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

In one line

Financial accounting says what the business as a whole earned; cost accounting says what each thing it made or did actually cost.

The question that makes the subject necessary

A firm makes three products and its profit and loss account shows a profit of Rs 14,00,000. That is a true and useful figure, and it answers to the shareholder, the bank and the tax department.

It cannot answer any of these:

• Which of the three products makes money and which is carried by the others?
• Should we accept an export order at a price below our usual one?
• Was this month's wastage worse than last month's?
• What should we quote for a job we have never done before?

Every one of those needs a cost per unit, and the profit and loss account has none. It is arranged by nature of expense - wages, rent, power - and not by what the money was spent on.

Cost accounting rearranges the same expenditure so that each rupee is attached to a cost object: a product, a job, a batch, a process, a service.

Three words to fix now

Cost object. The thing whose cost is being ascertained. A shirt, a repair job, a kilometre run by a bus, a patient-day in a hospital.

Cost unit. The unit of quantity in which the cost is expressed. Per shirt, per job, per tonne-kilometre, per patient-day. Choosing it is the first decision in any service costing question.

Cost centre. A location, person or item of equipment against which costs are gathered before being charged onward. A department, a machine, a foreman.

What cost accounting is NOT

It is not a second set of books that contradicts the first. It uses the same expenditure. Where the two profits differ, the difference is explainable item by item, and reconciling them is a topic of this very module.

It is not only for factories. MU names the provision of services expressly in her third concept, and a hospital, a transport company and a college all have cost units.

It is not estimation. A cost sheet is built from recorded figures. Estimating comes later, and it rests on the same technique.

It is not statutory in the way financial accounting is. Nobody files a cost sheet with the Registrar. It is prepared because management needs it - which is why its form is flexible and its logic is not.

Where the Cost Accounting Standards fit

The Institute of Cost Accountants of India has issued 25 Cost Accounting Standards, CAS-1 to CAS-25. They standardise how particular costs are determined, so that two accountants given the same facts reach the same figure.

In one line

Cost is classified by function into four cumulative stages - prime cost, factory cost, cost of production and cost of sales - each adding the costs of one part of the business.

Why classify at all

The same rupee can be described in several ways. Wages are a labour cost by nature, a direct cost by traceability, a variable cost by behaviour, and a factory cost by function. None of those is more correct than the others; each answers a different question.

Classification by function is the one that builds the cost sheet, because it follows the product through the business: it is made, then administered, then sold.

CAS-1 Classification of Cost is the standard on this. Its requirement, stated in our own words, is that costs be classified consistently and on a stated basis, so that cost statements can be compared between periods and between entities. It sets out the bases - by nature, by traceability, by behaviour, by function - and the elements of cost.

The three elements, first

Before the functional stages there are three elements:

Each element splits into direct and indirect.

Direct means traceable to the cost object economically and without apportionment. Indirect means it must be shared out.

The four stages

Stage 1: Prime cost

Prime cost = Direct material + Direct labour + Direct expenses

All three direct elements, and nothing indirect. Prime cost is the part of the cost that could be traced to the unit without any judgement.

Stage 2: Factory cost

Factory cost = Prime cost + Factory overhead

Also called works cost. Factory overhead is the indirect material, indirect labour and indirect expenses of the factory - the foreman's salary, factory rent, power, depreciation of plant, consumable stores.

Two adjustments belong here and students forget them: the opening and closing work-in-progress, because a factory cost is the cost of what was completed, not of what was worked on.

Stage 3: Cost of production

Cost of production = Factory cost + Administration overhead

Office and administrative overhead: the accountant's salary, office rent, audit fee, printing and stationery.

The adjustment here is finished goods stock, which converts cost of production into cost of goods sold.

Stage 4: Cost of sales

Cost of sales = Cost of goods sold + Selling and distribution overhead

Advertisement, salesmen's salaries and commission, carriage outward, warehouse cost of finished goods, bad debts.

And then:

Profit = Sales - Cost of sales

The four stages as one table

In one line

Financial accounting reports the result of the whole business to outsiders under rules; cost accounting reports the cost of each thing to management, in whatever form is useful.

The points of difference

Eleven points is more than any answer needs. Six or seven, each with its reason, is a full answer; the rest are there so the reader can pick the ones a particular question invites.

The four differences that cause the reconciliation

Three rows of that table are the whole of the reconciliation topic, and it is worth seeing that now.

Stock valuation differs. Financial accounting takes the lower of cost and net realisable value; cost accounting takes cost on the chosen method. Where they differ, the two profits differ.

Abnormal items are excluded from cost. An abnormal loss of material, an abnormal idle time, a loss by fire: cost accounting leaves them out because including them would make the product look expensive for a reason that has nothing to do with making it. Financial accounting includes them because they really happened.

Purely financial items appear in one set of books only. Interest received, dividend received, profit on sale of an asset, donation paid, loss on sale of an investment. They are neither a cost of making anything nor a revenue from selling it, so cost accounting does not see them.

And overhead is absorbed in cost accounting at a rate, so the amount charged to production is rarely the amount actually incurred. The difference is the over- or under-absorption, and it is the fourth cause.

In one line

A cost sheet builds the cost of a period's output in four cumulative stages, adjusting raw material stock inside direct material, work-in-progress at factory cost, and finished goods after cost of production.

The format

Learn it downward. Each bold line is a stage, and each stage is the one above plus one block of cost.

The three stocks, and why each sits where it does

Raw material stock sits INSIDE direct material. What is wanted is the material consumed, and consumption is opening stock plus purchases less closing stock. It cannot go anywhere else, because raw material has not yet entered production.

