CU-BCOM-SEM-III-Cost Accounting-Second Draft-converted

BACHELOR OF COMMERCE SEMESTER III COST ACCOUNTING BCM111

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:- 01133002345 For: CHANDIGARH UNIVERSITY 2 Institute of Distance and Online Learning CU IDOL SELF LEARNING MATERIAL (SLM)

First Published in 2021 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action. 3 CU IDOL SELF LEARNING MATERIAL (SLM)

CONTENTS Unit 1: Introduction...................................................................................................................5 Unit 2: Cost Concept................................................................................................................13 Unit 3: Installation Of Cost......................................................................................................20 Unit 4: Elements Of Cost.........................................................................................................27 Unit 5: Overhead Allocation And Apportionment...................................................................76 Unit 6: Unit Costing.................................................................................................................93 Unit 7: Reconciliation Of Cost And Financial Accounts.......................................................108 Unit 8: Operating Costing......................................................................................................118 Unit 9: Method Of Costing ....................................................................................................130 Unit 10 : Activity Based Costing ...........................................................................................149 Unit 11 : Target Costing ........................................................................................................159 Unit 12: Life Cycle Costing...................................................................................................171 4 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 1: INTRODUCTION Structure 1.0 Learning Objectives 1.1 Introduction 1.2 Objectives 1.3 Definitions 1.4 Advantages 1.5 Summary 1.6 Keywords 1.7 Learning Activity 1.8 Unit End Questions 1.9 References 1.0 LEARNING OBJECTIVES After studying this unit students will be able to: • Describe nature of cost accounting • Identify scope of cost accounting • Benefits of cost accounting • Outline the definitions in Cost Accounting • Analyze functions of Cost Accounting 1.1 INTRODUCTION With the rise of defense spending during World Wars I and II, the importance of cost accounting increased. Governments in many countries implemented cost plus contracts, in which the price was set at the cost of production plus a profit margin. The emergence of sophisticated product structures and the growth of cost accounting occurred between 1800 and 1925 A.D. Cost leadership is one of the strategic dimensions for achieving competitive dominance in the market, as we all know. To be more effective, cost leadership entails manufacturing products or providing services at a reduced cost while maintaining efficiency. If a company has a solid cost management scheme in place, it will produce the same results. We will address different facets of cost accounting and their uses in various production and service environments in this chapter. The popular misconception that Cost Accounting was established after the introduction of factory systems in England as a result of the Industrial Revolution is incorrect. And in the 5 CU IDOL SELF LEARNING MATERIAL (SLM)

fourteenth century, several cost accounting standards were in use. At the end of the nineteenth century, the modern cost accounting procedure was developed. Significant advancements in the area of cost accounting, on the other hand, were noted a quarter-century before the close of WWII. The scientific management revolution resulted in the introduction of uniform costing, a modern branch of cost accounting. After 1945, the need for data in future forecasting became apparent, and Cost Accounting grew further. Cost management is a new strategy that has just recently appeared. Cost Audit has now arisen as a sub-discipline that is rising. CHAPTER OVERVIEW Advantages Objectives of Definitions of cost cost accounting accounting Importance of cost Cost accounting Scope of Accounting - Cost Introduction accounting Role and Functions Fig 1.1 Cost Accounting 1.2 OBJECTIVES OF COST ACCOUNTING The main objectives of cost accounting are explained as follows: a) Ascertainment of cost: The primary goal of cost accounting is to accumulate and determine costs. For each cost object, both are done. There are two ways to figure out how much everything costs. Post costing refers to the examination of real data as reported in the financial books. It is specific and useful in Cost Plus contracts, where the final price is calculated based on real costs. Continuous costing: The cost of a job is determined as soon as it is finished or even when it is in progress. This is normally performed prior to the completion of a job or the creation of a product. It has the benefit of easily supplying expense information to management. 6 CU IDOL SELF LEARNING MATERIAL (SLM)

b) Determination of selling price: Benefit is the driving force behind businesses. As a result, sales must exceed spending in order to cover the cost of supplying the goods and services. Cost accounting includes the information used to determine the sale price. Though other external factors influence the sale price, cost accounting provides a foundation for setting the price. c) Cost control: One of the primary goals of a successful cost accounting system is to preserve budget control. It guarantees that expenditures are in line with predetermined requirements, with any deviations being identified and published on a regular basis. Following are few ways to keep expenses under control: • Establishing a predetermined quality • Assessing real output • Results comparison (actual vs. expected) • Variance analysis • Create a corrective action policy. d) Cost reduction: Cost reduction is a management technique in which the cost of an item is thought to be lowered further without compromising the product's quality. The three assumptions that go into defining cost reduction can be summarized as follows: • There is a cost savings per unit. • The preservation is of a permanent kind. • The products and/or services' utility and efficiency are unchanged, if not increased. e) Assisting the management in decision making: Cost accounting offers management knowledge and assists in the planning, execution, monitoring, and assessment of different operations. The cost accounting system not only provides information to internal managers, but it also assists external parties. Difference between Cost control and Cost reduction Cost Control Cost reduction It is about maintaining the costs in accordance Cost reduction is concerned with reducing with the established standards costs It aims to achieve the lowest cost under It recognizes no condition as permanent, since existing conditions any change will result in lower cost It analyses Past & present Cost reduction analyses present and future 7 CU IDOL SELF LEARNING MATERIAL (SLM)

Preventive function Corrective function Ends when targets are achieved It has no visible end 1.3 DEFINITIONS • Costing: It is a technique and process of ascertaining costs of product or services. The cost ascertainment is governed by the cost accounting principles and rules. • Cost Accounting: Cost Accounting is defined as classifying, recording and allocation of expenditure for the determination of the costs of products or services, and for the presentation of relevant data to the management in connection with the decision making. • Cost Accountancy: It is defined as “the application of Costing and Cost Accounting principles, methods and techniques to the science, art and practice of cost control and for ascertainment of profitability”. It includes presentation of information for the purposes of managerial decision making. • Cost analysis: It is the process of locating the factors responsible for difference in actual cost from the budgeted costs and fixing up of responsibility for differences in cost. It provides better cost management and helps in strategic decision making. • Cost Control: It is the process of regulating the action to keep the element of cost within the set parameters. • Cost Reports: This is the ultimate objective of Cost Accounting. The Cost reports are primarily prepared for use by the management at different levels. Such reports help in planning and control, performance appraisal and managerial decision making. • Cost Audit: It is concerned with verification of Cost accounts and check on the adherence to the Cost accounting plan. Its purpose is not only to ensure the arithmetic accuracy of cost records but also to ensure that the principles and rules have been applied correctly and consistently 1.4 ADVANTAGES OF COST ACCOUNTING Cost accounting has a number of benefits, which are summarized below. It is impractical to expect an organization to enjoy all of the benefits described here after installing a Cost Accounting system. The form, adequacy, and reliability of the cost accounting system installed, as well as the degree to which the various levels of management are willing to accept and act on the cost accounting system's guidance, will determine the quality and scope of the benefits obtained. 8 CU IDOL SELF LEARNING MATERIAL (SLM)

The following are some of the benefits of the Cost Accounting System: • A cost system identifies non-profitable operations, losses, and inefficiencies in any form, including: (a) Idle time and waste of manpower. (b) Material waste of any form and (c) Resource waste, such as excessive use of plant, equipment, and other services. • Cost accounting allows consumers to pinpoint the precise cause for a change in a company's benefit or loss. It defines the goods or product lines that are wasting money and yielding no returns, so they can be discontinued, or other steps taken. • Provides necessary data and information to management to aid in decision-making involving financial factors. • The use of cost accounting in determining the sale price is beneficial. Cost accounting acts as a guide to test the adequacy of sale prices, despite the fact that it is usually linked more to market economic conditions than to cost. • The optimal degree of productivity is determined using Standard Costing and Budgetary Control methods. • Cost comparison aids in cost management. Intra-firm or inter-firm comparisons are possible. A comparison can be made based on (1) work costs, (2) process costs, or (3) cost centres. • A cost structure gives the government, wage tribunals and commissions, as well as labour and trade unions, ready-to-use estimates. • If a company is not running at maximum capacity due to a number of factors such as a lack of demand or production bottlenecks, the cost of idle capacity can be easily measured and reported to management. • The implementation of a cost-cutting initiative, combined with operations research and value analysis, results in cost savings and, as a result, increased wealth for stakeholders. • Marginal costing is a valuable decision-making method for management. • Choosing cost centers or obligation centers to meet the needs of a Cost Accounting system means that the company's organizational structure has been adequately set out and that responsibility can be properly identified and assigned to individuals. • A successful inventory system is an important part of a cost system. 9 CU IDOL SELF LEARNING MATERIAL (SLM)

