ZeePedia buy college essays online


Cost and Management Accounting

<<< Previous TYPES OF BUDGET:Format of Cash Budget, Next >>>
 
img
Cost & Management Accounting (MGT-402)
VU
changes inversely with changes in activity level Assume that for an estimated activity level of
50,000 machine hours budgeted factory overhead is Rs. 150,000 which includes Rs 100.000 of
fixed cost. The absorption rate and its composition in this case is as follow:
FOH absorption rate:
Rs, 150,000/ 50.000 machine hrs
= Rs. 3 per machine hr.
The fixed rate:
Rs. 100,000/50.000 machine hrs
= Rs. 2 per machine hr.
The variable rate:
Rs 3 per machine hr less Rs. 2 per machine hr = Rs. 1 per machine hr.
It is very easily understood that Rs, 100.000 of fixed factory overhead can be absorbed only when
capacity attained till the end of year is 50,000 machine hours If capacity attained is less than the
budgeted capacity it means an unfavorable capacity variance, which will be signified by unabsorbed
fixed factory overhead. Assume that the capacity attained is 48,000 machine hours. At this capacity
level only Rs 96,000 of fixed factory overhead is absorbed (i.e. 48,000 hrs x Rs. 2) and the under
absorbed fixed cost of Rs 4,000(i.e. Rs. 100,000 less Rs. 96,000) represents the portion of factory
overhead variance cause by unfavorable capacity variance. Similarly, where capacity attained is
more than the budgeted capacity it is a favorable capacity variance which will be signified by over
absorbed fixed factory overhead. In other words capacity variance can be computed by multiplying
the difference in capacity (budgeted and attained) by the fixed rate. The same result is obtained by
taking. the difference between absorbed factory overhead and budgeted factor* overhead for
capacity attained.
Budget/Spending Variance
Budget variance is the difference between budgeted factory overhead for capacity attained and
actual factory overhead incurred. It represents either over-spending or under-spending.
If actual factory overhead is more than the budgeted, it is unfavorable budget variance. On the
other hand if actual factory overhead is less than the budgeted it is favorable budget variance.
In order to determine exact causes of budget variance, the difference between actual and budgeted
figures of each item of factory overhead is computed and communicated to the responsible person
for the purpose of control. The budget variance may be due to fixed factory overhead items or it
may be due to the variable items or the both.
Following practice question explains the computation and presentation of the variance and its
analysis.
123
img
Cost & Management Accounting (MGT-402)
VU
PRACTICE QUESTION
Shahzewaz Associates prepared following estimates for the year 2006.
Fixed factory overhead
Variable factory overhead
Direct labor hours Actual results for the year 19xx were as follow:
Fixed factory overhead
Rs. 450,000
Variable factory overhead
Rs. 600,000
Direct labor hours
200,000
Required: Calculate
(i)
Total factory overhead variance.
(ii)
Capacity variance.
(iii)
Budget variance.
Solution:
(i)
Total Factory Overhead Variance
Actual factory overhead
Fixed FOH + Variable FOH
Rs. 450.000 + Rs. 680,000
Rs. 1,130,000
Absorbed factory overhead
Capacity attained x Absorption rate
220,000 hours x Rs. 5.25
1,155,000
Over applied
25,000
(ii)
Capacity Variance
Absorbed factory overhead (220,000 x 5.25)
Rs. 1.155.000
Budgeted factory overhead for capacity attained
Fixed factory overhead + (Capacity attained x Variable rate)
(Rs. 450,000 + 220,000 hours x Rs. 3)
1,110,000
Favorable
45,000
(iii)
Budget Variance
Budgeted factory overhead for capacity attained
Rs. 1,110,000
Actual factory overhead
1,130,000
Unfavorable
20,000
Supporting Calculations
Absorption rate = (Rs 450.000 + Rs. 600,000)
200.000 direct labor hours
= Rs. 5.25 per direct labor hour
Variable rate
= Rs. 600.000
2,00,0000 direct labor hours
= Rs. 3 per direct labor hour
It should be remembered here that no definite conclusions can be drawn only on the basis of
factory overhead variance analysis, as presented above Analysis of factory overhead variance is a
part of whole process of variance analysis whereby direct materials variance and direct labor
variance are also computed and analysed. Complete study of variance analysis is a part of advanced
courses of cost accounting.
In the above practice question capacity attained in terms of direct labor hours is greater than the
budgeted capacity. This seemingly favorable capacity variance may, in fact, be due to unfavorable
factors. For example, direct labor may be less efficient and as a result same quantity of output is
124
img
Cost & Management Accounting (MGT-402)
VU
produced by working greater number of hours, or it may be due to defective materials which
require more conversion time and as such the hours worked over and above the budgeted capacity
have not resulted in extra output Similarly an unfavorable budget variance may be on account of
higher spending on preventive repairs and maintenance or higher spending on training of workers,
which is in effect beneficial for the organisation.
Here a practice question is discussed to explain High and Low Point Method. This method is a
technique to segregate fixed and variable portions of a total/semi-variable cost.
Practice Question
Predetermined factory overhead absorption rate computed by AI-Nasr Associates Rs. 6 per
machine hour. Budgeted factory overhead for activity level of 150.000 machine hours is Rs.
800,000 and for activity level of 100,000 machine hours it is Rs. 700,000. Actual factory overhead
incurred during the year is Rs. 710,000 at an actual volume of 120,000 machine hours.
Required:
(i)
Variable factory overhead absorption rate.
(ii)
Budgeted fixed factory overhead,
(iii)
Budgeted activity level on which the absorption rate is based
(iv)
Over or under absorbed factory overhead.
(v)
Volume variance
(vi)
Spending variance
Solution:
(i)
Variable Factory Overhead Absorption Rate:
Activity Level
Budgeted FOH
(Machine Hours)
(Rs.)
High
150,000
800,000
Low
100,000
700.000
50,000
100,000
For a change of 50,000 machine hour's m activity level there is a change of Rs, 100,000 in
budgeted factory overhead. This change in budgeted factory overhead is due to variable factory
overhead. Therefore,
Variable rate
=
Change in budgeted FOH
Change in activity level
Rs 100,000/50,000 machine hours
Rs. 2 per machine hour
125
img
Cost & Management Accounting (MGT-402)
VU
(ii) Budgeted Fixed Factory Overhead:
Total FOH for 150,000 machine hours
= Rs. 800.000
Budgeted variable FOH = 150,000 hrs Rs 2
= Rs. 300,000
Budgeted fixed FOH = Rs 800.000 less Rs. 300,000
= Rs. 500.000
OR
Total FOH for 100.000 machine hours
= Rs 700.000
Budgeted variable FOH =100.000 hrs x Rs. 2
= Rs 200.000
Budgeted fixed FOH = Rs, 700.000 less Rs. 200,000
=Rs. 500.000
(iii)Budgeted Activity Level
Budgeted activity level = Fixed FOH
Fixed rate
= Rs. 500.000/ (Rs. 6 less Rs. 2)
=125,000 machine hours
(iv) Over or under absorbed Factory Overhead:
Actual factory overhead
Rs. 710.000
Absorbed factory overhead
Actual volume x FOH absorption rate
120,000 hrs x Rs. 6
720.000
Over absorbed
10,000
(v) Volume Variance:
Absorbed factory overhead
Rs. 720,000
Budgeted FOH for actual volume
Fixed FOH + (Actual volume x Variable rate)
Rs, 500.000 + (120.000 hrs, x Rs. 2)
740,000
Unfavorable
20,000
(vi) Spending Variance:
Budgeted FOH for actual volume
Rs. 740,000
Actual factory overhead
710,000
Favorable
30,000
126
img
Cost & Management Accounting (MGT-402)
VU
LESSON# 18
JOB ORDER COSTING SYSTEM
It has been explained that a cost accounting system is composed of two sub-systems:
(i)
A system of recording and summarizing costs and
(ii)
A costing system.
Costing system means "the ascertainment of costs ", It includes determination of total cost as well as
unit cost. A costing system determines and reports to management total and unit cost of product
or project of service with details of cost components
Costing is compulsory for satisfying at least three important needs of management.
I. Unit cost must be known to assist the management in making price decisions.
II. Ascertainment of cost at every stage of production is important for exercising control over
costs.
III. In order to operate a system of accounting for costs, management needs to know cost of
materials, labor and overhead to be charged to work in process, cost of work completed
and transferred to finished goods and the cost of goods sold so that necessary debit and
credit entries can be passed.
Choice of a Costing System
Job Order Costing or Process Costing?
What type of costing system an accounting entity should adopt? It depends upon:
(1)
Nature of operations and
(2)
Information needs of management.
Take the example of a construction company that produces houses in response to customers'
orders and according to their specifications. All the times, the company remains engaged in the
construction of many houses at different sites for different customers. Such a company definitely
wants to know the cost incurred on each house separately so that customers' can be billed properly
and profit (or loss) on each contract may be ascertained. Here the nature of operations is such that
each house is clearly distinguishable from the other and separate calculation of cost for each house
is desirable and practically possible. This company will employ job costing system.
On the other hand take the example of a company producing cement. All of the bags of cement
produced are quite similar. Here separate calculation of cost of cement supplied to each
customer is neither desirable nor feasible. The company can calculate cost per bag of cement
produced by dividing total cost incurred during the accounting period by total number of bags
produced during the period.
Accordingly, the company can fix the price per bag and bill each customer according to the
number of bags supplied to him. This company will use process costing system.
Job costing and process costing are two basic types of costing systems and can be viewed
as two ends of a spectrum or range. In practice we find companies employing either one of
these two or some combination of features of the two both of these at the same time. For
example, a ready made garments manufacturer employs process costing to accumulate and
determine the cost of free size shirts produced by him in large quantity. At the same time he
uses job costing to accumulate the cost of waiters' uniforms supplied to a hotel under a
contract.
Job costing may be defined:
The costing system that separately accumulates costs incurred to produce each job in a situation where each job is
distinguishable from the other throughout the production process.
The job may be a single unit or a multi unit batch, a contract or a project, program or a service. Job
costing is employed by organisations possessing following characteristics:
1. Production is generally in response of customers' orders.
2. Every order has its own manufacturing specifications. Therefore, every job is different from the
other and requires different amounts materials, labor and overhead.
127
img
Cost & Management Accounting (MGT-402)
VU
3. Each job is clearly distinguishable from the other at all stages production process which makes
job-wise accumulation of possible.
4. Job-wise accumulation of cost is desirable and/or necessary for and profit determination and
5. Each job is generally of high value.
Following are the examples of organisations employing job costing include:
a) Accounting firms
b) Civil engineering
c) Furniture manufacturing
d) Medical care
e) Printing press
f) Ship-building
g) Advertising agencies
h) Computer programming
i) Jewellery manufacturing
j) Movie studios
k) Repair shops
As the costs are accumulated separately for each job, therefore, job costing requires considerable
amount of clerical work. Where production is carried in different departments of a factory,
department wise cost accumulation is also necessary for performance evaluation of departmental
management. In this way clerical work is further increased. Consequently, job costing is more
expensive as compared with process costing. Job costing is also called specific order costing or
production order costing.
Job order costing procedures
Most of the times, organisations employing job order costing are required to submit quotation
before finalization of customer's order. Therefore, naturally, the first step in job order costing is to
prepare an estimate of cost likely to be incurred to produce the job. The estimation is done by
coordination of sales, designing and production departments. On the basis of estimated cost price
is quoted. When customer's order has been initialized production planning and control
department takes the first step towards execution of the order.
On receipt of production order, cost accounting department prepares a job cost sheet for each
job. Job cost sheet may be defined as a document used for accumulating costs incurred to produce a job.
Design and contents of job cost sheet vary widely depending on customs of manufacturing
operations and information needs of management.
