CA Session 1

Copyright © Amity University1

PAN African eNetwork Project

Master of Finance & Control

Cost Accounting

Semester - II

Dr. Adarsh Arora

Copyright © Amity University

Topics Covered• Introduction to Cost Accounting• Relevance of Financial accounting• Relevance of Cost accounting• Relevance of Management accounting• Classification of Cost• Cost Centre• Cost Units• Cost Sheets• Advantages of cost sheets• Classification of material• Material Control Techniques


• Inventory Control Techniques• Valuation of Inventories• MCQ’s


INTRODUCTION TO COST ACCOUNTING

Cost Accounting is a system used to record, summarize and report cost information.

Cost information is presented in the form of special reports to the internal users, such as managers in the company, which is used in “deciding how to operate the organization”.

These “decisions” are simply the choices managers make about how their organizations should do things.

Some cost information, is provided to external users, such as shareholders and creditors as part of the financial statements).


Thus, cost accounting involves the accumulation, recording and reporting of costs and other quantitative data.

The information generated by the Cost Accounting system is used by an organization for internal purposes and for external purposes.

Providing cost information to managers (internal purposes) to assist them in decision-making is called Management Accounting.



RELEVANCE OF FINANCIAL ACCOUNTING:• Facilitate to Replace Memory• Facilitate to comply with legal requirement• Facilitate to ascertain net result of operations• Facilitate to ascertain financial position• Facilitate the users to take decision• Facilitate a comparative study• Facilitate control over assets• Facilitate the settlement of tax liability• Facilitate the ascertainment of value of business• Facilitate Raising Loan• Acts as legal evidence


RELEVANCE OF COST ACCOUNTING• The cost accounting system provides data about

profitable & unprofitable products & activities.• All items of costs can be analyzed to minimize the losses

& wastage emerging from the manufacturing processes & reduce the costs associated with different activities.

• Production/manufacturing methods may be improved or changed so that costs can be controlled & profit increased.

• Cost data can be obtained & compared with standard cost within the form or industry.

• Cost accounting helps management in avoiding losses arising due to many factors, such as low demand,


competitive conditions, change in technology, seasonal demand for the product.

• Cost accounting also provides data cost data & information to determine the price of the product.

• Negotiation with government & labour unions can easily be made with the information provided by the cost accounting system.

• More accurate & reliable financial accounts can be prepared promptly for use of management.

• An adequate cost accounting system ensures maximum utilization of physical & human resources, checks fraud & manipulations & helps employees as well as the employers in their basic goals of getting higher earnings & maximizing the profits of the concern.


RELEVANCE OF MANAGEMENT ACCOUNTING

Management Accounting offers the following advantages to the user, which are as follows:-

• It creates harmony in the relationship between the management and employees. It enables the management to improve its service to its customers.

• It provides information to all levels of management.• It helps the management in getting the maximum return

on capital employed.• It helps in improving the services of management to

customers.• It helps in the efficient conduct of business and thus acts

as an agent in the process of economic development.


• It helps in improving the services of management to customers.

• It helps the management in decision making process by taking into account the effect of changes in economic, commercial and non-commercial conditions by using qualitative information.

• Finally, the economic uplift of the community an development of a nation’s economy can be achieved by the use of management accounting.


CLASSIFICATION OF COST

Cost classification is the process of grouping costs according to their common characteristics. A suitable classification of costs is very helpful in identifying a given cost with cost centers or cost units.

Costs may be classified according to their nature, i.e., material, labor and expenses and a number of other characteristics.

Depending upon the purpose to be achieved and requirements of a particular concern the same cost figures may be classified into different categories.


The classification of costs can be done in the following ways:-

• By Nature of Element • By Functions • By Traceability • By Variability • By Controllability • By Normality • By Capital or Revenue • By Time


• By Association with Product • According to Planning and Control • For Managerial Decisions • Others.


CLASSIFICATION OF COST

1. By Nature of Element • The costs are divided into three categories i.e. Materials,

Labor and Overheads. Further sub-classification of each element is possible; for example, material can be classified into raw material components, spare parts, consumable stores, packing material, etc.

