HOSPITAL COST ACCOUNTING

MBAHMGT -204

ITFT Education Group, Chandigarh As Per Syllabus of Punjab Technical University (DEP)

UNIT-1 INTRODUCTION TO COST ACCOUNTING Cost Accounting is a process of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future. The Role of Cost Accounting Today In the recent past, cost accounting was often the tool used to calculate an inventory cost for balance sheet presentation and to calculate the cost of goods sold for the income statement. Today cost accounting is much more than an inventory cost tracking system. Cost accounting involves determining the cost of products and activities, but it does have a broader role: to furnish management with information used in planning and controlling activities, in improving quality and efficiency, and in formulating strategic policy. To be more specific, cost accounting can help management achieve the following: 1. Formulating and implementing plan and budget that motivate employee toward the achievement of company goals. 2. Establishing cost tracking methods that allow control of operations, cost saving, and improvements in quality. 3. Controlling inventory cost, minimizing inventory investment, and determining the cost of each product or service. 4. Pricing products and services in ways that are congruent with organizational goal. 5. Making prudent decisions that impact both short term and long term revenue and expenses Fundamentals of Cost Accounting It is the process of classifying, recording and appropriate allocation of expenditure for the determination of costs of product or services through the presentation of data for the purpose to take decisions and guide the business organization. Nature and scope of cost accounting Cost accounting can be defined within the accounting system as internal reporting for use in management planning, control, and in making routine and non-routine decisions, and external reporting to the extent that its product-costing function satisfies external reporting requirements for reporting to shareholders, government, creditors, investors and various outside interested parties. It consists of the following basic activities, whether it is for a manufacturing or service business or for a profit or nonprofit organization: 1. Cost recording and reporting, including classifying, summarizing, communicating, and interpreting cost data to interested parties, internal or external.

2. Cost measurement or estimation for specific products, services, or subunits of the organization. 3. Cost planning It involves selecting the goals of the organization and its subunits, expressed as operating objectives, and then identifying the means of accomplishing them. Plans are summarized in budgets which are expressed in terms of money measurements. 4. Cost control It sets predetermined standards (such as standard costs and budgets) by which performance can be measured. It then reports differences between planned and actual performances to direct attention to what went wrong. Furthermore, cost control aids in fixing responsibility for departures from a plan so that corrective actions can be taken. 5. Cost analysis, obtaining accurate product-costing data and managing it to assist managers in making critical decisions such as pricing, product mix, and process technology decisions and analyzing cost data, translating them into the information useful for managerial planning and control, and for making short-term and long-term decisions. Objectives of cost Accounting The objectives of cost accounting are ascertained of cost, fixation of selling price, proper recording and presentation of cost data to management for measuring efficiency and for cost control. The aim is to know the methods by which expenditure on materials, wages and overheads is recorded, classified and allocated so that the cost of products and services may be accurately ascertained; these costs may be related to sales and profitability may be determined. Yet with the development of business and industry, its objectives are changing day by day. The following are the main objectives of cost accounting:

To ascertain the cost per unit of the different manufactured by a business concern;

To provide a correct analysis of cost both by process or operations and by different elements of cost; To disclose sources of wastage whether of material, time or expense or in the use of machinery, equipment and tools and to prepare such reports which may be necessary to control such wastage; To provide requisite data and serve as a guide for fixing prices of products manufactured or services rendered; To advise management as to how these profits can be maximized and to ascertain the profitability of each of the products;
To exercise effective control of stocks of raw materials, work-in-progress, consumable stores and finished goods in order to minimize the capital locked up in these stocks;

To reveal sources of economy by installing and implementing a system of cost control for labour, overheads and materials;

To advise management on proposed capital projects and future expansion policies; To present and interpret data for management planning, evaluation of performance and control; To help in the implementation and preparation of budgets of budgetary control;

To organize an effective information system so that different levels of management may get the required information at the right time in right form for carrying out their individual responsibilities in an efficient manner; To guide management in the implementation and formulation of incentive bonus plans based on cost savings and productivity; To supply useful data to management for taking various financial decisions such as introduction of new products, replacement of labour by machine etc; To help in supervising the working of punched card accounting or data processing through computers;

To organize the internal audit system to ensure effective working of different departments; To organize cost reduction programs with the help of different departmental managers;

To provide specialized services of cost audit in order to prevent the errors and frauds and to facilitate prompt and reliable information to management. Advantages of Cost accounting 1. Help in Cost control 2. Help in Decision making 3. Guides in Price fixation 4. Help in cost reduction 5. Finds outs profitable and unprofitable operations 6. Finds out idle capacity Importance of Cost accounting Cost accounting has many importance. Specially, the following parties are benefitted from it. 1. Importance to management- Management is highly benefitted with the introduction of cost accounting. It helps to ascertain the cost and selling price of the product. Cost data help management to formulate the business policies. The introduction of budgetary control and standard cost would be an aid to analyze cost. Its also helps to find out reasons for profit or loss. It provides data to submit tender as well. Thus, cost accounting is an aid to management. 2. Importance to investors-Investors can obtain benefit fro the cost accounting. Investors want to know the financial conditions and earning capacity of the business. An investor must gather information about organization before making investment decision and investor can gather such information from cost accounting. 3. Importance of consumers-The ultimate aim of costing is to reduce the cost of production to minimize the profit of business. Reduction in the cost is usually passed on the consumers in the form of lower price. Consumers get quality goods at a lower price.

4. Importance to Employees-Cost accounting helps to fix the wages of the workers. Efficient workers are rewarded for their efficiency. It helps to induce incentive wage plan in business. 5. Importance to Government-Cost accounting is one of the prime sources to provide reliable data to internal as well as external parties. It helps government agencies to determine excise duty and income tax. Government formulates tax policy, industrial policy, export and import policy based on the information provided by the cost accounting. Methods of costing and its Relevance in organization function Different industries follow different methods for ascertaining cost of their products. The method to be adopted by business organization will depend on the nature of the production and the type of output. The following are the important methods of costing. Job Costing Job costing is concerned with the finding of the cost of each job or work order. This method is followed by these concerns when work is carried on by the customers request, such as printer general engineering work shop etc. under this system a job cost sheet is required to be prepared find out profit or losses for each job or work order. Contract Costing Contract costing is applied for contract work like construction of dam building civil engineering contract etc. each contract or job is treated as separate cost unit for the cost ascertainment and control. Batch Costing A batch is a group of identical products. Under batch costing a batch of similar products is treated as a separate unit for the purpose of ascertaining cost. The total costs of a batch is divided by the total number of units in a batch to arrive at the costs per unit. This type of costing is generally used in industries like bakery, toy manufacturing etc. Process Costing This method is used in industries where production is carried on through different stages or processes before becoming a finished product. Costs are determined separately for each process. The main feature of process costing is that output of one process becomes the raw materials of another process until final product is obtained. This type of costing is generally used in industries like textile, chemical paper, oil refining etc. Service (Operating) Costing This method is used in those industries which rendered services instead of producing goods. Under this method cost of providing a service is also determined. It is also called service costing. The organization like water supply department, electricity department etc. are the examples of using operating costing. Operation Costing This is suitable for industries where production is continuous and units are exactly identical to each other. This method is applied in industries like mines or drilling, cement works etc. Under this system cost sheet is prepared to find out cost per unit and profits or loss on production.