However, generally, a job cost sheet is designed to show the following information:
1. Job number
2. Name of the customer
3. Description and specifications of the job
4. Date of commencement of production
5. Date of completion of job.
6. Direct materials cost incurred on the job
7. Direct labor cost incurred on the job
8. Factory overhead applied to the job
9. Total cost of the job
10. Selling and administration expenses chargeable to the job
11. Sales price of the job
12. Profit (or loss) on the job
13. Where the job consists of a batch, the quantity produced and unit cost
14. Where cost estimates are prepared before production, estimated cost should also be shown for
comparison and efficiency evaluation.
128
img
Cost & Management Accounting (MGT-402)
VU
Job cost sheet is one of the basic documents used in job order costing. Upto the time the job is
incomplete; job cost sheet serves as a subsidiary record .for work in process control account and is placed in
work in process subsidiary ledger. On completion of job, the relevant job cost sheet is removed
from work in process subsidiary ledger.
Now it reveals the cost of completed job and serves as source document for debiting finished goods
account (or completed jobs control account) and for crediting work in process account.
Then it is placed in finished goods subsidiary ledger and serves as subsidiary record .for finished goods
account. When completed job is shipped to the customer, relevant job cost sheet serves as source
document for debiting cost of goods sold account and for crediting finished goods account. Then it
is placed in cost of goods sold subsidiary ledger where the same job cost sheet serves as subsidiary
record for cost of goods sold account.
Manufacturing process is, most of the times, divided into departments. This departmentalization
is the logical result of different types of operations performed to produce a product. For example,
furniture manufacturing is divided into cutting, assembling and finishing and polishing
departments; readymade garments manufacturing is divided into cutting, stitching finishing and
packing departments.
These departments are regarded as cost centers. Cost Centre means a division or segment for which a
separate individual is made responsible .for incurrence of cost. Accumulation of cost for each department is
necessary to achieve better control over cost. In job order costing it is necessary to identify cost
not only with the department but also with the relevant job.
Direct materials, direct labor and factory overhead to be charged to each job and to each
department are recorded in the following manners:
Direct Materials: Every materials requisition issued to secure direct materials bears the name of
department and job number for which materials are required. Periodically (weekly or fortnightly
etc) a summary of materials requisitions is prepared. Materials requisition summary analyses cost
of materials issued and ascertains cost of materials chargeable to each department and to each job.
Indirect materials issued cannot be associated with particular jobs, therefore, these are summarised
only by department. Instead of posting each individual materials issue to job cost sheets, the
periodic totals are recorded on relevant job cost sheets.
The periodic grand total are debited to work in process and factory overhead -control accounts and
credited to materials control account.
Direct Labor: Primary labor cost data are accumulated on Job Time Tickets. Job time tickets
contain names of departments and job numbers for which labor time is used. A labor cost analysis
sheet is prepared periodically that analyses the direct labor cost by departments and by jobs. As
indirect labor cost cannot be identified with particular jobs, therefore, labor cost analysis sheet
analyses it only by departments. The periodic totals are posted to job cost sheets and debited to
work in process and factory overhead control accounts.
Factory Overhead: Factory overhead is applied to jobs on the basis of predetermined
departmental factory overhead applied rates. Factory overhead is also periodically applied to the
jobs and entered in job cost sheets. Total applied factory overhead is debited to work in process
control account and credited to factory overhead applied account.
Practice Question
Job Order Costing. Shah Taj Engineering Works on April 5, 2006 started production of 100 lawn
mower of model EG- 72 ordered by Capital Development Authority. Islamabad, vide Order No.
2119-M dated April 1, 2006 at a price of Rs. 3,600 per lawn mower.
Production Planning Department allotted Job No. J-832-LM and instructed the factory to
complete production by April 20, 2006. However, the factory completed production on April 18,
2006.
129
img
Cost & Management Accounting (MGT-402)
VU
On April 11, weekly Materials Requisitions Summary. No. MRS-16 and weekly Labor Cost
Analysis Sheet No.LAS-16 showed following charges to Job No. J-832-LM.
.
Department 101
Department 102
Direct materials
Rs. 58,500
11,700
Direct labor
Rs. 13,500
15,750
(900 hours)
Materials Requisitions Summary No. MRS-17 and Labor Cost Analysis Sheet No. LAS-17
prepared on April 18 revealed following direct costs for the job.
Department 101
Department 102
Direct materials
Rs.71,500
Rs. 14,300
Direct labor
Rs. 16,500
Rs. 19,250
(1100 hours)
In department 101 factory overhead is applied @ 50% of direct labor cost and in department 102
@ Rs. 12 per direct labor hour. Marketing and administration expenses chargeable to the job were
respectively 7.5 % and 5% of the sale price. The lawn mowers were delivered to customer on April
22, 2006
Required:
(i) Prepare a Job Cost Sheet for Job No. J-832-LM.
(ii) Assuming that J-832-LM was the only job worked on during the two weeks period, pass
account entries in General Journal form to record:
(a) Cost incurred on the job:
(b) Completion of the job; and
(c) Sale of the job.
Solution
SHAH TAJ ENGINEERING WORKS LIMITED
JOB COST SHEET FOR JOB NO. J-832-LM
Customer's Name:
Capital Development Authority. Islamabad.
Order No. 2119-M Dated 02-04-2006 Description Lawn Mowers Model EG- 72
Total Cost Rs. 260.000 No. of units. 100Date Started 05-04-2006
Date wanted 20-04-2006 Date Completed 18-04-2006 Unit Sales Price Rs. 3,600 Unit Cost Rs.
2,600
DIRECT MATERIALS
Date
Mat. Req. Sum. Department 101
Department 102
Total
No
11-04-2006
MRS-16
Rs. 58,500
11,700
70,200
18-04-2006
MRS-17
71,500
14,300
85,800
Total
130,000
26,000
156,000
DIRECT LABOR
Date
Lab
Analysis Department 101
Department 102
Total
Sheet No.
11-04-2006
LAS-16
Rs. 13,500
15,750
29,250
18-04-2006
LAS-17
16,500
19,250
35,750
Total
30,000
35,000
65,000
130
img
Cost & Management Accounting (MGT-402)
VU
FACTORY OVERHEAD APPLIED
Date
Department 101
Department 102
Total
D.L
Rate
Amount
D.L
Rate
Amount
Cost
Hours
11-04-2006
13,500
50%
6,750
900
12
10,800
17,750
18-04-2006
16,500
50%
8,250
1,100
12
13,200
21,450
Total
15,000
24,000
39,000
Total Production Cost
Direct material cost
156,000
Direct labor cost
65,000
Factory overhead cost
39,000
260,000
Income Statement
Sales price 100 units @ Rs. 3,600
360,000
Cost of production
260,000
Gross profit
100,000
Operating expenses
Marketing Expenses (Rs. 360,000 x 7.5%)
27,000
Administration Expenses (Rs. 360,000 x 5%) 18,000
45,000
Net Income/profit
55,000
Problem Questions
Q. 1
Arman Advertisers on November 15, 2006 received an order from Pheasent Cosmetics Limited for
manufacturing and installation of a huge neon sign for a contract price of Rs. 180,000. Job No.
676-PN was allotted and manufacturing was begun on November 21, 2006 .The costs are charged
to the jobs periodically by means of weekly summaries.
Following costs were related to Job No. 676-PN
WEEK ENDED
Nov. 23
Nov. 30
Dec.7
Dec. 14
Rs.
Rs.
Rs.
Rs.
Direct materials
13,300
24,800
16,400
12,600
Direct labor
1,800
12,400
20,100
14,200
Factory overhead is applied @ 25% of prime cost. The Job was completed on December 14, 2006
Selling expenses are applied to the job @ 3 % of contract price and administration expenses @ 2%
of contract price.
Required: Prepare a job cost sheet containing above information
Q. 2
In order to submit quotation for air conditioning of Hina Shopping Centre, management of Indus
Electrical Industries made following estimates:
Direct materials Rs. 280,000;
Direct labor Rs. 120,000;
Predetermined overhead applied rate is 50% of direct labor cost;
131
img
Cost & Management Accounting (MGT-402)
VU
Predetermined rates for charging marketing and administration expenses are respectively 3% and
2% of the contract price.
On the basis of above estimates contract price was quoted as Rs. 575,000
The quotation was accepted by the owners of Hina Shopping Centre and the order was finalized
on October 6, 2006.
Job No. 1617 was assigned to the order and the work was started on October 12, 2006. Weekly
materials requisition summaries and labor cost analysis sheets showed following charges to Job
No. 1617.
Date
Direct Material
Direct labor
October 17
Rs. 120,000
Rs. 46,000
October 24
Rs. 96,000
Rs. 44,000
October 31
Rs. 60,000
Rs. 48,000
The job was completed on October 31. However, the time allowed for completion of job was upto
November 4.
Required
(i)
Prepare job cost sheet for Job No. 1617.
(ii)
Assuming that Job No. 1617 was the only job worked on during the above period, pass
entries in general journal form to record production and sale of the job. Job was accepted by the
customer on November 4 and cash received for the contract price.
Q. 3
Hussain Engineering Co. Ltd. produces machines as per customer's specifications. The following
data pertains to Job Order No. K 101:
Customer: Azam Banking Co.
Date Started: 06-08-2006.
Customer Order No. C 467.
Date Finished: 20-08-2006.
Dated: 31-07-2006. Total Cost of manufacture?
Sales Price?
Description: 6 Banking Machines.
Week End 13/08
Week End 20/08
Materials used. Dept. A.
Rs. 4,800
Rs. 2,600
Direct labor rate. Dept. A.
Rs 40 per hour
Rs. 40 per hour
Labor hours used, Dept. A.
1,200
800
Direct labor rate, Dept. B.
Rs 42 per hour
Rs. 42 per hour
Labor hour uses, Dept. B.
600
280
Machine hours. Dept. B.
400
240
Applied factory overhead Dept. A. Rs. 20/labor hr.
Rs. 20/labor hr.
Applied factory overhead Dept. B Rs. 18/machine hr
Rs.18/machine hr
Marketing and administrative costs are charged to each order @ 20% of the cost to manufacture
Required:
a)
Prepare a job order cost sheet
b)
Calculate sales price of the job, assuming that it has been contracted with a
markup of 40%
132
img
Cost & Management Accounting (MGT-402)
VU
LESSON# 19
PROCESS COSTING SYSTEM
(An introduction)
Definition
Process costing system applies when standardised goods are produced tom a series of inter-
connected operations.
In some industries, the output produced emerges from a continuous process. An example might be
an oil refinery; Oil in a raw state is input and subjected to a process of purification. Refined oil
emerges at the end of the process.
Problems that arise in such situations include the attribution of materials costs and conversion
costs to units of finished output and the occurrence of losses during the process (spoilt or lost
production).
The characteristics and application of process costing
Continuous production
In the job order costing, costs were directly allocated to a particular job. When standardised goods
or services result from a sequence of repetitive and continuous operations, it is useful to work out
the cost of each operation. Then because every unit produced may be assumed to have involved
the same amount of work, costs for a period are charged to processes or operations, and unit costs
are ascertained by dividing process costs by the quantity of output units produced This is know n
as process costing.
Series of interconnected operations
Process costing applies when standardised goods are produced from a series of interconnected
operations. Process costing system is employed by industries possessing following characteristics:
1. There is mass production of a single product or two or more products in successive runs
of scheduled duration e.g., vegetable canning or fruit juice bottling.
2. All units of output are exactly similar and are produced by the same manufacturing
process.
3. Entire manufacturing process is divided into departments or processes, each performing a
specific set of operations.
4. Completed output of each department, except the last one, is the raw materials for the next
department.
