Tag: Activity-Based Costing

Joint Cost refers to the common cost incurred during a single production process that yields multiple products simultaneously, known as joint products. These costs are incurred up to the split-off point, where the products become individually identifiable. Joint costs typically include raw materials, labor, and overheads that cannot be traced to a specific product. Since these products share the same production path initially, allocating joint costs among them is essential for accurate pricing and profitability analysis. This concept is commonly used in industries like oil refining, dairy, meat processing, and chemical manufacturing.

• Market or Sales Value at Split-off Method

This method allocates joint costs based on the relative sales value of each product at the split-off point. At this stage, the products become separately identifiable. It is ideal when products are saleable immediately after the joint process without additional processing. The logic is that products with higher sales value should bear a higher portion of the joint cost. This method is widely accepted due to its fairness and ease of application, especially when all products are marketable at the split-off point. However, it becomes impractical when products need further processing, or if market prices are volatile or unavailable at split-off. It suits industries like dairy, meat processing, or crude oil refining.

• Net Realizable Value (NRV) Method

In the NRV method, joint costs are allocated based on each product’s net realizable value, which is calculated by subtracting further processing and selling expenses from the final sales price. This method is particularly useful when products cannot be sold at the split-off point and require additional processing. NRV gives a realistic and fair cost allocation since it reflects actual profits that will be realized. It is commonly used in industries like chemicals, petroleum, and food processing where by-products and joint products are refined further. However, the challenge lies in estimating future costs and prices accurately, as these factors directly affect cost allocations.

• Reverse Cost Method

The reverse cost method involves working backward from the selling price of a joint product to determine how much joint cost it should absorb. First, you subtract estimated profit, selling, distribution, and post-split-off processing costs from the sales value. The balance becomes the assigned joint cost. This method is practical in industries where selling price and profit margins are predetermined or controlled, such as government supply contracts. It helps in cost estimation and pricing strategies, particularly when forward costing is difficult. However, the method is complex as it requires accurate estimates of margins and costs, and may not be suitable for all industries.

• Physical Units Method

This method uses physical output measures like weight, volume, or count to allocate joint costs among products. The idea is to divide costs in direct proportion to the physical quantity produced. It is simple and objective, requiring only production data. It is most effective when products are of similar value or importance. However, this method fails to account for differences in market value or profitability. High-value, low-volume products may be unfairly allocated a low portion of the joint cost. This method is typically applied in industries like mining, agriculture, or lumber, where output is measured in tons, liters, or logs.

• Average Unit Cost Method

The average unit cost method involves dividing total joint costs by the total number of units produced, and assigning this average cost to each unit, regardless of type. It is easy to use and suited to processes where all joint products are nearly identical in nature, size, and value. This method ignores sales value or processing cost differences and thus may lead to inaccurate cost representation for dissimilar products. It is often used in industries where outputs are homogeneous or interchangeable, like chemical manufacturing or refining. While simple, it lacks the refinement of other methods when dealing with diverse or high-value outputs.

By-product is a secondary product that is unintentionally or incidentally produced during the manufacturing of a main product or joint products. By-products usually have lower economic value compared to the main products and do not require separate production processes. They are often sold or reused to recover some part of the production cost. For example, in the sugar industry, molasses is a by-product obtained during sugar extraction from sugarcane. By-products can contribute to cost reduction and sustainability by minimizing waste and generating additional revenue from materials that would otherwise be discarded or underutilized.

Features of By-Product:

• Incidental Nature of Production

By-products are produced incidentally during the manufacturing of a main product or joint products. Their creation is not intentional or the primary goal of the production process. For example, in oilseed processing, oil is the main product, while oil cake is the by-product. These by-products emerge automatically as a result of chemical or physical reactions involved in the process. Companies do not set up production systems specifically for by-products, but they utilize or sell them if they hold commercial or economic value.

• Lower Economic Value

By-products generally have significantly less economic value compared to the main products. This lower value arises due to reduced demand, lower utility, or the fact that they are often waste or residue materials. While they may still generate some revenue, their contribution to overall profitability is usually minor. However, in large-scale operations, even the sale of by-products can offer noticeable financial benefits. For example, molasses in sugar production may not fetch high prices but can still offset processing costs if managed efficiently.