• The organization's cost audit system aids in the prevention and identification of fraud as well as the provision of accurate and reliable cost data to management and other stakeholders. 1.5 SUMMARY • Cost is the amount of money expended on, or due to, a particular event or operation (actual or notional). • Costing refers to the methods and procedures for determining costs. • Costing is beneficial to management, creditors, workers, and the economy as a whole. • Budgeting, standard costs, and real costs of procedures, systems, events, or goods, as well as variance analysis, profitability, and social utilization of funds, are all part of cost accounting. • Cost accounting standards include cost should be related to its cause; cost should be paid only after it has been incurred; and prudence should be disregarded. Anomalies should be removed from expense accounts; past expenses should not be charged to future periods; and double entry principles should be used wherever possible. 1.6 KEYWORDS • Cost Unit: Cost Unit is a unit of product or service in relation to which costs are ascertained. • Cost Reduction: The achievement of a real and lasting reduction in the unit cost of products produced or services provided without compromising their suitability for the intended use or lowering the product's quality is referred to as cost reduction. • Cost Object: Anything that requires a separate cost calculation is referred to as a Cost Item. A product, a service, a project, a customer, a brand category, an operation, a department, or a program, for example, is a cost item. • Cost Audit: The aim of a cost audit is to verify the accuracy of cost accounts and to ensure that the cost accounting plan is followed. Its aim is to ensure not only the arithmetical accuracy of cost records, but also that the principles and rules have been correctly applied. 1.7 LEARNING ACTIVITY 1. Determine the cost units of industries given below: Automobile, cement, Power, steel, transport, Hotel, education, Hospitals, Oil, Ore mining ___________________________________________________________________________ ___________________________________________________________________________ 2. List out cost objects for: 10 CU IDOL SELF LEARNING MATERIAL (SLM)

Products, services, project, activity, department, process. ___________________________________________________________________________ ___________________________________________________________________________ 1.8 UNIT END QUESTIONS QUESTIONS 11 A. Descriptive Questions: Short Questions 1. State the objectives of Cost Accounting. 2. Define Cost Accounting 3. Define cost audit 4. Advantages of Cost accounting 5. Difference between Cost control and Cost reduction Long Questions 1. Define is Cost Accounting and discuss its advantages in detail 2. Explain in detail the objectives of Cost Accounting 3. Discuss scope of Cost Accounting 4. Distinguish between Costing, Cost Accounting, Cost Accountancy 5. Discuss importance of cost Accounting in an organization B. Multiple Choice Questions 1. Cost is an essential component for Manufacturing Sector alone a. True b. False. c. Partly True d. cannot comment 2. Which of the following is applicable for Cost Control? a. It is related with the future b. It is a corrective function c. It ends when the targets are achieved d. It challenges the standards set 3. Purpose of Cost Audit is to check arithmetical accuracy of cost records CU IDOL SELF LEARNING MATERIAL (SLM)

a. True b. Partly True c. False d. cannot comment 4.________ helps in permanent reduction in Unit cost a. Cost control b. Cost reduction c. Cost Accounting d. None of these 5. Cost control helps in determining possibility of Cost reduction a. True b. False. c. Partly True d. cannot comment Answers 1-b,2-b,3-c,4-b,5-a 1.9 REFERENCES Textbooks: • T1 Introduction to Cost Accounting, Charles T. Horngren, PHI. • T2 Cost Accounting, Jawahar Lall & Seema Srivastava, TMH, 4th edition. Reference Books: • R1 Cost and Management Accounting, Arora M N, Vikas Publishing, 8thedition. • R2 Cost Accounting, S. N Maheshwari, S. Chand Publications. 12 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 2: COST CONCEPT Structure 2.0 Learning Objectives 2.1 Methods of costing 2.2 Techniques of costing 2.3 Summary 2.4 Keywords 2.5 Learning Activity 2.6 Unit End Questions 2.7 References 2.0 LEARNING OBJECTIVES After studying this unit students will be able to: • Describe Methods of cost accounting • Techniques of cost accounting • Analyze each method of Cost Accounting • Outline operating vs operation costing 2.1 METHODS OF COST ACCOUNTING There are 8 methods of costing accounting:- • Unit costing: Single or output costing is another name for this process. It refers to industries where units are similar, and output is continuous. The aim is to figure out both the overall cost and the cost per unit. A cost sheet is created to determine the cost per unit, taking into account inventory, Labour, and overhead costs. Mines, oil exploration units, cement works, brick works, and unit production cycles, as well as radios and washing machines, are examples of industries where unit costing is used. • Batch costing: It's comparable to work costing. A batch is a set of items that are all the same. The type and size of the units generated in a batch are consistent. As a result, each batch is accounted for separately as a cost unit. To assess the cost per unit, the total cost of a batch is determined and divided by the number of units in the batch. Batch costing is used in industries such as biscuit manufacturing, ready-made garment manufacturing, spare parts manufacturing, and pharmaceutical manufacturing. • Job costing: Specific-order costing is another name for it. It is adopted by industries in which there is no common product, and each job or work order is unique. The job is done strictly according to the customer's requirements, and it typically takes only a short period of time to complete. The aim of job costing is to figure out how much 13 CU IDOL SELF LEARNING MATERIAL (SLM)

each job costs separately. Printing presses, motor repair shops, vehicle garages, film studios, engineering industries, and other businesses use job costing. • Contract costing: Terminal costing is another name for it. This approach is exactly the same as work costing. However, it is used when a job can cost a lot of money and take a long time to complete. The job is done according to the customer's requirements. The aim of contract costing is to find out how much each contract costs separately. As a result, each contract has its own Contract account. This approach can be used by companies involved in shipbuilding, building construction, bridge construction, dam construction, and road construction. • Process costing: It's known as continuous costing. In certain industries, raw materials go through a series of steps before taking on the form of a finished product. To put it another way, the end result of one phase becomes the raw material for the next. At the end of each phase, a separate account is opened to calculate the overall cost as well as the cost per unit. Chemicals, textiles, paper, soap, and lather are examples of industries that use process costing. • Operating costing: Industries that provide services employ this system. Composite units such as passenger kilometers and tone kilometers are used to calculate the costs of such services. Operating costing, for example, reflects the cost of moving a passenger per kilometer in the case of a bus operator. Airlines, railways, road transport companies (both goods and passengers), hotels, cinema halls, power plants, and other businesses use operating costing. • Multiple costing: Composite costing is another name for it. It refers to a costing approach that incorporates two or more of the above approaches. It's used in industries where several parts are made separately and then put together to make a single product. • Operation costing: This is a more in-depth use of method costing. Per procedure must be costed separately. When mass production of a repetitive nature involving a number of operations is needed, this method is used. The main goal of this approach is to figure out how much each operation would cost. 2.2 TECHNIQUES OF COSTING The purpose of cost accounting is to compute the total cost of the production of goods or the cost of providing services. Various techniques of costing also help in cost control and cost reduction. A. Marginal Costing: • Marginal Costing is the ascertainment of marginal costs by differentiating between fixed costs and variable costs. • It is used to ascertain the effect of changes in volume or type of output on profit. 14 CU IDOL SELF LEARNING MATERIAL (SLM)

