. It is the important item to CONTROL, precisely because so little of it moves.

Slow moving, dormant and obsolete. A slow-moving item still moves, only rarely. A dormant item has had no movement at all for a stated period. An obsolete item can no longer be used, because the product it belonged to has been discontinued. The first calls for a lower stock level, the second for an enquiry, the third for disposal and for writing the loss off to profit and loss rather than burying it in cost.

Worked example

A store holds four items. Classify them by ABC analysis.

Item P is class A. It is one item of four and carries Rs 4,80,000 of Rs 5,64,000, which is about 85 per cent of the value. It gets tight control.

Item S is class C, although it is consumed thirty thousand times a year. Volume is not value.

Items Q and R fall in between and take routine treatment.

The lesson the question teaches is that the item handled most often is not the item worth controlling most closely.

What it does NOT mean

ABC is not about physical size.

Class C is not uncontrolled. It is controlled cheaply, by ordering plenty and looking rarely.

Perpetual inventory does not remove the need to count. It replaces one annual count with continuous verification.

VED does not replace ABC. They classify on different axes and are used together.

Quick revision

• ABC: classify by annual consumption value; few items carry most value; tight control on A, routine on B, loose on C.
• VED: classify by criticality - vital, essential, desirable - and use with ABC.
• Perpetual inventory: continuous records plus continuous stock-taking; balance known at any moment, discrepancies found early, production not stopped.
• Periodic: one annual count, production halted, errors found too late to trace.
• Two-bin for cheap items; just-in-time where supply is reliable.

Test yourself

1. On what basis does ABC analysis classify items? On annual consumption value, being units consumed multiplied by cost per unit, not on price or on physical quantity.

2. An item costs 40 paise and is consumed 30,000 times a year. Which class? Class C. Its annual value is small, however often it is handled.

3. What does VED classify by? Criticality: vital, essential and desirable, according to the consequence of running out.

4. Give two advantages of perpetual inventory over a periodic count. The stock balance is known at any moment without a count, and discrepancies are found early enough for the cause to be traced; production is also not interrupted for an annual count.

Answer in one sentence

What are the main inventory control techniques? Selective control by ABC analysis, which classifies items by annual consumption value so that tight control falls on the few items carrying most of the value; VED analysis, which classifies by criticality; perpetual inventory with continuous stock-taking, which keeps the balance known and finds discrepancies early; and simpler devices such as the two-bin system and just-in-time supply, alongside the fixing of stock levels and of the economic order quantity.

The check is that the two costs are equal. Rs 2,500 each. If they are not, the quantity is not the EOQ, and this is the fastest way to verify an answer.

Worked example 1a: the same answer by the tabular method

MU asks for the tabular method by name, sometimes alongside the formula in the same question, so it must be worked and not merely mentioned. It reaches the same figure by trying order sizes and totalling the two costs at each.

The same facts: 10,000 units a year, Rs 250 an order, carrying cost Rs 5 a unit a year.

The least total is Rs 5,000 at an order size of 1,000 units, which is what the formula gave.

Two things the table shows that the formula hides. First, at the best size the two costs are equal, at Rs 2,500 each, which is the property the formula is built on. Second, the total is flat near the bottom: ordering 800 or 1,250 instead of 1,000 costs Rs 125 more on Rs 5,000, about two and a half per cent. A supplier who will only sell in round hundreds has cost the firm almost nothing.

How to choose the sizes to try. Take the figure the formula gives and put two sizes either side of it. If the question forbids the formula, work from the number of orders instead: a year's supply, half a year, a quarter, and so on.

Worked example 2: a quantity discount

The same facts. The material costs Rs 50 a unit. The supplier offers a discount of 2 per cent if 2,000 units are ordered at a time. Carrying cost remains Rs 5 per unit per year. Should the offer be accepted?

The EOQ formula cannot answer this, because its fourth assumption - a constant price - no longer holds. The method is to compute the total annual cost including the purchase price under each option and compare.

Option 1: order the EOQ of 1,000 units at Rs 50.

Option 2: order 2,000 units at Rs 49, being Rs 50 less 2 per cent.

The offer should be accepted. Carrying cost doubles and ordering cost halves, but the discount of Re 1 a unit on 10,000 units outweighs both.

The purchase cost must be brought into the comparison. It is absent from Option 1 and Option 2 in the basic formula because it is the same under both; the moment a discount changes it, leaving it out gives the wrong answer.

What it does NOT mean

EOQ is not the quantity to keep in stock. It is the quantity to order at a time. How much to keep is the next chapter.

It does not minimise ordering cost or carrying cost. It minimises their total.

The formula does not survive a quantity discount, because its fourth assumption fails. Compare total costs instead.

Carrying cost is per unit per year. A percentage of price must be converted first.

Quick revision

• EOQ = square root of (2AO divided by C): A annual consumption, O ordering cost per order, C carrying cost per unit per year.
• At the EOQ, ordering cost equals carrying cost - use it as a check.
• Average stock is half the order quantity.
• Assumptions: steady known consumption, constant ordering cost, constant carrying cost, constant price, and availability.
• A quantity discount breaks the price assumption: compare the total annual cost including purchase price under each option.

Test yourself

1. State the EOQ formula and define each term. The square root of 2AO divided by C, where A is annual consumption in units, O is the ordering cost per order and C is the carrying cost per unit per year.

2. What is the quickest check that a computed EOQ is right? At the EOQ, total ordering cost equals total carrying cost.

3. Annual consumption is 10,000 units, ordering cost Rs 250 and carrying cost Rs 5 a unit a year. What is the EOQ? One thousand units, being the square root of 2 times 10,000 times 250 divided by 5.

4. Why can the EOQ formula not be applied where a quantity discount is offered? Because the formula assumes a constant price per unit; with a discount the purchase cost changes with the order size, so the total annual cost including purchase price must be compared under each option.

5. What is average stock at the EOQ? Half the order quantity, stock running from the full order down to nil.

Answer in one sentence

What is the economic order quantity? It is the order size at which the total of ordering cost and carrying cost is least, being the square root of twice the annual consumption multiplied by the ordering cost per order and divided by the carrying cost per unit per year, at which quantity ordering cost equals carrying cost, and which does not hold where a quantity discount makes the price vary with the size of the order.

The average level is half of 4,900, which is 2,450 units.

Read the reorder period as a range. Four to six weeks gives a minimum of 4, a maximum of 6 and a normal of 5, and each formula takes a different one.

Check the shape of the answer. Minimum below reorder level below maximum, and the average between minimum and maximum. If any of those is out of order, a rate has been used in the wrong formula.

What it does NOT mean

The maximum level is not the storage capacity. It is the level above which holding stock is not justified.

The minimum level is not zero stock. It is the buffer that remains in the ordinary course.

The reorder level is not the average of anything. Both its terms are maximums, deliberately.

Ordering happens at the reorder level, not at the minimum. By the time stock reaches the minimum, the order placed at the reorder level should be arriving.

Quick revision

• Reorder level = maximum consumption times maximum reorder period.
• Minimum = reorder level less (normal consumption times normal reorder period).
• Maximum = reorder level plus reorder quantity less (minimum consumption times minimum reorder period).
• Average = half of (minimum plus maximum), or minimum plus half the reorder quantity.
• Danger = normal consumption times the maximum reorder period for emergency purchase.
• The rates go maximum, normal, minimum down the first three formulae.
• Reorder quantity is usually the EOQ.
• Check: minimum below reorder level below maximum.

Test yourself

1. State the formula for reorder level, and say why both its terms are maximums. Maximum consumption multiplied by maximum reorder period, because the stock held at that level must last until delivery even if consumption is at its fastest and the supplier at his slowest.

2. Why does the maximum level formula use the minimum rates? Because stock is at its highest when the order arrives as early as possible after as little as possible has been consumed from the reorder level.

3. Consumption is 200 to 400 units a week, normal 300; reorder period 4 to 6 weeks; reorder quantity 2,400. What is the reorder level? 2,400 units, being 400 multiplied by 6.

4. What does falling below the minimum level indicate? That something has gone wrong - consumption faster than expected or delivery slower - because in the ordinary course the order placed at the reorder level should arrive before stock reaches it.

Answer in one sentence

How are stock levels determined? The reorder level is maximum consumption multiplied by the maximum reorder period; the minimum level is the reorder level less normal consumption over the normal reorder period; the maximum level is the reorder level plus the reorder quantity less minimum consumption over the minimum reorder period; and the average level is the mean of the minimum and maximum, or the minimum plus half the reorder quantity.

Returns, which every real ledger has and most examples do not

A stores ledger has four kinds of entry, not two. Receipts and issues are the two everyone learns; the other two are returns, and MU puts one of them into a question by a single line at the foot of the data.

A return to the supplier is a receipt reversed, so under first in first out it comes out of the lot it belonged to at that lot's own rate. Under weighted average, remove it at its invoice price and strike a fresh average on what is left; taking it out at the running average would leave the balance wrong, because the average includes older material that was never returned.

A return to store is an issue reversed, so it comes back at the rate at which it went out. Under first in first out it is usually shown as a separate lot at that rate, and under weighted average a fresh average is struck once it is back in.

Where the question puts it. A line such as "of the purchases on 5 December, 100 units were returned to the supplier on 8 December" sits under the table and is easy to read past. Read the notes under the data before you rule a single line, because a return missed on the second entry corrupts every balance after it.

What a method does NOT change

It does not change the total. Opening stock plus receipts equals issues plus closing stock, whatever the method. All a method does is split that total differently between the cost charged now and the value carried forward.

That is worth stating in an answer, because it shows the difference is one of timing rather than of amount. Over the life of the business every method gives the same total cost.

What it does NOT mean

FIFO is not about physical movement. A store may issue whatever unit comes to hand; FIFO is a pricing convention.

Weighted average is not the simple average of the prices. It is weighted by quantity, which is why a large purchase moves it more than a small one.

A method may not be switched to suit the year's profit. CAS-25 requires consistency and disclosure.

Quick revision

• The methods split the same total between issues and closing stock; they do not change it.
• FIFO: oldest prices to issues; in a rising market, low issue cost, high closing stock, high profit; closing stock at recent prices.
• Weighted average: rate = total value divided by total units, recomputed after every receipt and never after an issue; everything smoothed.
• Falling market: every effect reverses.
• CAS-25 requires an appropriate method, applied consistently and disclosed.

Test yourself

1. Under FIFO in a rising market, is profit higher or lower, and why? Higher. Issues are priced at the oldest and cheapest prices, so the cost charged to production is lower and closing stock is carried at the newest and dearest prices.

2. When is the weighted average rate recomputed? After every receipt. An issue removes units and value in the same proportion and cannot change the rate.

3. Does the choice of method change the total cost over the life of the business? No. It changes only how the total is split between the cost charged to production now and the value of stock carried forward.

4. What does CAS-25 require? That inventory be valued by an appropriate method, applied consistently, and that the method be disclosed.

Answer in one sentence

What are the methods of pricing material issues? Chiefly first in first out, under which issues take the oldest unexhausted prices so that in a rising market the cost charged to production is lowest and closing stock and profit are highest, and the weighted average, under which a fresh rate of total value divided by total units is struck after every receipt and both issues and stock are smoothed; the choice determines how the same total is split between cost and stock, not the total itself, and CAS-25 requires consistency and disclosure.

Proof of the weighted average ledger.

The comparison

The totals are identical and that is the point. Rs 18,250 came into the store under both methods; all that changed is how it was split.

Prices rose through the month, so FIFO charged less to production - Rs 12,850 against Rs 13,250 - and carried more into stock. Profit under FIFO is therefore higher by Rs 400 for the month, and the closing stock is higher by the same Rs 400.

Had prices fallen, every one of those statements would reverse.

The five checks to run on your own answer

Does opening plus purchases equal issues plus closing? Rs 18,250 under both. If not, the error is in the ledger.

Under FIFO, did you split the issues? Both issues here draw on two lots. An issue priced wholly at one rate is the commonest error.

Under weighted average, did you recompute only after receipts? Two receipts, two new rates. Recomputing after an issue wastes time and, if the arithmetic slips, introduces an error where none was possible.

Do the two methods differ by the same amount both ways? Issues differ by Rs 400 and closing stock differs by Rs 400, in opposite directions. If the two differences are unequal, one ledger is wrong.

Did you say which way profit moves, and why? The comparison is half the marks, and it needs the reason - prices rose - not just the figures.

In short

• Three columns, each with quantity, rate and value; carry the balance every line.
• FIFO: issues take the oldest unexhausted lots, and an issue may have to be split across two rates.
• Weighted average: new rate after every receipt, never after an issue.
• Prove the ledger: opening plus purchases equals issues plus closing stock.
• The two methods split the same total differently; they do not change it.
• Rising prices: FIFO gives lower issue cost, higher closing stock, higher profit. Falling prices reverse it.

Answer in one sentence

How is a stock ledger prepared under the two methods? By recording every receipt and issue in quantity, rate and value and carrying the balance forward on each line; under first in first out issues are priced at the oldest unexhausted lots and may be split across two rates, while under weighted average a fresh rate of total value divided by total units is struck after each receipt and applied to issues until the next receipt, both ledgers proving to the same total of opening stock plus purchases and differing only in how that total is split between issues and closing stock.

Where each lands in the cost sheet

Prime cost is the direct column. That is the whole of the classification chapter restated, and it is worth seeing it as one picture.

Worked example

Classify each and say where it lands.

Row three is the one students get wrong. The employer's provident fund contribution for a direct worker is part of the cost of employing him, so it follows his wages into prime cost. It is not an overhead merely because the employee never sees it.

Row seven is the second. Abnormal idle time is excluded from cost altogether, and it is one of the reconciliation items from Module I.

What it does NOT mean

Employee cost is not the wage bill. Contributions, benefits and welfare are part of it.

Direct expense is not a large expense. It is a traceable one.

Indirect labour is not unskilled labour. The works manager is indirect and the apprentice on a job is direct.

Abnormal idle time is not employee cost. It is excluded and charged to profit and loss.

Quick revision

• CAS-7 Employee Cost: gross payments to and on behalf of employees, including the employer's contributions and benefits for the period, net of recoveries, excluding abnormal costs.
• Employee cost is the employer's cost, not the employee's receipt.
• Direct labour to prime cost; indirect labour to factory overhead; the same person may be both, and time booking decides.
• CAS-10 Direct Expenses: expenses other than material and labour traceable to the cost object, at invoice or agreed price net of recoverable taxes and discounts, excluding abnormal items.
• Direct expenses: royalty per unit, hire of special plant, special moulds and designs, job-specific consultancy and licence fees.
• Prime cost is the direct column of the material, labour and expenses grid.

Test yourself

1. What does employee cost include beyond wages? Allowances, bonus and incentives, overtime, the employer's contributions to provident fund, pension and insurance, gratuity and leave attributable to the period, welfare facilities and normal idle time, net of recoveries from employees.

2. Is the employer's provident fund contribution for a direct worker a direct or an indirect cost? Direct. It is part of the cost of employing that worker and follows his wages into prime cost.

3. Define a direct expense and give two examples. An expense other than material and labour that can be traced economically to a cost object; for instance royalty payable per unit produced, or the hire of a special plant or mould for one job.

4. How is abnormal idle time treated? Excluded from cost altogether and charged to profit and loss, which makes it one of the causes of difference in a reconciliation.

Answer in one sentence

What are employee cost and direct expenses? Employee cost, under CAS-7, is the gross payment made to and on behalf of employees, including the employer's contributions and the benefits attributable to the period and net of recoveries, but excluding abnormal costs; and direct expenses, under CAS-10, are expenses other than material and labour that can be traced to a cost object, such as royalty per unit, the hire of special plant and the cost of a mould made for one order, both entering prime cost so far as they are direct.

Step 5 is the cost accountant's step and the other four are the paymaster's. The same total is being looked at two ways: as money owed to people, and as cost belonging to jobs.

Separation of duties. The person who records attendance, the person who prepares the payroll and the person who pays should not be the same, or a name can be added to the roll and the wages collected.

Two things a payroll question turns on

Paid holidays, and a daily rate

A daily-rated worker is paid for the days the contract pays for, not the days he works. Where the question says Sundays are paid holidays, a month of thirty days is thirty paid days, not the twenty-six he attended.

Read the working week too. "Forty-eight hours a week over six days, or eight hours a day" tells you the week, and with paid Sundays it tells you that the seventh day is paid as well. Count the days of the month, not the days of work, and say in a working note which you have used.

A monthly-rated worker needs no such computation. His figure is the month's salary, whatever the days.

The employer deposits BOTH shares

Provident fund and state insurance each have two contributions, and they behave differently:

So a question asking "the total provident fund to be deposited by the employer" wants BOTH shares added together, while a question asking "the labour cost to the employer" wants the gross wages plus his share only. They are different numbers from the same data, and a student who has learnt one answer gives it to both.

What it does NOT mean

Time keeping is not time booking. One is attendance, the other utilisation.

Net wages are not employee cost. The employer's contributions are a cost, and deductions are not a saving.

A job card does not replace a time sheet. They record the same hours from different directions.

Quick revision

• Time keeping records attendance: register, disc or token, time recording clock, card or biometric reader; every method short of biometric is defeated by substitution.
• Time booking records utilisation: daily and weekly time sheets, job cards, piece work cards, idle time cards.
• Attendance hours less booked hours equals idle time, and reconciling the two is the control.
• Payroll: gross wages, less deductions, equals net wages payable; plus the employer's contributions; then analysed across jobs and overhead.
• Separate the recording, the preparing and the paying.

Test yourself

1. Distinguish time keeping from time booking. Time keeping records a worker's attendance - the hours he was present, used to compute wages payable; time booking records what he did while present - the hours charged to each job, used to cost the jobs and to reveal idle time.

2. What is the chief weakness of a time recording clock, and what removes it? That one worker can punch another's card; a card or biometric reader that identifies the person removes it.

3. What is the difference between attendance hours and booked hours? Idle time, which must be identified and explained.

4. Are net wages the employee cost? No. Employee cost is the employer's cost, so deductions do not reduce it and the employer's own contributions must be added.

Answer in one sentence

Describe the attendance and payroll procedure. Attendance is recorded by time keeping, through a register, token, time recording clock or biometric reader, and the use of that attendance is recorded by time booking through time sheets and job cards; the payroll is then built from gross wages less statutory and other deductions to give net wages payable, with the employer's contributions added to arrive at cost, and the total analysed across jobs and overhead from the time booking records, the difference between attendance and booked hours being idle time.

Overtime: the statutory position

The Factories Act 1948 sets the hours; the wage follows from them.

"Ordinary rate of wages" is defined by the Act itself, in s.59(2), as basic wages plus the allowances the worker is entitled to, but not bonus and not overtime wages. That definition matters: a student who computes the premium on gross earnings including last year's bonus has the wrong base.

For a piece-rate worker, s.59(3) deems the time rate to be the daily average of his full-time earnings on the same or an identical job during the calendar month immediately preceding the month in which the overtime was worked.

