CAF - 5

MANAGEMENT
ACCOUNTING

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN i

First edition published by
The Institute of Chartered Accountants of Pakistan
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© The Institute of Chartered Accountants of Pakistan, July 2025

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ii THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 TABLE OF CONTENTS

CHAPTER PAGE

Chapter 1 Inventory valuation 1

Chapter 2 Overheads 37

Chapter 3 Activity based costing 91

Chapter 4 Labour costing 111

Chapter 5 Cost flow in production 141

Chapter 6 Job and service costing 179

Chapter 7 Process costing 211

Chapter 8 Joint and by-product costing 299

Chapter 9 Marginal costing and absorption costing 341

Chapter 10 Standard costing 387

Chapter 11 Variance analysis 403

Chapter 12 Target costing 533

Chapter 13 Cost-volume-profit (CVP) analysis 557

Chapter 14 Relevant costs 613

Chapter 15 Decision making techniques 649

Chapter 16 Inventory management 733

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iv THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN
 CHAPTER 1

INVENTORY
VALUATION

AT A GLANCE
IN THIS CHAPTER

AT A GLANCE
Inventory is one of the major components of manufacturing and
AT A GLANCE trading organisations and, in most cases, the higher proportion
of cost. Therefore, it is important to put proper controls over
SPOTLIGHT inventory’s cost and its usage cycle.
Inventory which is consumed during the production is treated
1. Materials: procedures and as expense whereas the unused inventory at the end of
documentations reporting period is treated as an asset in the financial
statements.
2. 2inventories and its valuation
Cost of inventories includes purchase cost and any cost incurred
to bring the inventory into saleable condition. In manufacturing
3. Self-test questions
entities, inventory includes raw material, work in progress and
finished goods.

SPOTLIGHT
STICKY NOTES
The inventories that are purchased in bulk quantities with
different prices during a period are allocated cost on the basis
of First-In-First-Out (FIFO) or Weighted Average Cost (AVCO).
Net realisable value (NRV) is the estimated selling price in the
ordinary course of business less the estimated cost of
completion and estimated cost necessary to make the sale.
Inventory should be valued at lower of cost or NRV in the
financial statements.
The primary purpose of preparing manufacturing account is to
ascertain the manufacturing costs of producing finished goods.

STICKY NOTES
Non-manufacturing entities are involved in the trading of goods
at a profit. Therefore, manufacturing entities prepare a
manufacturing account also in addition to trading account,
profit and loss account and statement of financial position.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

1 MATERIALS: PROCEDURES AND DOCUMENTATIONS

1.1 Material handling procedure and related documentations
Materials are the basic components of manufacturing and production process in a goods manufacturing entity.
Materials are also called raw materials which are used in the production of a finished products (such as Crude
Oil is a raw material for Petrol, Milk is a raw material for Yogurt, Yarn is a raw material for Garment whereas
Petrol, Yogurt and Garment are the finished products).
In some manufacturing processes, raw material cost is major part of its total production cost and any loss of
control over material may cause significant increase in production cost. It is, therefore, important for any entity
to control the material activities from purchase till its use.
An entity that purchases materials to be used in its production or further sale, must ensure that proper
AT A GLANCE

procedures are in place to enable the controls over their costs, purchase quantity, quality as well as usage
quantity.
In order to make the controls effective, their documentation is necessary so that verifiable records can be
maintained.
The following example shall illustrate the procedure of purchasing, storing and issuing the raw materials to the
production department.
 Example 01:
A Limited is engaged in the manufacturing of Cotton Garment. It uses yarn as its raw material. It requires 10
tons of yarn for the next production.
The Production Department raises the Material Requisition (M.R) to the Store / Warehouse of the company
SPOTLIGHT

depicting the quantity and time at which the stock is needed. The Store / Warehouse of the company raises a
Purchase Requisition (P.R) to the Purchase / Procurement Department. The Purchase / Procurement
Department raises a request for quotation to the yarn suppliers and on the basis of accepted quotation, raises a
Purchase Order (P.O) which is delivered to the supplier. The supplier on the basis of P.O (which includes
quantity, rate and time of delivery) delivers the yarn at the store / warehouse of A Limited and issues a Goods
Dispatch / Delivery Note (GDN) to the Store and Purchase/ Procurement Departments of “A Limited”. The
storekeeper / warehouse in-charge of “A Limited” issues a Goods Received Note (GRN) the copy of which is
given to the supplier and Purchase / Procurement Department after inspecting the goods along with the
invoice.
The Storekeeper / Warehouse in-charge arranges the goods on the First in First Out (FIFO) basis or Weighted
Average (AVCO) basis depending upon the company’s policy (usually perishable products are carried at FIFO
basis).
STICKY NOTES

The Store then issues the raw materials to the Production Department and prepares a Goods Issue Note (GIN).
The following table summarizes the above procedures and documents.

Process Documents
Production Department raise material requisition to Store / Warehouse Material Requisition
Store / Warehouse issues purchase requisition to Procurement / Purchase Purchase Requisition
Department
Procurement Department raises Purchase Order to the approved supplier Purchase Order
Supplier delivers goods at company’s warehouse Goods Dispatch / Delivery
Note and Invoice / Bill
The warehouse in-charge receives the goods and inspect Goods Received Note
The warehouse issues raw materials to the production department Goods Issue Note

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Documentation of purchase process is therefore needed:

• to ensure that the procedures for ordering, receiving and paying for materials has been conducted
properly, and there is no error or fraud.
• to provide a record of materials purchases for the financial accounts.
• to provide a record of materials costs for the cost and management accounts.
• to ensure physical controls over the materials and to ensure its proper usage.
• to ensure that each document is authorized by line manager.
The detailed procedures for purchasing materials and the documents used might differ according to the size,
complexity and nature of the business. However, the basic requirements are same for all types of business
where material purchases are made.

AT A GLANCE
1.2 Functions of storekeeper
Storekeeper has to perform four basic functions including receiving of goods, storing of goods, issuing of goods
and recording the inventory movements.

Receiving and Checking the Goods:

Whenever purchase department issues purchase order, the supplier/s deliver goods to store department of
entity. It is the basic responsibility of storekeeper to check that goods are intact, means that these goods are not
damaged and are in accordance with the specification provided in the purchase order.

Storage of Goods:

SPOTLIGHT
Storing looks more simple, but it’s one of the most important functions as negligence in proper storing may
cause damage or expiry of goods/ raw material. These goods must be stored in proper storage in such a way
that existing stock of goods/ raw material should be issued first. Similarly, few raw materials in industries
require specific storage like some chemicals should be stored in cold storage, otherwise, these could be
damaged.

Issuance of Goods:
Another important function of storekeeper is to issue the goods/ raw materials to relevant department against
purchase requisition. Storekeeper must ensure that the document is properly authorized by line manager
(authorized person) of that department.

STICKY NOTES
Recording the Inventory Movements:
All the transactions of receiving and issuing must be recorded by storekeeper; normally bin card is maintained
for each raw material item. Bin card includes quantities received and issued; running balance is maintained in
it. It helps the storekeeper to ensure that items of raw materials are not falling to re-order level, otherwise, new
purchase is required.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

2 INVENTORIES AND ITS VALUATION

2

2.1 Types of inventories:

In manufacturing entities, inventory comprises raw materials, work-in-process, stores, spares and tools and
finished goods.
Raw materials are purchased by manufacturing entities for consumption in the production during a period.
They are treated as expense when these are issued to production whereas those raw materials that still exist,
at the end of the reporting period are treated as current assets and are termed as inventories.
Work-in-process is the inventory on which partial costs have been incurred till period end but it is not yet
finished or completed and further cost is required to complete it. For instance, for manufacturing a litre of
mango juice, 100% of mango pulp (raw material) has been put into process whereas the labour has worked
only 50% up to the end of the reporting period. Due to this, the product is neither considered completed nor it
AT A GLANCE

is raw material any more. This kind of inventory is called work-in-process and is treated as current asset.
Finished goods are the final products which have been completed and stored in a warehouse known as
“Finished Goods Store”. The goods that have been sold to the customers are treated as cost of sales in the
financial statements whereas, the goods that have not been sold till the end of the reporting period are
considered as inventories.
Stores, spares and loose tools are used in the equipment and machinery and are kept in inventory so that in
case of any damage to the machinery or equipment, the production should not stop and necessary tools are
available in stock to resume the production at earliest. The unused stores, spares and loose tools at period end
is treated as inventory while used stores, spares and loose tools is charged as expense in financial statements.

2.2 Cost of inventories:

SPOTLIGHT

The following table explains the cost of each type of inventory:

Inventory Cost
Raw Material Purchase price including import duties & taxes (other than those subsequently
recoverable by the entity), transport, handling and other cost directly attributable
to the purchase of goods. Trade discounts, rebates, settlement discounts and other
similar items are deducted in determining the cost. (IAS 2)
Work-in-process Cost of raw material as determined above, plus direct labour cost and production
overhead costs to the extent of work done.
Stores, spares and tools Same as Raw Material
Finished Goods – for Same as Raw Material
STICKY NOTES

trading business
Finished Goods Cost of raw material as determined above, plus direct labour cost and production
overheads.

 Example 02:
Jawa Enterprises received consignment on January 15, 2019, consisting of 4 different types of material items, A,
B, C and D. The relevant data is given as under:
Description A B C D
Invoice price Rs. 500,000 400,000 300,000 200,000
Relative weight Kg 1,500 2,500 2,000 1,000
Total freight paid on consignment Rs. 350,000; of which 20% shall be refundable.
Required:
a) Calculate cost per kg of each material, if the freight is apportioned on the basis of invoice price.
b) Calculate cost per kg of each material, if the freight is apportioned on the basis of relative weight.

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CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

 Solution:
a) Calculation of cost per kg of each material, if the freight is apportioned on the basis of invoice price.
Freight cost of Rs. 280,000 shall be added in cost of inventories of each material while Rs. 70,000 (20% of
freight) shall not be included as it is refundable.
Freight is apportioned in the ratio of invoice price as 5:4:3:2.

Description A B C D

Invoice price Rs. 500,000 400,000 300,000 200,000

Freight Rs. 100,000 80,000 60,000 40,000

AT A GLANCE
Cost of inventory Rs. 600,000 480,000 360,000 240,000

Cost per kg 400.00 192.00 180.00 240.00

b) Calculation of cost per kg of each material, if the freight is apportioned on the basis of relative weight.
Freight is apportioned in the ratio of relative weight as 3:5:4:2.

Description A B C D

Invoice price Rs. 500,000 400,000 300,000 200,000

Freight Rs. 60,000 100,000 80,000 40,000

Cost of inventory Rs. 560,000 500,000 380,000 240,000

SPOTLIGHT
Cost per kg 373.33 200.00 190.00 240.00

2.4 Inventory Valuation Rule (NRV testing):

An entity is required to evaluate, at the end of each reporting period, the net realisable value of its inventories
and value the inventories at lower of:
• Cost or
• Net realisable value
The cost of the inventories is ordinarily lower than the net realisable value. Therefore, the inventories are

STICKY NOTES
carried at their costs. However, the cost may exceed the net realisable value in the following cases:
• The inventories are damaged,
• The inventories have become wholly or partially obsolete,
• The selling price of the inventories have declined, or
• The estimated cost of completion or estimated cost to be incurred to make the sale have increased
(IAS 2).
In such cases, the company needs to bring the inventories at their net realisable value.
Net realisable value is the estimated selling price in the ordinary course of business less the estimated cost of
completion and estimated cost necessary to make the sale (IAS 2).
It refers to the net amount that an entity expects to realize from the sale of the inventory in the ordinary course
of business (IAS 2).

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 Formula:

Rs.
Estimated Selling price XXX
Less: Estimated selling expenses (XXX)
Less: Estimated cost to complete (XXX)
Net Realisable Value XXX

 Example 06:
A business has three items of inventory currently carried at their cost. The market prices of the inventories
have fallen down due to sudden decrease in demand. Their estimated selling prices, cost of completion and
AT A GLANCE

selling costs are as under:

Cost Sales price Cost of completion Selling costs

Rs. Rs. Rs. Rs.
Finished Product A1 8,000 7,800 - 500
Finished Product A2 14,000 12,000 - 200
Work-in-process B1 16,000 14,000 1,500 200

Required:
Calculate the NRV of each inventory item.
SPOTLIGHT

 Solution:
Calculation of the NRV of each inventory item is given below:

Est. Selling price – Est. Cost of completion - Est. Selling Cost: Rs.
Finished Product A1 7,800 – 500 7,300
Finished Product A2 12,000 – 200 11,800
Work-in-process B1 14,000 – 1,500- 200 12,300

It is to be noted that for finished goods no further processing cost is needed and therefore, the formula for NRV
does not include cost to complete.
STICKY NOTES

 Example 07:
A business has following items of inventories with their costs and NRV.

Inventories Cost Cost of Completion Cost to Sell Selling Price

--------------- Rs. ---------------
Raw Materials 150,000 500,000 50,000 850,000
Work-in-process 450,000 250,000 50,000 850,000
Finished Goods – in good condition 700,000 - 50,000 850,000
Finished Goods – damaged during transport 700,000 300,000 50,000 850,000

Required:
Calculate the value at which the inventories should be carried.

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 Solution:
Calculating the value of inventories:

NRV (Est. Selling Price-Est. Cost Value at lower

Inventories Cost
to complete-Est. Cost to Sell) of cost or NRV
--------------- Rs. ---------------
Raw Materials 150,000 300,000 150,000
Work-in-process 450,000 550,000 450,000
Finished Goods – in good condition 700,000 800,000 700,000
Finished Goods – damaged during 700,000 500,000 500,000

AT A GLANCE
transport

It is to be noted here that the finished goods that were damaged during transport need to be worked on further
before sale, therefore, the formula of NRV shall now include cost to complete the goods.
 Example 08:
XYZ Limited manufactures four products. The related data for the year ended December 31, 20X3 is given
below:

A B C D

Opening inventory

- Units 10,000 15,000 20,000 25,000

SPOTLIGHT
- Cost (Rs.) 70,000 120,000 180,000 310,000

- NRV (Rs.) 75,000 110,000 180,000 300,000

Production in units 50,000 60,000 75,000 100,000

Costs of goods produced (Rs.) 400,000 600,000 825,000 1,200,000

Variable selling costs (Rs.) 60,000 80,000 90,000 100,000

Closing inventory (units) 5,000 10,000 15,000 24,000

STICKY NOTES
Damaged units included in closing inventory 300 600 800 1,500

Inventory valuation method in use Weighted Average Weighted Average FIFO FIFO
Unit cost of purchase from market (Rs.) 10.50 11.00 11.50 13.00
Selling price per unit (Rs.) 10.00 12.00 12.00 12.50
Unit cost to repair damaged units (Rs.) 3.00 2.00 2.50 3.50

The company estimates that selling expenses will increase by 10% in January 20X4.
Required:
Compute the amount of closing inventory that should be reported in the statement of financial position as on
December 31, 20X3.

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 Solution:
In computing the amount of closing inventory that should be reported in the statement of financial position as
on December 31, 20X3, following are the considerations.

Damaged Units A B C D
Cost per unit (A) (w-1) 7.83 9.47 11.00 12.00
SP 10.0 12.0 12.0 12.5
Less: Var Selling Cost (1.20) (1.35) (1.24) (1.09)
(60,000/55,000 (w-2) x 1.1)
(80,000/65,000 (w-2) x 1.1)
AT A GLANCE

(90,000/80,000 (w-2) x 1.1)

(100,000/101,000 (w-2) x 1.1)
Less: Cost to Complete (3.00) (2.00) (2.50) (3.50)
NRV (B) 5.80 8.65 8.26 7.91
Lower of Cost or NRV (B) 5.80 8.65 8.26 7.91
Defective Closing Units (C) 300 600 800 1,500
Value of Closing Damaged Units (B x C) (D) 1,740 5,188 6,610 11,866
GOOD UNITS A B C D
SPOTLIGHT

Cost per unit (A) 7.83 9.47 11.00 12.00

SP 10.00 12.00 12.00 12.50
Less: Variable Selling Cost (Calculated above) (1.20) (1.35) (1.24) (1.09)
NRV (B) 8.80 10.65 10.76 11.41
Lower of Cost or NRV (B) 7.83 9.47 10.76 11.41
Good Closing Units (C) 4,700 9,400 14,200 22,500
Value of Closing Good Units (B x C) (E) 36,815 88,990 152,828 256,745
Total Value of Closing Units (D + E) 38,555 94,177 159,438 268,611 560,781
STICKY NOTES

(w-1) Cost Computation

Product A
Weighted Average Rate = (70,000 + 400,000)/(10,000 + 50,000) = 7.833
Product B
Weighted Average Rate = (110,000 + 600,000)/(15,000 + 60,000) = 9.467
Product C
Rate during the period = 825,000/75,000 = Rs. 11
Product D
Rate during the period = 1,200,000/100,000 = Rs. 12

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(w-2) Sale Units A B C D

Opening Units 10,000 15,000 20,000 25,000
Produced 50,000 60,000 75,000 100,000
Closing Units (5,000) (10,000) (15,000) (24,000)
Sale Units 55,000 65,000 80,000 101,000

2.6 Journal Entries

Following journal entries are related to movement of raw material inventory under perpetual inventory
system.

AT A GLANCE
Description Journal Entry
When raw material is purchased Material Inventory Dr.
Accounts Payable Cr.
When raw material is issued to production Work in process Dr. (Direct material)
Factory overhead control Dr. (Indirect material)
Material Inventory Cr.
When raw material is returned to vendor Accounts Payable Dr.
Material Inventory Cr.
When raw material is returned from production to store Material Inventory Dr.

SPOTLIGHT
Work in process Cr. (Direct material)
Factory overhead control Cr. (Indirect
material)
Recording of loss of raw material inventory (Shortage) Factory overhead control Dr.
Material Inventory Cr.
Recording of inventory at NRV if cost exceeds NRV at Factory overhead control Dr.
period end Material Inventory Cr.
(With difference of cost and NRV)

 Example 09:

STICKY NOTES
Taking the data from example 03 above, journal Entries on basis of AVCO method of costing are given below:

Journal entries:

Debit Credit
Rupees
5 April Raw material 18,000
Account payable 18,000
(Cost of material purchased)
9 May Work in process 11,500
Raw material 11,500
(Issue of raw material to production)

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Debit Credit
Rupees
14 July Raw material 35,000
Account payable 35,000
(Cost of material purchased)
25 July Work in process 13,286
Raw material 13,286
(Issue of raw material to production)
22 October Raw material 16,000
AT A GLANCE

Account payable 16,000

(Cost of material purchased)
23 November Work in process 14,061
Raw material 14,061
(Issue of raw material to production)
22 December Work in process 14,061
Raw material 14,061
(Issue of raw material to production)
SPOTLIGHT

2.7 Manufacturing Account:

The primary purpose of preparing manufacturing account is to ascertain the manufacturing costs of producing
finished goods. Non-manufacturing entities are involved in the trading of goods at a profit. Therefore,
manufacturing entities prepare a manufacturing account also in addition to trading account, profit and loss
account and statement of financial position. The manufacturing account helps to better understand the cost-
effectiveness of manufacturing activities. After the ascertainment of the costs of finished goods, we need to
transfer this cost to Trading Account.
It comprises prime costs and production overheads adjusted by movement in work in progress in the year.
STICKY NOTES

Format: Cost of Goods Manufactured

Rs. Rs.

Purchases of raw material (including carriage in) net of returns Xx

+ Opening stock → raw material Xx

- Closing stock → raw material (xx)

Cost of materials consumed Xxx

+ Direct labour (wages) Xxx

+ Other direct expenses Xxx

Prime Cost (Total direct costs) Xxx

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Rs. Rs.

+ Factory / production / manufacturing overheads:

Rent xx

Depreciation xx

Electricity xx Xxx

Factory (manufacturing or production) cost Xxx

+ Opening stock → work in process Xxx

AT A GLANCE
- Closing stock → work in process (xxx)

COST OF GOODS MANUFACTURED Xxx

Format: Statement of Comprehensive Income

Rs. Rs.

Sales (net) xxx

Less: Cost of goods sold

Opening stock → Finished goods xx

SPOTLIGHT
+ Purchase of finished goods (if any) x

+ Cost of goods manufactured (as calculated above) xxx

- Closing stock → Finished goods (xx) (xxx)

Gross profit xx

STICKY NOTES
Less: Administration costs (xx)

Less: Selling and distribution costs (xx)

Net profit xx

3.3 Points to remember

• In the absence of ledger balances like Inventories, quantity manufactured etc., we need to calculate the
figures for Inventories, sales etc. from the available data.
• The Manufacturing Account format must show values and the quantities (if available in data).
• Units sold = Opening inventory + units manufactured- closing inventory
• In the absence of specific information, we always assume “first in-first out” basis, for closing inventory
valuation.

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 Example 10:
The following data has been extracted from the books of Beauty Bars Ltd at 31 December 2025:

Rs.
Inventory at 1 Jan 2025
Raw materials 15,000
Work in progress 10,000
Finished goods 25,000
Purchases of raw materials 50,000
Direct Labour 20,000
AT A GLANCE

Rent 22,000
Electricity 18,000
Office Salaries 30,000
Depreciation for the year:
Office 7,000
Factory 3,000
Advertisement 16,000

Inventory as on 31 Dec 2015

Raw materials 11,000
SPOTLIGHT

Work in progress 6,000

Finished goods 10,000

Rent and electricity are to be apportioned: Factory 70%, Office 30%

Required:
Make a manufacturing account for Beauty Mar Ltd for the year ended December 31, 2025.
 Solution:
Beauty Bars Limited
STICKY NOTES

Manufacturing Account
For the year ended 31 December 2025

Rs. Rs.

Purchases of raw material (including carriage in) net of returns 50,000

+ Opening stock → raw material 15,000

- Closing stock → raw material (11,000)

Cost of materials consumed 54,000

+ Direct labour (wages) 20,000

+ Other direct expenses 0

Prime Cost (Total direct costs) 74,000

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Rs. Rs.

+ Factory (production or manufacturing) overheads (expenses)

Rent [22,000 x 70%] 15,400

Depreciation 3,000

Electricity [18,000 x 70%] 12,600 31,000

Factory (manufacturing or production) cost 105,000

+ Opening stock → work in process 10,000

- Closing stock → work in process (6,000)

AT A GLANCE
COST OF GOODS MANUFACTURED 109,000

 Example 11:
The following balances were extracted from HM's accounts as at 31 March 2025.

Rs. in "000"

Purchase of raw material 450

Purchase returns 18

Carriage inward 10

SPOTLIGHT
Direct labour 400

Direct expenses 60

Rent 35

Electricity 45

Insurance 45

Factory supervision salaries 65

Office salaries 70

STICKY NOTES
Indirect factory wages 13

Factory cleaning 50

Office cleaning 50

Depreciation on machinery 90

Stocks at 1 April 2024:

- Raw material 110

- Work in progress 55

- Finished goods 80

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Additional information at 31 March 2025:

Rs. In "000"
Stocks:
Raw material 140
Work in progress 75
Finished goods 170

• Rent electricity and insurance are apportioned on the basis of 80% to factory and 20% to office.
Required
AT A GLANCE

Prepare HM's manufacturing account for the year ended 31 March 2025
 Solution:
M/s HM
Cost of Goods Manufactured for the period ended March 31, 2025

MANUFACTURING ACCOUNT Rs. 000

Purchases of raw material 450-18 432
Transportation cost 10
+ Opening stock → raw material 110
- Closing stock → raw material 140
SPOTLIGHT

Cost of materials consumed 412

+ Direct labour (wages) 400
+ Other direct expenses 60
Prime Cost (Total direct costs) 872
+ Factory (production or manufacturing) overheads (expenses)
Indirect wages 13
Rent 35 x 80% 28
Electricity 45 x80% 36
STICKY NOTES

Insurance 45 x80% 36
Supervisory salaries 65
Cleaning 50
Depreciation on machinery 90
Factory (manufacturing or production) cost 1,190
+ Opening stock → work in process 55
- Closing stock → work in process 75
COST OF GOODS MANUFACTURED 1,170

Following items were to be ignored (being non-production):

• Office salaries
• Office cleaning

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3 SELF-TEST QUESTIONS
Reconcile the physical inventory balances with the balances as per book.
 Question 01:
Quality Limited (QL) is a manufacturer of washing machines. The company uses perpetual method for
recording and weighted average method for valuation of inventory.
The following information pertains to a raw material (SRM), for the month of June 20X3.
i. Opening inventory of SRM was 100,000 units having a value of Rs. 80 per unit.
ii. 150,000 units were purchased on June 5, at Rs. 85 per unit
iii. 150,000 units were issued from stores on June 6.

AT A GLANCE
iv. 5,000 defective units were returned from the production to the store on June 12.
v. 150,000 units were purchased on June 15 at Rs. 88.10 per unit.
vi. On June 17, 50% of the defective units were disposed of as scrap, for Rs. 20 per unit, because these had
been damaged on account of improper handling at QL.
vii. On June 18, the remaining defective units were returned to the supplier for replacement under warranty.
viii. On June 19, 5,000 units were issued to production in replacement of the defective units which were
returned to store.
ix. On June 20, the supplier delivered 2,500 units in replacement of the defective units which had been
returned by QL.

SPOTLIGHT
x. 150,000 units were issued from stores on June 21.
xi. During physical stock count carried out on June 30, 2010 it was noted that closing inventory of SRM
included 500 obsolete units having net realisable value of Rs. 30 per unit. 4,000 units were found short.
Required:
Prepare necessary journal entries to record the above transactions.
 Solution:
Necessary journal entries to record the above transactions would be prepared as follows

Journal entries:

STICKY NOTES
Debit Credit

Rupees

5-Jun-20X3 Raw material 12,750,000

Account payable (150,000 x 85) 12,750,000

(Cost of material purchased)

6-Jun-20X3 Work in process 12,450,000

Raw material 12,450,000

(Issue of raw material to production)

12-Jun-20X3 Raw material 415,000

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

Debit Credit

Rupees

Work in process 415,000

(Defective material returned from the production)

15-Jun-20X3 Raw material 13,215,000

Account payable (150,000 x 88.1) 13,215,000

(Cost of material purchased)

AT A GLANCE

17-Jun-20X3 Cash (2,500 x 20) 50,000

Factory overheads 165,000

Raw material 215,000

(Defective units sold as scrapped)

18-Jun-20X3 Account payable 212,500

Raw material 212,500

(Defective material returned to the supplier)

SPOTLIGHT

19-Jun-20X3 Work in process 430,050

Raw material 430,050

(Replacement of defective material to production by the

store)

20-Jun-20X3 Raw material 212,500

Account payable (2,500 x 85) 212,500

STICKY NOTES

(Goods returned were replaced by the supplier)

21-Jun-20X3 Work in process 12,900,000

Raw material 12,900,000

(Issue of raw material to production)

30-Jun-20X3 Factory overheads - {500 x (86-30)} (obsolete items) 28,000

Factory overheads - (4,000 x 86) (shortages) 344,000

Raw material 372,000

(Cost of obsolete and shortages charged to factory

overheads)

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Receipts /(Issues)
Date Particulars
Quantity Rate Rupees
01-Jun-20X3 Balance 100,000 80.00 8,000,000
05-Jun-20X3 Purchases 150,000 85.00 12,750,000
Balance 250,000 83.00 20,750,000
06-Jun-20X3 Issues (150,000) 83.00 (12,450,000)
12-Jun-20X3 Returned from production 5,000 83.00 415,000
15-Jun-20X3 Purchases 150,000 88.10 13,215,000
Balance 255,000 86.00 21,930,000

AT A GLANCE
17-Jun-20X3 Defective goods sold (2,500) 86.00 (215,000)
18-Jun-20X3 Returned to supplier (2,500) 85.00 (212,500)
Balance 250,000 86.01 21,502,500
19-Jun-20X3 Replacement to production (5,000) 86.01 (430,050)
20-Jun-20X3 Replacement by supplier 2,500 85.00 212,500
Balance 247,500 86.00 21,284,950
21-Jun-20X3 Issues (150,000) 86.00 (12,900,000)
Balance 97,500 86.00 8,384,950
30-Jun-20X3 Shortage (4,000) 86.00 (344,000)

SPOTLIGHT
Balance 93,500 86.00 8,040,950

 Question 02:
Standard Limited (SL) is in the business of buying and selling electric ovens. It follows perpetual inventory
system and uses weighted average method for valuation of inventory. Following information is extracted from
SL’s records for the month of February 2021:
i. Opening inventory consisted of 220,000 units having average cost of Rs. 7,000 per unit.
ii. 280,000 units were purchased on 5 February 2021, at Rs. 7,200 per unit.
iii. 180,000 units were sold to Khurram Limited (KL) on 10 February 2021.

STICKY NOTES
iv. 5,000 defective units were returned by KL on 12 February 2021.
v. 30% of the defective units returned to SL, had a manufacturing fault and were returned to the supplier on
15 February 2021. Remaining defective units were damaged due to mishandling at the warehouse. These
units were disposed of as scrap on 20 February 2021 for Rs. 2,000 per unit.
vi. 5,000 units were sent to KL on 22 February 2021 in replacement of the defective units returned.
vii. 150,000 units were sold on 25 February 2021. On 28 February 2021, a physical stock count was carried
out and the following was discovered:
• 4,500 units were identified as obsolete having net realisable value of Rs. 6,000 per unit.
• 500 units were found missing.
Required:
Prepare necessary journal entries to record the above transactions.
 Solution:

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

Necessary journal entries to record the above transactions relating to inventory are as follows:

Journal entries:

Debit Credit
Rupees in ‘000
1-Feb-21 Inventory 2,016,000
Account payable 2,016,000
(Inventory purchased)
10-Feb-21 Cost of goods sold 1,280,160
AT A GLANCE

Inventory 1,280,160
(Sales made to KL)
12-Feb-21 Inventory 35,560
Cost of goods sold 35,560
(Defective units returned by KL)
15-Feb-21 Accounts Payable 10,800
Inventory 10,800
(Defective units returned by KL)
SPOTLIGHT

20-Feb-21 Cash (3,500 x 2,000) 7,000

Profit & Loss account (Bal) 17,891
Inventory 24,891
(Defective units sold as scrap)
22-Feb-21 Cost of goods sold 35,558
Inventory 35,558
(Replacement of defective units to KL)
STICKY NOTES

25-Feb-21 Cost of goods sold 1,066,739

Inventory 1,066,739
(Sales made)
28-Feb-21 Factory Overhead / Profit and Loss Account-NRV Adjustment 5,002
[4,500 x (7,111.59-6,000.00)]
Factory Overhead / Profit and Loss Account - Shortage (Abnormal Loss) 3,556
Inventory 8,558
(Cost of obsolete stock and shortages charged to factory overheads)

18 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

In order to prepare journal entries of above transactions, it is important to prepare stock ledger card of electric
ovens. It will help to identify cost assigned to each transaction.

Receipts /(Issues)
Date Particulars
Quantity Rate Rs. In ‘000
01-Feb-21 Balance 220,000 7,000.00 1,540,000
05-Feb-21 Purchases 280,000 7,200.00 2,016,000
Balance 500,000 7,112.00 3,556,000
10-Feb-21 Sales to KL (180,000) 7,112.00 (1,280,160)
12-Feb-21 Returned by KL 5,000 7,112.00 35,560
15-Feb-21 Returned to supplier-defective (1,500) 7,200.00 (10,800)

AT A GLANCE
Balance 323,500 7,111.59 2,300,600
20-Feb-21 Defective goods scrapped (3,500) 7,111.59 (24,891)
22-Feb-21 Replacement of defective to KL (5,000) 7,111.59 (35,558)
25-Feb-21 Sales (150,000) 7,111.59 (1,066,739)
28-Feb-21 Short inventory found in physical count (500) 7,111.59 (3,556)
Balance 164,500 7,111.59 1,169,856

 Question 03:
Orange Limited (OL) manufactures four products. The information related to its inventory of each product for
the year ended 30 June 2021 is as follows:

SPOTLIGHT
A B C D
Closing inventory (units) 15,000 25,000 5,000 8,000
Cost per unit using weighted average method (Rs.) 800 700 900 1,275
Retail price per unit inclusive of 10% sales tax (Rs.) 1,144 990 1,320 1,980
Variable selling cost per unit (Rs.) 80 75 100 110
Defective units (included in closing inventory) 2,400 4,000 - -
Rework cost per defective unit (Rs.) 260 320 - -

Additional information:

STICKY NOTES
• During physical inventory count of Product C, a discrepancy of 900 completed units was observed. On
investigation, it was found that 5,600 units supplied to a customer were erroneously recorded as 6,500
units.
• The defective units can be sold in the market at 60% of the current retail price without incurring any
rework and selling costs.
• Due to decrease in raw material prices, the products similar to B and D, offered by the competitors, are
available in the market at a discount of 15% and 20% respectively, of OL’s current retail price. OL would
have to adjust its sales prices accordingly.
Required:
a) Prepare journal entries to record the adjustments that need to be incorporated for correct valuation of
inventory along with the supporting calculations.
b) The adjusted value of inventory as at 30 June 2021.
c) Mention the situations under which the cost of inventories may exceed its net realisable value.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

 Solution:
a) Journal entries to record the adjustments that need to be incorporated for correct valuation of inventory
along with the supporting calculations are prepared below.

Debit Credit
S.no. Description
-------Rupees--------
1 Cost of goods sold (W-1) 210,000
Closing inventory - B (W-1) 210,000
2 Cost of goods sold (W-2) 1,204,000
Closing inventory-A and B (W-2) 1,204,000
3 Closing inventory - C (900X900) 810,000
AT A GLANCE

Cost of goods sold 810,000

A B C D
W-1: NRV loss on good units -------- Rupees--------
Cost [given] 800 700 900 1,275
Selling price 1,144 990 1,320 1,980
Sales tax adjustment [Selling price x (l0/110)]
(104) (90) (120) (180)
Adjustment for reduction in market price
SPOTLIGHT

[Selling price x (10/110)x15%; 20%]

- (135) - (360)
Adjusted selling price 1,040 765 1,200 1,440
Variable selling cost [given] (80) (75) (100) (110)
Net realizable value (NRV) 960 690 1,100 1,330
Lower of cost or NRV 800 690 900 1,275
NRV loss or unit - 10 - -
NRV loss on good units (21,000x10) 210,000
STICKY NOTES

W-2: NRV of defective units

NRV of good units (as above) 960 690
Rework cost (260) (320)
NRV altered work cost (A) 700 370

NRV without rework (B) 624 459

NRV - Higher of A or B 700 459
Lower of cost or NRV 700 459
NRV loss per unit 100 241
NRV loss on defective units 240,000 964,000
(2,400X100) (4,000X241)
Total NRV loss 1,204,000

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CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

b) The adjusted value of inventory as at 30 June 2021 is calculated below.

Inventory No. of units Rate Amount

Unit A - Good units 12,600 800 10,080,000
Unit A - Defective units 2,400 700 1,680,000
Unit B- Good units 21,000 690 14,490,000
Unit B- Defective units 4,000 459 1,836,000
Unit C 5,900 900 5,310,000
Unit D 8,000 1,275 10,200,000
Adjusted value of inventory 43,596,000

AT A GLANCE
c) Situations under which the cost of inventories may exceed its net realisable value are mentioned below.
• The inventories are damaged.
• The inventories have become wholly or partially obsolete.
• The selling prices of the inventories have declined.
• The estimated cost of completion or estimated cost to be incurred to make the sale have increased.
 Question 04:
Sitara Enterprises (SE) is engaged in manufacturing various products that are supplied to retailers and large
beauty parlours. SE’s cost accounting records show the following data for the quarter ended 31 August 2023:

SPOTLIGHT
Purchase
Raw Opening Closing Total
Purchases price per
material inventory inventory purchases
kg/unit
Rs. Rs.
A Kg 10,000 66,000 9,000 100 6,600,000
B Kg 30,000 315,000 48,000 80 25,200,000
C Kg - 20,000 2,000 70 1,400,000
D Kg 12,000 102,000 11,000 50 5,100,000

STICKY NOTES
E Unit 4,000 30,000 5,000 40 1,200,000
F Unit 10,000 65,000 12,000 30 1,950,000
Others 12,800,000
Total 54,250,000

Additional information:
i. SE uses perpetual inventory system to record raw materials, which are valued using FIFO method.
ii. The values of opening and closing inventories of raw materials, as per general ledger, are Rs. 10.25 million
and Rs. 15.7 million, respectively.
iii. Any adjustments in the value of inventory due to NRV or excess/shortage are accounted for directly to the
P&L.
iv. In view of the prevailing inflation, the suppliers of raw materials had increased the prices by 25%, at the
start of the quarter, i.e., 1 June 2023.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

v. A review of the records has revealed the following:

• The issuance of raw material A has erroneously been recorded using the LIFO method instead of FIFO.
• The issuance of 2,000 kg of raw material B was erroneously recorded as issuance of 3,000 kg of raw
material C.
vi. A physical stock check at quarter-end has identified the following:
• There is a shortage of 800 kg of raw material D.
• 500 units of raw material E were in excess. An investigation showed that 200 units of E were
erroneously delivered by the supplier, whereas the receipt of 300 units was not recorded as they were
delivered just before the close of business on the last day.
• 400 units of raw material F are damaged. These can be repaired at a cost of Rs. 3,000 or sold on ‘as is
AT A GLANCE

where is’ basis for Rs. 8,000.

Required:
Determine the value of the closing inventory of raw materials and the cost of raw material consumed, after
taking into account the above adjustments, for the quarter ended 31 August 2023.
 Solution:
The value of the closing inventory of raw materials and the cost of raw material consumed, after taking into
account the above adjustments, for the quarter ended 31 August 2023 are calculated below.

Valuation of raw material inventory Closing inventory Raw material consumed

-------Rupees--------
SPOTLIGHT

As per existing record 15,700,000 48,800,000

(10,250,000+54,250,000-
15,700,000)

Error in recording of RM -A (W-1) 180,000 (180,000)

Error in recording of B (2,000x80) (160,000) 160,000
Error in recording of C (3,000x70) 210,000 (210,000)
Shortage of 800 kg of RM -D (40,000) (800x50) -
Recording of purchase of 300 units of RM - E 12,000 (300x 40) -
STICKY NOTES

No impact of 200 units of RM -E belonging to 3rd party - -

Write down of RM - F to NRV (3,000) -
4, 000[12,000(400x30) - 8,000] or 3,000 whichever is
Lower
15,899,000 48,570,000

W-1: Error in recording: of RM - A Rupees

Closing inventory under FIFO (9,000x IOO) 900,000
Closing inventory under LIFO [9,000x 80(100÷1.25)] 720,000
Difference 180,000

“As is where basis” means: sale or transfer of an asset (inventory) in its current condition, meaning the buyer
assumes all responsibility for its state and any defects, with the seller making no warranties or promises about
quality or fitness.

22 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

 Question 05:
Shadman Enterprises Limited (SEL) produces two products, namely A and B. The following figures have been
extracted from the draft profit and loss account of SEL for the year ended 31 December 2023:

Product A Product B
Units Rupees Units Rupees
Sales 48,000 5,040,000 59,000 7,670,000
Cost of sales
Raw material - opening 5,000 400,000 6,000 500,000
Purchases 30,000 2,700,000 40,000 3,201,000

AT A GLANCE
Raw material - closing 10 000 (900,000) 7,000 (560,000)
Raw material consumed 2,200,000 3,141,000
Direct labour 1,100,000 1,200,000
Factory overheads 1,320,000 l,440 000
Manufacturing costs 4,620,000 5,781,000
Finished goods - opening 10,000 1,000,000 15,000 1,350,000
Finished goods - closing 12 ,000 (1,108,800) 16,000 (1, 541, 600)
Cost of sales (4,511,200) (5,589,400)

SPOTLIGHT
Gross profit 528, 800 2,080,600

Additional information:
i. Raw material Y is used for manufacturing product A, and raw material Z is used for manufacturing product
B.
ii. SEL uses FIFO method for inventory valuation.
iii. Both the products are produced in the same premises and total factory overheads are allocated between
them on the basis of cost of direct labour.
iv. Both direct and indirect labour are paid at Rs. 400 per labour hour.

STICKY NOTES
v. During the review by the internal auditors, the following issues have been identified:
vi. During the year, trade discounts of Rs. 120,000 on the purchase of raw material Y have been erroneously
credited to purchase of raw material Z.
vii. 250 indirect labour hours were erroneously recorded as direct labour hours of product A.
viii. Physical stock check by the auditor revealed that 2,000 units of product A and 1,000 units of product B
were in damaged condition. These can be sold at 20% below the normal selling price.
Required:
Compute the correct value of closing inventory of finished goods.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

 Solution:
The correct value of closing inventory of finished goods is computed below.

Product A Product B
------------ Rupees ------------
Raw material consumed - as reported 2,200,000 3,141,000
Impact of correction of discount (W-1) (80,000) 99,000
RM Consumed - after correction 2,120,000 3,240,000

Direct labour - as reported 1,100,000 1,200,000

AT A GLANCE

Less: Indirect labour charged to A (250 x 400) (100,000) -

Direct labour - after correction 1,000,000 1,200,000

Factory overheads - as reported 1,320,000 1,440,000

Add: Indirect labour previously charged to A (Bal. fig.) (20,000) 120,000
FOH after correction (allocated on the basis of labour cost) 1,300,000 1,560,000
[1,000÷2,200x (1,200÷2,200x 2,860)
2,860{2,760(1,320+ 1,440)
+ 100}]
SPOTLIGHT

Cost of goods manufactured – after corrections (Rs.) 4,420,000 6,000,000

Production (Units) 50,000 60,000
(12,000+48,000-10,000) (16,000+59,000-15000)

Manufacturing cost per unit - after corrections (Rs.) 88.4 100

Closing inventory of good finished goods at cost (Rs.) 884,000 1,500,000

(10,000x88.4) (15,000x100)

Closing inventory of damaged finished goods at lower of 168,000 100,000

cost or NRV (Rs.)
STICKY NOTES

[2,000x84(W-2)] [1,000x100 (W-2)]

Closing inventory (Rs.) 1,052,000 1,600,000

W-1: Impact of correction of discount Material Y Material Z

Discount per unit (Rs.) 4 3
(120,000÷30,000) (120,000÷40,000)

Closing inventory of raw material (Units) 10 000 7000

Adjustment in value of closing inventory (Rs.) (40,000) 21,000
(4x 10,000) (3x7,000)

Adjustment in raw material consumed (Rs.) (80,000) 99,000

(120,000-40,000) (120,000-21,000)

24 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

Product A Product II
W-2: Adjustment for damaged tmits ------------ Rupees ------------
Sale price per unit 105 130
(5,040 000÷48,000) (7,670,000÷59 000)

NRV of damaged units 84 104

(105x80%) (130x80%)

Cost per unit (as above} 88.4 100

Lower of cost or NRV 84 100

AT A GLANCE
Description A B C Total
Purchases during the period (kg) 132,000 90,000 50,000
Invoice value (Rs. in '000) 52,800 43,200 30,000 126,000
Freight-in (Rs. in '000) 21,760
Transit insurance (Rs. in '000) 3,780
Closing inventory (kg) 36,000 20,000 8,000
 Question 06:

SPOTLIGHT
Asghar Ali Associates (AAA) commenced business on 1 January 2023. It manufactures two products X and Y.
Following information pertains to its activities during the month of January 2023.
i. During the month, sales of X and Y were 11,600 units and 9,400 units respectively. Throughout the month,
AAA sold these products at 25% above cost.
ii. Product X requires 6 kg of raw material A and product Y requires 5 kg and 3 kg of raw materials B and C
respectively.
iii. Data relating to raw materials are as follows:

Description A B C Total
Purchases during the period (kg) 132,000 90,000 50,000

STICKY NOTES
Invoice value (Rs. in '000) 52,800 43,200 30,000 126,000
Freight-in (Rs. in '000) 21,760
Transit insurance (Rs. in '000) 3,780
Closing inventory (kg) 36,000 20,000 8,000

iv. Product X requires 5 labour hours per unit and product Y requires 3 labour hours per unit. The cost of
labour is Rs. 300 per hour.
v. Factory overheads during the period were Rs. 13,320,000.
vi. Sales includes 200 units of X and 400 units of Y which were returned by the customers because of being
damaged. These are with AAA. The defective units need to be reworked by incurring a per unit cost of Rs.
1,500 and Rs. 800 on products X and Y respectively, so they can fetch the current selling price.
Required:
Compute the value of closing finished goods as at 31 January 2023.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

 Solution:
The value of closing finished goods as at 31 January 2023 is determined below.
Asghar Ali Associates
Manufacturing cost per unit

X Y Total
------Rs. in '000------
Cost of raw material per unit
A [6 × 0.492 (W-1)] 2.95 -
B [5 x 0.574 (W-1)] - 2.87
AT A GLANCE

C [3 x 0.698 (W-1)) - 2.09

Cost of labour per unit [X: 300×5÷1,000]; [Y: 300×3÷1,000] 1.50 0.90
Factory overhead per unit [X: 5x0.109(W-2)];[Y: 3x0.109(W-2) 0.55 0.33
Cost per unit 5.00 6.19
Closing inventory (goods units) – value 22,000 28,474 50,474
[X: 4,400(W-3)×5]; [Y:4,600(W-3)×6.19]

Closing inventory (defective units) – value 950 2,476 3,426

[X: 200x4.75(W-4)]: [Y: 400×6.19(W-4)]
SPOTLIGHT

Total value of closing stocks 53,900

WORKINGS

W-1: Cost of raw material per kg A B C Total

----------- kg -----------
Raw material purchased (a) 132,000 90,000 50,000 272,000
------Rs. in '000------
Invoice value 52,800 43,200 30,000 126,000
STICKY NOTES

Freight (allocated in the ratio of quantity purchased) 10,560 7,200 4,000 21,760
Insurance in transit (allocated in the ratio of invoice value) 1,584 1,296 900 3,780
Total cost (b) 64,944 51,696 34,900 151,540
Purchase cost per kg (b + a) 0.492 0.574 0.698

W-2: Computation of factory overhead per labour hour X Y Total

Units produced 16,000 14,000
[X: 96,000(W-2.1)÷6]; [Y: 70,000(W-2.1) ÷5 OR 42,000(W-2.1) ÷3]
Labour hours used [X: 16,000×5]; [Y: 14,000×3] 80,000 42,000 122,000
Total overheads (Rs. in '000) 13,320
Overhead per labour hour (Rs. in '000) (13,320,000÷122,000) 0.109

26 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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A B C

W-2. 1: Computation of raw material consumed ----------- kg -----------

Raw material purchased 132,000 90,000 50,000

Less: Closing inventory (36,000) (20,000) (8,000)

RM consumed 96,000 70,000 42,000

X Y

W-3: Closing finished goods units ----------- units -----------

AT A GLANCE
Produced 16,000 14,000

Gross sales (11,600) (9,400)

Closing - good units 4,400 4,600

X Y

W-4: Per unit value of defective units ------Rs. in '000------

Normal selling price (5×1.25); (6.19×1.25) 6.25 7.74

Less: Rework cost (1.50) (0.80)

SPOTLIGHT
NRV 4.75 6.94

Cost 5.00 6.19

Lower of cost or NRV 4.75 6.19

 Question 07:
Soya Fry Limited manufacture Cooking Oil. Following information is available with respect to purchases and
overheads for the year ended 31 December 2014.

Details of purchases: Rs. (000)

STICKY NOTES
Raw material purchased 51,709
Packing material purchased (directly identified with product) 2,050
Transportation cost relating to raw material (70%) and packing material (30%) 300

Details of overheads Rs. (000)

Rent 2,700
Salaries and wages 2,500
Other variable overheads 5,000
Other fixed overheads 1,500

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

Other information:
The break-up of rent is as follows:

Rs. in (000)
Factory 2,000
Warehouse (50% for raw material, 10% for packing material and 40% for finished goods) 500
Shelf spacing in super markets 200

Break-up of salaries and wages, other variable and fixed overheads is as follows:

Allocation between
AT A GLANCE

Manufacturing Administration
Salaries and wages *60% 40%
Other variable overheads 80% 20%
Other fixed overheads 60% 40%
*Manufacturing salaries includes 70% direct wages to labourers working in factory which vary with the level of
production.

Normal production level is 45,000 units per annum. Actual production during the year was 40,000 units.
Opening and closing inventories are as follows:
SPOTLIGHT

1-Jan-2014 31-Dec-2014
……Rs. in ‘000’……
Packing material 700 285
Raw material 5,000 7,780
Finished goods 2,962 4,162
Work in process 1,950 3,000

Goods costing Rs. 200,000 (2013: Rs. 300,000) are considered as obsolete and should be fully provided.
Further, closing stock of finished goods include goods costing Rs. 75,000 which were damaged due to flood and
STICKY NOTES

can only be sold at 60% of its cost.

Required:
Disclose the above information in the note on ‘Cost of goods sold’ as would appear in the profit and loss account
for the year ended 31 December 2014.
 Solution:

COST OF GOODS SOLD Rs.

Cost of goods manufactured (as calculated below) 59,344

+ Opening stock → Finished goods 2,962 – 300 obsolete 2,662

- Closing stock → Finished goods 4,162 – 200 obsolete – 75 x 40% write down (3,932)

COST OF GOODS SOLD 58,074

28 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

MANUFACTURING ACCOUNT Rs.

Purchases of raw material 51,709

Purchases of packing material 2,050

Transportation cost (directly relate with materials) 300

+ Opening stock → raw material & packing 5,000 + 700 5,700

- Closing stock → raw material & packing 285 + 7,780 (8,065)

Cost of materials consumed 51,694

AT A GLANCE
+ Direct labour (wages) 2,500 x 60% = 1,500 x 70% 1,050

+ Other direct expenses -

Prime Cost (Total direct costs) 52,744

+ Factory(production or manufacturing) overheads (expenses)

Indirect wages 2,500 x 60% = 1,500 x 30% 450

Rent factory 2,000

Rent warehouse 500 x 60% 300

SPOTLIGHT
Other variable overheads 5,000 x 80% 4,000

Other fixed overheads 1,500 x 60% 900

Factory (manufacturing or production) cost 60,394

+ Opening stock → work in process 1,950

- Closing stock → work in process (3,000)

COST OF GOODS MANUFACTURED 59,344

STICKY NOTES
Following items were to be ignored (being not related to production):
Warehouse rent for finished goods & Rent for shelf spacing
 Question 08:
The following balances and transactions relate to month of March 2020 of Maria Enterprises (ME). ME
manufacture and sells only one product which it had patented and branded last year.

Inventory on 1 March 2020

Raw materials (direct materials only) 1,000 Kgs Rs. 150,000

Work in progress Nil Nil

Finished goods 800 Units Rs. 160,000

One kg of raw materials is used to manufacture one unit of finished goods. The budgeted production overheads
are Rs. 100,000 and normal capacity per month is 5,000 units.

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

Transactions during March 2020

Purchases of direct material 5,200 Kgs Rs. 780,000
Indirect material purchased and used Rs. 5,000
Issue of materials to production 4,800 Kgs FIFO basis
Total payroll Rs. 204,000
Payroll of production supervisors Rs. 20,000
Payroll relating to selling and admin department Rs. 40,000
Production expenses (other than depreciation) Rs. 39,600
Selling and admin expenses (other than depreciation) Rs. 35,400
AT A GLANCE

Depreciation (80% relates to production) Rs. 48,000

Sales 5,000 units Rs. 1,250,000

There is no WIP inventory at the end of March 2020. The finished goods inventory is measured using periodic
weighted average method using pre-determined absorption rate.
Required:
Prepare relevant ledger account, manufacturing account and statement of comprehensive income for the
month of March 2020.
 Solution:
SPOTLIGHT

Inventory (Materials)
Kgs Rs. Kgs Rs.
b/d 1,000 150,000 Production OH (indirect) 5,000
Purchase 5,200 780,000 Inventory (WIP) 4,800 720,000
Purchase 5,000 c/d 1,400 210,000
6,200 935,000 6,200 935,000

Issued to WIP using FIFO Rs.

1,000 Kgs @ Rs. 150 each 150,000
STICKY NOTES

3,800 Kgs @ Rs. 150 each (i.e. Rs. 780,000 / 5,200 Kgs) 570,000
720,000
Raw material inventory 1,000 + 5,200 purchased – 4,800 issued 1,400 Kgs
Value 1,400 Kgs @ Rs. 150 each Rs. 210,000

Payroll Account
Rs. Rs.
Cash / Accrual 204,000 Production OH (indirect) 20,000
Selling and admin 40,000
Inventory (WIP) 144,000
204,000 204,000

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CAF 5: MANAGEMENT ACCOUNTING CHAPTER 1: INVENTORY VALUATION

Production overheads
Rs. Rs.
Cash / Accrual 39,600 Inventory (WIP) 96,000
Inventory (Materials) 5,000 Cost of sales (under absorbed) 7,000
Payroll Account 20,000
Accumulated depreciation 38,400
Rs. 48,000 x 80%
103,000 103,000

AT A GLANCE
Pre-determined absorption rate Rs. 100,000 / 5,000 units Rs. 20 per unit
Absorbed overhead to WIP Rs. 20 x 4,800 units Rs. 96,000
Under absorbed = Rs. 103,000 – 96,000 Rs. 7,000

Selling and admin expenses

Rs. Rs.
Cash / Accrual 35,400 Profit or loss 85,000
Payroll Account 40,000

SPOTLIGHT
Accumulated depreciation 9,600
Rs. 48,000 x 20%
85,000 85,000

Inventory (WIP)
Kgs Rs. Units Rs.
b/d 0 0
Inventory (Materials) 4,800 720,000 Finished goods 4,800 960,000

STICKY NOTES
Payroll account 144,000
Production overheads 96,000
4,800 960,000 4,800 960,000

Inventory (Finished goods)

Units Rs. Units Rs.
b/d 800 160,000 Cost of sales 5,000 1,000,000
Inventory (WIP) 4,800 960,000 c/d 600 120,000
5,600 1,120,000 5,600 1,120,000
Rs. 1,120,000 / 5,600 units = Rs. 200 per unit

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Cost of Sales
Rs. Rs.
Finished goods (sold) 1,000,000
Production OH 7,000 Profit or loss 1,007,000
(under absorbed)
1,007,000 1,007,000

Sales
Rs. Rs.
AT A GLANCE

Profit or loss 1,250,000 Trade receivables/Cash 1,250,000

1,250,000 1,250,000
MANUFACTURING ACCOUNT
Kgs/Units Rs.
Purchases of Raw Materials 5,200 780,000
+ Opening stock → raw material 1,000 150,000
Materials available for consumption 6,200 930,000
- Closing stock → raw material (1,400) (210,000)
SPOTLIGHT

Materials consumed 4,800 720,000

+ Direct labour (wages) 144,000
+ Other direct expenses 0
Prime Cost (Total direct costs) 864,000
+ Factory(production or manufacturing) overheads (expenses)
Indirect materials 5,000
Indirect wages 20,000
STICKY NOTES

Depreciation (on production related assets) 38,400

Other factory or production expenses 39,600
103,000
Factory (manufacturing or production) cost 967,000
+ Opening stock → work in process 0
+ Purchase of WIP 0
Cost of goods available for manufacturing 967,000
- Closing stock → work in process 0
COST OF GOODS MANUFACTURED 4,800 967,000

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Statement of Comprehensive Income

Rs. Rs.
Sales (net) 1,250,000
Less: Cost of goods sold
Opening stock → Finished goods 160,000
+ Purchase of finished goods (if any) 0
+ Cost of goods manufactured (as calculated above) 967,000
Cost of goods available for sale 1,127,000
- Closing stock → Finished goods (120,000)

AT A GLANCE
(1,007,000)
Gross profit 243,000
Less: Selling and administration costs (85,000)
Net profit 158,000

SPOTLIGHT
STICKY NOTES

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING

STICKY NOTES

Inventory is valued at lower of cost or NRV

Net Realizable value is the estimated selling price in the ordinary course of business

The costs of large volume inventories are calculated using FIFO or

AT A GLANCE

AVCO method

FIFO & AVCO methods provide different results of cost of sales and closing value of
inventories if the prices are moving frequently

Format: Statement of Comprehensive Income

Rs. Rs.
SPOTLIGHT

Sales (net) XXX

Less: Cost of goods sold
Opening stock → Finished goods XX
+ Purchase of finished goods (if any) X
+ Cost of goods manufactured (as calculated below) XXX
Cost of goods available for sale XXX
- Closing stock → Finished goods (XX) (XXX)
STICKY NOTES

Gross profit XX
Less: Administration costs (XX)
Less: Selling and distribution costs (XX)
Net profit XX

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CAF 3: CMA CHAPTER 1: INVENTORY VALUATION

Format: MANUFACTURING ACCOUNT

Units Rs.
Purchases of raw material (including carriage in) net of XX XXX
returns
+ Opening stock → raw material XX XX

Cost of materials available for consumption XXX XXX

- Closing stock → raw material (XX) (XX)

Cost of materials consumed XXX XXX

AT A GLANCE
+ Direct labour (wages) XX

+ Other direct expenses XX

Prime Cost (Total direct costs) XXX

+ Factory(production or manufacturing) overheads

(expenses)

Indirect wages XX
Depreciation (on production related assets) XX

Insurance (relating to inventories or production) XX

SPOTLIGHT
Fuel and power (electricity) XX

Other factory or production expenses X

XX

Factory (manufacturing or production) cost XXX

+ Opening stock → work in process XX XX

+ Purchase of WIP XX XX

Cost of goods available for manufacturing XX XXX

STICKY NOTES
- Closing stock → work in process (XX) (XX)
COST OF GOODS MANUFACTURED XXX XXX

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 CHAPTER 1: INVENTORY VALUATION CAF 5: MANAGEMENT ACCOUNTING
AT A GLANCE
SPOTLIGHT
STICKY NOTES

36 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 2

OVERHEADS

AT A GLANCE
IN THIS CHAPTER
Production overheads are the expenses that are incurred in the
course of making a product, providing of service or running a
AT A GLANCE
department but those which cannot be traced directly and fully

AT A GLANCE
to the product, service or department.
SPOTLIGHT
Production overheads are charged to departments, cost centre,
1. Manufacturing expenses cost pools or products using a systematic four-step procedure,
i.e., allocation, apportionment, re-apportionment and absorption
2. Cost centres of overheads. Predetermined rate is determined at the forth step
for overhead absorption using estimated figures of the overhead
3. Steps of overhead absorption cost and the activity level.
Overheads are absorbed into cost units by multiplying
4. Over or under applied /
predetermined rate with actual activity level.
absorbed overhead
At the end of the period, the applied overhead is compared with
5. Self-test questions actual overhead to determine over or under absorption of

SPOTLIGHT
overheads.
SITCKY NOTES

STICKY NOTES

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 CHAPTER 2: OVERHEADS CAF 5: MANAGEMENT ACCOUNTING

1 MANUFACTURING EXPENSES
The expenses that are incurred in the process of producing goods are termed as manufacturing expenses.
Manufacturing expenses are of two types:
1. Direct expenses – The expenses that are fully traceable to the product, service or department that is being
costed. In other words, the expenses which can be attributable directly to specific cost object. These
expenses can be direct materials, direct labour and direct other expenses
 Examples:
• Direct materials are the raw materials that are specifically used for the product in consideration. For
example, milk is raw material used in production of butter or cheese.
• Direct labour is the labour which is directly involved in converting the raw material into a cost unit. For
AT A GLANCE

example, labour cost in connection with production of sugar.

• Other expenses that are specifically incurred for the product. For example, hiring cost of machine in order
to manufacture specific product.
2. Indirect expenses (Production overheads) – The expenses that are incurred in the course of making a
product, providing of service or running a department but those cannot be traced directly and fully to the
product, service or department. These expenses can be indirect materials, indirect labour and indirect
other expenses.
 Examples:
• Labour which is not directly involved in the conversion of raw material but indirectly involved in making of
the product. Such as supervisor who is responsible to supervise the production process is not directly
involved and therefore treated as indirect cost. Likewise, the salary paid to the production manager for
SPOTLIGHT

planning, scheduling and controlling the overall production activity is an example of indirect cost.
• Tools, spares and materials that are used in the machinery or equipment used in the production are the
examples of indirect materials
• Factory rent if the factory premises are hired, depreciation of machinery and equipment, and electricity
and other utility expenses incurred for the production facilities are the examples of other indirect expenses
In a nutshell, generally, manufacturing expenses generally comprise:
a) Direct materials,
b) Direct labours and
STICKY NOTES

c) Production / manufacturing / factory overheads.

Note:
Material cost + Labour cost are called ‘Prime Costs’
Labour cost + Overhead cost are called ‘Conversion Costs’

38 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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1.1 Cost Behaviors:

Cost behaviors refer to how a cost reacts to changes in the level of activity. As the activity level rises or falls, a
particular cost may rise or fall as well or it may remain constant. To help make such distinctions, the costs are
often categorized as ‘variable cost’ or ‘fixed cost’.
Variable costs are those that tend to change with level of activity in direct ratio with equal proportion. For
example, 100 units of raw materials are used to produce 100 units of the final product. It means, for one unit of
final product one unit of raw material will be required. If the cost of one unit of material is Rs.10, the cost of
100 units will be Rs. 1,000 (10x100). Similarly, assume that labour takes two hours to produce 1 unit of final
product. It means, 400 hours will be used to produce 200 units. If the labour charges Rs. 5 per hour, the cost of
using 400 hours will be Rs. 2,000. Since these costs vary with the variations in the output, therefore, these are
called variable costs.
The variable expenses are fixed per unit of output while they vary in total.

AT A GLANCE
Total variable cost and variable cost per unit is graphically represented as follows:

SPOTLIGHT
Note: Some costs are ‘semi-variable’ in nature. These are the costs whose one portion stays fixed
while the other portion varies in line with the change in volume. For example, electricity bill
comprises of fixed charges as line rent / fixed connection charges as well as variable charges based on
units of power consumed. It is represented through the following graph:

STICKY NOTES

Fixed costs are those costs that remain constant, irrespective of the level of output. For example, the rent of
the factory shall be charged on monthly basis whether or not the production is carried. The rent is charged for
the occupation of the premises and therefore, do not vary with the production.
Fixed expenses per unit reduce with the increase in volume while they are fixed in total.

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For example, factory rent is Rs. 10,000 per month. During month 1, the company produced 100 units and
during month 2 it produced 150 units. The rent per unit for month 1 and 2 would be Rs. 100 (10,000/100) and
Rs. 66.67 (10,000/150). However, the total fixed cost per month stays fixed at Rs. 10,000..
Total fixed cost and fixed cost per unit is graphically represented as follows:
AT A GLANCE

Note: Few fixed costs are called ‘Step fixed costs’. This means that they remain fixed if the volume of
output remains within a certain activity threshold but changes in steps when that activity threshold is
surpassed.
For example, a company uses one supervisor to supervise the production of 100,000 units a month. The
cost of supervisor is Rs. 15,000. Next month, the company intends to produce 125,000 units. Therefore, a
SPOTLIGHT

new supervisor would be required to supervise for additional 25,000 units. The supervisor cost now steps
up to Rs. 30,000 when the activity level of 100,000 units is increased.
Likewise, rent for a production facility might be fixed until the production capacity is reached, at which
point a larger facility is needed, resulting in a step increase in rent costs.
STICKY NOTES

1.2 Production overheads and non-production overheads:

Production Overheads:
Overheads that incur in relation to the production processes are called production overheads (also called
manufacturing overheads / factory overheads). For example, salary of factory supervisor, depreciation of
production machine, electricity cost of factory, rent of factory premises etc. Production overheads can be fixed
or variable. Any production overheads related to period are fixed production overheads like rent of factory
premises or plant. However, some production overheads that tend to change with level of activity are known as
variable production overheads like electricity consumption.

40 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Non-Production Overheads:
Overheads that incur to support the overall objectives of the business are called non-production overheads. For
example, salaries of sales team, salaries of finance, HR and IT teams, rent of the building occupied by finance, IT,
sales and HR departments (other than production department), Depreciation of computers being used in these
departments etc. These are classified as ‘Administrative Expenses, Marketing, Selling and Distribution
Expenses’ in the Statement of Comprehensive Income.
Administrative Expenses:
The term administration generally relates to the functions necessary for the overall running of the business.
Administrative costs include all costs associated with the general management of the organisation rather than
with manufacturing or selling. Examples of administrative activities include implementing and ensuring the
effectiveness of fire extinguishing system for the safety of employees and overall business, ensuring the overall
security of the business premises, the accounting and finance, human resource and information technology

AT A GLANCE
functions of the business. The costs incurred to run these functions are called administrative expenses.
These are mostly fixed expenses and charged to profit and loss account in the period in which they occur.
Marketing, Selling and Distribution Expenses:
These expenses are related to the process of selling inventory to customers. These costs include all costs that
are incurred to secure customer orders and get the finished product to the customer. Examples of marketing,
selling and distribution activities are advertising the company’s products / services on electronic and print
media, devising and implementing marketing strategies to enter new markets, obtaining information about
customers and competitors, distributing products to the markets for the customers, obtaining feedbacks from
customers after sales and providing after sales services. The costs so incurred in performing such activities are
classified as marketing, selling and distribution expenses.

SPOTLIGHT
These are both fixed and variable. Salaries of marketing staff, cost of advertisement, depreciation of equipment
used in the marketing and distribution department etc. are fixed expenses. Commission of sales staff which
depends on the number of units sold, delivery charges per weight of the unit or area of the carrier occupied by
the unit are considered as variable expenses.
The administrative and marketing, selling and distribution expenses are never made part of the cost of the
product. However, for internal reporting purposes (marginal costing) the variable marketing and selling costs
are charged to cost of goods sold in determining the contribution margin. (This concept is discussed in Chapter
10)
These multiple bifurcations of expenses are elaborated as under:

STICKY NOTES
Manufacturing
Expenses

Direct Expenses Indirect Expenses

(Production Overeads)

Variable Expenses Fixed Expenses Variable Expenses Fixed Expenses

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 41

 CHAPTER 2: OVERHEADS CAF 5: MANAGEMENT ACCOUNTING

Overheads

Production Overheads Non-Production Overheads

Variable
Variable Fixed admin and marketing
Fixed Overheads
Overheads marketing overheads overheads

In addition to classifying costs as manufacturing and non-manufacturing, they can also be classified as period
AT A GLANCE

cost and product cost. To understand the difference between product costs and period costs, we must first
recall the matching principle from financial accounting.
The matching principle is based on the accrual concept that costs incurred to generate a particular revenue
should be recognized as expenses in the same period in which that the revenue is recognized. This means that if
a cost is incurred to acquire or make something that will eventually be sold, the cost should be recognized as an
expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.
Period costs are all costs that are not product costs. Period costs are not included as part of the cost of either
purchased or manufactured goods. Instead, period costs are expensed in the period in which they are incurred.
 Example 01:
Classify the following expenses as manufacturing, administration or selling overheads.
SPOTLIGHT

• Depreciation of factory machinery

• Factory insurance
• Salary of the Finance Director
• Depreciation of the accounts clerk’s computer
• Petrol used in delivery vehicles
• Cost of an advertising campaign
 Solution

Overhead Classification
STICKY NOTES

Depreciation of factory machinery Manufacturing overhead

Factory insurance Manufacturing overhead
Salary of the Finance Director Administration overhead
Depreciation of the accounts clerk’s computer Administration overhead
Petrol used in delivery vehicles Selling overhead
Cost of an advertising campaign Selling overhead

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2 COST CENTRES
Cost centre is a department, function or an operating entity within an organisation that incurs expenses
(indirect expenses) but don't directly generate revenue and these expenses are then allocated to cost units or
products using a systematic process.
For example, assembly department in a factory can be a cost centre. The costs of assembly department would
be established and these costs could then be allocated among all cost units manufactured by the department.
Likewise, a machine can also be a cost centre as it is an operating entity within a factory. After the operating
cost of a machine is established, the same can then be allocated among all cost units produced by the machine
on a systematic basis.
Although, different entities can be considered as cost centres within the factory (elaborated above as well), the
most widely considered cost centres are the departments within the factory. Departments within the

AT A GLANCE
production premises (factory) can further be classified into:
• Production cost centre
• Service cost centre
A production cost centre (also known as production department) directly participates in manufacturing a
product, e.g., assembly department, heating department, processing department, finishing department, etc. A
service cost centre (also known as service department) provides support services to other production and/or
service cost centres, e.g., IT department, maintenance department, quality control department, canteen
department, etc.

SPOTLIGHT
STICKY NOTES

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 CHAPTER 2: OVERHEADS CAF 5: MANAGEMENT ACCOUNTING

3 STEPS OF OVERHEAD ABSORPTION

When more than one product is being produced using the same facilities, they are allocated cost on individual
basis. The costs that are directly attributable to the product can be easily allocated to that product, e.g., direct
materials, direct labour and other direct expenses. However, the costs that are not directly traceable to the
products (production overheads) need to be allocated using four systematic steps. This systematic allocation is
known as absorption of production overheads that are enlisted and detailed in the upcoming sections.
1. Allocation of Overheads
2. Apportionment of overheads
3. Apportionment of Service Departments’ Costs (Re-apportionment)
4. Overhead Absorption
AT A GLANCE

3.1 Allocation of Overheads:

Those production overheads that are directly traceable into cost centres are allocated to those centres in this
step. It must be noted that these overheads are directly traceable into cost centres but not the cost units. The
overheads that are directly traceable into production cost centres are allocated to those departments and the
same practice applies for the costs that are directly traceable into service cost centres. For example, the salaries
of employees who are working in production and service departments are directly traceable into those cost
centres and hence, must be allocated to those cost centres.

1.2 Apportionment of Overheads:

There are some production overheads that are not directly traceable into cost centres. Instead, these are
commonly incurred and therefore, must be shared among the cost centres on some fair bases. This process of
dividing such overheads among cost centres on some fair bases is termed as apportionment of overheads (also
SPOTLIGHT

known as primary apportionment). For example, rent of a factory is a common expense and must be be
apportioned among all production and service departments on the basis of floor area occupied by each
department.
Some common production overheads and their normally used basis for apportionment are presented in the
following table.

Common Production Overheads Popularly Used Apportionment Basis

Air conditioning Floor Area
Heating Floor Area
Building insurance Floor Area
STICKY NOTES

Building repair and maintenance Floor Area

Building rent Floor Area
Building depreciation Floor Area
Plant & Machinery Depreciation Cost or WDV
Plant & Machinery Insurance Cost or WDV
Plant & Machinery Repair & maintenance Cost or WDV
Janitorial Expenses Floor Area
Lighting Light Points
Canteen expenses Number of workers
Electricity Kilowatt hours
Fuel and Power Quantity/Amount of fuel consumed
Warehousing Cost Weight/volume/cost of direct materials consumed

44 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 5: MANAGEMENT ACCOUNTING CHAPTER 2: OVERHEADS

Examination point:
It must be noted that the aforementioned apportionment bases are the most commonly used bases for the
aforementioned respective production overheads. In the examination, the candidates might be given a list of
bases that may not contain any of the above bases. In that case, the most relevant base out of the given bases in
the question must be selected to apportion the respective overheads.
 Example 02: (Allocation and apportionment)
The AJFA & Co is preparing its production overhead budgets and therefore need to determine the
apportionment of these overheads to products. Cost centre expenses and related information have been
budgeted as below:
Production department Service departments
Total Machine Machine
Assembly Canteen Maintenance

AT A GLANCE
Shop A Shop B
Direct wages (Rs.) 518,920 128,480 99,640 290,800
Indirect wages (Rs.) 313,820 34,344 36,760 62,696 118,600 61,420
Consumable materials (incl. 67,600 25,600 34,800 4,800 2,400
maintenance)
Rent & rates (Rs.) 66,800
Building insurance (Rs.) 9,600
Heat & light (Rs.) 13,600
Power (Rs.) 34,400
Depreciation of machine (Rs.) 160,800
Area (Sq ft) 90,000 20,000 24,000 30,000 12,000 4,000
Value of machines (Rs.) 1,608,000 760,000 716,000 88,000 12,000 32,000

SPOTLIGHT
Power usage (%) 100 54 40 3 1 2
Direct labour hours 72,020 16,020 21,410 43,590
Machine usage hours 54,422 14,730 37,632 2,060
Required:
Prepare allocation and apportionment sheet of AJFA & Co.
 Solution:
Allocation and apportionment sheet of AJFA & Co is given below:
All amounts are given in Rupees.

STICKY NOTES
Production department Service departments
Base Machine Machine
Total Assembly Canteen Maintenance
Shop A Shop B
Indirect wages Allocated 313,820 34,344 36,760 62,696 118,600 61,420
Consumable materials Allocated 67,600 25,600 34,800 4,800 2,400
(incl. maintenance)
Rent & Rates Area sqft 66,800 14,844 17,813 22,267 8,907 2,969
Building insurance Area sqft 9,600 2,133 2,560 3,200 1,280 427
Heat & Light Area sqft 13,600 3,022 3,627 4,534 1,813 604
Power Power 34,400 18,576 13,760 1,032 344 688
usage %
Depreciation of Value of 160,800 76,000 71,600 8,800 1,200 3,200
machine machine
Allocated & Apportion 666,620 174,519 180,920 107,329 134,544 69,308
cost

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 CHAPTER 2: OVERHEADS CAF 5: MANAGEMENT ACCOUNTING

 Example 03:
A production centre has three production departments, A, B and C.
Budgeted production overhead costs for the next period are as follows:

Rs.

Factory rent 60,000

Equipment depreciation 80,000

Insurance 20,000

Heating and lighting 18,000

AT A GLANCE

Indirect materials:

Department A 7,000

Department B 6,600

Department C 9,400

Indirect labour:

Department A 40,000
SPOTLIGHT

Department B 27,000

Department C 20,000

Insurance costs relate mainly to health and safety insurance, and will be apportioned on the basis of the
number of employees in each department. Heating and lighting costs will be apportioned on the basis of
volume.
Other relevant information is as follows:

Total Department A Department B Department C

STICKY NOTES

Direct labour hours 18,000 8,000 6,000 4,000

Number of employees 50 20 16 14

Floor area (square metres) 1,200 300 400 500

Cost of equipment (Rs.000s) 1,000 200 600 200

Volume (cubic metres) 18,000 8,000 6,000 4,000

Required:
Calculate the overhead costs and overhead absorption rate for the period for each production department,
assuming that a separate direct labour hour absorption rate is used for each department.

46 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 5: MANAGEMENT ACCOUNTING CHAPTER 2: OVERHEADS

 Solution:
Calculation for the overhead costs and overhead absorption rate for the period for each production
department, assuming that a separate direct labour hour absorption rate is used for each department, would be
as follows.

Basis of apportionment Total A B C

--------------------Rs.-----------------
Indirect materials Given 23,000 7,000 6,600 9,400
Indirect labour Given 87,000 40,000 27,000 20,000
Factory Rent Floor area 60,000 15,000 20,000 25,000

AT A GLANCE
Depreciation Equipment cost 80,000 16,000 48,000 16,000
Insurance Employee numbers 20,000 8,000 6,400 5,600
Heating, lighting Volume 18,000 8,000 6,000 4,000
Total 288,000 94,000 114,000 80,000
Direct labour hours 8,000 6,000 4,000
Absorption rate (per direct labour hour) Rs. 11.75 Rs.19.00 Rs.20.00

1.2 Apportionment of Service Department’s Costs (Re-apportionment):

It is the process of apportioning the service department costs to production departments based on service

SPOTLIGHT
provided by service cost centres to production cost centres. It is also known as secondary apportionment.
There are three different methods of dealing with re-apportionment.
a) When service departments only provide services to production departments, direct allocation method is
used. In this method, service departments’ costs are not transferred to other service department/s. Instead,
these are apportioned to production departments only. The basis of re-apportionment, e.g., in terms of
ratio, percentages, etc. will be given in the question. For example, Service department X provides electricity
to three production departments A, B and C in the ratio of 3:2:1. Therefore, the cost of department X must
be re-apportioned among the production departments in the this ratio.
 Example 04: (Re-apportionment – Direct allocation method)
The RS company has provided you following data for its overheads. The allocated and apportioned cost of each

STICKY NOTES
department is given below:

Production Departments Service Departments

A B C Canteen Maintenance
Allocated and apportioned cost 150,000 100,000 60,000 30,000 40,000
Number of employees 80 60 10
Machine hours 3,000 4,500 2,500

Cost of service departments: canteen and maintenance is apportioned to production departments only.
Required:
Prepare the reapportionment sheet of overheads under direct allocation method.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 47

 CHAPTER 2: OVERHEADS CAF 5: MANAGEMENT ACCOUNTING

 Solution:
The reapportionment sheet of overheads under direct allocation method is given below:

Base Production Departments Service Departments

A B C Canteen Maintenance
Allocated and apportioned cost 150,000 100,000 60,000 30,000 40,000
Canteen cost Employees 16,000 12,000 2,000 (30,000) -
Maintenance cost Machine H 12,000 18,000 10,000 - (40,000)
178,000 130,000 72,000 - -
AT A GLANCE

b) When one service department provides services to production departments along with the other service
department but with no reciprocity, step down method is used. In this method, first, cost of that service
department is re-apportioned which provides services to all the departments including the other service
department. After that, the cost of that service department is re-apportioned which provides services to the
production departments only.
 Example 05: (Re-apportionment – Step down method)
The RS company has provided you following data for its overheads. The allocated and apportioned cost of each
department is given below.

Production Departments Service Departments

A B C Canteen Maintenance
SPOTLIGHT

Allocated and apportioned cost 150,000 100,000 60,000 34,000 40,000

Number of employees 80 60 10 20
Machine hours 3,000 4,500 2,500

Cost of service department canteen is transferred to maintenance department but maintenance department
cost is only transferred to production departments.
Required:
Prepare the reapportionment sheet of overheads under step down method.
 Solution:
STICKY NOTES

The reapportionment sheet of overheads under step down method is given below.

Base Production Departments Service Departments

A B C Canteen Maintenance
Allocated and apportioned cost 150,000 100,000 60,000 34,000 40,000
Canteen cost Employees 16,000 12,000 2,000 (34,000) 4,000
Maintenance cost Machine H 13,200 19,800 11,000 - (44,000)
179,200 131,800 73,000 - -

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 Example 06:
The Torrence manufacturing company has four production departments and three service departments:
Maintenance, Toolroom and Storeroom. The estimated annual production overheads for these seven
departments is given below:

Departments
Producing Service
Estimated overheads
01 02 03 04 Maintenance Tool-room Store-room
Amount in Rupees
Fixed production overheads 360,000 480,000 450,000 300,000 150,000 105,000 120,000

AT A GLANCE
Variable production overheads 240,000 220,000 200,000 200,000 108,000 105,000 30,000
Total 600,000 700,000 650,000 500,000 258,000 210,000 150,000

The management decided to distribute the service departments costs on a dual basis: (a) fixed production
overheads on standby or ready to serve basis and (b) variable production overheads on a billing or charging
rate basis. The fixed production overheads of the three service departments are to be distributed as shown in
below table.

Allocation of fixed production overheads of

Total 01 02 03 04
service departments
Amount in Rupees
Maintenance 150,000 50,000 40,000 30,000 30,000

SPOTLIGHT
Toolroom 105,000 35,000 25,000 25,000 20,000
Storeroom 120,000 60,000 30,000 20,000 10,000

The variable production overheads of the service departments are distributed on the basis of charging rate
based on the following plant survey and other pertinent data:

Departments Maintenance Toolroom Storeroom

(Area in sqft) (Number of employees) (Number of Material requisitions)
01 12,000 40 30,000

STICKY NOTES
02 10,000 30 30,000
03 9,000 20 28,000
04 5,000 10 12,000
Maintenance 5,000 5
Tool-room 3,000 3
Storeroom 1,000 2

Maintenance department cost is apportioned to other service departments along with production departments
but costs of tool-room and storeroom is transferred to production departments only.
Required:
Prepare the production overhead apportionment sheet on the basis of above data and analysis.

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 Solution:
Production overhead apportionment sheet on the basis of above data and analysis, is given below.

Departments
Producing Service
Estimated overheads
01 02 03 04 Maintenance Tool-room Store-room
Amount in Rupees
Fixed production overheads 360,000 480,000 450,000 300,000 150,000 105,000 120,000
Maintenance 50,000 40,000 30,000 30,000 (150,000)
Tool-room 35,000 25,000 25,000 20,000 (105,000)
AT A GLANCE

Storeroom 60,000 30,000 20,000 10,000 (120,000)

Apportioned fixed 505,000 575,000 525,000 360,000
production overheads (A)
Variable production 240,000 220,000 200,000 200,000 108,000 105,000 30,000
overheads
Maintenance (sqft) 32,400 27,000 24,300 13,500 (108,000) 8,100 2,700
Tool-room 45,240 33,930 22,620 11,310 (113,100)
Storeroom 9,810 9,810 9,156 3,924 (32,700)
SPOTLIGHT

Apportioned variable 327,450 290,740 256,076 228,734

production overheads (B)
Apportioned total 832,450 865,740 781,076 588,734
production overheads
(A+B)

c) When all service departments provide services to one another including production departments,
reciprocal method is used. For example, there are two service departments X and Y. Department X provides
services to department Y and all production departments. Likewise, Department Y provides services to
department X and all production departments. Two methods are used for doing re-apportionment in such
situation.
STICKY NOTES

• Repeated distribution method; and

In this method, cost of one service department is apportioned to all the departments according to the
determined proportion. This way, the cost of that department becomes zero. Thereafter, the cost of
other service department is distributed to all the departments in the given proportion. Now since the
departments share services, the department whose cost is distributed first has receive the portion of
cost from the departments whose costs are subsequently apportioned. This will happen with all the
service departments. Therefore, the process of distribution should be repeated till all the costs
including the ones after repeated distribution have become zero.
• Algebraic method (Simultaneous Equation Method)
In this method, simultaneous equations are made to solve the problem in shortest way.
These methods can be best understood through examples 07 and 08.

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 Example 07: (Re-apportionment – Repeated Distribution method and Simultaneous method)

In a factory with four production departments and two service departments, the operating costs for the month
of October were as shown below.

Rs.

Production Department 1 700,000

Production Department 2 300,000

Production Department 3 400,000

Service departments

AT A GLANCE
Canteen 78,000

Boiler house 100,000

1,578,000

The costs of running the canteen are apportioned to each department on the basis of the estimated use of the
canteen by employees in each department.
The costs of the boiler house are apportioned on the basis of the estimated consumption of power by each
department.
Required:

SPOTLIGHT
Apportion the service departments’ costs in the above situation using:
a) Repeated Distribution method
b) Simultaneous equation method
 Solution:
The service departments’ costs are therefore apportioned as follows:

Canteen Boiler house

% %

STICKY NOTES
Production Department 1 40 30

Production Department 2 20 30

Production Department 3 30 20

Service departments

Canteen - 20

Boiler house 10 -

a) Preparation of a statement showing the allocation of costs to the production departments using the
repeated distribution method would be as follows:
C = Canteen
BH = Boiler house

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Dept 1 Dept 2 Dept 3 C BH

Rs. Rs. Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000 78,000 100,000
Apportion:
BH (30:30:20:20) 30,000 30,000 20,000 20,000 (100,000)
98,000
C (40:20:30:10) 39,200 19,600 29,400 (98,000) 9,800
BH (30:30:20:20) 2,940 2,940 1,960 1,960 (9,800)
C (40:20:30:10) 784 392 588 (1,960) 196
BH (30:30:20:20) 59 59 39 39 (196)
AT A GLANCE

C (40:20:30:10) 15 8 12 (39) 4
BH (30:30:20:20) 1 1 1 1 (4)
C (40:20:30:10) 1 0 0 (1) 0
Total overhead 773,000 353,000 452,000

b) the simultaneous equations method.

Let X = the total overheads apportioned from the Canteen
and Y = the total overheads apportioned from the Boiler House
This gives us the simultaneous equations:
SPOTLIGHT

X = 78,000 + 0.2 Y … (1)

Y = 100,000 + 0.1 X … (2)
Re-arrange:
78,000 = X – 0.2 Y … (1)
100,000 = – 0.1 X + Y … (2)
Multiply (2) by 10
1,000,000 = – X + 10Y … (3)
STICKY NOTES

Add (1) and (3)

1,078,000 = 9.8Y
Y = 110,000
Therefore, from (1) and substituting Y = 110,000:
X = 78,000 + 0.2 (110,000) = 100,000.

Dept 1 Dept 2 Dept 3

Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000
Apportion:
BH (30%, 30% and 20% of 110,000) 33,000 33,000 22,000
C (40%, 20% and 30% of 100,000) 40,000 20,000 30,000
Total overhead apportionment 773,000 353,000 452,000

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 Example 08:
The expenses of the production and service departments of a company for a year are as follows:

Expenses before distribution of service Service provided

Department department cost (%age)
Rs. ‘000 Dept. X Dept. Y
Production department - A 500 50 40
-B 400 30 50
Service department – X 100 - 10
-Y 60 20 -

AT A GLANCE
Required:
Apportion the service departments’ costs in the above situation using:
a) Repeated Distribution method
b) Simultaneous equation method
 Solution:
For allocating the service departments expenses to production departments by:
a) Repeated distribution method

Service
Production Department

SPOTLIGHT
Department
A B X Y
Total expenses as given 500 400 100 60
Allocation of X department cost 50 30 (100) 20
Allocation of Y department cost 32 40 8 (80)
Allocation of X department cost 4 2 (8) 2
Allocation of Y department cost 1 1 - (2)
587 473 - -

STICKY NOTES
b) Simultaneous equation method
Let total expenses of department X inclusive of expenses allocated from department
Y=x
Let total expenses of department Y inclusive of expenses allocated from department
X=y
Then according to question
x = 100 + 0.1 y ------------ eq. (1)
y = 60 + 0.2 x -------------- eq. (2)
Putting the value of y from eq. (1) in eq. (2)
x = 100 + 0.1 (60 + 0.2x)
x = 100 + 6 + 0.02 x

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x – 0.02 x = 106
x = 108
y = 60 + 0.2 (108)
y= 60 + 22 = 82

ALLOCATIONS
Production Department
Description
A B
Product department costs 500 400
AT A GLANCE

Distribution of X department cost 54 32

(108  50%) & (108  30% )
Distribution of Y department cost 33 41
(82  40%) & (82  50% )
587 473

Additional Factors affecting the predetermined overhead rate:

1. Activity level selection
2. Inclusion or exclusion of fixed overheads
3. Single rate or several rates
SPOTLIGHT

Activity Level Selection:

Activity level can be described as the level at which the business performs its production activities. For
example, a company has the capacity to produce 100,000 units every month using 7,000 labour hours and
5,000 machine hours. However, in past months the company has only produced 80,000 units due to the market
demand. This shows that company’s activity level is 80% (80,000/100,000) of its maximum capacity.
If, the company expects that there is no change in the demand and therefore, the same number of units shall be
produced. This is called Normal Capacity and overhead rate should be based on this capacity.
If the company expects that the demand will increase or decrease and estimates a level at 90% or 70%, this is
called Total Budgeted Capacity and overhead rate should be based on this capacity.
STICKY NOTES

In rare cases, overhead absorption rate may also be based on Total Operating Capacity.
In normal capacity, the overhead rate is calculated using average utilization of plant and expenditures over a
period long enough to level out the highs and lows that occur in every business venture. A rate based on normal
capacity should not change periodically because of change in actual production. The rate will be changed when
the prices of certain expense items change or when fixed costs increase or decrease.
In budgeted capacity, the overhead rate is determined using the expected cost and budgeted activity for the
next production period. This method usually results in different predetermined rates for each period. When the
company is unable to judge its current performance on a long range (normal capacity), this activity level is
used.

Inclusion and Exclusion of Fixed Overheads:

In cost accounting, there are two methods of assigning costs to the cost units:
a) Absorption costing / conventional costing or full costing
b) Marginal Costing or Direct Costing

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In Absorption costing, both fixed and variable manufacturing expenses are included in product cost. However,
in Marginal costing, fixed expenses are considered as period cost and not the product cost and therefore, are
not included in the cost of the product. In this costing system, only variable manufacturing expenses are
included in product cost.
Similarly, when predetermined overhead rate is determined, both fixed and variable production overhead
expenses are taken into account when using absorption costing, whereas, only variable production overhead
costs are taken into account in marginal cost system. Therefore, in marginal costing, the fixed expenses shall be
charged off in the profit and loss account whereas a portion of fixed cost is absorbed in the actual production
under absorption costing. Both costing systems are covered in detail in Chapter 10.
Blanket or Departmental Overhead Absorption Rates:
Overhead absorption rates can be classified as:

AT A GLANCE
a) Blanket rate or Plant-wide rate or composite rate; and
b) Departmental rates or Cost centres or cost pool rates.
A blanket overhead absorption rate applies a single overhead absorption rate to all cost units. It is calculated
for the entire factory and is applied to all cost units irrespective of the cost centre in which they are produced.
It is simple to compute and apply and is relevant for companies that produce a single product or where
production overheads are evenly distributed across the cost centres. Here, total estimated production
overheads are divided by a single estimated activity base (e.g., total budgeted labour hours, total budgeted
machine hours, etc.) using the following formula:
Overhead absorption rate = Total Estimated Production Overheads
Total Estimated Activity Base
A departmental overhead absorption rate involves computing a separate overhead absorption rate for each

SPOTLIGHT
production cost centre which results in a more accurate overhead absorption. It is more complex to compute
and apply than the blanket rate and requires a detailed working for allocation of production overheads. If
multiple products are produced using multiple departments, and each of those products consume different
amount of overheads in each department, separate departmental overhead absorption rate should be used for
each department. Here, total estimated production overheads are divided by estimated activity base of each
cost centre (e.g., total departmental budgeted labour hours, total departmental budgeted machine hours, etc.)
using the following formula:
Overhead absorption rate = Total Estimated Departmental Production Overheads
Total Estimated Departmental Activity Base
 Example 09: (Blanket rate and departmental rates)

STICKY NOTES
A company makes two products, Product X and Product Y. Each product is processed through two cost centres,
CC1 and CC2. The following budgeted data is available.

CC1 CC2
Allocated and apportioned overheads Rs. 126,000 Rs. 180,000
Direct labour hours per unit
Product X 1.5 2.0
Product Y 1.2 2.6
The budgeted production is 12,000 units of Product X and 10,000 units of Product Y. Overheads are absorbed
into costs on a direct labour hour basis.
Required:
Calculate the budgeted total overhead cost per unit for Product X and Product Y using:
a) separate departmental overhead rates for departments CC1 and CC2
b) a single absorption rate for the entire factory

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 Solution:
The budgeted total overhead cost per unit for Product X and for Product Y can be calculated using:
a) Blanket rate
In blanket rate, the overhead costs and labour hours of both departments / cost centres shall be summed
and evenly distributed between both the products irrespective of their usage of the labour hours.
Thereafter, using the blanket overhead rate, the overhead cost shall be allocated to each product using
number of hours used by each product. Then the total allocated cost is divided by total units to arrive at the
cost per unit.
Factory Overhead rate = (𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑)/(𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠)
FOH rate = 306,000/((1.5 + 2.0) × 12,000 + (1.2 + 2.6) × 10,000)
AT A GLANCE

FOH rate = 306,000 / 80,000

Blanket rate of overhead = Rs. 3.825 per direct labour hour
b) Cost centre rates:
In cost centre rates, the total hours of each centre shall be calculated first. The overhead cost of each
department shall be divided by the total hours of that department to arrive at the absorption rate for each
department / cost centre. Thereafter, the overhead cost shall be charged to products on the basis of hours
used by each unit of products.

CC1 CC2
Total hours Total hours
SPOTLIGHT

Product X 12,000 × 1.5 18,000 12,000 × 2.0 24,000

Product Y 10,000 × 1.2 12,000 10,000 × 2.6 26,000
30,000 50,000

Total overheads Rs.126,000 Rs.180,000

Absorption rate per hour Rs.4.20 Rs.3.60

c) Absorption of overheads under both methods.

If blanket rate of overheads is used.
STICKY NOTES

Product X Product Y
Overhead cost/unit
Rs. Rs.
Product X (1.5+2.0) x 3.825 13.39
Product Y (1.2+2.6) x 3.825 14.54

If separate rates are used for each department, then absorption of overheads are:

Product X Product Y
Overhead cost/unit
Rs. Rs.
CC1 1.5 × Rs.4.20 6.30 1.2 × Rs.4.20 5.04
CC2 2.0 × Rs.3.60 7.20 2.6 × Rs.3.60 9.36
Total 13.50 14.40

56 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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In some situations, it is possible to go a stage further and establish separate overhead rates for small segments
within a department (such as group of similar machines in a department). These small segments are also called
cost centres.
When a departmental overhead rate is determined for the entire department, it may result in inaccurate
allocation of overheads when a department consists of a number of different production cost centres and the
products pass through those cost centres and consume their overhead costs in different proportions.
Therefore, determining overhead rates for each production centres / cost pools would help achieving the more
accurate results.
 Example 10:
On December 1, 20X3 Zia Textile Mills Limited purchased a new cutting machine for Rs. 1,300,000 to augment
the capacity of five existing machines in the Cutting Department. The new machine has an estimated life of 10
years after which its scrap value is estimated at Rs. 100,000. It is the policy of the company to charge

AT A GLANCE
depreciation on straight line basis.
The new machine will be available to Cutting Department with effect from February 1, 20X4. It is budgeted that
the machine will work for 2,600 hours in 20X4. The budgeted hours include:
• 80 hours for setting up the machine; and
• 120 hours for maintenance.
The related expenses, for the year 20X4 have been estimated as under:
i. Electricity used by the machine during the production will be 10 units per hour @ Rs. 8.50 per unit.
ii. Cost of maintenance will be Rs. 25,000 per month.
iii. The machine requires replacement of a part at the end of every month which will cost Rs. 10,000 on each
replacement.

SPOTLIGHT
iv. A machine operator will be employed at Rs. 9,000 per month.
v. It is estimated that on installation of the machine, other departmental overheads will increase by Rs. 5,000
per month.
Cutting Department uses a single rate for the recovery of running costs of the machines. It has been budgeted
that other five machines will work for 12,500 hours during the year 20X4, including 900 hours for
maintenance. Presently, the Cutting Department is charging Rs. 390 per productive hour for recovery of
running cost of the existing machines.
Required
Compute the revised machine hour rate which the Cutting Department should use during the year 20X4.

STICKY NOTES
 Solution
Calculation of Annual Charges of New Machine
Rupees
Total budgeted costs of existing five machines (Rs. 390 x (12,500 - 900)) 4,524,000
Add: Costs of new machines
Depreciation (1,300,000 – 100,000)/10 x 11/12 110,000
Electricity (2,400 x 10 x Rs. 8.50) 204,000
Cost of maintenance (Rs. 25,000 x 11) 275,000
Part replacement (Rs. 10,000 x 11) 110,000
Operator Wages (Rs. 9,000 x 11) 99,000
Departmental expenses (Rs. 5,000 x 11) 55,000
Total Cost 5,377,000
Productive Budgeted hours (12,500 + 2,600 - 900 - 120 - 80) 14,000
Adjusted machine hours rate 384.07

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 Example 11:
Ternary Engineering Limited produces front and rear fenders for a motorcycle manufacturer.
It has three production departments and two service departments. Overheads are allocated on the basis of
direct labour hours. The management is considering changing the basis of overhead allocation from a single
overhead absorption rate to departmental overhead rate. The estimated annual overheads for the five
departments are as under:

Production Departments Service

Fabrication Phosphate Painting Inspection Maintenance
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Direct materials 6,750 300 750
AT A GLANCE

Direct labour 1,200 385 480

Indirect material 30 75
Other variable overheads 200 70 100 30 15
Fixed overheads 480 65 115 150 210
Total departmental expenses 8,630 820 1,445 210 300
Maximum production capacity (Units) 20,000 25,000 30,000
Direct labour hours 24,000 9,600 12,000
Machine hours 9,000 1,000 1,200
Use of service departments:
SPOTLIGHT

Maintenance - Labour hours 630 273 147

Inspection - Inspection hours 1,000 500 1,500

Required:
a) Compute the single overhead absorption rate for the next year.
b) Compute the departmental overhead absorption rates in accordance with the below circumstances.
• The Maintenance Department costs are allocated to the production department on the basis of labour
hours.
• The Inspection Department costs are allocated on the basis of inspection hours.
STICKY NOTES

• The Fabrication Department overhead absorption rate is based on machine hours whereas the
overhead rates for Phosphate and Painting Departments is based on direct labour hours.
 Solution:
a) Computation of the single overhead absorption rate for the next year, would be as follows

Production departments Rs. (000)

Variable overhead 370
Fixed overhead 660
Service department
Inspection 210
Maintenance 300
1,540

58 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Estimated direct labour hours (DLH) Rs. (000)

Fabrication 24,000
Phosphate 9,600
Painting 12,000
Total estimated direct labour hours 45,600
Single overhead absorption rate = Estimated Total Overheads
Estimated Direct Labour Hours
= Rs. 1,540,000 = Rs. 33.77 per
direct labour hour
45,600 hours

AT A GLANCE
b) Computation of the departmental overhead absorption rates would be as follows:

Production Service
Fabrication Phosphate Painting Inspection Maintenance
Rupees in thousand
Variable Overhead 200 70 100 60 90
Fixed Overhead 480 65 115 150 210
Allocation of Maintenance Department Costs on the basis of labour hours
630 ÷ 1,050 x 300 180 (180)
273 ÷ 1,050 x 300 78 (78)

SPOTLIGHT
147 ÷ 1,050 x 300 42 (42)
Allocation of Inspection Department Costs on the basis of Inspection hours
1,000 ÷ 3,000 x 210 70 (70)
500 ÷ 3,000 x 210 35 (35)
1,500 ÷ 3,000 x 210 105 (105)
930 248 362 - -

Base Machine hours Direct labour hours

STICKY NOTES
number of hours 9,000 9,600 12,000
Departmental Overhead Rate (Rs.) 103.33 25.83 30.17

 Example 12:
Sparrow (Pvt) Limited (SPL) is engaged in the manufacture of two products A and B. These products are
manufactured on two machines M1 and M2 and are passed through two service departments, Inspection and
Packing, before being delivered to the warehouse for final distribution. SPL’s overhead expenses for the month
of August 2011 were as follows:

Rupees
Electricity 2,238,000
Rent 1,492,000
Operational expenses of machine M1 5,500,000
Operational expenses of machine M2 3,200,000

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Following information relates to production of the two products during the month:

A B
Units produced 5,600 7,500
Labour time per unit – Inspection department 15 minutes 12 minutes
Labour time per unit – Packing department 12 minutes 10 minutes

The area occupied by the two machines M1 and M2 and the two service departments is as follows:

Square feet
Machine M1 5,500
Machine M2 4,800
AT A GLANCE

Inspection department 12,000

Packing department 15,000

Machine M1 has produced 50% units of product A and 65% units of product B whereas machine
M2 has produced 50% units of product A and 35% units of product B.
Required:
Allocate overhead expenses to both the products A and B.
 Solution:
For Allocating overhead expenses to both the products A and B., the following calculation shall be made:
SPOTLIGHT

Allocation of costs to cost centres Basis Machine M1 Machine M2 Inspection Packing Total
Area Occupied 5,500 4,800 12,000 15,000 37,300
Allocation of Electricity Area 330,000 288,000 720,000 900,000 2,238,000
Allocation of rent Area 220,000 192,000 480,000 600,000 1,492,000
Operational cost 5,500,000 3,200,000 - - 8,700,000
6,050,000 3,680,000 1,200,000 1,500,000 12,430,000

ALLOCATION OF COST TO PRODUCTS

Basis of Cost Allocation A B TOTAL
STICKY NOTES

Units produced 5,600 7,500

Inspection time (hours) (5,600 x 15 min /60) & (7,500 x 12 min 1,400 1,500 2,900
/60)
Packing time (hours) (5,600 x 12 min /60) & (7,500 x 10 min /60) 1,120 1,250 2,370
Units produced on Machine M1 (50% A and 65% B) 2,800 4,875 7,675
Units produced on Machine M2 (50% A and 35% B) 2,800 2,625 5,425
Cost Allocated
Machine M1 cost (based on units produced on M1) 2,207,166 3,842,834 6,050,000
Machine M2 cost (based on units produced on M2) 1,899,355 1,780,645 3,680,000
Inspection department cost (based on inspection hours) 579,310 620,690 1,200,000
Packing department cost (based on packing hours) 708,861 791,139 1,500,000
5,394,692 7,035,308 12,430,000

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4 OVER OR UNDER APPLIED / ABSORBED OVERHEAD

Once the factory overhead rate is determined, it is used to absorb overhead costs to the cost units. The
overheads are absorbed based on actual activity on which the rate is calculated. Multiplying this rate with the
actual activity level results in absorbed or applied production overheads.
Absorbed Production Overheads = Pre-Determined Overhead Rate x Actual Activity Level
Some of the production overheads are not related to the product and hence, cannot be identified when the
production activity is taking place because these are related to a period. For example, electricity bill and rent is
paid on monthly basis, while production is taking place on daily and continuous basis. Therefore, production
overheads are recovered on an estimated bases using overhead absorption rate as discussed in section 3. As
the period passes, this pre-determined overhead rate is multiplied with actual activity level to absorb
overheads into cost units.

AT A GLANCE
At the end of each period end, the management calculates and compares the actual production overheads with
the applied production overheads and determine the over- or under-applied production overheads.
The over- or under-absorbed production overheads are calculated as follows:

Actual Factory Overhead xxx

Applied / Absorbed Factory Overhead

(Budgeted overhead rate x actual activity level of the selected base) (xxx)

Over or Under Applied / Absorbed Overhead xxx

SPOTLIGHT
• Over applied / absorbed means the actual overhead costs are lesser than the cost applied to the cost units
• Under applied / absorbed means the actual overhead costs are greater than the cost applied to the cost
units

Treatment of Over or Under Applied / Absorbed Overhead:

The over or under applied overhead so calculated is treated either as:
a) Period cost – charged to cost of goods sold, or
b) Product cost – charged to production (including closing inventory)

STICKY NOTES
For financial reporting purposes, it is often closed to cost of goods sold as period cost.

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The following figure summarizes all the steps of overhead absorption.

STEPS FOR OVERHEAD

ABSORPTION

Step 1: Direct Allocation

Step 2: Apportionment of
Common Expenses
(Primary Apportionment)
AT A GLANCE

Step 3: Re-Apportionment of
Service Departments’ Costs
(Secondary Apportionment)

Step 4: Overhead Absorption

2. Absorption of 3. Computation of
1. Overhead
Overheads using OAR under/over-absorbed
Absorption Rate & Actual activity overheads (Actual vs.
(OAR) level Absorbed Overheads)
SPOTLIGHT

 Example 13:
Amber Limited (AL) manufactures a single product. Following information pertaining to the year 20X4 has
been extracted from the records of the company’s three production departments.

Material Labour Machine

Department
Rs. in million Hours
Budgeted A 80 200,000 400,000
B 150 500,000 125,000
C 120 250,000 350,000
STICKY NOTES

Actual A 80 220,000 340,000

B 150 530,000 120,000
C 120 240,000 320,000

AL produced 3.57 million units during the period. The budgeted labour rate per hour is Rs. 120. The overheads
for Department-A is budgeted at Rs. 5.0 million, for Department-B at 15% of labour cost and for department-C
at 5% of prime cost of the respective departments. Actual overheads for department A, B and C are Rs. 5.35
million, Rs. 8.90 million and Rs. 7.45 million respectively.
Overheads are allocated on the following basis:
Department-A Machine hours
Department-B Labour hours
Department-C Percentage of Prime cost
There was no beginning or ending inventory in any of the production departments.

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Required:
a) Calculate budgeted overhead application rate for each department.
b) Calculate total and departmental actual cost for each unit of product.
c) Calculation over or under applied overhead for each department.
 Solution:
a) For calculating budgeted overhead application rate for each department, the following working shall be
made

Budgeted overhead rate for department-A Rs.

Budgeted Overhead rate per machine hour (OHD/MH Rs.5m/400,000) Rs. 12.5

AT A GLANCE
Budgeted overhead rate for department-B
Budgeted labour cost (Rs. 120 × 500,000) Rs. 60 million
Budgeted overhead (Rs. 60 m × 15%) Rs. 9 million
Budgeted overhead rate per labour hour (Rs. 9 m/0.5 m) Rs. 18
Budgeted overhead rate for department-C
Budgeted overhead as a % of Prime Cost (Rs.7.5 m /150 m) 5%

b) For calculation of the total and departmental actual cost for each unit of product, the following working
shall be made

SPOTLIGHT
Departments
Rupees in million
A B C
Material cost 80.00 150.00 120.00
Labour cost
(0.22 m × Rs. 120) 26.40
(0.53 m × Rs. 120) 63.60
(0.24 m × Rs. 120) 28.80

STICKY NOTES
Actual overhead cost 5.35 8.90 7.45
Total Cost 111.75 222.50 156.25
Unit cost (Cost/3.57 m. units) (Rs.) 31.30 62.32 43.77
Total Actual Cost per unit (Rs.) 137.39

c) For calculation of over or under applied overhead for each department, the following working shall be
made.

(0.34 m × 12.5) 4.25

(0.53 m × Rs. 18) 9.54
(Rs. 148.8 m × 5%) 7.44
Actual Overhead Cost 5.35 8.90 7.45
Under applied / (over) applied 1.10 (0.64) 0.01

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5 SELF-TEST QUESTIONS
 Question 01:
Nitrate Limited (NL), producing industrial chemicals, has three production and two service departments. The
annual overheads are as follows:

Production Departments Rupees in ‘000

A 56,000
B 50,000
C 38,000
Service Departments
AT A GLANCE

X 16,500
Y 10,600

The service departments’ costs are apportioned as follows:

Production Departments Service Departments

A B C X Y
Service Department X 20% 40% 30% 0% 10%
Service Department Y 40% 20% 20% 20% 0%
SPOTLIGHT

Required:
a) Apportion the costs of service departments using repeated distribution method.
b) Apportion the costs of service departments using simultaneous equation method.
 Solution:
a) Apportionment of costs of service departments using repeated distribution method is performed below.

Description Basis Total A B C X Y

-------------- Rupees --------------
Direct allocated and 171,100 56,000 50,000 38,000 16,500 10,600
STICKY NOTES

apportioned costs
X Re-Apportionment 20:40:30:10 - 3,300.0 6,600.0 4,950.0 (16,500) 1,650.0
- 12,250
Y Re- Apportionment 40:20:20:20 - 4,900 2,450 2,450 2,450 (12,250)
X Re- Apportionment 20:40:30:10 - 490 980 735 (2,450) 245
Y Re- Apportionment 40:20:20:20 - 98 49 49 49.00 (245)
X Re- Apportionment - 2:4:3 - 11 22 16 (49.00) -
Direct
171,100 64,799 60,101 46,200

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b) Apportionment of costs of service departments using simultaneous equation method is performed below.
A = 56,000 + 0.2X + 0.4Y
B = 50,000 + 0.4X + 0.2Y
C = 38,000 + 0.3X
X = 16,500 + 0.2Y
Y = 10,600 + 0.1X

Simultaneously Solve eq X and Y

Put Y in X

AT A GLANCE
X = 16,500 + 0.2 (10,600 + 0.1X)
X = 16,500 + 2,120 + 0.02X
0.98X = 18,620
X = Rs. 19,000

Put X back in Y

Y = 10,600 + 0.1 (19,000)

Y = Rs. 12,500

SPOTLIGHT
Put X and Y back in equations of A,B and C to calculate total production overheads in each direct
production department

A = 56,000 + 0.2 (19,000) + 0.4 (12,500) = Rs. 64,800

B = 50,000 + 0.4 (19,000) + 0.2 (12,500) = Rs.60,100
C = 38,000 + 0.3 (19,000) + 0.2 (12,500) = Rs. 46,200
 Question 02:
Noble Industries Limited has two production departments and two service departments. Information regarding
its factory overheads for the latest quarter and related details are as follows:

STICKY NOTES
Production Service
Departments Departments Total
A B X Y
Direct factory overheads Rs.in ‘000 105,000 85,000 30,000 20,000 240,000
Machine hours 1,890 1,710 - - 3,600
Floor area Square yards 1,200 1,050 250 150 2,650
Basis of allocation – Department X 50% 40% 10% 100%
Basis of allocation – Department Y 45% 40% 15% - 100%

In addition to direct overheads, there were common overheads of production and service departments, which
amounted to Rs. 53 million.
Required:
Compute the factory overhead rate for the production departments based on machine hours using the repeated
distribution method.

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 Solution:
The factory overhead rate for the production departments based on machine hours using the repeated
distribution method is calculated below.

Production Departments Service Departments

Total
A B X Y
--------------------- Rs. In ‘000 ---------------------
Direct factory overheads 105,000 85,000 30,000 20,000 240,000
Common overheads (based on floor area*) 24,000 21,000 5,000 3,000 53,000
129,000 106,000 35,000 23,000 293,000
AT A GLANCE

Allocation of department X 17,500 14,000 (35,000) 3,500 0

146,500 120,000 0 26,500 293,000
Allocation of department Y 11,925 10,600 3,975 (26,500) 0
158,425 130,600 3,975 0 293,000
Allocation of department X 1,988 1,590 (3,975) 397 0
160,413 132,190 0 397 293,000
Allocation of department Y 179 159 59 (397) 0
160,592 132,349 59 0 293,000
SPOTLIGHT

Allocation of department X 29 24 (59) 6 0

160,621 132,373 0 6 293,000
Allocation of department Y 3 2 1 (6) 0
160,624 132,375 1 0 293,00
Machine hours 1,890 1,710
FOH per machine hour 84.99 77.41

*(OR on the basis of direct factory overheads)

STICKY NOTES

 Question 03:
Salman Limited (SL) has two production departments, PD-A and PD-B, and two service departments, SD-1 and
SD-2. A summary of budgeted costs for the year ending June 2015 is as follows:

PD-A PD-B SD-1 SD-2 Total

----------------------- Rs. in ‘000 -----------------------
Direct labour 5,400 3,648 - - 9,048
Direct material 13,500 9,120 - - 22,620
Indirect labour 1,900 600 50 20 2,570
Indirect materials 900 1,100 150 55 2,205
Factory rent - - - - 1,340
Power cost - - - - 1,515
Depreciation - - - - 3,500

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Other related data is as follows:

PD-A PD-B SD-1 SD-2

Production (units) 2,250 800 - -
Direct labour hours (per unit) 20 38 - -
Machine hours 19,250 12,250 2,800 700
Kilowatt hours (000) 800 600 50 150
Floor area (square feet) 5,000 4,000 500 500
Basis of overhead application Machine hours Direct labour hours - -

AT A GLANCE
SL allocates the costs of service departments applying repeated distribution method. Details of services
provided by SD-1 and SD-2 to the other departments are as follows:

Service Departments PD-A PD-B SD-1 SD-2

SD-1 30% 65% - 5%
SD-2 55% 35% 10% -

Required
Compute the departmental overhead absorption rat.
 Solution
The departmental overhead absorption rate can be calculated as follows:

SPOTLIGHT
Allocation of overheads and overheads absorption rate

Total PD-A PD-B SD-1 SD-2

Allocation basis
Rs. in 000
Direct labour - - - - -
Direct material - - - - -
Indirect labour - 1,900 600 50 20
Indirect materials - 900 1,100 150 55

STICKY NOTES
Factory rent Floor area 1,340 670 536 67 67
Power Kilowatt hrs. 1,515 758 568 47 142
Depreciation Machine hrs. 3,500 1,925 1,225 280 70
6,153 4,029 594 354
Allocation of service departments cost:
SD-1 30:65:5 178 386 (594) 30
SD-2 55:35:10 211 134 39 (384)
SD-1 30:65:5 12 25 (39) 2
SD-2 55:35:10 1 1 0 (2)
6,555 4,576 - -
Allocation basis Machine hrs. D. labour hrs.
Machine/D. labour hours 19,250 30,400 800×38
Overhead absorption rate per hour Rs. 340.52 150.53

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 Question 04:
California Limited (CL) runs a factory which has two production departments AB and AC, and two service
departments SA and SB. CL allocates the cost-of-service departments using simultaneous equation method. A
summary of budgeted overheads for the year ending 31 December 2022 is as follows:

Rs. In ‘000
Factory rent 2,500
Fuel cost 1,800
Depreciation 2,000
Electricity and other utilities 1,100
AT A GLANCE

Other related information is given below:

Production department Service department

Total
AB AC SA SB
Machine hours 22,000 12,000 - - 34,000
Labour hours 8,000 10,000 - - 18,000
Floor area (square feet) 6,000 4,500 900 600 12,000
SA - % of services 40% 40% - 20%
SB - % of services 45% 40% 15%
SPOTLIGHT

Basis of overhead absorption Machine hours Labour hours

The per hour fuel consumption of machines in department AC is 50% more than that of machines in
department AB.
Required:
Compute the departmental overhead absorption rate
 Solution:
The departmental overhead absorption rates are computed below.

Allocation
STICKY NOTES

AB AC SA SB Total
basis
---------------------Rupees---------------------
Factory rent Floor area 1,250,000 937,500 187,500 125,000 2,500,000
(2500x6/12;4.5/12;0.9/12;0.6/12)
Fuel cost Machine hrs. 990,000 810,000 - - 1,800,000
(1800x22/40;18/40(W-1) (fuel
consumption)
Depreciation Machine hrs. 1,294,118 705,882 - - 2,000,000
(2000x22/34;12/34)
Electricity and utilities Floor area 550,000 412,500 82,500 55,000 1,100,000
(1100x6/12;4.5/12;0.9/12;6/12)
4,084,118 2,865,882 270,000 180,000 7,400,000

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Allocation
AB AC SA SB Total
basis
---------------------Rupees---------------------
Allocation of service departments cost
SA (40%:40%:20%) 122,474 122,474 (306,186) 61,238
SB (45%:40%:15%) 108,556 96,495 36,186 (241,237)
Total overhead apportionment 4,315,149 3,084,851 - - -
Allocation basis Machine hours Labour hours
Overhead absorption rate per hour (in Rs.) 196.14/machine hour 308.49/labour hour

AT A GLANCE
4,315,419/22,000 3,084,851/10,000

W-1

Weighted machine hours: Hours

AB (22,000x1) 22,000
AB (12,000x1.5) 18,000
40,000

W-2:
Let X= cost of service dept SA

SPOTLIGHT
Let Y= cost of service dept SB
Form equations:
X = 270,000 + 0.15Y ---------- (i)
Y = 180,000 + 0.2X ---------- (ii)
By solving simultaneously:
X = 306,186
Y = 241,237
 Question 05:

STICKY NOTES
A factory has three machines and produces two products, A and B. The following information is available in this
respect:

Machine 1 Machine 2 Machine 3

Operators required per machine 2 3 4
Machine hours required to produce each unit of A 0.7 0.6 0.5
Machine hours required to produce each unit of B 0.2 0.3 0.4
Electricity consumed per machine hour (kWh) 12 15 20

The budgeted overheads for the next quarter are Rs. 7.192 million, which include electricity and power costs
amounting to Rs. 2.912 million. All overheads, other than electricity and power, are allocated on the basis of
operator hours.
Required:
Determine the factory overhead rate per machine hour for each machine if the budgeted production for the
next quarter is 1,200 units of A and 800 units of B.

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 Solution:
If the budgeted production for the next quarter is 1,200 units of A and 800 units of B, the factory overhead rate
per machine hour for each machine can be calculated as follows.

Machine 1 Machine 2 Machine 3 Total

Machine hours required to produce A 840 720 600
1,200x0.7 1,200x0.6 1,200x0.5
Machine hours required to produce B 160 240 320
800x0.2 800x0.3 800x0.4
Total Machine Hours a 1,000 960 920
No. of machine operators required to b 2 3 4
AT A GLANCE

operate the machines

Total Operator Hours c=axb 2,000 2,880 3,680 8,560
Electricity consumed per machine hour d 12 15 20
(No. of kWh)
Total Electricity Consumption (kWh) e=axd 12,000 14,400 18,400 44,800
------------------Rupees------------------
Allocation of overheads
Electricity and Power 780,000 936,000 1,196,000 2,912,000
(based on electricity consumption)
All other overheads 1,000,000 1,440,000 1,840,000 4,280,000
SPOTLIGHT

(based on operator hours)

Total f 1,780,000 2,376,000 3,036,000 7,192,000
Factory overheads per machine hour (Rs.) f/a 1,780 2,475 3,300

 Question 06:
Opal Industries Limited (OIL) produces various products which pass through Processing and Finishing
departments. Logistics and Maintenance departments provide necessary support for the production. Following
information is available from OIL’s records for the month of June 20X1:

(i) Overhead costs Direct labour hours

STICKY NOTES

Departments *Budgeted Actual Budgeted Actual

-------- Rupees -------- -------- Rupees --------
Processing 560,000 536,000 14,000 14,350
Finishing 320,000 258,000 10,000 9,800
Logistics - 56,700 - -
Maintenance - 45,000 - -

*including apportionment of overhead costs of support departments

• Costs of support departments are apportioned as under:

Processing Finishing Logistics Maintenance

Logistics 50% 40% - 10%
Maintenance 35% 45% 20% -

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Required:
a) Allocate actual overhead costs of support departments to production departments using repeated
distribution method.
b) Compute under/over applied overheads for the month of June 20X1
 Solution
a) Allocate actual overhead costs of support departments to production departments using repeated
distribution method.

Allocation of support departments' actual overheads:

Production departments Support departments

AT A GLANCE
Processing Finishing Logistics Maintenance

Rupees

Cost incurred 536,000 258,000 56,700 45,000

Allocation of support departments' costs:

Logistics 28,350 22,680 (56,700) 5,670

50%:40%:0%:10%

Maintenance 17,734 22,802 10,134 (50,670)

35%:45%:20%:0%

SPOTLIGHT
Logistics 5,067 4,054 (10,134) 1,013

Maintenance 354 456 203 (1,013)

Logistics (Being immaterial amount, 113 90 (203) -

allocated to production dept. only) 50:40

Total - Actual overhead costs A 587,618 308,082 - -

b) Compute under/over applied overheads for the month of June 20X1.

Under/over applied overheads:

STICKY NOTES
Predetermined overhead rate:

Budgeted direct labour hours B 14,000 10,000

Budgeted overhead costs C 560,000 320,000

Budgeted overhead rate (C÷B) D 40.00 32.00

Overheads applied:

Actual direct labour hours E 14,350 9,800

Overheads applied (D×E) F 574,000 313,600

Overheads under/(over) applied (A-F) 13,618 (5,518)

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 Question 07:
Following information has been extracted from the records of RT Limited for August 20X3:

Departments
Production Service
P-1 P-2 P-3 S-1 S-2
Budgeted machine hours 60,000 100,000 120,000
Actual machine hours 60,500 110,000 100,000
Budgeted labour hours 50,000 200,000 75,000
Actual labour hours 55,000 190,000 75,000
AT A GLANCE

Budgeted material cost (Rs. ‘000) 50,000 40,000 3,000

Actual material cost (Rs. ‘000) 50,000 42,000 3,200
Budgeted overheads (Rs. ‘000) 1,200 2,000 2,250 600 700
Actual overheads (Rs. ‘000) 1,250 2,000 1,800 500 750
Services provided by S-1 20% 30% 40% - 10%
Services provided by S-2 30% 40% 20% 10% -
Basis of overhead application Machine Labour 75% of
hours hours Material cost

Required
SPOTLIGHT

a) Re-apportion the costs of service departments using repeated distribution method.

b) Compute department wise over / under applied overheads.
 Solution
a) Re-Re-apportionment of Actual Overheads:

Production Dept. Service Dept.

P1 P2 P3 S1 S2
Rupees in thousand
S1 overheads allocation % 20% 30% 40% 10%
STICKY NOTES

S2 overheads allocation % 30% 40% 20% 10%

Actual overheads as given 1,250 2,000 1,800 500 750
Allocation of S2 cost
30:40:20:10 225 300 150 75 (750)
Allocation of S1 cost
20:30:40:10 115 172 230 (575) 58
Allocation of S2 cost
30:40:20:10 17 23 11 6 (58)
Allocation of S1 cost
20:30:40:10 1 2 3 (6)
Allocation from service dept. 358 497 394
Total 1,608 2,497 2,194 − −

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Re-apportionment of Budgeted Overheads:

R.T Limited FOH Distribution Sheet

For the month of August, 2009 (Based on Budgeted Cost for Computation of Budgeted OAR)
Date Particulars Head Amount Basis Production Department Service Department
of A/c
P1 P2 P3 S1 S2
Budgeted 1,300,000 600,000 700,000
Overheads
Redistribution
S–1 20:30:40:10 120,000 180,000 240,000 (600,000) 60,000

AT A GLANCE
760,000
S–2 30:40:20:10 228,000 304,000 152,000 76,000 (760,000)
S–1 20:30:40:10 15,200 22,800 30,400 (76,000) 7,600
S–2 30:40:20:10 2,280 3,040 1,520 760 (7,600)
S–1 20:30:40:10 152 228 304 (760) 76
S–2 30:40:20:10 23 30 15 8 (76)
S–1 20:30:40:10 2 3 3 (8) -
1,300,000 365,657 510,101 424,242 0 0

SPOTLIGHT
b) Compute department wise over / under applied overheads.

Department wise over / under applied overheads:

P1 P2 P3
Budgeted OH’s 1,200,000 2,000,000 2,250,000
Re-distributed OH’s of service departments 365,657 510,101 424,242
Total budgeted OH’s (I) 1,565,657 2,510,101 2,674,242
Budgeted Base Machine Hours Labour Hours Material Cost
60,000 200,000 -
Budget OAR (II) Rs. 26.0943 Rs. 12.5505 75% of DMC

STICKY NOTES
Per M.H Per L.H Given
Actual data of Base (III) 60,500 190,000 Rs. 3,200,000
Applied FOH (III x II) Rs. 1,578,705 2,384,595 2,400,000
Actual FOH (W-1) 1,608,586 2,497,475 2,193,939
(Under)/Over FOH Applied (29,881) (112,880) 206,061

(W-1)
P-1 P-2 P-3
Actual FOH
Direct Incurred 1,250,000 2,000,000 1,800,000
Share of service dept’s (part a) 358,586 497,475 393,939
1,608,586 2,497,475 2,193,939

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 Question 08:
Hi-way Engineering Limited uses budgeted overhead rate for applying overhead to production orders on a
direct labour cost basis for department A and on a machine hour basis in department B.
The company made the following forecasts for August 2006:
Dept A Dept B
Budgeted factory overhead (Rs.) 216,000 225,000
Budgeted direct labour cost (Rs.) 192,000 52,500
Budgeted machine hours 500 10,000
During the month, 50 units were produced in Job no. CNG-011. The job cost sheet for the month depicts the
following information:
AT A GLANCE

Dept A Dept B
Material issued (Rs.) 1,500 2,250
Direct labour cost (Rs.) 1,800 1,250
Machine hours 60 150
Actual data for the month were as follows:
Dept A Dept B
Factory overhead (Rs.) 240,000 207,000
Direct labour cost (Rs.) 222,000 50,000
Machine hours 400 9,000
SPOTLIGHT

Required
a) Compute predetermined overhead rates for each department.
b) Compute total costs and unit cost of Job no. CNG-011.
 Solution
a) Predetermined overhead rates for each department would be computed as follows:

Dep A Dep B
Budgeted factory overhead (Rs.) 216,000 225,000
Pre-determined Overhead rate 216,000/192,000*100= 225,000/10,000=
STICKY NOTES

125% of labour cost 22.5 per machine hours

(activity= labour cost) (activity=machine hour)

b) The total costs and unit cost of Job no. CNG-011, would be as follows

Dep A Dep B Total

cost
Material issued (Rs.) 1500 2250 3750
Direct labour cost (Rs.) 1800 1250 3050
Factory overheads (actual activity*predetermined overhead rate) 2025 3375 5400
1800 x 112.5 %, 150 x 22.5 (1.25 x (22.5 x
1,800) 150)
Total cost 5325 6875 12200
Number of units 50 50 50
Per unit cost (total cost/number of units) 106.5 137.5 244

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c) The over / under applied overhead for each department would be as follows:

Dep A Dep B
Actual factory overheads 240,000 207,000
Applied factory overheads (actual activity*predetermined overhead rate) 249,750 202,500
222,000 x112.5%; 9,000 x22.5/MH (1.25 x (22.5 x
222,000) 9,000)
(over) / under applied factory overheads (9,750) 4,500

 Question 09:
Omega Industries Limited (OIL) produces two products Alpha and Beta. These products are processed through
Fabrication and Finishing departments. Quality control and Logistics departments provide all the necessary

AT A GLANCE
support for the production.
OIL allocates production overheads to Alpha and Beta at a pre-determined rate of Rs. 1,300 and Rs. 500 per
unit respectively. Any under/over absorbed overheads are adjusted to cost of sales.
Following actual data has been extracted from the cost records of OIL for the month of December 2015:

Fabrication Finishing Quality control Logistics Total

Indirect labour Rs. in 000 1,500 1,200 500 400 3,600

Factory rent Rs. In 000 2,000

Power Rs. In 000 1,200

SPOTLIGHT
Depreciation-plant Rs. In 000 9,000

Other information:

Cost of plant Rs. In 000 32,000 20,000 2,000 6,000 60,000

Floor area Square feet 10,000 5,000 3,000 2,000 20,000

Power KWH 50,000 40,000 4,000 6,000 100,000

Hours worked for Alpha 70% 60%

Hours worked for Beta 30% 40%

STICKY NOTES
Services provided by:

- Quality Control 40% 60% 100%

- Logistics 60% 35% 5% 100%

8,000 units of Alpha and 10,000 units of Beta were produced during the month of December 2015.
Required
a) Calculate product wise actual overheads for Alpha and Beta.
b) Make journal entries to record:
i. applied production overhead
ii. under/ over absorbed production overheads

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 Solution
Product wise actual overheads for Alpha and Beta are calculated below.

Allocation Service
Items Total Production departments
basis departments
Fabrication Finishing Quality control Logistics
Amount in Rs. 000
Indirect labour Given 3,600 1,500 1,200 500 400
Factory rent Floor area 2,000 1,000 500 300 200
Power KWH 1,200 600 480 48 72
AT A GLANCE

Depreciation Plant cost 9,000 4,800 3,000 300 900

1,148 1,572
Service departments:
Logistics 60:35:5 1,572 943 550 79 (1,572)
Quality control 40:60 1,227 491 736 (1,227)
9,334 6,466

Cost allocation to Alpha and Beta

Alpha Beta Total

SPOTLIGHT

Actual units produced 8,000 10,000 18,000

Overheads allocation on the basis of hours worked
Rs. In 000
- Fabricating in the ratio of 70:30 6,534 2,800 9,334
- Finishing in the ratio of 60:40 3,880 2,586 6,466
10,414 5,386 15,800

a) Journal entries to record (i) applied production overhead and (ii) Under/ over absorbed production
STICKY NOTES

overheads are given as under.

Debit Credit
Rs. In 000
Work in process (8,000 x 1,300) + (10,000 x 500) 15,400
Factory overheads control account 15,400
(Overheads charged to production at pre-determined rate)
Cost of sales (15,800 – 15,400) 400
Factory overheads control account 400
(Under applied overheads charged to cost of sales)

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 Question 10:
Bright Limited (BL) is engaged in the manufacturing of two products, Shine and Glow. Both these products are
processed through two production departments, A and B, while department X and Y provide services to both
the production departments. Below is a summary of the indirect costs incurred by BL for manufacture of
100,000 units of Shine and 60,000 units of Glow during the year ended 31 December 2020:

Rs. 000
Salaries and wages 115,000
Depreciation of machinery 80,000
Building insurance 25,000
Electricity 60,000

AT A GLANCE
280,000

Other information related to the four departments is given below:

Department A Department B Department X Department Y Total

Cost of machinery (Rs. 000) 250,000 150,000 400,000
Floor area (square feet) 15,000 6,000 6,000 3,000 30,000
No. of employees 150 50 25 25 250
Services provided by
- Department X 80% 20%

SPOTLIGHT
- Department Y 75% 15% 10%

The overhead absorption rates used by BL for allocation to Shine and Glow are Rs. 1,800 and Rs. 1,700 per unit
respectively. Any under/over absorbed overheads are adjusted to cost of sales.
Required
a) Compute product wise actual overheads for shine and glow.
b) Compute under / over absorbed overheads.
 Solution
a) Computation of product wise actual overheads for shine and glow is given below:

STICKY NOTES
Cost allocation to production departments

Service
Items Allocation basis Total Production departments
departments
A B X Y
Amount in Rs. 000
Salaries & No. of employees 115,000 69,000 23,000 11,500 11,500
wages (150:50:25:25=250)
Depreciation Cost of machine 80,000 50,000 30,000
(25:15=40)
Building Floor area 25,000 12,500 5,000 5,000 2,500
insurance (15:6:6:3=30)
Electricity Floor area 60,000 30,000 12,000 12,000 6,000
28,500 20,000

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Service
Items Allocation basis Total Production departments
departments
A B X Y
Amount in Rs. 000
Service departments:
Department Y 75:15:10 15,000 3,000 2,000 (20,000)
Department X 80:20 24,400 6,100 (30,500)
200,900 79,100

Cost allocation to Shine and Glow

AT A GLANCE

Shine Glow Total

Actual units produced 100,000 60,000 160,000
Overheads allocation on the basis of units
Rs. In 000
- Department A {Units (100:60)} 125,563 75,337 200,900
- Department B {Units (100:60} 49,437 29,663 79,100
175,000 105,000 280,000

b) Computation of Under / Over absorbed overheads is given below.

Absorbed overheads Actual overheads Under/(Over) absorbed

SPOTLIGHT

Rs. In 000
Shine @ Rs. 1,800 per unit 180,000 175,000 (5,000)
Glow @ Rs. 1,700 per unit 102,000 105,000 3000
282,000 280,000 (2,000)

 Question 11:
Alpha Limited is preparing its departmental budgets and product cost estimates for the next year. The costs
and related data for the year ending 31 December 2014 have been estimated as follows:

Machining Assembly Finishing Maintenance Total

STICKY NOTES

Rs. In 000
Direct wages 274 146 328 748
Indirect wages 46 27 36 137 246
Direct materials 365 46 18 429
Indirect materials 68 18 36 91 213
Power 465
Light and heat 46
Depreciation 108
Rent and rates 114
Warehousing cost 98
Other data:
Direct labour hours 12,000 8,000 16,000 6,000 42,000

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Machining Assembly Finishing Maintenance Total

Rs. In 000
Machine hours 40,000 2,000 3,000 45,000
No. of employees 6 4 8 3 21
Floor area (sqm) 1,000 400 300 300 2,000
Net book value of fixed assets (Rs. 000)
20,000 8,000 3,000 4,000 35,000

80% of the maintenance department’s time is used in the maintenance of machines whereas the remaining
time is consumed in cleaning and maintenance of factory buildings.
Required.

AT A GLANCE
Compute appropriate absorption rates for machining, assembly and finishing departments.
 Solution
Overhead analysis sheet for Alpha Limited for the year ending 31 December 2014:

Base Machining Assembly Finishing Maintenance Total

Rs. In 000
Indirect wages Actual 46 27 36 137 246
Indirect materials Actual 68 18 36 91 213
Power Machine hours 413 21 31 465

SPOTLIGHT
Light and heat Floor area 23 9 7 7 46
Depreciation NBV 62 25 9 12 108
Rent and rates Floor area 57 23 17 17 114
Warehousing cost Direct materials 83 11 4 98
752 134 140 264 1,290
80% based on 188 9 14 (211)
machine hours
Reallocation of 20% based on floor 31 13 9 (53)

STICKY NOTES
Maintenance costs area
971 156 163 - 1,290

Overhead absorption rates of each department

Machining Assembly Finishing

Overheads (Rs. 000) 971 156 163
Base 40,000 8,000 16,000
Machine hours Direct labour hours Direct labour hours
Overhead absorption rate (Rs.) 24.28 19.50 10.19

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 Question 12:
Zaiqa Limited (ZL) is engaged in the business of manufacturing fruit jam. It has three production and two
service departments. Following information is available from ZL’s records for the month of August 2013:

Rupees

Rent and rates 85,000

Indirect wages 60,000

General lighting 75,000

Power 150,000
AT A GLANCE

Depreciation machinery 50,000

Following further information relating to the departments is also available:

Production Departments Service Departments

Selection Jam making Bottling Storage Distribution

Direct wages (Rs.) 60,000 80,000 32,000 - -

Indirect Wages of service departments - - - 8,000 20,000

SPOTLIGHT

Power consumed (KWH) 1,000 6,000 2,000 1,000 -

Floor area (Sq. ft.) 1,500 2,000 1,250 1,000 500

Light points (Nos.) 10 20 15 5 10

Production hours 1,533 3,577 1,815 - -

Labour hours per bottle 0.10 0.25 0.15 - -

Cost of machinery (Rs.) 600,000 1,200,000 900,000 300,000 -

After production, the jam bottles are finally packed in a carton consisting of 12 bottles. The service
STICKY NOTES

departments costs are apportioned as follows:

Production Departments Service Departments

Selection Jam making Bottling Storage Distribution

Storage 10% 30% 40% - 20%

Distribution 20% 50% 30% - -

Raw and packing material costs of Rs. 36 and labour cost of Rs. 25 is incurred on each bottle.
Required
Compute cost of each carton.

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 Solution
Cost of each carton is calculated as under:

Primary Distribution of overheads

Production Departments Service Departments

Basis of Total
Apportionment overheads Jam
Selection Bottling Storage Distribution
making
Indirect
Wages of
service Given 28,000 8,000 20,000
departments

AT A GLANCE
(Rs.)
Rent and
Floor area 85,000 20,400 27,200 17,000 13,600 6,800
rates
General
Light points 75,000 12,500 25,000 18,750 6,250 12,500
lighting
Indirect
Direct wages 60,000 18,000 24,000 9,600 2,400 6,000
wages
Power KWH cons. 150,000 15,000 90,000 30,000 15,000 -
Depreciation Cost of mach. 50,000 10,000 20,000 15,000 5,000 -

SPOTLIGHT
Total departmental overheads 448,000 75,900 186,200 90,350 50,250 45,300

Secondary Distribution of overheads

Production Departments Service Departments

Total Jam
overheads Selection Bottling Storage Distribution
making
Total overheads 448,000 75,900 186,200 90,350 50,250 45,300
Storage (1:3:4:2) 5.025 15,075 20,100 (50,250) 10,050
Distribution (2:5:3) 11,070 27,675 16,605 - (55,350)

STICKY NOTES
Total 448,000 91,995 228,950 127,055
Production hours 1,533 3,577 1,815
Rate per hour (Rs.) 60.0 64.0 70.0

Cost of one carton

Rupees Rupees
Packing and raw materials (36 x 12) 432
Direct labour (25 x 12) 300
Overheads:
Selection (0.1 x 12 x 60) 72
Jam making (0.25 x 12 x 64) 192
Bottling (0.15 x 12 x 70) 126 390
Total 1,122

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 Question 13:
a) Faisal Enterprises Limited (FEL) produces three products A, B and C. Each product is produced in a
separate department. There are two service departments i.e. Repair & Maintenance (R&M) and
Stores.
Following data is available for the month of February 2023:

Production Service
Departments Departments Total
A B C R&M Stores
-------------------- Rs. in '000 --------------------
Indirect material cost 180 240 120 930 30 1,500
AT A GLANCE

Indirect labour cost 160 210 150 60 20 600

Fuel and electricity 1,520
Air-conditioning and lighting 150
Depreciation & insurance – Machines 665
Depreciation & insurance – Building 50
Other insurance 270

Other information:
SPOTLIGHT

Raw material cost (Rs. in ‘000) 60,000 45,000 30,000 - - 135,000

Labour hours (no. of hours) 2,000 3,000 4,000 - - 9,000
Machine hours (no. of hours) 5,000 6,000 8,000 - - 19,000
Area (in square meters) 200 300 400 60 40 1,000
% of apportionment of service
department’s cost:
R&M 25% 30% 35% - 10%
Stores 30% 25% 25% 20% -
STICKY NOTES

Finished Goods – opening 2,000 2,000 2,500 - -

Finished Goods – closing 1,500 3,000 2,000 - -
Units Sold 5,500 5,000 4,500 - -

Additional information:
i. Raw material and labour are consumed evenly during the production process.
ii. Direct labour is paid @ Rs. 300 per hour.
iii. FEL uses simultaneous equation method for apportioning service departments’ cost to production
departments.
Required:
Allocate the factory overheads to the departments, clearly displaying the basis of allocation, and determine the
cost of production of each unit

82 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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 Solution:
Supported with basis for allocation, factory overheads can be allocated to the departments as follows.
Faisal Enterprises Limited

Total Production Services Basis

A B C R&M Stores
-------------------Rs. In ‘000-------------------
Indirect material 1,500 180 240 120 930 30
Indirect labour 600 160 210 150 60 20
Fuel and electricity 1,520 400 480 640 - - Machine hours

AT A GLANCE
Air conditioning and lighting 150 30 45 60 9 6 Area
Depreciation and insurance - 665 175 210 280 - - Machine hours
machine
Depreciation and insurance - 50 10 15 20 3 2 Area
building
Other insurance 270 120 90 60 - - Raw material
cost
4,755 1,075 1,290 1,330 1,002 58

M = 1,002 + 0.2S -------(i)

SPOTLIGHT
S = 58 + 0.1M -------(ii)
Rearrange:
1,002 = M – 0.2S
58 = -0.1M + S
Multiply (ii) by 0.2
11.6 = -0.02 M + 0.2 S -------(iii)
Add (i) and (iii)

STICKY NOTES
1,013.6 = 0.98 M
M = 1,034
Therefore from (i) substituting M = 1,034
S = 58 + 0.1 (1,034)
S = 161

Total A B C R&M Stores

---------------------- Rs. In ‘000 ----------------------
Cost as above 4,755 1,075 1,290 1,330 1,002 58
Maintenance - 259 310 362 (1,034) 103
Store - 49 40 40 32 (161)
1,383 1,640 1,732 0 0

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Product-wise production cost per unit can be computed as follows:

Computation of cost per unit: Total A B C

------------ Rs. In ‘000 ------------

Raw material cost 135,000 60,000 45,000 30,000

Labour cost 2,700 600 900 1,200

(2,000x300) (3,000x300) (4,000x300)

Factory overheads (as above) 4,755 1,383 1,640 1,732

AT A GLANCE

Total production cost 61,983 47,540 32,932

 Question 14:
Venus Limited (VL) is a manufacturer of consumer goods. Below are the details related to overheads of its
production department for the year:

Total machine hours available (2500 hours per machine) 7,500

SPOTLIGHT

Machine maintenance hours (150 hours per machine) 450

Departmental overhead absorption rate per productive machine hour (Rs.) 850

The management of VL has decided to replace one of its existing machines having zero book value with a new
machine which will cost Rs. 1,200,000 and has a useful life of 10 years. The machine will be available for use
from the beginning of next year and is expected to run for 2,500 hours during the next year including:
i. 80 hours for setting up the machine; and
ii. 110 hours for machine maintenance.
STICKY NOTES

The estimated overheads for the year related to the new machine are given below:

Electricity consumption per hour Rs. 180

Annual maintenance cost Rs. 200,000

Indirect labour cost Rs. 50,000

It has also been decided that from the beginning of next year, one of the managers from another department
will be moved to the production department for monitoring the line efficiency. The manager’s salary is Rs.
30,000 per month.
Required:
a) Compute the revised overhead absorption rate for the production department for the next year.
b) Give a brief explanation on how an overhead absorption base should be selected along with some
examples of the bases for absorption.

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 Solution:
a) Revised overhead absorption rate for the production department for the next year is computed below.

Rupees

Existing budgeted overheads [850x(7,500-450)] 5,992,500

Increase/(decrease) in departmental cost:

Depreciation of new machine 1,200,000/10 120,000

Electricity 180x(2,500-80-110) 415,800

AT A GLANCE
Maintenance cost 200,000

Indirect labour 50,000

Production line manager 30,000x12 360,000

Less: Existing overheads of the machine being replaced [{850x(7,500-450)}/3] (1,997,500)

Revised budgeted overheads 5,140,800

Hours

SPOTLIGHT
Existing budget hours 7,500-450 7,050

Add: Budgeted hours of new machine 2,500-80-110 2,310

Less: Budgeted hours of old machine 7,050/3 (2,350)

Revised budgeted hours 7,010

Rupees

STICKY NOTES
Revised overhead absorption rate 5,140,800/7,010 733.35

b) A brief explanation on how an overhead absorption base should be selected along with some examples of
the bases for absorption is given below.
 Examples of bases of absorption
i. Machine hours
ii. Direct labour hours
iii. Physical output
iv. Direct material cost
v. Prime cost
vi. Direct labour cost
The base selection depends on the nature of business and it may vary from company to company, department
to department and one cost centre to the other.

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 Question 15:
i. Ahsan Enterprises (AE) produces three products Alpha, Beta and Gamma. The management has some
reservations on the method of costing. Consequently, the cost accountant has reviewed the records and
gathered the following information:
The costs incurred during the latest quarter were as follows:

Rupees
Direct material 240,000
Direct labour 1,680,000
Indirect wages – machine maintenance 600,000
AT A GLANCE

– stores 360,000
– quality control 468,000
– cleaning and related services 400,000
Fuel and power 2,800,000
Depreciation on plant, machinery and building 1,560,000
Insurance on plant and machinery 240,000
Insurance on building 60,000
Stores, spares and supplies consumed 1,800,000
SPOTLIGHT

Rent, rates and taxes 1,200,000

ii. The production report for the previous quarter depicted the following information:

Production Direct labour hours Machine hours per Inspection hours per
(units) per unit unit unit
Alpha 12,000 20.00 6.00 2.00
Beta 20,000 5.00 8.00 3.00
Gamma 45,000 4.00 10.00 4.00

iii. Other details are follows:

STICKY NOTES

Alpha Beta Gamma

Factory Space Utilization 40% 35% 25%
Cost of Machinery (Rs.000) 6,000 4,000 3,000
Stores Consumption (Rs.000) 720 270 810
No. of units inspected 600 400 1,350

The rate of depreciation for plant and machinery is 10% per annum.
Required:
a) Determine the factory overhead cost per unit for products Alpha, Beta and Gamma by using single factory
overhead rate based on direct labour hours.
b) Apportion production overheads amongst products Alpha, Beta and Gamma on some reasonable basis and
compute factory overhead cost per unit for each product.

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CAF 5: MANAGEMENT ACCOUNTING CHAPTER 2: OVERHEADS

 Solution:
a) Calculation of the factory overhead cost per unit for products Alpha, Beta and Gamma by using single
factory overhead rate based on direct labour hours is as follows.
𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠
9,488,000
520,000 (𝑤 − 1)
Factory Overhead Rate = Rs. 18.246 per direct labour hour

W-1 Alpha Beta Gamma Total

Physical Output 12,000 20,000 45,000 77,000

AT A GLANCE
Direct Labour Hours per unit 20.00 5.00 4.00
Total Hours (12,000 x 20) (20,000 x 5) (45,000 x 4) 520,000
= 240,000 = 100,000 =180,000

Absorption of overheads to cost objects

Once absorption rate is calculated, then this rate is used to absorb overheads to cost object. If cost object is
product, then actual base is determined and overhead absorption rate is applied to absorb overheads to
each product as “Actual base x OAR/base”. For example, if OAR is Rs. 50 per labour hour and 500 actual
labour hours are incurred in production of specific product, then overhead cost of Rs. 25,000 (500 x 50) is
included in cost of this product.

SPOTLIGHT
Alpha Beta Gamma Total
Allocation based on direct labour hours:
Direct Labour Hours (w-1) 240,000 100,000 180,000 520,000
Factory overhead rate 18.246 18.246 18.246
Cost allocated to the products (240,000x (100,000x (180,000x 9,488,000
18.246) = 18.246) = 18.246) =
4,379,076.923 1,824,615.385 3,284,307.692

b) Apportionment of production overheads amongst products Alpha, Beta and Gamma on some reasonable

STICKY NOTES
basis and computation of factory overhead cost per unit for each product is as follows.

Allocation
Alpha Beta Gamma Total
basis
Production (no. of units) A 12,000 20,000 45,000 77,000
Machine hours per unit 6 8 10
Total machine hours Units x Machine 72,000 160,000 450,000 682,000
hours per unit
Units inspected 600 400 1,350 2,350
Per unit inspection hours 2 3 4
Total no. of hours for units Units inspected x 1,200 1,200 5,400 7,800
inspected hours per unit

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Allocation
Alpha Beta Gamma Total
basis
Overhead allocation:
Indirect wages:
Machine maintenance Machine hours 63,343 140,763 395,894 600,000
Stores Store consumption 144,000 54,000 162,000 360,000
Quality control Inspected hours 72,000 72,000 324,000 468,000
Cleaning and related Factory space 160,000 140,000 100,000 400,000
services utilization
AT A GLANCE

Fuel and power Machine hours 295,601 656,892 1,847,507 2,800,000

Depreciation on plant and Machinery cost 600,000 400,000 300,000 1,300,000
machinery
Depreciation on building Factory space 104,000 91,000 65,000 260,000
(1,560,000-1,300,000) utilization

Insurance on plant and Cost of Machinery 110,769 73,846 55,385 240,000

machinery
Insurance on building Factory space 24,000 21,000 15,000 60,000
utilization
Stores, spares and Actual 720,000 270,000 810,000 1,800,000
SPOTLIGHT

supplies consumed
Rent, rates and taxes Factory space 480,000 420,000 300,000 1,200,000
utilization
Total overheads B Rs. 2,773,714 2,339,500 4,374,786 9,488,000
Cost per unit (B/A) Rs. 231.14 116.98 97.22

In this example we could see that rate is calculated for each expense using its related activity and then
allocation is based on the proportion utilized by the products of such activities.
STICKY NOTES

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STICKY NOTES

Manufacturing expenses are of two types: Direct expenses and Indirect

Expenses.
Direct expenses are directly traceable to the product/service/department
being costed. e.g. Direct material, Direct Labour and direct expenses. Indirect
expenses (Production overheads) cannot be traced directly to the product,
service or department

AT A GLANCE
Variable costs vary with the level of output and fixed cost remains constant
irrespective of the level of output.

Production Overheads incur in relation to the production processes (also

called manufacturing overheads / factory overheads). Non-Production
Overheads incur to support the overall objectives of the business. (classified
as ‘Administrative Expenses, Marketing, Selling and Distribution Expenses’ in
the Statement of Comprehensive Income.)

SPOTLIGHT
Activity levels used for overhead absorption can be physical output, direct
material cost, direct labour cost, prime cost, direct labour hours, machine
hours.

In addition to the selection of bases, the following factors also affect pre-
determined overhead rate:
1. Activity level: at which the business performs its production activities

STICKY NOTES
2. Inclusion or exclusion of fixed overheads: Absorption costing /
conventional costing/full costing or Marginal Costing/Direct Costing
3. Single rate or several rates Blanket rate/Plant-wide rate, Departmental
rates or Cost centers/cost pool rates.

The overhead costs of servicing departments are transferred to production

departments and service departments in the proportion of the facilities used

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When service departments share services with each other, the concept of
reciprocal apportionment is applied using one of the following methods:
a) Repeated distribution method
b) Simultaneous equation method

All the production related overhead costs are to be accumulated at the

smallest segment of the production process
AT A GLANCE

Overhead absorption rate is calculated to absorbed costs into cost units

At the period end, actual overhead is compared with applied
Overhead rate to calculate the over or under absorption
SPOTLIGHT
STICKY NOTES

90 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 3

ACTIVITY BASED
COSTING

AT A GLANCE
IN THIS CHAPTER

AT A GLANCE
Activity Based Costing is alternate to absorption costing in
which cost is charged to cost object on the basis of activities,
AT A GLANCE
rather than volume.
SPOTLIGHT Cost pool is accumulation of cost for each activity cost centre
whereas cost driver which drives the cost and provides basis for
1. Activity based costing apportionment of cost.
In absorption costing, cost is absorbed into products on the basis
2. Reasons for the development of
of volume, whereas in activity-based costing, cost is absorbed
activity based costing
into products on the basis of activities, rather than volume only.
3. Cost pool and cost driver More realistic costing can be made under activity-based costing
technique as more than one rates are used to absorb cost into

SPOTLIGHT
4. Costing under activity based cost object.
costing

5. Merits and demerits of activity

based costing

6. Self-test questions

SITCKY NOTES

STICKY NOTES

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1 ACTIVITY BASED COSTING

Activity based costing (ABC) is alternative technique to traditional absorption costing technique, which is used
to absorb indirect cost to cost object. It is a costing method that assigns indirect cost to activities and products
based on each product’s use of activities. In simple words, in ABC, “Products consume activities and activities
consume resources”.
ABC involves the process of identification of the factors which results the costs of an organisation’s major
activities (Cost Pool or cost bucket). Overheads are allocated and apportioned to activity cost centres or cost
pool. The overhead costs are ultimately absorbed into product on the basis of usage of activities. Products using
more activities should be charged with high cost of respective ‘cost pool’ or ‘cost bucket’ cost, irrespective of
high or low volume. The absorption rate for each activity is cost per unit of relevant cost driver.
Activity based costing can be defined as: “method of costing which involves identifying the costs of the main
AT A GLANCE

support activities and the factors that drive the costs of each activity. Support overheads are charged to
products by absorbing cost on the basis of the product’s usage of the factor driving the overheads.”
SPOTLIGHT
STICKY NOTES

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2 REASONS FOR THE DEVELOPMENT OF ACTIVITY BASED COSTING

Absorption costing is based on the fact that production overheads are driven by units of products. If higher
units are produced, higher production overheads are absorbed into products. These are normally absorbed
into products on volume-based cost drivers, for instance, labour hours, machine hours, number of units, etc.
However, activity-based costing is based on various cost driver rates that are more relevant in comparison with
the traditional absorption rates.

2.1. Evolution of Activity Based Costing

Traditional absorption costing was developed in a time when most manufacturers produced small range of
products which underwent similar operations. It was justified to include similar proportion of overheads into
product cost. In addition to above, overhead costs comprised of small fraction of total production cost or in
other words, the proportion of direct cost was higher than indirect cost. With the introduction of advanced

AT A GLANCE
manufacturing technologies or computer-aided manufacturing, the proportion of indirect costs was increased
significantly. The drastic shift from direct to indirect cost requires more complex system of absorption and
therefore, ABC was developed in order to calculate realistic cost of product.
In the past, most of the manufacturing was considered as labour-intensive and machine depreciation cost was
not significant, but with introduction of modern manufacturing environment, the dependence on machines was
enhanced, resulting higher depreciation cost. It increased the indirect cost to higher extent than direct cost
because of manufacturing environment was shifted from labour-intensive to machine-intensive.
The increase in market competition and more complex manufacturing environments, the product range have
increased. In this environment, the use of absorption costing may result in over-statement of cost due to higher
volume or understatement of cost to product with low volume. ABC attempts to overcome this problem.

SPOTLIGHT
STICKY NOTES

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3 COST POOL AND COST DRIVER

Cost Pool
A cost pool (also known as ‘cost bucket’) is an activity which consumes resources and for which overheads
costs are identified and allocated. Cost pool is major activity which accumulates the cost relevant to this
specific activity. The term activity and cost pool are often used interchangeably.
For example, set up or batch cost is cost pool and it accumulates any indirect cost relating to batch. More cost
will be incurred in case of more batches are produced.

Cost Driver
A cost driver is a factor that influences or drives the level of cost of an activity. For example, number of batches
AT A GLANCE

is the cost driver. An increase in number of batches will influence or drive the set-up cost.
The following table exhibits examples of various cost pools and their related cost drivers:

Cost Pools Cost drivers

Machine set up cost ‘Total Number of batches’ or ‘Set ups’

Materials handing cost / Total number of Material Requisitions; or

Materials Management Cost Weight/volume/cost of direct materials consumed

Dispatching cost Total Number of orders dispatched

SPOTLIGHT

Ordering cost Total Number of customer’s orders

Production scheduling cost Total Number of production runs

Quality Control / Quality Inspection cost Total Number of inspection hours

Number of quality inspections

Production Control/ Machine operational cost Total Number of machine hours

Utilities (Electricity, Water ,Gas, Telephone Bills, etc.) Units Consumed

STICKY NOTES

Floor Area

Maintenance Cost Maintenance hours or machine hours

Training and Supervision Number of employees or training hours

Customer Service Number of service calls or customer contacts

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4 COSTING UNDER ACTIVITY BASED COSTING

Cost of product can be calculated under activity-based costing with help of five basic steps:

Step-I
Identify an organisation’s major activities that support the manufacture of the organisation’s products or
services.

Step-II
Use cost allocation and apportionment methods to accumulate overhead costs to each of the organisation’s
major activities. In other words, group production overheads into major activities of the organisation. The costs
that accumulate for each activity cost centre is called cost pool or cost bucket.

AT A GLANCE
Step-III
Identify the factors which determine the size of the costs of an activity. It is called the cost driver and these are
identified for each cost pool.

Step-IV
Calculate overhead absorption rate for each activity, which can be calculated by dividing the cost pool by its
cost driver as follows:
Activity cost driver rate = Total cost of activity / Activity Driver

Step-V

SPOTLIGHT
Absorb the activity costs into products after charging overhead costs on the basis of their usage of the activity.
Overheads are charged by absorbing them into product costs at a rate per unit of cost driver.

The same is summarized in the figure.

STICKY NOTES

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 Example 01:
Mustajab Limited (ML) manufacturers four products, A, B, C and D. Output and cost data for the period just
ended are as follows:

Output Number of Material cost per Direct labour hours Machine hours
Products
units production runs unit Rs. per unit per unit
A 10 2 200 10 10
B 10 2 800 30 30
C 100 5 200 10 10
D 100 5 80 30 30
AT A GLANCE

Overhead costs are given as under:

Overhead costs Rs.

Short run variable overheads costs 30,800
Set up costs 109,200
Expediting and scheduling costs 91,000
Material handling costs 77,000
Total 308,000

ML absorbs short-run variable costs based on machine hours. Labour cost per hour is Rs. 50.
SPOTLIGHT

Required:
Calculate unit cost for each product using Activity based costing.
 Solution:

A B C D
Amount in Rupees
Direct materials 2,000 8,000 20,000 80,000
Direct labour 500 1,500 5,000 15,000
STICKY NOTES

Production overheads:
Short run variable cost W-1 700 2,100 7,000 21,000
Set up costs W-1 15,600 15,600 39,000 39,000
Expediting and scheduling costs W-1 13,000 13,000 32,500 32,500
Materials handling costs W-1 11,000 11,000 27,500 27,500
Total cost (A) 42,800 51,200 131,000 215,000
Unit produced (B) 10 10 100 100
Unit cost (A) / (B) 4,280 5,120 1,310 2,150

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W-1

Activity Cost pool Rs. Cost Driver Rate per cost driver
Short run variable costs 30,800 4,400 Rs. 7
machine hours per machine hour
Set up costs 109,200 14 Rs. 7,800
production runs per production run
Expediting and scheduling costs 91,000 14 Rs. 6,500
production runs per production run
Material handling costs 77,000 14 Rs. 5,500
production runs per production run

AT A GLANCE
 Example 02:
Rajput Enterprises manufactures two products, J and K, using the same equipment and similar processes. An
extract of the production data for these products for the month of June is shown below:

Product J Product K
Quantity produced in units 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40

SPOTLIGHT
Orders handled in the period 15 60

Overhead costs for the month of June are given below:

Rupees
Machine related costs 220,000
Production run set-ups costs 20,000
Order handling costs 45,000
Total 285,000

STICKY NOTES
Required:
Calculate the production overheads absorbed per unit of each product using Activity Based Costing.
 Solution:
Production overheads absorbed by one unit of each product using Activity based costing, is as follows:

Product J Product K
Machine related costs (15,000x10)/(7,000x10) 150,000 70,000
Production run set-ups costs (10x400)/(40x400) 4,000 16,000
Order handling costs (15x600)/(60x600) 9,000 36,000
Total overhead cost (A) 163,000 122,000
Units produced (B) 5,000 7,000
Unit cost (A) / (B) 32.60 17.43

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W-1

Activity Cost pool Rs. Cost Driver Rate per cost driver
Machine related costs 220,000 22,000 Rs. 10
machine hours per machine hour
Production run set-ups costs 20,000 50 Rs. 400
set ups per set up
Order handling costs 45,000 75 Rs. 600
orders handled per order

 Example 03:
AT A GLANCE

Star Limited produces three products, Sky, Moon and Sun and relevant data for the month of March 2021 is
given in the following table.

Sky Moon Sun

Actual units produced and sold 500,000 150,000 250,000
Machine hours per unit 0.01 0.05 0.04
Number of production set-ups 3 1 26
Number of components 8 12 20
Number of customer orders 21 4 25

The overhead cost incurred by Star Limited during the month of March 2021 is given below.
SPOTLIGHT

Rupees
Machining cost 36,000
Component cost 100,000
Set-up cost 180,000
Packing cost 150,000
Total 466,000

Required:
STICKY NOTES

Using ABC, calculate the product-wise overhead cost in total and per unit.
 Solution:
Using ABC, calculation of product-wise overhead cost in total and per unit, is given below.

Sky Moon Sun

Machining cost 8,000 12,000 16,000
Component cost 20,000 30,000 50,000
Set-up cost 24,000 36,000 120,000
Packing cost 63,000 12,000 75,000
Total overhead cost (A) 115,000 90,000 261,000
Units produced (B) 500,000 150,000 250,000
Unit cost (A) / (B) 0.23 0.60 1.044

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W-1

Activity Cost pool Rs. Cost Driver Rate per cost driver
Machining cost 36,000 22,500 W-2 machine hours Rs. 1.60 per machine hour
Component cost 100,000 40 components Rs. 2,500 per component
Set-up cost 180,000 30 set-ups Rs. 6,000 per set up
Packing cost 150,000 50 orders Rs. 3,000 per order

W-2 Machine hours

Products Units produced Machine hours per unit Machine hours

AT A GLANCE
Sky 500,000 0.01 5,000
Moon 150,000 0.05 7,500
Sun 250,000 0.04 10,000
Total 22,500

SPOTLIGHT
STICKY NOTES

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5 MERITS AND DEMERITS OF ACTIVITY BASED COSTING

Merits
1. The complexity of manufacturing has increased due to use of advance technologies and multiple products
range, along with shorter product life cycles. Activity based costing recognizes this complexity with
multiple cost drivers.
2. In competitive environment, entities must be able to assess its product profitability in more realistic
manner. Activity based costing technique helped entities to absorb indirect costs into products on the basis
of activities in order to calculate realistic product cost.
3. Activity based costing can be applied to all overhead costs, and not restricted to production overheads.
4. Activity based costing can be used easily in service costing as in product costing.
AT A GLANCE

Demerits
1. Activity based costing will be of limited benefit if overhead costs are primarily volume related or overhead
costs is not significant proportion of total costs.
2. Cost apportionment may still be required at the cost pooling stage for shared items of costs like rent,
depreciation of building. Apportionment can be an arbitrary way of sharing costs.
3. The cost of implementing and maintaining an activity-based costing system might exceed the benefits of
improved accuracy in product or service costs.
4. This model is difficult to understand and can even create problems in implementation due to fair
understanding of activities and their related costs.
5. The choice of both activities and cost drivers might be inappropriate.
SPOTLIGHT
STICKY NOTES

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6 SELF-TEST QUESTIONS
 Question 01:
Rizwan Industries has six standard products from stainless steel and brass. The company’s most popular
product is RI-11 and following budgeted data is given for product RI-11.

Activity Cost driver Cost driver volume/year Cost pool Rs.

Purchasing costs Purchase orders 15,000 750,000
Setting costs Batches produced 28,000 1,120,000
Material handling costs Material requisition 80,000 960,000
Inspection costs Inspections 28,000 700,000

AT A GLANCE
Machining costs Machine hours 500,000 1,500,000

Rizwan manufacturing industries data relating to RI-11 for the month of July, 2021 is given below.

Description
Purchase orders 25
Output in units 15,000
Production batch size in units 100
Material requisition per batch 6
Inspections per batch 1

SPOTLIGHT
Machine hours per unit 0.1

Required:
Calculate the unit overhead cost of product RI-11 using activity-based costing for the month of July 2021
 Solution:

Overhead Cost per unit of Product RI-11

Overheads Cost driver Rs.

STICKY NOTES
Purchasing costs Purchase orders 25 PO x Rs. 50/PO 1250
Setting costs Batches produced 150 Batches x 40/Batch 6000
Material handling costs Material requisition 900 req x 12/req 10800
Inspection costs Inspections 150 Insp x 25/Inspection 3750
Machining costs Machine hours 1500 MH x Rs. 3/MH 4500
total Overheads J 26300
Units K 15000
OH/Unit J/K 1.75

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W-1 Rate = Rs. per Cost driver

W-1

Cost driver
Activity Cost driver Cost pool Rs. (B) Cost per driver Rs. (B)/(A)
volume/year (A)
Purchasing costs Purchase 15,000 750,000 Rs. 50 per PO
orders
Setting costs Batches 28,000 1,120,000 Rs. 40 per batch
produced
Material Material 80,000 960,000 Rs. 12 per requisition
handling costs requisition
AT A GLANCE

Inspection costs Inspections 28,000 700,000 Rs. 25 per Inspection

Machining costs Machine 500,000 1,500,000 Rs. 3 per Machine Hours
hours

W-2 Product Batches, Inspections, Machine Hours

Purchase orders 25
Output in units 15,000
Production batch size in units 100
SPOTLIGHT

Material requisition per batch 6

Inspections per batch 1
Machine hours per unit 0.1
Batches 15000/100 150 batches
Requisition 150 batches x 6 900 requisitions
Inspection 150 batches x 1 150 Inspection
Machine Hours 15000 Units x 0.1 MH per Unit 1500 Machine Hours

 Question 02:
STICKY NOTES

JAM Enterprises, is engaged in the manufacturing of fishing equipment for fishing industry since a decade.
Recently, some of other manufacturers newly entered in to the same business of JAM Enterprises. As a result, a
price competitive situation has occurred in the market, to handle this situation JAM Enterprises wants to offer
best prices for the products as compare to competitors; JAM Enterprises changed his costing approach to ABC,
from traditional full costing approach.
The following budgeted information is related to JAM Enterprises for the forthcoming period:

Activity Product J Product A Product M

Sales and production (units) 30,000 20,000 10,000
Selling price per unit 4,600 9,600 7,400
Prime cost per unit 3,100 8,300 6,400
Machine hours per unit 2.5 5.5 4.5
Labour hours per unit 7.5 3.5 3.5

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The overheads that could be re-analyzed in to cost pools for the purpose of Activity based costing, are as
follows:

Cost pool Rs. 000 Cost driver Quantity for the period
Machine services 18,400 Machine hours 230,000
Assembly services 18,150 Direct labour hours 330,000
Set-up costs 1,200 Set-ups 250
Order processing 7,200 Customer orders 16,000
Purchasing 4,004 Supplier orders 5,600

Following estimates have also been provided for the period:

AT A GLANCE
Cost drivers Product J Product A Product M
Number of set-ups 70 100 80
Number of customer orders 4,800 4,500 6,700
Number of supplier orders 1,800 2,200 1,600

Required:
Calculate the product-wise profit statement, using activity-based costing.
 Solution:

SPOTLIGHT
Product-wise profit Statement

Cost drivers Product J Product A Product M

Rupees in thousands
Sales W-1 138,000 192,000 74,000
Less: Prime costs W-2 (93,000) (166,000) (64,000)
Less: Overheads W-3 (22,158) (16,728) (10,068)
Profit 22,842 9,272 (68)

STICKY NOTES
W-1 Sales

Products Units Sales price Rs. Sales in Rs. 000

Product J 30,000 4,600 138,000
Product A 20,000 9,600 192,000
Product M 10,000 7,400 74,000

W-2 Prime cost

Products Units Prime cost per unit Rs. Prime cost in Rs. 000
Product J 30,000 3,100 93,000
Product A 20,000 8,300 166,000
Product M 10,000 6,400 64,000

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W-3 Overhead rate per driver

Cost Pool Rs. In 000 Cost drivers Quantity for the period Rate per driver
Machine services 18,400 Machine hours 230,000 80
Assembly services 18,150 Direct labour hours 330,000 55
Set-up costs 1,200 Set-ups 250 4,800
Order processing 7,200 Customer orders 16,000 450
Purchasing 4,004 Supplier orders 5,600 715

W-4 Overhead cost

AT A GLANCE

Cost drivers Product J Product A Product M

Machine hours W-5 (A) 75,000 110,000 45,000
Labour hours W-6 (B) 225,000 70,000 35,000
Number of set-ups (C) 70 100 80
Number of customer orders (D) 4,800 4,500 6,700
Number of supplier orders (E) 1,800 2,200 1,600
Cost absorbed: Rupees in thousands
Machine services (A) x Rs. 80 6,000 8,800 3,600
SPOTLIGHT

Assembly services (B) x Rs. 55 12,375 3,850 1,925

Set-up costs (C) x Rs. 4,800 336 480 384
Order processing (D) x Rs. 450 2,160 2,025 3,015
Purchasing (E) x Rs. 715 1,287 1,573 1,144
Total overhead costs 22,158 16,728 10,068

W-5 Machine hours

Products Units Machine hours per unit Machine hours total

STICKY NOTES

Product J 30,000 2.5 75,000

Product A 20,000 5.5 110,000
Product M 10,000 4.5 45,000
Total: 230,000

W-6 Labour hours

Products Units Labour hours per unit Labour hours total

Product J 30,000 7.5 225,000
Product A 20,000 3.5 70,000
Product M 10,000 3.5 35,000
Total: 330,000

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 Question 03:
Giga Incorporations is at the leading edge of paint-spraying technology. It has three customers A, B and C, who
produce G-101, G-102 and G-103 products respectively. These products are finished by Giga Incorporation
after final completion. Product G-101 requires 6 coats of paint per unit, product G-102 requires 4 coats per unit
and product G-103 requires 3 coats of paint per unit respectively. All products are of different shapes and sizes
therefore, different quantities of paint are needed. Paint is delivered in batches of various sizes, depending
upon the finishing required.

Products Litres per unit

G-101 7

G-102 5

AT A GLANCE
G-103 4

Production details for each product are budgeted as follows for the coming month:

Description G-101 G-102 G-103

Units sprayed 500 400 300

Batches of paint required 10 8 6

Machine attendant time in minutes 45 60 50

Cost of paint per unit Rs. 550 500 450

SPOTLIGHT
Machine attendants are paid Rs. 86 per hour.
Estimated overheads in the coming month are given below:

Rupees

Paint stirring and quality control 50,000

Electricity 150,000

Filling of spraying machines 90,000

Cost drivers used for each activity are as follows:

STICKY NOTES
Activity Cost driver

Paint stirring and quality control Batches of paint

Electricity Coats of paint

Filling of spraying machines Litres of paint

Required:
Unit cost of each product using activity-based costing can be computed as follows.

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 Solution:

Calculation of Cost per unit of each product

G-101 G-102 G-103

Paint 550.00 500.00 450.00
Labour at Rs. 86 per hour 64.50 86.00 71.67
Paint stirring and quality control W-1 41.67 41.67 41.67
Electricity W-2 163.64 109.09 81.82
Filling of spraying machines W-3 94.03 67.16 53.73
AT A GLANCE

Unit cost 913.84 803.92 698.89

W-1 Paint stirring and quality control

Description G-101 G-102 G-103

Units (A) 500 400 300
Batches 10 8 6
Share of overheads (10:8:6)- (B) 20,833 16,667 12,500
Unit cost (B)/(A) 41.67 41.67 41.67
SPOTLIGHT

W-2 Electricity

Description G-101 G-102 G-103

Units (A) 500 400 300
Coats per unit (B) 6 4 3
Total coats (A) x (B) 3,000 1,600 900
Share of overheads (30:16:9)- (C) 81,818 43,636 24,546
Unit cost (C)/(A) 163.64 109.09 81.82
STICKY NOTES

W-2 Filling of spraying machine

Description G-101 G-102 G-103

Units (A) 500 400 300
Litres per unit (B) 7 5 4
Total coats (A) x (B) 3,500 2,000 1,200
Share of overheads (35:20:12)- (C) 47,015 26,866 16,119
Unit cost (C)/(A) 94.03 67.16 53.73

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 Question 04:
Shahid Pakistan Limited (SPL) is engaged in the production of three products: J, K and L. Following is the
extract from its latest annual management accounts:

Products Total
Description J K L
Units
Quantity produced and sold 50,000 40,000 30,000 120,000
---------------- Rs. in million ----------------
Material 100 200 250 550
Labour 50 40 25 115

AT A GLANCE
Factory overheads 80 64 40 184
Sales overheads 60 48 36 144
Total 290 352 351 993

Traditionally, SPL has allocated its factory and sales overheads on the basis of labour hours and sales volume,
respectively. However, SPL is currently considering the use of activity based costing for a more accurate
allocation of expenses. Following data has been collected in this regard:

Product J Product K Product L

Sales price per unit Rs. 10,000 12,000 14,000
Machine hours per unit hours 0.18 0.30 0.50

SPOTLIGHT
Batch size units 2,500 1,000 1,500
Average amount of sales order Rs. in millions 5 6 7

Break-up of overheads is as follows:

Rs. in millions
Factory overheads
Repairs and maintenance-machines 27
Set-up costs 24
Fuel and power 99

STICKY NOTES
Other fixed factory overheads 34
184
Sales overheads
Sales ordering department’s cost 6
Delivery expenses (units are of same size and weight) 54
Commission on sales 70
Other fixed sales overheads 14
144

The other fixed factory overheads and other fixed sales overheads accumulate from various minor expenses;
therefore, the Cost Accountant advised allocating them according to machine hours.
Required:
Compare the profitability of each product before and after the implementation of activity based costing.

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 Solution:
The profitability of each product before and after the implementation of activity based costing can be compared
as follows.

Profitability before implementation of activity based costing

Revenue/Expenses
Description
J K L Total
Quantity produced & sold (A) 50,000 40,000 30,000
Sales price per unit (Rs.) (B) 10,000 12,000 14,000
Rs. In ‘000
AT A GLANCE

Sales (A × B) 500,000 480,000 420,000 1,400,000

Less: Total cost 290,000 352,000 351,000 993,000
Profit 210,000 128,000 69,000 407,000
Profitability before implementation of activity based costing
Revenue / Basis of Value of drivers Revenue/Expenses
Expenses allocation J K L Total J K L Total
Rs. In ‘000
Sales Actual 500,000 480,000 420,000 1,400,000
Costs
SPOTLIGHT

Raw Actual 100,000 200,000 250,000 550,000

material
Labour Actual 50,000 40,000 25,000 115,000
Repairs & Machine 9,000 12,000 15,000 36,000 6,750 9,000 11,250 27,000
maintenance hours (50,000 (40,000 (30,000
of machines × 0.18) × 0.3) × 0.5)
Set-up costs No. of set- 20 40 20 80 6,000 12,000 6,000 24,000
ups (50,000 (40,000 (30,000
÷ 2,500) ÷ 1,000) ÷ 1,500)
STICKY NOTES

Fuel & Machine 9,000 12,000 15,000 36,000 24,750 33,000 41,250 99,000
power hours
Sales No. of 100 80 60 240 2,500 2,000 1,500 6,000
ordering orders (500,000 (480,000 (420,000
dept. cost ÷ 5,000) ÷ 6,000) ÷ 7,000)
Delivery No. of units 50,000 40,000 30,000 120,000 22,500 18,000 13,500 54,000
expenses
Commission Sales value 500 480 420 1,400 25,000 24,000 21,000 70,000
on sales (Rs. In
million)

Fixed Costs Machine 9,000 12,000 15,000 36,000 12,000 16,000 20,000 48,000
hours
Total cost 249,500 354,000 389,500 993,000
Profit 250,500 126,000 30,500

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STICKY NOTES

Activity based costing is alternate method of costing which involves

identifying the costs of the main support activities and the factors that drive
the costs of each activity. Support overheads are charged to products by
absorbing cost on the basis of the product’s usage of the factor driving the
overheads

AT A GLANCE
Indirect costs are absorbed into product costs on the basis of activities and
volume, and not merely on the basis of volume

A cost pool (also known as cost bucket) is an activity which consumes

resources and for which overheads costs are identified and allocated. Cost
pool is major activity which accumulates the cost relevant to this specific
activity. The term activity and cost pool are often used interchangeably.

SPOTLIGHT
A cost driver is a factor that influences or drives the level of cost of an
activity. For example, number of batches is the cost driver as increase in
number of batches will influence or drive the set-up cost.

STICKY NOTES

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 CHAPTER 3: ACTIVITY BASED COSTING CAF 5: MANAGEMENT ACCOUNTING
AT A GLANCE
SPOTLIGHT
STICKY NOTES

110 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 4

LABOUR COSTING

AT A GLANCE
IN THIS CHAPTER
Labour is an important element in a production cost, as most of
the industries are labour intensive and labour constitutes major
AT A GLANCE
cost of total cost of production

AT A GLANCE
SPOTLIGHT Industries that are dependent on human workforce have to
adopt strategies that benefit them in terms of human resource
1. Introduction to labour costing retention as well as keeping their labour cost low.
and labour cost control
Labour payment plans may be based on time, production or
skills.
2. Management of productivity and
efficiency Wage incentive plans refer to performance linked compensation
paid to improve motivation and productivity. Incentive schemes
3. wage incentive plans may either be short-term or long-term schemes.
Management must monitor labour performance in terms of
4. Learning curve theory productivity (efficiency) and effectiveness (cost).

SPOTLIGHT
5. Recording and accounting for A quantitative method called ‘Learning Curve’ is used to
labour cost calculate in advance the expected time to be taken by the labour
when they become fully conversant with the work.
6. Self-test questions

STICKY NOTES

STICKY NOTES

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1 INTRODUCTION TO LABOUR COSTING AND LABOUR COST CONTROL

Labour cost is the second important element of the cost of production after material cost. Labour costs
constitute a major portion of the total cost of a product or service that may take the form of wages, salaries
and/or other incentives of employee remunerations. The profitability and growth of the entity depends greatly
upon the proper utilization of the human resources that in turn needs to be properly recoded and controlled.
Most of the industries produce goods and services, requiring higher amount of labour cost and these are known
as labour intensive industries. The share of labour cost in these industries is significant and therefore, labour
cost control become more important. Main labour intensive industries are agriculture, mining, hospitality and
food service etc.

1.1 Types of labour cost:

AT A GLANCE

The labour cost has two types:

a) Direct Labour Cost: Direct labour cost is any cost that is specifically incurred for or can be readily charged
to or recognized with any cost unit, specific contract, job or work order. In cost accounting it is classified as
direct labour cost which becomes part of prime cost. For example: In a watch manufacturing factory, a
worker operating a molding machine to produce a part of wrist watch.
b) Indirect Labour Cost: Indirect labour is a cost that cannot be readily charged to or recognized with any
cost unit, specific contract, job or work order. Therefore, it is treated as part of the factory overheads. For
example: Wages paid to supervisor of a factory or salary paid to driver of delivery van used for distribution
of the product.

1.2 Measuring labour activity:

SPOTLIGHT

It is important to differentiate between “production” and “productivity” while measuring labour activity.
• Production: Production refers to the quantity or volume of the output produced i.e. the total number of
units produced. Production therefore is a measure of quantity of work.
• Productivity: Productivity unlike production is a measure of efficiency with which the units have been
produced. (explained later in this chapter under the topic, “Management of Productivity and Efficiency”)

1.3 Labour payment methods:

The choice of appropriate labour payment method is very important for any organisation as it:
• may affect the cost of the finished products specially when it is a labour intensive organisation,
STICKY NOTES

• casts a major impact on the morale and efficiency of the employees and serious consideration should
therefore be given to the possible motivational impact of the remuneration method being adopted.
The two widely known basic labour payment methods are time rate and piece work. These are discussed in
detail below:

Time rate
Time rate/ time work or basic pay is where the employee gets paid on the basis of his time spent at work. The
most common form of this type is a day-rate system.

The formula used for calculating wages under this method is:
Wages = Hours worked x Per hour pay rate

• If an employee works for more hours than the basic daily requirement or on days which do not constitute a
part of the working week (e.g. Saturdays and Sundays), then he may be entitled to an overtime payment.
The overtime hours are usually paid at a premium rate such as “time and a quarter”, “time and a half” or
“double-time”.

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Time and a quarter for example, means that 1.25 times the basic hourly rate is paid for hours worked in excess
of the basic requirement. The overtime premium is the extra rate paid over and above the basic rate.
If employees work unsocial hours, e.g. overnight, then they are entitled to a shift premium which is quite
similar to an overtime premium and means that the employees are paid at an increased hourly rate.
If an employee is paid overtime premium, his total labour cost can be computed through any of the following
methods. Labour cost computed under both methods will be the same.
Method 1: (Separating the normal and overtime hours)

Rs.
Cost of normal hours XX
Total cost of overtime hours XX

AT A GLANCE
Total Labour Cost XX

Method 2: (Separating the basic payment and overtime premium)

Rs.
Basic rate (of all hours) XX
Overtime premium (of overtime hours) XX
Total Labour Cost XX

 Example 01:
If the basic rate of pay per hour is Rs. 6 and overtime rate is time and a half, calculating the total labour cost
where a worker worked 12 hours a day in comparison with the basic requirement of 8 hours per day would

SPOTLIGHT
involve the following working under both methods:
Overtime Premium = Hours Worked – Normal (Standard) hours
Overtime Premium = 12 – 8 = 4 hours
 Method 1:

Rs.
Cost of normal hours (8 x Rs. 6) 48
Cost of Overtime hours (4 x Rs. 6 x 1.5) 36
Total Cost (8 x 6) + (4 x 9) 84

STICKY NOTES
 Method 2:

Rs.
Basic Pay (12 x Rs. 6) 72
Overtime premium (4 x Rs. 3) 12
Total Cost (8 x 6) + (4 x 9) 84

Piece rate system:

Under this method the employee is paid an agreed amount for each unit of output completed or for each task
carried out.

The wages under the piecework system can be calculated as:

Wages = Units produced x Per unit pay rate

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 Guaranteed Minimum Wage:

It is also normal under piecework scheme that the employees get a guaranteed minimum wage regardless of
the number of units produced. This safeguards them from loss of earnings when the production is low and is
not on account of their own fault.
This guaranteed minimum wage plan can have two variants.
• Variant 1:
Where a worker is paid higher of “cost based on actual production” and “guaranteed minimum wage”
When to Use?
- When the employer wants to incentivise productivity while still providing income security.
AT A GLANCE

- Suitable in industries where output can fluctuate due to external factors (e.g., machine breakdowns,
supply chain delays).
- Ideal for skilled or semi-skilled roles where output-based pay is the norm, but fluctuations in output
are not entirely under the worker's control.
- Used where the employer wants to protect workers from low earnings during slow periods without
undermining the piece-rate incentive system.
• Variant 2:
Where a worker is paid a “guaranteed minimum wage” irrespective of the units produced by him and the
additional payment based on his actual production. It is an application of semi-variable cost (as discussed
in chapter 3) as he will be entitled to some fixed payment (irrespective of his production) and a variable
SPOTLIGHT

payment (based on his actual production).

When to Use?
- When the employer wants to ensure a stable base wage, but strongly incentivise output through
variable performance-linked pay.
- Suitable in piece-rate environments with relatively consistent and controllable production conditions
(e.g., textile, manufacturing, packaging).
- Appropriate for high-volume, low-skill jobs where output can be directly tied to effort.
Which variant is more used in real life?
STICKY NOTES

Variant 2 is more commonly used in practice, especially in industries like manufacturing, agriculture, and
assembly lines, because:
- It provides predictable labor cost planning for employers.
- It clearly ties additional earnings to performance, making it easier to manage and communicate.
- Workers still receive a basic level of income, which helps retain staff even during lower-output periods.
- It aligns with performance-based HR policies in cost-sensitive and competitive industries.
 Example 02:
Application of Variant 1
Sara is paid Rs. 20 for each unit produced. It is agreed that she will be paid higher of the guaranteed minimum
wage of Rs. 2,000 and her actual production for a 40-hour week. For a series of 4 weeks of the month, she
produced 80, 90, 110 and 120 units.
Required.
Calculate total wages for the month.

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 Solution
In order to calculate total amount for the month, please see below:

Rs.
Week 1 [higher of: (80 units x Rs. 20 = 1,600) and Rs. 2000] 2,000
Week 2 [higher of: (90 units x Rs. 20 = 1,800) and Rs. 2000] 2,000
Week 3 [higher of: (110 units x Rs. 20 = 2,200) and Rs. 2000] 2,200
Week 4 [higher of: (120 units x Rs. 20 = 2,400) and Rs. 2000] 2,400
Total Wages for the month 8,600

AT A GLANCE
 Example 03:
Application of Variant 2
Sara is paid Rs. 20 for each unit produced in addition to a guaranteed wage of Rs. 2,000 for a 40-hour week. For
a series of 4 weeks of the month she produced 140, 160, 180 and 200 units.
Required.
Calculate total wages for the month.
 Solution
In order to calculate total amount for the month, please see below:

Rs.

SPOTLIGHT
Week 1 [(140 units x Rs. 20) + Rs. 2000] 4,800
Week 2 [(160 units x Rs. 20) + Rs. 2000] 5,200
Week 3 [(180 units x Rs. 20) + Rs. 2000] 5,600
Week 4 [(200 units x Rs. 20) + Rs. 2000] 6,000
Total Wages for the month 21,600

Wage payment based on skill:

Employees may be remunerated based on the skills and competencies they possess, regardless of their job title

STICKY NOTES
or level. This encourages continuous learning and development, as employees are incentivised to acquire new
skills to earn more. This is also termed as a wage differentiation due to varied skills. For example,
• Skilled workers are paid higher than apprentice for the same job.
• A technician who learns to repair a new type of equipment is compensated at a higher rate.

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2 MANAGEMENT OF PRODUCTIVITY AND EFFICIENCY

2.1 Labour Efficiency:
Labour efficiency measures how efficiently workers produce a given quantity of units. It can be calculated by
creating the ratio between standard hours (also known as time allowed) and actual hours (also known as time
taken). Efficiency can be calculated with the help of following formula.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 ℎ𝑜𝑢𝑟𝑠
𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 = 𝑥 100
𝐴𝑐𝑡𝑢𝑎𝑙 ℎ𝑜𝑢𝑟𝑠
Standard hours or time allowed is computed as follows:
Time Allowed = Standard hours per unit x Actual Production
AT A GLANCE

 Example 04:
It takes 30 minutes to produce a product and Majid produced 20 units in an 8-hour day. Majid’s efficiency can
be computed as follows:
Time Allowed = 30 / 60 x 20 = 10 hours
Efficiency =10 hours / 8 hours x 100 = 125%

2.2 Labour Productivity:

As mentioned before, labour productivity is a measure of efficiency with which the units have been produced. It
can measured as a ratio between actual production and standard production. It can also be expressed as a ratio
between actual production per hour and standard production per hour. Productivity may be defined as the
measurement of production performance using the expenditure of human effort as a yardstick. Greater
SPOTLIGHT

productivity can be achieved by better processes, improved or modern equipment and other factor that
improves the utilization of manpower. Productivity can be measured by following formula.
𝐴𝑐𝑡𝑢𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 = 𝑥 100
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
 Example 05:
Mr. X is supposed to produce six units in every hour at work. The standard productivity rate is six units per
hour for every employee. During the week he made 252 units in 38 hours of work.
Required:
Calculate the productivity ratio?
STICKY NOTES

 Solution:
It might be determined in either of the following two methods
 Method 1:
In 38 hours Mr. X should make (38 x 6) 228 units
But made 252 units
Productivity ratio = 252/228 x 100 110.5%
 Method 2: (in terms of efficiency)
Time allowed [252 units should take (252/6)] 42 hours
Time taken 38 hours
Productivity ratio = 42/38 x 100 110.5%
Comment: A productivity ratio greater than 100% indicates that the actual performance is better than the
standard or expected level of efficiency.

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2.3 Labour Efficiency vs. Productivity:

While both productivity and efficiency aim to improve performance, productivity focuses on the quantity of
output, while efficiency focuses on the utilization of resources in an efficient way and minimizing waste.
Moreover, productivity can be stated in one figure but in assessing efficiency, a single figure would not suffice.
For example, in Engine Installation Department of Motor company, 3 units per 8 labour hours is the
productivity of the department. However, in assessing efficiency, there should be any comparable figure, like
own historical data, industry average or budgeted productivity.
If Motor company achieved 3 units per 8 labour hours’ productivity in 2018 in Engine Installation Department
as against 2.8 units per 8 labour hours in 2017. The department efficiently utilized its human resources in the
year 2018 as compared to 2017.
Detailed differentiation between productivity and efficiency is given below.

AT A GLANCE
Labour Productivity Labour Efficiency
Definition It represents the relationship between This measures how effectively
the quantity of workers generate a given quantity of
units produced and labour hours. units.
Achieving Greater productivity can be achieved Efficiency improvement focuses on
improvement by better processes, improved or optimizing the standard hours
modern equipment, and other factors compared to the actual hours worked.
that improve the utilization of It can be improved by training labour
manpower. force.
Focus It emphasises the quantity or volume It emphasises the utilization of labour

SPOTLIGHT
of output produced in relation to hours and how efficiently tasks are
labour input. completed within a given time frame.
Cost Control It is more focused on cost control It is more directly related to
indirectly by improving output per controlling labour costs by managing
hour. time effectively.
Benchmarking It is often used for benchmarking It is typically benchmarked against
against industry standards or internal standards or pre-determined
competitors. time frame.
Variability It can vary with changes in It focuses on minimizing variations
production volume and process from standard time, aiming for

STICKY NOTES
improvements. consistency.
Performance evaluation It is primarily used for assessing It is often used for evaluating
overall organisational performance. individual or departmental
performance in terms of meeting time
standards.
Calculation Efficiency = Productivity =
(Standard hours)/(Actual hours) x 100 (Actual Production)/(Standard
Production) x 100

Efficiency is achieved through high motivation and skills of workers and by better processes and quality of
machines and tools. Improved productivity positively impacts the business profits and the earnings of workers.
It may be noted that productivity and efficiency measures generally indicate number of output as against the
labour input and do not usually refer to the quality and level of bad workmanship. The quality aspect is also
important to achieve the objectives of cost controls.

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2.4 The importance of measuring productivity and efficiency:

In a competitive business environment where the price of a product is difficult to be controlled by the
producers, the efficient utilization of resources is one of the key factors. Labour cost in many industries is so
significant that its efficiency can make the difference. A producer should be able to set standards of
performance in terms of hours and cost per hour or cost per unit of production.
The performance standards measure the performance in unit and rupee term and variances help the managers
to focus around the problem areas.
 Example 06:
In a production department the performance standards for a production of 3,000 units are set as 2,000 hours at
Rs. 90 per hour. If 2,200 hours are used at standard rate of Rs. 90 per hour to produce 3,000 units then there is
an unfavorable labour efficiency ratio of 90.91% (2,000 /2,200). In rupee term the unfavorable variance is Rs.
AT A GLANCE

18,000 computed as (100%-90.91%) x 2,200 x 90

There can be a variance as against the performance standards, which arises due to difference in wage rates.
Therefore, a total variance between the performance standards and actual results is analyzed in a way that we
arrive at the break up of both variances, namely, labour efficiency variance and labour rate variance. These
variances will be discussed in detail in chapter “Variance Analysis”.

2.5 Basis of labour cost control:

Labour cost control requires analysis of labour cost with different angles and perspectives, such as:
• cost per hour;
• cost by departments;
• cost by product lines;
SPOTLIGHT

• cost from direct and indirect cost perspective;

• costby rates; and
• cost by jobs or processes.
Labour cost controls aim to achieve maximum efficiency without compromising the quality and effectiveness of
the operations. Cost analysis and wage system help in achieving this objective.
 Example 07:
ABC Publishers Limited pays wages to workers working on book binding machine at the rate of Rs. 17 per
book. Workers are not paid for the misaligned binding and such book is scraped for Rs. 15 per kg. The policy
motivates the workers to work hard and maximize productivity. However, the rate of wastage in ABC is 3% as
STICKY NOTES

against industry average of 1%.

ABC re-visited the wage policy and felt that it is likely that workers tend to compromise the quality because of
insignificant loss they suffer due to bad quality. It intends to bring a policy whereby a deduction of Rs. 70 will
be made from the wages for each misaligned binding beyond 1% industry average. However, it is estimated
that such policy will reduce the efficiency of workers because they would reduce the speed to achieve desired
quality benchmark and avoid deduction.
The cost controller of ABC is supposed to work out the differential cost and revenue to evaluate the policy
before implementation. For this purpose, cost controller needs precise data with reasonable accuracy about the
machine capacity, labour related wastage, impact of slow speed and contribution margin per unit.
Effective labour cost control is achieved through different tools including;
• analyzing the targeted production,
• preparing labour budget and standardizing labour cost per unit,
• monitoring output, quality, wastage ratios, rework cost due to bad workmanship
• wage incentive systems.

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3 WAGE INCENTIVE PLANS

3.

Wage incentive plans refer to performance linked compensation paid to improve motivation and productivity.
Incentive schemes may either be short-term or long-term schemes.
In the modern industrial enterprise of mass production and many employees, a worker’s wage is based on
various factors which includes negotiated labour contracts with union, productivity analysis, job evaluation
process, profit sharing schemes and most important wage incentive plans. Initially, bonus/incentive schemes
had been introduced for workers who had been working under a time-based system, in order to compensate
them for their inability to increase their earnings.

3.1. Bonus Systems:

Bonus systems base workers’ earnings on a combination of extra time served and work done. The indirect

AT A GLANCE
labour is usually paid on a weekly or monthly basis, such wages and salaries may also be increased by bonus
payments.

SPOTLIGHT
Characteristics of bonus systems:
• A target is set and the performance is matched against that target.
• Employees feel trusted and motivated, the productivity increase and they are paid more for their increased
efficiency.

STICKY NOTES
• Despite the organisation’s labour cost being increased in terms of bonus payments, the total unit cost of the
output stands reduced due to efficiency and the profit per unit of sale is increased.
Note: Only those schemes should be applied, which provides benefits to both employer or employee. The
employer benefit can be judged from decrease in unit labour cost whereas employee’s benefit can be
highlighted by higher earnings in per hour rate.
The widely known bonus/ incentive schemes are discussed in the following paragraphs.

3.2. High day-rate system:

Under a high day-rate system employees get paid at a higher than average hourly rate provided they agree to
produce a given amount of product at a given quality. A target is given to employee and if the employee attains
that target, a higher rate per hour is applied, otherwise, normal rate is applicable. In other words, the target to
qualify for a high day-rate (bonus) is set in terms of units whereas the bonus is awarded in terms of time rate.

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 Example 08:
If Shahid makes 200 units in a 40-hour week, he would be paid Rs. 4 per hour. However, if he makes 240 units,
he will be paid at the rate of Rs. 5 per hour.
Required
a) Calculate the amount to be paid to Shahid in both the cases.
b) Calculate labour cost per unit.
c) Calculate cost per unit of output if the production overhead is recorded at the rate of Rs. 4 per direct labour
hour.
 Solution:
a) The amount to be paid to Shahid in both the cases, would be calculated as:
AT A GLANCE

Rs.

Amount to be paid to Shahid

Under low day-rate scheme 40 hours x Rs. 4 160

Under high day-rate scheme 40 hours x Rs. 5 200

b) In order to calculate labour cost per unit, amount paid would be:

Labour cost per unit

Under low day-rate scheme (40 x 4) 0.80/unit
SPOTLIGHT

200

Under high day-rate scheme (40 x 5) 0.833/unit

240

c) cost per unit of output if the production overhead is recorded at the rate of Rs. 4 per direct labour hour,
would be as follows:

Cost per unit

Under low day-rate scheme (40 x 8) 1.60/unit
STICKY NOTES

200

Under high day-rate scheme (40 x 9) 1.50/unit

240

Comment:
Though in the given example the labour cost per unit is lower under the low day-rate scheme but the total unit
cost is lower under the high day-rate scheme. Therefore, we see that the high day-rate scheme in the given
scenario would reward both i.e. the employer (a lower unit cost by 10p) and employee (an extra Rs.1 earned
per hour).

Advantages of high-day rate system:

• It is easier to calculate and understand.
• It assures the employee a consistently high wage.

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Disadvantages of high-day rate system:

• Employees cannot go beyond the fixed hourly rate for the extra effort they put in. In the example given
above, if the employee makes 280 units instead of 240 units in a 40 hours week, the cost per unit would
decrease even further but all the savings would go to the benefit of the employer and none would go to the
employee.
• The high wages might become the accepted wage level for normal working. Management might need to
keep checks on the productivity and efficiency levels of the employees.

3.3. Individual bonus schemes:

An individual bonus scheme sets out performance objectives/targets and usually forms part of the
performance appraisal systems of organisations. Every individual’s bonus is calculated separately and is unique
to every employee. More efficient employee gets more amount of bonus while less efficient employee might get

AT A GLANCE
lesser amount of bonus or even no bonus, if standard is not attained.
Individual bonus scheme may be planned on time rate basis or piece work basis.

Time saved sharing Bonus plan:

Also known as premium bonus plan, it is a time-rate based bonus plan that rewards the employees for
completing tasks faster than the standard time, with the bonus calculated based on the time saved with an
underlying objective of increasing efficiency. Time Saving is calculated as follows:
Time Saved = Time Allowed - Time Taken
Standard hours or time allowed is computed as follows:
Time Allowed = Standard hours per unit x Actual Production

SPOTLIGHT
 Example 09:
Standard production of an employee in the Assembly department is 20 units per hour in an 8-hour day. The
hourly rate is Rs. 30.
On the first day of the week, the employee produced 150 units, and on the second day, he produced 180 units.
He worked 8 hours on both days.
Required
Calculate the earnings of employee, effective rate per hour and labour cost per unit:
a) if bonus of 50% of time saved is applied.

STICKY NOTES
b) If bonus of 100% of time saved is paid to employee.
 Solution
a) If bonus of 50% of time saved is applied, the earnings of employee, effective rate per hour and labour cost
per unit is computed as under:

Day Actual units Standard units Extra units Bonus hours Basic pay Bonus Total
A A/ 20x 50% --------------Rupees-----------
1 150 160 - - 240 - 240
(30 x 8)

2 180 160 20 0.50 240 15 255

(30 x 8)

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Calculation of effective rate and cost per unit on each day Rs.

Day-1

Effective earnings by employee per hour (240/ 8) 30.00

Cost per labour hour for employer point of view (240 / 150) 1.60

Day-2

Effective earnings by employee per hour (255/ 8) 31.88

Cost per labour hour for employer point of view (255 / 180) 1.42

The above incentive plan is beneficial as it increases benefits to both employee and employer. From
AT A GLANCE

employee point of view, the effective earning rate per hour is increased from Rs. 30.00 per hour to Rs.
31.88 and from employer point of view, cost per labour hour was reduced from Rs. 1.60 per unit to Rs. 1.42
per unit.
b) If bonus of 100% of time saved is paid to employee; the earnings of employee, effective rate per hour and
labour cost per unit is computed as under.

Day Actual units Standard units Extra units Bonus hours Basic pay Bonus Total

A A/ 20 --------------Rupees-----------

1 150 160 - - 240 - 240

(30 x 8)
SPOTLIGHT

2 180 160 20 1 240 30 270

(30 x 8)

Calculation of effective rate and cost per unit on each day Rs.

Day-1

Effective earnings by employee per hour (240/ 8) 30.00

Cost per labour hour for employer point of view (240 / 150) 1.60
STICKY NOTES

Day-2

Effective earnings by employee per hour (270/ 8) 33.75

Cost per labour hour for employer point of view (270 / 180) 1.50

If bonus of time save is increased to 100%, then again the plan is beneficial as the effective earning rate per
hour is increased from Rs. 30.00 per hour to Rs. 33.75 and from employer point of view, cost per labour
hour was reduced from Rs. 1.60 per unit to Rs. 1.50 per unit.

Piecework based bonus plan:

A piecework-based bonus plan rewards employees for exceeding the production targets. The bonus is paid for
each unit produced beyond the production target. The ultimate objective is to enhance the productivity and
output.

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 Example 10:
The normal piece rate is Rs. 100 per unit. Rs.50 per unit bonus is set for each unit produced above 100 units
per week. If an employee produces 120 units in a week, total weekly wages will be computed as follows.
Extra units produced = Total production - Normal production
Extra units produced = 120 – 100 = 20 units

Rs.
Payment for normal units (100 x Rs. 100) 10,000
Payment for excess units (20 x Rs. 150) 3,000
Total Weekly Wages 13,000

AT A GLANCE
3.4. Group bonus schemes:
In cases where individual efforts cannot be exactly measured and employees work as a team, individual
incentive schemes become impracticable. In such scenarios, group incentive schemes are found to be more
relevant and feasible. Even in cases where an individual alone cannot complete his job without the cooperation
of his fellow workers, in that situation as well, group incentive schemes are given preference over the
individual bonus schemes.
Group bonus plans reward all team members equally based on overall performance of the team members. It
usually comes into play when individual output cannot be measured with accuracy. Therefore, team
performance is evaluated on the basis of time taken to complete the job rather than output produced. Usually,
the bonus earned by the group is divided among the group members on some reasonable basis, e.g., in
proportion to the number of hours worked by each member..

SPOTLIGHT
Advantages
• Group schemes reduce the clerical efforts to be put in for the calculations of individual incentive schemes.
• They are easy to be administered.
• Group schemes improve the team cohesion.

Disadvantages
• Employees might demand for minimum targets for accepting the scheme.

STICKY NOTES
• Employees doing the best and the worst might fall victim to team’s politics.

3.5. Profit sharing schemes:

A profit sharing scheme offers the employees a certain proportion of the organisation’s profits. In these
schemes, there might be few conditions, and bonus is payable to employees who vests the conditions
mentioned in this scheme. For example, condition is imposed by entity that only those employees are eligible
for profit sharing scheme, who have completed at least one year of service with the company.

Advantages
• The biggest advantage is that the organisation will pay only what it can afford to pay out of the actual
profits earned. In case of low profit, low proportion of bonus is declared and paid.
• Such schemes can be offered to indirect labour and other administrative staff.
• Such schemes expand employee benefits beyond regular salaries.
• Such schemes develop the mindset of employees to work for and contribute to the company's profitability.

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Disadvantages
• Employees may be putting in best of their efforts yet the organisation might still incur losses on account of
issues beyond the control of the employees.
• It is a long term commitment that the organisation is asking for. The employees have to wait for the bonus
until the year ends. The reward is not an immediate one.

3.6. Share incentive schemes:

A share incentive scheme is where the employees of the company are given an option to acquire the shares as
an incentive. In this way the employees’ morale rises so does their loyalty due to the feeling that they now have
a stake in the company they work for. Like profit sharing scheme, this scheme also develops the mindset of
employees to work for and contribute to the company's profitability.
AT A GLANCE

3.7. Evaluating the remuneration schemes:

A company may consider shifting to a new remuneration scheme from some existing scheme to enhance
employee motivation and productivity. In such cases, students may be asked in examination to evaluate and
recommend the most suitable scheme for the company. In this context following points must be considered.
A labour remuneration scheme should be evaluated based on its cost-effectiveness. The key is to compare the
total cost under each scheme and select the one that minimizes cost for the company while also motivating
employees. A new remuneration scheme may also affect overhead costs. Therefore, total conversion costs
under both the existing and proposed schemes should be calculated and compared to determine the most cost-
effective option.
A financially sound scheme maximizes output per unit of labour cost, ensures fairness, motivates performance,
and aligns with the organisation's profitability goals.
SPOTLIGHT

Note: The labour cost in the above scenario includes basic wages along with all incentives the employees are
entitled to, based on the hours worked or units produced.
STICKY NOTES

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4 LEARNING CURVE THEORY

4.1. Learning Effect:
Learning is the process by which an individual acquires skill, knowledge and ability. When a new product or
process is started, the performance of the worker is relatively low since the job has just recently started but if it
is fairly repetitive in nature then the learning phenomenon takes place. When the experience is gained, the
worker is likely to become more confident and knowledgeable about the task. Therefore, the performance
improves, which in turn reduces the time taken per unit and increases the productivity.
The effect that learning casts on employees, can be represented by a line called a learning curve. It displays the
relationship between the production time per unit and the cumulative number of units produced. Learning
curve has a direct impact on direct labour wages.

AT A GLANCE
Eventually when the worker has had enough experience and nothing more is left for him to learn, the learning
process stops i.e. the learning would stop after a certain time limit and beyond specific number of units
produced.

Assumptions
• The amount of time required to complete a unit of a product or a given task will decrease every time the
task is undertaken.
• The unit time will decrease at a decreasing rate, and
• The time reductions will have a predictable pattern.

4.2. Learning curve theory:

SPOTLIGHT
The learning curve theory refers to the phenomenon that the cumulative average time required per unit will
decrease by a constant percentage every time total output of the product doubles. Doubling of output is an
important part of the measurements determining the learning effect. In other words, learning effect is based on
Geometric progression such as 1 unit, then 2 units, then 4 units and so on.
For example, if we take 80% learning effect, the cumulative average time required per unit is reduced to 80% of
the previous cumulative average time when the output is doubled. Note that the cumulative average time is the
average time per unit for all units produced till now, inclusive of the first unit made.

4.3. Importance of Learning curve effect:

Learning curve theory helps users to predict how much time is required to complete the future tasks. It is

STICKY NOTES
helpful in determination of realistic cost of labour and is also useful in planning, control and decision-making.
In pricing decisions, it is extremely important to know the average time incorporating the learning effect.
Otherwise, cost will be higher if it is based on first unit which requires maximum time. In planning and control,
learning curve is also important because in standard costing, cost of one unit is calculated. If the learning effect
is ignored, then standard cost will be overstated, resulting unrealistic variances at period end.

4.4. Methods of learning curve:

The learning effect can be calculated with the help of two methods:
1. Tabular Method
2. Mathematical Method

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 Example 11:
If the first unit of output requires 100 hours and a 70% learning effect occurs, then determine the production
times for:
• Total production
• Incremental total hours
• Incremental hours per unit

Cumulative no. of Cumulative Total Incremental time

units produced avg. time/unit Time
Total Time per unit
time
AT A GLANCE

Hours Hours Hours Hours

1 100.0 (x1) 100
2 (70%) 70.0 (x2) 140 40 ÷1 40
4 (70%) 49.0 (x4) 196 56 ÷2 28
8 (70%) 34.3 (x8) 274.4 78.4 ÷4 19.6

 Formula:
Y = axb
Where
Y = cumulative average time per unit to produce x units
SPOTLIGHT

a = the time taken for the first unit of output

x = the cumulative number of units produced (output)
b = the learning curve factor (i-e. log LR/log2)
LR = the learning rate as a decimal
 Example 12:
Find the value of b when a 90% learning curve effect takes place.
 Solution
STICKY NOTES

b = log 0.9/log 2
= -0.0458/0.3010
= -0.152
 Example 13:
Calculate labour time to produce 50 units assuming learning rate of 80% will continue till first 30 units. Time
taken to produce first unit is 10 hours.
 Solution
First calculate total time required to produce first 30 units.
𝑌 = 𝑎𝑋 𝑏
Whereas b = log 0.80/log 2
= -0.3219
𝑇𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑡𝑜 𝑝𝑟𝑜𝑑𝑢𝑐𝑒 30 𝑢𝑛𝑖𝑡𝑠 = 10 𝑥 30−0.3219 𝑥 30
= 100.38 hours

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The next 20 units will take equal time per unit and will be equal to time taken by 30 th unit.
The calculation of time taken by 30th unit is calculated by difference between total time for 30 units (as
calculated above) and total time for 29 units.
𝑇𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑡𝑜 𝑝𝑟𝑜𝑑𝑢𝑐𝑒 29 𝑢𝑛𝑖𝑡𝑠 = 10 𝑥 29−0.3219 𝑥 29
= 98.10 hours
Hence, time taken to produce 29th unit is 2.28 hours (100.38-98.10).
Total time required to produce next 20 units (2.28 x 20) = 45.60 hours
Labour time to produce 50 units (100.38+45.60) = 145.98 hours

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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5 RECORDING AND ACCOUNTING FOR LABOUR COST

5.1 Recording labour costs
There are various departments within an organisation that are involved in collecting, recording and costing of
labour. The procedures involve production planning, time and motion study, timekeeping, labour budgeting,
etc. A brief detail of the departments involved and procedures performed by them in the due process is
discussed below.

Human Resource department

The HR department is primarily responsible for the hiring of employees, engaging them, their transfer,
departure and termination etc. This department maintains employees’ records and issues the reports for the
management to facilitate the decision making process of HR related issues.
AT A GLANCE

Production Planning department

The Production Planning department schedules work, issues the job orders to production departments and
chases up jobs in the factory when they run late.

Time keeping department

The timekeeping department keeps track of the time spent in the factory by each worker and the time spent by
each worker on each job. The time keeping activity might be carried out using any of the following tools with
reference to the relevance and importance to the nature of activity.
• Daily time sheets: The daily time sheet is filled in by the employee on everyday basis. It will record how
SPOTLIGHT

his/ her time in the factory has been spent. The total time on the sheet should however correspond to the
record on the attendance form.
• Weekly time sheets: They are similar to the daily time sheets but are sent to the cost office towards the
end of every week.
• Job cards: Job cards are job specific and are prepared for every job or batch separately. In a time sheet the
worker if engaged with many jobs will have several entries related to the respective jobs wherein in case of
job cards, each job card will contain the detail of activities carried out by the employee in respect to that
specific job only.
• Piecework or operation card: A Piecework ticket contains the record of total number of items produces
by the employee and the total number of the units rejected. Payment would be made for only the items that
STICKY NOTES

are as per the required standards.

Cost accounting department

The cost accounting department accumulates and classifies all the data related to the labour costs. The
information is then shared with the management to help determine the control measures if required.

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5.2 Journal entries for recording labour costs

The primary journal entry for payroll is the summary-level entry that is compiled from the payroll register and
which is recorded in either the payroll journal or the general ledger. This entry usually includes debits for the
direct labour expense, salaries and the company's portion of payroll taxes. There will also be credits to the
liability for payroll taxes that have not been paid, as well as for the amount of cash already paid to employees
for their net pay. The basic entry (assuming no further breakdown of debits by individual department) is:

(i) to record the total wages earned

Debit Credit

Payroll xxx

AT A GLANCE
Accrued Payroll tax xxx

Payroll advances xxx

Payroll deductions xxx

Accrued Payroll xxx

(ii) to record payment of the payroll

Debit Credit

Accrued Payroll xxx

SPOTLIGHT
Cash/Bank xxx

(iii) To record the closure of the Payroll account

Debit Credit

W-I-P – Direct Labour xxx

FOH – Indirect Labour xxx

Selling Expenses Control a/c – Sales Salaries xxx

STICKY NOTES
Administrative Expenses a/c – Office Salaries xxx

Payroll xxx

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6 SELF-TEST QUESTIONS
 Question 01:
Quality Plastics Limited (QPL) produces plastic bodies of various appliances according to the customers’
specifications. It has received an order for supply of 10,000 plastic bodies of a washing machine. The supply is
to be made within 30 days.
The following information is available:
i. QPL carries out production process in batches of 100 units each. Cost of the first batch is estimated as
under:

Rupees
Direct material (inclusive of 10% input losses) - 1,100 kg 66,000
AT A GLANCE

Direct labour cost at normal rate - 200 hours 44,000

Overheads at normal rate 200 hours 30,000

ii. It is estimated that due to learning curve effect, completion of the first, second, third and fourth batch
would require 200, 160, 148 and 140 hours respectively.
This learning effect would continue till completion of 64 batches only.
Learning effect at various learning levels is as under:

80% 85% 90%

–0.322 –0.235 –0.152
SPOTLIGHT

iii. It is estimated that after completion of the first 16 batches, material input losses would be reduced from
10% to 6%.
iv. QPL works a single shift of 8 hours per day. For the above order, QPL can spare 8,000 direct labour hours.
Overtime hours can be worked at 1.5 times the normal rate. During the overtime hours, overheads would
be 1.25 times the normal rate.
Required
Calculate the price that QPL should quote in order to earn a margin of 25% of the selling price.
 Solution
STICKY NOTES

The price that QPL should quote in order to earn a margin of 25% of the selling price would be computed as
follows:
Material Rs.
First 16 batches (16 x 66,000) 1,056,000
Next 84 batches 84 x (66,000 x 0.90/0.94) 5,308,085
Direct labour cost
Normal hours (8.000 x 220) 1,760,000
Overtime hours (2,079 W-1 x 220 x 1.50) 686,070
Overheads
Normal hours (8,000 x 150) 1,200,000
Overtime hours (2,079 W-1 x 150 x 1.25) 389,813
Total costs 10,399,968
Order price at a margin of 25% of the selling price 13,866,624

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W.1: Learning curve %:

Average hours per
Batch No. Cumulative hours Learning curve %
batch
1 200.00 200.00
2 (200+160) 360.00 180.00 (180/200) 90%
4 (360+148+140) 648.00 162.00 (162/180) 90%
Hours for first 64 batches 64*200*(64)-0.152 6,803
Hours for first 63 batches 63*200*(63) -0.152 (6,712)
Hours per batch after 63rd batch 91
Hours required:

AT A GLANCE
First 64 batches 6,803
Last 36 batches (91×36) 3,276
Total hours 10,079
Overtime hours (10,079 – 8,000) 2,079

 Question 02:
Toy Limited is engaged in the production of a single product. On the basis of past history, the management has
estimated the cost of production per unit, as follows:

Rupees

SPOTLIGHT
Raw material – 5 kg @ Rs. 40 per kg 200
Labour – 10 hours @ Rs. 25 per hour 250
Variable overheads – 60% of direct labour 150
Total 600

The annual production requirement is 100,000 units.

The management has been deeply concerned with the performance of its labour as it has been witnessing
various inefficiencies. The industrial relations department has recently carried out a study under the guidance
of a consultant. It has put forward a plan whereby the company’s wage policy is to be revised as under:
• Rate of wages would be increased by 12%.

STICKY NOTES
• Workers who perform their tasks in less than the estimated time of 10 hours per unit would be given a
premium of Rs. 18 per hour saved.
The consultant is of the view that the following efficiencies can be brought about by introducing the above
change:
i. Raw material input per unit includes wastage of 7%. It would reduce to 3%.
ii. 70% of the workers would work more efficiently and improve their efficiency by 20%.
iii. Overheads will be reduced to 55% of the revised cost of direct labour (including premium).
iv. The quality of production will improve and the rate of rejection will be reduced from 4% to 3%. Rejected
units are sold for Rs. 150 each.
Required
Determine that the wage plan recommended by the industrial relations department would be beneficial for the
company or not.

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 Solution
Determination of wage plan recommended by the industrial relations department whether it would be
beneficial for the company or not, would be calculated as under:
Net benefit from proposed plan
Rupees
Savings in raw material consumption W-1 824,000
Increase in labour cost W-2 (1,600,000)
Savings in overheads W-3 370,000
Decrease in rejections W-4 470,742
Net Savings 64,742
AT A GLANCE

W-1 Raw material consumption

Rupees
Raw materials consumption per unit – current- 5.000
Present wastage (5 x 7/100) (0.350)
Raw materials forming part of finished goods 4.650
Raw materials consumption per unit as revised (4.650/0.97) 4.794
Savings in raw material consumption (5.000-4.794) x 100,000 x 40 824,000
W-2 Labour cost
Rupees
SPOTLIGHT

Labour hours – current 10.00

Saving in labour hours due to efficiency (10 x 70% x 20%) (1.40)
Labour hours – revised 8.60
Labour cost: Revised wages (8.60 x 25 x 1.12) 240.80
Premium on hours saved (1.40 x 18) 25.20
Revised labour cost per unit 266.00
Increase in labour cost (Rs. 266-250) x100,000 1,600,000
W-3 Overheads
STICKY NOTES

Rupees
Current overheads per unit 150.00
Revised overheads per unit (266 x 0.55) 146.30
Saving in overheads (150-146.30) x 100,000 370,000
W-4 Rejections
Rupees
Present rejections {(100,000/0.96)-100,000} 4,167
Rejections in the new situation {(100,000/0.97)-100,000} 3,093
Present cost of rejections of 4,167 units @ Rs. 450 (600-150) 1,875,150
Revised cost of rejection for 3,093 units:
{(4.794 x 40)+266+146.30-150} x 3,093 1,404,408
Decrease in rejection (1,875,150-1,404,408) 470,742

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 Question 03:
Pakair Limited manufactures special tools. Information pertaining to payroll costs for the month of April 2010
is as under:
Department Gross salaries excluding overtime Overtime Income tax deductions
Rupees in thousands
Machining 1,000 75 25
Assembly 400 40 15
Tool-room 25 5 -
Warehouse 75 15 -
Details of other benefits are as under:

AT A GLANCE
i. 35 paid leaves are allowed per year including annual, casual and sick leaves.
ii. Annual bonus equal to one month salary is paid in June.
iii. The company maintains a contributory Provident Fund in which 8.33% of the monthly salary is
contributed by the employer as well as the employees.
iv. During April 2010, the employees availed leaves that cost Rs. 85,000.
v. Advances paid and recovered during the month amounted to Rs. 17,000 and Rs. 28,000 respectively.
vi. The company follows a policy of accruing bonus and paid leaves on a monthly basis.
Required.
Make Journal entries to record pay roll and its disbursement.

SPOTLIGHT
 Solution

The journal entries to record pay roll and its disbursement are given below:
Journal Entries Debit Credit
Rupees in ‘000
Payroll expense (W-1) 2,030.83
Provision for vacations pay (vacations availed during the month) 85.00
Payroll payable (1,635-193+85) 1,527.00
Contribution to provident fund payable (Co. & employees) 250.00
Provision for bonus 125.00

STICKY NOTES
Provision for vacation pay 145.83
Employees’ income tax payable 40.00
Advance against salary 28.00
(To record payroll cost, liability and provisions)
Work in process (1,338.88+545.56) 1,884.44
Factory overheads (36.60+109.79) 146.39
Payroll expenses 2,030.83
(To allocate payroll cost to WIP and factory overheads)
Advance against salary 17.00
Payroll payable 1,527.00
Contribution to provident fund payable (Co. & employees) 250.00
Employees’ income tax payable 40.00
Bank 1,834
(To record disbursement of payroll and payment of liabilities)

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W-1 Calculation of payroll

Cost Machining Assembly Tool room Stores Total

WIP Overheads
Rupees in ‘000
Payroll cost (A) 1,000.00 400.00 25.00 75.00 1,500.00
Overtime 75.00 40.00 5.00 15.00 135.00
1,075.00 440.00 30.00 90.00 1,635
Employer’s contribution to PF
(A x 0.833) 83.33 33.34 2.09 6.25 125.00
AT A GLANCE

Provision for year-end bonus

(A/12) 83.33 33.34 2.09 6.25 125.00
Provision for paid vacation
(A x 35/360) 97.22 38.89 2.43 7.29 145.83
1,338.88 545.56 36.60 109.79 2,030.83
Deductions from employees:
Employee income tax 25.00 15.00 - - 40.00
Employees’ contribution to PF
SPOTLIGHT

(A x 0.833) 83.33 33.33 2.08 6.25 125.00

Salary advance recoveries 28.00
108.33 48.33 2.08 6.25 193.00

 Question 04:
a) The following information relates to a week’s work for three employees:

Employee A Employee B Employee C

Output (units) 160 276 68
Time allowed (hours per unit) 0.5 0.25 0.75
STICKY NOTES

Basic hourly wage rate (Rupees) 80 100 70

Hours worked as direct labour 48 54 30
Hours worked as indirect labour - - 12

The normal working week is 42 hours. For the first six hours, overtime is paid at 50% above the normal rate.
Any further overtime is paid at double the normal rate. Bonus is paid at three-fifth of the normal rate for the
hours saved.
Required:
a) Calculate total wages of each employee.
b) Make a summary of payroll of LMN Factory Limited for the month of February 2014.
c) Make journal entries to record payroll cost for the month of February 2014.

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 Solution
a) Total wages of each employee is calculated below:

Particulars Employee A Employee B Employee C

Hours worked 48 54 42
Normal hours per week 42 42 42
Overtime hours 6 12 -

Normal wages (48×80), (54×100), (42×70) 3,840 5,400 2,940

First six overtime hours (6×80×50%), 240 300 -

AT A GLANCE
(6×100×50%)
Overtime hours > 6 hours (6×100) - 600 -
Total wages in Rs. (A) 4,080 6,300 2,940
Bonus amount
Hours allowed (160×0.5), (276×0.25), (68×0.75) 80 69 51
Direct hours worked 48 54 30
Bonus hours earned/Time saved 32 15 21
Hourly bonus rate - at three fifth of the normal rate (80×3/5)=48 (100×3/5)=60 (70×3/5)=42

SPOTLIGHT
Bonus in Rs. (B) 1,536 900 882
Total wages in Rs. (A + B) 5,616 7,200 3,822

b) The following is a summary of payroll of LMN Factory Limited for the month of February 2014:

Rupees
Basic salary 420,000
Allowances 147,000
Gross salary 567,000

STICKY NOTES
Deductions:
Loans to staff (13,000)
Income tax (15,500)
Employees' provident fund contribution (35,000)
Net salary 503,500

The company is also required to pay the following:

• Company’s contribution to the provident fund which is equal to employees’ contribution
• 5% of the basic salary to a government organisation.

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c) Journal Entries to record payroll cost for the month of February 2014 are given below:

Journal Entries Debit Credit

Rupees
Salaries 420,000
Allowances 147,000
Loans to staff 13,000
Staff income tax payable 15,500
Trustees- provident fund payable 35,000
Salary payable/bank 503,500
AT A GLANCE

(Payroll for the month of February 2014)

Co’s contribution to provident fund 35,000
Trustees- provident fund payable 35,000
(Being Co. contribution to PF for February 2014
Contribution to the Government organisation 21,000
Account payable - Government organisation 21,000
(Amount payable to a government organisation at 5% of basic salary for February
2014)
SPOTLIGHT

 Question 05:
A factory manufactures three components A, B and C.
During a week, the following was recorded:

Labour Grade Number of Employees Rate per Hour (Rs.) Individual Hours Worked
I 6 40 40
II 18 32 42
III 4 28 40
STICKY NOTES

IV 1 16 44

Actual output and standard times are given below:

Component Output Standard Minutes Per Component

A 444 30
B 900 54
C 480 66

The normal working week is of 38 hours. Overtime is paid at a premium of 50% of the normal hourly rate.
A group incentive scheme is in operation and a bonus is paid based on the time saved. The rate of bonus
payment is 75% of normal hourly rate. The time saved is allocated to each labour grade in proportion to the
number of hours worked by each group.
Required:
Calculate the total payroll showing the basic pay, overtime premium and bonus pay for each grade of labour.

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 Solution:
The total payroll showing the basic pay, overtime premium and bonus pay for each grade of labour is prepared
below.

Payroll Schedule
For The Last Week of June 30 2000
I II III IV TOTAL
Basic Pay
Individual Actual Hours 40 42 40 44
x No. of Employees 6 18 4 1

AT A GLANCE
= Total Actual hours Worked 240 756 160 44 1200
x Basic Rate 40 32 28 16
= Basic Pay (A) 9,600 24,192 4,480 704
Overtime Premium
Individual Actual Hours 40 42 40 44
Less Normal Working Hours (38) (38) (38) (38)
= Individual Overtime Hours 2 4 2 6
x No. of Employees 6 18 4 1

SPOTLIGHT
= Total Overtime Hours 12 72 8 6
x Overtime Premium Rate (50%) 20 16 14 8
= Overtime Premium (B) 240 1,152 112 48
Bonus
Time Saved (W-1) 72 226.8 48 13.2
x Bonus Rate Per Hour 30 24 21 12
= Bonus (C) 2160 5,443.2 1,008 158.4
Total Labour Cost (A+B+C) 12,000 30,787.2 5,600 910.4

STICKY NOTES
W-1
Working for time saved
Time saved=Total standard hours allowed-Total actual hours
Standard Hours Allowed Hours
Component A (444 units x 30 222
mins)/60
Component B (900 units x 54 810
mins)/60
Component C (480 units x 66 528
mins)/60
Total standard hours 1560
Less Actual hours worked 1200

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Payroll Schedule
For The Last Week of June 30 2000
I II III IV TOTAL
360
Allocation of 360 hours among Labour Grades
240 X (360/1200) 72
756 X (360/1200) 226.8
160 X (360/1200) 48
44 X (360/1200) 13.2
AT A GLANCE

 Question 06:
Zircon Limited (ZL) manufactures and supplies footballs for both domestic and international markets.
Following information is available from the company’s records.

Number of skilled workers 250

Standard working hours per month 200
Actual hours per unit of product 1.5
Standard labour rate per hour (Rupees) 42
Variable overhead rate per labour hour (Rupees) 75
SPOTLIGHT

The company manufactures 40,000 footballs per month. Overtime is paid to the workers at the rate of 75%
over and above the standard wage rate.
In order to increase the production efficiency and reduce the cost of conversion, the management is currently
evaluating various wage incentive plans. The production manager has suggested the following options to the
management.
Option 1: Introduce a piece wage system at the rate of Rs. 72 per unit. It is expected to improve the current
production efficiency from 65% to 78%.
Option 2: Introduce a monthly group bonus plan with a guaranteed wage of Rs. 48 per hour based on a
standard 1.4 hours per unit of product. This plan is expected to reduce the overtime by 60%.
STICKY NOTES

Required
Evaluate the above options in contrast with the existing schemes and advise management about most
economical option.
 Solution
The evaluation of above options in contrast with the existing schemes along with advise to management about
the most economical option is given below:

Conversion cost under existing scheme

Conversion cost Rupees

Normal hours (50,000 × Rs. 42) 2,100,000
Overtime hours (10,000 W-1 × Rs. 73.50) 735,000
Total labour cost 2,835,000
Variable overhead (60,000 × Rs. 75) 4,500,000

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Total conversion cost 7,335,000

Conversion cost under option 1

Conversion cost Rupees

No. of hours required per unit (1.5 × 0.65/ 0.78) 1.25
Total no. of hours required (40,000 × 1.25) 50,000
Rupees
Piece wages (40,000 × 72) 2,880,000
Variable overhead ( 50,000 × 75) 3,750,000

AT A GLANCE
Total conversion cost 6,630,000

Conversion cost under option 2

Conversion cost Hours

Labour hours available (250 × 200) 50,000
Overtime hours (10,000 × 40%) 4,000
Total labour hours 54,000
Standard hours allowed for the bonus plan (40,000 × 1.4) 56,000

SPOTLIGHT
Rupees
Guaranteed wages (56,000 × 48) 2,688,000
Variable overhead (54,000 × 75) 4,050,000
Total conversion cost 6,738,000

Recommendation: By implementing option 1 the conversion cost would be reduced to Rs 165.75 per unit
from the existing Rs. 183.38 per unit. The workers would be paid Rs. 2.880 million which is better than option
2. The workers would certainly try to earn this amount in the least possible time.
Therefore, option 1 would be the most economical choice for both the workers and the management.

STICKY NOTES
W-1 Overtime hours

Hours
No. of labour hours required (40,000 × 1.5) 60,000
Labour hours available at standard rate (250 × 200) 50,000
Overtime hours 10,000

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STICKY NOTES

Labour cost is measured with respect to ‘Production’ and ‘Productivity’

Labour intensive industries tend to develop labour and production

designated wage policies
AT A GLANCE

Labour performances are worked out at each period end to analyze the cost
and productivity outcome

Learning curve is used to calculate in advance the expected time to be taken

by the labour when they become fully conversant with the work

Payroll account generally includes debit for direct labour expense, salaries
SPOTLIGHT

and the company’s portion of payroll taxes. Credit would be liability or

amount of cash paid to the employees.
STICKY NOTES

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 CHAPTER 5

COST FLOW IN
PRODUCTION

AT A GLANCE
IN THIS CHAPTER

AT A GLANCE
Accounting is a systematic process of identifying, recording,
AT A GLANCE measuring, classifying, verifying, summarizing, interpreting and
communicating financial information
SPOTLIGHT Cost accounting is primarily about costing of the product and
Management accounting is all about Planning, Control and
1. Accounting information and Decision Making.
types of accounting systems
Accounting for the production of inventory mirrors the cost
2. Accounting for inventory flow from Raw Material accounts, wages control account,
Production overhead control account to WIP account and then
to finished goods and P&L account.
3. Cost bookkeeping systems
Integrated accounts combine both financial and cost accounts
4. Self-test questions

SPOTLIGHT
in one system of ledger accounts. Interlocking systems contain
separate cost accounting and financial accounting ledgers.
STICKY NOTES

STICKY NOTES

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1 ACCOUNTING INFORMATION AND TYPES OF ACCOUNTING SYSTEMS

Accounting is a systematic process of identifying, recording, measuring, classifying, verifying, summarizing,
interpreting and communicating financial information to provide insights into an organisation's financial
performance and position for various stakeholders.
Accounting information is used by both internal and external stakeholders to track financial performance,
make informed decisions, and ensure compliance with regulations.
Common types of accounting systems are financial accounting, cost accounting and management accounting.

1.1 Financial Accounting

Financial accounting system is concerned with providing information to the external users (shareholders,
lenders, government agencies, etc.) about a company's financial performance and financial position. It covers
AT A GLANCE

the complete accounting cycle, from recording events and transactions to preparing financial statements (the
statement of comprehensive income, statement of financial position, statement of cash flows, statement of
changes in equity and notes to the accounts). Financial accounting is regulated by external reporting standards
like, Internal Financial Reporting Standards (IRFS), Generally Accepted Accounting Principles (GAAPs), etc. to
ensure consistency, transparency, and comparability in financial reporting.
The terms cost accounting and management accounting are often used interchangeably. However, these two
accounting systems are different in their scope, operations and application.

1.2 Cost Accounting

Cost accounting is concerned with identifying, measuring, and controlling costs of producing a product,
rendering a service or performing an operation. Once the data about costs of products or services and the cost
SPOTLIGHT

of those activities is assembled, the data of operational activities is recorded in a ‘double entry’ system of cost
accounts in a ‘cost ledger’. The cost accounting data is captured, stored and subsequently analysed to provide
management information about costs.
Cost accounting information has an internal use and it helps businesses understand their cost structure,
identify areas for cost reduction, and improve operational efficiency. Unlike financial accounting, which follows
strict regulations and formats, cost accounting is not bound by external reporting standards or regulations.

1.3 Management Accounting

Management accounting, also known as managerial accounting, is concerned about providing information
(including statements, reports and documents) to the management for internal decision-making and in helping
them execute all management functions efficiently including planning, organizing, directing, and controlling. It
STICKY NOTES

provides both financial and non-financial information to the management to assist them in making informed
business decisions including make or buy decisions, limiting factor decisions, shutdown decisions, further
processing decisions, spare capacity decisions, option evaluation, etc. so that the profits can be maximized and
losses can be minimized.
Management accounting encompasses cost accounting as a part of its framework, but its scope is broader.
While management accounting information is frequently derived from an analysis of cost accounting data, it
can also include cost and revenue estimates from sources outside the cost accounting system. Additionally,
management accounting often focuses on future projections, offering insights into anticipated costs and profits.

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2 ACCOUNTING FOR INVENTORY

2.1 Accounting for the production of inventory

Cost Flow
Cost flow represents movement of cost and inventories through various ledgers until the units are sold and
closed to cost of sales. In this chapter, we will discuss how three elements of cost (Material, Labour and
Production overheads) combine to compute cost of sales.
As a simple starting point:
• For a retail company, the cost of goods sold is simply the purchase price of the goods.
• For a manufacturing company, the cost of goods sold is the total production cost including direct materials,

AT A GLANCE
direct labour and production overheads. The accounting systems must identify these costs and then
transfer them into finished goods (usually via work-in-progress) and thus into cost of sales.
 Illustration: Cost flow

SPOTLIGHT
This diagram implies that cost accounting can be studied as a series of steps:

Step
Stage of inventory Accounting treatment
No.

STICKY NOTES
1. The inventory is purchased Recognize costs in appropriate cost accounts
2. The inventory is issued to the Transfer costs from the cost accounts into work-in- progress
production process
3. Finished products are obtained at Transfer costs from work-in-progress into finished goods
the end of manufacturing process
4. Finished goods are sold Transfer costs from the finished goods account into the
statement of profit or loss (income statement) to become part
of cost of sales

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2.2 Explanation of Inventory ledgers

Raw materials
Raw materials ledger is inventory account and it shows the inventory movement. When raw material is
purchased it is debited and when material is issued, it is credited and transferred to work in progress account.
The balance at year end represents raw material inventory on hand and is shown in statement of financial
position.

Work in progress
Work in progress is another inventory account in manufacturing concern and it shows that goods are in
progress. It includes direct labour cost and absorbed production overheads, in addition to direct materials
transferred from raw material ledger. The work completed during the year is credited to work in progress and
AT A GLANCE

transferred to Finished goods. The year-end balance of work in progress is the production cost that is not yet
completed and is shown as inventory in statement of financial position.

Finished goods
Finished goods are the third category of inventory account which are maintained by manufacturing concerns.
This account is debited by amount transferred from work in progress and represents completed goods. When
the goods are sold, finished goods account is credited to cost of sales to complete the cost flow. The year-end
balance represents unsold finished goods and treated as inventory which is shown in statement of financial
position.
 Illustration: Cost flows showing reclassification of non-production wages
SPOTLIGHT
STICKY NOTES

Over (under) absorption of fixed production overhead

The fixed production overheads account is debited with the actual fixed production overhead incurred in the
period. Fixed production overheads are transferred into WIP using a pre-determined absorption rate (as
discussed in chapter 3 earlier). The difference between the absorbed overhead and the actual overhead is over
(under) absorption. This must be adjusted in the statement of profit or loss.

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 Illustration:

AT A GLANCE
 Example 01
A company manufactures and sells a range of products in a single factory. Its budgeted production overheads
for Year 6 were Rs.150,000, and budgeted direct labour hours were 50,000 hours.
Actual results in Year 6 were as follows:

Rs.
Direct materials costs 130,000
Direct labour costs 160,000
Fixed production overhead 140,000 (40,000 hours)

SPOTLIGHT
There was no opening or closing inventory at the beginning or end of Year 6.
The company uses an absorption costing system, and production overhead is absorbed using a direct labour
hour rate.
The information would be accounted for as follows.

Recognition of costs
Debit Credit
Materials control 130,000

STICKY NOTES
Salaries & Wages control 160,000
Production overhead control 140,000
Cash/payables 430,000

Transfer of costs into work-in-progress

Debit Credit
WIP 130,000
Materials control 130,000
WIP 160,000
Salaries & wages control 160,000
WIP (see working below) 120,000
Production overhead control 120,000

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Working
The predetermined absorption rate is Rs.150,000/50,000 hours = Rs.3 per direct labour hour.
Therefore, the amount transferred = Rs. 120,000 (40,000 hours  Rs. 3)
Transfer of costs from work-in-progress into finished goods

Debit Credit
Finished goods 410,000
WIP 410,000

Accounting for under-absorption of fixed production overhead

AT A GLANCE

Debit Credit
Cost of sales (see working below) 20,000
Production overhead control 20,000

Working: Under absorption

Rs.
Overhead absorbed (40,000 hours @ RS. 3 per hour) 120,000
Overhead incurred (actual cost) (140,000)
SPOTLIGHT

Under absorption of overheads (20,000)

This can be represented (in part) by the following diagram (figures in Rs. 000)
STICKY NOTES

/Cost of sales

2.3 Accounting entries in the cost accounting system

The following suite of journals describes the typical accounting entries that might be posted within a cost
accounting system that uses perpetual inventory system.

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Journals to recognize expenses as incurred

Entries related to raw materials

Debit Credit
Purchase of raw materials
Inventory control (raw materials) x
Payables (or cash) x
Issue of raw materials to production
Work in progress control (Direct materials) x
Production overhead control (Indirect materials) x

AT A GLANCE
Inventory control (raw materials) x
Return of raw materials from production to store
Inventory control (raw materials) x
Work in progress control (Direct materials) x
Production overhead control (Indirect materials) x
Raw materials returned to vendor
Payables (or cash) x
Inventory control (raw materials)

SPOTLIGHT
Entries related to labour
Debit Credit
Preparation of payroll
Salaries & wages control x
Deductions x
Accrued salaries & wages control x
Payment of payroll
Accrued salaries & wages control x

STICKY NOTES
Cash x
Transfer of salaries & wages to proper head of accounts
Work in progress control (direct labour) x
Production overhead control (indirect labour) x
Administrative cost x
Selling & marketing cost x
Salaries & wages control x
Recording of employer’s contribution
Production overhead control x
Administrative cost x
Selling & marketing cost x
Contribution payable x
Entries related to Production overheads

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Debit Credit
Recording of actual production overheads
Production overheads control x
Payables or cash or accumulated depreciation x
Absorbed production overheads to product cost
Work in progress control x
Production overheads control x
Close under or over absorbed overheads
In case of under absorbed overheads
Cost of sales (Income statement) x
AT A GLANCE

Production overheads control x

Transfer of completed goods to finished goods

Transfer of costs on completion of production

Finished goods inventory x
Work in progress control x
Entries when goods are sold
SPOTLIGHT

Recording of sales
Accounts receivables (or cash) x
Sales x

Recording of cost of sales

Cost of sales x
Finished goods inventory x
Closing entries
STICKY NOTES

Close Cost of sales

Income statement x
Cost of sales x

Close sales account

Sales x
Income Statement x

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3 COST BOOKKEEPING SYSTEMS

Cost book-keeping systems can be categorized into two types in terms of how the cost accounts relate to other
ledger accounts. These two systems are called:
• integrated accounts;
• interlocking accounts.

3.1 Integrated accounts

Integrated accounts can be defined as
• A single set of accounting records that provide financial and cost accounts using a common input of data.
• A system where all information (both financial and costing) is kept in a single set of books.

AT A GLANCE
As the name suggests, the cost accounts are integrated into the entity’s bookkeeping system. There is a single
general ledger which includes the cost accounts.
Double entry is simply the normal double entry associated with maintaining a set of accounts including the
entries described above.
In practice, most companies and ERP solutions available in the market use integrated accounting system.
Advantages of integrated accounts
• This system avoids duplication of effort between cost and financial accounting systems, by eliminating
unnecessary duplicate records.
• There is no need to reconcile the profits of cost and financial accounting, as single set of accounts calculates
profits for both.

SPOTLIGHT
• This system helps to reduce the cost of keeping two separate set of accounts.
Disadvantages of integrated accounts
• Using a single system for external reporting and the provision of management information reduces
flexibility. For example, inventory must be valued at full absorption cost for external reporting purposes (in
accordance with IAS 2: Inventories) but management might require marginal cost information for decision
making.
• The system causes delay in providing information to management. Since this system is developed to
provide information to both financial and cost accounting, it might get complicated.
• This system creates difficulty for large entities which require detailed cost and financial information on on-
going basis.

STICKY NOTES
 Illustration:
This diagram shows the various ledger accounts and accounting entries used within integrated accounts.
Chart of accounting flow in an integrated accounts system

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The direct materials account above might be named differently, for example, raw materials a/c, inventory (raw
materials) a/c, stores etc. Similarly, the WIP account might be described as inventory (WIP) a/c and the
finished goods account as inventory (finished goods) a/c.
Although the above diagram does not exhibit it but an entry for Over (under) absorption of fixed production
overhead will also be required as explained earlier in this chapter.
Profit or loss is calculated in the usual way as the balance on the P&L account. The balance would be
transferred to the accumulated profit account (retained earnings account).

3.2 Integrated accounts: Comprehensive illustration

The following illustration applies the accounting entries to ledger accounts for a comprehensive example.
The following balances and transactions relate to a manufacturing company.
AT A GLANCE

Opening inventories raw materials 10,000kg Rs.25,000

work in progress Nil
finished goods 1,000 units Rs.100,000
Materials Purchases 28,000 kg Rs.77,000
issues to production 30,000kg FIFO
Labour Paid 16,000 hours Rs.96,000
Direct labour 15,000 hours
Production overhead Rs.250,000
Standard overhead rate per hour Rs.20
SPOTLIGHT

Completed production 4,000 units

Closing inventories raw materials see above
work in progress Nil
finished goods 500 units FIFO
Sales revenue see above Rs. 540,000

Required:
Under integrated accounting system:
a) Pass accounting entries for the entire cost flow of production
STICKY NOTES

b) Make all necessary ledger postings

 Solution:
a) The Journal entries of above transactions are given below:

Entries related to materials Debit Credit

Materials Control 77,000
Payables 77,000
(Purchases of raw materials)
Work in progress control W-1 80,000
Materials Control 80,000
(Direct materials issued to production)

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W-1 Material issues on FIFO basis Rupees

From opening inventory-10,000 kg 25,000
From current purchase- 20,000 kg (77,000 x 20,000/28,000) 55,000
80,000

Entries related to labour Debit Credit

Salaries & Wages control 96,000
Cash 96,000
(Payment of wages made)
Work in progress control 90,000

AT A GLANCE
Production overheads control W-2 6,000
Salaries & Wages control 96,000
(Transfer of wages to proper head of accounts)

W-2
Number of hours: 16,000 − 15,000 1,000
Hourly rate: Rs. 96,000/16,000 hours Rs.6
Transfer (Rs.) 6,000

SPOTLIGHT
Entries related to production overheads Debit Credit
Production overheads control 250,000
Payables 250,000
(Actual production overheads recorded)
Work in progress control (15,000 x 20) 300,000
Production overheads control 300,000
(Production overheads were absorbed)

STICKY NOTES
Transfer of costs from WIP into finished goods Debit Credit
Finished goods inventory 470,000
Work in progress control W-3 470,000

W-3: Balance in WIP before transfer Rs.

Opening WIP −
Raw materials 80,000
Direct labour 90,000
Overhead absorbed 300,000
470,000
Less: Closing WIP −
Balance transferred to finished goods 470,000

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Note:

Cost per unit = Rs. 470,000 /4,000 units Rs. 117.50

Transfer of finished goods to cost of sales Debit Credit

Cost of sales W-4 511,250
Finished goods inventory 511,250

W-4 Units Rs.

Opening inventory of finished goods 1,000 100,000
AT A GLANCE

Production 4,000 470,000

5,000 570,000
Closing inventory of finished goods (@ Rs. 117.50) (500) (58,750)
4,500 511,250
Over-absorption of overhead
Production overhead control W-5 44,000
Cost of sales 44,000
SPOTLIGHT

W-5: Rs.
Overhead incurred 250,000
Transfer from wages control a/c 6,000
Actual overheads 256,000
Overhead absorbed 300,000
Over absorption 44,000

Recognition of sales Debit Credit

STICKY NOTES

Receivables 540,000
Sales 540,000
Sales 540,000
P&L control a/c 540,000
Closing of cost of sales Debit Credit
P&L control a/c 511,250
Cost of sales 511,250

Transfer of profit to accumulated profit Debit Credit

P&L control a/c W-6 72,750
Accumulated profit 72,750

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W-6: Profit for the period Rs.

Sales 540,000
Cost of sales
Opening inventory -
Raw materials 25,000
Finished goods 100,000
125,000
Production costs
Raw materials 77,000
Wages 96,000

AT A GLANCE
Overheads 250,000
423,000
Closing inventory
Raw materials 22,000
Finished goods 58,750
(80,750)
(467,250)
Profit 72,750

SPOTLIGHT
b) The general ledger T accounts after the double entries are as follows:

Raw materials
Rupees Rupees
Balance b/f 25,000
Payables 77,000 Work in progress control 80,000
Balance c/f 22,000
102,000 102,000

Salaries & Wages control

STICKY NOTES
Rupees Rupees
Cash 96,000 Overhead control 6,000
Work in progress control 90,000
96,000 96,000

Production Overhead control

Rupees Rupees
Payables 250,000 Work in progress control 300,000
Salaries & Wages control 6,000
Cost of sales 44,000
300,000 300,000

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Work in progress control

Rupees Rupees
Materials control 80,000 Finished goods 470,000
Salaries & Wages control 90,000
Production Overhead control 300,000
470,000 470,000

Finished goods
Rupees Rupees
AT A GLANCE

Balance b/f 100,000 Cost of sales 511,250

Work in progress control 470,000 Balance c/f 58,750
570,000 570,000

Sales
Rupees Rupees
P&L control a/c 540,000
Receivables 540,000
SPOTLIGHT

540,000 540,000

Cost of sales
Rupees Rupees
Finished goods 511,250 Production overheads control 44,000
Profit & Loss a/c 467,250
511,250 511,250

P&L control a/c

STICKY NOTES

Rupees Rupees
Cost of sales 467,250 Sales 540,000
Profit for the period 72,750
540,000 540,000

3.3 Interlocking accounts

Interlocking accounts involve using separate ledgers for costing and for financial reporting purposes. Each of
these ledgers includes an account (or accounts) to reflect the relationship with the other ledger (thus they are
said to interlock). Interlocking systems can vary in the range of transactions reflected in the cost ledger.
• In some systems, the cost ledger includes only costing information.
• In other systems, the cost ledger recognizes sales and the subsequent calculation of profit. For ease of
description, we will describe this system as being fully interlocking.

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There are separate records but these are kept in agreement or are readily reconcilable.
It is convenient to think of a business split into two entities (but remember that this is not necessarily the case):
• The head office maintains the general ledger which is used to generate external reports; and
• A factory maintains the cost ledger (or factory ledger) which is used to record manufacturing.
Each ledger contains an account which reflects each entity’s relationship with the other entity. Thus:
• The general ledger contains a Factory Ledger Control Account (FLC a/c). This is a receivable and shows
the assets that the head office owns that are held by the factory.
• The factory ledger contains a General Ledger Control Account (GLC a/c). This is a payable that shows the
assets that the factory is holding on behalf of the head office. At each period end this would be the sum of
raw materials, WIP and finished goods not yet sold.

AT A GLANCE
The balances on these accounts are a mirror image of each other and should agree.

Advantages of interlocking accounts

• Allows greater flexibility

Disadvantages of interlocking accounts

• Duplication of effort as entries need processing in both sets of ledgers
• Different profit figures may emerge
• Inventory valuations will be different between the two systems

SPOTLIGHT
• Reconciliation may be necessary (which takes time and effort)
The general ledger reflects this with the following double entries.
 Illustration: Expenses incurred by the head office for the factory

Debit Credit
General ledger
Purchase of direct materials
Factory ledger control a/c x
Payables x

STICKY NOTES
Payment for direct labour
Factory ledger control a/c x
Cash x
Production overhead incurred
Factory ledger control a/c x
Cash/payables x

The result of the above is that the factory ledger control account in the general ledger shows that the factory
“owes” these amounts to the head office. They are amounting the head office has invested in the factory.

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The amounts are entered in the factory ledger as follows.

 Illustration: Expenses incurred by the head office for the factory

Debit Credit
Factory ledger
Purchase of direct materials
Materials control X
General ledger control a/c X
Payment for direct labour
Work in progress control X
AT A GLANCE

General ledger control a/c X

Production overhead incurred
Production overheads control X
General ledger control a/c X

In the factory ledger, costs are transferred from the cost accounts into WIP and hence on to finished goods as
previously described. The finished goods are the output the head office receives from the factory for onwards
sale. The following entries are then made to reflect the completion and transfer of production. The goods may
not be physically moved from factory to head office but become available for sale.
SPOTLIGHT

Illustration: Completion of production Debit Credit

Completion of production: Factory ledger
General ledger control a/c x
Finished goods inventory x
Completion of production: General ledger
Cost of sales x
Factory ledger control a/c x

 Illustration:
STICKY NOTES

The following diagram provides an overview of the various ledger accounts and the flow of information
represented by the accounting entries used within interlocking accounts.

General ledger control account

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AT A GLANCE
FLC a/c = Factory ledger control account

3.4 Interlocking accounts: Comprehensive illustration

Continuing the same example given in section 3.2; the following pages will show how the balances and
transactions would be recorded in the cost ledger and the financial ledger.

Factory ledger

Entries related to materials Debit Credit

Materials control 77,000

SPOTLIGHT
General ledger control a/c 77,000
(Materials purchased)
Work in progress control 80,000
Materials control 80,000
(Materials issued to production)

Entries related to labour Debit Credit

Work in progress control 90,000

STICKY NOTES
Production overheads control 6,000
General ledger control a/c 96,000
(Transfer of salaries & wages to proper head of accounts)

Entries related to production overheads Debit Credit

Production overheads control a/c 250,000
General ledger control a/c 250,000
(Payment of production overheads by head office)
Work in progress control 300,000
Production overheads control a/c 300,000
(Overheads absorbed in production)

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Goods transferred to finished goods Debit Credit

Finished goods inventory 470,000
Work in progress control 470,000
(Goods completed and transferred to finished goods)
Record cost of goods sold Debit Credit
General ledger control a/c 511,250
Finished goods inventory 511,250
Close Over-absorption of overhead Debit Credit
Production Overhead control a/c 44,000
AT A GLANCE

General ledger control a/c 44,000

The Factory Ledger T accounts after the double entries are as follows:

Raw materials Control

Rupees Rupees
Balance b/f 25,000
General ledger control a/c 77,000 Work in progress control 80,000
Balance c/f 22,000
SPOTLIGHT

102,000 102,000
Production Overhead control
Rupees Rupees
General ledger control a/c 250,000 Work in progress control 300,000
General ledger control a/c 6,000
General ledger control a/c 44,000
256,000 256,000
Work in progress control
STICKY NOTES

Rupees Rupees
Materials control 80,000 Finished goods 470,000
General ledger control a/c 90,000
Production Overhead control 300,000
470,000 470,000
Finished goods
Rupees Rupees
Balance b/d 100,000 General ledger control a/c 511,250
Work in progress control 470,000 Balance c/f 58,750
570,000 570,000

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General Ledger Control Account

Rupees Rupees
Balance b/f 125,000
Materials control 77,000
Finished goods 511,250 Work in progress control 90,000
Production overheads control 6,000
Production overheads control 250,000
Balance c/f 80,750 Production overheads control 44,000
592,000 592,000

AT A GLANCE
General ledger

Entries related to materials, labour and production overheads Debit Credit

Factory ledger control a/c 77,000

Payables 77,000

(Purchases of raw materials by factory)

Salaries & Wages control 96,000

SPOTLIGHT
Cash 96,000

(Payment of wages by head office)

Factory ledger control a/c 96,000

Salaries & wages control 96,000

(Transfer of factory wages to factory ledger)

Factory ledger control a/c 250,000

Payables 250,000

STICKY NOTES
(Recording of liability against production overheads)

Recognition of sales and cost of sales Debit Credit

Receivables 540,000
Sales 540,000
(Recording of goods sold)
Cost of sales 511,250
Factory ledger control a/c 511,250
(Recording cost of goods sold)

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Closing of over absorbed to cost of sales Debit Credit

Factory ledger control a/c 44,000

Cost of sales 44,000

(Recording of goods sold)

Closing of cost of sales

P&L control a/c 467,250

AT A GLANCE

Cost of sales 467,250

Closing of sales

Sales 540,000

P & L control a/c 540,000

Transfer of profit to accumulated profit

SPOTLIGHT

P&L control a/c 72,750

Accumulated profit 72,750

Note: Workings are shown in comprehensive example in section 3.2.

The general ledger T accounts after the double entries are as follows:

Payables

Rupees Rupees
STICKY NOTES

Factory ledger control 77,000

Balance c/f 327,000 Factory ledger control 250,000

327,000 327,000

Cash

Rupees Rupees

Balance b/f X Salaries & Wages control 96,000

Balance c/f X

X X

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Salaries & Wages control

Rupees Rupees

Cash 96,000 Factory ledger control 96,000

96,000 96,000

Sales

Rupees Rupees

P&L control a/c 540,000 Receivables 540,000

AT A GLANCE
540,000 540,000

Profit & Loss Control Account

Rupees Rupees

Cost of sales 467,250 Sales 540,000

Profit for the year 72,750

540,000 540,000

Factory Ledger Control Account (FLC a/c)

SPOTLIGHT
Rupees Rupees

Balance b/f 125,000

Payables 77,000 Cost of sales 511,250

Salaries & Wages 96,000

Payables 250,000

Cost of sales 44,000 Balance c/f 80,750

STICKY NOTES
592,000 592,000

Cost of Sales

Rupees Rupees

Factory ledger control a/c 511,250 Factory ledger control a/c 44,000

Profit & loss control a/c 467,250

540,000 540,000

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Cost ledger control account (CLC)

This account is a summary account in the cost ledger that ensures double-entry bookkeeping and reconciles
with the financial ledger. Its main objective is to complete the double-entry system within the cost ledger,
ensuring that debits and credits balance. Since cost ledgers often don't include personal accounts (like cash or
bank), all transactions that originate in the financial accounts are recorded in the cost ledger through the CLC
account. For example, if materials are purchased against cash, the entry in the cost ledger would be: debit
Inventory Ledger Control Account and credit CLC Account.
 Illustration:
The following diagram provides an overview of the various ledger accounts and the flow of information
represented by the accounting entries used within fully interlocking accounts.
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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4 SELF-TEST QUESTIONS
 Question 01:
Mr. Azad had provided you the following information from his factory ledger for the quarter ended 31
December 2005.

Rs.
Control account balances as on October 1, 2005
Materials 49,500
Work in process 60,100
Finished goods 115,400

AT A GLANCE
Transaction for quarter ended 31 December 2005
Material purchased 108,000
Direct wages 50,200
Payments for factory overheads 30,900
Depreciation of factory building and machine 42,000

Other related information is as under:

• Closing stock of raw materials and finished goods at December 31, 2005 amounted to Rs. 50,300 and Rs.
125,800 respectively.

SPOTLIGHT
• Cost of goods produced is Rs. 222,500.
• Factory overheads are absorbed in production @ 160% of direct wages.
• Diesel costing Rs. 2,000 included in the factory overheads was transferred to head office for use in
generator.
• A bill for repairs amounting to Rs. 12,000 undertaken at the factory remained unpaid at the end of the
quarter.
• Material costing Rs. 2,400 was destroyed by rain.
Required

STICKY NOTES
Prepare Materials, Work in process, Finished goods, Factory overheads and Cost of sales ledgers.
 Solution
Preparation of Materials, Work in process, finished goods, Factory overheads and Cost of sales ledgers are
given below.

Materials
Rupees Rupees
Balance b/f 49,500 Profit & Loss 2,400
Purchase 108,000 Work in process (Bal) 104,800
Balance c/f 50,300
157,500 157,500

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Work in process
Rupees Rupees
Balance b/f 60,100 Finished goods 222,500
Wages 50,200
Factory overhead 80,320
Materials 104,800 Balance c/f 72,920
295,420 295,420

Finished Goods
AT A GLANCE

Rupees Rupees
Balance b/f 115,400 Cost of sales 212,100
Work in process 222,500 Balance c/f 125,800
337,900 337,900

Factory overheads
Rupees Rupees
Cash 30,900 Work in process 80,320
SPOTLIGHT

Accumulated 42,000 General ledger 2,000

depreciation
Payables 12,000 Cost of sales 2,580
84,900 84,900

Cost of sales
Rupees Rupees
Finished goods 212,100 Profit and loss 214,680
STICKY NOTES

Factory overheads 2,580

214,680 214,680

 Question 02:
The incomplete cost accounts for a period of Company A are given below:

Store ledger control account

Rs. 000 Rs. 000
Opening balance 2,640
Financial ledger control 3,363
Production wages control account
Rs. 000 Rs. 000
Financial ledger control 2,940

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Production overhead control account

Rs. 000 Rs. 000
Financial ledger control 1,790
Work in process control account
Rs. 000 Rs. 000
Opening balance 1,724

The balances at the end of the period in Rs. 000 were:

Store ledger Rs. 2,543
WIP ledger Rs. 2,295

AT A GLANCE
During the period 65,000 kilos of direct material were issued from stores at a weighted average price of Rs. 48
per kilo. The balance of materials issued from stores represented indirect materials.
Two thirds of the production wages are classified as ‘direct’. Average gross wage of direct workers was Rs. 20
per hour. Production overheads are absorbed at a predetermined rate of Rs. 30 per direct labour hour.
Goods were delivered immediately after completion, as no finished goods store is maintained.
Required
Complete cost accounts for the period.
 Solution
Completion of cost accounts for the period, are given below:

SPOTLIGHT
Store ledger control account
Rs. 000 Rs. 000
Opening balance 2,640 Work in process control (65,000x48)
3,120
Financial ledger control 3,363 Production overheads (Bal) 340
Closing balance 2,543
6,003 6,003
Production wages control account
Rs. 000 Rs. 000

STICKY NOTES
Financial ledger control 2,940 Work in process control (2,940,000
x 2/3) 1,960
Production overheads (Bal) 980
2,940 2,940
Production overhead control account
Rs. 000 Rs. 000
Financial ledger control 1,790 Work in process control (1,960,000
x 30/20) 2,940
Store ledger control 340
Production wages 980 Cost of sales (Under absorbed) 170
control
3,110 3,110

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Work in process control account

Rs. 000 Rs. 000
Opening balance 1,724 Cost of sales 7,449
Store ledger control 3,120
Production wages 1,960 Closing balance 2,295
control
Production overhead 2,940
control
9,744 9,744

 Question 03:
AT A GLANCE

The following information is available for the month of December 2000 of Khalid Enterprises:

Rs.
Accounts payable December 01 6,000
Work in process December 01 30,000
Finished goods December 01 50,000
Materials December 31 15,000
Accounts payable December 31 10,000
Finished goods December 31 60,000
Actual factory overheads 150,000
SPOTLIGHT

Cost of sales 300,000

Payment of accounts payable used only for material purchases 35,000

Factory overhead is applied at 200% of direct labour cost. Jobs still in process on December 31, have been
charged Rs. 6,000 for material and Rs. 12,000 for direct labour hours (1,200 hours). Actual direct labour hours
10,000 @ Rs. 8.00 per hour.
Required
Calculate material purchases, cost of goods manufactured, applied factory overheads, Work in process
December 31, Material used, Materials as on December 01 and under or over applied factory overhead.
STICKY NOTES

 Solution
Calculation of material purchases, cost of goods manufactured, applied factory overheads, Work in process
December 31, Material used, Materials as on December 01 and under or over applied factory overhead, along
with relevant ledgers, are given below:

Materials Inventory
Rs. Rs.
Balance b/f (Bal. Fig.) 58,000 Work in progress 82,000
Purchases 39,000 Balance c/f 15,000
97,000 97,000
Accounts payable
Rs. Rs.
Cash 35,000 Balance b/f 6,000
Balance c/f 10,000 Purchases (Balancing figure) 39,000
45,000 45,000

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Work in process
Rs. Rs.
Balance b/f 30,000
Materials (Bal. Fig.) 82,000 Finished goods 310,000
Payroll 80,000
Production overheads 160,000 Balance c/f W-2 42,000
W-1
352,000 352,000
Finished goods

AT A GLANCE
Rs. Rs.
Balance b/f 50,000 Cost of sales 300,000
Work in process (Bal. 310,000 Balance c/f 60,000
Fig.)
360,000 360,000
Production overheads
Rs. Rs.
Cash 150,000 Work in process 160,000

SPOTLIGHT
Cost of sales 10,000
160,000 160,000
Cost of sales
Rs. Rs.
Finished goods 300,000 Production overheads 10,000
Profit & Loss 290,000
290,000 290,000

STICKY NOTES
W-1 Factory overhead applied and over absorbed overheads Rs.
Factory overhead applied (80,000 x 200%) 160,000
Actual factory overheads 150,000
Over absorbed overheads 10,000

W-2 Closing inventory of work in process Rs.

Materials 6,000
Labour 12,000
Factory overhead applied (12,000 x 200%) 24,000
42,000

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 Question 04:
At 1 July a manufacturing company had the following balances in the general ledger adjustment account in its
cost ledger:

Rs.
Balance brought forward (credit) 5,625
Stores ledger control account 2,125
Finished goods stock control account 1,500
Work in progress control account 2,000
AT A GLANCE

Following items occurred in the four-month period up to 31 October.

Stock material purchased 12,000

Stock materials issued to production 12,500
Stock materials issued to maintenance department 1,000
Wages – direct 10,830
Included in direct wages is indirect work 600
Factory overheads incurred 4,200
Factory overheads absorbed into production 5,800
SPOTLIGHT

Work transferred to finished stock, at cost 24,000

Factory cost of sales 22,500
Sales at selling price 28,750
Administrative and selling costs (to be written off against profits) 4,250

Required
Open general ledger and ledger accounts for the inventory items in the cost ledger, post the items which
occurred in the four-month period up to 31 October and open up other accounts as considered necessary,
including a costing profit and loss account.
STICKY NOTES

General ledger control a/c

Rs. Rs.
Balance b/d 5,625
Sales account 28,750 Stores 12,000
Wages 10,830
Production overhead 4,200
Administration and selling expenses 4,250
Balance c/d 10,155 Profit and loss a/c 2,000
38,905 38,905
Balance b/d 10,155

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Stores ledger control a/c

Rs. Rs.
Balance b/d 2,125 Work in progress 12,500
General ledger control 12,000 Production overhead 1,000
Balance c/d 625
14,125 14,125
Balance b/d 625
Wages control a/c
Rs. Rs.

AT A GLANCE
General ledger control 10,830 Production overhead 600
Work in progress 10,230
10,830 10,830
Production overhead control a/c
Rs. Rs.
Stores ledger control 1,000 Work in progress 5,800
Wages control 600
General ledger control 4,200

SPOTLIGHT
5,800 5,800
Administration and selling expenses control a/c
Rs. Rs.
General ledger control 4,250 Profit and loss a/c 4,250
4,250 4,250
Sales a/c
Rs. Rs.

STICKY NOTES
Profit and loss a/c 28,750 General ledger control 28,750
28,750 28,750
Work in progress control a/c
Rs. Rs.
Balance b/d 2,000 Finished goods control 24,000
Stores 12,500
Wages 10,230
Production overhead 5,800 Balance c/d 6,530
30,530 30,530
Balance b/d 6,530

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Finished goods control a/c

Rs. Rs.
Balance b/d 1,500 Cost of sales 22,500
Work in progress 24,000
Balance c/d 3,000
25,500 25,500
Balance b/d 3,000
Cost of goods sold
Rs. Rs.
AT A GLANCE

Finished goods stock 22,500 Profit and loss a/c 22,500

22,500 22,500
Profit and loss a/c
Rs. Rs.
Cost of goods sold 22,500 Sales 28,750
Administration and 4,250
selling expenses
Profit (to general ledger 2,000
SPOTLIGHT

control)
28,750 28,750

 Question 05:
Kaat Ltd operates separate cost accounting and financial accounting systems. The following manufacturing and
trading statement has been prepared from the financial accounts for the quarter ended 31 March.

Rs. Rs.
Raw materials
Opening stock 48,000
STICKY NOTES

Purchases 108,800
156,800
Closing stock (52,000)
Raw materials consumed 104,800
Direct wages 40,200
Production overhead 60,900
Production cost incurred 205,900
Work in progress
Opening stock 64,000
Closing stock (58,000) 6,000
Cost of goods produced carried down 211,900

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Sales 440,000
Cost of goods sold
Finished goods opening stock 120,000
Cost of goods produced brought down 211,900
331,900
Finished goods closing stock (121,900) (210,000)
Gross profit 230,000

The following information has been extracted from the cost accounts:

AT A GLANCE
Control account balances at 1 January

Rs.
Raw material stores 49,500
Work in progress 60,100
Finished goods 115,400

Transactions for the quarter

Rs.
Raw materials issued 104,800

SPOTLIGHT
Cost of goods produced 222,500
Cost of goods sold 212,100
Loss of materials damaged by flood (insurance claim pending) 2,400

A notional rent of Rs.4,000 per month has been charged in the cost accounts. Production overhead was
absorbed at the rate of 185% of direct wages. Profit at the end of the period is shown as Rs.238,970.
Required
a) Prepare the following control accounts in the cost ledger:
i. Raw materials stores

STICKY NOTES
ii. Work in progress
iii. Finished goods
iv. Production overhead.
 Solution Preparation of the relevant control accounts in the cost ledger, would be as follows:

Raw materials stores a/c

Rs. Rs.
Balance b/f 49,500 Work in progress 104,800
Purchases 108,800 Loss due to flood 2,400
Balance c/f 51,100
158,300 158,300
Balance b/f 51,100

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Work in progress control a/c

Rs. Rs.
Balance b/f 60,100 Finished goods 222,500
Raw materials 104,800 Balance c/f 56,970
Direct wages 40,200
Production overhead 74,370
279,470 279,470
Balance b/f 56,970
Finished goods control a/c
AT A GLANCE

Rs. Rs.
Balance b/f 115,400 Cost of sales 212,100
Work in progress 222,500 Balance c/f 125,800
337,900 337,900
Balance b/f 125,800
Production overhead
Rs. Rs.
General ledger control 60,900 Work in progress 74,370
SPOTLIGHT

Notional rent 12,000

Overhead 1,470
overabsorbed
74,370 74,370

 Question 06
Sapphire limited (SL) fabricates parts for auto manufacturers and follows job order costing. The company’s
head office is situated in Lahore but the factory is in Karachi. A separate set of records is kept at the head
office and at the factory. Following details were extracted from SL’s records for the month of February 20X4.
STICKY NOTES

Jobs
A B C
Materials issued to production (units)
Material X 40,000 - 10,000
Material Y - 75,000 25,000
Direct labour hours worked (hours) 6,000 9,000 15,000
Labour rate per hour (Rs.) 75 60 65

The other related information is as follows:

i. Materials purchased on account:
• 100,000 units of material X at Rs. 25 per unit
• 150,000 units of material Y at Rs. 35 per unit

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ii. The head office prepared the payroll and deducted 8% for payroll taxes. The payroll amounted to Rs. 3.0
million out of which Rs. 1.0 million pertained to selling and administrative staff salaries. After charging
direct labour cost to each job the balance amount of payroll cost was attributed to general factory
overhead.
iii. Factory overhead was applied to the jobs at Rs. 25 per direct labour hour.
iv. Actual factory overheads amounted to Rs. 700,000 including depreciation on machinery amounting to Rs.
400,000. All payments were made by head office.
v. Over or under-applied factory overheads are closed to cost of goods sold account.
vi. Jobs A and B were completed during the month. Job A was sold for Rs. 2.0 million to one of the auto
manufacturers on credit. The customer however, agreed to settle the transaction at 2% cash discount.

AT A GLANCE
vii. Selling and administrative expenses, other than salaries paid during the month were Rs. 500,000.
Required
Record journal entries to record all the above transactions in SL’s factory ledger and general ledger for the
month of February 20X4.
 Solution
Journal entries to record all the above transactions in SL’s factory ledger and general ledger for the month of
February 20X4, would be prepared as follows:

General Journal entries

Factory Ledger General Ledger

SPOTLIGHT
Particulars Particulars
Debit Credit Debit Credit
Material X 2,500,000 Factory Ledger 7,750,000
Material Y 5,250,000 Trade Creditors 7,750,000
General Ledger 7,750,000
(Purchase of material)
Payroll 2,000,000 Factory Ledger 2,000,000
General Ledger 2,000,000 Selling and administrative 1,000,000
expenses

STICKY NOTES
Accrued Payroll 2,760,000
(Payroll accrual) Payroll taxes 240,000
No Entry Accrued payroll 2,760,000
Payroll Taxes 240,000
Bank 3,000,000
(Payment of payroll & taxes)
Work in process A 1,000,000
Work in process B 2,625,000
Work in process C 1,125,000 No Entry
Material X 1,250,000
Material Y 3,500,000

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General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
(Issuance of raw material to WIP)
Work in process A 450,000
Work in process B 540,000
Work in process C 975,000 No Entry
Factory overheads 35,000
Payroll 2,000,000
AT A GLANCE

(Direct labour cost allocated to WIP)

Work in process A 150,000
Work in process B 225,000
Work in process C 375,000 No Entry
Factory overheads - applied 750,000

(Factory overheads applied to WIP)

SPOTLIGHT

Factory overheads 700,000 Factory Ledger 700,000

General Ledger 700,000 Bank 300,000
Accumulated Depreciation 400,000
(Actual factory overheads transferred)
Factory overheads - applied 15,000 Factory Ledger 15,000
General Ledger 15,000 Cost of goods sold 15,000
STICKY NOTES

(Over applied overheads transferred to cost of goods sold)

Finished goods A 1,600,000
Finished goods B 3,390,000 No Entry
Work in process A 1,600,000
Work in process B 3,390,000

(Jobs A and B completed and transferred to finished goods)

General Ledger 1,600,000 Cost of goods sold 1,600,000
Finished goods A 1,600,000 Factory Ledger 1,600,000

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General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
(Job A delivered and transferred to cost of goods sold)
No Entry Trade Debtors 2,000,000
Sales 2,000,000
(Job A sold to customer)
No Entry Bank 1,960,000
Cash discount 40,000

AT A GLANCE
Trade debtors 2,000,000
(Amount realized from
customer)
No Entry Selling and administrative 500,000
expenses
Bank 500,000
(Payment of Selling and admin.
Expenses)

 Question 07:

SPOTLIGHT
Mirza Limited is engaged in the manufacturing of spare parts for automobile industry. The company records
the purchase and issue of materials in a store ledger which is not integrated with the financial ledger. It is the
policy of the company to value inventories on weighted average basis. The valuation is carried out by the
Finance Department using stores memorandum record. A physical stock count is carried out after every six
months. Any shortage/excess is then adjusted in the financial as well as stores ledger.
On December 31, 20X3, physical stock count was conducted by the Internal Auditor of the company. He
submitted the following statement to the Finance Department:

Balance (in units) Cost per unit (Rs.)

Item Code Financial

STICKY NOTES
Store Ledger Physical Average Current
Records

010-09 20,500 20,500 20,000 2.00 2.25

013-25 10,000 10,000 10,000 4.00 1.50

017-10 5,500 5,500 5,000 1.00 1.10

022-05 4,000 4,500 5,500 2.00 2.00

028-35 1,200 1,200 1,000 2.75 2.50

035-15 640 600 600 3.00 3.50

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On scrutinizing the details, Finance Department was able to ascertain the following reasons:

Item Code Reasons

010-09 500 units were defective and therefore the Internal Auditor excluded them while taking the
physical count.
013-25 This item is not in use and is considered obsolete. The net realizable value is Rs. 0.60 per unit.
017-10 Shortage is due to theft.
022-05 A receipt of 1,000 units was not recorded. The remaining difference is due to errors in
recording the quantity issued.
028-35 200 units returned to a supplier were not recorded. The invoiced cost was Rs. 3 per unit.
AT A GLANCE

035-15 Discrepancy is due to incorrect recording of a Goods Receipt Note.

Required
b) Prepare necessary Journal entries to record the adjustments in the financial ledger.
c) State how would you make the necessary adjustments in the store ledger.
 Solution
a) Journal Entries in Financial Ledger

Dr. Cr.
---- Rupees ----
SPOTLIGHT

(i) Cost of sales/ FOH/ Abnormal loss 1,000

Stores Ledger A/c 1,000
(Record the normal loss of item # 010-09)
(ii) Cost of sales/ FOH 34,000
Provision for obsolescence 34,000
(Record the provision for obsolescence against item # 013-25)
(iii) Cost of sales/ FOH/ Abnormal loss 500
Stores Ledger A/c 500
STICKY NOTES

(Record the theft of item # 017-10)

(iv) (a) Stores Ledger A/c 2,000
Creditors / Cash 2,000
(Record the purchase of items # 022-05)
(b) No adjustment
(v) Creditors/ Cash 600
Stores Ledger A/c 600
(Record the return of item # 028-35)
(vi) No adjustment

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b) Recording in Stores Ledger

i. The quantity should be shown as issued in the store ledger.
ii. No adjustment.
iii. 500 units should be shown in the issue column and adjust the balance accordingly.
iv. a) 1,000 units should be recorded on the receipt side of individual stores ledger
account.
b) The issue column of the individual store ledger account should be reduced by 500 units.
v. 200 units should be reduced from the receipt and accordingly adjust the balance columns of the
individual store ledger account.
vi. The postings of incorrectly recorded Goods Receipt Note should be corrected.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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STICKY NOTES

The objective of accounting for production of inventory is to record and mirror

the cost throughout the production process.

The cost flows from:

• material account, wages control account,
AT A GLANCE

production overhead account to WIP account;

• then to finished goods accounts; and
• ultimately to Profit and loss account.

Cost book-keeping systems can be categorized into two types in terms of how
the cost accounts relate to other ledger accounts:
• integrated accounts;
• interlocking accounts.
SPOTLIGHT

Integrated accounts combine both financial and cost accounts in one system of
ledger accounts. A reconciliation between cost and financial profits is not
necessary with an integrated system.

Interlocking accounts are recorded in factory ledger for cost accounts and
general ledger for other accounts, which are readily reconcilable.
STICKY NOTES

178 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 6

JOB AND
SERVICE COSTING

AT A GLANCE

AT A GLANCE
IN THIS CHAPTER A costing method is one which is designed to suit the way goods
are processed or manufactured or the way that services are
AT A GLANCE provided.
A job is a cost unit which consists of a single order or contract.
SPOTLIGHT Job costing is a basic cost accounting method applicable where
work consists of separate contracts, jobs or batches.
1. Job costing
The cost of a job consists of direct material cost, direct labour
cost, direct expenses, production overheads and administrative,
2. Service costing
selling and distribution overheads.
3. Self-test questions Service organisations do not make or sell tangible goods. Service
costing differs from other costing methods. With many services
STICKY NOTES

SPOTLIGHT
the cost of direct materials consumed will be relatively small
compared to labour, direct expenses and overheads cost.
The output of most service organisations is often intangible and
difficult to define. A unit cost is therefore difficult to calculate.
Specific characteristics of services are intangibility, simultaneity,
perishability and heterogeneity.

STICKY NOTES

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1 JOB COSTING
1.1 The nature of job costing
Job costing is used when a business entity carries out tasks or jobs to meet specific customer orders. Although
each job might involve similar work, they are all different and are carried out to the customer’s specific
instructions or requirements. In order words, job order costing is used in situations where many different
products are manufactured each period on request of customer.
Examples of ‘jobs’ include:
• work done for customers by builders or electricians;
• audit work done for clients by a firm of auditors;
• repair work on motor vehicles by a repair firm;
AT A GLANCE

• printing work, where printing job is done on the specification of customers, not readily available for sales.
It is simplest method of costing, where each job is assigned a unique job number and all direct cost is allocated
to respective jobs as they are incurred. However, indirect cost is assigned to job costing mostly on absorption
costing principle. Marginal costing may also be used depending upon the policy of company.
1.2 The cost of a job
As discussed in above paragraph, each job is given unique number for the purpose of measuring profit of each
job, after allocating the costs to each job.
Job costing differs from most other types of costing system because every job is a cost unit which consists of a
single order or contract and the costing is being done for every job separately. The expected cost of a job has to
be estimated so that a price for the job can be quoted to a customer.
SPOTLIGHT

The features of Job costing are as follows:

• Work is undertaken to customer’s special attention, thus, creating flexibility in creating customer demands.
For example, specific design of furniture on request of customer is manufactured.
• Normally, each job takes short period of time, but still there might be chance of getting large order.
• Jobs move through processes and operations as a continuously identifiable unit.
• Each job usually differs in one or more respects from every other job and therefore a separate record must
be maintained to show the details of a particular job.
• Job costs are allocated on a job cost sheet or job cost card.
• Rectification work is the cost of rectifying substandard work. It is to be charged as direct cost of the job
STICKY NOTES

concerned if not a frequent occurrence and can be directly attributable to a job. It is to be treated as
production overhead if regarded as normal part of the work and it is of recurring nature.
A job costing system is usually based on absorption costing principles, and in addition a cost is included for
non-production overheads, as follows.
Illustration: Job cost Rs.
Direct materials 500
Direct labour 300
Direct expenses 200
Prime cost 1,000
Production overhead absorbed 750
Production cost of the job 1,750
Non-production overheads 400
Total job cost 2,150

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In many cases, job costs include not just direct materials costs and direct labour costs, but also direct
expenses, such as:
• the rental cost of equipment hired for the job
• the cost of work done for the job by sub-contractors
• the depreciation cost of equipment used exclusively on the job.
Production overheads might be absorbed on any suitable base as discussed in Chapter 3.
Non-production overheads might be added to the cost of the job:
• as a percentage of the prime cost of the job, or
• as a percentage of the production cost of the job.

AT A GLANCE
1.3. Job cost card or sheet
A job order cost sheet or card is a form prepared for a job that record all manufacturing costs both direct and
indirect and also non-manufacturing costs absorbed to specific job. It includes details of materials issued along
with quantities; direct labour including time consumed on each job and other direct expenses incurred in
connection with specific job. Indirect manufacturing cost and non-manufacturing costs are absorbed into
product or service cost on the basis of absorption rate as discussed in section 1.2. above.
Following examples reflect process of recording the costs into job order cost sheet or card.
 Example 01:
The following cost information has been gathered about Job number 453.

SPOTLIGHT
The direct materials cost is Rs.10,000, the direct labour cost is Rs.6,000 and direct expenses are Rs.4,000.
Direct labour costs Rs.20 per hour. Production overheads are charged at the rate of Rs.30 per direct labour
hour and non-production overheads are charged at the rate of 40% of prime cost. Total production of job
number 453 is 5,000 units.
Required:
Calculate the total production cost and unit cost for Job 453.
 Solution:
The job cost and unit cost for Job 453 is calculated as follows:

Job cost: Job 453 Rs.

STICKY NOTES
Direct materials 10,000
Direct labour 6,000
Direct expenses 4,000
Prime cost 20,000
Production overhead (6,000 x 30/20) 9,000
Production cost of the job 29,000
Non-production overheads (40% of prime cost i.e. Rs. 20,000) 8,000
Total job cost 37,000
Unit cost of job (37,000 / 5,000) 7.40

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 Example 02:
A company operates a job costing system. Job number 6789 will require Rs.3,450 of direct materials and
Rs.2,100 of direct labour, which is paid Rs.14 per hour. Production overheads are absorbed at the rate of Rs.30
per direct labour hour and non-production overheads are absorbed at the rate of 30% of production cost.
Expected sales price of the job, assuming above order contains 1,000 units and company expects 20% markup.
Required:
Calculate the unit sale price for job number 6789.
 Solution:

Rs.
AT A GLANCE

Direct materials 3,450

Direct labour 2,100
Prime cost 5,550
Production overheads (2,100 × Rs.30/ Rs. 14) 4,500
Full production cost 10,050
Non-production overheads (30% × Rs.10,050) 3,015
Full cost of sale for the job 13,065
Add: Markup at 20% 2,612
Sales value of job 15,678
SPOTLIGHT

Unit sales price (15,678/ 1,000) 15.68

1.4 Cost records and accounts for job costing

In order to establish the cost of each individual job in a costing system, it is necessary to have procedures for
recording direct costs in such a way that they can be allocated to specific jobs. Production overheads and non-
production overheads can be charged using overhead absorption rates within a system of absorption costing.
The procedure with accounting entry of each cost charged to job is given in following paragraphs.

Accounting for Materials

STICKY NOTES

Debit Credit
Purchases of materials
Materials control X
Accounts payable X

Purchase returns of materials

Accounts payable X
Materials control X

Issuance of direct materials to job

Work in progress- Job No. 123 X
Materials control X

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Debit Credit
Return of excess direct materials from job
Materials control X
Work in progress- Job No. 123 X

Issuance of indirect materials to job

Production overhead control X
Materials control X

Accounting for Labour

AT A GLANCE
Debit Cresdit
Recording of payroll
Salaries & Wages control X
Accrued payroll (Assuming no deductions) X
Recording of direct and indirect labour
Work in progress- Job No. 123 X
Production overhead control X
Salaries & wages control X

SPOTLIGHT
Accounting for Production overheads

Debit Credit
Recording of actual production overheads
Production overhead control X
Payable or cash or other credits X

STICKY NOTES
Record production depreciation within overheads
Production overhead control X
Accumulated depreciation X
(assets used in production)

Absorption of production overheads to jobs

Work in progress- Job No. 123 X
Production overhead control X

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Accounting for completion and sales of job

Debit Credit
Completion of job and delivering it to customer without storing in finished goods
Cost of sales X
Work in progress-Job No. 123 X

Completion of job and delivering it to finished goods’ store followed by transferring to the
customer
Finished Goods X
AT A GLANCE

Work in progress-Job No. 123 X

Cost of Sales X
Finished Goods X

Sales of job
Accounts receivables X
Sales X
SPOTLIGHT

This job order cost flow (as just explained through journal entries) is further elaborated through the following
diagram.
STICKY NOTES

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Illustration: Job cost account

Work in process account: Job 123
Rs. Rs.
Materials control 1,800 Finished Goods / Cost of sales 7,800
Salaries & wages control 3,000
Production overhead control 3,000
7,800 7,800

When the job is finished, the total cost is transferred to either the finished goods account or the cost of sales,

AT A GLANCE
depending on whether the goods are first stored in the finished goods store..
 Example 03:
The following information relates to job activity in the month of June.

Job 0503 Job 0402 Job 0607

Contract price Rs. 500,000 Rs. 980,000 Rs. 600,000
Commenced 3 May 2 April 7 June
Completed 25 June Not completed 19 June
Opening WIP comprised: Nil
Direct materials (all material X) Rs. 5,000 Rs. 10,000

SPOTLIGHT
Direct labour (all grade A) Rs. 10,000 Rs. 18,000
Variable production overheads Rs. 12,000 Rs. 21,600
Fixed production overhead Rs. 12,800 Rs. 23,040
Rs. 39,800 Rs. 72,640
Material issues from stores:
Material X 200 kgs 800 kgs 900 kgs
Material Y 400 kgs 600 kgs
Labour
Grade A 60 hours 120 hours 150 hours

STICKY NOTES
Grade B 25 hours 100 hours 20 hours
Costs:
Material X Rs. 220 per kg
Material Y Rs. 500 per kg
Grade A Rs. 250 per hour
Grade B Rs. 400 per hour
Variable overhead recovery rate Rs. 300 per hour
Fixed production overhead is absorbed using direct labour hours
Budgeted fixed production overhead Rs. 160,000
Budgeted labour hours 500 hours
Actual fixed production overhead expenditure in the period Rs. 161,000

The company needed to hire a special machine for job 0402 at a cost of Rs. 5,000 in the current month.

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20 kgs of raw material were returned to stores on completion of job 0607.

For internal profit reporting purposes administration and marketing expenses are added to cost of sales at
20% of full product cost at the time of completion of the job. Actual administration and marketing expense in
the period were Rs. 130,000.
(Note: The system suggested is similar to that for the receivables control account backed up by the receivables
ledger. In this case there is a WIP control account backed up by the job costing ledger).
Required:
Prepare the following:
a) Schedule of Resources
b) Journal entries to record costs in the job accounts
AT A GLANCE

c) Job cost accounts (Ledgers)

d) Job cost cards
e) Journal entries to record costs in the general ledger (Assuming that the company operates a system using a
control account in its general ledger for jobs show the double entry (as T-accounts) to account for job
activity in the period)
a) Task 1 – Schedule of resources used in month

Material X Kgs Cost per kg Rs.

Job 0503: 200 220 44,000
Job 0402 800 220 176,000
SPOTLIGHT

Job 0607 900 220 198,000

Less returns (20) 220 (4,400)
880 220 193,600
1,880 220 413,600
Material Y Kgs Cost per kg Rs.
Job 0503: 400 500 200,000
Job 0402 600 500 300,000
STICKY NOTES

1,000 500 500,000

Labour grade A Hours Cost per hour Rs.
Job 0503: 60 250 15,000
Job 0402: 120 250 30,000
Job 0607: 150 250 37,500
330 250 82,500
Labour grade B Hours Cost per hour Rs.
Job 0503: 25 400 10,000
Job 0402: 100 400 40,000
Job 0607: 20 400 8,000
145 400 58,000

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Variable overhead Hours Cost per hour Rs.

Job 0503: 60 + 25 = 85 300 25,500
Job 0402: 120 + 100 = 220 300 66,000
Job 0607: 150 + 20 = 170 300 51,000
475 300 142,500
Fixed overhead Hours Cost per hour Rs.
Job 0503: 85 320 27,200
Job 0402: 220 320 70,400

AT A GLANCE
Job 0607 170 320 54,400
475 320 152,000

b) Task 2 – Journal entries to record costs in the job accounts

Debit Credit
Issues of Material X
Job 0503 account 44,000
Job 0402 account 176,000
Job 0607 account 198,000

SPOTLIGHT
Material X inventory account 418,000
Returns of Material X
Material X inventory account 4,400
Job 0607 account 4,400
Issues of Material Y
Job 0503 account 200,000
Job 0402 account 300,000
Material Y inventory account 500,000

STICKY NOTES
Grade A labour
Job 0503 account 15,000
Job 0402 account 30,000
Job 0607 account 37,500
Salaries & Wages control account 82,500
Grade B labour
Job 0503 account 10,000
Job 0402 account 40,000
Job 0607 account 8,000
Salaries & Wages control accounts 58,000

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Debit Credit
Variable overhead
Job 0503 account 25,500
Job 0402 account 66,000
Job 0607 account 51,000
Production overhead control account 142,500
Fixed overhead
Job 0503 account 27,200
Job 0402 account 70,400
AT A GLANCE

Job 0607 account 54,400

Production overhead control account 152,000
Hire cost
Job 0402 account 5,000
Cash 5,000
Transfer of costs on completed sales
Cost of sales account 706,000
Job 0503 Account 361,500
SPOTLIGHT

Job 0607 Account 344,500

Note: Those jobs that are not closed in June, are reflected as closing balances of their respective job
accounts.
c) Task 3 – Job cost accounts

Job 0503
Rs. Rs.
Balance b/d 39,800
STICKY NOTES

Issues from stores:

Material X 44,000
Material Y 200,000
Labour:
Grade A 15,000
Grade B 10,000
Variable overhead 25,500
Fixed overhead 27,200 Cost of sales 361,500
361,500 361,500

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Job 0402
Rs. Rs.
Balance b/d 72,640
Issues from stores:
Material X 176,000
Material Y 300,000
Labour:
Grade A 30,000
Grade B 40,000

AT A GLANCE
Variable overhead 66,000
Fixed overhead 70,400

Machine hire 5,000 Balance c/d 760,040

760,040 760,040
Job 0607
Rs. Rs.
Issues from stores: Returns to stores
Material X 198,000 Material X 4,400

SPOTLIGHT
Labour:
Grade A 37,500
Grade B 8,000
Variable overhead 51,000
Fixed overhead 54,400 Cost of sales 344,500
348,900 348,900

d) Task 4–Job cost cards (showing the resources allocated to the jobs and the allocation of administration
and marketing expenses for the jobs completed in the period. Also incorporate the revenue for the
period and show the profit or loss on those jobs completed)

STICKY NOTES
Job 0503 Job 0402 Job 0607
Material X
In opening WIP 5,000 10,000 -
In period 44,000 176,000 193,600
49,000 186,000 193,600
Material Y (in period) 200,000 300,000
Grade A labour
In opening WIP 10,000 18,000 -
In period 15,000 30,000 37,500
25,000 48,000 37,500
Grade B labour 10,000 40,000 8,000

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Job 0503 Job 0402 Job 0607

Variable overhead
In opening WIP 12,000 21,600
In period 25,500 66,000 51,000
37,500 87,600 51,000
Fixed overhead
In opening WIP 12,800 23,040
In period 27,200 70,400 54,400
40,000 93,440 54,400
Machine hire 5,000
AT A GLANCE

Factory cost 361,500 760,040 344,500

Administration and marketing @ 20% 72,300 68,900
Cost of sale 433,800 413,400
Contract price 500,000 600,000
Profit 66,200 186,600

e) Task 5– Journal entries to record costs in the general ledger (Assuming that the company operates a
system using a control account in its general ledger for jobs show the double entry (as T-accounts) to
account for job activity in the period)
The following journals were not asked for but they are included to help you to understand the double
SPOTLIGHT

entry in the general ledger.

Debit Credit
a Issues of Material X
WIP control account 418,000
Inventory control account 418,000
b Returns of Material X
Inventory control account 4,400
WIP control account 4,400
c Issues of Material Y
STICKY NOTES

WIP control account 500,000

Inventory control account 500,000
d Grade A labour
WIP control account 82,500
Payroll control account 82,500
e Grade B labour
WIP control account 58,000
Payroll control account 58,000
f Variable overhead
WIP control account 142,500
Variable overhead account 142,500

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Debit Credit
g Fixed overhead
WIP control account 152,000
Fixed production overhead account 152,000
h Hire cost
WIP control account 5,000
Cash 5,000
i Transfer of costs on completed sales
Cost of sales account

AT A GLANCE
Job 0503 361,500
Job 0607 344,500
706,000
WIP control account 706,000

WIP control
Rs. Rs.
Balance b/d

SPOTLIGHT
Job 0503 39,800
Job 0402 72,640
112,440
a) Inventory control 418,000 b) Inventory control 4,400
c) Inventory control 500,000
d) Payroll control 82,500
e) Payroll control 58,000
f) Var. overhead 142,500

STICKY NOTES
g) Fixed overhead 152,000
h) Hire cost 5,000 i) Cost of sales 706,000
Balance c/d 760,040
1,470,440 1,470,440
Balance b/d 760,040
Cost of sales
i) WIP control a/c 706,000
Fixed production overhead
Balance b/d 161,000 g) WIP control a/c 152,000
(Actual spend)

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We now need to recognize the following entries. Once again journals are provided for your
convenience.

Debit Credit
j Administration and marketing mark-up (20% of cost of sales figure)
Profit & Loss (20% of 706,000) 141,200
Administration and marketing control a/c 141,200
Note that this is the same sum of the two figures shown on the job cost
card in task 4 (72,300 + 68,900)
k Transfer of balance on cost of sales to the income statement
Profit & Loss 706,200
AT A GLANCE

Cost of sales account 706,200

l Under recovery of fixed production overhead
Profit & Loss (161,000 – 152,000) 9,000
Fixed production overhead account 9,000
m Over recovery of administration and marketing overhead
Administration and marketing control a/c 11,200
Profit & Loss (141,200 – 130,000) 11,200
n Recognition of revenue on finished jobs
Receivables (500,000 + 600,000) 1,100,000
SPOTLIGHT

Income statement 1,100,000

 Example-04:
Ahmer and Company is engaged in production of engineering parts. It receives bulk orders from bicycle
manufacturers and follows job order costing. On July 1, 20X3 two jobs were in progress whereas two jobs were
opened during the year. The details are as follows:

JOBS
A B C D
Work in process – opening (Rs.) 1,400,000 2,500,000 - -
Raw material issued from stores (Rs.) 800,000 1,200,000 1,500,000 600,000
STICKY NOTES

Direct labour hours worked (Hours) 20,000 30,000 15,000 18,000

Rate of direct labour per hour (Rs.) 20 18 16 15

Other related information is as follows:

i. Factory overhead is applied to the jobs at Rs. 10 per labour hour.
ii. Actual factory overheads for the year amounted to Rs. 900,000.
iii. Under/over applied factory overheads are charged to profit and loss account.
iv. Job A was completed during the year. All the goods were shipped to the customers.
v. Job B was also completed during the year. However, about 10% of the goods were rejected during
inspection. These were transferred to Job C where they will be used after necessary adjustments.
Required:
Prepare journal entries to record all the above transactions.

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 Solution:
Journal entries to record all the above transactions can be prepared as follows:
General Journal entries
Date Particulars Ledger folio Debit Credit
1 Work in process –Job A 800,000
Work in process –Job B 1,200,000
Work in process –Job C 1,500,000
Work in process –Job D 600,000
Materials control 4,100,000
(Issuance of raw material to WIP)

AT A GLANCE
2 Work in process –Job A (20,000 x 20) 400,000
Work in process –Job B (30,000 x 18) 540,000
Work in process –Job C (15,000 x 16) 240,000
Work in process –Job D (18,000 x 15) 270,000
Salaries & Wages control 1,450,000
(Direct labour cost allocated to WIP)
3 Work in process –Job A (20,000 x 10) 200,000
Work in process –Job B (30,000 x 10) 300,000
Work in process –Job C (15,000 x 10) 150,000

SPOTLIGHT
Work in process –Job D (18,000 x 10) 180,000
Production overhead control 830,000
(Factory overheads applied to WIP @ Rs. 10 per direct labour
hours)
4 Profit and loss account (900,000-830,000) 70,000
Factory overheads Control 70,000
(Factory overheads applied transferred to overheads control
a/c and under applied overheads charged to P&L account)
5 Finished goods A 2,800,000
(1,400,000+800,000+400,000+200,000)

STICKY NOTES
Work in process –Job A 2,800,000
(Job A completed and transferred to finished goods)
6 Finished goods B 4,086,000
90% of (2,500,000+1,200,000+540,000+300,000)
Work in process –Job C 454,000
10% of (2,500,000+1,200,000+540,000+300,000)
Work in process –Job B 4,540,000
(Job B completed and transferred to finished goods, 10%
rejected items transferred to Job C)
7 Cost of goods sold 6,886,000
Finished goods A 2,800,000
Finished goods B 4,086,000
(Jobs A and B delivered and transferred to cost of goods sold.)

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2 SERVICE COSTING
2.1 The nature of services and operations
It is usual to explain costing in terms of how to calculate and record the costs of manufactured products.
However, many business entities do not make and sell products; they provide services.
Service organisation do not make or sell tangible goods. Services are any activity carried out by a party to the
benefit of another that is essentially intangible and does not result in the ownership of anything.
Examples include hotel services, consultancy services, legal and accounting services, providers of telephone
services (telecommunications companies), providers of television and radio channels, entertainment services,
postal services, medical services, and so on.
AT A GLANCE

Characteristics of services
These are major characteristics of services:
• Intangibility: They do not have a physical substance unlike goods. They have no physical existence.
• Inseparability: Consumption and creation of a service cannot be separated. Services are consumed as they
are created. A service does not exist until it is consumed by the person being served.
• Variability: Services face the problem of maintaining consistency in the standard of output. Goods can
usually be supplied to a standard specification. This is more difficult to achieve for services, because each
service is distinct from other service(s).
• Perishability: Services cannot be stored. They do not have a shelf life.
• Lack of ownership: Services do not result in the transfer of property in anything. The purchase of a
SPOTLIGHT

service only confers on the customer a temporary benefit.

• Heterogeneous: a haircut is heterogeneous and so the exact service received will vary each time, not only
will two hairdressers cut hair differently, but a hairdresser will not consistently deliver the same standard
of haircut.
Operations
Operations are activities. Like services, they do not result in a finished product to sell to customers. Examples
of operations include a customer service center taking telephone calls and e-mails from customers, and the
staff canteen providing meals to employees.

2.2 Service costing, product costing and job costing compared

STICKY NOTES

Costs can be established for services, such as hotel accommodation, telephone calls, auditing work, holidays
and travel, and so on. The costs of a service are the sum of direct materials, direct labour, direct expenses (if
any) and a share of operational overheads.
Costs can also be established for operations, in a similar way.
Service costing differs from costing in manufacturing industries in several ways.
• There is no production system; therefore, there are no production overheads.
• Direct materials costs are often a fairly small proportion of total costs (for example, the direct materials
costs to a telecommunications company of providing telephone services are very small).
• In some service industries, direct labour costs are high (for example, in the film-making industry,
accountancy and investment banking).
• General overhead costs can be a very high proportion of total costs.
• Inventory is usually very small; therefore, absorption costing is usually of little or no value for management
information purposes.

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Not all entities that provide services will use service costing. The purpose of service costing is to provide
information to management about the costs of different services that the entity provides, and the profitability
of each of the different services. Each service should be fairly standard. If they are not standard services, it is
more sensible to use job costing to calculate the cost of each ‘job’ of service. For example:
• Service costing might be used by a hospital to record or calculate the cost of each of the different services
provided by the hospital, such as the cost of treating a patient for a particular condition such as cardiac
arrests etc.
• Job costing might be used by a professional firm such as a firm of accountants or solicitors, where the cost
of each job depends largely on the amount of time spent on each job by the professional staff.
2.3 Cost units in service costing: composite cost units
One of the main problems with service costing is that it can be difficult to identify a suitable cost unit for the

AT A GLANCE
service. It is often appropriate to use a composite cost unit in service costing. It is known as composite cost unit
like in railway industry where cost is calculated on the basis of passenger/km. This is a cost that is made up
from two variables, such as a cost per man per day (a cost per ‘man/day’). Here, the two variables are ‘men’
(the number of employees) and ‘days’.
Examples of composite cost units used in service costing are as follows:
• The cost per room per night. This is a useful unit cost in the hotel services industry.
• The cost per passenger mile or the cost per passenger kilometer (the average cost of transporting a
passenger for one mile or one kilometer). This unit measure of cost is used by transport companies that
provide bus or train services.
• The cost per ton mile delivered (the average cost of transporting one ton of goods for one mile). This unit

SPOTLIGHT
cost is commonly used for costing freight services and delivery operations.
• The cost per patient/day (the average cost of treating one patient for one day) or the cost per hospital
bed/day (the cost of maintaining one hospital bed in a hospital for one day). These costs are used by health
service providers.
• The cost per man day. This unit cost is widely used in professional services, such as auditing, legal services
and consultancy services.
Composite cost units can be used in addition to a ‘job costing’ type of service costing system. For example, a
firm of accountants might calculate the cost of each job performed for a client. In addition, it might calculate the
average cost per man day for the professional services such as taxation, auditing, consultancy etc. that it
provides.

STICKY NOTES
• The cost of each service ‘job’ enables management to monitor costs and profits on individual jobs for a
customer.
• The composite cost, which is an average cost for all ‘jobs’ allows management to monitor the general level
of costs.

2.4 Calculating the cost per unit of service (or operation)

The cost of a service unit (or composite cost unit) is calculated as follows.
 Formula

Total costs of the service

Cost per unit of service
Number of units of service

In case of absorption cost, total costs include direct material, direct labour and production overheads whereas
in marginal cost, total costs include direct material, direct labour and variable production overheads.
The total number of service units might be a bit more difficult to calculate. Here are a few examples.

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 Example 05:
A hotel has 80 standard twin-bedded rooms. The hotel is fully-occupied for each of the 350 days in each year
that it is open. The total costs of running the hotel each year are Rs. 3,360,000.
What would be a useful measure of the cost of providing the hotel services?
A useful unit cost is the cost per room/day. This is the average cost of maintaining one room in the hotel for one
day.
Room available in a year = 80 rooms × 350 days = 28,000
Cost per room/day = Rs. 3,360,000/28,000 = Rs 120.
 Example 06:
A train company operates a service between two cities, Southtown and Northtown. The distance between the
AT A GLANCE

cities is 400 miles. During the previous year, the company transported 200,000 passengers from Southtown to
Northtown and 175,000 passengers from Northtown to Southtown. The total costs of operating the service
were Rs.60 million.
What would be a useful measure of the cost of providing the train service between the two cities?
A useful unit cost is the cost per passenger/mile. This is the average cost of transporting one passenger for one
mile.
Passenger/miles per year = (200,000 × 400) + (175,000 × 400) = 150 million.
Cost per passenger per mile = Rs. 60,000,000/150,000,000 = Rs.0.40.
SPOTLIGHT
STICKY NOTES

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3 SELF-TEST QUESTIONS
 Question 01:
The Composite Manufacturing Company uses job order costing. At the beginning of May, two jobs were in
process:

Job 469 Job 475

-------------Rs. In ‘000---------------
Materials 9,000 7,500
Direct labour 4,200 3,300

AT A GLANCE
Applied production overhead 6,300 4,950

There was no inventory of finished goods on May 1. During the month Job 476 to 481 were started. Materials
requisitions for May totalled Rs. 55,300; direct labour cost Rs. 48,600 and actual production overheads Rs.
75,000. Production overhead is absorbed at the rate of 150% of direct labour cost.
The only job still in process at the end of May is Job 481, with costs of Rs. 5,900 for materials and Rs. 4,200 for
direct labour.
Job 479, the only finished job on hand at the end of May, has a total cost of Rs. 9,500.
Required
Prepare:

SPOTLIGHT
a) T accounts for work in process, finished goods, cost of goods sold and factory overhead control.
b) General entries to record the cost of goods manufactured, cost of goods sold and closing of over or under
absorbed production overheads to cost of goods sold,
 Solution
a)

Work in process control

Rs. In ‘000 Rs. In ‘000
Balance b/d W-1 35,250 Finished goods (Bal. Fig.) 195,650

STICKY NOTES
Materials control 55,300
Salaries & wages control 48,600
Production overhead
control (48,600 x 150%) 72,900 Balance c/d W-2 16,400
212,050 212,050
Finished goods
Rs. In ‘000 Rs. In ‘000
Work in process control 195,650 Cost of sales (Bal. Fig.) 186,150
Balance c/d 9,500
195,650 195,650

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Cost of goods sold

Rs. In ‘000 Rs. In ‘000
Finished goods 186,150
Production overheads 2,100 Profit & Loss account 188,250
control
188,250 188,250

Production overheads control

Rs. In ‘000 Rs. In ‘000
AT A GLANCE

Cash or payables (Actual) 75,000 Work in process control 72,900

Cost of sales 2,100
75,000 75,000

W-1 Opening Inventory of WIP Job 469 Job 472 Total

---------Rs. In ‘000------------
Materials 9,000 7,500 16.500
Direct labour 4,200 3,300 7,500
SPOTLIGHT

Applied production overhead 6,300 4,950 10,250

Total 19,500 15,750 35,250

W-2 Closing Inventory of WIP-Job 481 Rs. In ‘000

Materials 5,900
Direct labour 4,200
Applied production overhead (4,200 x 150%) 6,300
Total 16,400
STICKY NOTES

(b) Journal entries

Date Particulars Debit Credit
Rs. in '000
Finished goods 195,650
Work in process control 195,650
(Recording of cost of goods manufactured)
Cost of goods sold 186,150
Finished goods 186,150
(Recording of cost of goods sold)
Cost of goods sold 2,100
Production overhead control 2,100
(Closing of under absorbed production overheads)

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 Quuestion 02:
Best Products Limited, provided the following data for January 2021.

Rs. In 000
Materials:
Inventory, January 1, 2021 12,000
Purchases on account 36,000
Labour:
Accrued, January 1, 2021 3,600
Paid during January 30,000

AT A GLANCE
Factory overhead costs:
Supplies (issued from materials) 1,800
Indirect labour 4,200
Depreciation 1,200
Other production overheads (all from outside suppliers on account) 17,400

Job A Job B Job C

Work in process: Rs. In ‘000
Work in process January 1, 2021 1,200 - -

SPOTLIGHT
Jobs costs during January, 2021:
Direct materials 4,800 7,200 6,000
Direct labour 6,000 9,600 8,400
Absorbed production overheads 6,000 9,600 8,400

Job A: Started in December, 2020, finished during January and sold to customer for Rs. 25,200,000.
Job B: Started in January, 2021, not yet finished.
Job C: Started in January 2021, finished during January 2021 and now in the finished goods warehouse
awaiting customer’s disposition. There was no finished goods inventory at start of January, 2021.

STICKY NOTES
Required
Prepare relevant ledger accounts for the month of January, 2021.
 Solution:

Materials control
Rs. In ‘000 Rs. In ‘000
Balance b/d 12,000 Production overheads control 1,800
Accounts payable 36,000 Work in process –Job A 4,800
Work in process –Job B 7,200
Work in process –Job C 6,000
Balance c/d 28,200
48,000 48,000

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Work in process –Job A

Rs. In ‘000 Rs. In ‘000
Balance b/d 1,200
Materials control 4,800
Payroll 6,000
Production overhead 6,000 Finished goods 18,000
control
18,000 18,000
AT A GLANCE

Work in process –Job B

Rs. In ‘000 Rs. In ‘000
Materials control 7,200
Payroll 9,600
Production overhead 9,600 Balance c/d 26,400
control
26,400 26,400
Work in process –Job C
Rs. In ‘000 Rs. In ‘000
SPOTLIGHT

Materials control 6,000

Payroll 8,400
Production overhead 8,400 Finished goods 22,800
control
22,800 22,800

Finished Goods
Rs. In ‘000 Rs. In ‘000
STICKY NOTES

Work in process- Job A 18,000 Cost of sales 18,000

Work in process- Job B 22,800 Balance c/d 22,800
40,800 40,800

Production overheads control

Rs. In ‘000 Rs. In ‘000
Materials control 1,800 Work in process –Job A 6,000
Payroll 4,200 Work in process –Job B 9,600
Accumulated 1,200 Work in process –Job C 8,400
depreciation
Accounts payable 17,400 Cost of sales 600
24,600 24,600

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Payroll
Rs. In ‘000 Rs. In ‘000
Accrued payroll 28,200 Work in process –Job A 6,000
Work in process –Job B 9,600
Work in process –Job C 8,400
Production overheads 4,200
28,200 28,200

Accrued Payroll

AT A GLANCE
Rs. In ‘000 Rs. In ‘000
Cash 30,000 Balance b/d 3,600
Balance c/d 1,800 Payroll 28,200
31,800 31,800

Cost of sales
Rs. In ‘000 Rs. In ‘000
Finished goods 18,000

SPOTLIGHT
Production overheads 600 Profit and Loss 18,600
control
18,600 18,600

Sales
Rs. In ‘000 Rs. In ‘000
Profit and Loss 25,200 Accounts receivables 25,200
25,200 25,200

STICKY NOTES
 Question 03:
RI Limited (RIL) is engaged in the manufacturing of spare parts for industrial machines. RIL receives bulk
orders from its customers and follows job order costing. Following data pertains to two of the jobs which were
started in the month of February 2018:

Job F01 Job F02

Size of job order (Units) 5,400 3,600
Labour hours used 27,500 21,600
Labour rate per hour Rs. 360 Rs. 400

i. Each unit of both jobs require 24 kg of raw material S40. Purchase price of S40 was Rs. 30 per kg.
ii. The inventory of S40 at beginning and end of the month was Rs. 2,940,000 and Rs. 1,740,000 respectively.

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iii. Wages were paid on 28 February 2018. Income tax withheld from the wages amounted to Rs. 500,000
which would be deposited in government treasury in the following month.
iv. Job F01 was in process at month-end. However, Job F02 was completed during the month of February and
finished goods were sent to warehouse. During the delivery to the customer, 500 units were damaged
badly and their realizable value is 50% of the cost.
Total labour hours utilized during the month were 100,000. Factory overheads are applied at Rs. 120 per direct
labour hour. Under/over applied factory overheads are charged to cost of sales at month-end. Total actual
factory overheads amounted to Rs. 11,000,000, out of which 40% were fixed.
Required:
Prepare journal entries to record the transactions for the month of February 2018.
AT A GLANCE

 Solution
Journal entries to record the transactions for the month of February 2018 can be prepared as follows:

Journal entries

Debit Credit
Date Particulars
----- Rs. in '000 -----
1 Materials control (W-1) 5,280
Supplier/cash 5,280
(Purchased raw material)
SPOTLIGHT

2 Work in process -JobF01 (W-1) 3,888

Work in process -JobF02 (W-1) 2,592
Materials control 6,480
(Allocated raw material consumed to the jobs)
3 Work in process -JobF01 (27,500×360) 9,900
Work in process -JobF02 (21,600×400) 8,640
Payroll 18,540
(Allocated direct labour to the jobs)
STICKY NOTES

4 Payroll 18,540
Accrued payroll tax 500
Bank/Cash 18,040
(Paid of payroll)
5 Work in process -JobF01 (27,500×120) 3,300
Work in process -JobF02 (21,600×120) 2,592
Factory overheads applied 5,892
(Applied factory overheads to the jobs @ Rs. 120 per direct
labour hour)
6 Finished goods (2,592+8,640+2,592) 13,824
Work in process -JobF02 13,824

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Debit Credit
Date Particulars
----- Rs. in '000 -----
(Transferred WIP of job F02 to finished goods)
7 Damaged goods inventory (at NRV) (13,824/3,600×500×50%) 960
Abnormal loss - P&L (13,824/3,600×500×50%) 960
Finished goods 1,920
(Recorded 500 damaged units)
8 Cost of sales (13,824–1,920) 11,904

AT A GLANCE
Finished goods 11,904
(Transferred total finished goods to cost of sales)
9 Factory overheads applied (100,000×120) 12,000
Cost of sales (overhead over applied) 1,000
Factory overheads control 11,000
(Transferred applied factory overheads to control a/c and
charged under applied overheads to cost of sales)
10 Factory overheads control 11,000
Cash/suppliers 11,000

SPOTLIGHT
(Recorded actual factory overheads incurred)

W-1: Purchase of raw materials Rs. In 000

Material consumption - F01 (5,400×24×30) 3.888.00
Material consumption - F02 (3,600×24×30) 2,592.00
Add: Closing stock of raw material Given 1,740.00
Less: Opening stock of raw material Given (2,940.00)
Purchases - Raw material 5,280.00

STICKY NOTES
 Question 04:
Modern Engineering Workshop (MEW) is engaged in production of customized spare parts of textile
machinery. The following information pertains to the jobs worked by MEW during the month of June 2014:

Job 101 Job 202

Size of job order 4,000 units 5,000 units

------------ Rs. in ‘000 ------------

Opening work in process 15,000 -

Raw material consumed 10,000 31,000

Direct labour used (Rs. 100 per hour) 5,000 8,000

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i. Overheads are applied to jobs at Rs. 25 per direct labour hour. Under/over applied overheads are
transferred to cost of sales.
ii. Job 101 was completed during the month and the goods were sent to the warehouse for delivery to the
customer. During the transfer to the warehouse, 160 units were damaged. Net realizable value of the
damaged units was Rs. 500,000. Remaining units were transferred to the customer.
iii. Job 202 is in process; however, 2,000 units are fully complete and were transferred to the warehouse
during the month while 3,000 units are 70% complete as at 30 June 2014.
iv. Actual overheads for the month of June 2014 amounted to Rs. 4,000,000.
Required:
Prepare journal entries to record the above transactions.
AT A GLANCE

 Solution
In order to prepare journal entries to record the above transactions, please see below:

Journal entries
Debit Credit
Date Particulars
Rs. in '000
1 Work in process Job # 101 10,000
Work in process Job # 202 31,000
Materials control 41,000
SPOTLIGHT

(Raw material consumed for jobs)

2 Work in process Job # 101 5,000
Work in process Job # 202 8,000
Payroll 13,000
(Direct labour cost allocated to jobs)
3 Work in process Job # 101 5,000/100*25 1,250
Work in process Job # 202 8,000/100*25 2,000
Factory overheads applied 3,250
STICKY NOTES

(Overheads applied to the jobs @ Rs. 25 per direct labour hour)

4 Factory overheads applied 3,250
Cost of sales – overhead under applied (4,000–3,250) 750
Factory overheads control 4,000
(Transfer of applied factory overheads to control a/c and under applied overheads
charged to cost of sales)
5 Finished goods (Job # 101) (15,000+10,000+5,000+1,250) *3,840/4,000 30,000
Damaged goods (at NRV) 500
Profit and loss account (damaged goods cost exceeding NRV) 750
(31,250×160/4,000)-500
Work in process Job # 101 31,250
(WIP of Job order # 101 transferred to finished goods)

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Journal entries
Debit Credit
Date Particulars
Rs. in '000
6 Cost of sales 30,000
Finished goods 30,000
(Finished goods of Jobs # 101 transferred to cost of sales)
7 Finished goods (31,000+8,000+2,000)/ (2,000+3,000*0.7) *2,000 20,000
Work in process Job # 202 20,000
(Units fully completed for Job # 202 transferred to finished goods)

AT A GLANCE
 Question 05:
Gulshan Enterprises Limited (GEL) is engaged in the manufacturing of specialized drilling equipment for the oil
and gas industry. The following data pertains to the jobs undertaken by GEL during the month of August 2023:

Job A227 Job B391 Job C528

Size of job order (units) 20 40 30
----------Rs. In million----------
Selling price per unit 55 72 10
Cost – opening balance 600 400
Cost incurred during the month:

SPOTLIGHT
- Material issued 280 1,760 1,600
- Labour cost incurred 10 40 20
- Factory overheads See note 1

Note 1: Factory overheads

Factory overheads are allocated to jobs on the basis of labour cost. During the month, factory overheads
amounted to Rs. 245 million.
On 16 August 2023, a special machine was hired on rent for three months, exclusively for use on Job C528. A
rent of Rs. 4.8 million was paid in advance, while the remaining amounting to Rs. 2.4 million will be paid at the
end of the three-month period. The transportation cost incurred in bringing the machine to the site amounted

STICKY NOTES
to Rs. 0.3 million. The costs incurred in respect of this machine have not been included in the factory overheads
amount.

Additional information:
i. Job A227 was completed on 25 August 2023. Upon completion, unused materials costing Rs. 5 million were
transferred to Job B391. All 20 units were transferred to the finished goods store, from which 14 units
were transported to the client on 31 August 2023. The remaining 6 units were transported on 2 September
2023.
ii. On 31 August 2023, 16 units from Job B391 were completed and transferred to the finished goods store. It
is estimated that the further cost required to complete the job will amount to Rs. 95 million.
iii. In a fire on 10 August 2023, some of the materials issued on Job C528 having a cost of Rs. 18 million was
destroyed. 80% of the materials were insured, and GEL received a claim for those materials. The remaining
materials were sold as scrap for Rs. 1 million.
Required:
Prepare journal entries to record the transactions for the month of August 2023.

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 Solution:
The journal entries to record the transactions for the month of August 2023 are given below.
Gulshan Enterprises Limited
Journal entries
For the month of August 2023
Debit Credit
Date Particulars
-----Rs. in million----
Aug-23 Work in process – Job A 227 2580
Work in process – Job B 391 1,760
AT A GLANCE

Work in process – Job C 528 1,600

Raw Material 3,640
(Material issued during the month)
Aug-23 Work in process – Job A 227, 10
Work in process – Job B 391 40
Work in process – Job C 528 20
Payroll Control Account 70
SPOTLIGHT

(Direct labour cost incurred during the month)

Aug-23 Work in process – Job A 227 (245÷70)x10 35
Work in process – Job B 391 (245÷70)x40 140
Work in process – Job C 528 (245÷70)x20 70
Factory overhead 245
(Factory overhead incurred during the month)
16-Aug-23 Work in Process – Job 528 7.2(4.8+2.4) ÷3x0.5 1.2
STICKY NOTES

Prepaid Rent 4.8-1.2 3.6

Cash 4.8
(Rent of machine hired for Job C 528 and partial advance paid)
16-Aug-23 Work in Process – Job 528 0.3÷3x0.5 0.05
Prepaid transportation 0.3-0.05 0.25
Cash 0.3
(Transport charge for bringing hired machine to factory)
25-Aug-23 Work in Process – Job B 391 5
Work in process – Job A 227 5
(Material transferred between jobs)

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Debit Credit
Date Particulars
-----Rs. in million----
25 Aug 23 Finished goods – Job A227 (W-1) 920
Work in process-Job A 227 920
(Transferred WIP of all (20) units of Job A 227 to finished goods
store)
31-Aug-23 Accounts Receivable 14x55 770
Sales 770

AT A GLANCE
(Transferred (Sale) 14 units of Job A 227 to the client)
31-Aug 23 Cost of Sales 14x46(W-1) 644
Finished goods – Job A 227 644
(Charged cost of 14 units of Job A 227 to the cost of sales
account)
31-Aug-23 Finished Goods – Job B391 16x61(W-1) 976
Work in process – Job B391 976
(Transferred WIP of 16 units of Job B391 to finished goods

SPOTLIGHT
store)
10-Aug-23 Cash 14.4(18x80%)+1 15.4
Profit and loss Account Bal. 2.6
Work in Process – Job C 528 18
(Insurance claim for raw material destroyed in fire and
remaining sold as scrap)

W-1: Computation of job cost A227 B391

STICKY NOTES
------Rs. In million------
Opening balance 600 400
Material issued 280 1,760
Internal transfer (5) 5
Labour cost (a) 10 40
Factory overhead [(245 ÷ 70)x(a)] 35 140
Further estimated cost - 95
920 2,440
Size of job order 20 40
Per unit cost 46 61

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 Question 06:
Power Limited (PL) is engaged in the business of overhaul and repair of turbo-generators. The company uses
job order costing system. Following data has been extracted from the cost cards relating to jobs completed in
the month of August 2013:

Rs. ‘000

Material issued 55,000

Direct labour 41,000

Overhead on material 25%

AT A GLANCE

Overheads on direct labour 80%

The clients are billed at each month-end on the basis of cost cards and PL earns a profit of 20% of the invoice
value for each completed job.
Actual expenses for the month of August 2013 were as under:

Rs. ‘000

Factory wages (inclusive of indirect labour) 65,000

Factory expenses 15,000

Store expenses 7,500

SPOTLIGHT

Other office expenses 4,500

Following information is also available:

i. Material requisitions not recorded in the cost cards amounted to Rs. 5,600,000.
ii. Direct labour shown as indirect in the cost cards amounted to Rs. 2,900,000.
iii. Details of stock and work in process for the month of August 2013 are as under:

Opening Closing
STICKY NOTES

-----Rs. ‘000-----

Stock of materials 5,000 5,500

WIP – material 10,000 10,500

WIP - labour 2,500 4,500

Required:
Calculate the following for the month of August 2013:
a) Purchases
b) Direct labour
c) Under / over absorbed overheads
d) Actual profitability of completed jobs

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 Solution:

Purchases for the month of August 2013: Rs. in '000

Materials issued as per cost cards 55,000
Add: Materials issued but not booked in cost cards 5,600
Closing stock of: raw material 5,500
Less: Opening stock of: raw material (5,000)
Purchases 61,100
Direct labour for the month of August 2013:
Direct labour as per cost card 41,000

AT A GLANCE
Add: Direct labour booked as indirect in cost cards 2,900
Direct labour 43,900

Unabsorbed overheads
Indirect labour (65,000 – 43,900) 21,100
Factory expenses 15,000
Store expenses 7,500
Actual overheads for the period 43,600

SPOTLIGHT
Overhead - on material [ (55,000+5,600) ×25%] 15,150
Overhead - on labour [ (41,000+2,900) ×80%] 35,120
Absorbed overheads as per cost cards 50,270
Over absorbed overhead (6,670)

Actual profitability of completed jobs for the month of August 2013:

Sales (W-1) 190,338
Actual Material consumed [10,000 – 10,500] + [55,000 + 5,600] (60,100)
Actual Direct labour [2,500 – 4,500] + [41,000 + 2,900] (41,900)

STICKY NOTES
Actual overhead (43,600)
(145,600)
Less: Other office expenses (4,500)
Net Profit 40,238

W-1:
Materials consumed 60,100
Direct labour 41,900
Overhead - on material 15,150
Overhead - on labour 35,120
152,270
Profit (152,270 ÷ 80 × 20) 38,068
Sales 190,338

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STICKY NOTES

Job costing is a costing method used where each cost unit is separately
identifiable. The work is undertaken to customer’s specific requirements and
the job is of short duration. The main focus of Job costing is to calculate cost of
a specific job or batch.

Costs for each job are collected on a job cost card. Costs includes Material,
labour and overheads. Overheads are absorbed in to the cost of jobs using
AT A GLANCE

pre-determined overhead absorption rates.

Service costing can be used by companies operating in a service industry

often by companies wishing to establish the cost of services carried out by
some of their departments

Service costing differs from the other costing methods. With many services
the cost of direct materials consumed will be relatively small compared to the
SPOTLIGHT

labour, direct expenses and overheads cost.

STICKY NOTES

210 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 7

PROCESS
COSTING

AT A GLANCE
IN THIS CHAPTER

AT A GLANCE
Process Costing is used where production is a continuous
process and it is not possible to identify separate units of
AT A GLANCE Production.
SPOTLIGHT The output of one process is the input to a subsequent
process until product is transferred to Finished Goods.
1. Introduction to process costing There is often a loss in process which is called normal loss
2. Losses due to spoilage, wastage, evaporation etc.
3. Abnormal gain If actual loss is greater than normal loss the difference is
called abnormal loss and if actual loss is less than normal
4. Process costing with closing work in loss, we treat the difference as abnormal gain.
progress
Losses and Gain can occur at different stages in the

SPOTLIGHT
5. Opening work in progress process
6. Work in progress and losses Loss or spoilage may have a scrap value; the scrap value of
7. Losses and gains at different stages in normal loss will probably be deducted from the cost of
the process material in the process.
8. Types of losses The scrap value of abnormal loss (or abnormal Gain) will
probably be set off against its cost, in an abnormal loss/
9. Cost of rework gain account, and only the balance on the account will be
10. Self-test questions written to the P & L account at the end of the period.
Process account may have closing and opening WIP.
STICKY NOTES
There are two methods to deal with opening WIP – FIFO

STICKY NOTES
and Weighted Average.

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1 INTRODUCTION TO PROCESS COSTING

1.1 Process costing
A process costing system is a technique employed to calculate the overall production cost for each unit in
industries that produce large quantities of similar or identical products through a continuous process. It
gathers costs from each department or process and assigns them to the individual units produced. Products are
produced in the same manner and consume the same amount of direct costs and overheads. It is, however,
difficult to assign costs to individual units of output. The completed product may take several set of processes
and the output of one process serves as the input to a subsequent process until a completed product is
produced.
Examples, of manufacturing industries where process costing is widely used, are:
AT A GLANCE

• chemicals manufacturing;
• food processing
• petroleum refining
• the manufacture of liquids;
• paint manufacturing
• brewing industry and
• the continuous processing of high volumes of low-cost food items such as tins of peas or beans, or bottles of
tomato ketchup.
In these types of production process, losses in process might occur and there are often problems in measuring
SPOTLIGHT

exactly the amount of unfinished work-in-process at the end of a period. The losses and their accounting
treatment are discussed in later sections of this chapter.
The basic principle of costing is the same as for other types of costing. The cost of a unit of output from a
process is measured as the total cost of resources consumed by the process divided by the total units produced.

1.2 Features of Process Costing

Process costing provides a system of costing where any or all of these characteristics occur.
• The output of one process serves as the input to a subsequent process until conversion into finished
product takes place in the last process.
• Output is normally measured in total quantities, such as tones, kilograms or litres produced, or in very
STICKY NOTES

large quantities of small units (such as the number of cans or tins).

Materials might be added in full at the start of a process or sometimes during specific percentage of
completion or might be added gradually throughout the process. The materials are processed to produce
the final output.
• Material costs and conversion costs (direct labour and production overheads) are accumulated for each
process or department. The accumulated costs are subsequently assigned to the units produced during a
specific period.
• In process costing, the term "equivalent units" is used to measure unfinished units of production.
Equivalent units reflect the number of fully completed units that could have been completed based on the
amount of work performed on both finished and partially finished units.
• There might be losses in the process (due to evaporation, spoilage, wastage or chemical reaction) so the
quantity of output might therefore be less than the quantity of materials input. Process costing provides a
system of costing that allows for expected losses in the manufacturing process.
• The total costs are divided by the number of equivalent units to determine the cost per unit.

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• Ultimately, the costs are distributed between the finished goods and the work-in-process inventory.
Therefore, process costing provides a method of measuring and costing work-in-process inventory.Output
from production might be a single product, but there may be joint products and by products.
The features of process costing can be summarized with the help of the following figure.

AT A GLANCE
SPOTLIGHT
1.3 Flow of cost in process costing and comparison with Job order costing
The major differences between process costing and job order costing is that in process costing, production
moves from one process to subsequent process, until final completion occurs. Final product is then transferred
to finished goods after accumulation cost process. On the other hand, in job order costing, cost is assigned to
each job separately and is then transferred to finished goods after completion of that independent job.
The cost accumulation procedure follows this production flow and control accounts are established for each
department or process and all direct and indirect costs are assigned to each process. The cost of first process is
transferred to second process and accumulates with cost of second process. This cost accumulation procedure
continues, until goods are completed and transferred to finished goods.

STICKY NOTES
1.4 The basics of Process Costing
Where a series of separate processes is required to manufacture the finished product the output of one process
becomes the input to the next until the final output is made in the final process. For example, if two processes
are involved in producing a finished product, the accounts would be like this.
 Illustration:
Simple process account

Process 1 Account
Units Rs. Units Rs.
Materials 100 1,000
Conversion cost 500 Transfer to Process 2 100 1,500
100 1,500 100 1,500

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Process 2 Account
Units Rs. Units Rs.
Material from process 1 100 1,500
Added materials 50 500
Direct labour 700
Production overhead 400 Output to Finished 150 3,100
Goods
150 3,100 150 3,100

Note that direct labour and production overhead may be treated together as conversion cost.
AT A GLANCE

Conversion costs in both processes are added gradually throughout the process. Cost transfer from process 1 to
process 2 is treated ‘materials from process 1’ for Process 2.

1.5 Addition of Materials in Subsequent Process

As mentioned before, in process costing, as the units pass through the production processes, the finished goods
output of one process becomes the raw materials input of the next process. In addition to the units from the
previous process, new materials may also be added in the next process. In order to separately distinguish the
costs incurred in different processes or departments, the cost from the previous process may be labelled as
“Direct Materials – Process 1” or “Cost from Process 1” or “Transfer from Process 1”.
 Example 01
SPOTLIGHT

ABC company manufactures product A101 which is produced in two processes and following data represents
500 units produced during the month of March 2019.

Units Rs.
Material input – Process I 500 35,000
Added material – Process II 5,200
Conversion cost – Process I 12,750
Conversion cost – Process II 17,450

There is no losses and work in progress in both processes and all input units are converted into finished
STICKY NOTES

product.
Required:
Prepare Process I and II accounts for the month of March 2019.
 Solution:
Process I and II accounts for the month of March 2019 are given below:

Process I Account
Units Rs. Units Rs.
Materials 500 35,000
Conversion cost 12,750 Process II 500 47,750
47,750 47,750

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Process II Account
Units Rs. Units Rs.
Materials-Process I 500 47,750
Added material 5,200
Conversion cost 17,450 Finished goods 500 70,400
70,400 70,400

Cost per unit of Product A101 is Rs. 140.80 (70,400/ 500)

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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2 LOSSES
2.1. Normal loss
A feature of process manufacturing is that there is often some loss or wastage in production and output
quantities are less than input quantities of materials.
Normal loss is the expected loss in the process due to evaporation of liquids, wastage or rejected units.
 Formula: Normal loss

Normal loss = Quantity of material input − Expected output OR

Quantity of material input = Normal loss + Expected output OR
Expected output = Quantity of material input − Normal loss
AT A GLANCE

Normal loss is usually expressed as a percentage of the input units of materials.

 Example 02:
Normal loss of a process is 10%.
A company puts 5,000 litres into the process.
Normal loss is 10% of 5,000 = 500.
Expected output from the process would be 90% of 5,000 litres = 4,500 litres
Normal loss is unavoidable in the normal course of events. It is inherent in the physical and chemical reactions
that take place in a process.
SPOTLIGHT

2.1.1. Normal loss with no recovery value

The normal losses are inherent to production process and cannot be avoided. Therefore, in process account, if
it has no scrap value (like in case of evaporation), no cost is assigned (credited) to normal loss in process
account. As consequence, the cost per unit of finished product will increase.
Example 03:
A person buys one litre tin of soup for Rs. 500.
Normal evaporation during cooking is 10%.
When the soup is ready to eat there is 0.9 litres left.
STICKY NOTES

The person has paid Rs. 500 for 0.9 litres and this is unavoidable.
The implication of this simple example is as follows.
The normal loss is something that is unavoidable in order to get the good output. The cost of the lost units is
part of the cost of obtaining the good output.
All of the cost should be assigned to the good output and none to the normal loss.
The cost of input per litre is Rs. 500 whereas cost of output per litre is Rs. 555.55 as the cost of normal loss is
assigned to good units.
 Formula: Unit cost of good output

Total process costs

Per unit Cost of good output =
Expected units of output

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 Example 04:
The following information relates to a production process:

Input quantities 2,000 litres

Normal loss 10%
Therefore expected output 1,800 litres
Actual output 1,800 litres
Direct materials cost Rs. 3,600
Direct labour cost Rs. 300
Production overhead absorbed Rs. 600

AT A GLANCE
Required:
Calculate the cost per unit produced.
 Solution:

The cost per unit produced can be calculated as follows:

Rs.
Direct materials 3,600

SPOTLIGHT
Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs.2.50

 Example 05:

Descriptions Process X Process Y

STICKY NOTES
Materials Added (KGs) 10,000 2,000
Materials (Rs.) 30,000 3,000
Direct Wages (Rs.) 16,000 40,000
Production OH as % of Direct Wages 25% 30%
Normal Loss% 5% 5%

There is no work in process and abnormal losses in both processes. The losses have no scrap value.
Required:
Prepare the process X and Process Y accounts.

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 Solution:
The process X and Process Y accounts are prepared, as follows.

Process X A/c
KGs Rs. KGs Rs.
Direct Materials 10,000 30,000 Normal Loss 500 -
Direct Wages 16,000 Process Y 9,500 50,000
Production OH 4,000
10,000 50,000 10,000 50,000
AT A GLANCE

Process Y A/c
KGs Rs. KGs Rs.
Process X 9,500 50,000 Normal Loss 575 -
Direct 2,000 3,000 Output 10,925 105,000
Materials
Direct Wages 40,000
Production OH 12,000
11,500 105,000 11,500 105,000
SPOTLIGHT

Process account in the cost ledger

The process cost account (shown above) is a work-in-progress account for the process. The debit side of the
account records input as direct materials, direct labour costs and production overheads absorbed. The credit
side of the WIP account records the cost of the finished output.
The account also includes memorandum columns for the quantities of direct materials input and the quantities
of output and loss. Normal loss is shown so that the quantities columns add up to the same amount on the debit
or credit sides, but the normal loss has no cost (as it’s cost is built into the cost of output).

2.1.2. Normal loss with recovery value

STICKY NOTES

In some cases, loss units in a process are in physical form and have a scrap value. The normal loss quantity
might not be physically lost but is changed in some way, so that it is not the same as good output. However, it
can be scrapped off at a certain scrap value. For example,
• In a food processing plant, some fruits or vegetables might spoil, but the spoiled parts could be sold at a
scrap value.
• In a metalworking factory, some metal scraps might be generated, but these scraps can be sold to scrap
metal recyclers.
If normal loss has a scrap value, the company is able to recover some of the input costs to the process. The
scrap value reduces the cost of the process.
To reflect this in the process account, the normal loss is credited at its scrap value and the calculation of the
cost of good output can be calculated with the help of following formula.

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 Formula:
Total process costs − Scrap value of the normal loss
Per unit Cost of good output =
Expected units of output
The concept can be easily understood with the help of following example.
 Example 06:
The following information relates to a production process X.

Input quantities 2,000 litres

Normal loss 10%
Therefore expected output 1,800 litres

AT A GLANCE
Actual output 1,800 litres
Scrap value of normal loss Rs. 0.9 per litre
Direct materials cost Rs. 3,600
Direct labour cost Rs. 300
Production overhead absorbed Rs. 600

Required:
Prepare the process account X.
 Solution:

SPOTLIGHT
The cost per unit produced can be calculated as follows: Rs.
Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Less scrap value of normal loss (200 litres  0,9) (180)
4,320

STICKY NOTES
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs.2.40

The process account can be completed as follows

Process X
Litres Rs. Litres Rs.
Materials 2,000 3,600 Output (actual) at Rs. 2.4 each 1,800 4,320
Direct labour 300
Prod. O’hd 600 Normal loss 200 180
2,000 4,500 2,000 4,500

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2.1.3. Normal loss with cost of disposal

In other cases, a company might have to pay to dispose-off losses in a process and additional cost might be
incurred to its disposal. For example, the substance to be scraped off might be toxic and has to be disposed-off
by bearing some cost so that no harm is caused to the population of the vicinity, wildlife or marine life..
The cost of disposal represents an additional cost to the process.
To reflect this in the process account, the normal loss is measured at zero but the expected costs of disposal are
debited to the process account.
 Formula:

Total process costs + Disposal costs of the normal loss

Per unit Cost of good output =
Expected units of output
AT A GLANCE

 Example 07:
The following information relates to a production process X

Input quantities 2,000 litres

Normal loss 10%
Therefore expected output 1,800 litres
Actual output 1,800 litres
Disposal cost of normal loss Rs. 1 per litre

Note: Take remaining data from example 04.

SPOTLIGHT

Required:
Prepare the process account.Solution:The cost per unit produced can be calculated as follows:

Rs.
Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Disposal costs of normal loss (200 litres  1) 200
STICKY NOTES

4,700
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.6111

The process account can be completed as follows

Process X
Litres Rs. Litres Rs.
Materials 2,000 3,600 Output (actual) at Rs. 1,800 4,700
2.6111 each
Direct labour 300
Prod. overhead 600
Disposal cost of 200 Normal loss 200 −
normal loss
2,000 4,700 2,000 4,700

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2.2. Abnormal Loss

As discussed above, normal loss is the expected amount of loss in a process. However, actual loss might be
more than the expected or normal loss. When actual loss exceeds normal loss, there is abnormal loss. The
difference between total actual loss and normal loss is abnormal loss.
 Formula:

Abnormal loss = Actual loss – Expected (normal) loss

From earlier:
Quantity of material input = Normal loss + Expected output
But:
Expected output = Actual output + Abnormal loss

AT A GLANCE
Therefore:
Quantity of material input = Normal loss + Actual output + Abnormal loss
Total loss = Normal loss + Abnormal loss.

Abnormal loss is not expected and might occur due to negligence, carelessness or natural disaster. It is,
therefore, important to assign it cost. By giving a cost to abnormal loss, management information about the loss
can be provided, and management can be made aware of the extent of any problem that might exist with
excessive losses in process.
2.2.1. Accounting for abnormal loss
If it is assumed that all losses in process occur at the end of the process, units of abnormal loss are valued in
exactly the same way as the units of finished output. This might seem a little strange but the idea is to highlight

SPOTLIGHT
the impact of the loss.
The cost per unit of abnormal loss is therefore the same as the cost of units of good output. This is exactly the
same as before.
 Formula:
Total process costs − Scrap value of the normal loss
Per unit Cost of good output =
Expected units of output
The cost of units of abnormal loss is treated as an expense for the period, and charged as an expense in the
income statement for the period.
 Example 08:

STICKY NOTES
The following information relates to a production process X.

Input quantities 2,000 litres

Normal loss 10%
Therefore expected output 1,800 litres
Actual output 1,700 litres
Therefore abnormal loss 100 litres

Note: Take remaining data from example 04.

Required:
Prepare the following:
• Process account X
• Abnormal loss account.

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 Solution:

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.5
AT A GLANCE

Costing:
Cost of finished output = 1,700 units  Rs.2.50 = Rs.4,250.
Cost of abnormal loss = 100 units  Rs.2.50 = Rs.250.
The process account can be completed as follows

Process X
Litres Rs. Litres Rs.
Materials 2,000 3,600 Output (actual) at 1,700 4,250
Rs. 2.5 each
Direct labour 300 Abnormal loss 100 250
SPOTLIGHT

Production 600
overheads
Normal loss 200 −
2,000 4,500 2,000 4,500

Abnormal loss can be prepared as follows, assuming that it has no scrap value.

Abnormal Loss Account

Litres Rs. Litres Rs.
STICKY NOTES

Process X 100 250 Profit & Loss A/C 100 250

250 250

The appropriate abnormal loss double entry in the cost ledger is:

Debit Credit
Abnormal loss account X
Process accounts X

The entry to close the abnormal loss account at period end is:

Debit Credit
Profit and Loss Account X
Abnormal Loss Account X

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At the end of the financial period, the balance on the abnormal loss account is written off as a cost in the costing
income statement. Unlike normal loss, the cost of abnormal loss is not built into inventory, however, the cost of
abnormal loss is treated as a period cost rather than a product cost.

2.2.2. Abnormal loss with recovery value

When loss has a scrap value, the scrap value of normal loss is deducted from the process cost, as explained
earlier.
Abnormal loss will also have a scrap value but this is treated differently to the scrap value of normal loss.
• The cost of expected units of output is calculated in the usual way and scrap value of abnormal loss will not
affect cost per unit of output.
• The scrap value of normal loss is normal loss units  scrap value per unit (as usual).

AT A GLANCE
• In the process account, the cost of abnormal loss is measured at the cost of expected units (just as before).
• Periodically, the units in the normal loss account are transferred to a scrap account at scrap value.
• The balance on the abnormal loss account is an expense for the period (measured at the cost of the units
less the scrap value of abnormal loss).
• This means that scrap value of abnormal loss is set off against the cost of abnormal loss in the abnormal
loss account, not in process account.
 Example: 09:
The following information relates to a production process X.

Input quantities 2,000 litres

SPOTLIGHT
Normal loss 10%
Therefore expected output 1,800 litres
Actual output 1,700 litres
Therefore abnormal loss 100 litres
Scrap value of losses Rs. 0.9 per litre

Note: Take remaining data from example 04.

Required:
Prepare the following:

STICKY NOTES
• Process account X
• Abnormal loss account.
• Scrap Account
 Solution:

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Scrap value of normal loss (200  Rs.0.90) (180)
Total production cost 4,320
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.4

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Costing:
Cost of finished output = 1,700 units  Rs. 2.40 = Rs. 4,080.
Cost of abnormal loss = 100 units  Rs. 2.40 = Rs. 240.
Normal loss = 200 units  Rs. 0.9 = Rs. 180
The process account can be completed as follows

Process X
Litres Rs. Litres Rs.
Materials 2,000 3,600 Output 1,700 4,080
Direct labour 300 Abnormal loss 100 240
AT A GLANCE

Prod. Overhead 600 Normal loss 200 180

2,000 4,500 2,000 4,500

Abnormal loss account with scrap value is prepared as follows.

Abnormal loss account

Litres Rs. Litres Rs.
Process X account 100 240 Scrap account 100 90
Income statement 150
SPOTLIGHT

100 240 100 240

Scrap account
Litres Rs. Litres Rs.
Process X account 200 180 Cash 300 270
(normal loss)
Abnormal loss 100 90
account
300 270 300 270
STICKY NOTES

The appropriate abnormal loss double entry in the cost ledger is:

Debit Credit
Abnormal loss account X
Process accounts X

The entry to close the abnormal loss account at period end is:

Debit Credit
Profit and Loss Account X
Scrap account X
Abnormal Loss Account X

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3 ABNORMAL GAIN
Abnormal loss occurs when actual loss is more than the expected (normal) loss. Abnormal gain occurs when
the actual loss is less than normal loss. Abnormal gain is the difference between the expected normal loss and
the actual loss. It might be due to enhanced efficiency of the manufacturing process, if the gain is expected to be
permanent then the expected loss ratio should be revised.
 Formula: Abnormal gain

Abnormal gain = Expected (normal) loss – Actual loss

From earlier:
Expected output = Actual output + Abnormal loss

AT A GLANCE
Gain is opposite in sign so goes to the other side of the expression:
Expected output + Abnormal gain = Actual output
Actual loss = Normal loss – Abnormal gain

3.1. Accounting for abnormal gain: no scrap value for loss

The method of costing for abnormal gain is the same in principle as for abnormal loss. If it is assumed that all
losses occur at the end of the process, the cost per unit of finished output and the value/cost of abnormal gain
are calculated as the cost per expected unit of output. (i.e. the cost of good output)
The unit cost credited to abnormal gain is therefore the same as the cost of units of good output. This is exactly
the same as before.

SPOTLIGHT
 Formula: Cost of good output

Total process costs − Scrap value of the normal loss

Per unit Cost of good output =
Expected units of output

The differences between costing for abnormal loss and costing for abnormal gain are that:
• Abnormal gain is a benefit rather than an expense. Whereas abnormal loss is written off as a cost at the end
of the financial period, abnormal gain is an adjustment that increases the profit for the period.
• Abnormal gain account has credit balance and is recorded as a debit entry in the process account, because
it is a benefit.

STICKY NOTES
• The other side of the double entry is recorded in an abnormal gain account. At the end of the period, the
balance on the abnormal gain account is then transferred to the income statement as a benefit for the
period, adding to profit.
 Example 10:
The following information relates to a production process X.

Input quantities 2,000 litres

Normal loss 10%
Therefore expected output 1,800 litres
Actual output 1,850 litres
Therefore abnormal gain 50 litres

Note: Take remaining data from example 04.

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Required:
Prepare the following:
• Process account X
• Abnormal gain account.
 Solution:

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Conversion costs (direct labour + production overheads) 900
Total production cost 4,500
AT A GLANCE

Expected output (90% of 2,000) ÷1,800 litres

Cost per litre Rs. 2.5

Costing:
Cost of finished output = 1,850 units  Rs. 2.50 = Rs. 4,625.
Cost of abnormal gain = 50 units  Rs. 2.50 = Rs. 125.
Normal loss = zero (as there is no scrap value).
The process account can be completed as follows
SPOTLIGHT

Process X
Litres Rs. Litres Rs.
Materials 2,000 3,600 Output 1,850 4,625
Conversion cost 900
Abnormal gain 50 125 Normal loss 200 nil
2,050 4,625 2,050 4,625

Abnormal gain account

STICKY NOTES

Litres Rs. Litres Rs.

Income 50 125 Process X 50 125
statement
50 125 50 125

The balance on this account is taken to the costing income statement at the end of the period, and added to the
reported profit.

The appropriate double entry in the cost ledger is:

Debit Credit
Process account X
Abnormal gain account X

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3.2. Abnormal gain where loss has a scrap value

When loss has a scrap value, the value of abnormal gain is actually less than the amount shown in the process
account. The process has been more efficient and produced more good output than expected but there are less
normal loss units so the revenue from scrap is less than expected.
Accounting for the scrap value of abnormal gain is similar to accounting for the scrap value of abnormal loss.
• In the process account (WIP), abnormal gain is valued at the cost per expected unit of output.
• The scrap value of normal loss is normal loss units  scrap value per unit (as usual).
• The scrap value of abnormal gain is recorded as a debit entry in the abnormal gain account (in a similar
way to recording the scrap value of abnormal loss as a credit entry in the abnormal loss account).
• The scrap value of the abnormal gain is set off against the value of the abnormal gain in the abnormal gain

AT A GLANCE
account, not in process account.
• The balance on the abnormal gain account is the net value of abnormal gain (value of abnormal gain minus
the scrap value not earned from the normal loss). This balance is transferred as a net benefit to the cost
accounting income statement at the end of the accounting period.
 Example 11:
Abnormal gain where loss has scrap value.
The following information relates to a production process X.

Input quantities 2,000 litres

Normal loss 10%

SPOTLIGHT
Therefore expected output 1,800 litres
Actual output 1,850 litres
Therefore abnormal gain 50 litres
Scrap value of losses Rs. 0.9 per litre

Note: Take remaining data from example 04.

Required:
Prepare the following:
• Process account X

STICKY NOTES
• Abnormal loss account.
• Scrap Account
 Solution:
The cost per unit produced can be calculated as follows:

Rs.
Direct materials 3,600
Direct labour 300
Production overheads 600
Scrap value of normal loss (200  Rs.0.90) (180)
Total production cost 4,320
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.4

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Costing:
Cost of finished output = 1,850 units  Rs. 2.40 = Rs. 4,440.
Cost of abnormal gain = 50 units  Rs. 2.40 = Rs. 120.
Normal loss = 200 units  Rs. 0.90 = Rs. 180.
The process account can be completed as follows
Process X
Litres Rs. Litres Rs.
Materials 2,000 3,600 Output 1,850 4,440
Conversion cost 900
Abnormal gain 50 120 Normal loss 200 180
AT A GLANCE

2,050 4,620 2,050 4,620

Accounting for the abnormal gain and the normal loss

The double entry to account for the losses can be completed as follows

Abnormal gain account

Litres Rs. Litres Rs.
Scrap account 50 45 Process X account 50 120
Income statement 75
50 120 50 120
SPOTLIGHT

The balance on this account is Rs.75. This is treated as an addition to profit in the cost accounting income
statement for the period.

Scrap account
Litres Rs. Litres Rs.
Process X a/c (normal 200 180 Abnormal gain 50 45
loss) account
Cash 150 135
200 270 200 180

The company expected to be able to sell 200 litres of scrap product. The abnormal gain means that they only
STICKY NOTES

have 150 litres to sell. The scrap value of 50 litres is adjusted against abnormal gain account.
 Example 12:
AK chemicals process high quality plastic sheeting in a continuous manufacturing operation. All materials are
input at the beginning of the process. Conversion costs are incurred evenly throughout the process. The cost in
process is given in the following table.
Process Rs.
Materials cost 90,000
Conversion costs 72,650

40,000 units were put into process and 36,000 units were transferred to finished goods. There is no opening or
closing work in progress. Past experience indicates that approximately 7.5% of the units started are found to be
defective on inspection by quality control. The scrap value of loss is Rs. 1.80 per unit.
Required:
Prepare the process account and abnormal loss account.

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 Solution:

Process account and abnormal loss account is prepared as below.

Process Account
Units Rs. Units Rs.
Materials 40,000 90,000 Normal loss 3,000 5,400
Conversion cost 72,650 Abnormal loss 1,000 4,250
Finished goods 36,000 153,000
40,000 162,650 40,000 162,650

AT A GLANCE
Calculation of cost per unit = (162,650 – 5,400) / 37,000 = Rs. 4.25
Cost assigned to output (Finished goods) = 36,000 x 4.25 = Rs. 153,000
Cost assigned to Abnormal Loss = 1,000 x 4.25 = Rs. 4,250

Abnormal loss account

Units Rs. Units Rs.
Process 1,000 4,250 Scrap account 1,000 1,800
account
Income statement 2,450

SPOTLIGHT
1,000 4,250 1,000 4,250

 Example 13:
HL Limited manufactures product B201 which was produced in two processes i.e. Process A and Process B.
Relevant data for the month of April 2020 is given below.

Process A Process B
Units started/ received from process A 60,000 55,000
Units lost in process 5,000 2,500
Units transferred to Process B/ Finished goods 55,000 52,500

STICKY NOTES
Normal Loss in % 5% 5%
Cost data: Rupees Rupees
Materials 65,200 -
Conversion cost 102,500 35,600

There shall be no work in progress in both process. Scrap value of losses in process A is Rs. 0.80 per unit
whereas in process B Rs. 1.20 per unit. Assuming all losses were occurred at end of both process.
Required:
Prepare the following accounts:
• Process account A
• Process account B

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 Solution:
Process A, Process B and Abnormal loss/ gain accounts for the month of April 2020 are prepared, as under.

Process A Account
Units Rs. Units Rs.
Materials 60,000 65,200 Normal loss 3,000 2,400
Conversion cost 102,500 Abnormal loss 2,000 5,800
Finished goods 55,000 159,500
60,000 167,700 60,000 167,700
AT A GLANCE

Calculation of cost per unit = (167,700 – 2,400) / 57,000 = Rs. 2.90

Cost assigned to normal loss = 3,000 x 0.80 = Rs. 2,400
Cost assigned to output (Finished goods) = 55,000 x 2.90 = Rs. 159,500
Cost assigned to Abnormal Loss = 2,000 x 2.90 = Rs. 5,800

Process B Account
Units Rs. Units Rs.
Process I- 55,000 159,500 Normal loss 2,750 3,300
Materials
Conversion cost 42,350
SPOTLIGHT

Abnormal gain 250 950 Finished goods 52,500 199,500

55,250 202,800 55,250 202,800

Calculation of cost per unit = (201,850 – 3,300) / 52,250 = Rs. 3.80

Cost assigned to normal loss = 2,750 x 1.20 = Rs. 3,300
Cost assigned to output (Finished goods) = 52,500 x 3.80 = Rs. 199,500
Cost credited to Abnormal Gain = 250 x 3.80 = Rs. 950
STICKY NOTES

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4 PROCESS COSTING WITH CLOSING WORK IN PROGRESS

4.1. Sharing out process costs between finished units and unfinished inventory
When manufacturing is a continuous process, there may be unfinished work-in-progress (WIP) at the start and
end of a period. This section looks at closing WIP, whereas opening WIP will be dealt later in this chapter. In all
the examples in this section, it is assumed that there is no opening WIP.
It stands to reason that the cost or value of an unfinished unit is less than the cost of a completed unit. The costs
of the process must be shared between finished output and unfinished work-in-process on a fair basis.
Previous sections have explained that costs are allocated to output by calculating a cost per unit. This involves
dividing a cost figure by the number of units of expected output.
Ignoring all complexities, we normally assume that all costs occur evenly throughout the process. For instance,

AT A GLANCE
70% completion means that costs should be allocated up to 70% to the respective units.
In order to allocate the cost to closing work in progress, it is important to know about equivalent production
unit concept, normally termed as ‘equivalent units’.
4.2. Equivalent units
Equivalent units represent the production in terms of completed units. At the end of any given period, there are
likely to be partly completed units (work in process). It is evident that some of the costs pertaining to this
period are attributable to partially completed units. A number of partially completed units is the equivalent of
a number of complete units depending on their degree of completion. As mentioned above, ignoring any
complication, It is normally assumed that the costs are added uniformly throughout the process.
 Illustration:

SPOTLIGHT
200 units that are 50% complete are equivalent to 100 (50%  200) complete units
The above indicates that cost incurred on partially completed 200 units is equal to 100 completed units. The
easiest way of calculation is multiplying the WIP units with percentage of completion, assuming that cost occur
evenly throughout the process.
Complication
In all of the previous examples a cost per unit was calculated by dividing the total process costs (perhaps
adjusting for expected normal loss or cost of disposal) by the expected number of units.
The existence of work in progress complicates this because the work in progress might be complete to different
degrees in respect of different cost inputs. For example, a unit in the closing work in progress might be 80%
complete with respect to material but only 50% complete with respect to labour.

STICKY NOTES
In this case, the number of equivalent units of direct materials cost in a period will therefore differ from the
number of equivalent units of labour.
A cost per unit is calculated for each type of cost using the equivalent units for that cost. The cost of output is
then based on these individual costs.
Costs for finished output and closing inventory can be calculated from the number of equivalent units and the
cost per equivalent unit.
4.3. A three-stage calculation
A three-stage calculation is recommended in this situation:
• Stage 1: Prepare a statement of equivalent units to calculate the equivalent units for each type of cost in the
output from the process and for closing WIP
• Stage 2: Prepare a statement of cost per equivalent unit for each type of cost and it is known as per unit
cost of each cost element.
• Stage 3: Prepare a statement to calculate the cost of finished output and closing WIP from the statement of
equivalent units and statement of cost per equivalent unit.

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4.4 Example related to closing WIP without losses (single process)

 Example 14:
The following information relates to a production process X.

Input quantities 4,000 units

Completed output 3,500 units
Closing WIP 500 units

All the direct materials are added to production at the beginning of the process.
Closing inventory of 500 units is therefore 100% complete for materials but is only 40% complete for
conversion
AT A GLANCE

The costs incurred in the period were: Rs.

Direct materials 24,000
Converison costs: 7,400

Required:
Prepare the process account.
 Solution:
Statement of equivalent units would require be as follows:

Equivalent units
SPOTLIGHT

Total Percentage Direct Conversion

Output
units complete materials costs
Finished output 3,500 100% 3,500 3,500
Closing WIP:
Materials 500 100% 500
Conversion 40% 200
4,000 4,000 3,700

Statement of cost per equivalent unit

STICKY NOTES

Direct materials Conversion costs

Total costs Rs.24,000 Rs.7,400
Equivalent units ÷ 4,000 ÷ 3,700
Cost per equivalent unit Rs.6 Rs.2

Statement of evaluation

Rs.
Cost of finished goods (3,500  (Rs. 6 + Rs. 2)) 28,000
Cost of closing WIP
Materials (500 units  Rs. 6) 3,000
Conversion (200 units  Rs. 2) 400
3,400

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These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Direct materials 4,000 24,000 Finished goods 3,500 28,000
Conversion costs - 7,400 Closing WIP 500 3,400
4,000 31,400 4,000 31,400

4.5 Example related to closing WIP without losses (two processes)

 Example 15:

AT A GLANCE
A manufacturing company operates two processes. Output from Process 1 is transferred as input to Process 2.
Output from Process 2 is the finished product.
Data for the two processes in January are as follows:

Process 1
Opening work in process Nil
Units put into the process 14,000
Units completed and transferred to the next process (Process 2) 10,000
Closing work-in-progress 4,000

SPOTLIGHT
Material cost added during the period Rs.70,000
Conversion cost added during the period Rs.48,000

Materials are input into Process 1 at the start of the process and conversion costs are incurred at a constant
rate throughout processing. The closing work-in-progress in Process 1 at the end of January is estimated to be
50% complete for the conversion work.

Process 2
Opening work-in-process Nil
Units transferred into the process from Process 1 10,000

STICKY NOTES
Closing work-in-progress 1,000
Units completed and transferred to finished goods inventory 9,000
Costs for the period:
Conversion cost added during the period Rs.57,000
Added materials during Process 2 Rs.36,000

The materials from Process 1 are introduced at the start of processing in Process 2, but the added materials are
introduced at the end of the process 2. Conversion costs are incurred at a constant rate throughout processing.
The closing work-in-progress in Process 2 at the end of January is estimated to be 50% complete.
Required:
a) Calculate the cost of completed output from Process 1 and Process 2
b) Calculate the cost of the closing work-in-process in each process at the end of January.
c) Prepare the Process 1 account and the Process 2 account for January.

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 Solution
There is no opening inventory in either process; therefore, there is no difference between the weighted average
cost and FIFO valuation methods.

Process 1

Equivalent units Total Direct materials Conversion costs

Total units Equivalent units Equivalent units
Completed units 10,000 10,000 10,000
Closing inventory 4,000 4,000 (4,000 × 50%) 2,000
Total equivalent units 14,000 14,000 12,000
AT A GLANCE

Cost Rs.70,000 Rs.48,000

Cost per equivalent unit Rs.5 Rs.4

Cost assigned to units transferred to Process 2 Rs.

Cost of finished goods (10,000  (Rs. 5 + Rs. 4)) 90,000

Cost assigned to closing WIP inventory Rs.

Materials (4,000 x 5) 20,000
SPOTLIGHT

Conversion cost (4,000 x 50% x 4) 8,000

28,000

The process account is prepared as follows:

Process 1 account
units Rs. units Rs.
Direct materials 14,000 70,000 Process 2 account 10,000 90,000
Conversion costs 48,000 Closing inventory c/f 4,000 28,000
STICKY NOTES

14,000 118,000 14,000 118,000

Process 2

Conversion
Total Materials from Process 1 Added materials
costs
Equivalent units
Equivalent Equivalent
Total units Equivalent units
units units
Completed units 9,000 9,000 9,000 9,000
Closing inventory 1,000 1,000 500 0
Total equivalent units 10,000 10,000 9,500 9,000
Cost Rs.90,000 Rs.57,000 Rs.36,000
Rs.9 Rs.6 Rs.4

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Note: The added materials are added at the end of the process, which means that there are no added materials
in the (unfinished) closing inventory.

Cost assigned to units transferred to Finished goods Rs.

Cost of finished goods (9,000  (Rs. 9 + Rs. 6 + Rs. 4)) 171,000

Cost assigned to closing WIP inventory Rs.

Cost of process I (1,000 x 9) 9,000
Conversion cost (1,000 x 50% x 6) 3,000
12,000

AT A GLANCE
The process account is prepared as follows:

Process 2 account
units Rs. units Rs.
Materials from Process 1 10,000 90,000 Finished goods 9,000 171,000
Conversion costs 57,000
Added materials 36,000 Closing inventory c/f 1,000 12,000
10,000 183,000 10,000 183,000

SPOTLIGHT
STICKY NOTES

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5 OPENING WORK IN PROGRESS

5.1. Introduction to opening work in progress
Closing work in progress in one period is treated as opening work in progress in next period of same process.
Opening work in progress adds another level of complexity.
When there is opening work in progress, there are two types of cost on the debit side of the account. These are
the costs that were incurred last period and brought forward as work in progress and the costs that were
incurred in the current period. The issue is whether they should be treated together or separately. It depends
upon the selection of inventory method by management for WIP. Following are the two methods of valuation of
WIP.
• weighted average cost method treats all costs on the debit side of the account in the same way.
AT A GLANCE

• first-in, first-out (FIFO) method allocates the costs in opening WIP to the finished goods and then spreads
the remaining costs elsewhere.

5.2. Opening Work In Progress: Weighted Average Cost Method

5.2.1. The underlying principle

When the weighted average cost method is used, the assumption is that all units produced during the period
and all units of closing inventory should be valued at the same cost per equivalent unit for materials and the
same cost per equivalent unit for conversion costs.
An average cost per equivalent unit is calculated for all units of output and closing inventory. This includes the
units that were partly-completed at the beginning of the period (and which were therefore valued as closing
WIP at the end of the previous period).
SPOTLIGHT

The calculation of equivalent units is based on the number of units finished in the period (it does not matter
when they were started) and the number of units in closing WIP.

5.2.2. The three-stage calculation

The costs are worked out in a similar way to the previous example (where there was no opening WIP).
• Statement of equivalent units. Prepare a statement of equivalent units for finished output and for closing
WIP. It is similar to equivalent units calculated in above examples.
• Statement of cost per equivalent unit. Calculate the cost per equivalent unit for direct materials and the
cost per equivalent unit for conversion costs. However, remember to include the cost of the opening WIP.
STICKY NOTES

The materials cost of the opening WIP should be included in the total direct materials cost, and the
conversion costs in the opening WIP should be added to the conversion costs for the current period.
You will normally have to calculate a separate cost per equivalent units for materials and for conversion
costs. This is because the equivalent units of closing inventory will be different for materials and
conversion costs.
• Statement of evaluation. Having calculated the equivalent units and a cost per equivalent unit, prepare a
statement of evaluation in which cost is assigned to all units accordingly.
 Example 16:
The following information relates to a production process X.

Opening inventory 3,000 units

Material cost in opening WIP (100% complete) Rs. 12,600
Conversion costs in opening WIP (30% complete) Rs. 970

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During the month

Input quantities 7,000 units
Completed output 8,000 units
Closing WIP (100% complete for direct materials and 60% complete for conversion costs). 2,000 units
All the direct materials are added to production at the beginning of the process.
Closing inventory of 2,000 units is therefore 100% complete for materials but is only 60% complete for
conversion.
The costs incurred in the period were:
Rs.

AT A GLANCE
Direct materials 28,000
Converison costs: 17,430

Required:
Prepare the process account.
 Solution:

Statement of equivalent units

Equivalent units
Output Total units Percentage complete Direct materials Conversion costs

SPOTLIGHT
Finished output 8,000 100% 8,000 8,000
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 10,000 9,200

And the Statement of cost per equivalent unit, would be as follows

Direct materials Conversion costs

Total costs

STICKY NOTES
Costs in opening WIP Rs. 12,600 Rs. 970
Costs in the period Rs. 28,000 Rs.17,430
Rs. 40,600 Rs.18,400
Equivalent units ÷ 10,000 ÷ 9,200
Cost per equivalent unit Rs. 4.06 Rs. 2.00

Statement of evaluation

Rs.
Cost of finished goods (8,000  (Rs. 4.06 + Rs. 2.00)) 48,480
Cost of closing WIP
Materials (2,000 units  Rs. 4.06) 8,120
Conversion (1,200 units  Rs. 2.00) 2,400
10,520

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These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 8,000 48,480
Conversion costs - 17,430 Closing WIP 2,000 10,520
10,000 59,000 10,000 59,000

5.2.3. Weighted average cost method: summary

The weighted average cost method for process costing with opening WIP can be summarized as follows:
AT A GLANCE

• All output and closing inventory is valued at the same cost per equivalent unit
• Cost of opening inventory + Costs in the period = Total costs
• Units of closing inventory + Units of output in the period = Total equivalent units
• Cost per equivalent unit = Total costs/Total equivalent units
 Illustration for the summary of weighted average calculation of cost per unit, is below

Direct Conversion
materials costs
Cost of opening inventory X X
SPOTLIGHT

Costs incurred in the period X X

Total costs Xm Xcc
Number of units output Y Y
Equivalent units of closing inventory Y Y
Total equivalent units Ym Ycc
Cost per equivalent unit (Xm/Ym) (Xcc/Ycc)

5.3. Opening Work In Progress: FIFO Method

5.3.1. FIFO method in process costing

STICKY NOTES

The first-in, first-out (FIFO) method of process costing is based on the assumption that the opening units of
work-in-process at the beginning of the month will be the first units completed. The cost of these units is their
value at the beginning of the period plus the cost to complete them in the current period. Therefore, cost of
opening WIP is not merged with cost of current production units, rather, it is separately allocated to units
transferred on first-in-first-out basis.
It is necessary to calculate the number of equivalent units of work done in the period. This consists of:
• The equivalent units of direct materials and conversion costs required to complete the opening WIP. These
are the first units completed in the period.
• The equivalent units of finished output in the period that was started as well as finished in the period.
These have one equivalent unit of direct materials and one equivalent unit of conversion costs. The total
number of these units is:
- the total fisnished output in the period
- minus the quantity of opening WIP (which are completed first)
• The equivalent units of closing WIP (calculated in the normal way).

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5.3.2. The three-stage calculation

The three-stage calculation with the FIFO method is similar to the calculation method previously described,
with the exception that in the statement of evaluation, the cost of finished output consists of:
• The finished cost of opening WIP which is the sum of:
- the costs in the opening WIP value at the start of the period; plus
- the costs in the current period to complete these units; plus
• the cost of finished output started as well as finished in the period.
Study the following example carefully.
 Example 17:

AT A GLANCE
The following information relates to a production process X.

Opening inventory 3,000 units

Material cost in opening WIP (100% complete – therefore 0% is needed in this period) Rs. 12,600

Conversion costs in opening WIP (30% complete – therefore 70% is needed in this period) Rs. 970

Rs. 13,570

During the month

SPOTLIGHT
Input quantities 7,000 units

Completed output 8,000 units

Closing WIP (100% complete for direct materials and 60% complete for conversion costs). 2,000 units

All the direct materials are added to production at the beginning of the process.
Closing inventory of 2,000 units is therefore 100% complete for materials but is only 60% complete for
conversion.
The costs incurred in the period were:

STICKY NOTES
Rs.

Direct materials 28,000

Converison costs: 17,430

Required:
Prepare the process account.

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 Solution:
In solving for Statement of equivalent units, please see below:

Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
Started last period
Opening WIP 3,000
Materials 0% nil
Conversion 70% 2,100
Started and finished in the period 5,000 100% 5,000 5,000
AT A GLANCE

Finished in period 8,000 5,000 7,100

Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 7,000 8,300

Statement of cost per equivalent unit

Total costs in current period Rs. 28,000 Rs.17,430

Equivalent units ÷ 7,000 ÷ 8,300
SPOTLIGHT

Cost per equivalent unit Rs. 4.00 Rs. 2.10

Statement of evaluation

Rs.
Cost of goods finished in the period (8,000 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100  Rs. 2.10) 4,410
STICKY NOTES

17,980
Started and finished in this period [5,000  (Rs. 4.00 + Rs. 2.10)] 30,500
48,480
Cost of closing WIP
Materials (2,000 units  Rs. 4.00) 8,000
Conversion (1,200 units  Rs. 2.10) 2,520
10,520

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These costs would be recorded in the process account as follows

Process (WIP) account

units Rs. units Rs.

Opening WIP 3,000 13,570

Direct 7,000 28,000 Finished goods 8,000 48,480

materials

Conversion - 17,430 Closing WIP 2,000 10,520

costs

AT A GLANCE
10,000 59,000 10,000 59,000

(Tutorial note: If you compare this example using FIFO with the previous example using the weighted average
cost method, you will see that the cost of finished output and value of closing WIP is the same in each case. This
is a coincidence. Normally, the two methods provide different costs for finished output and different closing
WIP valuations.)

5.3.3. FIFO method: summary

The first-in, first-out method for process costing with opening WIP can be summarized as follows.
• The cost of the opening units completed in the current period is calculated separately from the cost of the
units that are started and finished in the current period.

SPOTLIGHT
• A cost per equivalent unit is calculated for the current period, as follows:
 Illustration for the summary of FIFO based calculation of cost per unit, is given below

Direct materials Conversion costs

Costs incurred in the current period TCm TCc

Equivalent units of work in the current period:

to complete opening WIP X Y

to start and finish units X Y

STICKY NOTES
to make closing WIP X Y

Total equivalent units of work in this period Xm Ycc

Cost per equivalent unit in the current period TCm / Xm TCc / Ycc

• These costs are used to apportion the process costs in the current period between:
- the cost of completing the opening WIP
- the cost of units started and finished in the current period
- the value of closing inventory.

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• Having calculated costs for the current period, the valuation of output from the process is calculated as
follows:
and illustration for the summary of evaluation of outputs under the FIFO method, is given below:

Rs.
Cost of Items started in the previous period and finished in this period
Opening WIP X
Cost of finishing the opening WIP
To complete material X
To complete other costs X
AT A GLANCE

X
Cost of items started and finished in this period X
Cost of items finished in the period X
Cost of items started in this period
Material X
Other costs X
X
Total process costs X
SPOTLIGHT
STICKY NOTES

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6 WORK IN PROGRESS AND LOSSES

6.1. Introduction
Earlier in the chapter, we explained that normal loss is not assigned any cost, unless it has scrap value and in
this case, normal loss shall be assigned a value, equal to its scrap value. This clarified that the scrap recovery
reduces the overall cost of the process.
We saw that abnormal loss is measured in the same way as good production, because we assume that losses
were occurred at end of process. The number of abnormal loss units are included in the expected good output
used in the cost per unit calculation.
The same principles are followed when a question requires the calculation of cost per unit by component
through the calculation of equivalent units. The number of equivalent units taken to build the abnormal loss

AT A GLANCE
must be included in the total number of equivalent units.
The following examples help to understand the treatment of normal and abnormal losses along with closing
work in progress.
 Example 18:
Following data is related to process I of ABC Limited for the month of May, 2020.

Process 1
Opening work in process Nil
Units started 20,000
Units transferred to process 2 15,000

SPOTLIGHT
Units in process (80% completed) 3,000
Normal loss 10%
Cost data:
Direct materials Rs. 78,000
Conversion cost Rs. 121,800

Normal loss has scrap value of Rs. 3 per unit. Material was added at start of the process 1 and conversion cost
was spread evenly throughout the process.
Required:

STICKY NOTES
Prepare the process 1 account.
 Solution:
Process 1 account for the month of May, 2020 and its relevant calculation is given below:

Calculation of equivalent units:

Equivalent units Total Direct materials Conversion costs

Total units Equivalent units Equivalent units
Completed units 15,000 15,000 15,000
Closing inventory 3,000 3,000 (3,000 × 80%) 2,400
Total equivalent units 18,000 18,000 17,400

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Calculation of Unit cost

Cost Equivalent Unit Unit Cost

Rs. Rs.
Direct materials 78,000
Less: scrap value of normal loss (2,000 x 3) (6,000)
72,000 18,000 4.00
Conversion cost 121,800 17,400 7.00
Total unit cost 11.00

Cost assigned to units transferred to Finished goods Rs.

AT A GLANCE

Cost of finished goods (15,000  11) 165,000

Cost assigned to closing WIP Inventory Rs.

Direct materials (3,000 x 4) 12,000
Conversion cost (3,000 x 80% x 7) 16,800
28,800

Process I Account is given as under:

Process 1 account
units Rs. units Rs.
SPOTLIGHT

Direct materials 20,000 78,000 Normal loss 2,000 6,000

Conversion costs 121,800 Process 2 15,000 165,000
Closing inventory 3,000 28,800
14,000 199,800 14,000 199,800

 Example 19:
Following data is related to process I of ABC Limited for the month of May, 2020.

Process 1
STICKY NOTES

Opening work in process Nil

Units started 20,000
Units transferred to process 2 15,000
Units in process (80% completed) 3,000
Normal loss 8%
Cost data:
Direct materials Rs. 95,200
Conversion cost Rs. 106,800

Normal loss has scrap value of Rs. 2 per unit. Material was added at start of the process 1 and conversion cost
was spread evenly throughout the process.
Required:
Prepare the process 1 account.

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 Solution:
Process 1 account for the month of May, 2020 and its relevant calculation is given below:
Calculation of equivalent units:

Equivalent units Total Direct materials Conversion costs

Total units Equivalent units Equivalent units
Completed units 15,000 15,000 15,000
Closing inventory 3,000 3,000 (3,000 × 80%) 2,400
Abnormal loss 400 400 400
Total equivalent units 18,400 18,400 17,800

AT A GLANCE
Calculation of Unit cost

Cost Equivalent Unit Unit Cost

Rs. Rs.
Direct materials 95,200
Less: scrap value of normal loss (1,600 x 2) (3,200)

92,000 18,400 5.00

Conversion cost 106,800 17,800 6.00
Total unit cost 11.00

SPOTLIGHT
Cost assigned to units transferred to Finished goods Rs.
Cost of finished goods (15,000  11) 165,000

Cost assigned to closing WIP Inventory Rs.

Direct materials (3,000 x 5) 15,000
Conversion cost (3,000 x 80% x 6) 14,400
29,400

STICKY NOTES
Cost assigned to units transferred to Abnormal loss Rs.
Cost of finished goods (400  11) 4,400

Process I Account is given as under:

Process 1 account
Units Rs. units Rs.
Direct materials 20,000 95,200 Normal loss 1,600 3,200
Conversion costs 106,800 Process 2 15,000 165,000
Abnormal Loss 400 4,400
Closing inventory 3,000 29,400
14,000 202,000 14,000 202,000

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 Example 20:
The following information relates to a production process X
Input quantities 4,000 units
Normal loss (all units having a scrap recovery of Rs. 1) 10% of input
Completed output 3,000 units
Closing WIP 500 units
All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to conversion as they
are 100% complete for material).
Closing inventory of 500 units is therefore 100% complete for materials but is 60% complete for conversion.
AT A GLANCE

The costs incurred in the period were: Rs.

Direct materials 24,016
Converison costs: 7,370
Required:
Prepare the process account X.
 Solution:
Note: It is useful to construct an extra working with these questions to show the physical number of units.
Closing work in progress and losses – (Preliminary working)
SPOTLIGHT

Units
Opening WIP 0
Input 4,000
Total possible units 4,000
Normal loss (10% of input) (400)
Expected good output 3,600
Actual good output (3,000)
Closing WIP (500)
Abnormal loss 100
STICKY NOTES

Closing work in progress and losses

Statement of equivalent units

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 3,000 100% 3,000 3,000
Closing WIP:
Materials 500 100% 500
Conversion 60% 300
Abnormal loss
Materials 100 100% 100
Conversion 50% 50
3,600 3,600 3,350

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Statement of cost per equivalent unit

Total costs Rs.24,016 Rs.7,370

Expected scrap recovery of normal loss (10%  4,000 units  Rs. 1) Rs. (400)
Rs.23,616 Rs.7,370
Equivalent units ÷ 3,600 ÷ 3,350
Cost per equivalent unit Rs.6.56 Rs.2.20

Statement of evaluation

Rs.

AT A GLANCE
Cost of finished goods (3,000  (Rs. 6.56 + Rs. 2.20)) 26,280
Cost of closing WIP
Materials (500 units  Rs. 6.56) 3,280
Conversion (300 units  Rs. 2.20) 660
3,940
Cost of closing abnormal loss
Materials (100 units  Rs. 6.56) 656
Conversion (50 units  Rs. 2.20) 110

SPOTLIGHT
766

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. Units Rs.
Direct 4,000 24,016 Finished goods 3,000 26,280
materials
Normal loss 400 400

STICKY NOTES
Conversion - 7,370 Abnormal loss 100 766
costs
Closing WIP 500 3,940
4,000 31,386 4,000 31,386

6.2. Inspection Activity During Processing:

Inspection is a quality control process where products or services are evaluated against established standards
to ensure they meet the required specifications. This inspection activity can be implemented at various stages
of the manufacturing process so that the scrap/loss units are identified before 100% costs are incurred are
incurred on them.
Up till now, abnormal or gain units were valued just like fully completed units. However, if units are rejected as
scrap or loss at an inspection stage before the completion of processing, the concept of equivalent units should
be used to decide the cost of the abnormal loss or the value of the abnormal gain. Equivalent units can be used
provided that an estimate is made of the degree of completion of units at the time the inspection takes place in
the process. Differing degrees of completion might be used for direct materials and conversion costs.

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Valuation of abnormal loss when inspection takes place during the process
When inspection takes place during the process, the cost of any abnormal loss should be calculated by:
• establishing the equivalent units of direct materials and conversion costs for the loss where the stage of
completion for abnormal loss units will be equal to the stage of inspection.
• calculating a cost per equivalent units
using the calculations of equivalent units and cost per equivalent unit to obtain a cost for finished output
and abnormal loss in the period.

Valuation of abnormal gain when inspection takes place during the process
The same principles apply to the valuation of abnormal gain when inspection takes place during the process.
However, there is one important difference. Equivalent units of abnormal gain are given a negative value and
AT A GLANCE

are subtracted from the total equivalent units of output in the period.
Perhaps the easiest way to think of the reason for this is that abnormal gain is on the opposite side of the
process account (the debit side) from actual finished output (credit side) and abnormal gain equivalent units
are subtracted because they offset the cost of the finished output.

6.3. Opening WIP and losses (Weighted average)

 Example 21:
The following information relates to a production process X

Opening inventory 3,000 units

SPOTLIGHT

Material cost in opening WIP (100% complete) Rs. 12,600

Conversion costs in opening WIP (30% complete) Rs. 970
During the month
Input quantities 7,000 units
Normal loss (all units having a scrap recovery of Rs. 1) 3.5%
Completed output 7,500 units
Closing WIP (100% complete for direct materials and 60% 2,000 units
complete for conversion costs).
STICKY NOTES

All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to conversion as they
are 100% complete for material).
Closing inventory of 2,000 units is therefore 100% complete for materials but is 60% complete for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000
Converison costs: 17,430

Required:
Prepare the process account X.

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 Solution:

Calculation of abnormal loss:

Units
Opening WIP 3,000
Input 7,000
Total possible units 10,000
Normal loss (35% of 10,000 units) (350)
Expected good output 9,650

AT A GLANCE
Actual good output (7,500)
Closing WIP (2,000)
Abnormal loss 150

Statement of equivalent units

Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
Finished output 7,500 100% 7,500 7,500

SPOTLIGHT
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
Abnormal loss
Materials 150 100% 150
Conversion 50% 75
9,650 9,650 8,775

STICKY NOTES
Statement of cost per equivalent unit

Direct materials Conversion costs

Total costs Rs. Rs.
Costs in opening WIP 12,600 970
Costs in the period 28,000 17,430
Expected scrap recovery of normal loss (350)
(3.5%  10,000 units  Rs. 1)
40,250 18,400
Equivalent units ÷ 9,650 ÷ 8,775
Cost per equivalent unit 4.17098 2.09687

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Statement of evaluation
In order to avoid difference due to rounding off, it is important to take values of unit cost up to 5 decimal
places.

Rs.
Cost of finished goods (7,500  (Rs. 4.17098 + Rs. 2.09687)) 47,009
Cost of closing WIP
Materials (2,000 units  Rs. 4.17098) 8,342
Conversion (1,200 units  Rs. 2.09687 2,516
10,858
Abnormal loss
AT A GLANCE

Materials (150 units  Rs. 4.17098) 626

Conversion (75 units  Rs. 2.09687) 157
783

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Opening WIP 3,000 13,570 Finished goods 7,500 47,009
Direct materials 7,000 28,000 Normal loss 350 350
SPOTLIGHT

Conversion costs - 17,430 Abnormal loss 150 783

Closing WIP 2,000 10,858
10,000 59,000 10,000 59,000

6.4 Opening WIP and losses (FIFO)

 Example 22:
The following information relates to a production process X.

Opening inventory 3,000 units

Material cost in opening WIP (100% complete Rs. 12,600
STICKY NOTES

Conversion costs in opening WIP (30% complete) Rs. 970

Rs. 13,570
During the month
Input quantities 7,000 units
Normal loss (all units having a scrap recovery of Rs. 1) 3.5%
Completed output 7,500 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to conversion as they
are 100% complete for material).

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Closing inventory of 2,000 units is therefore 100% complete for materials but is 60% complete for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000
Conversion costs: 17,430

Required:
Prepare the process account X.
 Solution:
Calculation of abnormal loss (units)

Units

AT A GLANCE
Opening WIP 3,000
Input 7,000
Total possible units 10,000
Normal loss (3.5% of 10,000 units) (350)
Expected good output 9,650
Actual good output:
Started in the previous period but finished in this period (3,000)
Started and finished in this period (4,500)
Output in this period (7,500)

SPOTLIGHT
Closing WIP (2,000)
Abnormal loss 150

Statement of equivalent units

Output Equivalent units

Total Percentage Direct Conversion
units complete materials costs
Started last period
Opening WIP 3,000

STICKY NOTES
Materials 0% nil
Conversion 70% 2,100
Started and finished in the 4,500 100% 4,500 4,500
period
Finished in period 7,500 4,500 6,600
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
Abnormal loss
Materials