Work-in-progress sits at FACTORY COST. Factory cost is the cost of production completed. Work begun and not finished must come out; work begun last period and finished this one must come in. It is adjusted after factory overhead because partly finished units have already absorbed some overhead.

Finished goods stock sits after COST OF PRODUCTION. It converts the cost of what was produced into the cost of what was sold. It cannot go earlier, because finished goods have borne administration overhead.

Carriage inward and carriage outward

Carriage inward is a cost of bringing material in, so it is part of direct material and goes in at the top.

Carriage outward is a cost of delivering to the customer, so it is selling and distribution overhead and goes in at the bottom.

They are eight lines apart and a question that gives both is testing exactly that.

Items that never enter a cost sheet

Purely financial items are excluded, and listing them is worth a mark:

• interest paid or received; dividend received;
• profit or loss on the sale of an asset or investment;
• income-tax; donations; charity;
• writing off goodwill, preliminary expenses or discount on shares;
• abnormal losses - abnormal wastage, loss by fire, abnormal idle time;
• appropriations of profit - transfer to reserve, dividend paid.

How this question is marked

One statement, worked downward, with every stage labelled. The four bold lines are worth marks in themselves.

Show the raw material build-up. Opening stock, purchases, carriage inward, closing stock, then the consumed figure. Writing the consumed figure alone earns the figure and not the method.

Say nothing about the financial items - but leave them out. A one-line note that they are excluded shows the marker it was a decision rather than an oversight.

The question

Vaibhav Industries gives the following for the year ended 31 March 2027.

Prepare a cost sheet.

Working note: raw material consumed

Working note: factory overhead

The cost sheet

Stage 1, prime cost.

Stage 2, factory cost.

Stage 3, cost of production.

Stage 4, cost of goods sold and cost of sales.

Stage 5, profit.

Note. Interest on the bank loan of Rs 74,000 and the abnormal loss of material by fire of Rs 55,000 are purely financial items and are excluded from the cost sheet. Both are charged in the financial accounts, and both will appear in the reconciliation.

In one line

A service has no stock and no work-in-progress, so its cost statement has no stage adjustments; the work is in choosing the cost unit and in splitting costs into fixed, variable and semi-variable.

Why the format changes

A manufacturer's cost sheet is shaped by three stocks. A service cannot be stored: a hotel room unsold last night is gone, a bus seat unfilled is gone.

So the three stock adjustments disappear, and with them most of the structure. What replaces it is a different question: cost per what?

CAS-4 covers the provision of services as well as the production of goods - its full title is the cost of production, acquisition or supply of goods or provision of services - and its requirement, in our own words, is that the cost statement disclose the elements of cost and the basis on which they were determined.

Choosing the cost unit

A simple unit counts one thing: per bed, per student, per call.

A composite unit multiplies two, because one alone would not compare like with like. A lorry carrying 2 tonnes for 100 kilometres and one carrying 10 tonnes for 20 kilometres both run 100 and 20 kilometres, but they do different amounts of work.

State the unit before computing anything. An answer that computes a total cost and divides by the wrong quantity has done all the work and lost the marks.

The three classes of cost

Depreciation can be either, and the question decides. Charged over the asset's life it is fixed; charged per kilometre run it is variable. Read which the question gives.

The format

Worked example

Konkan Carriers runs one lorry. In the year to 31 March 2027 it made 60 trips, each carrying 8 tonnes a distance of 250 kilometres out, returning empty. Costs for the year were: insurance and road tax Rs 84,000; driver's and cleaner's wages Rs 3,00,000; garage rent Rs 60,000; diesel Rs 5,40,000; tyres and lubricants Rs 96,000; repairs Rs 1,20,000; depreciation Rs 2,40,000, charged on a time basis. Compute the cost per tonne-kilometre.

In one line

The two profits differ because some items enter one set of books only, some are valued differently in each, and overhead is charged to cost at a rate rather than at what was actually spent.

Derive them, do not memorise them

The differences follow from the comparison already made. Cost accounting exists to find the cost of making something; financial accounting exists to report what happened to the business. So:

1. anything that happened to the business but not to the product is in the financial accounts only;
2. anything that is a cost of the product but not a transaction of the period is in the cost accounts only;
3. where both record the same thing but measure it differently, the profits differ by the measurement.

Those three sentences generate the whole list.

Group 1: in the financial accounts only

Incomes credited in financial accounts and not in cost accounts:

• interest received; dividend received; rent received
• profit on the sale of an asset or an investment
• transfer fees received

Expenses debited in financial accounts and not in cost accounts:

• interest paid on loans and debentures
• loss on the sale of an asset or an investment
• donations and charity
• income-tax
• goodwill, preliminary expenses, discount on issue of shares or debentures written off
• penalties and fines
• abnormal losses - loss by fire, abnormal wastage, abnormal idle time
• appropriations of profit - transfer to reserve, dividend paid

The test for this group: ask whether the item is part of the cost of making or selling the product. If not, it is here.

Group 2: in the cost accounts only

Items charged in cost accounts as a matter of cost technique, which the financial accounts do not record as an expense:

• notional rent on premises the firm owns
• notional interest on the proprietor's own capital
• notional salary of a proprietor who works in the business

They are charged so that the cost is comparable with a firm that rents its premises and borrows its capital. They are not transactions, so the financial accounts have nothing to record.

Group 3: valued differently in each

Stock. Financial accounting values stock at the lower of cost and net realisable value; cost accounting values it at cost on the method adopted. Raw material, work-in-progress and finished goods can each differ.