There are limits on how much overtime may be worked, and they sit in the exempting provisions rather than in s.59:

A quarter here is three consecutive months beginning on the first of January, April, July or October.

Overtime premium, and who bears it

Split the overtime wage in two. Because s.59 gives twice the ordinary rate, the payment for an overtime hour is:

The normal element is always direct labour on the job. The question is where the premium goes, and there are four answers:

Overtime worked

A worker's ordinary rate is Rs 45 an hour. In a week he works 9 hours of overtime. Show the payment and its treatment under each cause.

The payment is 9 hours at twice Rs 45, that is Rs 810, made up of the normal element 9 × 45 = Rs 405 and the premium 9 × 45 = Rs 405.

Every row totals Rs 810, because the money paid does not change; only its destination does. That is the whole of the topic in one table.

What it does NOT mean

Overtime premium is not the overtime wage. It is the excess over the ordinary rate, and the ordinary-rate half stays with the job in every case.

Normal idle time is not "small" idle time. The test is whether it is inherent in the work, not how many hours it runs to.

Abnormal idle time is not an overhead. It leaves cost entirely.

The ordinary rate is not gross earnings. Section 59(2) excludes bonus and overtime wages from it.

Quick revision

• Idle time = attendance hours less booked hours.
• Normal, unavoidable: inflate the labour rate or charge to factory overhead.
• Abnormal, avoidable: exclude from cost, charge to Costing Profit and Loss.
• Factories Act: nine hours a day (s.54), forty-eight a week (s.51), a half-hour interval every five hours (s.55), spreadover ten and a half hours (s.56).
• Overtime is paid at twice the ordinary rate (s.59), the ordinary rate being basic wages plus allowances but not bonus or overtime wages (s.59(2)).
• Overtime is capped at fifty hours a quarter under exempting rules (s.64(4)) and seventy-five under an exempting order (s.65(3)), sixty hours a week in both.
• Overtime premium: to the job if the customer asked; to overhead if general pressure; to the department if its own fault; to profit and loss if abnormal.

Test yourself

1. Distinguish normal from abnormal idle time. Normal idle time is inherent in the work and unavoidable, such as setting up and personal needs, and is borne by production through an inflated labour rate or factory overhead; abnormal idle time arises from avoidable causes such as a breakdown or a strike, and is excluded from cost and charged to costing profit and loss.

2. At what rate must overtime be paid, and on what base? At twice the ordinary rate of wages under s.59(1) of the Factories Act 1948; the ordinary rate is basic wages plus allowances, excluding bonus and overtime wages, by s.59(2).

3. A customer pays extra to have his order finished by Saturday and the men work overtime. How is the premium treated? It is charged to that job, because the cause and the benefit both belong to that customer.

4. Where does the premium go when overtime is worked to make up production lost in a power failure? To the Costing Profit and Loss Account, because the cause is abnormal.

5. A worker is present 200 hours, of which 10 are normal idle and 10 abnormal idle, at Rs 45 an hour. What is the cost of a productive hour? Rs 47.50. Gross wages are Rs 9,000, less Rs 450 of abnormal idle time charged to profit and loss, leaving Rs 8,550 to be absorbed by 180 productive hours.

Answer in one sentence

Explain idle time and overtime and their treatment in cost accounts. Idle time is the excess of attendance hours over hours booked to jobs, normal idle time being unavoidable and borne by production through an inflated labour rate or factory overhead while abnormal idle time is excluded from cost and charged to costing profit and loss; overtime is work beyond nine hours a day or forty-eight a week, for which s.59 of the Factories Act 1948 requires twice the ordinary rate of wages, and of the two halves of that payment the ordinary-rate element is direct labour on the job while the premium follows its cause, going to the job if the customer asked for it, to factory overhead if it arose from general pressure of work, to the department if the department was at fault, and to costing profit and loss if the cause was abnormal.

If the flux is taken as separations plus accessions, accessions are 60 + 240 = 300, and the rate is (100 + 300) ÷ 1,000 × 100 = 40 per cent. State which form you have used, because the two answers differ by the whole of the expansion.

Causes of labour turnover

Avoidable, which is where management can act:

• low wages, or wages below what a neighbouring factory pays;
• bad working conditions, and unsafe or unpleasant work;
• no prospect of promotion;
• poor relations with a supervisor;
• lack of housing, transport or welfare facilities;
• unsuitable placement, a man in the wrong job.

Unavoidable, which no employer can prevent:

• retirement and death;
• marriage, and moving with a family;
• illness and permanent disability;
• discharge for misconduct or continued inefficiency;
• the end of a seasonal job.

Only the avoidable half is worth spending money on. A high ratio caused by retirements needs a recruitment plan, not a wage revision.

Costs of labour turnover

The two move against each other. Spending on prevention reduces replacement cost, and a management that spends nothing on the left column pays more in the right. Preventive costs are apportioned over departments by the number of workers; replacement costs are charged to the department that incurred them, or to general overhead where the turnover is a company-wide problem.

What it does NOT mean

Turnover is not the number who left. It is a rate, measured against the average roll.

A new appointment for expansion is not a replacement. It goes into accessions, not into R.

A discharge is still a separation. The employer's decision to end the employment is a separation as much as the worker's.

A low ratio is not always good. A factory that never loses anybody is also not bringing in new skill, and some turnover among the inefficient is desirable.

Quick revision

• Average number on the roll = (opening + closing) ÷ 2.
• Separation rate = S ÷ A × 100. Replacement rate = R ÷ A × 100. Flux rate = (S + R) ÷ A × 100.
• Exclude new appointments for expansion from replacements.
• Causes divide into avoidable - wages, conditions, promotion, supervision - and unavoidable - retirement, death, marriage, illness, discharge.
• Costs divide into preventive and replacement, and they move against each other.
• Preventive costs are apportioned by number of workers; replacement costs go to the department that caused them.

Test yourself

1. State the three methods and their formulae. Separation, S ÷ A × 100; replacement, R ÷ A × 100; flux, (S + R) ÷ A × 100, where A is the average number of workers on the roll.

2. Forty men leave, thirty are engaged in their place and a hundred more for a new plant. The average roll is 500. What is the replacement rate? Six per cent. Only the thirty engaged in place of leavers are replacements; the hundred engaged for the new plant are accessions for expansion.

3. Name three avoidable causes. Low wages, bad working conditions and no prospect of promotion; unsuitable placement and poor supervision are equally acceptable.