• Common in Process Industries

By-products are typically found in continuous or process industries where production involves chemical or mechanical transformations. Industries such as sugar, steel, paper, oil refining, and food processing often produce by-products. For instance, in the steel industry, slag and furnace gas are by-products generated during smelting. The nature of these industries makes it unavoidable to produce some amount of by-products. Their management becomes an integral part of production planning, especially when aiming for sustainability or cost-effectiveness.

• Cost Allocation Complexity

Allocating costs to by-products is complex because they are not the primary focus of production. Most companies do not allocate significant joint costs to by-products; instead, they may use methods like the net realizable value (NRV) or sales value at split-off for cost determination. Often, the income from selling by-products is treated as other income or used to reduce the cost of the main product, depending on accounting policies. This ensures accurate cost assessment without overburdening the main product.

• May Require Further Processing

Some by-products may need additional processing before they can be sold or used. This further processing adds extra cost but may significantly enhance the by-product’s value. For example, crude glycerin obtained as a by-product in biodiesel production can be purified for use in pharmaceuticals or cosmetics. Decisions regarding further processing depend on factors like market demand, processing cost, and profitability. In such cases, the by-product transitions closer to a co-product if its economic significance increases.

• Revenue Contribution

Though secondary, by-products can contribute to overall revenue. Especially in large-scale production, the cumulative value of by-products may offer substantial cost savings or profits. For instance, sawdust from wood processing can be sold to particleboard manufacturers. Revenue from by-products is often used to reduce the total cost of manufacturing or increase the profitability of the main product. Efficient utilization of by-products supports better financial performance and helps companies maximize their output value.

• Supports Environmental Sustainability

Utilizing by-products helps reduce industrial waste and promotes eco-friendly production practices. Instead of discarding them, businesses can find alternate uses, recycle them, or convert them into useful products. For example, rice husk, a by-product in rice milling, is used as biofuel or in construction materials. This reuse lowers environmental impact, aligns with sustainability goals, and improves a company’s green image. Effective by-product management also reduces disposal costs and aligns with circular economy practices.

Example of By-Product:

A common example of a by-product is molasses in the sugar industry. When sugarcane is processed to extract sugar, molasses is left behind as a thick, dark syrup. It is not the main objective of production but emerges naturally during the process. Although molasses has lesser value than sugar, it can still be sold or further processed to produce alcohol, ethanol, or animal feed. This helps sugar mills reduce waste, earn additional revenue, and increase overall production efficiency without incurring extra major production costs.

Accounting for By-Products Methods:

• Other Income Method

Under the Other Income Method, the by-product is not assigned any share of joint production cost. Instead, when it is sold, the income earned from the sale is treated as non-operating income or other income in the profit and loss account. This method is used when the by-product has very low value or is not significant to the main operations. The costs incurred on the by-product, if any, such as packaging or transport, are deducted from the sales value to arrive at net income. The method simplifies cost allocation but does not reflect true profitability of the process. It is suitable when the by-product is sold in small quantity or not directly linked to production decisions.

• Cost Reduction Method

In the Cost Reduction Method, the revenue from the sale of a by-product is deducted from the total cost of production of the main product. The by-product is not assigned a portion of the joint cost but is instead used to reduce the expense of the main product, thereby lowering the cost per unit of output. This method is suitable when the by-product has some economic value and is regularly generated. It is often preferred in manufacturing industries to reflect the real net cost of producing the main item. This approach is simple and helps managers assess the efficiency of the production process while accounting for all value-adding outputs.

• Net Realizable Value (NRV) Method

The Net Realizable Value (NRV) Method values the by-product based on its expected selling price minus any further processing or selling costs. The NRV of the by-product is then credited back to the joint production process, reducing the overall cost assigned to the main product. This method is useful when the by-product requires additional processing to be saleable. It gives a more realistic view of the benefit derived from by-products. NRV can vary based on market conditions, so estimates must be updated regularly. This method is widely accepted in accounting standards and reflects more accurate profitability when compared to simple cost reduction or other income methods.

• Market Value or Sales Value Method

The Market or Sales Value Method allocates joint costs to by-products proportionally based on their market or sales value at the split-off point. Both the main and by-products share a portion of the cost according to their ability to generate revenue. This method is especially useful when the by-product has a substantial value and is almost equal in importance to the main product. It ensures fair cost distribution, though it may require frequent updates due to market price fluctuations. This method aligns with the matching principle in accounting and presents a clearer picture of each product’s profitability. It is suitable for industries like petrochemicals or food processing.

