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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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LESSON # 10
ACCOUNTING FOR LOSSES
There is always a chance of occurrence of losses during the manufacturing process and even in the
finished goods godown. Such losses are classified as normal loss and abnormal loss:
LOSSES
Normal losses
Abnormal losses
Normal loss
Occurrence of this type of loss is always expected. It is unavoidable loss and is inherent in the
manufacturing process or its chances of happening are more likely than not. For example; while
transporting petrol, it is normal that a little quantity will be evaporated.
Abnormal loss
It is an unexpected loss. Measures are always taken to avoid abnormal losses. For example; security
system is installed to secure loss by theft from godown of finished goods. Safety measures are
undertaken during manufacturing process against any loss of breakage of the output. Special care is
taken during transportation of petrol to avoid its leakage.
Normal and abnormal losses are treated differently in the financial accounting and in the cost
accounting as well. Following is the self explanatory chart that will help in understanding the
difference between accounting treatment of the two different types of losses.
Treatment in Financial Accounting
Normal loss
Abnormal loss
1. Ignored (no treatment).
1. Specifically recorded
2. Per unit cost increases.
2. Inventory per unit cost remains same
3. Normal losses are absorbed by the good
units.
Treatment in Cost Accounting
Normal loss
Abnormal loss
1. Charged to FOH account.
1. Charged to specific WIP account.
2. Overall per unit cost increases
3. No impact on individual job cost.
In manufacturing process there are two types of distortions that can be identified as losses:
1. Defective output/work
2. Spoiled output
Defective output/work
At the end of or during the manufacturing process the inspection or quality control department
tells about the defective output/work. This can be made good by adding further cost into it. For
example; in a winding department, 10 of the capacitors were found improperly wound up. A
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further cost of material, labor and FOH will be required to re-wind these capacitors. Doing this
will remove the defect. (Output means completed units/work means in process).
Spoiled output
This is cost of the goods that have been destroyed because of any reason. This can not be made
good and therefore are sold as scrap inventory.
LOSSES
Types of
Defective Output/Work
Spoiled Output
losses
Having some
Having no
recoverable value
recoverable value
Cost of loss
Total cost of
Additional cost (Material,
Total cost of
charged as
production (less)
Labor, FOH)
production
expenses
recoverable value
Accounting
Scrap inventory
FOH control A/C
Entries
FOH control A/c
Material
FOH control A/c
Normal
WIP or Job A/c
Payroll
WIP or Job A/c
losses
FOH applied/(items)
Accounting
Scrap inventory
WIP or Job A/C
Entries
WIP or Job A/c
Material
Abnormal
No Entry
Payroll
losses
FOH applied/(items)
Accounting treatment
Normal loss
Normal losses are charged to factory overhead control account and thence become part of
the total production/manufacturing cost.
The additional cost incurred to remove the defect is charged to the factory overhead cost,
as it is explained in the accounting entry shown in the above table.
Whereas, the total cost of spoiled output is taken out of the cost already charged to the
job and is then split into to two; scrap inventory and factory overhead cost. Scrap
inventory shows the amount recoverable from the spoiled output through its disposal and
the balancing amount that is estimated to be irrecoverable is charged to the factory
overhead cost. Where nothing is expected to be recovered from the scrap inventory, total
cost of the spoiled output is taken out of the job and charged to the factory overhead.
Abnormal loss
Abnormal losses are charged to the specific job/work in process account and thence
become part of the cost of the specific job. This treatment causes an increase in the cost of
the job.
The additional cost incurred to remove the defect is charged to the work in process
account, as it is explained in the accounting entry shown in the above table.
Whereas, a part of the cost of spoiled output that is expected to be recoverable (scrap
inventory), is taken out of the cost charged to the job. The estimated irrecoverable cost
(loss portion) remains a part of cost of the job, which means that the loss has been charged
to the job.
Scrap inventory shows the amount recoverable from the spoiled output through its
disposal. Where nothing is expected to be recovered from the scrap inventory, no
accounting entry in this case is required to be passes, as total cost of the spoiled output is
irrecoverable and should remain in the cost of the job.