• Otherwise known as Direct Costing, Contributory Costing, Variable Costing, Comparative Costing, Differential Costing and Incremental Costing. B. Standard Costing and Variance analysis: • Standard costing is a technique where the comparison between actual costs and standard costs. • Standard Costs are useful for the cost estimation and price quotation and for indicating the suitable cost allowances for products, process and operations • They are effective tools for cost control only when compared with the actual costs of operation. • The standards costs are used for this comparison are pre-determined. Such standard costs of materials, labor and overheads are calculated with scientific and technical analysis. • They help in setting up benchmark for the whole industry. C. Budgetary Control: • Budgetary Control may be defined as the process of continuous comparison of actual costs and performance with the pre-established budgets in relation to the responsibilities of the executives to the specific budgets for the achievement of a target in accordance with the policy of the organization and to provide a basis for revision of budget. • Therefore, Budgetary Control involves mainly establishment of budgets, continuous compassion of actual with budgets for achievement of targets, revision of budgets in the light of changed circumstances. • The classification of budgets into various categories certainly helps to make the budgetary control more effective because the maximum use is made of the functional budgets. Functional Budgets over the goals to be attained by the functional executives and thus assume the greatest significance D. Uniform Costing: • Uniform Costing may be defined as the application and use of the same costing principles and procedures by different Organizations under the same management or on a common understanding between members of an association. • It is thus not a separate technique or method. • It simply denotes a situation in which a number of organizations may use the same costing principles in such a way as to produce costs which are of the maximum comparability. 15 CU IDOL SELF LEARNING MATERIAL (SLM)

• It consists of exchange of information, voluntarily of course, concerning production, sales cost with various types of break-up, prices, profits, etc., among the firms who are interested or willing to make the device a success. • The basic purposes of such comparison are to find out the work points in an organization and to improve the efficiency by taking appropriate measures to wipe out the weakness gradually over a period of time. E. Historical costing: • It is the ascertainment of costs after they have been incurred. • This type of costing has limited utility. • Two types of Historical costing, viz., Post costing and continuous costing. • Post costing: It means analysis of actual information as recorded in the financial books. It is accurate and useful in case of Cost plus contracts, where price is determined finally on the basis of actual costs. • Continuous costing: Cost is ascertained as soon as a job is completed or even when job is in process. This is usually done before a job is done or product is made. It has an advantage of providing cost information to the management promptly. F. Absorption costing: It is the practice of charging all costs, both variable and fixed to operations, processes or products .This differs from marginal costing where fixed costs are excluded. 2.3 SUMMARY • Costs were categorized based on time, nature or materials, degree of traceability to the product, connection with the product, changes in operation or volume, function, accounting duration, controllability, expenditure for analytical and decision-making purposes, and so on. • Costing techniques include historical or conventional costing, natural costing, marginal costing, standardized costing, direct costing, absorption costing, and activity-based costing. This section contains information on work costing, contract costing, batch costing, terminal costing, service costing, process costing, unit costing, organizational costing, multiple or hybrid costing, departmental costing, and other costing methods. 2.4 KEYWORDS • Cost Centre: Cost Centre is a location, function, or items of equipment in respect of which costs may be ascertained and related to cost units for control purposes. 16 CU IDOL SELF LEARNING MATERIAL (SLM)

• Cost Driver: Cost Driver is the factor influencing the level of cost, often used in the context of ABC to denote the factor which links activity resource consumption to produce outputs, for example, the number of purchase orders would be a cost driver for procurement cost 2.5 LEARNING ACTIVITY 1. What methods of costing would you apply in the following industries? State how cost should be ascertained in each case? (i) Building, (ii) Colliery, (iii) Soap works, (iv) Motor cars, (v) Radio sets, (vi) Ship building ___________________________________________________________________________ ___________________________________________________________________ 2.6 UNIT END QUESTIONS QUESTIONS A. Descriptive Questions Short Questions 1. Discuss methods of Cost accounting. 2. Define batch costing? 3. Discuss briefly on the following, indicating in which kinds of industries or undertakings, the different methods could be suitably applied: a. Single or output costing b. Process costing c. Operating Costing 4. Discuss about budgetary control. 5. Discuss, with reason in brief whether the following statements are true or false: (i) Cost Accounting is not needed by a non-profit organization such as a hospital. (ii) Notional costs and imputed costs mean the same thing. (iii) Rent on owned building is included in cost accounts (iv) Notional costs are not included while ascertaining costs. (v) Conversion costs and overheads are interchangeable terms. Answer: [True: (ii), (iii) only] 17 CU IDOL SELF LEARNING MATERIAL (SLM)

Long Questions 1. Discuss Techniques of costing in detail 2. Discuss methods of costing in detail 3. Discuss standard costing and variance Analysis 4. Distinguish between unit, job and batch costing with examples 5. Cost accounting assists: (a) in controlling efficiency; (b) in pricing products; and (c) in providing a basis for operating policy. Amplify these points, giving reasons for your views. B. Multiple choice questions: 1. Batch Costing is suitable for a. Sugar Industry b. Chemical Industry c. Pharma Industry d. Oil Industry 2. Depreciation is an example of a. Fixed Cost b. Variable Cos c. Semi Variable Cost d. None of these 3. Process costing method is suitable for: a. Steel industry b. Crane manufacturing organization c. Road roller manufacturing company d. Transport industry 4. Joint Cost is suitable for a. Infrastructure Industry b. Ornament Industry. c. Oil Industry d. Fertilizer Industry 5. Standard Cost is a pre-determined cost 18 CU IDOL SELF LEARNING MATERIAL (SLM)

a. True b. False c. Partly True d. None of these Answers 1-c 2-a 3-a 4-c 5-a 2.7 REFERENCES Textbooks: • T1 Introduction to Cost Accounting, Charles T. Horngren, PHI. • T2 Cost Accounting, Jawahar Lall & Seema Srivastava, TMH, 4th edition. Reference Books: • R1 Cost and Management Accounting, Arora M N, Vikas Publishing, 8thedition. • R2 Cost Accounting, S. N Maheshwari, S. Chand Publications. 19 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 3: INSTALLATION OF COST Structure 3.0 Learning Objectives 3.1 Installation of cost accounting system 3.2 Requisites of cost accounting system 3.3 Difference between Cost and Management accounting 3.4 Difference between Cost and Financial accounting 3.5 Summary 3.6 Keywords 3.7 Learning Activity 3.8 Unit End Questions 3.9 References 3.0 LEARNING OBJECTIVES After studying this unit students will be able to: • Describe Installation of cost accounting system • Analyze Requisites of cost accounting system • Outline Meaning of Cost, management, and financial accounting 3.1 INSTALLATION OF COST SYSTEM OR COST ACCOUNTING SYSTEM Until implementing a cost system, close consideration should be given to all of the factors involved, as otherwise the system would be unsuccessful, and the maximum benefits will not be realized. Until installing a cost method, consider the following factors: - • The type, process, and stages of development, the number of varieties and quantities of each product, and other technical factors should all be considered, as well as how complicated or simple the production processes are and how much control they have. • The factory's scale, structure, and organization should all be investigated. • The methods for purchasing, receiving, storing, and issuing materials should be reviewed and updated as required. • The methods of wage payment should be investigated. • It's necessary to bear in mind the management's needs and the cost-cutting strategy they've introduced. • The price of the machine to be built should be taken into account. It goes without saying that the system's installation and service should be cost-effective. 20 CU IDOL SELF LEARNING MATERIAL (SLM)