Depreciation. The cost accounts may charge it on a machine-hour or output basis; the financial accounts on a straight-line or written-down-value basis.

Group 4: overhead absorbed at a rate

This is the group most often got wrong, and the one MU's Course Outcome 4 points at.

Cost accounting cannot wait until the year end to know what overhead was. It charges production at a predetermined rate, fixed in advance from an estimate. At the end of the period the amount absorbed by production is compared with the amount actually incurred:

How this question is marked

State which profit you are starting from, in the heading. "Reconciliation statement showing profit as per cost accounts reconciled with profit as per financial accounts" is not decoration; it fixes the direction of every sign that follows.

Give each item its reason, not just its sign. "Interest on loan, charged in financial accounts only" earns more than "interest, less".

Two columns, additions and deductions, then one net figure. A single running column is hard to follow and easy to get wrong.

The question

The cost accounts of Ratnagiri Products show a profit of Rs 4,86,000 for the year ended 31 March 2027. The financial accounts show a different figure. On examination:

• interest received on investments, Rs 24,000, was not recorded in the cost accounts;
• dividend received, Rs 16,000, likewise;
• interest paid on a bank loan, Rs 74,000, appears in the financial accounts only;
• a donation of Rs 15,000 was paid;
• a loss of Rs 22,000 arose on the sale of old furniture;
• factory overhead was over-absorbed in the cost accounts by Rs 42,000;
• administration overhead was under-absorbed by Rs 29,000;
• opening stock of finished goods was valued Rs 18,000 higher in the cost accounts than in the financial accounts;
• closing stock of finished goods was valued Rs 30,000 higher in the cost accounts.

Prepare a reconciliation statement and ascertain the profit as per financial accounts. Then prepare the statement the other way round.

Sorting the items first

Sort before you compute. Every mark in this question is in the direction, and the arithmetic is trivial once the sorting is right.

Statement 1: from the cost profit to the financial profit

Additions.

Deductions.

The reconciliation.

How to use this chapter

Cover the answers. Work Question 1 downward with all four stages labelled, then carry its profit into Question 2.

Check the cost sheet before starting the reconciliation. Cost of sales plus profit must equal sales. If it does not, the error is above and Question 2 will compound it.

Question 1, cost sheet

Sahyadri Manufacturing gives the following for the year ended 31 March 2027.

Prepare a cost sheet showing prime cost, factory cost, cost of production, cost of goods sold, cost of sales and profit.

Question 2, reconciliation

Take the profit as per cost accounts from Question 1. On examination of the financial accounts for the same year:

• the dividend received of Rs 18,000 was not recorded in the cost accounts;
• factory overhead was over-absorbed in the cost accounts by Rs 26,000;
• income-tax of Rs 1,20,000 was paid;
• goodwill of Rs 40,000 was written off;
• closing stock of finished goods was valued Rs 22,000 higher in the cost accounts than in the financial accounts.

Prepare a reconciliation statement and ascertain the profit as per financial accounts.

Question 3, short answers

Answer each in one or two sentences.

(a) Where in a cost sheet is work-in-progress adjusted, and why there?

(b) A lorry carries a load 300 kilometres and returns empty. How many kilometres enter the tonne-kilometre computation?

(c) Overhead was over-absorbed by Rs 50,000. Starting from the cost profit, is it added or deducted?

(d) Name three items that appear in a cost sheet but never in a profit and loss account.

---

Answers

Question 1

Working note: raw material consumed.

Working note: factory overhead.

The cost sheet.

In one line

Material cost is the cost of the physical inputs, and it is controlled first because in most manufacturing it is the largest single element and the easiest to lose.

What is included

CAS-6 Material Cost is the standard on this. Its requirement, stated in our own words, is that material cost be determined at the cost of purchase, which includes the purchase price and every cost of bringing the material to its present location and condition, net of taxes and duties recoverable from the authorities.

So the cost of a material is built up like this:

Two lines decide most questions.

Trade discount is deducted; cash discount is not. A trade discount is a reduction in price; a cash discount is a reward for paying early, which is a financial matter.

Recoverable tax is not a cost. Where input tax credit can be claimed, the tax is recovered from the government and never falls on the product. Where it cannot, it does.

Why material is controlled first

It is usually the biggest element. In most manufacturing, material is a larger share of cost than labour or overhead, so a one per cent saving on material is worth more than a one per cent saving anywhere else.

It is physical, and therefore losable. Labour cannot be stolen, spoiled or allowed to rust. Material can, and every one of those is a real cost.

It ties up money. Stock is cash the business cannot use, and the whole of the next three chapters - order quantity, stock levels, control techniques - exists to answer one question: how little can we hold without stopping production?

Two opposite errors, and control sits between them:

Direct and indirect material

Direct material is traceable to the cost object economically: the timber in a table, the cloth in a shirt, the steel in a girder. It enters prime cost.

Indirect material cannot be so traced, or is too small to be worth tracing: glue, cleaning materials, lubricants, small tools. It enters factory overhead.

The line is economic, not physical. The nails in a wooden crate are physically in the product; if tracing them costs more than knowing their cost is worth, they are indirect.

In one line

Material moves through requisition, order, receipt, inspection and issue, and each step leaves a document whose purpose is that no one person can both authorise and record.

The cycle, document by document

The purchase requisition and the purchase order are different documents raised by different people, and that separation is the control. The storekeeper says what is needed; the purchase department decides from whom and at what price.

The three documents most often confused

Purchase requisition asks the purchase department to buy. Internal.