• Replacement Cost Method

In the Replacement Cost Method, the value of the by-product is assessed based on the current market cost to replace the same material if it were to be purchased from an external source. This value is credited to the process account, and no joint cost is allocated directly. This method is used when the by-product is consumed internally, and the goal is to measure the cost-saving benefit from not having to purchase that material. It is commonly seen in industries using scrap or waste as fuel or raw material. The method is practical and efficient when actual market replacement prices are known and stable.

• Standard Cost Method

The Standard Cost Method assigns a pre-determined cost per unit to the by-product, based on historical data, estimates, or budgeted figures. This cost is used to value the by-product and is credited to the process account to reduce the cost of the main product. The method provides consistency and ease of calculation, particularly when by-products are consistently produced. However, it may not reflect current market trends unless the standard costs are revised periodically. This method is often used in internal reporting or budgeting where simplicity and predictability are needed, rather than accuracy in real-time financial results.

Accounting for By-products Journal entries:

Joint products are two or more products generated simultaneously from a single production process using common raw materials and inputs, where each product has significant economic value. These products are not the result of separate manufacturing operations, and they emerge together up to a certain stage known as the split-off point. After this point, the products may undergo further processing individually. Examples include petrol, diesel, and kerosene obtained from crude oil. The cost incurred before the split-off is considered joint cost and is allocated among the joint products using various cost allocation methods like physical units or sales value.

Functions of Joint Product:

• Maximizing Resource Utilization

Joint product manufacturing helps maximize the use of raw materials and production inputs by producing multiple products from a single process. This ensures that every part of the input, such as crude oil or milk, is converted into various valuable outputs. Efficient utilization reduces waste and increases the productivity of available resources, leading to cost-efficiency and better returns on investment for companies operating in industries like petrochemicals, dairy, and agriculture.

• Cost Sharing Across Products

In joint product processes, costs incurred before the split-off point are distributed among all resulting products. This cost-sharing mechanism allows businesses to allocate production costs more fairly and systematically. It helps prevent overburdening a single product with the full cost of input, making pricing more competitive. Cost sharing improves profitability analysis and enables better control over pricing and budgeting for each product derived from the joint production process.

• Enhancing Profitability

By generating several products from the same raw material and process, joint production enhances a company’s profitability. Even if one product has lower market demand, revenue from other joint products can offset losses. For example, in meat processing, bones, skin, and meat are sold as different products, ensuring diversified revenue streams. This approach helps stabilize income and enhances overall business performance by tapping into various market segments with multiple product offerings.

• Diversifying Market Offerings

Joint products allow businesses to diversify their market offerings without the need for separate production lines. This diversification reduces business risk and allows entry into different customer segments. For instance, in dairy processing, a single batch of milk can yield cream, butter, cheese, and whey. Such variety enhances market reach and brand strength, providing consumers with a range of products while maintaining cost-efficiency within a single integrated process.

• Improving Inventory Management

The joint product approach allows better planning and coordination in managing inventories. Since several products are produced together, companies can plan production schedules more effectively. It reduces the chances of surplus or stockouts of specific items. Coordinated production also simplifies storage and distribution logistics, as batch outputs are predictable. This organized flow helps in timely fulfillment of customer demand, reducing holding costs and wastage across multiple product categories.

• Facilitating Pricing Decisions

With joint products, pricing strategies become more analytical and informed. The cost allocation of joint production helps managers determine a reasonable price for each product based on cost contribution and market demand. It also aids in setting minimum selling prices and deciding whether a product should be sold at split-off or processed further. This financial clarity supports competitive pricing while ensuring that all products contribute to profitability.

• Aiding Managerial Decision-Making

Joint product accounting provides crucial insights that assist in managerial decision-making. Understanding the cost structure, market potential, and profitability of each joint product enables management to optimize product mix, resource allocation, and production levels. It supports decisions such as whether to process a product further or sell it at split-off, introduce a new joint product, or discontinue an existing one based on performance metrics and profit margins.

• Supporting Sustainability and Waste Reduction

Joint product manufacturing aligns with sustainable business practices by ensuring minimal wastage of raw materials. For example, in agricultural processing, husks, seeds, and shells can be processed into animal feed or biofuel. This approach not only adds economic value but also reduces environmental impact. By turning by-products into marketable joint products, companies contribute to circular economy goals, enhance corporate social responsibility, and improve their reputation for environmental stewardship.

Example of Joint Product:

A classic example of joint products is found in the petroleum industry. When crude oil is refined, it simultaneously produces multiple valuable outputs such as:

• Petrol (Gasoline)

• Diesel

• Kerosene

• Lubricating Oil

• Jet Fuel

Accounting for Joint Products:

• Market or Sales Value at Split-off Point Method

This method allocates joint costs to joint products based on their sales value at the split-off point, i.e., the point where products become separately identifiable. The higher the product’s sales value, the more joint cost it absorbs. This method reflects the revenue-generating potential of each product and is widely accepted for cost allocation. It’s ideal when products can be sold immediately after split-off without further processing. It ensures a fair cost division according to each product’s economic value at the earliest stage of separability.

• Net Realizable Value (NRV) Method

Under this method, the joint cost is apportioned based on the net realizable value of each product. NRV is calculated by subtracting any additional processing and selling expenses from the final sales value. It is appropriate when products need further processing after split-off. The NRV method provides a realistic picture of profitability by accounting for all costs before a product reaches the market. This approach is frequently used in industries like chemicals or oil refining where joint products undergo different levels of processing before sale.

• Reverse Cost Method

In the Reverse Cost Method, joint costs are assigned by working backwards from the estimated selling price. After deducting profit margin, selling and distribution, and further processing costs, the residual figure is taken as the allocated joint cost. This method is useful when product prices are predetermined and profit margins are fixed. It gives a logical and systematic method for tracing cost backwards and is beneficial when cost control and pricing are highly structured.

• Physical Units Method

This method allocates joint costs based on the physical quantity (like weight, volume, or units) of joint products produced. It is simple and does not consider market value, making it ideal when joint products are of similar nature and value. However, it can be misleading if products differ significantly in value. It’s often used when cost accounting systems are basic or when physical data is more readily available than financial figures.

• Average Unit Cost Method

Here, joint costs are divided by the total number of units produced, and the same average cost is assigned per unit to each joint product. It is easy to apply and appropriate when all joint products are similar in terms of size, value, and function. This method assumes uniform cost structure and ignores market value, making it less suitable for products with wide differences in market demand or profitability.

Journal Entries Table

Process Costing is widely used in industries where production is continuous and the output is uniform. The Process Account is a fundamental part of this system, helping allocate costs for each stage or department of production. It facilitates cost control, pricing, and profitability analysis. A process account records all costs—material, labor, and overheads—incurred in each process, including losses and gains.

Process Losses:

In any process industry, some degree of loss is inevitable due to the nature of the operations. For instance, in chemical manufacturing or food processing, evaporation, shrinkage, spoilage, and leakage may occur. These losses can be classified as:

• Normal Process Loss

• Abnormal Process Loss

Losses are a natural and essential component to account for when calculating the cost per unit. Proper treatment ensures that the company does not undervalue or overvalue its products.

Normal Process Loss:

Normal process loss refers to the expected or unavoidable loss that occurs during the manufacturing process under normal operating conditions. These losses are inherent in production and cannot be eliminated even under efficient operating conditions.

Examples of Normal Process Loss:

• Evaporation in chemical manufacturing

• Breakage in glass production

• Spoilage in food processing

Accounting Treatment:

• Normal losses are not recorded as separate items in the accounts.

• The cost of normal loss is absorbed by the good units produced.

• If the normal loss has a scrap value, it is credited to the Process Account.

illustration:

Let’s say 1,000 units are introduced into Process A. The expected normal loss is 10% (100 units). If the cost of processing is ₹9,000, and the scrap value of loss is ₹1 per unit:

• Scrap Value = 100 units × ₹1 = ₹100

• Net Cost = ₹9,000 – ₹100 = ₹8,900

• Good Output = 900 units

• Cost per unit = ₹8,900 / 900 = ₹9.89

So, the cost of the normal loss is effectively borne by the remaining good units.

Abnormal Process Loss:

Abnormal process loss is the loss that occurs over and above the normal loss. It is not expected and may be due to machinery breakdown, human error, power failure, substandard materials, or poor supervision. It reflects inefficiency and is treated differently in accounts.

Accounting Treatment:

• The cost of abnormal loss is calculated at the same rate as good units.

• Abnormal loss is debited to the Abnormal Loss Account and credited in the Process Account.

• Any scrap value is deducted from the abnormal loss and the balance is transferred to the Costing Profit & Loss Account.

illustration:

If from 1,000 input units, only 850 good units are produced, while normal loss was expected at 10% (i.e., 100 units), then 50 units are considered abnormal loss.