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Practice Question
Q. 1
A & Co manufactured 500 ceiling fans to fill an order by incurring:
Direct material
Rs.
150,000
Direct labor cost
100,000
F.O.H (60% of labor cost)
60,000
Total production cost
310,000
Some of the work was found defective, to make good such loss, following cost was incurred:
Rework cost on defective work
Material
Rs. 10,000
Labor
30,000
F.O.H (60% of Labor cost)
18,000
Required:
Pass accounting entries to record the cost incurred along with the adjusting entry
for re-work cost, treating the loss as:
a)
Normal
b)
Abnormal
Solution
a) Normal loss
Work in process A/C
310,000
Material
150,000
Payroll
100,000
F.O.H applied
60,000
FOH ­ Control A/C
58,000
Material
10,000
Payroll
30,000
F.O.H applied
18,000
Finished goods A/C
310,000
Work in process A/C
310,000
Cost per unit =
310,000/500 =
Rs. 620 per unit
b) Abnormal loss
Work in process A/C
310,000
Material
150,000
Payroll
100,000
F.O.H applied
60,000
Work in process A/C
58,000
Material
10,000
Payroll
30,000
F.O.H applied
18,000
Finished goods A/C
368,000
Work in process A/C
368,000
Cost per unit =
368,000/500 =
Rs. 736 per unit
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Q. 2
Using the data in Q. 1, now suppose the spoiled output is 50 fans, which can be sold as scrap for
Rs. 200 each.
Cost of spoiled output
= Rs. 310,000 x 50
=
Rs. 31,000
Estimated recoverable amount = Rs. 200 x 50
=
Rs. 10,000
Cost of loss
Rs. 21,000
Solution
a) Normal loss
Work in process A/C
310,000
Material
150,000
Payroll
100,000
F.O.H applied
60,000
Scrap inventory
10,000
FOH ­ Control A/C
21,000
Work in process A/C
31,000
Finished goods A/C
279,000
Work in process A/C
279,000
Cost per unit =
279,000/500 =
Rs. 558 per unit
b) Abnormal loss
Work in process A/C
310,000
Material
150,000
Payroll
100,000
F.O.H applied
60,000
Scrap inventory
10,000
Work in process A/C
10,000
Finished goods A/C
300,000
Work in process A/C
300,000
Cost per unit =
300,000/500 =
Rs. 600 per unit
Different documents are used in the process of requisition, purchasing, production and for
procurement of material. These are used in sequence presented in the following diagram:
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Material / Store requisition
Purchase requisition
Purchase order
Delivery note
Purchase invoice
Goods received
note
Bin card
Store ledger card
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Material/Store Requisition
It is a document through which work station incharge requires/receives material from the store. It
is sent to the store incharge duly approved by the production manager, stating the number of units
required for consumption based on which the store incharge issues the required material to the
work shop.
Purchase Requisition
It is forwarded by the store department to the purchase department, indicating the maximum and
minimum stock levels, it also states the reorder level along with the economic order quantity. It is
used to require further purchase to be made by the purchase department. It also indicates the
current position of the material in the store.
Purchase Order
It is used to place order to the supplier for purchase of further material. This document contains
information regarding the quantity, specification, rate, discount, settlement term, time of delivery,
and dealing person. Based on the purchase order the supplier manages to deliver material to the
ordering entity.
Delivery Note
It is issued by the supplier/seller to the purchaser, mentioning the quantity and specification of the
material dispatched. On receipt of the material the recipient acknowledges by the signing the
delivery note and returns it back to the supplier
Purchase Invoice
It is the document that evidences the transaction of purchase of material. It is issued by the seller
stating quantity, rate, discount, and amount of the purchased material. Settlement terms are also
stated at bottom of the invoice. Receiving an invoice means that money is payable to the supplier.