Purchase order instructs the supplier to supply. External, and a contract.

Material requisition asks the storekeeper to issue material already in stock. Internal, and it is the document that charges a job.

Bin card against stores ledger

Two records of the same thing, kept by two different people, is the point. If they disagree, something has gone wrong, and comparing them is a standard control.

Why the documents matter to a cost accountant

They are where the cost sheet's figures come from. The material requisition says which job to charge. The goods received note and the invoice say what the material cost. Without them the cost per unit is a guess.

And they are the audit trail. A cost that cannot be traced to a document cannot be defended.

In one line

Control is selective: ABC analysis concentrates effort on the few items that carry most of the value, and perpetual inventory keeps the records right without stopping the factory.

ABC analysis

The idea. In almost any store, a small number of items account for most of the money. Treating every item alike wastes effort on the trivial and starves the critical.

The proportions vary with the business and should not be quoted as fixed percentages. What is fixed is the shape: value is concentrated in few items.

The measure is annual VALUE, not price. An item costing a rupee, consumed a million times a year, is a class A item. An expensive item bought once is not.

Method, in four steps. Compute annual consumption value for each item; rank them descending; cumulate the value; draw the lines where the cumulative value justifies a change of treatment.

VED analysis

Classifies by criticality rather than value:

VED and ABC answer different questions and are used together. A cheap gasket may be class C by value and vital by criticality, and it is the combination that decides the stock held.

Perpetual and periodic inventory

Perpetual inventory is a system of records; continuous stock-taking is the physical verification that proves them. They go together and the phrase usually means both.

Why it matters more than it sounds. A discrepancy found in March, when the item was issued in June, cannot be investigated. Found in June, it can.

The other techniques named in practice

Two-bin system. Stock is kept in two bins; when the first empties, that is the signal to reorder, and the second carries production until delivery. Crude, cheap, and effective for class C items.

Just-in-time. Material arrives as it is needed, so stock approaches nothing. It lowers carrying cost to almost zero and raises the cost of any failure in supply, so it needs reliable suppliers and short, certain lead times.

Setting stock levels, which is the next chapter but one, and fixing the order quantity, which is the next chapter. Those two are the arithmetic of control; these are its policy.

In one line

The economic order quantity is the order size at which ordering cost and carrying cost are equal, and therefore the size at which their total is least.

Why there is a best size at all

Two costs pull in opposite directions.

Ordering cost is incurred each time an order is placed - the buyer's time, the paperwork, inspection, follow-up. Order more often and this rises.

Carrying cost is incurred on stock held - interest on the money locked up, storage, insurance, obsolescence, deterioration. Order larger quantities and average stock rises, so this rises.

Ordering in tiny quantities makes ordering cost enormous; ordering a year's supply at once makes carrying cost enormous. Somewhere between, their total is least, and that quantity is the EOQ.

The formula

EOQ = the square root of (2 multiplied by A multiplied by O, divided by C) where A = annual consumption in units O = ordering cost per order C = carrying cost per unit per year

C is the term that goes wrong. It must be per unit per year. Where the question gives carrying cost as a percentage of the unit price - say 20 per cent of Rs 25 - then C is Rs 5, and the percentage must be applied before the formula.

The assumptions, and why they are worth stating

The formula holds only if:

1. consumption is steady and known;
2. the ordering cost per order is constant, whatever the size;
3. the carrying cost per unit is constant;
4. the price per unit is constant, whatever the quantity; and
5. material is available whenever ordered.

Assumption 4 is the one a discount breaks, and that is the second worked example.

Worked example 1: the basic computation

A factory consumes 10,000 units of a material a year. Each order costs Rs 250 to place. Carrying cost is Rs 5 per unit per year. Compute the economic order quantity, the number of orders, and the total of ordering and carrying cost at that quantity.

The economic order quantity is the square root of 10,00,000, which is 1,000 units.

Average stock is half the order quantity. Stock runs from 1,000 down to nil and back, so on average 500 units are held.

In one line

Reorder level is when to order, minimum is the cushion below which stock should not fall, maximum is the ceiling above which it should not rise, and average is the middle.

Reorder level

Reorder level = Maximum consumption multiplied by Maximum reorder period

Why the maximums. The reorder level must hold out until the new delivery arrives even if everything goes wrong: consumption at its fastest and the supplier at his slowest. Using averages would leave the store empty half the time.

Reorder period, also called lead time, is the time between placing an order and receiving it.

Minimum level

Minimum level = Reorder level less (Normal consumption multiplied by Normal reorder period)

Why normal here. From the reorder level, in the ordinary course, the store will consume at the normal rate for the normal lead time and the delivery will arrive. Whatever is left at that moment is the buffer that exists for the abnormal case.

It is a safety stock, not a target. Falling below it is a signal that something has gone wrong.

Maximum level

Maximum level = Reorder level + Reorder quantity less (Minimum consumption multiplied by Minimum reorder period)

Why the minimums here. Stock is highest when an order arrives at the worst possible moment for stock: the delivery comes as early as it can and consumption in the meantime was as slow as it could be, so least was used from the reorder level before the whole order landed on top of it.

The reorder quantity is usually the EOQ, which is why the two topics are set together.

Average level

Average level = (Minimum level + Maximum level) divided by 2

or, equivalently in the simple case,

Average level = Minimum level + half the reorder quantity

Danger level

Danger level = Normal consumption multiplied by the maximum reorder period for emergency purchase

Below this, ordinary replenishment will not arrive in time and emergency action - buying locally, at a worse price - is required.