If cost per unit is ₹10 and there’s no scrap value, the cost of abnormal loss = 50 units × ₹10 = ₹500
This ₹500 is debited to the Abnormal Loss Account.

Abnormal Gain:

Sometimes, actual loss is less than the expected normal loss. This difference is called abnormal gain. It usually indicates better efficiency, superior quality of materials, or improvement in the production process.

Example:

If 1,000 units are input into Process A and normal loss is expected to be 100 units, but only 80 units are lost, the 20 units saved is called abnormal gain.

Accounting Treatment:

• The cost of abnormal gain is calculated at the same cost per unit as good units.

• Abnormal Gain Account is debited, and Process Account is credited.

• Scrap value of expected normal loss for the saved units is credited to the Abnormal Gain Account.

• The net abnormal gain is transferred to the Costing Profit & Loss Account.

illustration:

Cost per unit = ₹10
Abnormal Gain = 20 units
Scrap value = ₹2 per unit
Abnormal Gain Value = 20 × ₹10 = ₹200
Scrap Saved = 20 × ₹2 = ₹40
Net Gain = ₹200 – ₹40 = ₹160 → credited to the Costing P&L Account

Inter-Process Profit:

In some industries, especially where production is carried out in several processes, goods are transferred from one process to another at a profit rather than at cost. This is done to evaluate the efficiency and profitability of each process.

Objective of Inter-Process Profit:

• To assess the performance of individual departments or processes.

• To simulate market pricing between departments.

• To ensure accountability at each process level.

How It Works:

• Process 1 produces goods at a cost of ₹100 per unit.

• It transfers them to Process 2 at ₹120 per unit (i.e., with a 20% profit).

• Process 2 treats ₹120 as the cost of input.

This method helps in internal evaluation, but it must be adjusted while preparing final accounts, especially for unsold closing stock, to eliminate unrealized profits.

Accounting Treatment:

• Profit is shown in the transfer from one process to another.

• Closing stock (if any) should be valued at cost only (not including the inter-process profit).

• The unrealized portion of profit is deducted in financial statements to reflect actual cost.

illustration:

• Cost in Process 1 = ₹100

• Transfer to Process 2 at 20% profit = ₹120

• Closing stock in Process 2 = 100 units

• Unrealized profit = 100 units × ₹20 = ₹2,000

• This profit is deducted from profit in final statements.

An incomplete contract refers to a contract that is still under execution and not yet fully completed by the end of an accounting period. In such cases, work may be partially done, and costs incurred and revenues earned must be accounted for accordingly. Since the contract spans multiple periods, only a reasonable portion of the profit is recognized based on the work certified and cost incurred. This method ensures fair reporting of financial results, avoiding the overstatement or understatement of profits. Incomplete contracts are common in construction, engineering, and infrastructure projects that involve long durations.

Principles of Incomplete Contract:

• Prudence Principle

The principle of prudence emphasizes that profits should not be overstated and that only reasonable profits should be recognized from incomplete contracts. Since the work is not yet fully finished, uncertainties may arise due to cost overruns, disputes, or delays. Therefore, profit should be recognized only to the extent it is certain and realizable. Any expected loss, however, should be provided for in full. This principle protects the business from showing inflated profits that might later be reversed, thus ensuring more realistic financial reporting and minimized future risk exposure.

• Percentage of Completion Method

Under this principle, revenue and profit are recognized in proportion to the percentage of the contract work completed. This allows for progressive income recognition rather than waiting until the contract is fully finished. The method uses either work certified or cost incurred as a base to determine the extent of completion. The stage of completion guides the amount of profit to be transferred to the Profit & Loss Account. This principle ensures the matching of income with the period in which the related costs are incurred, promoting transparency and fairness in reporting.

• Realization Principle

According to this principle, income is recognized only when it is realized or realizable. In the context of incomplete contracts, profit should be recognized only on work that has been certified by the client’s engineer or architect, as this represents work officially acknowledged and billed. Work uncertified should be valued at cost without recognizing any profit. This approach ensures that revenues are not prematurely booked. It is a conservative accounting principle that safeguards the integrity of financial statements and avoids recognizing income from work that may not yet result in payment.