Multiple Costing It means combination of two or more of the above methods of costing. Where a product comprises many assembled parts or components (as in case of motor car) costs have to be ascertained for each component as well as for the finished product for different components, different methods of costing may be used. It is also known as composite costing. This type of costing is applicable to industries producing motor vehicle, radio, T.V. etc COST STRUCTURE Cost structure refers to the types and relative proportions of fixed and variable costs that a business incurs. The concept can be defined in smaller units, such as by product, service, product line, customer, division, or geographic region. Cost structure is used as a tool to determine prices, if you are using a cost-based pricing strategy, as well as to highlight areas in which costs might potentially be reduced or at least subjected to better control. To define a cost structure, we need to define every cost incurred in relation to a cost object. The following bullet points highlight key elements of the cost structures of various cost objects:

Product cost structure Fixed costs. Direct labor, manufacturing overhead Variable costs. Direct materials, commissions, production supplies, piece rate wages Service cost structure Fixed costs. Administrative overhead Variable costs. Staff wages, bonuses, payroll taxes, travel and entertainment Product line cost structure Fixed costs. Administrative overhead, manufacturing overhead, direct labor Variable costs. Direct materials, commissions, production supplies Customer cost structure Fixed costs. Administrative overhead for customer service, warranty claims Variable costs. Costs of products and services sold to the customer, product returns, credits taken, early payment discounts taken

Concept of Cost It is difficult to define the term cost. The term cost is ambiguous and uncertain. In general cost means the amount of resource used in exchange for goods or services. The resource used shall be money or moneys worth, which is usually expressed in monetary units. The cost has to be looked in relation to 1. Nature of business- a cost has to be studied in relation to its nature of business. E.g. a manufacturing organization is interested in knowing the cost per unit of its product, whereas the organization rendering services such as electricity and transport are interested in ascertaining the cost of services they undertook. The cost per unit can be easily ascertained by dividing the total expenditure by number of units produced or quantum of services rendered. This is

relatively easy if the organization produce s only a single product. But if more than one product is produced, other factor have to be considered for determining the cost. 2. Purpose A cost has to be studied in relation to its purpose. E.g, the purpose is fixation of selling price cost. All items of expenditure relating to production, admin and selling will have to be included. But if the purpose is valuation of inventories, only cost of production will have to be taken into account. 3. Condition accost has to be ascertained under different condition also. For instance, while dealing with inventory, work in progress is valued at factory cost, whereas stock of finished goods is valued at production cost. Different condition lead to different modes of valuation of cost. 4. Context the term cost may not stand on its own and has to be qualified. It is a generic term. It is generally used to include all the various types of costs. However, when the term is used specifically, it is always modified with reference to the context cost by such descriptions as prime cost, variable cost, opportunity cost and sunk cost. Cost classification We first classify costs according to the three elements of cost: a) Materials b) Labour c) Expenses

Product and Period Costs: We also classify costs as either 1 2 Product costs: the costs of manufacturing our products; or Period costs: these are the costs other than product costs that are charged to, debited to, or written off to the income statement each period. The classification of Product Costs: Direct costs: Direct costs are generally seen to be variable costs and they are called direct costs because they are directly associated with manufacturing. In turn, the direct costs can include:

Direct materials: plywood, wooden battens, fabric for the seat and the back, nails, screws, glue. Direct labour: sawyers, drillers, assemblers, painters, polishers, upholsterers Direct expense: this is a strange cost that many texts don't include; but (International Accounting Standard) IAS 2, for example, includes it. Direct expenses can include the costs of special designs for one batch, or run, of a particular set of tables and/or chairs, the cost of buying or hiring special machinery to make a limited edition of a set of chairs.

Total direct costs are collectively known as Prime Costs and we can see that Product Costs are the sum of Prime costs and Overheads.

Indirect Costs: Indirect costs are those costs that are incurred in the factory but that cannot be directly associate with manufacture. Again these costs are classified according to the three elements of cost, materials labour and overheads.

Indirect materials: Some costs that we have included as direct materials would be included here. Indirect labour: Labour costs of people who are only indirectly associated with manufacture: management of a department or area, supervisors, cleaners, maintenance and repair technicians Indirect expenses: The list in this section could be infinitely long if we were to try to include every possible indirect cost. Essentially, if a cost is a factory cost and it has not been included in any of the other sections, it has to be an indirect expense. Here are some examples include: Depreciation of equipment, machinery, vehicles, buildings Electricity, water, telephone, rent, Council Tax, insurance Total indirect costs are collectively known as Overheads.

Finally, within Product Costs, we have Conversion Costs: these are the costs incurred in the factory that are incurred in the conversion of materials into finished goods. The classification of Period Costs: The scheme shows five sub classifications for Period Costs. When we look at different organisations, we find that they have period costs that might have sub classifications with entirely different names. Unfortunately, this is the nature of the classification of period costs; it can vary so much according to the organisation, the industry and so on. Nevertheless, such a scheme is useful in that it gives us the basic ideas to work on. Administration Costs: Literally the costs of running the administrative aspects of an organisation. Administration costs will include salaries, rent, Council Tax, electricity, water, telephone, depreciation, a potentially infinitely long list. Notice that there are costs here such as rent, Council Tax, that appear in several sub classifications; in such cases, it should be clear that we are paying rent on buildings, for example, that we use for manufacturing and storage and administration and each area of the business must pay for its share of the total cost under review. Without wishing to overly extend this listing now, we can conclude this discussion by saying that the costs of Selling, the costs of Distribution and the costs of Research are all accumulated in a similar way to the way in which Administration Costs are accumulated. Consequently, our task is to look at the selling process and classify the costs of running that process accordingly: advertising, market research, salaries, bonuses, electricity, and so on. The same applies to all other classifications of period costs that we might use. Finance Costs: Finance costs are those costs associated with providing the permanent, long term and short term finance. That is, within the section headed finance costs we will find dividends, interest on long term loans and interest on short term loans.

Finally, we should say that we can add any number of subclassifications to our scheme if we need to do that to clarify the ways in which our organisation operates. We will also add further subclassifications if we need to refine and further refine out cost analysis.

COST SHEET FORMAT Particulars Opening Stock of Raw Material Add: Purchase of Raw materials Add: Purchase Expenses Less: Closing stock of Raw Materials Raw Materials Consumed Direct Wages (Labour) Direct Charges Prime cost (1) Add :- 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 Stock of WIP Less: Closing Stock of WIP Works cost (2) *** *** *** *** *** *** *** *** *** *** *** *** Amount Amount *** *** *** *** *** *** *** ***

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 Finished Goods 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 Bad Debts Cost of Sales (5) Profit (balancing figure) Sales Notes:1) Factory Over Heads are recovered as a percentage of direct wages 2) Administration Over Heads, Selling and Distribution Overheads are recovered as a percentage of works cost. *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***

Cost center and Profit center A profit center is a part of a business that generates revenue while also taking on its own costs, making it possible to calculate the department's profit as a self-contained unit. Profit centers may include a general or specific field in which a business operates or a specific market that it operates in, as long as the costs and revenues for that market can be distinguished from those that apply to other markets. Unlike a profit center, a cost center is not operated with the intention of earning revenue or making a profit directly. Instead, it is a part of a business that generates costs without making money. A cost center only enables profit centers to generate revenue. For example, in a small retail business, each store, or each class of products, may operate as a profit center, while the customer service and human resources divisions operate as cost centers. Normal loss and Abnormal loss Certain losses are inherent in the production process and cannot be eliminated. These losses occur under efficient operating conditions and are referred to as Normal or uncontrollable losses. In addition to losses which cannot be avoided, there are some losses which are not expected to occur under efficient operating conditions, for example the improper mixing of ingredients, the use of inferior materials and the incorrect cutting of cloths. These losses are not an inherent part of the production process and are referred to as abnormal or controllable losses. Normal loss is the loss expected during a process. It is not given a cost. Abnormal losses is the extra loss resulting when actual loss is greater than normal or expected loss ,and it is given a costs. Since an abnormal loss is not given a cost, the cost producing these units is borne by the good units of output. Abnormal loss and gain units are valued at the same rate as good units. Abnormal events do not therefore affect the cost of good production. Their costs are analyzed separately in an abnormal loss or abnormal gain account.