The four formulae side by side

Maximum, normal, minimum - in that order down the table. That is the pattern worth remembering, and each has a reason above.

Worked example

A material is consumed at a normal rate of 300 units a week, a minimum of 200 and a maximum of 400. The reorder period is 4 to 6 weeks. The reorder quantity is 2,400 units. Compute the reorder level, minimum level, maximum level and average level.

In one line

The same physical material can be priced out in different ways, and in a rising market FIFO charges the oldest, cheapest prices to production and leaves the newest, dearest in stock.

Why a method is needed at all

A store receives 200 units at Rs 20 and later 300 at Rs 25. Production draws 250. Which 250?

Physically it may not matter; the units are identical. But the cost charged to production, and therefore the profit, depends entirely on the answer. A method has to be chosen and applied consistently.

CAS-25 Valuation of Inventory is the standard on this. Its requirement, in our own words, is that inventory be valued by a method that is appropriate and applied consistently, and that the method used be disclosed, so that cost statements are comparable between periods.

First in, first out

The oldest stock is issued first. Issues take the earliest prices still unexhausted; the closing stock is made up of the most recent purchases.

In a falling market every one of those reverses.

Its strength is that closing stock is at prices close to current cost, so the balance sheet figure is realistic.

Its weakness is that production is charged with out-of-date prices, so a quotation based on that cost can be too low when prices are rising.

Weighted average

A new average is struck after every receipt, and issues are priced at that average until the next receipt changes it.

Weighted average rate = Total value in stock divided by Total units in stock

It smooths. Issues and closing stock both sit between the extremes, so neither profit nor the balance sheet swings with each purchase.

Recompute the average after every RECEIPT, not after every issue. An issue removes units and value in the same proportion, so it cannot change the rate. That is the single commonest error in working a stock ledger.

The comparison, as a table

One sentence to carry: in a rising market FIFO gives the lowest issue cost, the highest closing stock and the highest profit; weighted average sits between; and in a falling market it is the other way round.

How this question is marked

Three columns, each with quantity, rate and value: receipts, issues, balance. A ledger with only values cannot be followed.

Carry the balance forward on every line, including the lines where nothing happens to it.

Under weighted average, show the new rate on the receipt line. That is where it changes, and a marker looks for it.

Prove the ledger at the end. Opening plus receipts must equal issues plus closing stock. It is one line and it catches almost every arithmetic slip.

The question

The following relate to material X for April 2027.

Prepare the stock ledger under the first in first out method and under the weighted average method, and compare the results.

Method 1: first in first out

The 10 April issue of 250 units is priced in two parts: the whole of the opening 200 at Rs 20, then 50 from the 5 April lot at Rs 25. That is what first in first out means, and splitting the issue is the technique.

The 25 April issue likewise takes the remaining 250 at Rs 25 and 50 from the new lot at Rs 27.

Proof of the FIFO ledger.

Method 2: weighted average

The rate changes only on the two receipt lines. On 5 April, Rs 11,500 over 500 units is Rs 23.00. On 18 April, Rs 12,500 over 500 units is Rs 25.00.

The 10 April issue does not change the rate. It removes 250 units and Rs 5,750 of value, which is exactly Rs 23.00 a unit, so the balance stays at Rs 23.00. That is why the average is recomputed after receipts and never after issues.

In one line

Employee cost is the whole cost of employing people, not just the wage; direct expenses are the costs other than material and labour that can still be traced to a cost object.

What employee cost includes

It is not the take-home pay, and it is not even the gross wage. It is everything the employer spends because a person is employed.

CAS-7 Employee Cost is the standard on this. Its requirement, in our own words, is that employee cost be measured at the gross payments made to and on behalf of employees, including the employer's contributions and the benefits attributable to the period, net of recoveries from employees, with abnormal costs excluded and the basis of any allocation disclosed.

The principle to carry: the employer's cost, not the employee's receipt.

Direct and indirect employee cost

Direct labour is traceable to the cost object economically - the machinist on the job, the tailor on the garment. It enters prime cost.

Indirect labour cannot be so traced - the supervisor, the storekeeper, the sweeper, the maintenance fitter. It enters factory overhead.

The same person can be both in the same week: a fitter working on a job is direct for those hours and indirect for the hours he spends on general maintenance. The time booking records decide, which is why the next chapter is about them.

Direct expenses

Direct expenses are expenses other than material and labour which can be traced to a cost object. They complete prime cost, and they are the smallest of its three parts.

Examples that MU sets:

• royalty paid per unit produced;
• hire of a special plant or tool for one job;
• the cost of a special design, drawing or mould made for one order;
• fees paid to a consultant for a particular job;
• carriage on a special material bought for one order;
• cost of patents or licence fees relating to specific production.

CAS-10 Direct Expenses requires, in our own words, that direct expenses be determined at the invoice or agreed price net of recoverable taxes and discounts, identified with the cost object, with abnormal and non-recurring items excluded.

The test is traceability, not size. Royalty of a few paise a unit is a direct expense because it is traceable; factory rent of lakhs is not, because it is not.

In one line

Time keeping records that a worker was present; time booking records what he did while he was there; and the difference between the two is idle time.

Time keeping: recording attendance

Purpose. To know who was present and for how long, so that wages can be calculated, attendance-linked benefits given, and the discipline of the factory maintained.

Methods, from oldest to most usual:

The weakness column matters more than the list. Every method up to biometric identification is defeated by one worker answering for another, and that is the control problem time keeping exists to solve.

Time booking: recording what the time was spent on

Purpose. To charge the right job with the right hours, so that the cost per job is right and idle time is visible.