5. Manufacturing operations may result in production of joint products or by products.
6. Production is not in response to customers' orders but in anticipation of demand.
Examples of industries using Process Costing include:
Bottling, Pharmaceuticals, Cement, Paint, Coal, Distilleries Electricity, Ice, Soap, Sugar, Canning,
Chemicals, Cooking oil, Electric appliances, Flour, Natural gas, Petroleum Products, Rubber, Steel,
Textile. Under process costing, for the purpose of cost control, each department involved in
manufacturing process is regarded as a cost centre and product costs are accumulated separately
for each department. Cost Centre means a division or segment for which an individual is made responsible
.for the incurrence of cost
Departmental costs are passed through department work in process accounts and not through a
single work in process control account as in job costing. As all units are produced from the same
raw materials and by same manufacturing operations, therefore, it is assumed that same cost is
chargeable to each unit. Instead of accumulating cost of individual units, an average unit cost is
computed by dividing total cost by total output of the period. Cost is associated only with
departments and not with jobs. It reduces clerical efforts for accumulation and analysis of cost. In
this way process costing is less expensive, as compared with job costing.
133
img
Cost & Management Accounting (MGT-402)
VU
The Process Cost Sheet also called Cost of Production Report is the basic document in process
costing. This document is prepared for each department and shows the quantities processed, total
and unit cost, and cost of work transferred out, and still in process. .
Following table is meant to make the difference between the two costing systems more clear.
Job order costing system
Process costing system
Where different products
Application
Where single standard
having peculiar
product is produced or
specifications are produced
two or more standard
against customers' orders
products are produced in
successive runs.
Production is for stock
and in anticipation of
demand.
In order to determine cost
Accumulation of Cost
of each job, costs are
Costs are associated only
compiled job wise. At the
same time, to evaluate
with departments
efficiency of departmental
management cost are also
compiled department wise
Unit cost is computed on
completion of job. The job
may itself be a single cost
Cost per unit
unit e.g. a machine or it may
An average unit cost is
be a multi unit
computed at the end of
costing period by dividing
total cost by units of output
Only one work in process
of the period.
control account is
maintained
A separate work in process
control
account
is
More clerical efforts are
Work in process a/c
maintained
for
each
needed to accumulate costs
producing department
by jobs and by departments,-
therefore, the system is more
Cost accumulation is simple
expensive
as costs are accumulated only
Cost of operating the system
by departments; therefore,
the system is comparatively
less expensive.
134
img
Cost & Management Accounting (MGT-402)
VU
Process costing procedures
In process costing industries standard products are produced in accordance with production
budget. Therefore, it becomes unnecessary to issue a production order. Production Planning and
Control Department communicates production targets to departmental heads by means of written
letters. Data of quantities produced by each department are collected and compared with budgeted
quantities for control purposes. These information are collected by departmental supervisors or
quality inspectors may recording these data. Each producing department is a cost centre because
for the purpose of cost control management is interested in ascertaining departmental costs.
In process costing, generally, a separate work in process account is maintained for each producing
department.
Data Collection
Collection of departmental cost figures of direct materials, direct labor and factory overhead is
based on similar procedure as for, job order costing. However, the source documents used for the
data collection are comparatively simple. These documents identify costs only with departments
and not with jobs as well.
Direct Materials:
Production people secure materials by issuing properly authorised Materials Requisitions. At the
end of each month, these requisitions are sorted and a Materials Requisition Summary indicating
cost of direct and indirect materials issued to each department is prepared. Monthly totals of
direct and indirect materials issued are debited to departmental work in process control accounts
and factory overhead control account respectively and credited to materials control account.
Direct Labor:
Instead of using Job Time Tickets, labor cost data are accumulated on Clock Cards and Daily
Time Sheets. These documents show labor time utilized by each department and classification of
labor cost as direct and indirect. At the end of each month, labor cost data accumulated on these
source documents are summarised in Labor Cost Analysis Sheet indicating direct and indirect
labor cost for each department. Monthly totals of direct labor are debited to departmental work in
process accounts and indirect labor is debited to factory overhead control account.
Factory Overhead:
Factory overhead costs, other than indirect materials and indirect labor discussed earlier, are
accumulated in Voucher Register and in General Journal by means of adjusting entries for
depreciation, expired insurance etc, Monthly total, are debited to factory overhead control
account.
Factory overhead is charged to production through predetermined departmental factory overhead
applied rates. Some industries using process costing charge actual factory overhead to
departments. This method gives satisfactory results if production is stable from month to month,
But if there are fluctuations in production volume, charge of actual factory overhead is
unsatisfactory especially when considerable portion of factory overhead is a fixed cost,
Cost of Completed Output:
Cost of completed output of each production department is calculated in Cost of Production
Report. Cost of units completed and transferred out is credited to work in process control account
of the respective department and debited to work in process control account of the department
receiving the units. Cost transferred out by the last department is, however, debited to finished
goods control account
135
img
Cost & Management Accounting (MGT-402)
VU
Cost of Production Report
In process costing Cost of Production Report also called Process Cost Sheet is the key
document. At the end of costing period, generally a month, a Cost of Production Report is
prepared. It summarizes the data of quantity produced and cost incurred by each producing
department. It also serves as a source document for passing accounting entries at the end of
costing period.
Cost of production report is divided into five sections. Each section is meant to provide specific
information. A brief description of these sections is presented below:
1.
Quantity schedule.
2.
Cost accumulated in the department/process.
3.
Calculation of equivalent units produced.
4.
Calculation of cost per unit.
5.
Accounting treatment / apportionment of the accumulated cost
Quantity Schedule:
The first section Quantity Schedule contains input and output data in terms of quantities. The
information is presented in the following order.
(i)
Units in process at the beginning of costing period.
(ii)
Units started in process or received from preceding department during the period.
(Total of (i) and (ii) constitutes total units to be accounted for)
(iii)
Units completed and transferred to next department or to finished goods.
(iv)
Units completed but still in the department.
(v)
Units in process at the end of the period and their degree of completion.
(vi)
Units lost in process during the period indicating whether normal loss or abnormal loss.
The stage of completion at which the loss occurs is also specified.
(Total of (iii) , (iv) , (v) and (vi) is again the total units to be accounted for)
The quantity schedule assists management to look at a glance production performance of
departments as well as it provides necessary data for preparing remaining sections of the report.
Cost accumulated in the department/process.
The second section Cost Accumulated to Departments shows total cost for which the
departments are accountable. Total costs include cost of beginning work in process inventory,
cost transferred in from the preceding department and cost of direct materials, direct labor and
factory overhead added by the department. If there is normal loss of units, unit cost received
from preceding department requires adjustment. This adjustment for lost units is also shown in
this section. This section provides data for debiting work in process control accounts of the
departments.
Calculation of equivalent units produced.
In order to arrive at cost per unit of output, total of each cost element is divided by the number of
units produced, For this purpose, where at the end of costing period, there are some partially
completed units in process, these units must be stated in terms of equivalent completed units, For
example, if 4,000 units. are in process at the end of month estimated as 50% complete, these will
be equivalent to 2,000 completed units. These equivalent units are added to units completed by
the department to arrive at equivalent production. Then total cost is divided by this equivalent
production figure to calculate unit cost.
136
img
Cost & Management Accounting (MGT-402)
VU
Calculation of cost per unit
In process costing, costs are averaged over the units produced. The costs accumulated to a process
for a period are collected and divided by the number of units equally produced during the period.
Accounting treatment / apportionment of the accumulated cost
The last section presents a summary to the explaining the accounting treatments of the costs
incurred in the department. This includes
(i)
Adjustment for lost units for normal loss, if any.
(ii)
Cost transferred out.
(iii)
Cost of abnormal loss, if any.
(iv)
Cost of work in process ending inventory and
(v)
Any other accounting adjustment, if necessary to present.
Cost of production report is generally presented to management with supplementary reports of
usage of materials, labor and factory overhead.
Standard format of a simple
Cost of Production Report
I- Quantity Schedule:
Units put into the process
***
Units completed in this process & transferred
to next department.
***
Units not yet completed at the end of the
Period.
***
***
II- Cost Accumulated In The Department / Process:
Direct Material Cost
***
Direct Labor
***
Factory Overhead (Applied)
***
***
III- Calculation of Equivalent Units Produced
100% of completed units + % completed of the in process units
IV- Calculation Of Per Unit Cost
=
Total Cost
.
Equivalent Units Produced
V-
Accounting Treatment
1- Finished goods
2- Closing Work in process
137
img
Cost & Management Accounting (MGT-402)
VU
Problem Questions
Q. 1
Heera Manufacturing Company manufactures a product. Production made and manufacturing
costs incurred in the first department during the month of October .are given below:
10,000 units were started in process out of which 9,400 units were transferred to next department
and remaining 600 units were 1/2 complete as to materials, labor and overhead. Direct materials
Rs. 19,400, direct labor Rs. 24,250 and factory overhead Rs. 14,550 was charged to production.
Required: Cost of production report for the month.
Q. 2
Production and cost data of first production department of Excellent Manufacturing Company for
the month of March 2006 are as follow:
Units started in process were 5,000. Units completed and transferred to second department were
4,500. Remaining units were in process estimated to be 50%, 40%, 60% completed as to materials,
labor and factory overhead respectively. Costs of materials, labor and overhead were Rs. 50,000,
Rs. 60,000 and Rs. 40,000 respectively.
Required: Cost of production report.
138
img
Cost & Management Accounting (MGT-402)
VU
LESSON# 20, 21, & 22
PROCESS COSTING SYSTEM
Practice Question
Q. 1
Mini Soap Manufacturing unit completed and transferred out 600 soaps to department-11 at the
end of the week. In department-11 500 soaps completed and transferred out. Units which were
still in process 100 (100% material, Conversion cost 60%).
Rs.
Cost received from preceding department
540
Following costs were incurred by department-11:
Direct Material
150
Direct Labor
112
Factory overhead
168
430
970
Required: Prepare cost of production report
Cost of Production Report
Department-II
I-Quantity Schedule:
Units received previous department
600
Unites completed and transfer to
next department
500
Units still in process
100
600
II-Cost Accumulated in the Department / Process:
Cost received from preceding department
Rs.
540
Cost added by department-11:
Direct Material
150
Direct Labor
112
Factory overhead
168
430
970
III-Calculation of Equivalent Units Produced:
(100% of completed units + % of units in process)
Units completed in department-I = 500 + 100 = 600
Direct Material:
500+(100x100%)
= 600
Direct Labor  :
500+(100x60%)
= 560
F.O.H
:
500+(100x60%)
= 560
IV- Unit Cost:
As to Previous department:
Total cost / Number of Equivalent units produced = 540 / 600 = 0.90
As to Direct Material:
150 / 600 = 0.25
As to Direct Labor:
112 / 560 = 0.20
As to F.O.H:
135 / 900 = 0.15
1.65
V- Apportionment of the Accumulated Cost:
Cost of units transferred to the next department
No of completed units x Total cost per unit:
500
x
1.65
=
825
Units in process:
Cost of preceding department 100 x 0.9
=
90
Direct Material
100 x 0.25
=
25
139
img
Cost & Management Accounting (MGT-402)
VU
Direct Labor
60 x 0.20
=
12
F.O.H
60 x 0.30
=
18
145
970
Q. 2
Mini Soap Manufacturing unit started to incurring cost in first department for 1000 soaps. At the
end of the week 600 soaps were completed, 300 still in process and 100 units lost. 100% of direct
material had been incurred but 75% conversion cost was yet incurred on the incomplete work.
The detail of costs incurred by the department:
Rs.