• Cost Matching Principle

This principle ensures that costs incurred are matched with the revenue recognized during a specific accounting period. When recognizing a portion of the contract profit, only the costs directly related to the certified work should be considered. This avoids misrepresentation of financial performance and aligns with accrual-based accounting. By applying this principle, businesses can provide a more accurate picture of profitability and financial health over the duration of long-term contracts. It helps prevent both underreporting and overreporting of profits in any accounting period.

• Conservatism in Valuation

Incomplete contracts often include elements like work uncertified, retention money, and unbilled revenues, which are inherently uncertain. Therefore, valuation should be done conservatively. Work uncertified should be shown at cost only, retention money should be recorded as a receivable only when reasonably assured, and escalation claims should not be included unless accepted. This principle encourages businesses to be cautious in recognizing income and assets, thereby protecting stakeholders from misleading financial information and helping maintain the financial stability of the business in the long run.

• Provision for Contingencies

Due to the long-term nature of contracts, various uncertainties can arise—such as changes in material costs, labor disputes, climatic issues, or policy changes. The principle of providing for contingencies involves retaining a portion of the notional or estimated profit until the contract is complete. This reserve acts as a safety margin against unforeseen circumstances. The retained profit appears in the balance sheet under work-in-progress and is not transferred to the Profit & Loss Account until the contract is fully completed and final results are known.

Contract Costing is a form of specific order costing used predominantly in the construction industry and other sectors where work is executed as per customer specifications over a long period. It involves tracking costs associated with a particular contract or project, which may span months or years. Each contract is treated as a cost unit, and all direct and indirect expenses—like materials, labor, overheads, and plant usage—are allocated accordingly.

Important Terminologies of Contract Costing:

1. Cost of Work Certified

This refers to the portion of the contract work that has been completed and verified by the contractee’s (client’s) architect or engineer. It represents the value of work approved for payment, based on progress certificates. It does not include uncertified or incomplete work. The contractor is entitled to receive payment for this portion, subject to retention and other terms. Cost of Work Certified is crucial for accounting, as it helps determine revenue recognition and profitability for ongoing contracts. It ensures both parties agree on the stage-wise value of completed work during the project.

2. Cost of Work Uncertified (Work-in-Progress)

This represents the value of work completed by the contractor but not yet certified or approved by the client. Though the work is physically done, it has not been officially measured or accepted for billing. This may be due to timing differences or partial completion of a specific task. It is considered work-in-progress and included as an asset in the contractor’s books. Costing records maintain this separately from certified work, as its valuation involves estimation and is typically valued at cost without any profit margin until certified.

3. Work-in-Progress (WIP)

Work-in-progress is the total value of work done on a contract that is still incomplete at the end of the accounting period. It includes both certified and uncertified work. WIP is treated as an asset in the balance sheet because it represents value created but not yet fully realized through payment. Accurate WIP valuation is essential for presenting a true picture of the financial status of ongoing contracts. It helps in profit recognition under contract costing and impacts the financial results, especially in long-term construction or manufacturing contracts.

4. Retention Money

Retention money is the amount withheld by the contractee (client) from the contractor’s interim payments, usually a fixed percentage of the certified value. It is retained until the contract is completed and defects liability period has passed. This acts as a security against defective work or incomplete jobs. The contractor receives the retained amount only after successfully fulfilling all contract obligations. Retention ensures quality compliance and safeguards the client’s interest. Though deducted from progress payments, retention money is shown as a receivable (asset) in the contractor’s balance sheet.

5. Notional Profit

Notional Profit is the difference between the value of work certified and the cost of work certified. It is a temporary or unrealized profit that arises in incomplete contracts. Since the contract is not fully completed, notional profit helps estimate the amount of profit that can be prudently recognized. Only a portion of notional profit is transferred to the Profit & Loss Account based on the stage of completion and cash received. This ensures that income is matched with actual contract performance and avoids overstatement of profits.

Notional Profit = Work Certified – Cost of Work Certified

6. Estimated Profit

Estimated Profit is the difference between the contract price and the total estimated cost to complete the contract. It reflects the expected total profit upon full completion of the project. It is used especially when a contract is nearing completion, and the business wants to recognize a portion of the final profit in the accounts. The portion transferred to the Profit & Loss Account is based on the percentage of completion and payments received. Estimated profit offers a more forward-looking approach than notional profit in contract accounting.