• The framework should be easy and straightforward to use. • If the method is acceptable and well-suited to the company, it can be run efficiently. • Original entry forms and documents should be structured to require the least amount of clerical work and cost. • The system should be configured in such a way that cost management can be implemented efficiently. • Appropriate procedures for reporting to different levels of management should be included in the framework. This should be based on exception-based standards. 3.2 REQUISITES OF A GOOD COST ACCOUNTING SYSTEM THERE ARE A FEW MAIN CHARACTERISTICS THAT A GOOD COST ACCOUNTING SYSTEM SHOULD HAVE. THESE CHARACTERISTICS WILL BE ADDRESSED FURTHER DOWN. • THE COST ACCOUNTING SYSTEM SHOULD BE TRANSPARENT AND EASY TO USE. IT SHOULD BE ABLE TO FULFIL THE ORGANIZATION'S REQUIREMENTS. • THE DATA AND INFORMATION USED BY THE COST ACCOUNTING SYSTEM SHOULD BE AUTHENTIC AND CORRECT ENOUGH TO PROVIDE ACCURATE REPORTING, ENABLING MANAGEMENT TO MAKE THE BEST DECISIONS POSSIBLE. • THERE IS A NEED FOR UNIFORMITY AND CONSISTENCY IN THE CLASSIFICATION, TREATMENT, AND REPORTING OF COST DATA AND INFORMATION SO THAT THE SYSTEM'S RESULTS CAN BE COMPARED. • THE COST ACCOUNTING SYSTEM SHOULD BE INTEGRATED WITH FINANCIAL ACCOUNTING, OPERATIONS RESEARCH, ESTIMATES, TAXES, AND OTHER SYSTEMS TO ENSURE THAT THE FINDINGS ARE CLEAR. • THE COST ACCOUNTING SYSTEM SHOULD BE FLEXIBLE ENOUGH TO ALLOW FOR REQUIRED REVISIONS AND ADJUSTMENTS IN ORDER TO ACCOMMODATE CHANGES IN TECHNOLOGICAL, REGULATORY, AND OTHER REQUIREMENTS. • THE INTRODUCTION OF A COST ACCOUNTING METHOD THAT ASSISTS MANAGEMENT IN MAKING STRATEGIC BUSINESS DECISIONS SHOULD SATISFY THE MANAGEMENT. 3.3 DIFFERENCE BETWEEN COST AND MANAGEMENT ACCOUNTING BASIS OF COST ACCOUNTING MANAGEMENT COMPARISON ACCOUNTING 21 CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning The recording, The accounting in which the classifying and both financial and non- Information summarizing of cost financial information are Type data of an provided to managers is Objective organization is known as Management known as cost Accounting. Scope accounting. Quantitative Quantitative and Qualitative. Specific Procedure Ascertainment of Providing information to Recording cost of production. managers to set goals and Planning forecast strategies. Interdependency Concerned with Impart and effect aspect of ascertainment, costs. allocation, distribution and No accounting aspects of cost. Yes Records past and It gives more stress on the present data analysis of future projections. Short range and long range planning Short range planning Cannot be installed without cost accounting. Can be installed without management accounting. 3.4 DIFFERENCE BETWEEN COST AND FINANCIAL ACCOUNTING BASIS OF COST ACCOUNTING FINANCIAL ACCOUNTING COMPARISON 22 CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning Cost Accounting is an Financial Accounting is an accounting system, accounting system that Information through which an captures the records of type organization keeps the financial information about track of various costs the business to show the Which type of incurred in the correct financial position of cost is used for business in production the company at a particular recording? activities. date. Users Records the information in Records the monetary terms. Valuation of information related to Stock material, labor and Only historical cost. Mandatory overhead, which are Time of used in the production Users of information reporting process provided by the financial Both historical and accounting are internal and 3.5 SUMMARY pre-determined cost external parties like creditors, shareholders, Information provided customers etc. by the cost accounting is used only by the Cost or Net Realizable internal management Value, whichever is less. of the organization like Yes for all firms. employees, directors, managers, supervisors Financial statements are etc. reported at the end of the At cost accounting period. No, except for manufacturing firms it is mandatory. Details provided by cost accounting are frequently prepared and reported to the management. 23 CU IDOL SELF LEARNING MATERIAL (SLM)

• There is a distinction between financial accounting, cost accounting, and management accounting. • Management accounting is a branch of accounting that deals with locating, presenting, and analyzing data for the following purposes: • Formulating strategy. • Organizing and coordinating activities. • Taking decisions. • Maximizing resource utilization. • Shareholders and those outside the company are informed. • Employees are informed. • Keeping assets secure. • Management accounting tools and strategies include: 1) Monetary preparation, 2) Financial statement analysis is a term that refers to the study of financial statements. 3) Costing at the margins, 4) Differential costing is a term used to describe how different costs are calculated. 5) Capital budgeting is a term used to describe the process of planning for future expenditures. 6) Cash flow analysis is a form of financial analysis that looks at how much money is coming in 7) Costing at a standard rate 8) Controlling the budget, 9) Linear programming techniques, 10) Statistical quality assurance, 11) Investment graph 12) Chart with sales and earnings, and so on. 3.6 KEYWORDS • Financial Accounting: Financial accounting is a specific branch of accounting involving a process of recording, summarizing, and reporting the myriad of transactions resulting from business operations over a period. • Management Accounting: Management accounting also is known as managerial accounting and can be defined as a process of providing financial information and resources to the managers in decision making. Management accounting is only used by the internal team of the organization, and this is the only thing which makes it different from financial accounting. 3.7 LEARNING ACTIVITY 24 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Determine the Cost drivers in the following segment of activities a. Audit Firm b. Credit control c. Customer care operator d. Content writers ___________________________________________________________________________ ___________________________________________________________________________ 3.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Financial Accounting? 2. What is Management Accounting? 3. Differentiate Cost Accounting and Management Accounting based on recording data 4. How does a good cost Accounting system help in cost reduction? 5. Differentiate cost and financial Accounting Long Questions 1. Difference between Cost and Management accounting 2. Describe the essentials that should be considered before you design such a system. 3. “Financial accounting treats costs very broadly while the cost accounting does this in much greater detail” Distinguish between financial and cost accounting. 4. Discuss requisites of a good cost Accounting System 5. Discuss about installation of Cost accounting System B. Multiple Choice Questions 1. HP petrol must maintain ________ wise cost Accounts. a. Unit wise b. Product wise c. Process wise d. None of these 2. Profit is the resultant of two varying factors _______________ and _______________. a. Sales cost b. Revenue , income c. Gain, Loss d. None of these 25 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Advertisement agency follows ________ costing and Suggestive unit of cost is ___________. a. Batch , No. of advertisements b. Operating , Units c. Job , Assignment d. None of these 4. Step(s) involved in cost control? a. Measure Actual performance b. Institute corrective action c. Measure adjusted performance d. Both A & B 5. Factor Influencing cost are called as a. Cost reduction b. Cost control c. Cost Driver d. Cost Accounting Answers 1-c 2-a 3-c 4-d 5-c 3.9 REFERENCES Textbooks: • T1 Introduction to Cost Accounting, Charles T. Horngren, PHI. • T2 Cost Accounting, Jawahar Lall & Seema Srivastava, TMH, 4th edition. Reference Books: • R1 Cost and Management Accounting, Arora M N, Vikas Publishing, 8thedition. • R2 Cost Accounting, S.N Maheshwari, S.Chand Publications 26 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 4: ELEMENTS OF COST Structure 4.0 Learning Objectives 4.1 Elements of cost 4.2 Classification of costing 4.3 Material 4.4 Labour 4.5 Overheads 4.6 Summary 4.7 Keywords 4.8 Learning Activity 4.9 Unit End Questions 4.10 References 4.0 LEARNING OBJECTIVES After studying this unit students will be able to: • Analyze Methods of cost accounting • Describe Classification of cost. • Outline concepts in Material, Labour, Overheads • Outline meaning of Cost • Analyze meaning of Overheads 4.1 ELEMENTS OF COST Meaning Cost: Cost is defined as the amount of expenditure (actual or notional) incurred on or attributable to a given thing or to ascertain the cost of a given thing. 27 CU IDOL SELF LEARNING MATERIAL (SLM)

Elements of cost Material Labour Expenses Fig 4.1 Elements of Cost Direct Material Cost Direct materials are those that can be easily detected in a product and measured and directly charged to it. As a result, these products are directly integrated into the product and become part of the final product. Direct materials are usually categorized as the following: (i) All raw materials, such as jute for gunny bags, pig iron for foundries, and fruits for the canning industry. (ii) Materials purchased specifically for a work, procedure, or order, such as glue for book binding or starch powder for yarn dressing. (iii) Bought or manufactured parts or components, such as transistor-radio batteries (iv) Basic packaging items, such as cartons, wrappings, and cardboard boxes. Indirect Material Cost The word \"indirect materials\" refers to materials that aren't normally found in the finished product. “Materials that cannot be distributed but can be apportioned to or consumed by cost centers or cost units,” according to the definition. There are the following: (i) Stores such as lubricants, cotton waste, bricks, and cements that are used in the maintenance of machinery, homes, and other structures. (ii) Stores used by service departments, i.e., non-productive departments such as Powerhouse, Boiler House, and Canteen, among others, and 28 CU IDOL SELF LEARNING MATERIAL (SLM)