Direct material 500
Direct labor
225
Factory overhead
135
Required: Prepare cost of production report
Cost Of Production Report
Department-I
I-Quantity Schedule:
Units started in process
1000
Units completed in the department
600
Units still in process
300
Units Lost (Normal)
100
1,000
II-Cost Accumulated in the Department / Process:
Total
Rs
Direct Material
500
Direct Labor
225
F.O.H
135
860
III-Calculation of Equivalent Units Produced:
Direct material 600+ (300x100%)
= 900
Direct labor
600+ (300x75%)
= 825
F.O.H
600+ (300x75%)
= 825
IV- Unit Cost:
Direct material
500/900
= 0 .555
Direct labor
225/825
= 0.27272
F.O.H
135/825
= 0.163636
0.992
V- Apportionment of the Accumulated Cost:
Cost of units transferred to the next department
600
x
0.992
595
Work in process:
Direct Material
300 x 0.5555 = 167
Direct Labor
300 x 0.2727 = 61
F.O.H
300 x 0.16363 = 37
265
860
140
img
Cost & Management Accounting (MGT-402)
VU
Normal Loss in First Department.
Loss of units during manufacturing process is, in many industries, a normal condition. This loss
may be due to unavoidable spoiled work or wastage, evaporation or shrinkage etc. In other words,
normal loss represents the lost units expected to arise even under efficient operating conditions.
Such a loss is inherent in manufacturing operations and cannot be avoided, for this reason; cost of
normal loss is absorbed by the good units produced. It has the affect of increasing unit cost of
good output. Total cost of the department is not divided by all units processed, instead. It is
divided only by the good units produced.
Practice Question
During the month of January 2006 direct materials worth Rs. 300,000 were issued to produce
26,000 units of finished product. Direct labor to process these materials totaled Rs. 110,000 and
factory overhead Rs. 55,000. During the month processing of 20,000 units were completed and
these units were transferred to next department, whereas, 1,000 units were lost during processing
(the loss is regarded as normal). All of the direct materials had been issued for the units in process
at the end of month, but these units were only 40% converted. Cost of Production Report for the
month 'based on above inforn1ation is given below:
Ginza Beauty products
Department I
Cost of Production Report
For the Month of January, 2006.
Quantity Schedule
Units started in process
26,000
Units transferred to next department
20,000
Units still in process
5,000
(100% materials, 40% labor & FOH)
Units lost in process
Normal loss
1,000
26,000
Cost accumulated to Department
Total
Units
Rs.
Rs.
Cost added by the department:
Direct materials
300,000
12
Direct labor
110,000
5
Factory overhead
55,000
2.50
Total cost to be accounted for
465,000
19.50
Cost Apportioned
Transferred to next department
(20,000 units x Rs. 19.50)
Rs. 390,000
Rs.
Work in process ending inventory:
Direct materials (5000 units x Rs. 12.00)
60,000
141
img
Cost & Management Accounting (MGT-402)
VU
Direct labor (5000 units x 40% x Rs. 5.00)
10,000
FOH (5000 units x 40% x Rs. 2.50)
5,000
75,000
465,000
Whenever, normal loss occurs in the first department, it requires no separate calculation. Number
of units so lost is ignored while computing equivalent production. The result is a decrease in
equivalent production quantity (the denominator) and an increase in unit cost.
In the above cost of production report, equivalent production of department I include 20,000
completed units plus 5,000 units in work in process ending inventory adjusted for their stage of
completion.
Normal Loss in Departments Subsequent to the First.
It is stated earlier that cost of normal loss is absorbed by the good units produced and this is done
by omitting lost units from equivalent production quantity. Same procedure applies when units are
lost during processing in a department subsequent to the first.
However, here an adjustment in unit cost from preceding department is also necessary. In the above report
total cost of Rs. 390,000 received from department I was for 20,000 units. Out of these 20,000
units, 500 units were lost. Now total cost of Rs. 390,000 applies only to 19,500 remaining good
units. This decrease in number of units will cause an increase in unit cost from preceding department.
In department 2, after the lost units have been taken into account, unit cost from department I
come to Rs. 20.00 (i.e. Rs. 390,000 + 19,500 units). This increase of Rs. 0.50 (i.e. Rs. 20.00 less Rs.
19.50) is called adjustment for lost units.
The adjustment for lost units can be computed by anyone of the following two methods. For the
purpose of explanation assume the following:
Assembling department received from cutting department 32,000 units at a total cost of
Rs.120,000 resulting in a unit cost of Rs. 3.75. During processing in assembling department 2,000
units were lost. The lost units are considered as normal.
First Method: Firstly find unit cost received from preceding department after adjustment for lost
units and then deduct it from the unit cost before adjustment; the difference is adjustment per unit.
Unit cost after adjustment is calculated by dividing total cost from preceding department by good
units left after the loss.
Computations are illustrated as follow:
Rs
Unit cost after adjustment
Rs. 120,000/30,000 units
4.00
Unit cost before adjustment
3.75
Adjustment per unit
0.25
Second Method: Find total cost of lost units at which they are received by the department. This
total cost is now to be absorbed by the remaining good units. How much cost is to be absorbed by
each good unit is computed by dividing remaining good units into total cost of lost units. The
resulting figure is adjustment per good unit.
These computations are explained as follows:
Cost of lost units accumulated upto preceding department
2,000 units x Rs. 3.75
Rs. 7,500
Adjustment per unit Rs. 7.500/30,000 units
Rs. 0.25
142
img
Cost & Management Accounting (MGT-402)
VU
Normal Loss at the End of Process:
Preceding discussion of normal loss is for a situation where units are lost at the beginning or
during manufacturing process in the department. In many industries, lost units are identified by
quality inspectors at the end of manufacturing process when all production costs have been
incurred by the department. In such cases cost of units lost is charged to completed units only and
no portion of loss is absorbed by Units in work in process ending inventory
For this purpose lost units are included in equivalent production and the adjustment for lost units
is not required, cost of lost units is included in cost of units completed and transferred out or still
in the department. This treatment increases unit cost of completed units only.
Assuming that in department 2 lost units are discovered in final inspection at the end of process,
cost of production report of the department will be as follow:
Ginza Beauty products
Department 2
Cost of Production Report
For the Month of January 2006
Quantity Schedule.
Units received from preceding department
20,000
Units transferred to next department
16,000
Units still in process
(80% direct labor & factory overhead)
3,500
Units lost in process
Normal loss (at the end of process)
500
20,000
Total
Unit
Cost Charged to Department.
Rupees
Rupees
Cost from preceding department
390,000
19.50
Cost added by department:
Direct labor
36,284
1.88
Factory overhead
72,568
3.76
Total cost added by department
108,852
5.64
Total cost to be accounted for
498,852
25.14
Cost Accounted for as Follow
Rupees
Rupees
Transferred to next department
(16,000 units x Rs. 25.93)
414,810
Work in process ending inventory
Cost from preceding department
(3,500 units x Rs. 19.50)
68,250
Direct labor (3,500 units x 80% x Rs 1.88)
5,264
FOH (3.500 units x 80% x Rs. 3.76)
10,528
84,042
Total cost accounted for
498,852
Equivalent units produced
16,000 + (3,500 x 80%) + 500 = 19,300 units
Cost per unit
Direct labors
36,284/19,300 units
1.88
Factory overhead
72,568/19,300 units
3.76
Cost transferred to next department
16000 units x Rs. 25.14
402,240
Add cost of lost units
500 units x Rs. 25.14
12,570
143
img
Cost & Management Accounting (MGT-402)
VU
Total cost
414,840
Unit Cost of Units Transferred out:
Rs. 414,840
= 25.9256
16,000 units
The logic of charging cost of normal loss at the end of process only to completed units is that
these units have goon through quality inspection, whereas, units still in process are yet to pass the
inspection, of-course, units till in process include spoiled units as well. Therefore, units in work in
process ending inventory shall be charged with the cost of spoiled units, .1cluded therein, only
after these units will have goon through quality inspection. In many industries units being
processed in a department are checked at a definite stage before the end of process, say at 75% or
90% stage of completion. In this case cost of normal loss is charged only to those nits which have
passed through the stage at which quality check is made. These units may be still in process or may
have been completed and transferred out.
Abnormal Loss
Abnormal loss is the loss of units not expected to arise under efficient operating conditions. It is
not inherent in the manufacturing process; instead, it is on account of some accident or
carelessness. The reasons of abnormal loss include defective materials or poor workmanship,
machine breakdown or some other contingency. Abnormal loss represents inefficiencies in the
manufacturing process; therefore, it is improper to treat it as a part of product cost of good units.
Cost of abnormal loss is treated as separate unfavorable item and is shown as such in cost of
production report. It is debited to factory overhead control account or to a separate expense
account to be charged directly against revenues of the period and is credited to the departmental
work in process control account. Being an indicator to inefficiency, abnormal loss requires
immediate attention of management.
For the purpose of computing unit cost, units of abnormal loss are, included in equivalent
production after adjustment for degree of completion. Consequently unit cost represents, cost per
unit as if there were no loss.
PRACTICE QUESTION
Q. 3
Mini Soap Manufacturing unit completed and transferred out 600 soaps to department-11 at the
end of the week. In department-11 450 soaps completed and transferred to finished goods. Units
which were still in process 100 and 50 units lost (Normal). Units in process 100% with the
reference of material and 60% with conversion cost.
Rs.
Cost received from preceding department
540
Following costs were incurred by department-II:
Direct Material
150
Direct Labor
112
Factory overhead
168
430
970
Required: Prepare cost of production report
Solution:
Cost of Production Report
Department-II
I-Quantity Schedule:
Units received previous department
600
144
img
Cost & Management Accounting (MGT-402)
VU
Units completed and transfer to
Finished goods
450
Units still in process
100
Units lost (Normal)
50
600
II-Cost Accumulated in the Department / Process:
Rs.
Cost received from preceding department
540
Cost added by department-11:
Direct Material
150
Direct Labor
112
Factory overhead
168
430
970
III-Calculation of Equivalent Units Produced:
(100% of completed units + % of units in process)
Units completed in department-I = 450 + 100 = 550
Direct Material:
450+(100x100%)
= 550
Direct Labor  :
450+(100x60%)
= 510
F.O.H
:
450+(100x60%)
= 510
IV- Unit Cost:
Previous department = 540 / 550 = 0.98182
Direct Material
150 / 550 = 0.272727
Direct Labor
112 / 510 = 0.21961
F.O.H
135 / 510 = 0.32941
1.80357
V- Apportionment of the Accumulated Cost :
Transferred to finished goods
450
x
1.80357
812
Work in process:
Cost of preceding department
(100 x 0.98182)
98
Direct Material
(100 x0.272727)
27
Direct Labor
(60 x 0.21961)
13
F.O.H
(60 x 0.32941)
20
158
970
Transfer to Finished Goods
Cost of preceding department (450 x 0.98182)
442
Direct Material
(450 x0.272727)
123
Direct Labor
(450 x 0.21961)
99
F.O.H
(450 x 0.32941)
148
812
145
img
Cost & Management Accounting (MGT-402)
VU
Q. 4
Mini Soap Manufactures Co. started to incurring cost in first department for 1000 soaps. At the
end of the week 600 soaps were completed and 300 still in process . 100% of direct material had
been incurred. But 75% conversion cost was yet incurred on the incomplete work. Remaining 100
units were abnormally lost (completed 100% material, 50% conversion cost)
Following in the detail of cost incurred:
Direct material Rs.
500
Direct labor
225
Factory Overhead
135
860
Required: Prepare cost of production report
Cost Of Production Report
Department-I
III-Calculation of Equivalent Units Produced:
Direct material:
600+(400x100%)+(100x100%) = 1000
Direct labor  : 600+(300x75%)+(100x50%) = 875
F.O.H
:
600+(300x75%)+(100x50%) = 875
IV- Unit Cost:
Direct material:
500/1,000
= 0 .50
Direct labor  :
225/875
= 0.25714
F.O.H
:
135/875
= 0.15428
0.91142
V- Apportionment Of the Accumulated Cost to Finished Goods:
Cost of units transferred to the next department
600
x
0.91142
=
547
Closing W.I.P Inventory:
Direct Material
300 x 0.50
= 150
Direct Labor
300 x 75% x 0.25714
= 58
F.O.H
300 x 75% x 0.15428
= 34
242
Abnormal Loss
Direct Material = 100 x 0.5
= 50
Direct Labor  = 50 x 0.25714
= 13
FOH
= 50 x 0.15428
= 8
71
860
Problem Question
Q. 1
Orient Industries. Limited produces a product that passes through two departments. Production
data for the first month of its operations are as follow:
Department A  Department B
Production Costs:
Rupees
Rupees
Direct materials
140,000
28,000
Conversion costs
200,000
70,000
Units
Units
Production units:
Started / received in process
23,000
13,000
Transferred out
18,000
13,000
Still in process
2/3 complete
3,000
146
img
Cost & Management Accounting (MGT-402)
VU
1/5 complete
2,500
In department B there is an abnormal loss of 1,500 units when 1/3 complete.