Estimated Profit = Contract Price – Estimated Total Cost

7. Escalation Clause

An escalation clause is a provision in the contract that allows for an adjustment in the contract price if there are significant changes in the cost of materials, labor, or other inputs during the contract period. This clause protects the contractor from unexpected cost increases due to inflation, fuel hikes, government policy changes, or supply shortages. It also benefits the client if prices fall, as contracts may include downward revisions. The clause ensures fair compensation and helps maintain financial feasibility, especially in long-term projects with unpredictable cost fluctuations.

Economic Batch Quantity (EBQ) is the optimal number of units to be produced in a single batch that minimizes the total cost of production and inventory. It is similar to the Economic Order Quantity (EOQ) concept but applies to internal production rather than purchasing. EBQ helps balance two types of costs: setup costs (costs incurred each time a batch is produced) and carrying costs (costs of holding inventory). By determining the ideal batch size, companies can reduce production downtime, lower storage costs, and enhance efficiency, making it a vital tool in batch-oriented manufacturing environments.

Functions of Economic Batch Quantity (EBQ):

• Minimizes Total Inventory Cost

One of the primary functions of EBQ is to reduce the combined cost of setup and carrying inventory. Producing in too small batches increases setup frequency, raising setup costs. Conversely, large batches raise inventory holding costs. EBQ strikes a balance between the two, ensuring that neither cost becomes excessive. By calculating the most economical quantity to produce at one time, businesses can maintain optimal inventory levels. This leads to cost savings, better utilization of resources, and improved overall profitability.

• Optimizes Production Scheduling

EBQ plays a crucial role in streamlining production schedules. By determining the ideal batch size, companies can plan production runs more efficiently, reducing idle time between batches. This helps in minimizing production disruptions and machine downtime. Knowing how much to produce and when enables better workforce planning, machine allocation, and raw material procurement. As a result, production activities become smoother, more predictable, and easier to manage. It also helps prevent bottlenecks, supporting continuous and efficient manufacturing processes across departments.

• Improves Inventory Management

Using EBQ ensures that inventory levels are kept within a manageable range, neither too high nor too low. This helps reduce excess stock that could lead to storage issues, damage, or obsolescence. At the same time, it ensures that there are sufficient items to meet demand, preventing stockouts. This balance improves the efficiency of warehouse operations and reduces wastage. Better inventory management also enhances cash flow, as less capital is tied up in unused stock, and resources are more effectively allocated.

• Enhances Decision-Making

EBQ provides critical data for managerial decision-making. Knowing the economic batch size allows managers to make informed decisions about order quantities, production cycles, procurement, and cost management. It serves as a quantitative foundation for developing efficient production and inventory strategies. With accurate EBQ figures, companies can better negotiate with suppliers, set realistic delivery timelines, and determine pricing strategies. This clarity enables quicker and smarter business decisions, improving responsiveness to market changes and aligning operational goals with financial planning.

• Supports Cost Estimation and Control

By standardizing batch sizes, EBQ aids in more precise cost estimation for production and inventory. It helps businesses determine fixed and variable costs per unit and plan budgets accordingly. When batch sizes are consistent and cost-effective, cost control becomes more manageable. Companies can set benchmarks and compare actual costs with estimated ones, identifying inefficiencies or areas for improvement. EBQ helps to prevent overproduction or underproduction, ensuring that costs do not exceed expected levels and operations remain financially sustainable.

• Assists in Meeting Demand Efficiently

EBQ ensures that production aligns with customer demand without creating shortages or excess stock. It helps businesses produce the right quantity at the right time, satisfying market needs while controlling costs. By aligning production cycles with sales forecasts, EBQ minimizes the risk of unfulfilled orders or unused inventory. This function is particularly beneficial in industries with fluctuating demand, where overproduction can lead to losses. EBQ supports just-in-time principles and responsive supply chains, making organizations more agile and competitive.

Components of Economic Batch Quantity (EBQ):

• Setup Cost per Batch

Setup cost refers to the fixed expenses incurred every time a new batch is initiated. These costs include machine preparation, calibration, labor for setup, and downtime during the changeover. Unlike variable costs, setup costs remain constant regardless of the number of units produced in the batch. The higher the setup cost, the larger the EBQ will be, as it spreads the cost over more units to reduce the per-unit setup expense. Accurate estimation of setup costs is essential for determining the most economical batch size.

• Demand Rate (Annual Consumption)

The demand rate is the total quantity of a product required by customers or internal processes over a specific period, usually a year. It is a key factor in EBQ calculations because it influences how frequently production batches need to be scheduled. A higher demand rate generally results in a higher EBQ to maintain supply levels efficiently. Knowing the exact or forecasted annual consumption helps manufacturers determine how many batches are needed and how large each batch should be to meet customer needs without incurring excess costs.