4. Distinguish preventive from replacement cost. Preventive cost is spent to keep workers from leaving, such as welfare, medical services and fair wages, and is apportioned over departments by the number of workers; replacement cost is incurred because they left, such as selection, training, lost output and higher spoilage, and is charged to the department concerned.

Answer in one sentence

What is labour turnover and how is it measured? Labour turnover is the rate at which workers leave and are replaced, measured against the average number on the roll, and computed by the separation method as separations over the average roll, by the replacement method as replacements over the average roll with new appointments for expansion excluded, and by the flux method as separations plus replacements over the average roll, its causes dividing into avoidable ones such as low wages and bad conditions and unavoidable ones such as retirement and death, and its costs into preventive costs spent to retain workers and replacement costs incurred because they left.

Worked example

A factory's payroll for a month is Rs 5,00,000, including the employer's contributions. The time booking records show direct labour of Rs 3,20,000. Indirect factory labour is Rs 1,20,000, office salaries Rs 30,000 and sales salaries Rs 15,000. Abnormal idle time caused by a power failure amounts to Rs 15,000. Show how the wages are charged.

Read the last row. The credits equal the debit, so the account closes and nothing has been left unplaced. Of the Rs 5,00,000, only Rs 3,20,000 reaches prime cost; Rs 1,65,000 becomes overhead and Rs 15,000 leaves cost altogether.

What it does NOT mean

Utilisation is not efficiency. Utilisation asks whether the hours were used at all; efficiency asks how much was produced in them, and that is the next chapter but one.

Indirect labour is not outside cost. It is inside cost, as overhead. Only abnormal idle time leaves.

Direct labour is not the whole of the payroll of the production department. The supervisor and the storekeeper stand in that department and are indirect.

Quick revision

• Hours paid for, less normal and abnormal idle time, equals productive hours; utilisation = productive ÷ paid × 100.
• Direct labour is traceable, enters prime cost; indirect labour is not, enters overhead. Traceability, not skill, is the test.
• Wages Control Account: debited with gross wages plus employer's contributions; credited to Work in Progress, Factory Overhead, Administration and Selling Overhead, and Costing Profit and Loss for abnormal idle time.
• The account must close. Credits that fall short of the debit mean an element of the payroll has not been placed.

Test yourself

1. How is the utilisation percentage computed? Productive hours booked to jobs, divided by the hours paid for from the attendance records, times a hundred.

2. What is the test for direct labour? Whether the hours can be traced economically to a cost object, which the job card establishes; skill and grade are irrelevant.

3. Name the four destinations of the Wages Control Account. Work in Progress for direct labour, Factory Overhead for indirect factory labour and normal idle time, Administration and Selling Overhead for office and sales salaries, and the Costing Profit and Loss Account for abnormal idle time.

4. Payroll is Rs 5,00,000, of which direct labour is Rs 3,20,000 and abnormal idle time Rs 15,000. How much is overhead? Rs 1,65,000, being the balance after the direct labour charged to work in progress and the abnormal idle time charged to profit and loss.

Answer in one sentence

Explain the utilisation and charging of labour cost. Utilisation measures the productive hours actually booked to jobs as a proportion of the hours paid for, the difference being normal and abnormal idle time; and labour cost is charged through the Wages Control Account, which is debited with the gross wages and the employer's contributions and credited by transferring direct labour to work in progress, indirect factory labour and normal idle time to factory overhead, office and sales salaries to administration and selling overhead, and abnormal idle time to the Costing Profit and Loss Account, the account closing only when every rupee of the payroll has been placed.

What goes wrong when this is missed. Charge the hours to production instead, and two statements are wrong at once: the year's cost of production is overstated by the whole of the labour, and the asset is understated by the same amount and will be under-depreciated for every year of its life.

The control is a separate series of numbers. Capital job numbers are kept in a different series from work orders, so that a clerk pricing the time sheets cannot confuse the two, and the total booked to capital jobs is reconciled with the additions to fixed assets in the financial accounts.

Worked example

A fitter attends 200 hours in a month at Rs 45 an hour. His time sheets show 120 hours on Work Order 214, 30 hours on Batch 77, 40 hours on Capital Job C-9 erecting a new storage rack, and 10 hours booked to Standing Order 3, machine cleaning. Show the charge.

The hours reconcile with attendance, so nothing is unaccounted for. Only Rs 6,750 is production cost; Rs 1,800 is capitalised and Rs 450 is overhead.

What it does NOT mean

A capital job is not an overhead. It leaves the cost of production entirely, but by a different door from abnormal idle time: it goes into an asset, not into profit and loss.

A standing order is not a work order. One collects indirect work all year, the other is opened and closed for a piece of production.

A batch is not a job. The batch is the unit; costing each item inside it defeats the purpose.

Quick revision

• Hours are booked to a work order, a batch, a capital job or a standing order.
• Work order and batch to Work in Progress; standing order to overhead; capital job to the asset.
• AS 10 requires costs directly attributable to bringing an asset to working condition, including employee benefits arising from the construction, to be included in its cost.
• Charging capital-job hours to production overstates the year's cost and understates the asset.
• Keep capital job numbers in a separate series, and reconcile the total with additions to fixed assets.
• The check: work orders plus standing orders plus idle time equals attendance hours.

Test yourself

1. What is a standing order number? A number kept open through the year to collect a recurring class of indirect work, such as machine cleaning or maintenance, whose cost is charged to overhead rather than to a job.

2. How are hours on a capital job treated, and why? They are capitalised into the cost of the asset and depreciated over its life, because AS 10 requires costs directly attributable to bringing the asset to working condition, including the employee benefits arising from constructing it, to form part of its cost.

3. What happens if capital-job hours are charged to production? The cost of production for the year is overstated by that labour and the asset is understated by the same amount, so depreciation is too low for every year of the asset's life.

4. A batch of 500 units absorbs 120 hours at Rs 45. What is the labour cost a unit? Rs 10.80, being Rs 5,400 divided by 500 units.

Answer in one sentence

How are labour hours identified with work orders, batches and capital jobs? Every paid hour is booked against a number, a work order for a job, a batch number where identical units are made together, a capital job number for work on the company's own asset, or a standing order for recurring indirect work, so that hours on work orders and batches become direct labour in work in progress, hours on standing orders become overhead, and hours on capital jobs are capitalised into the asset under AS 10 rather than charged against the year's production, the sum of all bookings and idle time being reconciled with the attendance hours as the control.

The three ratings distinguished

Job evaluation happens before anybody is engaged. It compares one post with another on skill, effort, responsibility and working conditions, and produces a wage structure.

Merit rating judges qualities - regularity, initiative, co-operation, judgment, reliability - and is partly a matter of opinion, which is why it is done on a form with defined grades rather than left to a supervisor's memory.

Efficiency rating is arithmetic. Standard hours over actual hours, and no opinion enters it.

What it does NOT mean

Efficiency is not utilisation. Utilisation asks whether the hours were used at all; efficiency asks how much came out of them.

Efficiency rating is not merit rating. One is a percentage from a time study, the other an assessment of personal qualities.

A rating below 100 is not necessarily the worker's fault. Bad material, a worn machine and poor instructions all show up in his figure.

Quick revision

• Efficiency = standard hours for actual output ÷ actual hours worked × 100.
• The standard comes from work study: method study, then time study, plus allowances.
• Above 100 earns incentive; below 100 calls for training or investigation; everybody far above 100 means the standard is loose.
• Job evaluation rates the job to fix the wage; merit rating rates the man's qualities; efficiency rating rates his output.
• Efficiency rating feeds the incentive scheme, promotion, training and the revision of standards.

Test yourself

1. State the formula. Standard hours for the actual output divided by actual hours worked, times a hundred.

2. A worker takes 40 hours to make 5 units for which the standard is 10 hours each. What is his efficiency? 125 per cent: 50 standard hours against 40 actual hours.

3. Every worker in a department is rated at 140 per cent. What should management suspect? That the standard is loose and needs a fresh time study, rather than that the whole department is exceptional.

4. Distinguish merit rating from efficiency rating. Merit rating assesses the worker's personal qualities such as regularity, initiative and reliability, for promotion and placement; efficiency rating measures his output against the standard time, as a percentage, for incentive payment and cost control.

Answer in one sentence

Explain efficiency rating procedures. Efficiency rating expresses the standard hours allowed for a worker's actual output as a percentage of the hours he actually worked, the standard being fixed by work study, so that a rating above a hundred earns incentive, one below it calls for training or an investigation of the conditions, and a whole department far above it indicates a loose standard; and it is distinct from job evaluation, which rates the job to fix its wage, and from merit rating, which assesses the worker's personal qualities.

Let A be the time allowed, T the time taken, S the time saved, and R the rate an hour.

The Halsey-Weir variant pays 30 per cent instead of 50; the principle is unchanged.

The comparison, worked

The time allowed for a job is 40 hours and the rate is Rs 45 an hour. Compute the earnings under Halsey and Rowan where the worker takes 30 hours, 20 hours and 10 hours.

Case A: 30 hours taken, 10 hours saved.

Halsey bonus is 50 per cent of 10 hours at Rs 45. Rowan bonus is 10 ÷ 40 of the time wages, that is one quarter of Rs 1,350.

Case B: 20 hours taken, 20 hours saved.

Case C: 10 hours taken, 30 hours saved.

The rule the three cases prove:

Write that rule down and check your answer against it. If your Rowan figure beats Halsey when the man saved three-quarters of the time, the arithmetic is wrong.

Effective hourly rate, and why Rowan is safer

Under Rowan the effective rate can never reach twice the ordinary rate, because the earnings work out to R × (1 + S ÷ A) and the time saved can never equal the whole time allowed. Under Halsey there is no such ceiling, as case C shows at Rs 112.50 against an ordinary rate of Rs 45.

That ceiling is Rowan's point. It protects the employer where a loose standard has been set, which is exactly the situation the last chapter warned about. Halsey rewards a loose standard without limit; Rowan does not.

The other side of it. Halsey is simpler to explain and to compute, and a worker can see at once that he keeps half of what he saves. Rowan's formula is harder to explain on the shop floor, and a worker who saves a great deal feels the ceiling as a penalty.

When the time allowed and the rate are not given

MU often makes you find both before you can start. The formulae are useless until you have the time allowed, the time taken and the rate an hour, and a question can hide each of them.

Worked on those figures: 200 units, expected 15 minutes each raised by 20 per cent, 45 hours taken, weekly wage Rs 405.

Time allowed 60 hours, time taken 45, time saved 15 hours, rate Rs 9 an hour.

Halsey's bonus is half of 15 hours at Rs 9. Rowan's is 15 ÷ 60 of the time wages, that is a quarter of Rs 405.

Check it against the rule. Fifteen hours saved out of sixty allowed is under half, so Rowan must pay more, and it does.

The dearness allowance goes on afterwards and is in neither bonus. Had one been given at Rs 10 per eight-hour day, 45 hours is five and five eighths days, so Rs 56.25 would be added to each column, changing both earnings and neither bonus.

What it does NOT mean

A premium bonus scheme is not a piece rate. The time wage is guaranteed in both Halsey and Rowan, so a worker who takes longer than allowed still gets his hours.

Rowan is not always better for the worker. It is better only while the time saved is under half the time allowed.

Taylor's plan is not Merrick's. Taylor has two rates and penalises the below-standard worker; Merrick has three and does not.

Bonus is not part of the ordinary rate for overtime. Section 59(2) of the Factories Act 1948 excludes bonus from the ordinary rate of wages.

Quick revision

• Time rate: hours × rate. Piece rate: units × rate, usually with a guaranteed time wage.
• Taylor: two rates, about 80 and 120 per cent, no guarantee, severe.
• Merrick: three rates - ordinary up to 83 per cent, 110 per cent to 100, 120 per cent above.
• Gantt: time rate below standard, time rate plus about 20 per cent at standard, high piece rate above.
• Emerson: no bonus below about two-thirds efficiency, rising to 20 per cent at 100, then 1 per cent for each 1 per cent above.
• Halsey bonus = half the time saved at the hourly rate. Rowan bonus = time saved over time allowed, applied to the time wages.
• Rowan pays more when less than half the time is saved; Halsey when more than half; equal at exactly half.
• Rowan's effective rate can never double the ordinary rate; Halsey's has no ceiling.

Test yourself

1. State the Halsey and Rowan bonus formulae. Halsey pays 50 per cent of the time saved at the hourly rate; Rowan pays the time wages multiplied by the fraction time saved over time allowed.

2. Time allowed 40 hours, time taken 30, rate Rs 45. Compute both. Halsey Rs 1,575, being time wages of Rs 1,350 plus a bonus of Rs 225; Rowan Rs 1,687.50, being Rs 1,350 plus a bonus of Rs 337.50.

3. When do the two schemes pay the same? When the time saved is exactly half the time allowed.

4. Why does an employer with an untested standard prefer Rowan? Because Rowan's effective hourly rate can never reach twice the ordinary rate, so a loose standard cannot be exploited without limit, whereas Halsey's bonus has no ceiling.

5. Distinguish Taylor's plan from Merrick's. Taylor sets two piece rates with no guaranteed wage and pays the low rate on the whole output of a worker below standard; Merrick sets three graduated rates and imposes no penalty rate, the ordinary rate applying up to 83 per cent efficiency.

Answer in one sentence

Compare the Halsey and Rowan premium bonus schemes. Both guarantee the worker his time wage and share the value of the time saved between him and the employer, Halsey paying half the time saved at the hourly rate and Rowan paying the time wages multiplied by the ratio of time saved to time allowed, so that Rowan pays more while less than half the time allowed is saved, the two are equal at exactly half, and Halsey pays more beyond that; and because Rowan's earnings amount to the hourly rate multiplied by one plus the ratio of time saved to time allowed, its effective rate can never reach twice the ordinary rate, which protects an employer whose standard has been set loosely, while Halsey has no such ceiling but is simpler to compute and to explain.

Labour cost per productive hour = 4,80,000 ÷ 9,600 = Rs 50.

The overtime premium is split, and the split is the marker's test. Rs 4,000 follows the job because the customer asked for the work to be expedited; Rs 8,000 goes to factory overhead because general pressure of work is nobody's job in particular. Both figures were in gross wages at step 1, and both are still there at step 6 - the statement has moved them, not created or destroyed them.

Four workers on one job: the five things a question asks

Four employees work in department M for the month of April exclusively on Job 120. A is paid Rs 10,000 a month; B, C and D are paid Rs 150, Rs 120 and Rs 100 a day. The normal week is forty-eight hours over six days, or eight hours a day, and Sundays are paid holidays; there were no other holidays in the month. Provident fund is 8 per cent of wages by the employee and 8 per cent by the employer; state insurance is 3 per cent by the employee and 5 per cent by the employer. Materials for the job cost Rs 60,000 and overheads are 50 per cent of prime cost.

Find the net wages payable, the provident fund and state insurance the employer must deposit, the labour cost chargeable to the job, and the total cost of the job.

Start with the days. April has thirty days, Sundays are paid, and there were no other holidays, so each daily-rated worker is paid for thirty days.

(a) Net wages payable.

(b) Provident fund deposited by the employer.

(c) State insurance deposited by the employer.

(d) Labour cost chargeable to the job.

(e) Total cost of Job 120.

Three places this question is lost.

The employees' deductions are in (a) and (b) but never in (d). They are already inside gross wages; adding them again to reach cost counts the same money twice.

The employer's rates differ between the two funds - 8 per cent for provident fund against his employees' 8, but 5 per cent for state insurance against their 3. Using one rate for both halves of a fund is the commonest slip.

Net wages payable is not a cost figure at all. It is what leaves the bank. The cost is Rs 23,843, the bank pays Rs 18,779, and the difference of Rs 5,064 goes to the two authorities.

Where each item goes: a checklist

The two "nowhere" rows are where marks are lost. A deduction from the worker's pay is not a reduction of the employer's cost, and adding the employee's own provident fund share on top of gross wages counts it twice.

What it does NOT mean

Total employee cost is not gross wages. The employer's contributions and benefits come on top.

It is not net wages either. Deductions do not reduce cost.

Abnormal idle time is not deducted from the worker's earnings. It is deducted from the cost charged to production, and charged to profit and loss instead.

Quick revision

• Order: earnings, add the employer's costs, total employee cost, less abnormal idle time, cost charged to production, split between direct and overhead.
• Provident fund on basic and dearness allowance; state insurance on gross wages. Two bases, not one.
• Deductions from pay are not deducted from cost; recoveries from employees are.
• Overtime at the ordinary rate follows the job; the premium follows its cause.
• Labour cost per productive hour = direct labour charged ÷ productive hours.

Test yourself

1. Why is the employer's provident fund contribution added rather than deducted? Because employee cost is what the employer spends on employing the worker, and the contribution is his spending even though the worker does not receive it in hand.

2. On what base is each contribution computed in the example? Provident fund on basic wages and dearness allowance; state insurance on gross wages, which includes the incentive.

3. Where does abnormal idle time appear? As a deduction after total employee cost, charged to the Costing Profit and Loss Account and never reaching production.

4. A worker allowed 60 hours takes 45 at Rs 40 an hour on the Rowan scheme. What are his gross wages before allowances? Rs 2,250, being time wages of Rs 1,800 and a bonus of Rs 450, the bonus being one quarter of the time wages because 15 hours were saved out of 60 allowed.

5. Is income-tax deducted at source part of employee cost? No. It is a deduction from the worker's pay out of wages already counted, and counting it again would be counting the same money twice.

Answer in one sentence

How is a labour cost statement prepared? It begins with earnings, that is basic wages, allowances, incentive and overtime; adds the employer's own costs of provident fund and state insurance on their respective bases together with gratuity, leave and welfare, to give total employee cost; deducts abnormal idle time, which is charged to the Costing Profit and Loss Account, to give the employee cost charged to production; and splits that between direct labour taken to work in progress and indirect labour and normal idle time taken to factory overhead, the overtime premium being placed in whichever of the two its cause requires.

(b) Orders and cost at that quantity.

The two costs are equal, which is the property that defines the economic order quantity. If they are not equal in your answer, the quantity is wrong.

(c) Stock levels.

Note the two forms of the average. Some texts take the average as the minimum level plus half the reorder quantity, which gives 1,700 + 600 = 2,300. Both are accepted; say which you have used.

Check the usage figure. The question gives annual consumption and the number of working weeks, and 24,000 ÷ 48 = 500 a week, which agrees with the normal usage stated. A question whose two figures disagree is telling you to use the weekly ones.

Question 2

(a) First in first out.

Cost of issues Rs 19,200. Closing stock 100 units, Rs 3,000.

(b) Weighted average.

A fresh average is struck after every receipt and never after an issue.

Cost of issues Rs 11,000 plus Rs 8,400 = Rs 19,400. Closing stock 100 units, Rs 2,800.

The proof both methods must satisfy.

Material available was Rs 8,000 plus Rs 5,200 plus Rs 9,000 = Rs 22,200 under both. The method decides how that total is split between what went out and what remains; it cannot change the total. Do this proof before you leave the question.

Comment. Prices rose through the month, from Rs 20 to Rs 30. Under first in first out the older and cheaper units are issued first, so the cost of issues is lower and the closing stock higher, and reported profit is correspondingly higher. The weighted average smooths the rise, charging issues at a rate between the old and the new.

Question 3

Classify first, and check the roll.

That is the closing number the question states, so the classification is right. Had the 104 been counted as replacements the rates would change while the roll still closed, which is why the classification must be argued and not merely assumed.

Average number on the roll = (760 + 840) ÷ 2 = 800.

Accessions are 40 replacements plus 104 new appointments = 144. The two flux figures differ by the whole of the expansion, which is why the form used must be stated.

Question 4

Time saved is 40 less 25, that is 15 hours.

Halsey.

Effective hourly rate = 1,950 ÷ 25 = Rs 78.

Rowan.

Effective hourly rate = 2,062.50 ÷ 25 = Rs 82.50.

Which the employer prefers, and the rule. Here the employer prefers Halsey, which costs Rs 1,950 against Rs 2,062.50. The general rule is that Rowan pays more while the time saved is less than half the time allowed, the two are equal at exactly half, and Halsey pays more beyond that. Fifteen hours saved out of forty allowed is under half, so Rowan is the dearer, and the arithmetic agrees.

Labour cost a unit, on 10 units.

A closing observation worth a mark. At the ordinary rate the 40 hours allowed would have cost Rs 2,400. Both schemes cost less than that while paying the worker more than his time wage of Rs 1,500, and that division of the value of the time saved is the whole idea of a premium bonus scheme.

Marking yourself

Two of these are asked almost every time: welfare and supervision go on the number of workers, and depreciation goes on the value of plant.

Primary distribution, worked

A factory has three production departments A, B and C and one service department S. Overheads for the period are: rent Rs 20,000; lighting Rs 4,000; depreciation on plant Rs 30,000; supervision Rs 12,000. Indirect wages are allocated directly: A Rs 3,000, B Rs 2,500, C Rs 1,500, S Rs 1,000. Floor area is 2,000, 1,500, 1,000 and 500 square feet; light points 20, 15, 10 and 5; value of plant Rs 60,000, Rs 40,000, Rs 30,000 and Rs 20,000; workers 30, 20, 15 and 15.

Check the last column against the last row. The four departments add to Rs 74,000 and so do the five overheads. A primary distribution that does not cross-check is wrong, and the check costs one line.

Secondary distribution

The service department's total must be got into the production departments, because only they have units passing through them.

Continuing the example, S is apportioned to A, B and C on direct wages in the ratio 5:3:2.

The grand total is unchanged at Rs 74,000. Secondary distribution moves overhead sideways; it never creates or destroys any.

Absorption rates

Absorption charges a department's overhead onto the work passing through it.

The choice follows the work. A department where the machines do the work absorbs on machine hours; one where the people do it absorbs on labour hours. Absorbing on wages in a machine shop charges the most overhead to the cheapest worker, which is exactly backwards.

Machine hour rate, worked

Compute the machine hour rate. Supervisor's salary Rs 4,500 a year, of which the machine takes one tenth of his time. Repairs and maintenance Rs 90 a year. Factory rent Rs 2,400 a year; the machine occupies one quarter of the area. Insurance premium Rs 150 a year. Water Rs 150 and steam Rs 225 a year. The machine cost Rs 35,000 with carriage inward of Rs 5,000, has a scrap value of Rs 10,000 and a life of ten years. It runs 1,500 hours a year and consumes 15 units of power an hour at 10 paise a unit.

Depreciation first. The cost of the machine includes the carriage inward that brought it in, so it is Rs 35,000 plus Rs 5,000, that is Rs 40,000; less the scrap value of Rs 10,000, over ten years, gives Rs 3,000 a year.

Two traps in that computation. The carriage inward on the machine is capitalised, not expensed, so it raises depreciation rather than appearing as an expense of the year; that is the same rule as the capital job in the labour chapter. And power is a running charge, computed per hour directly, not spread over the year's hours like the standing charges.

Over- and under-absorption

Overhead is absorbed at a rate fixed in advance, and the actual overhead is never the same figure.

This is where the appendix rejoins the book. Over- and under-absorbed overhead is one of the standard causes of difference in a reconciliation, and the reconciliation chapters carry it. A student who never computes an absorption rate still has to know which way the difference runs.

Quick revision

• Overhead = indirect material + indirect labour + indirect expenses.
• Allocation charges a whole item to one department; apportionment splits an item between several.
• Primary distribution covers all departments; secondary distribution closes the service departments into the production ones, by direct, step ladder or reciprocal methods.
• Bases: area for rent, light points for lighting, value of plant for depreciation, horsepower for power, number of workers for welfare and supervision.
• Absorption rates: percentage of material, wages or prime cost; labour hour rate for labour-intensive work; machine hour rate for machine-intensive work.
• Machine hour rate = standing charges an hour plus running charges an hour, with the machine's cost taken inclusive of carriage inward and net of scrap value.
• Over-absorption understates costing profit; under-absorption overstates it.

Test yourself

1. Distinguish allocation from apportionment. Allocation charges the whole of an item to a single department because it belongs wholly to it; apportionment divides an item between departments on a basis that reflects how each benefits from it.

2. On what basis are welfare expenses and depreciation on plant apportioned? Welfare on the number of workers; depreciation on the value of plant.

3. When is a machine hour rate preferred to a labour hour rate? Where the work is done chiefly by machines, so that overhead varies with machine running time rather than with the hours people spend.

4. A machine costs Rs 35,000 with carriage inward Rs 5,000, has a scrap value of Rs 10,000 and a life of ten years. What is the annual depreciation? Rs 3,000. The carriage inward is part of the machine's cost, so Rs 40,000 less Rs 10,000 over ten years.

5. Overhead absorbed exceeds overhead incurred. What has happened to the costing profit? It is understated, because more overhead has been charged to cost than was actually spent, and the difference is added back in the reconciliation.

Answer in one sentence

Explain the treatment of overheads. Overheads, being indirect material, labour and expenses, are collected under standing order numbers, then allocated whole to a department where they belong wholly to it and apportioned between departments on a suitable basis where they do not, which together make the primary distribution; the service departments' totals are then closed into the production departments by direct, step ladder or reciprocal secondary distribution; and each production department's total is absorbed onto the work passing through it by a rate chosen to suit the work, a machine hour rate for machine-intensive work and a labour hour rate for labour-intensive work, the difference between what is absorbed and what is incurred being over- or under-absorption, which is one of the causes of difference between the cost and the financial profit.