Required: Prepare cost of production report for the month
Q. 2
Delight Food Products produces 'Squash Cubes" by continuous processing. During February 19 -'
producing department XYZ received 8,000 cubes from the preceding department aI1d after
processing, transferred 5,500 cubes to next department. During the month there was normal loss
of 400 cubes at the end of process. 600 cubes, 75% converted, were lost due to negligence of a
worker. There was no work in process beginning inventory, the ending inventory was estimated as
60% converted. Following product costs were charged to the department during February:
Rs.
Cost from preceding department
16,400
Direct materials
2,000
Direct labor
3,625
Factory overhead
5,075
Rs. 27,000
In department XYZ all materials are added at the start of process.
Required: Cost of production report for February 2006
Q. 3
Quantity schedule of Mirza and Company shows that 12,000 units were started in process during
the month of June. 7,000 units were completed and transferred to next department. 4,000 units,
25 % complete as to materials and 50% complete as to labor and factory overhead, were in
process at the end of June. The remaining units were lost during processing. Costs incurred by the
department were materials Rs. 90,000 labor Rs. 70,000 and factory overhead Rs. 50,000. .
Required: Cost of production report for the month.
Q. 4
Tahir Manufacturing Company uses process costing. Costs of direct materials, direct labor and
factory overhead incurred by department A during April 2000, were Rs. 25,000, Rs. 30,000 and Rs.
20,000 respectively. The quantity schedule shows that 8,000 units were started in process. 5,000
units were transferred to next department. 2,000 units were still in process (all materials, 50%
labor and 25 % factory overhead). The remaining units were lost, in process.
Required: Cost of production report for April, 2000.
Q. 5
During April, 20,000 units were transferred in from Department A at a cost of Rs. 39,500.
Materials cost of Rs. 6,500 and conversion cost of Rs. 9,000 were added in Department B. On
April 30, Department B had 5,000 units of work in process 60% complete as to conversion costs.
Materials are added in the beginning of the process in Department B.
Required: Cost of production report.
147
img
Cost & Management Accounting (MGT-402)
VU
LESSON# 23 & 24
PROCESS COSTING SYSTEM
(Opening balance of work in process)
Work-in-process and equivalent units
Partially-processed units
At the end of a period there may be some units which have been started but have not been
completed. These are closing work-in-process units.
At this stage we assume for simplicity that there is no opening work-in-process. In that case the
output for a period will consist of two classes of finished units of production:
Those that have been started and fully processed within the period
Those that have been started during the period, but not finished by the end of the period. This
closing work-in-process will be completed during the following period;
Further costs will be incurred in order to achieve this.
Equivalent units
Once processing has started on a unit; of output, to the extent that it remains in an uncompleted
state it can be expressed as a proportion of a completed unit. For example, if 100 units are exactly
half-way through the production process in terms of the amount of cost they have absorbed, they
are effectively equal to 50 complete units. Therefore, 100 units which are half-complete can be
regarded as 50 equivalent units that are complete.
Practice Question
A manufacturer starts processing on 1 March. In the month of March he starts work on 20,000
units of production. At the end of March there are 1,500 units still in process and it is estimated
that each is two thirds complete. Costs for the-period total Rs19,500.
Calculate the value of the completed units and the work-in-process at 31 March.
In practice it is unlikely that all inputs to production will take place at the same time, as was
suggested in the example above. For instance, materials are frequently added at the beginning of a
process, whereas labor may be applied throughout the process. Thus, work-in-process may be
more complete as regards one input or cost element than as regards another. Equivalent units must
thus be calculated for each input and costs applied on that basis,
Practice Question
In this activity, use the same data as in Activity 1 except that:
 all materials have been input to the process
 work-in-process is only one-third complete as regards labor
Costs for the period are as follows:
Materials
10,000
Labor
9,500
Total
19,500
Costs for a process are allocated to equivalent units to calculate valuations for finished goods and
work-in-process.
The FIFO and weighted average methods of cost allocation
In the previous examples it was assumed that there was no opening stock of work-in-process. In
reality, of course, this is unlikely to be the case, and changes in levels of work-in-process during me
period can give rise to problems. There are basically two methods of accounting for such changes.
The weighted average (or averaging) method
The FIFO method.
148
img
Cost & Management Accounting (MGT-402)
VU
Weighted average method
In the weighted average method opening stock values are added to current costs to provide an
overall average cost per equivalent unit. No distinction is therefore made between units in process
at the start of the period and those added during it and the costs associated with them
Problem Question
FL Manufacturing Co Ltd
Process information for month ended 31 December
Work-in-process 1 December (15,000 units, two-fifths complete)
Rs. 10,250 (work-in-process value made up of: materials Rs 9,000
Plus conversion costs Rs1,250).
Units started during December
30,000
Units completed during December
40,000
Work-in-process 31 December (half completed)
5,000
Material cost added in month
24,750
Conversion cost added in month
20,000
Materials are wholly added at the start of the process.
Conversion takes place evenly throughout the process.
Calculate the values of finished production for December and work-in-process at 31 December,
using the weighted average method.
Choosing the valuation method in practice
In practice the FIFO method is little used, for two main reasons:
 It is more complicated to operate
 In process costing, it seems unrealistic to relate costs for the previous period to the current
period of activities.
Choosing the valuation method in examinations
In order to use the weighted average or FIFO methods to account for opening work-in-process
different information is needed, as follows:
Method
Information needed
For weighted average.
An analysis of the opening work-in-process value
into cost elements (i.e. materials, labor)
For FIFO
The degree of completion of the opening work in
process for each cost element.
If all of the information is available so that either method may be used, the question will specify
the required method.
Where there is opening work-in-process, two methods of cost allocation can be used which make
different assumptions and produce different stock valuations. They are FIFO and weighted
average.
PRACTICE QUESTION
Q. 1
Mini Soap Manufacturing unit providing following information
Units of opening work in process
200 units
Units put into the process
800 units
Units completed and transfer out
1000 units
Units of opening work in process 100% completed as per direct material and 75% completed with
direct labor and factory overhead cost.
149
img
Cost & Management Accounting (MGT-402)
VU
Cost incurred on opening work in process:
Direct Material
Rs. 6,000
Direct Labor
2,000
Factory overhead
1,000
9,000
Cost incurred during the accounting period on units put in the process:
Direct Material
Rs. 20,000
Direct Labor
10,000
Factory overhead
8,000
38,000
Required: Prepare cost of production report of process-1 (using FIFO and Weighted Average
method of inventory costing)
Cost of Production Report
Department-1
I-Quantity Schedule:
Units of opening work in process
200
Units put in the process
800
1,000
Units completed and transfer out
1,000
II-Cost Accumulated in the Process:
Direct Material (6,000 + 20,000)
26,000
Direct Labor (2,000 + 10,000)
12,000
F.O.H (1,000 + 8,000)
9,000
47,000
III-Calculation of Equivalent Units Produced (FIFO)
As to Direct Material 200 x 0% +  800
800
As to Conversion cost 200 x 25% + 800
850
IV- Unit Cost (FIFO) :
Direct Material
20,000 / 800
= 25
Direct Labor
10,000 / 850
= 11.7647
F.O.H
8,000 /850
= 9.4118
= 46.1765
V- Cost Apportionment/Accounting Treatment (FIFO) :
Cost of opening work in process
Cost already incurred on opening WIP Rs. 9000
Material
100% complete
0
Labor 200 x 25 % = 50 x 11.7647 =
588
FOH  200 x 25 % = 50 x 9.4118 =
471
10,059
Cost of units put into the process during the period
800 x 46.1765
36,947
47,000
150
img
Cost & Management Accounting (MGT-402)
VU
III-Calculation of Equivalent Units Produced (W. Avg method)
Material and Conversion cost = 1000 units
IV- Unit Cost (W. Avg) :
Direct Material 26,000 / 1,000
= 26
Direct Labor
12,000 / 1,000
= 12
F.O.H
9,000 / 1,000
= 9
47
V- Cost Apportionment
Cost of units transferred to the next department:
1000
x
47
= 47,000
Q. 2
Mini Soap Manufacturing unit providing following information:
Units of opening work in process
200
Units put into the process
800
1000
Units of closing work in process
300
Units completed and transfer out
700
Cost incurred on opening work in process:
Direct Material
Rs. 6,000
Direct Labor
2,000
Factory overhead
1,000
9,000
Cost incurred on units put in the process:
Direct Material
Rs. 20,000
Direct Labor
10,000
Factory overhead
8,000
38,000
47,000
Units of opening work in process 100% completed as per direct material and 75% completed with
direct labor but the units of closing work in process 100% completed as per material and 50%
direct labor.
Required: Prepare cost of production report of process-1
Cost of Production Report
Calculation of Equivalent Units Produced (Weighted Average Method)
Material
Labor
FOH
Completed units
700
700
700
Opening WIP
300
(300 x50%)
(300 x50%)
150
150
Total
1000
850
850
151
img
Cost & Management Accounting (MGT-402)
VU
Per unit cost (W.Avg)
Material
26,000 / 1000 = 26
Labor
12,000 / 850= 14.1176
FOH
9,000 / 850 = 10.5882
Total
50.7058
Cost Apportionment
Cost of units transferred to the next department:
700
x
50.7058
= 35,494
Work in process
Material
300 x 26 =
7,800
Labor
150 x 14.1176 =
2,118
FOH
150 x 10.5882 =
1,588
11,506
47,000
Equivalent production (FIFO)
Opening WIP Completed # of Closing work in
Total
units (Current
process
period )
(% of completion)
Material
0
500
300
800
Labor
(200 x 25%)
500
(300 x 50%)
700
25
150
FOH
(200 x 25%)
500
(300 x 50%)
700
25
150
Cost Per Unit (FIFO)
Direct Material:
20,000 / 800
= 25
Direct Labor:
10,000 / 700
= 14.2857
F.O.H
:
8,000 / 700
= 11.4286
152
img
Cost & Management Accounting (MGT-402)
VU
1- Cost of units transferred to next department
a- Opening work in process
Cost already incurred
9,000
Direct Labor  200 x 25% = 50 x 14.2857 =  714
FOH
200 x 25% = 50 x 11.4286 =  571
10,285
b- Cost of completed units
500 x 50.7143
25,358
Cost transferred to next department
35,643
2- Closing work in process
Material 300 x 25
= 7500
Labor
150 x 14.2857 = 2142
FOH  150 x 11.4286 = 1715
11,357
47,000
Q. 3
Units of opening work in process
2,000
Units produced during the period
16,000
18,000
Units completed and transfer out
14,800
Work in progress at the end
3,200
Stage of completion
Material
Labor & Overhead
Opening WIP
100%
50%
Closing WIP
100%
25%
Cost incurred on opening work in process:
Direct Material
Rs. 24,000
Direct Labor
3,200
Factory overhead
3,200
30,400
Cost incurred during the current period :
Direct Material
Rs. 20,000
Direct Labor
63,680
Factory overhead
63,680
319,360
349,750
Required: Prepare cost of production report of process-1
153
img
Cost & Management Accounting (MGT-402)
VU
Cost of Production Report
Calculation of Equivalent Units Produced (Weighted Average Method)
Material
Labor & FOH
Completed units
14,800
14,800
Opening WIP
3,200
(3,200 x50%)
800
Total
18,000
15,600
Equivalent production (FIFO)
Opening WIP Completed # of  Closing work in
Total
units (Current
process
period )
(% of completion)
Material
0
12,800
3,200
16,000
Labor &
(2000 x 50%)
12,800
(300 x 25%)
14,600
FOH
1000
800
Per unit cost (W.Avg)
Per unit cost (FIFO)
Material
2,16,000 / 18,000 = 12
19,200 / 16,000 =
12
Labor
66,880 / 15,600 =
63,680 / 14,600 =
4.2872
4.3616
FOH
66,880 / 15,600 =
63,680 / 14,600 = 4.3616
4.2872
Total
20.5744
20.7232
154
img
Cost & Management Accounting (MGT-402)
VU
Cost Apportionment (Weighed Average Method)
Transfer to next department
14,800 X 20.5744 =
304,500
Work in process
Material
3200 x 12 = 38,400
Labor
800 x 4.2872 = 3430
FOH
800 x 4.2872 = 3430
45,260
349,760
Cost Apportionment (Weighed Average Method)
1- Cost of units transferred to next department
a- Opening work in process
Cost already incurred
30,400
Direct Labor  1000 x 4.3616 =
4316
FOH
1000 x 4.3616 =
4316
39,122
b- Cost of completed units
12,800 x 20.7232
265,258
Cost transferred to next department
304,380
2- Closing work in process
Material 3,200 x 12
= 38,400
Labor  800 x 4.3616
= 3,490
FOH  800 x 4.3616
= 3,490
45,380
349,760
155
img
Cost & Management Accounting (MGT-402)
VU
LESSON# 25 & 26
COSTING/VALUATION OF JOINT AND BY PRODUCTS
Following are self explanatory diagrams which help in understanding the concept of joint product
and by products.