(iii) Materials that are not deemed worthwhile to be treated as direct materials due to their low cost. Direct Labour / Employee Cost • The cost of employees can be attributed to a cost object in an economically feasible way. • In simple words, it is that labor which can be conveniently identified or attributed wholly to a particular job, product or process or expended in converting raw materials into finished goods. • Wages of such labor are known as direct wages. Indirect Labour/ Employee Cost • Indirect labor refers to the wages of that labor that cannot be directly traced to a cost item but can be apportioned to or consumed by cost centers or cost units. • Charge-hands and supervisors; repair workers; men working in service departments, inventory processing, and internal transportation; apprentices, trainees, and instructors; clerical staff and labour employed in time and security offices are examples of such labor. Direct or Chargeable Expenses • Direct expenses include all expenditures other than direct material or direct labor that are directly incurred for a particular product or process, and they include all expenditures related to the manufacturing of a product or rendering of a service that can be identified. As part of the prime cost, such charges are paid directly to the cost account in question. Examples of direct expenses are: (i) GST. (ii) Royalty. (iii) Architect or Supervisor’s fees. (iv) Cost of rectifying defective work. (v) Travelling expenses to the city. (vi) Experimental expenses of pilot projects. (vii) Expenses of designing or drawings of patterns or models. (viii) Repairs and maintenance of plant obtained on hire; and (ix) Hire of special equipment obtained for a contract. Overhead • Overheads are expenditures that are not clearly visible or allocable to a cost object, such as indirect supplies, indirect personnel costs, and indirect expenses. • Overheads are defined as the amount of indirect material, indirect labour, and other expenses, such as services, that cannot be charged directly to specific cost units; therefore, overheads are all expenses other than direct expenses. 29 CU IDOL SELF LEARNING MATERIAL (SLM)

• Overheads, in general, are all costs incurred by or in conjunction with the general organization of the entire or part of the undertaking, i.e., the cost of operating equipment and facilities used by the undertaking, as well as the cost of capital asset maintenance. Prime Cost • The aggregate of Direct Material, Direct Labour and Direct Expenses is called Prime Cost. • Generally, it constitutes 50% to 80% of the total cost of the product, as such, as it is primary to the cost of the product and called Prime Cost. Cost Object • Cost object is the technical name for a product or a service, a project, a department or any activity to which a cost relates. • Cost object is anything for which a separate measurement of cost is required • Establishing a relevant cost object is very crucial for a sound costing system. • The Cost object could be defined broadly • Cost object may be a Product, Service, customer, or a Brand category etc. Cost Driver • A Cost Driver is a factor or variable which effects the level of cost. • Generally, it is an activity which is responsible for cost incurrence. • Level of activity or volume of production is the examples of cost driver. Responsibility Centres: • To have a better control over the organization management delegates its responsibility and authorities to various departments or persons. • Such departments or persons are called as responsibility centers. • They are held responsible for performance in terms of expenditure, revenue, profitability. Cost Centre • CIMA defines a cost centre as “a location, a person, or an item of equipment (or a group of them) in or connected with an undertaking, in relation to which costs ascertained and used for the purpose of cost control”. • It is a part of the organization that does not produce direct profits and adds the cost of running a company. • Examples of cost centre: Research and development departments, marketing, help desk. 30 CU IDOL SELF LEARNING MATERIAL (SLM)

Cost centers are of two types: • Personal Cost Centre: A personal cost centre consists of person or group of persons. • Impersonal Cost Centre: An impersonal cost centre consists of a location or item of equipment or group of equipment. Revenue centers: These are responsibility centers which are accountable for generation of revenue for the entity. Profit centre: • These are the responsibility centers which have both responsibility of generation of revenue and incurrence of expenditures. • Since the managers of profit centers are accountable for revenue as well as expenditure as well. • Profitability is the basis for the measurement of performance of these responsibility centers. Investment centers: • These are the responsibility centers which are not only responsible for the profitability but also has the authority to make capital investment decisions. • The performance of these centers is measured on basis of Return of investment besides profit. 4.2 CLASSIFICATION OF COST Classification of cost is the arrangement of items of costs in logical groups having regard to their nature or purpose. The basis for cost classification is as follows: 31 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 4.2 Classification of cost As per Elements: MATERIAL is the substance from which the product is produced. It can be both direct and indirect. • It refers to products that are a big part of the final product and can be traced back to the units. (i) All products obtained expressly for a particular job/process are referred to as direct materials. (ii) All content obtained from stores and later requisitioned. (iii) Bought or manufactured components. (iv)The most important packaging materials. (v) The transfer of material from one phase to another. • Indirect material: Indirect materials are any materials that are used for purposes other than manufacturing and can be easily allocated to particular physical units. Oil, grease, consumable shops, printing and stationary materials are only a few examples. Labour: Labour cost can be classified into direct labor and indirect labor. • Direct labor: It is characterized as the wages paid to workers who are involved in the manufacturing process and whose time can be easily and affordably traced to product 32 CU IDOL SELF LEARNING MATERIAL (SLM)

units. Wages paid to compositors in a printing press, foundry workers in a cast iron works, and so on. • Indirect labor: Indirect labor is characterized as labor used to perform tasks that are not directly related to the products or services provided. It's impossible to connect it to unique output units. Wages of storekeepers, foremen, timekeepers, managers, and inspectors are some examples. Expenses: Expenses may be direct or indirect. • Direct expenses: These costs are correlated with a single cost unit and can be tracked back to it. Cost of a special layout, design, or sketches, hiring of a certain tool or piece of equipment for a work, fees charged to contractors in connection with a job, and so on are examples. • Indirect expenses: These are costs that cannot be assigned to a cost centre or cost unit in a straightforward, convenient, and complete manner. Leasing, rates and taxes, insurance, electricity, lighting and heating, depreciation, and so on are examples. As Per Function: A company performs a number of functions. Functional costs may be classified as follows: Manufacturing/production Costs: It is the expense of running an organization's manufacturing division. It includes direct supplies, direct labor, direct expenditures, packaging (primary) costs, and all other production-related overhead costs. Administration Costs: They are indirect and cover all expenses incurred in formulating policies, directing the company, and overseeing the activity of a business that are not connected to research, growth, manufacturing, delivery, or sale. Selling and Distribution Cost: The cost of attempting to build and stimulate demand, such as advertising, market analysis, and the cost of making reconditioned packages available for re-use, such as warehousing, cartage, and so on. The cost of shipping articles to and from potential buyers, as in the case of goods on sale or return, is often referred to as distribution cost. Research and Development Costs: They include the cost of discovering new ideas, process, products by experiment and implementing such results on a commercial basis Pre-production Cost: Certain costs are incurred when a new factory is built, or a new product is launched. Trial runs are available. Pre-production expenses are classified as deferred revenue expenditures and are handled as such. They are deducted from projected production costs. As Per Traceability: 33 CU IDOL SELF LEARNING MATERIAL (SLM)

Cost can be distinguished as direct and indirect. Direct Costs: Direct costs are those that can be easily traced back to a product, costing unit, cost centre, or particular operation, such as the cost of wood for furniture manufacturing. It's also referred to as traceable expense. Indirect Cost: It is difficult or impossible to attribute indirect costs to a single product. They are used in a variety of items, such as a factory manager's paycheck. It's also known as general costs. Direct costs may be assigned to a costing unit or cost centre directly. Indirect expenses, on the other hand, must be assigned to various goods. As per Nature or activity or volume: Costs can be classified as fixed, variable and semi-variable cost. Fixed Costs: The Chartered Institute of Management Accountants, London, defines fixed cost as “the cost which is incurred for a period, and which, within certain output and turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover)”. Examples are rent, property taxes, insurance, supervisors’ salaries etc. • Fixed cost can be classified into the following categories for the purpose of analysis: • Committed Costs: These costs are incurred to maintain certain facilities and cannot be quickly eliminated. The management has little or no discretion in this cost, e.g., rent, insurance etc. • Policy and Managed Costs: Policy costs are incurred for implementing particular management policies such as executive development, housing, etc. Such costs are often discretionary. Managed costs are incurred to ensure the operating existence of the company e.g., staff services. • Discretionary Costs: These are not related to the operations and can be controlled by the management. These costs result from special policy decisions, new researches etc., and can be eliminated or reduced to a desirable level at the discretion of the management. • Step Costs: Such costs are constant for a given level of output and the increase by a fixed amount at a higher level of output. Variable Cost: Direct materials and direct labour are examples of variable costs that differ directly and proportionately with production. It's important to note that while the variable cost per unit remains constant, the overall cost varies with production levels. 34 CU IDOL SELF LEARNING MATERIAL (SLM)