Documents:

The job card follows the job; the time sheet follows the worker. Both exist because a cost accountant needs to look at it from both ends.

Why both records are needed

Time keeping gives the hours to be PAID for. Time booking gives the hours to be CHARGED to jobs. They should agree, and where they do not, the difference is idle time and must be explained.

The reconciliation of the two is the control, and it is the reason the next chapter exists: a worker paid for eight hours and booked to jobs for seven has an hour that somebody must account for.

Payroll procedure

The payroll, or wages sheet, is prepared from those two records and runs:

1. gross wages - time or piece earnings, plus allowances, overtime and incentive earnings;
2. less deductions - provident fund, employees' state insurance, professional tax, income-tax deducted at source, advances, fines;
3. net wages payable;
4. plus the employer's own contributions, which are a cost though not a payment to the worker;
5. analysis of the total across jobs, departments and overhead, from the time booking records.

In one line

Idle time is time paid for but not worked; overtime is time worked beyond the statutory hours and paid for at twice the rate; and in both, the accounting question is who bears the extra.

Idle time

Idle time is the difference between the time a worker is paid for and the time booked to jobs. The attendance record gives the first figure and the time booking record the second, which is why the previous chapter had to come first.

Normal idle time

Inherent in the work and unavoidable, so it is treated as a cost of production:

• the time taken to walk from the gate to the workplace;
• setting up a machine, and cleaning it at the end of a shift;
• tea breaks and time for personal needs;
• normal waiting for instructions, tools or the next job;
• the fatigue that no employer can remove.

Treatment. Two methods are permitted, and both are correct:

1. Inflate the direct labour rate, so that the productive hours carry the idle hours; or
2. charge it to factory overhead as an item of indirect labour.

Abnormal idle time

Avoidable, and not inherent in the work, so it is excluded from cost altogether and charged to the Costing Profit and Loss Account:

• a machine breakdown or a power failure;
• a shortage of material caused by bad purchasing;
• a strike or a lock-out;
• a fire, a flood or an accident;
• want of orders, where the plant is kept idle for want of work.

The reason it is excluded is the reason it appears in a reconciliation. Costs must be comparable between periods, and an abnormal loss in one month would make that month's cost per unit meaningless.

Idle time worked

A worker is paid Rs 45 an hour. In a month he is present for 200 hours, of which 10 hours are normal idle time and 10 hours abnormal idle time caused by a power failure. Compute the wages, the amount charged to costing profit and loss, and the inflated hourly rate.

Inflated hourly rate = 8,550 divided by 180 productive hours = Rs 47.50 an hour.

Read the answer. The worker's rate is Rs 45, but each productive hour costs the factory Rs 47.50, because the normal idle hours have to be paid for out of the productive ones. The abnormal ten hours are not in that figure at all.

In one line

Labour turnover is the rate at which workers leave and are replaced, measured against the average number on the roll, and it is computed three ways that give three different answers.

Why it is measured

Because replacing a worker costs money that never appears as a line in the accounts. The cost is real and it is spread across selection, training, spoilage and lost output, and the turnover ratio is the only figure that makes it visible to management.

The three methods

Let S be separations in the period, R replacements, and A the average number of workers on the roll.

The average number on the roll is the opening number plus the closing number, divided by two.

A separation is not a replacement. A man who leaves a post that is then abolished is a separation and no replacement; a man engaged for a newly created post is neither, because he replaces nobody. New appointments for expansion are excluded from replacements, and that exclusion is the single most common error in the sum.

A fourth form is sometimes printed in which the flux is taken as separations plus accessions, accessions being replacements plus new recruits for expansion. Where a question gives new appointments separately, say which form you are using; the marker is looking for the treatment of the expansion figure, not for a particular total.

Worked example

On 1 April a factory had 900 workers on its roll and on 31 March 1,100. During the year 80 workers left of their own accord and 20 were discharged. 60 workers were engaged in place of those who went, and a further 240 were engaged for a new department. Compute labour turnover under all three methods.

Average number on the roll = (900 + 1,100) ÷ 2 = 1,000.

Separations = 80 + 20 = 100. A discharge is a separation as much as a resignation: the reason for leaving does not change the fact of leaving.

Replacements = 60. The 240 engaged for the new department are not replacements, because nobody left those posts. They are accessions for expansion, and excluding them is the single most common error in this sum.

Check the roll. Opening 900, less 100 separations, plus 60 replacements, plus 240 new appointments, gives 1,100, which is the closing number the question states. Do this check before computing anything: if the roll does not close, a figure has been read into the wrong class, and the usual culprit is a new appointment counted as a replacement.

In one line

Utilisation asks how much of the time paid for became productive time, and charging asks where each rupee of the payroll goes: to a job, to overhead, or out of cost altogether.

Utilisation of labour

The hours a factory pays for are not the hours it gets. The gap is measured by working down a short ladder, and each step is a different kind of loss.

Utilisation percentage = productive hours ÷ hours paid for × 100.

Why it is worth computing. A factory can raise output without engaging a single extra worker if it closes the gap, and the ratio tells management how large the prize is. A utilisation of 90 per cent on a payroll of 200 workers means twenty workers are being paid for nothing.

Direct and indirect labour

Direct labour is traceable to the cost object and enters prime cost. Indirect labour is not, and enters overhead.

The distinction is about traceability, not skill or grade. The chapter on employee cost made this point and it is worth the repetition, because MU's topic names both words in the same line: an apprentice working on a job is direct, and the works manager is indirect.