Financial Accounting Vs Cost Accounting 1) It involves the preparation of a set of final accounts for each accounting period in accordance with the accounting standards and company legislation. It gives the overall financial picture of a company. 1) It is an internal management tool which provides appropriate timely information of management to help them for taking better decisions by applying the techniques viz; standard costing, budgetary control, marginal costing. 2) It can not provide information for future 2) It can forecast for future period by the period techniques of budgeting. 3) It can not provide information for day to 3) It can provide day to day decision by day decision making . applying the concepts of marginal costing , budgetary control etc. 4) It can not provide information to assess the 4) The techniques of budgeting and standard performance of various persons of the costing enable the management to perform the department to see that cost don not exceed the function. reasonable limit for a given quantum of work.

Besides above, the following distinction between financial and cost accounting has been discussed i) To provide investors, creditor or other external parties with useful information about the financial position, financial performance and cash flow prospect of an enterprise. i) To provide the manager with information useful for planning, evaluation and rewarding performance and sharing with other outside parties and to apportion decision making authority over the firm resources. ii) Primarily financial statements (profit & ii) Many different types of report loss a/c and balance sheet and cash flow depending on the nature of business statement and related notes) provides and the specific information needs of investors, creditors and other users of the management. Example; Budget information to support external decision financial projection, bench mark making process. studies, activity based cost report and cost of quality assessment. iii) It follows generally accepted accounting iii) rules are set within the organization principles including those formally to produce information relevant to the established in the authoritative accounting needs of management. literature and standard industry practice.

PURPOSE

TYPE OF REPORT

STANDARDS FOR PRESENTATION

TIME PERIOD

i) Usually a year, quarter or month. Most report focus on completed periods. Emphasis is pl aced on the current period with prior periods often shown for comparison. ii) Outsiders as well as managers . These outsiders includes shareholders, creditors, prospective investors, regulatory authorities and the general public.

v) Any period- year, quarter , month,week,day even a work shift .Some reports are historical in nature. Other focus on estimates and results expected in the future period. vi) Management (Different reports to different managers), customers, auditors, suppliers and others involved in an organization value chain.

USER OF INFORMATION

UNIT 2 Costing of Service Departments and other Related Areas

Many companies in all sectors of the economy, and not-for-profit and governmental organizations as well, allocate service department costs to production or user departments, and ultimately to the products and services that they provide. For example, hospitals use sophisticated methods for allocating costs of service departments such as Housekeeping, Patient Admissions, and Medical Records to patient wards and outpatient services, and then to individual patients. Historically, these allocations were important to hospitals because Medicare reimbursement was based on actual costs. To the extent that the hospital allocated service department costs to Medicare patients, Medicare covered these costs. Companies that allocate service department costs do so for one or more of the following reasons: 1. To provide more accurate product cost information. Allocating service department costs to production departments, and then to products, recognizes that these services constitute an input in the production process. To improve decisions about resource utilization. By imposing on division managers the cost of the service department resources that they use, division managers are encouraged to use these resources only to the extent that their benefit exceeds their cost. To ration limited resources. When production departments have some discretion over their utilization of a service department resource, charging production departments for the resource usually results in less demand for it than if the resource were free to the production departments.

2.

3.

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure that all service department costs are allocated. Budgeted rates provide service department managers incentives to control costs, and also provide user departments more accurate information about service department billing rates for planning purposes. In either case, service department costs should be allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible. Here are some examples: Allocate building maintenance costs based on square footage; Allocate costs of the company airplane based on miles flown; Allocate costs of the data processing department based on CPU time.

In some cases, companies benefit from allocating fixed costs using a different allocation base than variable costs. For example, fixed costs might be allocated based on an estimate of long-term usage by the production departments.
A. Direct Method of Allocation When support department costs are allocated only to the producing departments, the direct method of allocation is being used. This is the most simple and straightforward of the three allocation methods. Under this method, No support department costs are allocated to any other support department. All interactions between the support departments are ignored.

B.

C.

Sequential Method of Allocation The sequential (or step) method of allocation recognizes that interactions among support departments do occur. 1. Cost allocations are performed in a step-down fashion. a. The costs of the support department rendering the greatest service are allocated first. b. Once a support departments costs have been allocated, no costs are allocated back to it. c. The costs allocated from a support department are its direct costs plus any costs it receives in allocations from other support departments. 2. Sequential allocation may be more accurate than the direct method because it recognizes some interactions among the support departments. Its disadvantage, however, is that it does not recognize all of the interactions between support departments. Reciprocal Method of Allocation In the reciprocal method of allocation, all of the interactions between support departments are recognized by its reciprocity on cost allocation. 1. The total cost of a support department is the sum of its direct costs plus the proportion of service received from other support departments. The total cost reflects interactions among the support departments.
Total cost = Direct costs + Allocated costs

D.

2. A series of simultaneous linear equations must be constructed and solved to perform reciprocal cost allocation. Comparison of the Three Methods 1. The advantages of better allocation must outweigh the increased cost of using a more theoretically preferred method. 2. Rapid changes in technology make allocation unnecessary. For example, there is no need for support department cost allocation in the JIT environment because the manufacturing cells (i.e., producing departments) are performing many support functions.

Allocation of cost
Todays organizations face growing pressure to control costs and enable responsible financial management of resources. In this environment, your organization is expected to provide services costeffectively and deliver business value while operating under tight budgetary constraints. One way to contain costs is to implement a cost allocation methodology, where your business units become directly accountable for the services they consume. An effective cost allocation methodology enables your organization to identify what services are being provided and what they cost, to allocate costs to business units, and to manage cost recovery. Cost allocation is a process of providing relief to shared service organization's cost centers that provide a product or service. In turn, the associated expense is assigned to internal clients' cost centers that consume the products and services. For example, the CIO may provide all IT services within the company and assign the costs back to the business units that consume each offering. Companies allocate costs for four major reasons:

1. To provide information needed for decision making. 2. To reduce the frivolous use of common resources. 3. To encourage managers to evaluate the efficiency of internally provided services. 4. To calculate the full cost of products for financial reporting purposes and for determining costbased prices.

Service Departments to be covered under in case of hospitals

Service departments do not generate revenue themselves and they help other departments, all their costs must be allocated again to other departments. This will be a simple task provided that none of the service departments provides services to other service department(s). Things are complicated when service departments receive services from each other 1. 2. 3. 4. 5. 6. 7. 8. Central Sterile Services Department Laundry Compressor Water supply Oxygen Nitrous oxide Food and beverages House keeping

The problem here is that the cost reallocation process of two service departments, both of which benefit from each other, will repeat itself because each of them will receive a portion of reallocated service department costs which have to be allocated again and again. Assume a company has a certain number of production departments and two service departments, A and B, and that both of them receive services from each other. If we reallocate service department A's cost first and service departments B's cost later, department A's balance will no longer remain zero because it will receive a portion of reallocated cost of department B. Thus, we will be forced to repeat the process many times.

JOB ORDER COSTING and BATCH COSTING

Introduction The term costing refers to the techniques and processes of determining costs of a product manufactured or services rendered. The rst stage in cost accounting is to ascertain the cost of the product offered or the services provided. In order to do the same, it is necessary to follow a particular method of ascertaining the cost. The methods of costing are applied in various business units to ascertain the cost of product or service offered. Different methods of costing are required to be used in different types of businesses. For example, costing methods used in a manufacturing business will differ from the methods used in a business that is offering services. Even in a manufacturing business, some business units may have production in a continuous process, i.e. output of a process is an input of the subsequent process and so on, while in some businesses production is done according to the requirements of customers and hence each job is different from the other one. Different methods of costing are used to suit these diverse requirements. These methods of costing are discussed in detail in this chapter. Methods of Costing As mentioned in the above paragraph, the methods of costing are used to ascertain the cost of product or service offered by a business organization. There are two principle methods of costing. These methods are as follows I] Job Costing II] Process Costing Other methods of costing are the variations of these two principle methods. The variations of these methods of costing are as follows. I] Job Costing: Batch Costing, Contract Costing, Multiple Costing. II] Process Costing: Unit or Single Output Costing, Operating Costing, Operation Costing The Job Costing and its variations are discussed in detail in the following paragraphs. I] Job Costing: This method of costing is used in Job Order Industries where the production is as per the requirements of the customer. In Job Order industries, the production is not on continuous basis, rather it is only when order from customers is received and that too as per the specications of the customers. Consequently, each job can be different from the other one. Method used in such type of business organizations is the Job Costing or Job Order Costing. The objective of this method of costing is to work out the cost of each job by preparing the Job Cost Sheet. A job may be a product, unit, batch, sales order, project, contract, service, specic program or any other cost objective that is distinguishable clearly and unique in terms of materials and other services used. The cost of completed

job will be the materials used for the job, the direct labor employed for the same and the production overheads and other overheads if any charged to the job. The following are the features of job costing. It is a specic order costing A job is carried out or a product is produced is produced to meet the speci c requirements of the order Job costing enables a business to ascertain the cost of a job on the basis of which quotation for the job may be given. While computing the cost, direct costs are charged to the job directly as they are traceable to the job. Indirect expenses i.e. overheads are charged to the job on some suitable basis. Each job completed may be different from other jobs and hence it is difcult to have standardization of controls and therefore more detailed supervision and control is necessary. At the end of the accounting period, work in progress may or may not exist. Methodology used in Job Costing As discussed above, the objective of job costing is to ascertain the cost of a job that is produced as per the requirements of the customers. Hence it is necessary to identify the costs associated with the job and present it in the form of job cost sheet for showing various types of costs. Various costs are recorded in the following manner. Direct Material Costs: Material used during the production process of a job and identied with the job is the direct material. The cost of such material consumed is the direct material cost. Direct material cost is identiable with the job and is charged directly. The source document for ascertaining this cost is the material requisition slip from which the quantity of material consumed can be worked out. Cost of the same can be worked out according to any method of pricing of the issues like rst in rst out, last in rst out or average method as per the policy of the organization. The actual material cost can be compared with standard cost to nd out any variations between the two. However, as each job may be different from the other, standardization is difcult but efforts can be made for the same. Direct Labor Cost: This cost is also identiable with a particular job and can be worked out with the help of Job Time Tickets which is a record of time spent by a worker on a particular job. The job time ticket has the record of starting time and completion time of the job and the time required for the job can be worked out easily from the same. Calculation of wages can be done by multiplying the time spent by the hourly rate. Here also standards can be set for the time as well as the rate so that comparison between the standard cost and actual cost can be very useful. Direct Expenses: Direct expenses are chargeable directly to the concerned job. The invoices or any other document can be marked with the number of job and thus the amount of direct expenses can be ascertained. Overheads: This is really a challenging task as the overheads are all indirect expenses incurred for the job. Because of their nature, overheads cannot be identied with the job and so they are apportioned to

a particular job on some suitable basis. Pre determined rates of absorption of overheads are generally used for charging the overheads. This is done on the basis of the budgeted data. If the predetermined rates are used, under/over absorption of overheads is inevitable and hence rectication of the same becomes necessary. Work in Progress: On the completion of a job, the total cost is worked out by adding the overhead expenses in the direct cost. In other word, the overheads are added to the prime cost. The cost sheet is then marked as completed and proper entries are made in the nished goods ledger. If a job remains incomplete at the end of an accounting period, the total cost incurred on the same becomes the cost of work in progress. The work in progress at the end of the accounting period becomes the closing work in progress and the same becomes the opening work in progress at the beginning of the next accounting period. A separate account for work in progress is maintained. Advantages of Job Costing The following are the advantages of job costing. Accurate information is available regarding the cost of the job completed and the prots generated from the same. Proper records are maintained regarding the material, labor and overheads so that a costing system is built up Useful cost data is generated from the point of view of management for proper control and analysis. Performance analysis with other jobs is possible by comparing the data of various jobs. However it should be remembered that each job completed may be different from the other. If standard costing system is in use, the actual cost of job can be compared with the standard to nd out any deviation between the two. Some jobs are priced on the basis of cost plus basis. In such cases, a prot margin is added in the cost of the job. In such situation, a customer will be willing to pay the price if the cost data is reliable. Job costing helps in maintaining this reliability and the data made available becomes credible. Limitations of Job Costing Job costing suffers from certain limitations. These are as follows. It is said that it is too time consuming and requires detailed record keeping. This makes the method more expensive. Record keeping for different jobs may prove complicated. Inefciencies of the organization may be charged to a job though it may not be responsible for the same.

In spite of the above limitations, it can be said that job costing is an extremely useful method for computation of the cost of a job. The limitation of time consuming can be removed by computerization and this can also reduce the complexity of the record keeping. Format of Job Cost Sheet The format of job cost sheet is given below. XYZ LTD. JOB ORDER COST SHEET Customer Invoice No. Date: Product Description Particulars Direct Materials: Dept I Dept II Dept III Total Direct Labor Overheads Total Costs Dates and Ref. No. Total Amount [ Rs] Per Unit [Rs] Selling Price Per Unit: Job Order No: Cost Per Unit: Total Cost

1-A factory uses a job costing system. The following data are available from the books at the year
ending on 31st March 2007 Particulars Direct Materials Direct Wages Prot Selling and Distribution Overheads Administrative Overheads Factory Overheads Amount [Rs] 180,0000 150,0000 121,8000 105,0000 84,0000 90,0000

Required: A. Prepare a job cost sheet showing the prime cost, works cost, production cost, cost of sales and sales value. B. In the year 2007-08, the factory has received an order for a number of jobs. It is estimated that the direct materials would be Rs.240,0000 and direct labor would cost Rs.150,0000. What would be the price for these jobs if the factory intends to earn the same rate of pro t on sales, assuming that the selling and distribution overheads have gone up by 15%. The factory recovers factory overhead as a percentage of direct wages and administrative and selling and distribution overhead as a percentage of works cost, based on the cost rates prevalent in the previous year. Solution: JOB COST SHEET OF XYZ LTD. For the year ended 31st March, 2007

Particulars Direct Costs: - Direct Materials Direct Labor Prime Cost [Direct Materials + Direct Labor] Factory Overheads

Amount [Rs.] 18,00,000 15,00,000

Amount [Rs.]

33,00,000 9,00,000 Factory/Works Cost [Prime Cost + Factory Overheads] 42,00,000 Administrative Overheads Cost of Production [Factory Cost + Administrative Overheads] Selling and Distribution Overheads Cost of Sales [Cost of Production + Selling and Distribution Overheads ] Prot [As Given ] Sales [Cost of Sales + Prot ] 73,08,000 II] Batch Costing: In the job costing, we have seen that the production is as per the orders of the customers and according to the specications mentioned by them. On the other hand, batch costing is used where units of a product are manufactured in batches and used in the assembly of the nal 8,40,000 50,40,000

10,50,000 60,90,000

12,18,000

product. Thus components of products like television, radio sets, air conditioners and other consumer goods are manufactured in batches to maintain uniformity in all respects. It is not possible here to manufacture as per the requirements of customers and hence rather than manufacturing a single unit, several units of the component are manufactured. For example, rather than manufacturing a single unit, it will be always benecial to manufacture say, 75, 000 units of the component as it will reduce the cost of production substantially and also bring standardization in the quality and other aspects of the product. The nished units are held in stock and normal inventory control techniques are used for controlling the inventory. Batch number is given to each batch manufactured and accordingly the cost is worked out. Costing procedure in batch costing is more or less similar to the job costing in the sense that cost is worked out for each batch rather than job. Direct costs like direct materials, direct labor and direct 127expenses are charged directly to the job as they are traceable to the job. The source documents used for them are material requisitions, labor records and records pertaining to the direct expenses. Indirect costs, i.e. overheads are allocated or apportioned to the batch on some suitable basis. Thus a batch cost sheet is prepared to show the total cost of the batch. One of the important aspects of batch type production is to decide the batch size. Actually the determination of appropriate batch size of the production has con icting views. If production is produced in large quantities, the impact of the setting up cost will be lower as the setting up cost is xed per batch. But on the other hand if the production quantity is large, the inventory carrying cost will be high as more inventory will have to be carried over in the store. The carrying cost of the inventory includes cost of storage, risk of pilferage, spoilage, obsolescence and interest on the investments blocked in the inventories. Therefore the size of the batch should not be either too small or too large. On the basis of a trade off between large size and small size, an appropriate size of the batch should be decided. This batch size is known as Economic Batch Quantity that is similar to the concept of Economic Order Quantity. This quantity is determined with the help of the following formula. Economic Batch Quantity = 2AS / C Where A = Annual requirements of the product S = Setting up cost per batch C = Carrying cost per unit of inventory per annum. III] Contract Costing: Contract Costing is a method used in construction industry to nd out the cost and profi t of a particular construction assignment. The principles of job costing are also applicable in contract costing. In fact Contract Costing can be termed as an extension of Job Costing as each contract is nothing but a job completed. Contract Costing is used by concerns like construction rms, civil engineering contractors, and engineering rms. One of the important features of contract costing is that most of the expenses can be traced to aparticular contract. Those expenses that cannot be traced to a particular contract are apportioned to the

contract on some suitable basis. The cost computation in case of a contract is done on the following basis. A. Material Cost: Direct Material required for a particular contract is debited to the Contract Account. There may be some quantity of material which is returned back to the store. In such cases, material returned note is prepared and is either credited to the Contract Account or deducted from the material debited to the Contract Account. Similar treatment is given to the material transferred from one contract to another one. Material Transfer Note is prepared to record these transactions of transfer. Material remaining at the site at the end of a particular accounting period is shown as closing stock after valuation of the same and carried forward to the next period. B. Labor Cost: Wages paid to the workers engaged on a particular contract should be charged to that contract irrespective of the work performed by them. If there are common workers on more than one contract and/or if the workers are transferred from one contract to the other contract, time sheets must be maintained and wages may be distributed on the basis of time spent on each contract. Some of the workers may be working in the central of ce or central stores, their wages can be apportioned to a particular contract on suitable basis like time spent etc. C. Expenses: All expenses incurred for a particular contract should be charged to that contract. In case of any indirect expenses incurred for the organization as a whole, they should be charged to the contract on some suitable basis. Direct expenses can be charged directly to the contract. D. Plant and Machinery: Depreciation on the plant and machinery used for the contract is to be charged to the contract account. The depreciation may be charged on any of the following basis. If a plant is specially purchased for a particular contract and is expected to be used for the contract for long time, thus being exhausted at site, the total cost of the plant will be debited to the contract account. After the completion of the contract, if it is no longer required, it will be sold at the site itself and the sale proceeds are credited to the contract account. If it is not sold, the contract is credited with the depreciated [revalued amount value]. Thus the amount of depreciation is debited to the contract account. The main drawback of this method is that the debit side of the contract account is unnecessarily inated with the cost of the plant value and thus the cost of contract is shown very high. For removing this drawback, the difference between the original cost at the commencement of the contract and the depreciated value at the end of the period is worked out and charged to the contract account as depreciation. If a plant is used for a contract for a short period, there is no need of debiting the cost of the plant to the contract account. The amount of depreciation is worked out on the basis of per hour and charged to the contract on that basis. The hourly rate is calculated by dividing the depreciation and other operating expenses of the plant by the total estimated working hours of the plant. Sometimes plants may be taken on hire for a particular contract. In such cases the amount of rent paid should be debited to the contract account. V. Subcontract: Sometimes due to certain situations, a sub contractor is appointed to carry out certain special work for the main contract. This special work done by the sub contractor becomes a direct

charge to the main contract and accordingly debited to the contract account. The payments made to the sub contractor are charged to the main contract as direct expenses and no detailed break up of the same is required. Material supplied to the sub contractor without any charge, is debited to the contract account as direct material and machinery, tools etc supplied to him on rent should be depreciated on appropriate basis and debited to the contract account. Rent received for the use of such tools and machines should be credited to the contract account or deducted from the nal bill of the sub contractor. VI. Additional Work: Sometimes additional work may be necessary in addition to the work originally contracted for. This forms a separate charge and if the amount involved is large, a subsidiary contract is generally entered into with the contract. VII. Special Aspects Of Contract Account: There are certain special aspects of contract accounts. These are discussed below. Certied Work: In contracts which are expected to continue for a long period of time, it is a normal practice that the contractor obtains certain sums from the contractee from time to time. This is done on the value of contract completed and certied by the architect/surveyor appointed by the contractee. The amount received by the contractor is not 100% of the value of the work certied but is less than the same, as the balance amount is kept as retention money. For recording this transaction, any of the following two methods may be used. I. In the rst method, the contract account is credited with the value mentioned in the certicate and personal account of the contractee is debited. Cash received is credited with the contractees account and the balance is shown as a debtor representing the retention money. II. In the second method, the contract account is credited with the value of the certi cate and the contractees account is debited with amount payable immediately and a special retention money account is debited with the amount so retained. Treatment of Prot on incomplete Prot: Several contracts take more time than one nancial year before they are complete. The questions arises as to whether the prots on such contracts should be taken into consideration after the completion of the contract or whether a portion of the same should be taken into accounts every year on certain basis. If prot is taken into consideration after the completion of contracts and if in a single year several contracts are completed, the prots shown will be very high while in another year, if none of the contracts are completed, amount of prots shown will be very low. Thus there will be distortions in the amount of prots. Therefore it becomes necessary to compute the amount of prot on partly completed contracts and take credit of appropriate amount in the prot and loss account by using the following guidelines. Value of certied work only should be taken into consideration while determining the profit. Value of work not certied should not be taken into consideration. In case of contracts which are less than 25% complete, no prots should be taken into consideration and consequently no credit should be taken to Prot and Loss Account.

In case of contracts which are more than 25% complete, but less than 50% complete, the following method should be used for computing the prot to be credited to the Prot and Loss Account. 1/3 Notional Prot/ Cash Received/Work Certied. Notional prot is the difference between the value of work certi ed and cost of work certi ed. It is computed in the following manner. Notional Prot = Value of work certi ed [cost of work to date cost of work completed but not certied] In case of contracts complete between 50% and 90% [more than 50% but less than 90%] the following method is used for computing the pro t to be credited to the Prot and Loss Account. 2/3 Notional Prot X Cash Received/Work Certied. In case of contracts completed 90% or more than that, it is considered to be almost complete. In such cases, the estimated total prot is first determined by deducting the total costs to date and additional expenditure necessary to complete the contract from the contract price. The portion of prot so arrived is credited to the Profit and Loss Account by using the following formula. Method I:- Estimated Prot*Work Certied /Contract Price Method II:- Estimated Prot*Work Certied /Contract Price Cash Received/Work Certied or Estimated Prot Cash Received/Work Certied. The method II is preferable to the rst one. In case, additional expenditure to complete the contract not mentioned, the amount of prot to be transferred to the Prot and Loss Account is determined using the following formula. Notional Prot X Work Certied/Contract Price If there is a loss, the total amount of loss should be transferred to the Prot and Loss Account by crediting the contract account. It will be observed that in case of incomplete contract, amount of prot credited to the Prot and Loss Account is reduced proportionate to the work certied and cash received. The reason is that this being unrealized prots should not be used for distribution of dividend. Similarly, the principle of conservatism should also be applied in computing and crediting the prots. Illustration: Compute a conservative estimate of prot on a contract [80% complete] from the following particulars. Illustrate at least four methods of computing the prot. Particulars Total expenditure to date Estimated further expenditure to complete the contract [including contingencies] Contract price Work certi ed Work uncerti ed Cash received Amount[Rs.] 1, 02,000 20, 400 1, 83,600 1, 20,000 10, 200 97, 920

Solution: The amount of pro t on incomplete contract can be computed according to any of the following four methods. Before computing the same, we will compute the amount of pro t on the contract and then show the working of the methods. Prots on incomplete contract: Total Contract Price: Less: Expenditure to date: Estimated further expenditure: Total expenditure. Estimated Profits o Amount of Prot to be taken to the Prot & Loss A/c o 1st Method: Rs.61, 200/Rs.183600 * Rs.120000 = Rs.40, 000 o 2nd Method: Estimated Prots * Work Certied/Contract Price * Cash Received/Work Certied o Rs.61200 * Rs.120000/Rs.183600 *Rs.97920/Rs.120000 = Rs.32640 o 3rd Method: Estimated Prots *Cost of Work to date/Estimated Total Cost o Rs.61200 * Rs.102000/Rs.122400 = Rs.51000 o 4th Method: Estimated Prots * Cost of Work to Date/Estimated Total Cost * Cash Received /Work Certied o Rs.61200 *Rs.102000/Rs.122400 * Rs.97920/120000 = Rs.41616131 Special Points in Contract: I. Cost Plus Contracts: This type of contract is generally adopted when the probable cost of contract cannot be ascertained in advance with reasonable accuracy. In this type of contract, the contractor receives his total cost plus a prot, which may be a percentage of cost. These types of contracts give protection to the contractor against uctuations in prots as he is guaranteed about his prot irrespective of the actual costs. However in order to avoid any dispute in future, it is always advisable to specify the admissible costs in advance. Similarly the customer may also reserve the right of demanding cost audit in order to check the reliability of the claim of the contractor regarding increase in the costs. II. Target- price contracts: In such cases, the contractor receives an agreed sum of prot over his predetermined costs. In addition, a gure is agreed as the target gure and if actual costs are below this target, the contractor is eligible for bonus for the savings. Rs. 1,02,000 Rs. 20,400 Rs 1,22,400 Rs.61,200 Rs. 1,83,600

III. Escalation Clause: In order to protect the contractor from the rise in the price, an escalation clause may be inserted in the contract. As per this clause, the contract price is increased proportionately if there is a rise in input costs like material, labor or overheads. The condition that may be laid down is that the contractor will have to produce a proof regarding the rise in the price.

PROCESS COSTING Introduction The methods of costing basically aim at nding out the cost of a product or service, which is offered by the organization. Process Costing is also a method of costing which is used in those industries where the production is in continuous process, i.e. the output of one process becomes the input of the subsequent process and so on. Examples of such industries are, paint works, chemical plants, food manufacturing, oil rening, paper mill, textile mills, sugar factories, fruit canning, dairy and so on. In such industries, the input is put in the rst process and the output of each process becomes the input of the subsequent process till the nal product emerges from the last process. This method is employed where it is not possible to trace the items of prime cost [which consists of all direct costs] to a particular order because its identity is lost in the continuous production. Thus it is not possible to compute the cost of say, 200 liters of oil or 200 kg of sugar produced as thousands of liters of oil or thousands of kg of sugar is manufactured at the same time. We can get the cost per liter or kg by dividing the total cost by the total production produced during that period. The features and intricacies of process costing are discussed in the subsequent paragraphs. Features of Process Costing We have discussed in the previous paragraph that process costing is employed in continuous production industries where the ow of production is in a sequence and the output of one process becomes the input of the subsequent one. The objective of process costing is to nd out the cost of each process by identifying the direct costs with the particular process and apportioning the indirect costs i.e. overheads to each process on some suitable basis. The units coming out the process as the nished output are uniform in all the respects and hence the cost per unit is computed by dividing the total cost by the total production units. In case, some units are incomplete at the end of a particular period, equivalent units are worked out of such incomplete units and then the cost per unit is computed. The features of process costing are discussed in the following paragraphs. 1) The production is in continuous ow and is uniform. All units coming out as nished products are uniform with each other in all respects. 2) The product is manufactured in a continuous ow and hence individual units lose their identity. 3) The unit cost is obtained by dividing the total cost for a particular period by the total output. This is the average cost of the product units. 4) Cost per process is ascertained and cost of each process is transferred to the subsequent process until the nished product emerges. 5) In a particular process normal and abnormal losses emerge. Normal loss is a loss, which is inevitable in any process and thus cannot be avoided or controlled. Any loss, which, is over and above, the normal loss is called as abnormal loss and is to be accounted for separately. For example, if 1000 units are put in Process 1 and it is anticipated that there will be a normal loss of 1% in the process, the output expected is 1,000 1% of 1,000 that is 990. If actual production is 980, there is an abnormal loss of 10

units. On the other hand if the production is 995, there is an abnormal gain of 5 units. Abnormal gain and abnormal loss are to be accounted for in the process cost accounts. 6) Sometimes each process may be treated as prot center and so while transferring the cost from one process to another, a percentage of prot is added in the cost of that process. This is known as inter process prot and needs to be accounted for in the process cost accounts. 7) Though the cost per unit is computed by dividing the total cost by the number of units, there can be a problem on incomplete units at the end of a particular accounting period. In such cases equivalent units have to be worked out for computing the cost per unit. Preparing Process Cost Accounts 1) As explained above, the objective of process costing is to work out the cost of each process, transfer the same to the subsequent process and nally ascertain the total cost of production. Therefore it is necessary to charge various costs to each process. For this, the factory is divided into distinct processes or operations and an account is kept of each process to which all the costs are debited. The following are the various elements of cost, which are shown in the process accounts. Materials: Raw materials required for each process is drawn from stores against material requisitions. Proper procedure like preparing and authorizing the requisition, pricing of the issues, return of materials to the stores, transfer of material from one process to another should be followed while issuing the materials. Cost of materials consumed should be computed as per the method employed for pricing of the issues and the cost should be debited to the process account. Labor: Wages paid to workers and supervisory staff should be charged to the particular process if they can be identied with it. If workers work on two or more processes, proper allocation should be made according to some basis like time spent on each process. Direct Expenses: If expenses are identiable with a particular process, they should be charged to that process. For example, cost of electricity, depreciation may be charged directly to a process if they are identiable with it. Overheads: By nature, overheads are indirect expenses and hence cannot be identied with a particular process. These expenses can be apportioned on some suitable basis and charged to the process. 2) Important aspects an Process Accounts: While preparing process cost accounts, some important aspects are to be taken into consideration. These aspects are given below. Normal Loss: Normal loss is a loss, which is inevitable in any process. Thus if the input is 100, the output may be 95 if the normal loss is anticipated as 5%. Accounting treatment of normal loss is explained and illustrated in the subsequent paragraphs. Abnormal Loss/Abnormal Gain: If the actual output is less than the normal output [Normal output = Input Normal Loss], the difference between the two is the abnormal loss. On the other hand if the actual output is more than the normal output, the difference between the two is abnormal gain. Thus in the example given above, the normal output is 95 which is 100 5% of 100 as the normal loss. If the

actual output is 93 units, 2 units will be abnormal loss and if the actual output is 97 units, 2 units will be abnormal gain. Abnormal loss/gain is to be treated differently and is illustrated subsequently. Inter Process Prots : Sometimes, while transferring the cost of one process to the subsequent one, some percentage of prot is added in it. This is called as inter process prots. This is done when a process is treated as prot center. In such cases, unrealized prot is to be computed and shown separately. This is also illustrated separately. 3) Pro Forma of Process Account [Without normal/abnormal loss/gain]: A simple process account is prepared in the following manner. Process I Account Debit Particulars Direct Materials Qty Rate Rs Amount Rs Particulars Output Transferred To Process II Qty Rate Rs Credit Amount Rs

Direct labour Direct Expenses Production Overheads Total Total Note: Process II and subsequent Process Accounts will be prepared in the same fashion. In the nal process, the cost and output will be transferred to the nished goods stock accounts. Illustrations 1) Product A is a product produced after three distinct processes. The following information is obtained from the accounts of the company for a particular period. Particulars Total Amount Rs 2,200 400 500 Process I Rs 1,800 100 300 Process II Rs 300 200 Process III Rs 100 100 200

Direct Material Direct Labor Direct Expenses

Production overheads are incurred Rs.800 and is recovered at 200% of direct wages. Production during the period was 100 kg. There was no opening or closing stock. Prepare Process Accounts assuming that there is no process loss.

Solution: Process I Account Debit Particulars Qty Kg 100 Rate Rs. 18.00 Amount Rs. 1,800 Particulars Qty Kg 100 Output: 100kg Credit Rate Rs. 24 Amount Rs 2,400

Direct Materials

Output Transferred to Process II

Direct Labor Direct Expenses Production Overheads 200% of direct labor Total 100

1.00 3.00

100 300

2.00 24.00

200 2,400

Total

100

24

2,400

Process II Account Debit Particulars Qty Kg Rate Rs. 24.00 Amount Rs 2,400 Particulars Qty Kg 100

Output: 100 kg Credit Rate Rs. 33 Amount Rs. 3,300

Transferred From Process I 100

Output Transferred to Process II

Direct Materials Direct Labor Direct Expenses Production Overheads 200% of direct labor Total 100

3.00 2.00

300 200

4.00 33.00

400 3,300 Total 100 33 3,300

Debit Particulars Qty Kg Rate Rs.

Process I11 Account Credit Amount Rs Particulars Qty Kg

Output: 100 kg

Rate Rs.

Amount Rs.

Transferred From Process II

100

33.00

3,300

Output Transferred to Finished Stock

100

39

3,900

Direct Materials Direct Labor Direct Expenses Production Overheads 200% of direct labor Total 100

1.00 1.00 2.00

100 100 200

2.00 39.00

200 3,900 Total 100 39 3,900

In the above illustration, the assumption was that there is neither normal loss or abnormal loss/gain. However there can be normal and/or abnormal loss/gain and hence the treatment of such losses should be understood properly. The treatment of such losses is given below. _ Normal Loss: The fundamental principle of costing is that the good units should bear the amount of normal loss. Normal loss is anticipated and in a process it is inevitable. The cost of normal loss is therefore not worked out. The number of units of normal loss is credited to the Process Account and if they have some scrap value or realizable value the amount is also credited to the process account. If there is no scrap value or realizable value, only the units are credited to the process account. _ Abnormal Loss: If the units lost in the production process are more than the normal loss, the difference between the two is the abnormal loss. The relevant process of account is credited and abnormal loss account is debited with the abnormal loss valued at full cost of finished output. The amount realized from sale of scrap of abnormal loss units is credited to the abnormal loss account and the balance in the abnormal loss account is transferred to the Costing Profit and Loss Account. _ Abnormal Gain: If the actual production units are more than the anticipated units after deducting the normal loss, the difference between the two is known as abnormal gain. The valuation of abnormal gain is done in the same manner like that of the abnormal gain. The units and the amount is debited to the relevant Process Account and credited to the Abnormal Gain Account. Target costing Target costing is a pricing method used by firms. It is defined as "a cost management tool for reducing the overall cost of a product over its entire life-cycle with the help of production, engineering, research and design". A target cost is the maximum amount of cost that can be incurred on a product and with it the firm can still earn the required profit margin from that product at a particular selling price. Target costing is a system under which a company plans in advance for the product price points, product costs,

and margins that it wants to achieve. If it cannot manufacture a product at these planned levels, then it cancels the product entirely. With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability. The primary steps in the target costing process are: 1. Conduct research. The first step is to review the marketplace in which the company wants to sell products. The team needs to determine the set of product features that customers are most likely to buy, and the amount they will pay for those features. The team must learn about the perceived value of individual features, in case they later need to determine what impact there will be on the product price if they drop one or more of them. It may be necessary to later drop a product feature if the team decides that it cannot provide the feature while still meeting its target cost. At the end of this process, the team has a good idea of the target price at which it can sell the proposed product with a certain set of features, and how it must alter the price if it drops some features from the product. 2. Calculate maximum cost. The company provides the design team with a mandated gross margin that the proposed product must earn. By subtracting the mandated gross margin from the projected product price, the team can easily determine the maximum target cost that the product must achieve before it can be allowed into production. 3. Engineer the product. The engineers and procurement personnel on the team now take the leading role in creating the product. The procurement staff is particularly important if the product has a high proportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product. They may also be involved in outsourcing parts, if this results in lower costs. The engineers must design the product to meet the cost target, which will likely include a number of design iterations to see which combination of revised features and design considerations results in the lowest cost. 4. Ongoing activities. Once a product design is finalized and approved, the team is reconstituted to include fewer designers and more industrial engineers. The team now enters into a new phase of reducing production costs, which continues for the life of the product. For example, cost reductions may come from waste reductions in production (known as kaizen costing), or from planned supplier cost reductions. These ongoing cost reductions yield enough additional gross margin for the company to further reduce the price of the product over time, in response to increases in the level of competition.

FEATURES It is an integral part of the design and introduction of new products. A target selling price is determined by using various sales forecasting techniques. Establishment of target production volumes. Determine cost reduction targets. A fair degree of judgment. A series of intense activities. A team based set-up to achieve its objectives.

UNIT 5 ACTIVITY BASED COSTING IN A CORPORATE HOSPITAL

Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing. CIMA defines ABC as An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs. Objective of Model With ABC, a company can soundly estimate the cost elements of entire products ACTIVITIES and services. That may help inform a company's decision to either:

Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim) Or identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim).

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives. Methodology Methodology of ABC focuses on cost allocation in operational management. ABC helps to segregate

Fixed cost Variable cost Overhead cost

The split of cost helps to identify cost drivers, if achieved. Direct labor and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The cost driver is a factor that creates or drives the cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions (cost driver) takes at the counter and then by measuring the number of each type of transaction. For the activity of running machinery, the driver is likely to be machine operating hours. That is, machine operating hours drive labour, maintenance, and power cost during the running machinery activity.

Activity Based Costing in Hospitals. Background Activity Based Costing (ABC) began appearing as a costing methodology in industries other than healthcare in the 1990s. Since then ABC has continued to evolve, now encompassing Time-Driven ABC and Activity-Based Management (ABM). Many healthcare executives continue to ask how ABC can be applied in healthcare and how it relates to existing costing methods. Some hope it can offer a breakthrough or at least advantages over current methods, which are perceived variously as inaccurate or too costly to build and maintain. ABC proponents are correct in their criticism of traditional hospital costing methods that embody too closely these characteristics of state and federal cost reports: -Single cost component -Ratios of departmental Costs to Charges (RCC) -No split of direct versus indirect costs -Cost apportionment based on price of charge code items -Statistics and allocation methods from the HCFA 2552 Costs developed in this manner are likely to be inaccurate, and are also not easily traced back to their roots, because fixed/variable and direct/indirect distinctions are not carried through the process. These characteristics also make it impossible to model the effects of activity changes. ABC offers advantages over traditional costing because it relates costs to activity drivers rather than just fixed and variable designations. Traditional methods of costing tend to bury overhead in product costs through very general allocations. In contrast, ABC attempts to tie areas usually thought of as overhead to their own activity measures. ABC attempts to reveal all activities contributing to cost, allowing managers to eliminate activities that do not add value, and thus ABC is often heard in connection with reengineering efforts. By identifying each activity, ABC can also better reveal expected or modeled resource use through Activity Based Modeling (ABM). ABC is also often mentioned in connection with supply chain management, as a means of identifying non-value-adding steps in the supply chain. Terminology Knowing some ABC terminology is helpful in any costing discussion: Cost Drivers: Activities that drive cost in the department. In industry, inspections, tests, set ups, clean ups, number of items in inventory, engineering changes are typical cost drivers. In healthcare examples include number of patients, number of surgeries and hours of surgery. In ABC, costs fall into one of four major categories, each of which will have a driver:

1-Unit Level-costs directly associated to each unit of output. In most service departments, a unit of output is a diagnostic or therapeutic activity that is captured through order management and patient accounting functions. Film in a radiology exam is an example of a unit level cost. Other examples could include a labor Relative Value Unit (RVU), estimated or studied minutes to complete the procedure. 2-Batch Level-costs associated with a batch of activities, regardless of the size of the batch. Some activities such as patient billing, dietary and medical records might be assigned directly to patients as a batch level expense, based on statistics like patient days, number of meals or number of diagnoses and procedures coded. 3-Product Level-costs associated with a service line, regardless of number of batches or unit output. Many center of excellence programs have specialized staff and expenses that are not used by other programs. Examples would be academic residencies, program marketing and promotion and specialized imaging and diagnostic equipment and facilities. Product level costs could be allocated using statistics like equivalent patient days for patients meeting specific criteria for a given service line. 4-Production Sustaining-costs that cannot be directly associated to a product in any other way. Examples in healthcare might be general marketing, administration and personnel. Depending on the ABC expert you ask it is possible that interpretation of these terms could vary. It's also important to remember that the degree to which a costing system is ABC is best measured along a continuum and that no system is completely perfect in its ABC compliance. The degree to which ABC ideals are achieved depends on economics: will the value of the increased goodness of the data be greater than the cost of collecting it? The degree to which ABC is achieved depends as much on available data and implementation as it does software capabilities. To call one system ABC while suggesting another of not being ABC is usually oversimplification or labeling to suit some other purpose. Importance . Fortunately, most healthcare providers have been working over the last three decades to implement costing methods that embody ABC concepts, without calling it ABC. For example, licensees of TRENDSTAR Horizon Performance Manager (HPM) are capable of doing a reasonably good job of handling ABC costing methods. Typical implementations include: -Multiple cost components -User-defined cost component names -Segregation of direct and indirect costs -Use of charge codes and other user-defined cost drivers -User-defined activity measures and statistics

-Use of price, RVUs, estimated minutes or studied standards -Rollup of actual activities by patient -Modeling of activities and cost consequences Of course, availability of data will determine the ease with which ABC principles are met. Here are some examples in which obtaining healthcare data is likely to be a challenge: Unit cost level: ABC practitioners prefer to use discrete activities like transport, making appointments, analyzer calibration, communicating results and so on. Unfortunately automated capture methods for such measures do not generally exist in healthcare; where they do, they are buried in many different systems, often not by patient. In healthcare, the specific outputs of a service department are captured automatically in the form of order/billing items. These have become the de facto activity drivers because they are economically feasible. New activity capture systems have been suggested many times over the years, but an important caveat in healthcare data capture is that valid activity data must be a byproduct of patient care activities. Otherwise compliance by busy caregivers and service staff will be nonexistent. If little confidence exists in the existing order/charge management systems' quality or applicability, it may be time to revise the order/charge description master with an eye toward better activity costing support, as well as addressing the issues of timely coding, regulatory compliance and pricing. Nursing labor is the single most expensive resource in any hospital, yet costing of patient care activities remains the most underdeveloped costing area of all. Part of the reason for this may be failed prior efforts to use easily-gamed acuity systems. The good news is that there is a reasonable solution available for users of automated patient care documentation systems. As these systems become more widely available, they track all activities performed for a patient by the nursing staff (e.g., ambulate 50 feet, IV site management, patient education) and can thus supply highly accurate activity data as a byproduct. Batch and Product level: New statistics must be captured and interfaced to the decision support system to support these cost levels. The level of detail required is fairly reasonable if it is kept to major departmental outputs, and is therefore generally both economical and useful. The Production Sustaining level is the where overhead allocations are performed. The ABC approach is to make many departments typically thought of as overhead into service departments with activity drivers, including medical records, interns and residents, medical management, and program management. New statistics are generally needed to support this. For the remaining overhead departments, stringent ABC practitioners may call for capture of new statistics for allocation, while others may be satisfied with more traditional measures such as the traditional square footage and other direct or accumulated expenses. The good news is that existing systems can be moved gradually toward greater ABC compliance. Prioritization and planning with the owners of the information systems providing the activity data are vital to keep the cost system evolution moving in the right direction and in the right order. In the interim, additional activity feeds by patient can meet demand for improved information where it is

feasible to do so. Opportunities Departmental productivity is an area that has been well covered in healthcare for many years. Costing of activities ties in nicely to productivity by supplying a core set of labor measures for both purposes, making both applications more worthwhile to maintain. ABC practitioners also need to recognize a larger opportunity, which is that it may be easier, for example, to do 10 percent fewer diagnostic tests than do them 10 percent cheaper. To do this, hospitals have to streamline the patient care process, to determine the effectiveness (e.g. value added) of the individual patient care activities. Tremendous strides have already been made in this area, and much more remains to be done. Evidence based medicine is the domain of caregivers, physicians, patient care and other clinical staff. The cost accountant provides support to the process via accurate cost data and clinical utilization so that clinicians can judge the clinical value versus economic costs of discrete clinical activities. By applying the cost driver concept to clinical decision making, users may be able to obtain new uses of cost accounting data. Essentially, one clinical decision can drive a chain of events, so the cost of the decision is not limited to the initial decision or a single dose of a drug. For example, the decision to give a patient a particular antibiotic may also create a need to monitor serum levels of the antibiotic, and may trigger adverse reactions, all of which contribute more cost than the antibiotic itself. Clinical decisions are often drivers of many, many related activities and costs.