It is often mentioned in terms of units rather than time. The cost behavior patterns may be affected by management decisions. Variability is a relative term. Semi-fixed (Semi-Variable) costs: These costs are made up of both fixed and variable costs. They fluctuate with volume due to the variable element, and they do not shift in direct proportion to output due to the fixed element. Costs that are semi-variable change in the same direction as output, but not in the same proportion. Depreciation is an example; the overall depreciation for two shifts working could be just 50% higher than for a single shift working. They can adjust in response to relatively minor changes in production, but not in the same way. As per Time: Historical Costs: These costs are ascertained after they are incurred. Such costs are available only when the production of a particular thing has already been done. They are objective in nature and can be verified with reference to actual operations. Pre-determined Costs: These costs are calculated before they are incurred on the basis of a specification of all factors affecting cost. Such costs may be: Estimated costs: Costs are estimated before goods are produced; these are naturally less accurate than standards. Standard costs: This is a particular concept and technique. This method involves: (a) setting up predetermined standards for each element of cost and each product; (b) comparison of actual with standard to find variation; (c) pin-pointing the causes of such variances and taking remedial action. Payment Based This is classified into two types: Explicit and Implicit cost Explicit cost: These costs are known as out-of-pocket cost and refer to cost involving immediate payment of cash. Examples: salaries, wages, postage, stationery, interest on loan etc. Implicit cost: These costs do not involve any immediate cash payment. These are not recorded in the books of accounts. Otherwise known as economic costs. Example: Depreciation 35 CU IDOL SELF LEARNING MATERIAL (SLM)

As per decision making Opportunity Costs: Opportunity cost is the cost of selecting one course of action and the losing of other opportunities to carry out that course of action. It is the amount that can be received if the asset is utilized in its next best alternative. Example: Capital is invested in plant and machinery. It cannot be now invested in shares or debentures. The loss of interest and dividend that would be earned is the opportunity cost. Opportunity costs are not recorded in the books. It is important in decision making and comparing alternatives. Sunk Costs: A sunk cost is one that has already been incurred and cannot be avoided by decisions taken in the future. As it refers to past costs, it is called unavoidable cost. This cost is not useful for decision making as all past costs are irrelevant. SUNK COST = PURCHASE PRICE OF AN ASSET – SALVAGE VALUE Differential Cost: Differential cost has been defined as “the difference in total cost between alternatives, calculated to assist decision making”. Differential cost is the increase or decrease in total costs resulting out of: • Producing and distributing a few more or few less of products. • A change in the method of production/distribution. • An addition or deletion of a product or a territory; and • The selection of an additional sales channel. Joint Costs: When a single raw material is processed, it produces two or more separate items at the same time. When a stage of development known as the split-off point is reached, the joint products are not distinguishable as separate types of product. The costs incurred up to the point of separation are referred to as joint costs. One product may be of significant importance while others, known as by-products, are of minor importance. Common Costs: Common costs are those costs which are incurred for more than one product, job, territory or any other specific costing object. They are not easily related with individual products and hence are generally apportioned. Example: Rent of the factory is a common cost to all departments located in factory. Imputed Costs: Common costs are those costs which are incurred for more than one product, job, territory or any other specific costing object. They are not easily related with individual products and hence are generally apportioned. Example: Rent of the factory is a common cost to all departments located in factory. 36 CU IDOL SELF LEARNING MATERIAL (SLM)

Uniform Costs: As such, they are not distinct costs. Uniform costing refers to a collection of costing standards and procedures used by a group of businesses. They're useful for comparing companies. Replacement Costs: As such, they are not distinct costs. Uniform costing refers to a collection of costing standards and procedures used by a group of businesses. They're useful for comparing companies. As per Normality Avoidable Costs: Avoidable costs are those costs which under the present conditions need not have been incurred. Example: Spoilage in excess of normal limit; Unavoidable Costs: Unavoidable costs are those costs which under the present conditions must be incurred. As per Controllability Cost can be Controllable and Non-Controllable. Controllable Cost: The Chartered Institute of Management Accountants defines controllable cost as “cost which can be influenced by its budget holder”. Non-Controllable Cost: It is the cost which is not subject to control at any level of managerial supervision. 4.3 MATERIAL Inventory Control (Material Control) Inventory management is the systematic control and regulation of material purchases, storage, and use in order to ensure an even flow of output while preventing unnecessary material expenditure. Material management that is effective eliminates material shortages and wastages that would otherwise go unnoticed. Objectives of Inventory Control: • To ensure a continuous flow of necessary materials, parts, and components for a smooth and efficient production process. • Reduce inventory expenditure while keeping organizational needs in mind. • To allow for efficient material storage in order to protect inventories from fire and theft while reducing handling time and expense. 37 CU IDOL SELF LEARNING MATERIAL (SLM)

• To keep the amount of excess and obsolete products to a bare minimum. Techniques of Inventory Control: • Min-max Plan • The Two-bin System • Order Cycling System • ABC Analysis • Fixation of various levels • Use of Perpetual Inventory System and Continuous Verifications • Use of Control Ratios • Review of Slow and Non-moving Items. Min-Max Plan • It is one of the oldest methods of material control. • Under this plan the analyst lays down a maximum and minimum for each stock item keeping in view its usage, requirements and margin of safety required to minimize risks of stock-outs. • The minimum level establishes the reorder point and order is placed for that quantity of material which will bring it to the maximum level. • The method is very simple and based upon the premise that minimum and maximum quantity limits for different items can fairly be well defined and established. The Two-Bin System • The basic procedure used under this system is that for each item of stock, two piles, bundles, or bins are maintained. • The first bin stocks that quantity of material which is sufficient to meet its usage during the period that elapses between receipt of an order and the placing of the next order. • The second bin contains the safety stock and also the normal amount used from order to delivery date. • The moment stock contained in the first bin is exhausted and the second bin is tapped, a requisition for new supply is prepared and submitted to the purchasing department. Since no bin-tag (quantity record of materials) card is maintained, there is absence of perpetual material record under this bin. ORDER CYCLING SYSTEM • In the order cycling system, quantities in hand of each item or class of stock is reviewed periodically say, 30, 60 or 90 days. 38 CU IDOL SELF LEARNING MATERIAL (SLM)

• If in the course of a scheduled periodic review it is observed that the stock level of a given item will not be sufficient till the next scheduled review keeping in view its probable rate of depletion, an order is placed to replenish its supply. • Review period will vary from firm to firm and also among different materials in the same firm. • Critical items of stock usually require a short review cycle. Order for replenishing a given stock item, is placed to bring it to some desired level which is often expressed in relation to number of day’s or week’s supply. ABC Analysis • ABC plan is based upon segregation of materials for selection control. It measures the money value, i.e., cost significance of each material item in relation to total cost and material value. • The logic behind this kind of analysis is that the management should study each item of stock in terms of its usage, lead time, technical or other problems and its relative money value in the total investment in inventories. • Critical, i.e., high value items deserve very close attention, and low value items need to be devoted minimum expense and effort in the task of controlling inventories. • If it is convenient different items may be classified into only three categories and labeled as A, B, and C respectively depending upon whether they are high value items, middle value items or low value items. Fixation of Various Levels • Fixation of Norms of Inventory Holdings • The fixation of inventory levels is also known as the demand and supply method of inventory control. • Generally, the Organization fixes following stock levels: Maximum Level: This represents the minimum quantity above which stocks should not be held at any time. Maximum stock level = Re-order level + Re-ordering quantity – (Minimum consumption x Minimum re-order period). Minimum Level: This represents the minimum quantity of stock that should be held at all times. 39 CU IDOL SELF LEARNING MATERIAL (SLM)