Input
Output
Output
Joint product
By Product
Considerably Significant
Incidental Produce
Example: Sugarcane Juice
Example: Crude Oil (Diesel & Petrol)
(Husk or Pulp is a by product)
Department A
(Cost Accumulated)
Direct Material, Direct Labor, FOH
Joint Product Joint Product Joint Product
By Product
By Product
A (a)
A (b)
A (c)
Requiring no
Requiring
Direct Material Direct Material Direct Material
further
further
Direct Labor  Direct Labor  Direct Labor
process
process
FOH
FOH
FOH
For by products:
Basis of Cost Allocation
Physical Quantity Ratio
Selling Price Ratio
Hypothetical Market
Value Ratio
156
img
Cost & Management Accounting (MGT-402)
VU
Valuing by-products and joint products
By-products
Either of the following methods may be adopted when valuing by-products:
(a) The proceeds from the sale of the by-product may be treated as pure profit
(b) The proceeds from the sale, less any handling and selling expenses, may be applied in reducing
the cost of the main products.
If a by-product needs further processing to improve its marketability, such cost will be deducted in
arriving at net revenue, treated as in (a) or (b) above.
Recorded profits will be affected by the method adopted if stocks of the main product are
maintained.
Accounting for joint products
Joint products are by definition, subject to individual accounting procedures. Joint costs may
require apportionment between products if only for joint valuation purposes.
The main bases for apportionment are as follows:
Physical measurement of joint products
When the unit of measurement is different, e.g. liters and kilos, some method should be found of
expressing them in a common unit. Some joint costs are not incurred strictly equally for all Joint
products: such costs can be separated and apportioned by introducing weighting factors.
Market value
The effect is to make each product appear to be equally profitable. Where certain products are
processed after the point of separation, further processing costs must be deducted from the market
values before joint costs are apportioned.
Technical estimates of relative use of common resources
Apportionment is, of necessity, an arbitrary calculation and product costs which include such an
apportionment can be misleading if used as a basis for decision-making.
Problems of common costs
Even if careful technical estimates are made of relative benefits, common costs apportionment will
inevitably be an arbitrary calculation. When providing information to assist decision-making,
therefore, the cost accountant will emphasize cost revenue differences arising from the decision.
Here are some examples of decisions involving joint products:
withdrawing, or adding, a product
Special pricing
Economics of further processing.
Apportioned common costs are not relevant to any of the above decisions although a change in
marketing strategy may affect total joint costs, e.g. withdrawing a product may allow capacity of the
joint process to be reduced.
In the short or medium term, it is probably impractical and/or uneconomic to alter the processing
structure. The relative benefit derived by joint products is, therefore, irrelevant when considering
profitability or marketing opportunities.
157
img
Cost & Management Accounting (MGT-402)
VU
PRACTICE QUESTION
Q. 1
Physical quantity method
Cost Allocation at Split off Point
1960 liter fresh milk put in the process
Skim Milk
1,000 Liter
Cream
500 Liter
Butter
200 Liter
Ghee
100 Liter
Yogurt
60 Liter
Miscellaneous 100 Liter
Cost incurred for 1,960 liters of milk is Rs. 15,680
Solution
Skim Milk
= 15,680 / 1960 x 1000 = 8,000
Cream
= 15,680 / 1960 x 500 = 4,000
Butter
= 15,680 / 1960 x 200 = 1,600
Ghee
= 15,680 / 1960 x 100 = 800
Yogurt
= 15,680 / 1960 x 60  = 480
Miscellaneous
= 15,680 / 1960 x 100 = 800
Q. 2
Cost incurred in the department Rs 70,000
Drum sticks
Rs. 4 per gram
Breast pieces
Rs. 6 per gram
Wings
Rs. 3 per gram
Miscellaneous Rs. 2 per gram
Drum stick
20,000 X 4
= 80,000
Breast pieces
10,000 X 6
= 60,000
Wings
6,000 X 3
= 18,000
Miscellaneous
4,000 X 2
= 8,000
1,66,000
Solution
Drum stick
= 70,000 / 1,66,000 x 80,000 = 33,735
Breast pieces
= 70,000 / 1,66,000 x 60,000 = 25,300
Wings
= 70,000 / 1,66,000 x 18,000 = 7,590
Miscellaneous
= 70,000 / 1,66,000 x 8,000 = 3,375
70,000
Physical Quantity Ratio
Total quantity produced 40,000 grams
Drum stick
20,000
Breast pieces
10,000
Wings
6,000
Miscellaneous
4,000
40,000
158
img
Cost & Management Accounting (MGT-402)
VU
Drum stick
= 70,000 / 40,000 x 20,000
= 35,000
Breast pieces
= 70,000 / 40,000 x 10,000
= 17,500
Wings
= 70,000 / 40,000 x 6000
= 10,500
Miscellaneous = 70,000 / 40,000 x 4000
= 7,000
70,000
Q. 3. ABC limited produces three products O, P and Q by the operation. Cost accumulated during
the operation.
Direct Material 1000 kg @ Rs 2 =
Rs. 2,000
Direct Labor
5,000
FOH
8,000
15,000
Output
O
500 Kg
Sold at split off point for Rs 20 / kg
P
300 kg
Enters into a second process
Q
200 kg
Enters into a second process
Second process for product P
Cost incurred: Total
Per Unit
Direct Labor cost
Rs. 6,000
Rs. 20
FOH
Rs. 3,000
Rs. 10
Product P is 100% complete & sold for Rs 70 / kg
Second process for product Q
Cost incurred: Total
Per Unit
Direct Labor cost
Rs. 1,400
Rs. 7
FOH
Rs.  600
Rs. 3
Product Q is 100% complete & sold for Rs 30 / kg
Solution
Method # 1
Physical Quantity Ratio
Process-1
Quantity Schedule
Units put in the process 1,000 kg
Completed units of product "O"
500 kg
Transfer to further process
Product "P"
300
Product "Q"
200
1000
Cost Accumulated as follow:
Direct Material
2,000
Direct Labor
5,000
FOH
8,000
15,000
159
img
Cost & Management Accounting (MGT-402)
VU
Cost Allocation / Accounting Treatment
Product O
=
15,000 x500 / 1000 = 7,500
Product P
=
15,000 x 300 / 1000 = 4,500
Product Q
=
15,000 x 200 / 1000 = 7,500
Product O
No further process is required
Completed & Sold
Sold 500 x 20 = 10,000
Cost 500 x 15 = 7,500
Gross Profit
2,500
Product P
Cost Accumulated
Cost received from Process 1
Rs. 4,500
Direct Labor
6,000
FOH
3,000
13,500
Unit Cost = 13,500 / 300 = 45 / Kg
Transfer to finished goods = 300 x 45 = 13,500
Sales  300 x 70
= 21,000
Less Cost 300 x 45
= 13,500
7,500
Product Q
Cost Accumulated
Cost received from Process 1
Rs. 3,000
Direct Labor
1,400
FOH
600
5,000
Unit Cost
5,000 / 200 = 25 / Kg
Transfer to finished goods = 200 x 25 = 5,000
Sales  200 x 30
= 6,000
Less Cost 200 x 25
= 5,000
1,000
Method # 2 Hypothetical market Value Basis
O
P
Q
Rs
Rs
Rs
Final Price
20
70
30
Additional Cost per kg
In further processing
Direct Labor
-
20
7
Factory Overhead
-
10
3
Hypothetical Market Value
At split off point
20
40
20
160
img
Cost & Management Accounting (MGT-402)
VU
Cost Allocation in the Process-1
Product O (Finished) 15,000 / 80 x 20
= 3,750
Product P Transferred to process II 15,000 / 80 x 40
= 7,500
Product Q Transferred to process II 15,000 / 80 x 20
= 3,750
15,000
Product P
Process -II
Quantity Schedule
Received From process-I
300
Completed and transfer out
300
Cost Accumulated
Cost received from process-1
7,500
Cost added
Direct Labor
6,000
FOH
3,000
9,000
16,500
Cost Apportionment / Accounting Treatment
Cost transfer to finished good
Rs 16,500
16,500 / 300 = 55 per kg
300 x 55 = 16500
Sales
300 x 70
= 21,000
Less Cost
300 x 55
= 16,500
Gross Profit
4,500
Product
Q
Process -II
Quantity Schedule
Received From process-I
200
Completed and transferred out
200
Cost Accumulated
Cost received from process-1
3,750
Cost added
Direct Labor
1,400
FOH
600
5,750
Cost Apportionment / Accounting Treatment
Cost transfer to finished good
Rs 5,750
5750 / 200 = 28.75 per kg
200 x 28.75 = 5,750
Sales 200 x 30
= 6,000
Less Cost 300 x 55
= 5,750
250
By Products
Some examples of by products are given below:
161
img
Cost & Management Accounting (MGT-402)
VU
Main Product
By Product
Soap
Glycerin
Meat
Hides & Fats
Flour
Bran
Classification of by product
By product can be classified into two categories:
1. Requiting no further process, for example Bran
2. Requiting further processing, for example Hides
Accounting for By Products
Income Approach
Costing Approach
Sales Income
Credit the cost of main product with the:
1- Treat as other income
1- Replacement cost / Opportunity
2- Treat as a deduction form
Cost of By Product
Cost goods sold
3- Treat as a deduction form
2- Predetermined price / Standard
Cost goods manufactured
Cost
Realizable Income
1- Treat as a deduction form
Cost goods manufactured
162
img
Cost & Management Accounting (MGT-402)
VU
PRACTICE QUESTION
Following is a question on by product:
Main product
By product
Opening stock
-----
-----
Production during the year
4,000
800
Closing stock
400
100
Cost incurred
64,000
-----
Cost of 3600 units (64,000/4000x3600)
57,600
-----
Sales price (Per unit)
30
2.50
Further processing cost
0.50
Solution
Method # 1
Rupees
Treat as an other income
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost
64,000
Less Closing stock (16 x 400)
(6,400)
57,600
Gross Profit
50,400
Add other income
1,400
51,800
Sales of By Product
(700 x 2.5)
1,750
Less Further Processing cost (700 x 0.5)
350
1,400
Method # 2
Rupees
Treat as a deduction from cost of goods sold
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost
64,000
Less Closing stock (16 x 400)
6,400
57,600
Less Sales value of By Product
(1,400)
56,200
Gross Profit
51,800
Method # 3
Rupees
Treat as a deduction from cost of goods manufactured
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost (64,000 ­ 1,400)
62,600
Less Closing stock (62,600 x 10%)
6,260
56,340
Gross Profit
56,660
163
img
Cost & Management Accounting (MGT-402)
VU
Realizable Value Basis
Production cost on By Product
800 x 2.50 =
2,000
Additional cost on By Product
800 x 0.50 =
400
Realizable Value
1,600
Treat as a deduction from cost of goods manufactured
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost (64,000 ­ 1,600)
62,400
Less Closing stock
(62,400/4,000=15.6 x 400)
6,240
56,160
Gross Profit
51,840
Further example of by product
Joint Cost Rs. 206,800
Further Cost
Sales Price Market Value
Incurred per
pound
Grade 1
20,000 lb
1
5
(5-1) = 4 x 20,000
80,000
Grade 2
40,000
0.2
4
(4-0.2) = 3.8 x 40,000
152,000
Grade 3
60,000
0.5
3
(3-0.5) = 2.5 x 60,000
150,000
Grade 4
80,000
0.2
2
(2-0.2) = 1.8 x 80,000
144,000
Grade 5
50,000
0.1
1
(1-0.1) = 0.9 x 50,000
45,000
Total
250,000
Multiple Choice Questions
A chemical compound is made by raw material being processed through two processes. The
output of Process A is passed to Process B where further material is added to the mix. The details
of the process costs for the financial period number 10 were as shown below:
Process A
Direct material
2,000 kilograms at Rs5 per kg
Direct labor
Rs 7,200
Process plant time 140 hours at Rs60 per hour
Process B
Direct material
1,400 kilograms at Rs12 per kg
Direct labor
Rs 4,200
Process plant time 80 hours at Rs72.50 per hour
The departmental overhead for Period 10 was Rs 6,840 and is absorbed into the costs of each
164
img
Cost & Management Accounting (MGT-402)
VU
process on direct labor cost.