• Materials: Materials are the principal substances that go into the production process and are transformed into finished goods. Materials are further classified as direct materials and indirect materials. Direct materials are that materials that can be directly identified with and easily traced to finished goods. In manufacturing organizations, the cost of direct materials constitutes a major proportion


of the finished product cost. All the other materials that go into the production of the finished goods are called indirect material costs. Indirect materials generally form a part of the manufacturing overheads.

For example. a furniture manufacturer, teak wood is a direct material as it can be traced easily to the furniture made, and the nails, adhesives and other sundry materials can be treated as indirect materials.

Labor: Labor refers to the human effort to produce goods and services. It is a factor of production; the talents, training, and skills of people which contribute to the production of goods and services. It involves the physical and mental effort.

It can be further classified into direct and indirect labor.


Direct labor is the effort of employees who transforms direct materials into a finished product and it is physically traceable to the finished good or service. In some industries labor cost forms a significant portion of total costs.

The labor which cannot be traced to a product is considered to be the indirect labor. The indirect labor forms part of factory overhead. In the above example, the cost of the workers who directly expend their energy on making the furniture with the help of tools and machines is considered to be the direct labor. The salary paid to a supervisor, who oversees the activities of a team of workers is considered as indirect labor.


• Overheads: Those elements of costs necessary in the production of an article or the performance of a service which are of such a nature that the amount applicable to the product or service cannot be determined accurately or readily. Usually they relate to those objects of expenditures which do not become an integral part of the finished product or service – such as rent, heat, light, supplies, management, supervision, etc.

• In other words, overheads consist of indirect materials, indirect labor and other indirect expenses. The overheads can be classified into factory overheads, office and administration overheads and selling and distribution overheads.

• Continuing with the above example, cost of factory


lighting, rent of the factory, rent of administrative building, salary of administrative staff and managers, depreciation of machinery etc. constitute overheads.

2. By Functions • It leads to grouping of costs according to the broad

divisions of functions of a business undertaking or basic managerial activities, i.e. production, administration, selling and distribution. According to this classification costs are divided as follows:

Manufacturing and Production Costs • This category includes the total of costs incurred in

manufacture, construction and fabrication of units of production.


The manufacturing and production costs comprise of direct materials, direct labor and factory overheads.

Administrative Costs • This category includes costs incurred on account of

planning, directing, controlling and operating a company. For example, salaries paid to managers and other administrative staff.

Selling and Distribution Costs • Selling costs and distribution costs are most often

confused to be one and the same. However, there is a distinction between the two. Selling costs are defined as “the cost of seeking to create and stimulate demand and of securing orders”. Example of selling costs are advertisement, salesman salaries, etc.


Whereas, distribution costs are defined as “the cost of sequence of operations which begin with making the packed product available for dispatch and ends with making the reconditioned, returned empty packages, if any available for re-use. For example, insurance on goods in transit, warehousing etc. are distribution costs.

3. By Traceability • According to this classification, total cost is divided into

direct costs and indirect costs• Direct costs are those costs which are incurred for and

may be conveniently identified with or easily traced to a particular cost center or cost unit. The common examples of direct costs are materials used and labor employed in manufacturing an article or in a particular


process of production. • Indirect costs are those costs which are incurred for the

benefit of a number of cost centers or cost units and cannot be conveniently identified with a particular cost center or cost unit. Examples of indirect costs include rent of building, management salaries, machinery depreciation, etc.

• The nature of the business and the cost unit chosen will determine the costs as direct and indirect. For example, the hire charges of a mobile crane used onsite by a contractor would be regarded as a direct cost since it is identifiable with the project/site on which it is employed, but if the crane is used as a part of the services of a factory, the hire charges would be regarded as indirect


cost because it will probably benefit more than one cost center or department.

The distinction between direct and indirect cost is essential because the direct costs of a product or activity can be accurately identified with the cost object while the indirect costs have to be apportioned on the basis of certain assumptions about their incidence.

4. By Variability • The basis for this classification is the behavior of costs in

relation to changes in the level of activity or volume of production. On this basis, costs are classified into three groups viz. fixed, variable and semi-variable.


• Fixed Costs • Fixed costs are those which remain fixed in total with

increase or decrease in the volume of output or activity for a given period of time or for a given range of output. Fixed costs per unit vary inversely with the volume of production, i.e. fixed cost per unit decreases as production increases and increases as production decreases. Examples of fixed costs are rent, insurance of factory building, factory manager’s salary, etc.

• Variable Costs • Variable costs are those which vary in total directly in

proportion to the volume of output. These costs per unit remain relatively constant with changes in volume of production or activity.


Thus, variable costs fluctuate in total amount but tend to remain constant per unit as production level changes. Examples: direct material costs, direct labor costs, power, repairs, etc.

• Semi-variable Costs • Semi-variable costs are those which are partly fixed and

partly variable. For example, telephone expenses include a fixed portion of monthly charge plus variable charge according to the number of calls made; thus total telephone expenses are semi-variable.

• Other examples of such costs are depreciation, repairs and maintenance of building and plant, etc. These are also called semi-fixed costs or mixed costs.


5. By Controllability

On this basis costs are classified into two categories:• Controllable Costs • If the costs are influenced by the action of a specified

member of an undertaking, that is to say, costs which are at least partly within the control of management they are called controllable costs.

• An organization is divided into a number of responsibility centers and controllable costs incurred in a particular cost center can be influenced by the action of the manager responsible for the center.

• Generally speaking, all direct costs including direct material, direct labor and some of the overhead


expenses are controllable by lower level of management. • Uncontrollable Costs • If the costs cannot be influenced by the action of a

specified member of an undertaking, that is to say, which are not within the control of management they are called uncontrollable costs. Most of the fixed costs are uncontrollable.

For example, rent of the building is not controllable and so is managerial salaries. Overhead cost, which is incurred by one service section or department and is apportioned to another which receives the service is also not controllable by the latter.

• Controllability of costs depends on the level of management (top, middle or lower) and the period of time (long-term or short term).


6. By Normality

On this basis, is the costs are classified into two categories.

• Normal Cost

It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. It forms a part of production cost.

• Abnormal Cost

It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is not considered as a part of production cost, hence it is charged to Costing Profit and Loss Account.


7. By Time• Costs can be classified as

(i) Historical costs and

(ii) Predetermined costs. • Historical Costs • The costs which are ascertained after being incurred are

called historical costs. Such costs are available only when the production of a particular thing has already been done. Such costs are only of historical value and not at all helpful for cost control purposes.

• Predetermined Costs• Such costs are estimated costs, i.e. computed in

advance of production taking into consideration the


previous periods’ costs and the factors affecting such costs. If they are determined on scientific basis they become standard cost.

Such costs when compared with actual costs will give the variances and reasons of variance and will help the management to fix the responsibility and to take remedial action to avoid its recurrence in future.

8. According to Planning and Control • Cost accounting furnishes information to the

management which is helpful in discharging the two important functions of management i.e. planning and control. For the purpose of planning and control, costs are classified as:-

• Budgeted costs and • Standard costs.


• Budgeted Costs

Budgeted costs represent an estimate of expenditure for different phases or segments of business operations, such as manufacturing, administration, sales, research and development, for a period of time in future which subsequently becomes the written expression of managerial targets to be achieved.

Various budgets are prepared for different phases/ segments of business, such as sales budget, raw material cost budget, labor cost budget, cost of production budget, manufacturing overhead budget, office and administration overhead budget.


• Standard Cost

The Institute of Cost and Management Accountants, London defines standard cost as “the predetermined cost based on a technical estimate for materials, labor and overhead for a selected period of time and for a prescribed set of working conditions”. Thus, standard cost is a determination, in advance of production, of what should be its cost under a set of conditions.

9. For Managerial Decisions

On this basis, costs may be classified into the following categories:-

• Marginal Cost

Marginal cost is the additional cost to be incurred if an additional unit is produced.


In other words, marginal cost is the total of variable costs, i.e. prime cost plus variable overheads. It is based on the distinction between fixed and variable costs.

• Out of Pocket Costs

This is that portion of the cost which involves payment, i.e. gives rise to cash expenditure as opposed to such costs as depreciation, which do not involve any cash expenditure. Such costs are relevant for price fixation during recession or when make or buy decision is to be made.

• Differential Costs

If there is a change in costs due to change in the level of activity or pattern or method of production they are known as differential costs.


If the change increases the cost, it will be called incremental cost and if the change results in the decrease in cost it is known as decremental cost.

• Sunk Costs

Sunk cost is another name for historical cost. It is a cost that has already been incurred and is irrelevant to the decision making process. A good example is depreciation on a fixed asset.

• Imputed (or notional) Costs

These costs appear in cost accounts only. For example notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid. When alternative capital investment projects are being evaluated it is necessary to consider


the imputed interest on capital before a decision is arrived as to which is the most profitable project.

• Opportunity Cost

It is the maximum possible alternative earnings that will be foregone if the productive capacity or services are put to some alternative use. For example, if an owned building is proposed to be used for a project, the likely rent of the building is the opportunity cost which should be taken into consideration while evaluating the profitability of the project.

• Replacement Cost

It is the cost at which there could be purchase of an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.


• Avoidable and unavoidable Cost

Avoidable costs are those which can be eliminated if a particular product or department with which they are directly related to, is discontinued.

For example, salary of the clerks employed in a particular department can be eliminated, if the department is discontinued.

Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager or factory rent cannot be eliminated even if a product is eliminated.


10. Other Types of Costs

• Future Costs:- Are those costs that are expected to be incurred at a later date.

• Programmed Cost:- Certain decisions reflect the policies of the top management which results in periodic appropriations and these costs are referred to as programmed cost. For example, the expenditure incurred by the company under the “Jawahar Rojgar Yojana” program initiated by the prime minister is a programmed cost which reflects the policy of the top management.

• Joint Cost

Joint cost is the cost of manufacturing joint products up to or prior to the split-off point. Cost incurred after the split-off point is called separable cost. Joint cost is common to


the processing of joint products and by-products till the point of separation and cannot be traced to a particular product before the point of split-off.

• Conversion Cost

Conversion cost is the cost incurred in converting the raw material into finished product. It can be calculated by deducting the cost of direct materials from the production cost.

• Discretionary Costs

Discretionary costs are those costs which do not have obvious relationship to levels of capacity or output activity and are determined as part of the periodic planning process. In each planning period the management decides on how much to spend on certain


discretionary items such as advertising, research and development, employee.

• Committed Cost

Committed cost is a fixed cost which results from the decisions of the management in the prior period and is not subject to the management control in the present on a short run basis. They arise from the possession of production facilities, equipment, an organization setup, etc.

Some examples of committed costs are:- plant and equipment depreciation, taxes, insurance premium and rent charges.


COST CENTRE

The smallest segment of activity or area of responsibility for which costs are accumulated.

In the manufacture and sale of a product or in the rendering of a service, several activities may have to be performed.

These activities are usually carried out by different departments or sections of the company.

For example:- In a pharmaceutical company, the raw materials may be purchased by a purchase department, stocked up in a store, processed in one or more processing departments, packed in a packing department and sold by a sales and distribution department.


• Hence cost statistics are conveniently accumulated for each department.

• In Cost Accounting each department would be called a Cost Center. Typically cost centers are departments, but in some instances, a department may contain several cost centers.

• For example, a machining department may be under one foreman but it may contain various groups of machines, such as lathes, milling machines, etc.


COST UNITS • Managers are often interested in knowing the cost of

something. The ‘something’ for which the cost has to be ascertained is known as cost objective or cost object or cost unit.

• Examples of cost units include products, activities, departments, number of patients treated, sales regions, etc.

• For example:- If a factory produces motor cars then the cost unit would be a motor car because the costs are all incurred in producing motor cars.


COST SHEET• Cost sheet is a statement which is prepared usually to

present the detailed costs of total production during the period in question.

• It provides information relating to cost per unit at different stages of the total cost of production or at different stages of completion of the product.


ADVANTAGES OF COST SHEET • It discloses the total cost and the cost per unit. • It enables a manufacturer to keep a close watch and

control over the cost of production.• It provides a comparative study of various elements of

current cost with past results and std cost.• It acts as a guide to the manufacturer and helps him in

formulating production policies.• It helps in fixing up the sales price more accurately• It helps in minimizing the cost of production.• It helps in submission of accurate quotations of tenders

for supply of goods.


Illustration 1:

From the following particulars, prepare a Cost Sheet for the year ended 31.12.2007.

Rs• Stock of finished good (1.1.2007) 6000• Stock of raw material (1.1.2007) 40000• WIP (1.1.2007) 15000• Purchase of raw material 4,75,000• Carriage inward 12,500• Factory rent, taxes 7250• Other production exp 43000• Stock of finished goods (31.12.2007) 15000• Wages 1,75,000• Work manager salary 30000• Factory employees salary 60000


• Power expenses 9500• General expenses 32500• Sales for the year 8,60,000• Stock of raw materials (31.12.07) 50,000• WIP (31.12.2007) 10000


Particulars Amount (Rs) Amount (Rs)Raw Material consumed:Opening stock of raw material 40,000Add: Purchases 4,75,000 Carriage inward 12,500Less: Closing stock of raw material 50,000Wages I Prime CostAdd: Factory overheads:Factory rent, taxesOther production expWork manager salaryFactory employees salaryPower expensesAdd: Opening stock of WIP 15000Less Closing stock of WIP 10,000II Works or factory costAdd: Office overheadsGeneral Expenses 32500III Cost of productionAdd: Opening stock pf finished goods 6000Less: Closing stock pf finished goods 15,000IV Cost of goods soldProfitSales

4,77,5001,75,0006,52,500

72504300030,00060,0009,500

8,07,250

8,39,750

8,30,75029,2508,60,000

SOLUTION


CLASSIFICATION OF MATERIAL

The term ‘materials’ refers to all commodities consumed in the process of production. The material is an important part of cost of a product. Without material no manufacturing is possible.

Material may be direct or indirect.• Direct Material: All materials which can be conveniently

identified or attributed wholly to a particular cost unit are termed as direct materials.

• It is an integral part of the finished product. • For example, timber used in manufacturing furniture,

cotton in textile, sugarcane in sugar etc.


Indirect Material:-

All materials which can not be conveniently associated with a particular cost unit are called indirect materials.

Though such materials also become a part of finished product but they are used in such small quantities that their allocation to a particular cost centre is difficult & futile.

For example, nails used in the manufacture of furniture, thread in shoe, oil, grease etc.


CONCEPT & OBJECTIVES OF MATERIALS CONTROL• Materials cost constitutes a prime part of the total cost of

production of manufacturing firms. • Proper accounting, therefore, for & control over materials

purchase, consumptions, & inventories are important for effective management of a business firm.

• Materials control basically aims at efficient purchasing of materials, their efficient storing & efficient use or consumption.

• Material control consists of control at two levels:-

(i) Quantity controls, and

(ii) Finance controls.


Maintenance of investment in inventory at the lowest level.

In detail, the following are the objectives in a good system of material control:-– Material of the desired quality will be available when

needed for efficient & uninterrupted production.– Material will be purchased, only when it is required,

and in economic quantities.– The investment in material will be made at lowest

level consistent with operating requirement.– Purchase of material will be made at the most

favorable prices under the best possible terms.– Material will be protected against loss by fire, theft,

spoilage etc.


– Material should be stored in such a way that they can provide minimum of handling time & cost.

– Vouchers will be approved for payment only if the material has been received & is available for issue.

– Issues of material are properly authorized & properly accounted for.

– Materials are, at all times, charged as the responsibility of some individual.


MATERIAL CONTROL TECHNIQUES

1. ECONOMIC ORDER QUANTITY (EOQ):-

One of the major inventory management problems to be resolved is how much inventory should be added when inventory is replenished.

1. If the firm is buying raw materials, it has to decide lots in which it has to be purchased on replenishment.

2. If the firm is planning a production run, the issue is how much production to schedule (or how much to make).

These problems are called order quantity problems, and the task of the firm is to determine the optimum or economic order quantity (or economic lot size).


Assumptions of EOQ

1. Constant or uniform demand: Although the EOQ model assumes constant demand, demand may vary from day-to-day. If demand is stochastic that is, not known in advance – the model must be modified through the inclusion of a safety stock.

2. Constant unit price: The EOQ formula derived is based on the assumption that the purchase price Rs. P per unit of material will remain unaltered irrespective of the order size. Quite often, bulk purchase discounts or quantity discounts are offered by suppliers to induce customers for buying in larger quantities.


3. Constant carrying costs: Unit carrying costs may vary substantially as the size of the inventory rises, perhaps decreasing because of economies of scale or storage efficiency or increasing as storage space runs out and new warehouses have to be rented.

This situation can be handled through a modification in the original model similar to the one used for variable unit price.

4. Constant ordering costs: While this assumption is generally valid, its violation can be accommodated by modifying the original EOQ model in a manner similar to the one used for variable unit price.


• Instantaneous delivery: If delivery is not instantaneous, which is generally the case, the original EOQ model must be modified by including of a safety stock.

• Independent orders: If multiple orders result in cost savings by reducing paperwork and transportation cost, the original EOQ model must be further modified. While this modification is somewhat complicated, special EOQ models have been developed to deal with this.

Determining an optimum inventory level involves two types of costs:-

(a) Ordering costs and

(b) Carrying costs.


• The economic order quantity is that inventory level, which minimizes the total of ordering and carrying costs.

EXAMPLES OF ORDERING AND CARRYING COSTS

Let’s take a quick look at the various cost items that come under ordering and carrying costs respectively.

Ordering Costs • Requisitioning • Order placing • Transportation • Receiving, inspecting and storing • Clerical and staff


Carrying Costs • Warehousing • Handling • Clerical and staff • Insurance • Deterioration and obsolescence


Where -

A = annual demand

O = ordering cost per order

C = carrying cost per unit


Example:-

Your firm buys casting equipment from outside suppliers @Rs.30/unit. Total annual needs are 800 units. You have with you following further data:-

1. Annual return on investment: 10%

2. Rent, insurance, taxes per unit per year: Re.1

3. Cost of placing an order: Rs.100

How will you determine the economic order quantity?



2. STOCK LEVELS• Re-order Point/Level

We have discussed the problem of “how much to order” by determining the economic order quantity, we have yet to seek the answer to the second problem, “ when to order”.

This is a problem of determining the re-order point. Let’s see what re-order point is?

The re-order point is that inventory level at which an order should be placed to replenish the inventory.

To determine the re-order point under certainty, we should know:-

(a) Lead time,


(b) Average usage, and

(c) Economic orders quantity.

Under such a situation, re-order point is simply that inventory level which will be maintained for consumption during the lead-time. That is:-

Reorder point = (lead time in days x daily usage ) + Safety Stock

Or

Maximum re-order period *Maximum Usage• Lead-time

It is the time normally taken in replenishing inventory after the order has been placed. By certainty we mean that usage and lead-time do not fluctuate.


• Safety stock

The demand for material may fluctuate from day to day or from week to week.

Similarly, the actual delivery time may be different from the normal lead-time.

If the actual usage increases or the delivery of inventory is delayed, the firm can face a problem of stock- out, which can prove to be costly for the firm.

Therefore, in order to guard against the stock-out, the firm may maintain a safety-stock-some minimum or buffer inventory as cushion against expected increased usage and/or delay in delivery time.


• Maximum and minimum Level:-

Maximum Level:

It represents that level of stock above which the stock should not be allowed to rise. It is to be foxed keeping in mind unnecessary blocking of capital in stores.

• Maximum Level= Re=order Level + Re-order quantity-(Minimum consumption*Minimum re-order period)

Minimum Level:• It is that level which below which the inventory of any

item should not be allowed to fall. It is also known as safety or buffer stock.

• Minimum Level= Re-order level- (Normal consumption*Normal re-order period)


Average Level:-

This level of stock may be determined by using the following formula:

Average Level= (Maximum Level + Minimum Level) / 2

Or

= Minimum level+1/2(Re-order quantity)• Danger Level: This level is generally determined below

the minimum level & represents the level where immediate steps are taken for getting stock replenished.

In some cases, danger level of stock is fixed above the minimum level, but below the re-order level.

• Danger Level= Average consumption * Lead time for emergency purchases.


Example:-

Suppose a firm expects a total demand for its product over the planning period to be 10,000 units, while the ordering cost per order is Rs.100 and the carrying cost per unit is Rs.2. Substituting these values,

EOQ =

= 1,000 units

Thus if the firm orders in 1,000 unit lot sizes, it will minimize its total inventory costs.


SELECTIVE INVENTORY CONTROL

3. ABC ANALYSIS • Usually a firm has to maintain several types of

inventories. It is not desirable to keep the same degree of control on all the items.

• The firm should pay maximum attention to those items whose value is the highest. The firm should, therefore, classify inventories to identify which items should receive the most effort in controlling.

• The firm should be selective in its approach to control investment in various types of inventories.

• This analytical approach is called the ABC analysis and tends to measure the significance of each item of inventories in terms of its value.


• The ABC analysis concentrates on important items and is also known as control by importance and exception (CIE). As the items are classified in the importance of their relative value, this approach is also known as proportional value analysis. (PVA)


Steps involved in implementing the ABC analysis

The following steps are involved in implementing the ABC analysis:-

1. Classify the items of inventories, determining the expected use in units and the price per unit for each item.

2. Determine the total value of each item by multiplying the expected units by its units price.

3. Rank the items in accordance with the total value, giving first rank to the item with highest total value and so on.

4. Compute the ratios (percentage) of number of units of each item to total units of all items and the ratio of total value of each item to total value of all items.


5. Combine items on the basis of their relative value to form three categories: A, B and C.


Example:- • A firm has 7 different items in its inventory. The average

number of each of these items held, along with their unit costs, is listed below. The firm wishes to introduce an ABC inventory system. Suggest a breakdown of the items into A, B & C classifications.


Solution:-

ABC Analysis


Figures in column (5) are in lakhs. Here you will find of how the ABC system works.

Under this system all the items are classified into three groups. A category inventory constitutes the first 70% of inventory.

These inventories are required for strict control. The next is B category where moderate control is imposed.

The last one is the C category. So as per this method which type of inventory requires the special attention is identified.


PRICING/VALUATION OF INVENTORIES

There are different ways of valuing the inventories and knowledge of these methods of valuing stocks is essential for an efficient inventory management process.

The following methods can be adopted to value the raw material:

• First-In-First-Out (FIFO): When a firm adopts the FIFO method to price its raw material, the issue of material from the stores will be in the order which it was received. Thus the pricing will be based on the cost of material that was obtained first.

• Last-In-First-Out (LIFO): In the LIFO method, the material issued will be priced based on the material that


has been purchased recently.• Weighted Average Cost Method: The pricing of

materials will be done on weighted average basis (weights will be given based on the quantity).

• Standard Price Method: Material is priced based on a standard cost which is predetermined. When the material is purchased the stock account will be debited with the standard price. The difference between the purchase price and the standard price will be carried into a variance account.

• Replacement/Current Price Method: In this method, material is priced at the value that is realizable at the time of the issue.


Practical Questions:-

Q1 Calculate EOQ from the following:

(a) Consumption during the year: 600 units

(b) Ordering cost Rs 12 per order

(c) Carrying cost 20%

(d) price per unit Rs 20

Q2 From the following particulars calculate:

Normal usage 100 units per day

Minimum usage 60 units per day

Maximum usage 130 units per day

Economic order quantity 5000 units

Re-order period 25 to 30 days


MCQ’s

Q1 The costing approach wherein actual costs are ascertained after they have been incurred is:-

A. Marginal costing

B. Direct costing

C.Standard costing

D.Historical costing


Q2 Which of the following statements is/are true?

A. Cost accounting is not a part of management accounting.

B. Cost accounting is a system to record, summarize and report cost information.

C.Cost accounting is a post mortem of past costs.

D.Cost accounting is not necessary if financial accounting provides necessary analysis.


Q3 Which of the following is least likely to be an objective of cost accounting system?

A. Product costing

B. Optimum sales mix determination

C.Maximization of profit

D.Sales commission determination


Q4 The cost which reflects the policies of the top management which result in periodic appropriations are called as-

A. Future cost

B. Discretionary cost

C.Committed cost

D.Programmed cost


Q5 Costing Technique in which all costs, variable as well as fixed, are charged to product, operations or services is-

A. Historical costing

B. Absorption costing

C.Marginal costing

D.Direct costing


Q6 Depreciation charged on Plant & Machinery is

1. Future cost

2. Discretionary cost

3. Committed cost

4. Programmed cost


Q7 Costs that are not relevant for decision-making and are not affected by increase or decrease in volume are

1. Out of pocket cost

2. Sunk cost

3. Differential cost

4. Imputed cost

Thank You

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Documents

CA Session 1