The same worker can be both in the same week. A fitter's hours on Job 214 are direct and his hours on general plant maintenance are indirect, and the time booking records are what splits him.

Charging labour cost: the Wages Control Account

Every rupee of the payroll enters one account and leaves it by one of four doors. That account is the Wages Control Account, and drawing it is the neatest possible answer to "how is labour cost charged".

Debited with: the gross wages of the period, plus the employer's contributions.

Credited with, and so charged to:

The account must close. If the four credits do not add back to the debit, an element of the payroll has not been placed, and that is the check a marker applies.

In one line

Every hour a worker is paid for must be identified with something - a work order, a batch, a capital job or a standing order - and what it is identified with decides where the money lands.

The four things an hour can be booked to

The standing order number is the one students have not met. A work order is opened for a piece of production and closed when it is finished; a standing order stands open all year to collect a class of indirect work, so that "machine cleaning" has a number to be booked against and does not disappear into an unexplained gap.

Work orders

A work order number is opened for each job or production order. The time booking document carries it, and the hours booked against it, priced at the worker's rate, become the direct labour of that job.

The control is arithmetical. For each worker, hours booked to all work orders plus hours booked to standing orders plus idle time must equal his attendance hours. Where they do not, the foreman is asked, and the difference is not allowed to settle silently into overhead.

Batches

Where identical units are produced together, the batch is the cost unit. Hours are booked to the batch number, and the cost per unit is the batch cost divided by the units in the batch.

Example. A batch of 500 identical brackets absorbs 120 direct labour hours at Rs 45 an hour, that is Rs 5,400, so the direct labour cost is Rs 10.80 a bracket.

Do not book hours to individual units in a batch. The clerical cost of it would exceed anything learnt, and that is the whole reason batch costing exists.

Capital jobs

A capital job is work the factory's own men do on the company's own asset - erecting a shed, installing a machine, building a jig that will last for years, fabricating plant for the company's own use.

Those hours are not a cost of the period's production. They are part of the cost of the asset, and are debited to the asset account and depreciated over its life.

AS 10 (Revised) Property, Plant and Equipment requires, in our own words, that the cost of an item of property, plant and equipment include the costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management, and it names employee benefits costs arising directly from the construction or acquisition among them. Own labour on a capital job is exactly such a cost.

In one line

Efficiency rating measures what a worker produced against what he was expected to produce, expressed as a percentage of standard hours to actual hours.

The formula

Efficiency percentage = standard hours for the actual output ÷ actual hours worked × 100.

The numerator is not the standard hours of the period. It is the standard time allowed for the work the man actually did. Getting this the wrong way round is the common error: a man who produces nothing in eight hours has an efficiency of zero, not of a hundred.

Where the standard comes from

Work study. A method study fixes the best way of doing the job, and a time study then measures how long that method takes for a qualified worker working at a normal pace, with allowances added for rest, personal needs and unavoidable delay. The result is the standard time, and it is the yardstick everything in this chapter is measured against.

A standard is a fact about the method, not about the man. If the method changes, the standard must be re-set, and a standard left unrevised after the machine was replaced will show everybody as brilliant.

Worked example

The standard time for a component is 10 hours. In a week of 40 hours a worker completes 5 components. Compute his efficiency.

A second worker completes 3 components in the same 40 hours.

Both men were paid for 40 hours. The first delivered 50 hours of work and the second 30, and no attendance record could have told management that.

Reading the rating

The last row is the one worth remembering. A rating is evidence about the standard as much as about the worker, and a scheme that pays bonus on a loose standard costs money for output that would have come anyway.

What efficiency rating is used for

• Incentive payment, which is the next chapter: nearly every premium scheme pays on the time saved, which is the same information in another form;
• promotion and increments, on evidence rather than impression;
• identifying training needs, worker by worker and department by department;
• revising standards, where a whole section moves together;
• fixing the labour hour rate, because a department that runs at 80 per cent efficiency needs more hours, and more wages, for the same output.

In one line

A remuneration system decides what a worker is paid for, time or output, and an incentive scheme pays him more for producing more while still guaranteeing him a wage.

The two basic systems

Time rate

Earnings = hours worked × rate per hour.

Its virtue is security and its vice is that it rewards presence, not production. Two men on the same rate earn the same whether one produces twice the other's output.

Piece rate

Earnings = units produced × rate per unit.

Its virtue is that it rewards output directly and its vice is that it does not guarantee a wage. A worker held up by a machine breakdown earns nothing, quality suffers when speed is paid for, and the material wasted in a hurry can cost more than the labour saved.

A guaranteed time rate is usually added so that a worker cannot earn less than his time wage, which removes the worst of the objection.

Incentive schemes on output

Taylor's differential piece rate. Two rates and no guaranteed wage: a low rate for output below standard and a high rate for output at or above it, applied to the whole output. The usual figures taught are 80 per cent of the ordinary piece rate below standard and 120 per cent at or above. It is severe, because a worker one unit short of standard loses on every unit he made.

Merrick's multiple piece rate. Three steps, and no penalty rate:

Gantt task and bonus. A time wage is guaranteed. Below standard the worker gets the time rate only; at standard he gets the time rate plus a bonus, usually 20 per cent; above standard he is paid at a high piece rate on his whole output.

Emerson's efficiency plan. A time wage is guaranteed. No bonus below about two-thirds efficiency; a bonus rising gradually to 20 per cent at 100 per cent efficiency; and above that, 20 per cent plus one per cent more for each one per cent of efficiency above the standard.