Process A
Process B
Expected output was
80% of input
90% of input
Actual output was
1,400 kgs
2,620 kgs
Assume no finished stock at the beginning of the period and no work-in-progress at either the
beginning or the end of the period.
Normal loss is contaminated material which is sold as scrap for Rs0.50 per kg from Process A and
Rs1.825 per kg from Process B, for both of which immediate payment is received.
Q. 1
For process A what is the scrap value of the normal loss?
A
Rs  200
B
Rs 2,000
C
Rs 1,000
D
Rs
0
Q. 2
What is the abnormal loss for process A in units?
A
100
B
200
C
300
D
400
Q. 3
What is the cost per kg for process A?
A Rs 18,575
B Rs 13,454
C Rs 14.575
D Rs 16,575
Problem Question
Q. 1
Kong CO. manufactures two products, one in process A, the other in process B. The following
information applies to the processes for Period.
All materials are input at the start of each process, conversion costs (labor and overhead) are
incurred evenly throughout the process, and losses are identified at the end of process A and can
be sold for 10p per liter. The dosing work-in-progress is % of the way through the process.
Write up the accounts for process A and for process B
Process A
Process B
Material input-1
4.000 liters costing
200 kg costing
Rs 3,000
Rs 2,000
Labor and overhead
Rs 3,440
Rs 3,900
Transfers to finished goods
13,000 liters
180 kg
Opening work-in-progress
Nil
Nil
Closing work-in-progress
Nil
20 kg
Normal loss as % of input
10%
Nil
Q. 2
Mineral Separators Ltd operates a process which produces four unrefined minerals known as W,
X. Y and Z. The joint costs for operating the process for Period V were as below.
Process overhead is absorbed by adding 25% of the labor cost. The output for Period V was as
165
img
Cost & Management Accounting (MGT-402)
VU
shown below.
There were no stocks of unrefined materials at the beginning of Period V, and no work-in-
progress, but the stocks shown below were on hand at the end of the period, although there was
no work-in-progress at that date.
The price received per ton of unrefined mineral sold is shown below and it is confidently expected
that these prices will be maintained.
You are required:
(a) To calculate the cost value of the closing stock, using sales value as the basis of your calculation.
(b) To calculate the cost value of dosing stock, using weight of output as the basis of your
calculation.
166
img
Cost & Management Accounting (MGT-402)
VU
LESSON# 27 & 28
MARGINAL AND ABSORPTION COSTING
(Product costing systems)
Following diagram helps to recall the behavior of different cost elements.
Cost Elements
Direct Material
Direct Labor
Factory Overhead Cost
Variable & Fixed Cost
Variable Cost
Marginal cost is the cost the variable cost that changes with the production of each next unit.
Marginal and Absorption Costing
So far we have been looking at the various different types of cost and have gradually built up the
total cost of a cost unit by aggregating the cost of direct materials, direct labor, direct expenses,
variable overheads and fixed overheads (absorbed into cost units). We can display this total cost as
part of a profit and loss account (namely cost of sales). In doing so we must remember to adjust
the profit and loss account for any overhead under- or over-absorbed.
This adjustment is only necessary because we are including fixed overheads in the cost of the cost
unit. In other words, we are presenting cost information according to absorption costing
principles. However, there is another method of presenting cost information, i.e. marginal costing.
Marginal Costing
Under this system, we do not attempt to absorb fixed overheads into cost units, and so we avoid
the difficulties of setting absorption rate, adjusting for under or over-absorbed overhead, etc.
Cost units are valued at their marginal cost only (not their fully absorbed cost). In other words the
cost of a cost unit is presented as the total of direct materials, direct labor, direct expenses and
variable overheads (but not fixed overheads).
Of course, this does not mean that we can simply ignore fixed overheads It is simply that we
choose to treat all fixed overheads as period costs, rather than trying to attribute them to individual
cost units You will find that this presentation of cost information has distinct advantages over-
absorption costing when it comes to decision making.
A key concept in marginal costing is that of contribution margin.
Contribution Margin is defined as the sales value of a cost unit minus its variable cost.
Absorption and marginal costing
167
img
Cost & Management Accounting (MGT-402)
VU
In absorption costing, fixed manufacturing overheads are absorbed into cost units. Thus stock is
valued at absorption cost and fixed manufacturing overheads are charged in the profit and loss
account of the period in which the units are sold.
In marginal costing, fixed manufacturing overheads are not absorbed into cost units, Stock is
valued at marginal (or variable) cost and fixed manufacturing overheads are treated as period costs
and are charged in the profit and loss account of the period in which the overheads are incurred.
Practice Question
A Company produces a single product and has the following budget:
Company Budget Cost Per Unit
Rs.
Selling price
10
Direct materials
3
Direct wages
2
Variable overhead
1
Fixed production overhead is Rs. 10,000 per month; production volume is 5,000 units per month.
Calculate the cost per unit to be used for stock valuation under:
(a) Absorption costing
(b) Marginal costing.
Solution
(a) Absorption cost per unit
Rs
Direct materials
3
Direct wages
2
Variable overhead
1
Absorbed fixed overhead
Rs 10,000
2
5000 units
Cost per Unit
8
(b) Marginal cost per unit
Direct materials
3
Direct wages
2
Variable overhead
1
Cost per Unit
6
The stock valuation will be different for marginal and absorption costing. Under absorption
costing stock will include variable and fixed overheads whereas under marginal costing stock will
only include variable overheads.
Further practice question explaining the concept of product cost, period cost and cost per unit
under two product costing systems:
168
img
Cost & Management Accounting (MGT-402)
VU
Absorption Costing
Marginal Costing
100 units
100 units
Direct Material
8,000
8,000
Rs. 80 per unit
5,000
5,000
Direct Labor
Rs. 50 per unit
3,000
3,000
Factory Overhead
2,000
Variable FOH
Fixed FOH
18,000
16,000
Product Cost
2,000
Fixed Cost
(Period Expenses)
Cost per Unit
Under Absorption costing
18,000
Rs. 180 per unit
100
Under Marginal costing
16,000
Rs. 160 per unit
100
Contribution Margin
Contribution margin is the difference between sales and the variable cost of sales.
This can be written as:
Contribution margin = Sales less variable costs of sales
Contribution margin is short for "contribution to fixed costs and profits".
The idea is that after deducting the variable costs from sales, the figure remaining is the amount
that contributes to fixed costs, and once fixed costs are covered the remaining amount is that of
profits.
Contribution and profit
Marginal costing values goods at variable cost of production (or marginal cost) and contribution
can be shown as follows;
Marginal costing: Profit calculation
Rs X
Sales
(X)
Less: variable costs
X
Contribution margin
(X)
Less: fixed costs
X
Profit
Profit is contribution less fixed costs. In absorption costing this is effectively calculated in one
stage as the cost of sales already includes fixed costs
169
img
Cost & Management Accounting (MGT-402)
VU
Absorption costing: profit calculation
Rs
Sales
X
Less: absorption cost
(X)
Profit
X
Profit statements under absorption and marginal costing
To produce financial statements in accordance with IFRS 2, absorption costing must be used, but
either marginal or absorption costing can be useful for internal management reporting the choice
made will affect:
The way in which profit information is presented
The level of reported profit if sales do not exactly equal production (i.e. stock is increasing or
decreasing).
PRACTICE QUESTION
This example continues with the Company from the above practice question.
Show profit statements for the month if sales are 4,800 units and production is 5,000 units under
(a) Total absorption costing
(b) Marginal costing.
Solution
(a) Profit statement under absorption casting
Rs.
Rs
Sales (4,800 @ Rs10)
48,000
Less:
Cost of sates
Opening stock
Production
(5,000 @ Rs. 8)
40,000
Less: Closing stock (200 @ Rs. 8)
(1,600)
(38.400)
Operating profit
9,600
(b) Profit statement under marginal costing
Sales (4.800 @ Rs10)
48,000
Less:
Cost of sates
Opening stock
Production (5,000 @ Rs6)
30,000
Less: Closing stock (200 @ Rs6)
(1,200)
(28,800)
Contribution
19,200
Less: Fixed overheads
10,000
Operating profit
9,200
170
img
Cost & Management Accounting (MGT-402)
VU
PRACTICE QUESTION
Absorption Costing
Marginal
100 units
Costing
100 units
Direct Material
8,000
8,000
Rs. 80 per unit
Direct Labor
5,000
5,000
Rs. 50 per unit
Factory Overhead
Variable FOH
3,000
3,000
Fixed FOH
2,000
Product Cost
18,000
16,000
Fixed Cost
(Period Expenses)
2,000
Cost per Unit
Under Absorption costing
18,000
Rs. 180 per unit
100
Under Marginal costing
16,000
Rs. 160 per unit
100
Prepare income statements under absorption and marginal costing systems assuming the following
facts:
a)
All produced units Sold
b)
No. of units sold
80
No. of units in closing stock
20
No. of units produced
100
c)
No. of units sold
110
No. of units in opening stock
10
No. of units produced
100
171
img
Cost & Management Accounting (MGT-402)
VU
Selling price Rs. 240 per unit
Solution
a)
All Units Sold
Absorption
Marginal
costing
costing
Sales  (110 x 240)
24,000
24,000
Less Product cost
100 x 180
18,000
100 x 160
16,000
Gross profit
6,000
Contribution margin
8,000
Less Fixed cost
0
(2000)
Profit
6,000
6,000
b)
80 units sold & 20 units in closing stock
Absorption costing
Marginal costing
Sales 80 x 240
19,200
19,200
Production cost
100 x 180 =
18,000
100 x 160 =
16,000
Less closing stock
20 x 180 =
(3600)
20 x 160 =
(3,200)
14,600
12,800
Less Fixed cost
2,000
Contribution Margin
4,600
Profit
4,600
4,400
c)
110 units sold
Absorption costing
Marginal costing
Sales 110 x 240
26,400
26,400
Opening stock
10 x 180 =
1,800
10 x 160 =
1,600
Production cost
100 x 180 =
18,000
100 x 160 =
16,000
19,800
17,600
Less Fixed cost
2,000
Contribution Margin
6,600
Profit
6,600
6,800
Reconciliation of the difference in profit
The difference in profit is due to there being a movement in stock levels - an increase from 0 to
200 units over the month.
172
img
Cost & Management Accounting (MGT-402)
VU
Under absorption costing closing stock has been valued at Rs 1,600 (i.e. Rs 8 per unit which
includes Rs 2 of absorbed fixed overheads). Under marginal costing the increase in stock is valued
at Rs 1,200 (i.e. at Rs 6 per unit) and all fixed overheads are charged to the profit and loss account.
Only if stock is rising or falling will absorption costing give a different profit figure from marginal
costing. If sales equal production, the fixed overheads absorbed into cost of sales under absorption
costing will be the same as the period costs charged under marginal costing and thus the profit
figure will be the same.
The two profit figures can therefore be reconciled as follows:
Rs
Absorption costing profit
9,600
Less: fixed costs included in the increase in stock (200 x Rs2)
(400)
Marginal costing profit
9,200
If stock levels are rising from opening to closing balance
Absorption Costing profit > Margin Costing profit
If stock levels are falling from opening to closing balance
Absorption Costing profit < Margin Costing profit
(Fixed costs carried forward are charged in this period, under absorption costing)
If stock levels are the same
Absorption Costing profit = Margin Costing profit
Absorption Costing  Marginal Costing
Produced units = Units
Same Profit
Same Profit
sold
Produced units > Units
More Profit
Less Profit
sold
Produced units < Units
Less Profit
More Profit
sold
Reconciliation of the above practice question
b)
80 units sold & 20 units in closing stock
Rs
Absorption Profit
4,800
Less Closing Stock @ Fixed FOH Rate
20
x
20
(400)
Marginal Costing Profit
4,400
c)
110 units sold with an opening stock of 10 units
Absorption Profit
6,600
Add Opening Stock @ Fixed FOH Rate
10
x
20
200
Marginal Costing Profit
6,800
173
img
Cost & Management Accounting (MGT-402)
VU
Reconciliation formula to learn
Rs
Profit as per absorption costing system
xxx
Add Opening stock @ fixed FOH rate at opening date
xxx
Less Closing stock @ fixed FOH rate at closing date
xxx
Profit as per marginal costing system
xxx
Advantages of marginal costing
(Relative to the absorption costing)
Preparation of routine operating statements using absorption costing is considered less informative
for the following reasons:
1. Profit per unit is a misleading figure: in the example above the operating margin of Rs2 per
unit arises because fixed overhead per unit is based on output of 5,000 units. If another basis
were used margin per unit would differ even though fixed overhead was the same amount in
total
2. Build-up or run-down of stocks of finished goods can distort comparison of period operating
statements and obscure the effect of increasing or decreasing sales.
3. Comparison between products can be misleading because of the effect of arbitrary
apportionment of fixed costs. Where two or more products are manufactured in a factory and
share all production facilities, the fixed overhead can only be apportioned on an arbitrary basis.
4. Marginal costing emphasizes variable costs per unit and fixed costs in total whereas absorption
costing accounts for all production costs to calculate unit cost. Marginal costing therefore
reflects the behavior of costs in relation to activity. Since most decision-making problems
involve changes to activity, marginal costing is more appropriate for short-run decision-making
than absorption costing.
PRACTICE QUESTION
This practice question illustrates the misleading effect on profit which absorption costing can have.
A company sells a product for Rs10. and incurs Rs4 of variable costs in its manufacture. The fixed
costs are Rs900 per year and are absorbed on the basis of the normal production volume of 250
units per year. The results for the last four years, when no expenditure variances arose- were as
follows:
2nd year
3rd year
4th year  Total
Item
1st year
units
units
units
units
Opening stock
200
300
300
Production
300
250
200
200
950
300
450
500
500
950
Closing stock
200
300
300
200
200
Sales
100
150
200
300
750
Rs
Rs
Rs
Rs
Rs
Sales value
1,000
1,500
2,000
3,000
7,500
Prepare a profit statement under absorption and marginal costing.
174
img
Cost & Management Accounting (MGT-402)
VU
Solution
The profit statement under absorption costing would be as follows:
1st year
2nd year
3rd year
4th year
Items
Total
Rs.
Rs.
Rs.
Rs.
Rs.
Opening stock @ Rs7.60
1,520
2,280
2,280
Variable
costs
of
1,200
1,000
800
800
3,800
production @ Rs4
Fixed costs 900/250
1,080
900
720
720
3,420
=Rs3.60
2,280
3,420
3,800
3,800
7,220
Closing stock @Rs7.60
1,520
2,280
2,280
1,520
1,520
Cost of sales
(760)
(1,140)
(1,520)
(2,280)
(5,700)
(Under)/over absorption
180
Nil
(180)
(180)
(180)
(w)
Net Profit
420
360
300
540
1,620
Working:
Calculation of over / under absorption
Fixed cost control account
Incurred Year 1
900
Absorbed
1,080
300 x Rs. 3.60
Over absorption
180
1,080
1,080
Year 2
900
250 x Rs. 3.60
Year 3
900
200 x Rs. 3.60
720
Under absorption
180
900
900
Year 4
900
200 x 3.60
720
Under absorption
180
900
900
175
img
Cost & Management Accounting (MGT-402)
VU
If marginal costing had been used instead of absorption, the results would have
been shown as
follows:
Item
1st year
2nd year
3rd year
4th year
Total
Rs
Rs
Rs
Rs
Rs
Sales
1,000
1,500
2,000
3,000
7,500
Variable cost of sales
(@ Rs4)
400
600
800
1,200
3,000
Contribution margin  600
900
1,200
1,800
4,500
Fixed costs
900
900
900
900
3,600
Net profit/ (loss)  (300)
-
300
900
900
The marginal presentation indicates clearly that the business must sell at least 150 units per year to
break even, i.e. Rs900 + (10 - 4), whereas it appeared, using absorption costing, that even at 100
units it was making a healthy profit.
The total profit for the four years is less under the marginal principle because the closing stocks at
the end of the fourth year are valued at Rs800 (Rs4 x 200) instead of Rs 1,520, i.e. Rs720 of the
fixed costs are being carried forward under the absorption principle.
The profit figures shown may be reconciled as follows:
Year 1
Year 2
Yea 3
Yea r4
Total
Rs
Rs
Rs
Rs
Rs
Profit / (loss)
Under marginal costing
(300)
Nil
300
900
900
Add: Fixed overheads
Absorbed in stock increase
200 x Rs3.60 =
720
100 x Rs3.60=
360
200 x Rs3.60=
720
Less: Fixed overheads
Absorbed in stock decrease
100 x 3.60=
(360)
Profit per absorption
420
360
300
540
1,620
Problem Questions
Q.1. A factory manufactures three components X, Y and Z and the budgeted production for the
year is 1,000 units1,500 units and 2,000 units respectively. Fixed overhead amounts to Rs6.750 and
has been apportioned on the basis of budgeted units: Rs 1,500 to X, Rs 2,250 to Y and Rs 3,000 to
Z. Sales and variable costs are as follows:
X
Y
Z
Selling price  Rs.
4
6
5
Variable cost Rs.
1
4
4
Q. 2. A company that manufactures one product has calculated its cost on a quarterly production
budget of 10.000 units. The selling price was Rs 5 per unit. Sales in the four successive quarters of
the last year were as follows:
Quarter 1
10,000 units
Quarter 2
9,000 units
Quarter 3
7,000 units
176
img
Cost & Management Accounting (MGT-402)
VU
Quarter 4
5,500 units
The level of stock at the beginning of the year was 1,000 units and the company maintained its
stock of finished products at the same level at the end of each of the four quarters.
Based on its quarterly production budget, the cost per unit was as follows:
Cost per unit
Rs.
Prime cost
3.50
Production overhead
0.75
Selling and administration overhead
0.30
Total
4.55
Fixed production overhead, which has been taken into account in calculating the above figures,
was Rs 5,000 per quarter. Selling and administration overhead was treated as fixed, and was
charged against sales in the period in which it was incurred.
You are required to present a tabular statement to bring out the effect on net profit of the
declining volume of sales over the four quarters given, assuming in respect of fixed production
overhead that the company:
(a) Absorbs it at the budgeted rate per unit
(b) Does not absorb it into the product cost, but charges it against sales in each quarter (i.e. the
company uses marginal costing).
Advantages of Absorption Costing
(Relative to marginal costing)
Absorption costing is widely used and you must understand both principles.
The only difference between using absorption costing and marginal costing as the basis of stock
valuation is the treatment of fixed production costs.
The arguments used in favor of absorption costing are as follows:
1. Fixed costs are incurred within the production function, and without those facilities
production would not be possible. Consequently such costs can be related to production
and should be included in stock valuation.
2. Absorption costing follows the matching concept by carrying forward a proportion of the
production cost in the stock valuation to be matched against the sales value
3. When the items are sold.
4. It is necessary to include fixed overhead in stock values for financial statements routine
cost accounting using absorption costing produces stock values which include a share of
fixed overhead.
5. Overhead allotment is the only practicable way of obtaining job costs for estimating prices
and profit analysis.
6. Analysis of under-/over-absorbed overhead is useful to identify inefficient utilization of
production resources.
Arguments against absorption costing
The fixed costs do not change as a result of a change in the level of activity. Therefore such costs
cannot be related to production and should not be included in the stock valuation.
The inclusion of fixed costs in the stock valuation conflicts with the prudence concept, therefore
the fixed costs should be written off in the period in which they are incurred.
177
img
Cost & Management Accounting (MGT-402)
VU
PRACTICE QUESTION
Following information relates to a manufacturing company
Selling price
Rs. 20 per unit
Units produced
30,000
Units sold
20,000
Variable cost
Direct material
Rs. 5 per unit
Direct labor
Rs. 3 per unit
F.O.H
Rs. 1 per unit
Selling & administrative expenses
Rs. 2 per unit
Fixed cost
F.O.H
Rs 120,000
Selling & administrative expenses
Rs. 15,000
Solution
Working for cost per unit under
Absorption Costing
Fixed FOH Rate
120,000/30,000 =
4
Variable FOH Rate
Direct Material
5
Direct Labor
3
FOH
1
9
13
Marginal Costing
Variable FOH Rate
Direct Material
5
Direct Labor
3
FOH
1
9
Income Statement under Absorption Costing System
Rupees
Sales (20,000 x 20)
400,000
Less Cost of goods sold
Opening stock
0
Add Production cost
(13 x 30,000)
390,000
Less Closing stock
(13 x 10,000)
130,000
260,000
Gross Profit
140,000
Less Operating expenses
Selling & Administrative expenses
Variable expenses
(20,000 x 2) =
40,000
Fixed expenses
15,000 55,000
Net profit
85,000
178
img
Cost & Management Accounting (MGT-402)
VU
Income Statement under Marginal Costing System
Rupees
Sales
400,000
Less Variable cost of goods sold
Opening stock
0
Add Variable production cost
(9 x 30,000)
270,000
Less Closing stock
(9 x 10,000)
90,000
180,000
Gross contribution margin
220,000
Less Variable Selling & Admin Expenses
(2 x 20,000)
40,000
Contribution margin
180,000