Goods Received Note
It is prepared by the inspection department after verifying the quantity and quality of the material
received. Received material along with the goods received note is sent to the store incharge.
Bin Card
Store incharge after receiving the material as per the goods received note, places the material at its
location and makes an entry in the bin card. Bin card is used to maintain physical record of the
material received in and issued from the store. It updated for balance in the store after each
transaction. It also contains information regarding reorder level, economic order quantity,
maximum and minimum stock levels, maximum and minimum daily consumption, and lead time.
It is placed at the location where the material is stored.
Store Ledger Card
It is maintained by the accounting department, more precisely stating it is maintained by the cost
accounting department that is concerned about the calculation of cost per unit. It is similar to the
bin card as far as receipt and issue of the quantity of material is concerned, but the main purpose
of maintaining the store ledger card is to know the cost of material consumed and material in store
along with the cost per unit of the material. Store ledger card is maintained using the FIFI, LIFO
and W Avg methods.
Inventory Turnover Ratio
Inventory Turnover ratio shows the stock position of the store room. In how many times
inventory is used in a year and for how long the inventory is held in the store.
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Inventory Turn over Ratio
Cost of goods sold or Material consumed =
times
Average Inventory
Average Inventory
Opening Inventory +
Closing Inventory = Average inventory
2
Stock holding period
Number of days in a year =
number of days
Inventory turnover ratio
PRACTICE QUESTION
Opening stock
1,000 units
Material Purchase
7,000 units
Closing Stock
500 units
Material consumed
Rs. 7,500
Solution
Inventory Turn over Ratio
Material consumed
Average Inventory
7500
.=
10 times
(1000+500)/2
Inventory holding period
No of days in a year
Inventory Turn over Ratio
= 36 days
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MULTIPLE CHOICE QUESTIONS
The following information is to be used for questions 1 and 2
A national chain of tyre fitters stocks a popular tyre for which the following information is
available:
Average usage:  140 tyres per day
Minimum usage:  90 tyres per day
Maximum usage:  175 tyres per day
Lead time:
10 to 16 days
Re-order quantity:  3,000 tyres
1 Based on the data above, at what level of stocks should a replenishment order be issued?
A  2,240
B  2,800
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C  3,000
D  5,740
2 Based on the data above, what should be the maximum level of stocks possible?
A  2,800
B  3,000
C  4,900
D  5,800
3
Moura uses the economic order quantity formula (EOQ) to establish its optimal reorder
quantity for its single raw material. The following data relates to the stock costs:
Purchase price:  15 per item
Carriage costs:
50 per order
Ordering costs:  5 per order
Storage costs:
10% of purchase price plus 0.20 per unit per annum
Annual demand is 4,000 units.
What is the EOQ to the nearest whole unit?
A  53 units
B  170 units
C  485 units
D  509 units
4 Which of the following statements is correct?
A store ledger account will be updated from goods received note only.
A. A stores requisition will only detail the type of product required by a customer.
B. The term 'lead time' is best used to describe the time between receiving an order and
paying for it.
C. To make an issue from stores authorization should be required.
5 What would be the most appropriate cost unit for a cake manufacturer?
Cost per:
A Cake
B Batch produced
C Kilogram produced
D Production run
The following information relates to questions 6 and 7
Turner Limited has the following stock record:
Date
Number of units
Cost (Rupees)
1 March Opening stock 100 units
at 3.00/unit
3 March  Receipt
200 units
at 3.50/unit
8 March  Issue
250 units
15 March Receipt
300 units
at 3.20/unit
17 March Receipt
200 units
at 3.30/unit
21 March Issue
500 units
23 March Receipt
450 units
at 3.10/unit
27 March Issue
350 units
6 What is the valuation of closing stock using LIFO at each issue?
A Rs. 460
B Rs. 465
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C Rs. 467
D Rs. 469
7
What is the valuation of issues using the weighted average method of stock valuation at each
issue?
A  Rs. 3,248
B  Rs. 3,548
C  Rs. 3,715
D  Rs. 4,015
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS