Unit-10: Cost Accounting Basics

Notes
Structure
10.1 Introduction
10.2 lmportantTerms
10.3 Difference between cost Accounting and Costing
10.4 Objectives of Cost Accounting
10.5 Difference between Financial Accounting and Cost Accounting
10.6 Importance of Cost Accounting
10.7 Limitation of Cost Accounting
10.8 Cost Classification
10.9 Cost Sheet
10.10 Summary

Objectives
The objectives of this lesson are

To make student aware of basics of cost accounting, costing and its

advantages.

To explain the classification of costs from various angles.

To explain in brief the various inventory valuation method and Accounting

Standard applicable (AS-2).

10.11ntroduction
The organizations and managers are most of the times interested in and worried
for the costs. The control of the costs of the past, present and future is part of the
job of all the managers in a company. In the companies that try to have profits, the
control of costs affects directly to them. Knowing the costs of the products is essential
for decision-making regarding price and mix assignation of products and services. The
cost accounting systems can be important sources of information for the managers of
a company. For this reason, the managers understand the forces and weaknesses of
the cost accounting systems, and participate in the evaluation and evolution of the cost
measurement and administration systems. Unlike the accounting systems that help in
the preparation of financial reports periodically, the cost accounting systems and reports
are not subject to rules and standards like the Accounting Standards. As a result,
there is a wide variety in the cost accounting systems of the different companies and
sometimes even in different parts of the same company or organization. However, to
alleviate the problem Cost Accounting Standards are evolving.

10.21mportant Terms
1. Cost is the spending money that represents the manufacture of a product or
providing a service. In other words, the cost is the economic effort (the payment of
salaries, the purchase of materials, the manufacture of a product, securing funds
for financing the management of the company, etc..) that must be done to achieve
an operational objective. Failure to reach the desired goal, it is said that a company
has had losses.

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2. Cost accounting is the process of determining and accumulating the cost of Notes
product or activity. It is a process of accounting for the incurrence and the control
of cost. It also covers classification, analysis, and interpretation of cost. In other
words, it is a system of accounting, which provides the information about the
ascertainment, and control of costs of products, or services. It measures the
operating efficiency of the enterprise. It is an internal aspect of the organisation.
Cost Accounting is accounting for cost aimed at providing cost data, statement
and reports for the purpose of managerial decision making. The Institute of Cost
and Management Accounting, London defines "Cost accounting is the process
of accounting from the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centres and cost units. In the
widest usage, it embraces the preparation of statistical data, application of cost
control methods and the ascertainment of profitability of activities carried out or
planned".

3. Costing includes "the techniques and processes of ascertaining costs." The

'Technique' refers to principles which are applied for ascertaining costs of
products, jobs, processes and services. The 'process' refers to day to day
routine of determining costs within the method of costing adopted by a business
enterprise. Costing involves "the classifying, recording and appropriate allocation of
expenditure for the determination of costs of products or services; the relation of
these costs to sales value; and the ascertainment of profitability".

10.3 Difference Between Cost Accounting And Costing

The terms 'costing' and 'cost accounting' are many times used interchangeably.
However, the scope of cost accounting is broader than that of costing. Following
functional activities are included in the scope of cost accounting:

1. Cost book-keeping: It involves maintaining complete record of all costs incurred

from their incurrence to their charge to departments, products and services. Such
recording is preferably done on the basis of double entry system.

2. Cost system: Systems and procedures are devised for proper accounting for
costs.

3. Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc.,

is the important function of cost accounting. Cost ascertainment becomes the basis
of managerial decision making such as pricing, planning and control.

4. Cost Analysis: It involves the process of finding out the causal factors of actual
costs varying from the budgeted costs and fixation of responsibility for cost
increases.

5. Cost comparisons: Cost accounting also includes comparisons between cost

from alternative courses of action such as use of technology for production, cost of
making different products and activities, and cost of same product/ service over a
period of time.

6. Cost Control: Cost accounting is the utilisation of cost information for exercising
control. It involves a detailed examination of each cost in the light of benefit derived
from the incurrence of the cost. Thus, we can state that cost is analysed to know
whether the current level of costs is satisfactory in the light of standards set in
advance.

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Notes 7. Cost Reports: Presentation of cost is the ultimate function of cost accounting.
These reports are primarily for use by the management at different levels. Cost
Reports form the basis for planning and control, performance appraisal and
managerial decision making.

10.40bjectives of Cost Accounting

There is a relationship among information needs of management, cost accounting
objectives, and techniques and tools used for analysis in cost accounting. Cost
accounting has the following main objectives to serve:

1. Determining selling price

The objective of determining the cost of products is of main importance in cost
accounting. The total product cost and cost per unit of product are important in deciding
selling price of product. Cost accounting provides information regarding the cost to
make and sell product or services. other factors such as the quality of product, the
condition of the market, the area of distribution, the quantity which can be supplied etc.,
are also to be given consideration by the management before deciding the selling price,
but the cost of product plays a major role.

2. Controlling cost
Cost accounting helps in attaining aim of controlling cost by using various
techniques such as Budgetary Control, Standard costing, and inventory control. Each
item of cost [viz. material, labour, and expense] is budgeted at the beginning of the
period and actual expenses incurred are compared with the budget. This increases the
efficiency of the enterprise.

3. Providing information for decision-making

Cost accounting helps the management in providing information for managerial
decisions for formulating operative policies. These policies relate to the following
matters:

(a) Determination of cost-volume-profit relationship.

(b) Make or buy a component

(c) Shut down or continue operation at a loss

(d) Continuing with the existing machinery or replacing them by improved and
economical machines.

4. Ascertaining costing profit

Cost accounting helps in ascertaining the costing profit or loss of any activity on an
objective basis by matching cost with the revenue of the activity.

5. Facilitating preparation of financial and other statements

Cost accounting helps to produce statements at short intervals as the management
may require. The financial statements are prepared generally once a year or half
year to meet the needs of the management. In order to operate the business at high
efficiency, it is essential for management to have a review of production, sales and
operating results. Cost accounting provides daily, weekly or monthly statements of units
produced, accumulated cost with analysis. Cost accounting system provides immediate
information regarding stock of raw material, semi finished and finished goods. This
helps in preparation of financial statements.

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10.5 Difference Between Financial Accounting And Cost Accounting Notes

After studying financial accounting and cost accounting, you can understand the
difference between these two accounting systems. Therefore, difference between
financial accounting and cost accounting is as follows:

1. Objective Financial Accounting provides information about financial performance

through financial statements whereas Cost accounting provides information of cost
to control the cost and for decision making.

2. Nature Financial Accounting classifies, records, presents, and interprets

monetary transactions while Cost Accounting records, classifies, presents the cost
of product by breaking into material, labour and overheads cost.

3. Recording Financial Accounting records Historical data. While Cost Accounting

also records and presents the of data estimated/budgeted data. It makes use of
both the historical costs and pre-determined costs..

4. Users Financial Accounting users may include users inside and outside the
business. While Cost accounting information are mainly used by internal
management shareholders, creditors, at different levels.

5. Analysis of Financial Accounting shows the profit! loss of the period. While
analysis of Cost data provides the details of cost, cost of each product, process,
profits job, contracts, etc.

6. Time period Financial Statements are prepared for a definite period, usually a
year while cost record can be prepared on as required basis.

7. Presentation A set format is used for Financial Statements but for cost
accounting, there are not any set formats presenting cost information.

In spite of the above differences, both financial and cost accounting are in
agreement regarding actual cost data and product costing analysis. Values of stock
and cost of goods produced and sold are the main examples. For the preparation of
the position statement, financial accountant receives the necessary data from the cost
accountant.

10.61mportance of Cost Accounting

The limitation of financial accounting has made the management to realize the
importance of cost accounting. The importance of cost accounting are as follows:

1. Importance to Management
Cost accounting provides invaluable help to management. It is difficult to indicate
where the work of cost accountant ends and managerial control begins. The
advantages are as follows :

(a) Helps in ascertainment of cost. Cost accounting helps the management in

the ascertainment of cost of process, product, Job, contract, activity, etc., by
using different techniques such as Job costing and Process costing.

(b) Aids in Price fixation. By using demand and supply, activities of competitors,
market condition to a great extent, also determine the price of product and cost
to the producer does play an important role. The producer can take necessary
help from his costing records.

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Notes (c) Helps in Cost reduction. Cost can be reduced in the long-run when cost
reduction programme and improved methods are tried to reduce costs.

(d) Elimination of wastage.As it is possible to know the cost of product at every

stage, it becomes possible to check the forms of waste, such as time and
expenses etc., are in the use of machine equipment and material.

(e) Helps in identifying unprofitable activities. With the help of cost accounting
the unprofitable activities are identified, so that the necessary correct action
may be taken.

(f) Helps in checking the accuracy of financial account.Cost accounting helps

in checking the accuracy of financial account with the help of reconciliation of
the profit as per financial accounts with the profit as per cost account.

(g) Helps in fixing selling Prices. It helps the management in fixing selling prices
of product by providing detailed cost information.

(h) Helps in Inventory Control. Cost furnishes control which management

requires in respect of stock of material, work in progress and finished goods.

(i) Helps in estimate. Costing records provide a reliable basis upon which tender
and estimates may be prepared.

2. Importance to Employees . Worker and employees have an interest in which they

are employed. An efficient costing system benefits employees through incentives
plan in their enterprise, etc. As a result both the productivity and earning capacity
increases.

3. Cost accounting and creditors. Suppliers, investor's financial institution and other
moneylenders have a stake in the success of the business concern and therefore
are benefited by installation of an efficient costing system. They can base their
judgment about the profitability and prospects of the enterprise upon the studies
and reports submitted by the cost accountant.

4. Importance to National Economy. An efficient costing system benefits national

economy by stepping up the government revenue by achieving higher production.
The overall economic developments of a country take place due to efficiency of
production.

5. Data Base for operating policy. Cost Accounting offers a thoroughly analysed cost
data which forms the basis of formulating policy regarding day to day business,
such as:
(a) Whether to make or buy decisions from outside?
(b) Whether to shut down or continue producing and selling at below cost?
(c) Whether to repair an old plant or to replace it?

10.7 Limitations of Cost Accounting

Like other branches of accounting, cost accounting is not an exact science but is
an art which has developed through theories and accounting practices based on
reasoning and common sense. These practices are not static but changing with time.
Cost accounting lacks a uniform procedure. There is no stereotyped system of cost
accounting applicable to all industries. There are widely recognised cost concepts but

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understood and applied differently by different industries. Cost accounting can be used
only by big enterprises. Notes
The limitations of cost accounting are as follows:

1. It is expensive because analysis, allocation and absorption of overheads

require considerable amount of additional work.

2. The results shown by cost accounts differ from those shown by financial
accounts. Preparation of reconciliation statements frequently is necessary to
verify their accuracy. This leads to unnecessary increase in workload.

3. It is unnecessary because it involves duplication of work. Some industrial

units are functioning efficiently without any costing system.

4. Costing system itself does not control costs. If the management is alert and
efficient, it can control cost without the help of the cost accounting. Therefore it
is unnecessary.

10.8 Cost Classification

The term cost is used in many different ways. The reason is that there are many
types of costs, and these costs are classified differently according to the immediate
need of management. For example, managers may want cost data to prepare external
financial reports, to prepare planning budgets, or to make decisions. Each different use
of cost data demands a different classification and definition of cost. For example, the
preparation of external financial reports require historical cost data, whereas decision
making may require predictions about future costs. In the following paragraphs it has
been discussed many of possible use of cost data and how costs are defined and
classified for each use.

10.8.1 Manufacturing and Non-manufacturing Costs:

1. Manufacturing Costs . are those costs that are directly involved in manufacturing
of products and services. Examples of manufacturing costs are raw material
costs and salary of labor workers. Manufacturing cost is divided into three broad
categories by most companies.

(a) Direct materials cost The materials that go into final product are called raw
materials. This term is somewhat misleading, since it seems to imply unprocessed
natural resources like wood pulp or iron ore. Actually raw materials refer to
any materials that are used in the final product; and the finished product of one
company can become raw material of another company. For example plastic
produced by manufacturers of plastic is a finished product for them but is a raw
material for Compaq Computers for its personal computers. Sometimes it is not
worth the effort to trace the costs of relatively insignificant materials to the end
products. Such minor items would include the solder used to make electrical
connection in a Sony TV or the glue used to assemble a chair. Materials such
as solder or glue are called indirect materials and are included as part of
manufacturing overhead, which is discussed later on this page.

(b) Direct labor cost The term direct labor is reserved for those labor costs that can
be essentially traced to individual units of products. Direct labor is sometime called
touch labor, since direct labor workers typically touch the product while it is being
made. The labor cost of assembly line workers, for example, is a direct labor cost,
as would the labor cost of carpenter, bricklayer and machine operator.

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Labor costs that cannot be physically traced to the creation of products, or that can
Notes be traced only at a great cost and inconvenience, are termed indirect labor and treated
as part of manufacturing overhead, along with indirect materials. Indirect labor includes
the labor costs of janitors, supervisors, materials handlers, and night security guards.
Although the efforts of these workers are essential to production, it would be either
impractical or impossible to accurately trace their costs to specific units of product.
Hence, such labor costs are treated as indirect labor.

In some industries, major shifts are taking place in the structure of labor costs.
Sophisticated automated equipment, run and maintained by skilled workers, is
increasingly replacing direct labor. In a few companies, direct labor has become such
a minor element of cost that it has disappeared altogether as a separate cost category.
However the vast majority of manufacturing and service companies throughout the
world continue to recognize direct labor as a separate cost category.

Direct Materials cost combined with direct labor cost is called prime cost.

In equation form: Prime Cost= Direct Materials Cost+ Direct Labor Cost. For
example total direct materials cost incurred by the company is Rs4,500 and direct labor
cost is Rs3,000 then prime cost is Rs7,500 (Rs4,500 + Rs3,000).

(c) _Manufacturing overhead, the third element of manufacturing cost, includes

all costs of manufacturing except direct material and direct labor. Examples of
manufacturing overhead include items such as indirect material, indirect labor,
maintenance and repairs on production equipment and heat and light, property
taxes, depreciation, and insurance on manufacturing facilities. Indirect materials
are minor items such as solder and glue in manufacturing industries. These are
not included in direct materials costs. Indirect labor is a labor cost that cannot
be trace to the creation of products or that can be traced only at great cost and
inconvenience. Indirect labor includes the labor cost of janitors, supervisors,
materials handlers and night security guards. Costs incurred for heat and light,
property taxes, insurance, depreciation and so forth associated with selling
and administrative functions are not included in manufacturing overhead.
Studies have found that manufacturing overhead averages about 16% of sales
revenue. Manufacturing overhead is known by various names, such as indirect
manufacturing cost, factory overhead, and factory burden. All of these terms are
synonymous with manufacturing overhead.

Manufacturing overhead cost combined with direct labor is called conversion cost.
In equation form:
Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost
For example if total direct labor cost is Rs3,000 and total manufacturing overhead
cost is Rs2,000 then conversion cost is Rs5,000 (Rs3,000 + Rs2,000).
2. Non-manufacturing Costs: Non-manufacturing costs are those costs that are
not incurred to manufacture a product. Examples of such costs are salary of sales
person and advertising expenses. Generally non-manufacturing costs are further
classified into two categories.

(a) Marketing or Selling Costs: these Marketing or selling costs include all costs
necessary to secure customer orders and get the finished product into the
hands of the customers. These costs are often called order getting or order
filling costs. Examples of marketing or selling costs include advertising costs,
shipping costs, sales commission and sales salary.

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(b) Administrative Costs: include all executive, organizational, and clerical costs
associated with general management of an organization rather than with Notes
manufacturing, marketing, or selling. Examples of administrative costs include
executive compensation, general accounting, secretarial, public relations, and
similar costs involved in the overall, general administration of the organization
as a whole.

10.8.2 Product Costs Versus Period Costs:

Product costs include all the costs that are involved in acquiring or making product.
In the case of manufactured goods, these costs consist of direct materials, direct labor,
and manufacturing overhead. Period costs are all the costs that are not included in
product costs. Therefore, Non manufacturing costs are period costs.

10.8.3 Cost Classifications for Predicting Cost Behavior (Variable and Fixed cost):
Quite frequently, it is necessary to predict how a certain cost will behave in
response to a change in activity. Cost behavior refers to how a cost will react or
respond to changes in the level of business activity. As the level of activity rises and
falls, a particular cost may rise and fall as well-or it may remain constant. For planning
purposes, a manager must be able to anticipate which of these will happen; and if a
cost can be expected to change, the manager must know by how much it will change.
To help make such distinctions, costs are often characterized as variable or fixed.

1. A variable cost is a cost that varies, in total, in direct proportion to changes in

the level of activity. The activity can be expressed in many ways, Such as units
produced, units sold, miles driven, beds occupied, hours worked and so forth.
Direct material is a good example of variable cost.

2. A fixed cost is a cost that remains constant, in total, regardless of changes in the
level of activity. Unlike variable costs, fixed costs are not affected by changes in
activity. Consequently, as the activity level rises and falls, the fixed costs remain
constant in total amount unless influenced by some outside forces, such as price
changes. Rent is a good example of fixed cost. Fixed cost can create confusion if
they are expressed on per unit basis. This is because average fixed cost per unit
increases and decreases inversely with changes in activity. Examples of fixed cost
include straight line depreciation, insurance property taxes, rent, supervisory salary
etc. Mixed cost is also known as semi-variable cost. A mixed/semi variable cost is
one that contains both variable and fixed cost elements. The relationship between
mixed cost and level of activity can be expressed by the equation y = a + bX.

10.8.4 Cost classification for Assigning Costs to Cost Objects (Direct and Indirect
Cost):
1. A direct cost is a cost that can be easily and conveniently traced to the particular
cost object under consideration. A cost object is any thing for which cost data is
required including products, customers jobs and organizational subunits. For
example, if a company is assigning costs to its various regional and national sales
offices, then the salary of the sales manager in its Mumbai office would be a direct
cost of that office.

2. An indirect cost is a cost that cannot be easily and conveniently traced to the
particular cost object under consideration. For example a soup factory may
produce dozens of verities of canned soups. The factory manager's salary would
be an indirect cost of a particular verity such as chicken noodle soup. The reason
is that the factory manager's salary is not caused by any one variety of soup. To
be traced to a cost object such as a particular product, the cost must be caused
by the cost object. This salary of manger is called common cost of producing the
various products of the factory. A common cost is a cost that is incurred to support a

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number of costing objects but cannot be traced to them individually. A common cost
Notes is a particular type of indirect cost.

A particular cost may be direct or indirect, depending on the cost object. While,
in the above example, the soup factory manager's salary is an indirect cost of
manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In
the first case, the cost object is the chicken noodle soup product. In the second case,
the cost object is the entire manufacturing division.

10.8.4 Decision making costs-cost classification for decision making:

Costs can be classified for decision making purposes. Costs are important feature
of many business decisions. For decision making purposes cost is usually classified as
differential cost, opportunity cost, and sunk cost. It is essential to have a firm grasp of
these cost concepts.

1. Differential Cost. Decisions involve choosing between alternatives. In business,

each alternative will have certain costs and benefits that must be compared to the
costs and benefits of the other available alternatives. A difference in cost between
any two alternatives is known as differential cost. A difference in revenue between
any two alternatives is known as differential revenues. Differential cost includes
both cost increase (incremental cost) and cost decrease (decremental cost).
In general the difference (cost and revenue) between alternatives are relevant
in decision making. Those items that are the same under all alternatives can be
ignored.

2. Quality Costs: Quality cost can be defined as a cost that is incurred to avoid
defaults before the products are shipped to the customers or to satisfy the
customers by removing the faults if defaulted products have been shipped to
customers to secure the good will of the company. Quality costs can be broken
down into four broad groups. Two of these groups are known as prevention costs
and appraisal costs. These are incurred in an effort to keep defective products from
falling into the hands of customers. The other two groups of costs are known as
internal failure costs and external failure costs. These are incurred because defects
are produced despite efforts to prevent them. These are also known as costs of
poor quality. C

3. Opportunity cost is the potential benefit that is given up when one alternative is
selected over another. To illustrate this important concept, consider the following
example:

Example:

Vicki has a part-time job that pays her Rs200 per week while attending college. She
would like to spend a week at the beach during spring break, and her employer has
agreed to give her the time off, but without pay. The Rs200 in lost wages would be an
opportunity cost of taking week off to be at the beach.

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4. Sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in future. Notes
Example:

To illustrate a sunk cost, assume that a company paid Rs50,000 several years ago
for a special purpose machine. The machine was used to make a product that is now
obsolete and is no longer being sold. Even though in hindsight the purchase of the
machine may have been unwise, no amount of regret can undo that decision. And it
would be folly to continue making the obsolete product to recover the original cost of
the machine. In short, the Rs50,000 originally paid for the machine has already been
incurred and cannot be differential cost in any future decision. For this reason, such
costs are said to be sunk costs and should be ignored in decision making.

10.9Cost Sheet
Cost sheet is a statement of cost. In other words, when costing information are set
out in the form of a statement, it is called cost sheet. It is usually adopted when there is
only one product is produced and all costs are incurred for that product only. Cost sheet
may be prepared for a week, monthly, quarterly or yearly indicating various components
of cost as prime cost, works cost, cost of production, cost of goods sold, total cost and
also profitability on a production.

The preparation of cost sheet depends on the cost data provided by cost
accounting. Due to differences in the nature of cost data there are three different cost
sheet Performa may be used.

1. Cost sheet with break up cost: These types of cost sheet contains two column as
total cost, cost per unit of out put. A specimen of cost sheet with imaginary figure.

2. Cost Sheet with treatment of Stock: This type of cost sheet is maintained in case
of manufacturing concern. Generally there are three types of stock as (1) Stock of
Raw material, (2) Stock of work in progress and (3) Stock of finished goods. The
treatment of stock in cost sheet has been given in a separate Performa.

3. Estimated cost sheet or price quotation: quotation means quoting the minimum
Price for obtaining a specific order. The quotation is send in the form or estimated
cost sheet having one column. In estimated cost sheet all elements of cost and
overhead expenses are calculated in the following manner.

Estimated direct material

Estimated labor cost

Estimated overheads

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Standard Cost Sheet - Format

Notes
Particulars Amount Amount
Opening Stock of Raw Material ...
Add:Purchase of Raw materials ***
:Purchase Expenses ***
Less:Closing stock of Raw Materials
Raw Materials Consumed ...
-I"*
Direct Wages (Labour) ***
Direct Charges
Primecost(1)
***
...
:-Factory Over Heads:
Factory Rent ***
Factory Power ...
Indirect Material ***
Indirect Wages Supervisor ***
Salary
Drawing Office Salary ...
***

Factory Insurance ***

Factory Asset Depreciation
Works cost Incurred
***
...
Add:Opening StockofWIP ***
Less:Closing Stock of WIP ***
Works cost (2) ***
Add:- Administration Over Heads:-
Office Rent ...
Asset Depreciation ***
General Charges ***
Audit Fees ***
Bank Charges ***
Counting house Salary ***
Other Office Expenses ***
Cost of Production {3) ***
Add:Opening stock of FinishedGoods ***
Less:Closing stock of Finished Goods ***
Cost of Goods Sold ***
Add:- Selling and Distribution OH:-
Sales man Commission ***
Sales man salary ***
Traveling Expenses ***
Advertisement ***
Delivery man expenses ***
Sales Tax ***

Cost of Sales (5)

Profit (balancing figure)
Sales

10.10 Summary
Cost accounting is an ex panded phase of the general or financial accounting of
a business concern which provides management promptly with the cost of producing
or selling each article or of rendering a particular service". In other words, cost
accoun ting is a step further to and a refinement of financial accounting. in which cost of
manufacturing and selling each product or job or rendering service is determined, not at

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the time of accounting period but at the time when the product is manufactured or any
service is rendered. In simple words, costing is a systematic procedure for determining Notes
the unit cost of output produced or services rendered. It provides for an analysis of the
expenditure which enables the management to know not only the total cost but also
its constituents. In short, cost accounting is the process of accounting for cost, which
begins with regarding and classifying of incomes and expenditures and ends with the
preparation of periodical statements and reports for ascertaining and controlling costs.
As predicted today, cost accounting may be defined as the process of measuring,
analyzing and Computing.

Check Your Progress

1 Cost accounting can be used only in manufacturing organization.

2 Cost Accounting is not a branch of financial accounting.

3 Cost accounting is not necessary for a non-profit making service

organization.

4 Prosperous and profit making concerns do not need costing system.

5 All cost are not controllable.

6 Indirect costs are those, which are not identified with a particular cost centre.

7 Notional expenses are not included for ascertaining costs.

8 Prime cost is the total of direct material, direct labour and direct expenses.

9 Fixed costs per unit remain fixed.

10 Transactions of purely financial nature are excluded from cost accounts.

11 One of the functions of cost accounting is proper matching of cost with revenues.

12 The emphasis of cost accounting is on control

13 Basic methods of costing are job costing and process costing

14 Conversions cost plus direct material is factory cost

15 Cost of sale is factory cost plus administration and selling and distribution
cost

16 On the basis of behaviour of cost, overheads are classified into Fixed and variable
cost

17 Opportunity costs are hypothetical or notional cost

18 The ascertainment of costs after they have been incurred is known as historical
costs

19 Cost reduction is a never-ending process while cost control has a definite

goal.

20 If an expenses can be identified with a specific cost unit, it is treated as direct

expenses

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21 Notional expenses are included for ascertaining cost.

Notes
22 Future Cost are not relevant while making management decisions

23 Cost allocation is the allotment of the whole items of costs to cost centre or cost
units.

24 Irrelevant costs are important for decision-making.

25 Additional fixed cost is irrelevant cost.

Questions and Answers

1. Write in one sentence how in the following cases it is a limitation of cost accounting

(a) It is expensive.

(b) It increases the workload

(c) It is unnecessary for cost control.

2. Write against each of the following indicating the party i.e. management, employees
and creditors, benefited from cost accounting :

a. Using budgetary control and standard costing, costing used to control material
cost, labour cost, etc.

b. Installation of an efficient costing system results in the increase in productivity

and earnings capacity.

c. Studies and reports submitted by the cost accountant enables judging the
profitability and prospects of the enterprise.

d. It enables to check the wastage in term of time and expenses

3. What is Cost Accounting? How it is different from Costing?

1. What is the difference between Cost Accounting and Financial Accounting?

2. "Usage of Costing Information for the management is Enormous despite the

limitation" explain.

3. What is Cost Sheet? What are different Methods of preparing cost sheet? Give
a sample worksheet format.

4. From the following particulars you are required to prepare a statement showing

(a) The cost of material consumed

(b) Prime Cost

(c) Work Cost

(d) Total Cost and

(e) Cost Of sales and profit

Rs

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Accounting for Managers 135
Stock of finished goods on 31.12.03 73,000

Stock of Raw -Materials on 31.12.03 35,000 Notes

Purchase of raw- materials 7,60,000

Productive wages 5,20,000

Stock of finished goods on 31.12.04 82,500

Stock of raw materials on 31.12.04 37,500

Sale of finished of goods 15,45,800

Works overhead charges 1,30,200

Offices and general charges 69,700

Further Readings
1. Horngren.C.T., Accounting For Management Control -An Ntroduction, Englewood
Cliffs, Prentice Hall, 1965.

2. Maheswari, S.N., Management Accounting, Sultan Chand & Sons, New Delhi.

3. Hingorani, Ramanathan & Grewal, Management Accounting.

4. Jain S.P. And Narang, K.L., Cost Accounting.

Amity Directorate of Distance and Online Education

 Unit-11: Inventory Valuation Methods
Notes
Structure
11.1 Introduction
11.2 What is Inventory?
11.3 Inventory Valuation Method
11.4 Why is inventory Valuation Method Important?
11.5 Impact of Inventory Valuation Method on Financials
11.6 Accounting Standard on Inventory Valuation
11.7 Summary

Objectives
The aim of this unit is to give:

brief introduction about inventory management.

explain the various methods of inventory valuation and their impact.

11.11ntroduction
Inventory accounting is the method by which a business determines the value
of assets both for financial statements and tax purposes. Inventory is comprised of
fixed assets that are intended for sale or being used in production. The value of your
inventory is determined by taking the value of the beginning inventory, adding the net
cost of purchases, and then subtracting the cost of goods sold. This results in the
ending inventory value. Retailers and manufacturers cannot expense the cost of goods
sold until those goods have actually been sold. Until then, those items are counted as
assets on the balance sheet.

11.2 What Is Inventory?

Inventory is defined as assets that are intended for sale, are in process of being
produced for sale or are to be used in producing goods. Inventory is also referred as
Stock.T he following equation expresses how a company's inventory is determined:

In other words, you take what the company has in the beginning, add what they
have purchased,
Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending
Inventory subtract what they've sold and the result is what they have remaining.

11.31nventory Valuation Methods

The accounting method that a company decides to use to determine the costs of
inventory can directly impact the balance sheet, income statement and statement
of cash flow. There are three inventory-costing methods that are widely used by both
public and private companies:

1. First-In First-Out (FIFO) -This method assumes that the first unit making its way
into inventory is the first sold. For example, let's say that a bakery produces 200
loaves of bread on Monday at a cost of Rs1 each, and 200 more on Tuesday at
Rs1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday,
the COGS is Rs1 per loaf (recorded on the income statement) because that
was the cost of each of the first loaves in inventory. The Rs1. 25 loaves would be
allocated to ending inventory (appears on the balance sheet).

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Accounting for Managers 137
2. Last-In, First-Out (LIFO) - This method assumes that the last unit making its way
into inventory is sold first. The older inventory, therefore, is left over at the end of Notes
the accounting period. For the 200 loaves sold on Wednesday, the same bakery
would assign Rs1.25 per loaf to COGS while the remaining Rs1 loaves would be
used to calculate the value of inventory at the end of the period.

3. Average Cost- This method is quite straightforward; it takes the weighted average
of all units available for sale during the accounting period and then uses that
average cost to determine the value of COGS and ending inventory. In our bakery
example, the average cost for inventory would be Rs1.125 per unit, calculated as
[(200 X Rs1) + (200 X Rs1.25)]/400.

4. Specific Identification Method. A less commonly used, but important method to

valuation is called specific identification. This method is used for high-end items that
are more easily tracked. In some cases, this method can be used for more common
items, but less value is realized from this accounting method is such cases. This
is because powerful and detailed tracking software is required to employ specific
identification on large numbers of goods. The cost of such software often outweighs
the financial benefits that might be gained.

Inventory transactions in May 2010

Units Purchased
Da -1ransa 10ns Um!C lnven!ory Um!s
(Sold)
Way1 Begmmng.lnven"'ry 700 Rs10 700
way a Purchase 100 Rs12 BOO
Way a Sale (500) ??
.. 300
tlay 15 Purchase 600 Rs14 900
tlay 19 Purchase 200 Rs15 1,100
tlay 25 Sale Sale (400) ..
?? 700
tlay 27 End!ng.lnveniory (100) ..
?? 600
tlay 31 ??
..
Ending Inventory = Beginning Inventory + Units Purchased - Units Sold
= 700 + 900 - 1,000 = 600 units

Example (FIFO Meihot!)

FIFO valuation under perpetual inventory system

Daie -tmnsacitons UntiS Sold UntiCo lnveniory UntiS
tlay 1 Begmmng.lnvenl<lry 700 Rs10 700
tlay3 Purchase 100 Rs12 800
tlaya Sale r1) (500) ..
?? 300
tlay 15 Purchase 600 Rs14 900
tlay 19 Purchase 200 Rs15 1,100
tlay 25 SaJer21 (400) ..
?? 700
tiB1J27 SaJer3) (100) ..
?? 600
Way31 End!ng.lnveniory ?.?.
('1) 500 units sold
= 700 units from beginning inventory of at Rs10 unit cost.

Cost of goods sold = 500xRs10 = Rs5,000

('2) 400 units sold

= 200 units from beginning inventory at Rs10 unit cost
+ 100 units from May 3 purchases at Rs12 unit cost
+ 100 units from May 15 purchases at Rs14 unit cost

Cost of goods sold= 200xRs10 + 100xRs12 + 100xRs14

= Rs2,000 + Rs1,200 + Rs1,400 = Rs4,600

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138 Accounting for Managers

Notes (' 3) 100 units sold

1OOunits from May 15 purchases at Rs14 unit cost

Cost of goods sold 100x Rs14= Rs1,400

Tlllal coat o1' goods sold

500xRs10+200xRs10 + 1OOxRs12+ 100xRs14 + 1OOxRs14
Rs5,000 + Rs2,000+Rs1,200 + Rs1,400 + Rs1,400
Rs5,000 + Rs4,600+ Rs1,400 Rsll ,000

Coat of endinglnVWitory
Beginninginventory+ Cost of purchases - Cost of goods sold
Rs7,000 + (100xRs12 + 600xRs14 + 200xRs15)- Rs11,000
Rs7,000 + Rs12,600 Rs11,000 Rlll,600

Checking
Quantity of endinginventory
Beginning inventory+ Units purchased- Units sold
700 + 900 - 1,000 600 units

Cost of endinginventory
400 x Rs14 (May 15 purchase)+ 200 x Rs15 (May 19 purchase)
Rs5,600+ Rs3,000= Rl8,800

Eumpi(LIFO -:>

Tra nsactions UnltBSold Un Cost lnvanlolyUnltB

Date
May1 Begmn1ng Inventory 700 R s10 700
May3 Purchase 1011 Rs12 8011
Mays Sa 1er11 (500) ?1 3011
May15 Purchase 8011 R s14 9011
May19 Purchase 2011 Rs15 1,100
May 25 Sale r2) (4011 ) ?1 700
May 27 Sale r31 (1011) ?? 8011
May31 Ending I nventory ?1

("1) 500 units sold

100 units from May 3 purchases at Rs12 unit cost
= 400 units from beginninginventory at Rs10unit cost

Cost of goods sold100xRs12 + 400xRs10

= Rs1,200 + Rs4, 000 Rs5,200

("2) 400units sold

= 200 units from May 19 purchases at Rs15 unit cost
+ 200 units from May 15 purchases at Rs14 unit cost

Cost of goods sold= 200xRs15 + 200xRs14

= Rs3,000 + Rs2, 800= Rs5,600

("3) 100 units sold

= 100 units from May 15 purchases at Rs14 unit cost

Cost of goods sold1OOxRs14 Rs1,400

Totalcost of goods sold

1OOxRs12+ 400xRs10+200x Rs15 + 200xRs14 + 1OOxRs14
= Rs1,200 + RaMOO + Rs3,000 + Rs2,800+ Ra1,400
= Rs5,200 + Rs5,800 + Rs1,400 = Rs12,400

Cost olending inventory

= BeginningInventory+ Cost of purchases- Cost of goods sold
Rs7,000 + (100xAs12 +600xRs14+ 200x Rs15)- Rs12,400
= Rs7,000 + Rs12,60G- Rs12.400 = Rs7,200

[Checking]
Quantity of endinginventory
=Beginninginventory+ Units purchased- Units sold
=700 + 900- 1, 000 = 600 uni ts

Cost of ending inventory

= 300xRs1O(beginning Inventory)+ 300xRs14(May 15 purchase)
= Rs3,000 + Rs4, 200 = Rs7,200

Nota:400 units from beginningInventory wena sold on May a.

200 units from May 15purchase weresold on May 25.
100 units from May 15 purchasewena sold on May 27.

100 units from May 3 purchas e w ane sold on May 8.

200 units from May 25 purchase wena sold on May 25.

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Accounting for Managers 139

11.4 Why Is Inventory Valuation Method Important? Notes

If inflation were nonexistent, then all three of the inventory valuation methods would
produce the exact same results. When prices are stable our bakery would be able to
produce all of its loafs of bread at Rs1, and FIFO, LIFO and average cost would give us
a cost of Rs1 per loaf. Unfortunately, the world is more complicated. Over the long term,
prices tend to rise, which means the choice of accounting method can dramatically
affect valuation ratios.

11.51mpact Of Valuation Methods On Financials

If prices are rising, each of the accounting methods produce the following results:

1. FIFO gives us a better indication of the value of ending inventory (on the balance
sheet), but it also increases net income because inventory that might be several
years old is used to value the cost of goods sold. Increasing net income sounds
good, but remember that it also has the potential to increase the amount of taxes
that a company must pay.

2 LIFO isn't a good indicator of ending inventory value because the left over inventory
might be extremely old and, perhaps, obsolete. This results in a valuation that is
much lower than today's prices. LIFO results in lower net income because cost of
goods sold is higher.

3. Average cost produces results that fall somewhere between FIFO and LIFO.

If prices are decreasing then the complete opposite of the above is true._

Example

Let's examine the inventory of X Ltd to see how the different inventory valuation
methods can affect the financial analysis of a company.

Monthly Inventory Purchases

Month Units Purchased Cost/ea Total Value
January 1,000 Rs10 Rs10,000
February 1,000 Rs12 Rs12,000
March 1,000 Rs15 Rs15,000
Total 3,000
Beg1nn1ng Inventory = 1,000 un1ts purchased at Rs8 each (a total ot 4,000 un1ts)

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140 Accounting for Managers

Notes Income Statement (simplified):January-March*

Item LIFO FIFO Average
Sales= Rs60,000 Rs60,000 Rs60,000
3,000 units
@Rs20
each
Beginning 8,000 8,000 8,000
lnvenlory
P!.!rchases :37,000 37,000 37,000
Ending B.OOO 15.000
Inventory
(appears
on B/S)
*See
calculation
below
COGS RS:37,000 Rs30,000 Rs33,750
Expenses 10.000 10.000 10.000
Net Rs13,000 Rs20,000 Rs16,250
Income

*Note: All calculations assume that there are 1,000 units left for ending inventory:
(4,000 units- 3,000 units sold= 1,000 units left)

What we are doing here is figuring out the ending inventory, the results of which
depend on the accounting method, in order to find out what COGS is. All we've done is
rearrange the above equation into the following:
Beginning Inventory+ Net Purchases- Ending Inventory= Cost of Goods Sold
LIFO Endnig
1 1.000 units X RsB each = RsB,OOO
Inventory Cost =
Remember that the last units in are sold first; therefore, we leave the oldest units for ending
inventory.

FIFO Ending
1 1.000 units X Rs15 each= Rs15,000
Inventory Cost =
Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest
units for ending inventory.

Average Cost Ending Inventory = ((1,000 X 8) + (1,000 X 10) + (1,000 X 12) +

(1,000 x 15)]14000 units = Rs11.25 per unit

1,000 units X Rs11.25 each= Rs11,250

Remember that we take a weighted average of all the units in inventory.

Using the information above, we can calculate various performance and leverage ratios.Let's
assume the following:

Assets (not including inventory) Rs150,000

Current assets (not includinq inventory) Rs100,000
Curranh
! abtl"les RsLO,OOO
-iolal habthaas RsSO,ODD

Each inventory valuation method causes the various ratios to produce significantly different
results (excluding the effects of income taxes):

Railo UFO FIFO Avai'B.Ili&CoSi

Dab!--4o-Asssl 0.32 D.30 0.31
Working.Cap11B 2.7 2.88 2.78
nvanloiY -turnover 7.5 0 5.3
Gross Profit Margin 38% 50% 4lf)b

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Accounting for Managers 141
As you can see from the ratio results, inventory analysis can have a big effect on
the bottom line. Unfortunately, a company probably won't publish its entire inventory Notes
situation in its financial statements. Companies are required, however, to state in the
notes to financial statements what inventory system they use. By learning how these
differences work, you will be better able to compare companies within the same
industry.

Under certain circumstances, valuation of inventory based on cost is impractical. If

the market price of a good drops below the purchase price, the lower of cost or market
method of valuation is recommended. This method allows declines in inventory value
to be offset against income of the period. When goods are damaged or obsolete, and
can only be sold for below purchase prices, they should be recorded at net realizable
value. The net realizable value is the estimated selling price less any expense incurred
to dispose of the good.

11.6 Accounting Standard On Inventory Valuation- Accounting

Standard -2 (As-2)
AS-2 deals with valuation of inventory , sailent features of the accounting standard
are appended below:

1. This standard should be applied in accounting for inventories other than WIP arising
under construction contracts, WIP of service providers, shares, debentures and
financial instruments held as stock in trade, producers' inventories of livestock,
agricultural and forest products and mineral oils, ores and gases to the extent
measured at net realisable value in accordance with well established practices in
those industries.

2. Inventories are assets held for sale in ordinary course of business, in the process
of production of such sale, or in form of materials to be consumed in production
process or rendering of services.

3. Inventories do not include machinery spares which can be used with an item of
fixed asset and whose use is irregular.

4. Net realisable value is the estimated selling price less the estimated costs of
completion and estimated costs necessary to make the sale.

5. Cost of inventories should comprise all costs incurred for bringing the inventories to
their present location and condition.

6. Inventories should be valued at lower of cost and net realisable value. Generally,
weighted average cost or FIFO method is used in cases where goods are ordinarily
interchangeable.

7. Specific Identification Method to be used when goods are not ordinarily

interchangeable or have been segregated for specific projects.

8. Disclose the accounting policies adopted including the cost formula used, total
carrying amount of inventories and its classification.

In certain business operations, taking a physical inventory is impossible or

impractical. In such a situation, it is necessary to estimate the inventory cost. Two very
popular methods are 1)- retail inventory method, and 2)- gross profit (or gross margin)
method. The retail inventory method uses a cost to retail price ratio. The physical

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142 Accounting for Managers

inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to
Notes determine the estimated cost of the ending inventory. The gross profit method uses the
previous years average gross profit margin (i.e. sales minus cost of goods sold divided
by sales). Current year gross profit is estimated by multiplying current year sales by that
gross profit margin, the current year cost of goods sold is estimated by subtracting the
gross profit from sales, and the ending inventory is estimated by adding cost of goods
sold to goods available for sale.

11.7 Summary
Choosing the appropriate methodology is a difficult task as there are many
unknown variables that go into the decision, such as inflation or shelf life. With high
inflation, or in markets with prices increasing, companies will achieve a higher profits
by matching sales against inventory which was produced at lower prices; earnings per
share will increase but so will tax liability due to an increase in profits. Using LIFO on
the other hand will produce the opposite effect. In essence, you will be matching new
sales against higher production costs, thereby lowering net income and EPS. Some
companies may actually prefer this to keep their tax liability down. Companies cannot
use different methodologies when reporting to the government and their shareholders
so choosing either one may be a gift or a curse. Also remember, when analyzing
inventory valuations, it is important to compare one company against another company
in the same industry.As a implementation of accounting standard , companies use the
"lower of cost or market". This means that if inventory values were to plummet, their
valuations would represent the market value (or replacement cost) instead of FIFO,
LIFO or average cost. Understanding inventory calculation might seem overwhelming,
but it's something one need to be aware of.

Questions and Exercises

1. What are various methods of inventory valuation? Please explain.

2. Which Accounting Standard is applicable for Inventory Valuation? Explain the

features

3. Calculate the value of a 400 unit ending inventory using the following data and the
LIFO, FIFO , and the Weighted Average methods of inventory valuation. State the
advantage and disadvantage of each method.

Check Your Progress

1. Inventory includes raw material, ................and Finished Stock.

2. With high inflation, or in markets with prices increasing, companies will achieve a
higher profits by following.......................... Method of inventory valuation.

3. In weighted average method the ....... is required to be calculated on each

receipt.

4. As per Accounting Standard-2 (AS2) , Inventories should be valued at lower of

....... and.

5. Method to be used when goods are not ordinarily interchangeable or

have been segregated for specific projects

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Accounting for Managers 143

lnveniory Uni UniiCosi Toial Cosi Notes

Purchase Daie
Jan 1 250 Rs 50 Rs 12,500
Apr4 100 52 5,200
Sepi16 200 55 11,000
Dec 10 300 57 17,100
850 45,800

Further Readings
1. Horngren.C.T., Accounting For Management Control -An Ntroduction, Englewood
Cliffs, Prentice Hall, 1965.

2. Maheswari, S.N., Management Accounting, Sultan Chand & Sons, New Delhi.

3. Hingorani, Ramanathan & Grewal, Management Accounting.

4. Jain S.P. And Narang, K.L., Cost Accounting.

Amity Directorate of Distance and Online Education