Premium bonus schemes: Halsey and Rowan

Both guarantee the time wage and both share the value of the time saved between the worker and the employer. That sharing is what makes them premium bonus schemes rather than piece rates, and it is why an employer will accept them: the labour cost a unit falls even while the worker earns more.

In one line

The labour cost statement carries the payroll from what the worker earns to what production is charged, adding the employer's own costs, taking out what is abnormal, and splitting what is left between jobs and overhead.

The order the statement must take

Steps 2 and 4 are what make this a cost statement rather than a wage sheet. A paymaster stops at step 1 and then deducts; a cost accountant adds at step 2, because the employer's contribution is his cost even though the worker never sees it.

One worker, including incentive

A worker is allowed 60 hours for a job and takes 45. His rate is Rs 40 an hour and he is on the Rowan scheme. He is paid a dearness allowance of Rs 450 for the period. Provident fund is 12 per cent of basic wages and dearness allowance, and the employer's share of state insurance is 3.25 per cent of gross wages. Compute the employee cost and the cost of an hour worked.

Time saved is 60 less 45, that is 15 hours. The Rowan bonus is the time wages multiplied by 15 ÷ 60, that is one quarter.

Cost of an hour worked = 3,057.75 ÷ 45 = Rs 67.95.

Read the two bases in the second table. Provident fund is on basic wages and dearness allowance, which is Rs 1,800 plus Rs 450; state insurance is on gross wages, which includes the bonus. Using one base for both is the error this example exists to prevent.

And read the last figure against the first. The man's rate is Rs 40 an hour and each hour he works costs the factory Rs 67.95, of which Rs 10 is bonus, Rs 10 is allowance and Rs 7.95 is the employer's own contributions.

A department, for a month

Prepare the labour cost statement of a machining department for a month from the following. Basic wages Rs 3,60,000. Dearness allowance Rs 90,000. Production incentive Rs 46,000. Overtime: Rs 12,000 at the ordinary rate and Rs 12,000 of premium, of which Rs 4,000 relates to a job the customer asked to be expedited and Rs 8,000 to general pressure of work. Employer's provident fund at 12 per cent of basic wages and dearness allowance; state insurance at 3.25 per cent of gross wages. Gratuity and leave attributable to the month Rs 20,000; canteen and welfare Rs 15,000. Abnormal idle time Rs 9,900. Direct labour charged to jobs is Rs 4,80,000, the balance being indirect labour and normal idle time. Productive hours in the month were 9,600.

How to use this chapter

Cover the answers. Work each question on paper, then compare. Where you differ, find the step rather than the figure: in these four questions the step is almost always one of four things - a new appointment counted as a replacement, a contribution taken on the wrong base, an issue priced before the receipt that preceded it, or a maximum usage put where a normal one belongs.

---

Question 1: Economic order quantity and stock levels

A company uses 24,000 units of a material a year, evenly over 48 working weeks. The cost of placing an order is Rs 150 and the cost of carrying one unit for a year is Rs 5.

Usage is normally 500 units a week, but has fallen to 300 and risen to 700. The supplier takes between 4 and 6 weeks to deliver, 5 weeks being normal.

You are required to compute (a) the economic order quantity, (b) the number of orders a year and the total of ordering and carrying cost at that quantity, and (c) the reorder level, minimum level, maximum level and average stock level.

---

Question 2: Stock ledger under two methods

The following are the receipts and issues of a material for January.

Prepare the stores ledger under (a) first in first out and (b) the weighted average method, and state the value of the closing stock under each. Comment on the difference.

---

Question 3: Labour turnover

A factory had 760 workers on its roll on 1 April and 840 on 31 March. During the year 48 workers left of their own accord and 16 were discharged. 40 workers were engaged in place of those who went, and 104 were engaged for a newly opened section.

Compute labour turnover by the separation, replacement and flux methods, and show the flux rate again on the basis that accessions include the new appointments. Verify your classification against the closing roll.

---

Question 4: Halsey and Rowan compared

The time allowed for a job is 40 hours and the worker completes it in 25. His rate is Rs 60 an hour.

Compute his earnings and his effective hourly rate under the Halsey scheme and under the Rowan scheme. State which scheme the employer would prefer here and give the general rule. If the job consisted of 10 identical units, state the labour cost a unit under each scheme.

---

Answers

Question 1

(a) Economic order quantity.

The formula is the square root of twice the annual consumption times the ordering cost, divided by the carrying cost a unit a year.

Why this chapter is here, and how to use it

MU's syllabus for this paper has two modules and neither is overheads. The examinable content of Cost Accounting - I is classification, the cost sheet, reconciliation, material cost and employee cost, and the twenty-six chapters before this one cover all of it.

But the past papers ask overheads in every sitting, because they were set on the older scheme in which this paper carried them, and MU's own Course Outcome 4 on the NEP page promises that the learner will design and justify overhead absorption rates. So this chapter exists, briefly, so that nothing an examiner has actually asked is missing from the book.

Read it last, and read it lightly. If your time is short, everything before this chapter matters more.

What an overhead is

An overhead is an indirect cost - indirect material, indirect labour and indirect expenses added together. It is a cost that cannot be traced economically to one cost object, and that is the whole of the definition.

The four steps, in order

Collection, allocation, apportionment, absorption. They are not synonyms, and a question that says "distribute" means one of them in particular.

Allocation is whole; apportionment is split. That distinction is worth a mark on its own and is asked as a distinguish-between.

Primary distribution is steps 2 and 3 together, over all departments including service departments. Secondary distribution then closes the service departments into the production departments.

Bases of apportionment

The basis must bear a relation to the cost. These are the ones MU's questions use.