• Holding Cost per Unit per Year

Holding cost, also known as carrying cost, includes all expenses associated with storing unsold inventory. This can involve storage space, insurance, depreciation, obsolescence, and opportunity costs. In EBQ, the holding cost is calculated on a per-unit, per-year basis and directly affects the economic batch size. If holding costs are high, smaller batches are more economical to minimize storage duration. Conversely, lower holding costs support larger batches. A precise understanding of holding costs allows companies to maintain a balance between production efficiency and inventory management.

• Unit Production Cost (Optional)

Although not always included in the EBQ formula, the unit production cost can be relevant when calculating total cost implications. This cost includes raw materials, direct labor, and variable overheads required to produce one unit of output. It does not typically affect the EBQ directly unless it varies with batch size. Including unit production cost helps in making broader financial decisions, such as pricing, budgeting, and cost analysis. When used in conjunction with EBQ, it provides a comprehensive view of cost per unit and batch profitability.

In a Job Costing System, each job is treated as a separate cost unit, and all related costs—direct materials, direct labor, and applied overheads—are accumulated under that job. These costs are recorded through accounting entries in the books to ensure proper tracking and financial reporting.

The cost accounting process in job costing is divided into the following stages:

1. Purchase of Raw Materials

Raw materials are first purchased and stored in the Raw Materials Inventory account.

Journal Entry:

2. Issue of Direct Materials to Job

When materials are issued specifically for a job, the cost is transferred to the Work-in-Progress (WIP) Inventory account.

Journal Entry:

3. Issue of Indirect Materials

Materials not directly traceable to a specific job (like lubricants) are treated as factory overhead.

Journal Entry:

4. Direct Labor Charges

Wages paid to employees working on a specific job are considered direct labor and charged to the job account.

Journal Entry:

5. Indirect Labor Charges

Wages paid to factory supervisors, cleaners, or other indirect staff are considered overheads.

Journal Entry:

6. Overhead Applied to Job

Overhead costs are applied to jobs using a predetermined overhead rate based on labor hours or machine hours.

Journal Entry:

7. Job Completion

Once the job is complete, the total cost is transferred from Work-in-Progress to Finished Goods Inventory.

Journal Entry:

8. Sale of Job

If the job is sold, the sales revenue is recorded, and the cost of goods sold is transferred.

a. Record Sale:

b. Transfer Cost to Cost of Goods Sold (COGS):

Summary Table of Job Cost Accounting Entries

Job Cost Sheet is a detailed document used in job order costing to record and track all costs associated with a specific job or order. It includes direct materials, direct labor, and applied manufacturing overhead for each job. Each job is assigned a unique job number, and the sheet helps in monitoring the job’s cost, setting the selling price, and evaluating profitability. It ensures cost control and accurate pricing, especially in industries with customized production. Once the job is completed, the total cost from the job cost sheet is transferred to the Cost of Goods Manufactured (COGM).

Reports in Job Costing System:

• Job Cost Sheet Report

This is the primary report in a job costing system. It records and summarizes all costs associated with a specific job. It includes details like job number, description, customer name, materials used, labor hours, overheads applied, total cost, and cost per unit (if applicable).

• Material Consumption Report

This report tracks the quantity and value of materials issued to each job. It uses data from material requisition slips and helps in identifying how much raw material was consumed per job.

• Labor Utilization Report

This report details the labor hours spent on each job and the corresponding labor cost. It is prepared using time sheets or job cards.

• Overhead Application Report

This report shows how factory overheads have been allocated to different jobs using a predetermined overhead rate (e.g., based on labor hours or machine hours).

• Job Profitability Report

This report compares the total job cost with the revenue earned from that job. It shows whether the job was profitable or incurred a loss.

• Work-in-Progress (WIP) Report

This report lists all jobs that are still under production and not yet completed. It includes costs accumulated so far on each job.

• Completed Jobs Report

This report lists all jobs that have been completed within a certain period. It summarizes the cost incurred and revenue generated for each job.

• Job Variance Report

This report compares estimated costs with actual costs for each job. Variances may occur in materials, labor, or overheads.

• Summary Job Cost Report

This consolidated report gives an overview of multiple jobs handled during a specific period. It presents summarized data on materials, labor, overhead, total cost, and profit or loss.