Minimum level = Re-order level - (Normal consumption x Normal re-order period). Danger Level: Normal issues of stock are usually stopped at this level and made only under specific instructions. Safety stock level = Ordering level – (Average rate of consumption × Re-order period) OR (Maximum rate of consumption - Average rate of consumption) × Lead time Ordering Level: It is the level at which indents should be placed for replenishing stocks. Ordering level = Minimum level + Consumption during time lag period OR Maximum consumption x Maximum re-order period. OR Maximum consumption x Lead time + Safety Stock The ordering level is calculated from the following factors: (a) The expected usage (b) The minimum level (c) The lead time. Illustration: Materials X and Y are used as follows: Minimum usage − 50 units each per week Maximum usage − 150 units each per week Normal usage − 100 units each per week Ordering quantities X = 600 units Y = 1,000 units Delivery period X = 4 − 6 weeks Y = 2 − 4 weeks Calculate for each material (i) Maximum level (ii) Minimum level and (iii) Ordering level. Solution: Material X Ordering level = Maximum usage x Maximum delivery period =150 x 6 = 900 units. Minimum level = Ordering level - (Normal usage x Normal delivery period) = 900 − (100 x 5) = 400 units Maximum level = (Ordering level + Ordering quantity) − (Minimum usage x Minimum delivery period) = 900 + 600 − (50 x 4) = 1,500 – 200 = 1,300 units. 40 CU IDOL SELF LEARNING MATERIAL (SLM)

Material Y Ordering level = Maximum usage x Maximum delivery period = 150 x 4 = 600 units Minimum Level = Ordering level − (Normal usage x Normal delivery period) = 600 − (100 x 3) = 300 units. Maximum Level = (Ordinary level + Ordering quantity) - (Minimum usage x Minimum delivery period) = 600 + 1,000 − (50 x 2) = 1,600 − 100 = 1,500 units. Normal delivery period has been computed as follows: Material X= 4+6 = 5 weeks 2 Material Y= 2+4 = 3 weeks 2 Ordering Quantity: The optimum ordering quantity, i.e., the quantity for which the cost of holding plus the cost of purchasing is the minimum is known as Economic ordering Quantity and is calculated by the following formula: EOQ = √2CO I When the quantity of materials ordered is less, the cost of carrying will decrease but ordering cost will increase and vice versa. Illustration: Find out the economic ordering quantity (EOQ) from the following particulars. Annual usage: 6000 units Cost of material per unit: Rs. 20 Cost of Placing and receiving one order: Rs.60 Annual carrying cost of one unit: 10% of inventory value Solution: EOQ = √2CO I Where C = Annual usage of material i.e., 6,000 units. O = Cost of placing one order i.e., Rs.60 I = Annual carrying cost of one unit i.e., Rs.20 x 10= Rs.2 EOQ =√2∗6000∗60 =√360000 = 600 Units. 2 41 CU IDOL SELF LEARNING MATERIAL (SLM)

Perpetual inventory system and continuous stock verification: • The perpetual inventory system is intended as an aid to material control. It is a system of stock control followed by stores department. • The system follows a method of recording stores by which information about each receipt, issue and current balance of stock is always available. • \"Perpetual inventory system is a method of recordings stores balances after every receipt and issue, to facilitate regular checking and obviate closing down of work for stock-taking.\" • Perpetual inventory system comprises of: Comparison of Bin Cards (quantitative perpetual inventory) and Stores Ledger Accounts (quantitative-cum-valued perpetual inventory), Continuous Stock-Taking (Physical perpetual inventory) Bin Card: • A bin card is a quantitative record of receipts, issues and closing balances of items of stores. • Each item is accompanied by a separate bin card. • The bin card is posted as and when a transaction takes place. • Only after the transaction is recorded, the items are received/issued. • On receipt of materials, the quantity is entered in the bin card from the goods received note in the receipt column and the issues to various departments in the issue column. • The balance quantity is calculated and recorded. BIN CARD Code No.: Level of Stock: Description: Maximum: Unit of Quantity: Minimum: Location Code: Danger: Ordering: Ordering Qty: Date Doc. No. Receipts Issues Balance On Order Reserved 42 CU IDOL SELF LEARNING MATERIAL (SLM)

Stores Ledger • The store ledger is maintained to record all receipt and issue transactions in respect of materials. • The quantities and the values are entered in the receipts, issues and balance columns. Additional information regarding quantity on order and quantity reserved may be recorded. • Separate sheets for each item or continuous stores ledger may be maintained. • The sheets should be serially numbered to obviate the risk of removal or loss. STORES LEDGER Code No.: Level of Stock: Supplier’s Name: Description: Maximum: Unit of Quantity: Minimum: Location Code: Danger: Ordering: Ordering Qty: Date Receipts Issues Balance On Order Reserved Qty Rate Value Qty Rate Value Qty Rate Value P.O. Qty G.R. Qty No No. Difference between Bin Card and Stores Ledger Bin Card Stores Ledger 1) It is a quantity record • It is a record of quantity and value. 2) It is kept inside the stores • It is kept outside the stores. 3) It is maintained by the storekeeper • It is maintained by the accounts department 4) The postings are done before the • The postings are done after the transactions transactions take place. 5) Each transaction is individually • Transactions may be posted periodically and posted in total. 43 CU IDOL SELF LEARNING MATERIAL (SLM)

Use of Control ratio: Inventory turnover ratio: It helps management to avoid capital being locked up unnecessarily. This ratio reveals the efficiency of stockkeeping. Inventory turnover ratio is given by the formula∶ Review of slow and non-moving items: • The money locked up in inventory is money lost to the business. • If more money is locked up, lesser is the amount available for working capital and the cost of carrying inventory also increases. • Stock turnover ratio should be as high as possible. • Loss due to obsolescence should be eliminated or these items used in some profitable work. • Slow moving stocks should be identified and speedily disposed of. • The speed of movement should be increased. • Materials become useless or obsolete due to changes in product, process, design or method of production, slow moving stocks have a low turnover ratio. 44 CU IDOL SELF LEARNING MATERIAL (SLM)

• Capital is locked up and cost of carrying have to be incurred. • Hence management should take effective steps to minimize losses. Methods of Purchasing Purchasing can be broadly classified as centralized and localized purchasing Centralized Purchasing: In a large organization, manufacturing units are many. In such cases centralized purchasing is beneficial. The advantages of centralized purchasing are: • Expert and specialized expertise is available. • Bulk sales have advantages. • Purchase costs can be decreased, and the sale price can be reduced. • Since market dynamics are well known, further power can be exercised. • It is beneficial to centralize purchasing when goods must be imported. • Convenience and economy in compiling and analyzing data. • It can profit from market fluctuations. • Inventory investment may be minimized. • Other benefits include complete accountability and clear purchasing practices. • Considerations to consider when deciding on centralization include geographical separation of plants, homogeneity of goods, type of material purchased, supply location, and so on. Decentralization of Purchases: The advantages of localized purchasing or decentralization of purchases are:- • Each plant can have its own unique requirements. • Direct communication with suppliers can be created, and this can be given special attention. • There is a way to shorten the time between indenting and receiving products. • Each plant's technical specifications can be determined. Purchase Procedure: The steps usually followed for purchase of materials may be enumerated as follows: Indenting for materials: The stores department plans and sends indents to the purchase department for the purchase of products for stock replenishment (regular indents) or a particular job (special indents). Regular indents are prepared on a regular basis and positioned when the ordering stage for various stock products is reached. The ordered quantity for each 45 CU IDOL SELF LEARNING MATERIAL (SLM)

object is equal to the quantity indented. The special indents are focused on requests from the planning or production departments, respectively. Issue of tenders to suppliers: Tenders are sent to vendors or published in newspapers by the purchasing department. The suppliers give their price and delivery/payment terms. The tenders are opened and a comparative statement is prepared after the deadline for quotations has expired. Tenders are rendered in three copies. Two of them are sent to vendors, and one is held by the purchasing department. In the original, the supplier specifies his terms. Placing of purchase orders: Normally, a buying order is duplicated six times. One copy is sent to the retailer, warehouses, inspection department, store accounting unit, purchase department, and progress department. The purchasing order is essential from a legal and accounting standpoint. From a legal standpoint, it binds all parties to the contract's terms. From an accounting standpoint, it denotes the sum that must be expended. It means that the items will be approved by the stores department, and the bill will be accepted by the accounts department. Inspection: The supplier delivers the products to the specified venue. The retailer prepares two delivery challans, one of which is returned. It's a delivery confirmation. The inspection department, development department, or repair department (as the case may be) is notified after receiving the products. The inspector verifies that the materials meet the requisite quality, norm, and tolerances, among other things. After the inspection, a triplicate inspection report is prepared and sent to the retailer, the shops, and the inspection department. Receiving Stores: For the quantity of stock approved in inspection, the stores department prepares a Stores Receipt Note. The Storekeeper is in charge of the stocks after issuing the Stores Receipt. The stores receipt is the paper used to enter receipts into the Bin Card and Stores Ledger. It is prepared in quadruplicate and sent to the supplier, as well as the accounting and purchasing departments of the stores, with one copy remaining with the stores. This copy is enclosed with the supplier's bill. The accounting division of the store compares the note to the sales order. Checking and passing of bills for payment: Bills issued by the purchasing department are sent to the accounting department of the store for verification of quantity, price, and arithmetical accuracy. Special items on the bills, such as freight and packaging costs, are checked against the purchase order. Later, the bill is passed for payment. Storekeeping: Store keeping is a service function. The storekeeper is a custodian of all the items kept in the store. The stores should be maintained properly, and cost minimized. The main objectives of store keeping are:- • To protect stores against losses 46 CU IDOL SELF LEARNING MATERIAL (SLM)

• To keep goods ready for delivery/issue • To provide maximum service at minimum cost. The duties and functions of Storekeeper can be summarized as follows: • Materials should be received, unloaded, inspected, and then transferred to the appropriate storage location. The supplies must be kept in appropriate locations, and receipts must be registered in appropriate books. • Stores documents should be kept in an effective and organized manner so that materials can be found quickly and information for different departments can be collected. • The stores should have maximum security, safety, and accessibility by using the least amount of space possible. It is essential to mount suitable storage devices. • To avoid harm from ambient conditions, the components should be given a special coating. • All issues should be adequately documented in a timely, reliable, and accurate manner. All issues should be properly approved, and all protocols should be followed. • The storekeeper is in charge of coordinating materials control according to the form of production, company size, organizational structure, and so on. • Ensure that all transactions are registered in the Bin Card and that it is valid. • Anything must be in its proper location. • Holding store levels at the appropriate levels. • Shops that are safe to make physical inspection easier. • Managing and supervising employees in the stores department. • A periodic analysis of various scales, measuring devices, conversion ratios, and other related items is needed. • Flames, rust, erosion, dust, robbery, weather, heat, cold, moisture, and degradation, to name a few. Issue of materials: Materials issued from stores are debited to the jobs or work orders which received them and credited to the materials account. These jobs are debited with the value of materials issued to them There are many methods of pricing material issues. The most important being: • FIFO, 47 CU IDOL SELF LEARNING MATERIAL (SLM)

• LIFO, • simple and weighed average methods. First in First Out (FIFO): • In this process, merchandise is issued first from the oldest consignment on hand, and it is priced at the cost at which it was placed in stores. To put it another way, materials that are obtained first are published first. The units in the opening stock of materials are considered as if they would be issued first, followed by the units from the first purchase, and so on, until the units in the closing stock of materials are priced at the most recent cost of purchases. • This approach is best used when costs are dropping because the cost of issuing materials to jobs or work orders is high while the cost of replacing materials is low. • However, in the event of rising prices, this approach will be ineffective since the issue price of production materials will be low, whereas the cost of substitute materials will be high. The following example will illustrate how issues of materials are valued under this method. Illustration: The received side of the Stores Ledger Account shows the following particulars: Jan. 1 Opening Balance: 500 units @ Rs.4 Jan. 5 Received from vendor: 200 units @ Rs.4.25 Jan.12 Received from vendor: 150 units @ Rs.4.10 Jan.20 Received from vendor: 300 units @ Rs.4.50 Jan.25 Received from vendor: 400 units @ Rs.4 Issues of material were as follows: Jan. 4- 200 units, Jan.10- 400 units; Jan. 15- 100 units; Jan 19- 100 units; Jan.26- 200 units; Jan.30- 250 units. Issues are to be priced on the principle of “first in first out”. Write the Stores Ledger Account in respect of the materials for the month of January. 48 CU IDOL SELF LEARNING MATERIAL (SLM)

Solution: Date Particulars Receipts Issues Balance Quantity (Units) Total Cost(Rs) Unit cost(Rs) Quantity (units) Total Cost(Rs) Unit cost(Rs) Quantity (Units) Unit cost(Rs) Per unit 01-Jan Balance b/d - -- - - - 500 2000 4 04-Jan Requisition slip no - - - 200 800 4 300 1200 4 05-Jan Goods received note no 200 850 4.25 - - - 300 1200 4 10-Jan Requisition slip no - 200 850 4.25 - - 300 1200 4 100 425 4.25 100 425 4.25 100 425 4.25 - - 150 615 4.1 12-Jan Goods received note no 150 615 4.1 - 15-Jan Requisition slip no - 150 615 4.1 19-Jan Requisition slip no - - - 100 425 4.25 50 205 4.1 - - 100 410 4.1 50 205 4.1 20-Jan Goods received note no 300 1350 4.5 300 1350 4.5 - 50 205 4.1 300 1350 4.5 25-Jan Goods received note no 400 1600 4 26-Jan Requisition slip no - 400 1600 4 30-Jan Requisition slip no - - - 50 205 4.1 150 675 4.5 150 675 4.5 400 1600 4 - - 150 675 4.5 300 1200 4 100 400 4 Last in Last Out (LILO) • Issues are priced using this approach in reverse order of purchase, which means the prices of the most recent available consignment are used. • In times of increasing prices, this approach is appropriate because material would be released from the most recent consignment at a price that is closely linked to current prices. • Valuing inventory problems at the price of the most recent available consignment can assist management in determining sustainable commodity sale prices. Simple Average Method • The price is determined by dividing the sum of the prices of the products in the stock from which the commodity to be priced may be drawn by the number of prices used in that total. • Since the quantity purchased in each lot is overlooked, this approach may result in over- recovery or under-recovery of material costs from production. Illustration: 1000 units purchased @ Rs.10 2000 units purchased @ Rs.11 3000 units purchased @ Rs.12 Simple average price will be Rs.11, calculated as below: 49 CU IDOL SELF LEARNING MATERIAL (SLM)

Rs.10 + Rs.11 + Rs.12 = Rs.11 3 Weighted Average Methods: In this method, price is calculated by dividing the total cost of materials in the stock from which the materials to be priced could be drawn by the total quantity of materials in that stock. In the above example, the weighted average price is Rs.11.33 per unit calculated as follows 1000 x Rs.10+ 2000 x Rs.11 + 3000 x Rs.12 = Rs.11.33 1000+2000+3000 In the periods of heavy fluctuations in the prices of materials, the average cost method gives better results because it tends to smooth out the fluctuations in prices by taking the average of prices of various lots in stock. Illustration: A company manufacturer 5,000 units of a product per month. The cost of placing an order is 100. The purchase price of the raw material is 10 per kg. The re-order period is 4 to 8 weeks. The consumption of raw materials varies from 100 kg to 450 kg per week. The average weekly consumption being 275 kg. The carrying cost of inventory is 20% per annum. Assuming 52 weeks in a year, you are required to calculate — (i) Re-order quantity. (ii) Maximum level. (iii) Minimum level; and (iv) Average level. Solution (i) Re-order quantity (ROQ) = √Ca2r×ryAinnnguCaolsRtePqe×r OUrnditePreinrgACnonsutm Annual Requirement = Weekly Requirement × 52 = 275 × 52 = 14,300 Ordering Cost = 100 Carrying Cost = 20% per annum = 20% × 10 = 2 50 CU IDOL SELF LEARNING MATERIAL (SLM)