Tag: Indian Financial System Osmania University b.com Notes

1. Standard Rate:

This method is adopted by those industries which adopt standard Costing technique. The standard overheads and standard base is set on the basis of past experience and necessary adjustments are made based on the factors which affect it. The standard overhead is divided by a standard base, gives a standard rate of overhead absorption.

The following formula is used for the purpose:

Overhead Rate = Standard overhead for a Period / Standard base for the period

2. Rate Per Unit of Output:

Under this method, the overheads are absorbed on the basis of number of units produced. The overhead absorption rate is obtained by dividing the overheads to be absorbed by the number of units produced.

It is expressed in the form of formula as follows:

Overhead Rate = Overhead to be absorbed / No. of units produced

Suitability:

This method is suitable where the finished goods are identical in nature.

Advantages:

It is the simplest method among all the methods.

Disadvantages:

1. This method is not suitable where different varieties of finished products are manufactured.
2. If historical overhead rate of recovery is adopted it involves considerable delay in computing the overhead rate as one has to wait for the completion of production for the given period.

Machine Hour Rate:

This method refers to the overheads incurred for running a machine for one hour. This rate is ascertained by dividing the amount of factory overhead apportioned to a machine by the number of machine hours for the concerned period.

Expressed in the form of a formula:

Machine hour rate = Factory Overhead/ No. of Machine Hours

Suitability:

This method is most suited where machines are used predominantly for production purpose.

Advantages:

1. This is most scientific, accurate and logical method of overhead absorption.
2. It helps in knowing the existence and extent of idle time of machines.
3. This method takes into account time factor and hence gives accurate results.
4. It helps in comparing the efficiency and cost of operating different machines.
5. It helps management in choosing between manual labour and machines.

Disadvantages:

1. This method is not suitable in manual labour-based factories.
2. It involves maintenance of additional records for noting down the machines hours operated.

Labour Hour Rate:

Under this method, overheads are absorbed on the basis of direct labour hours worked. The overhead rate is obtained by dividing the overheads to be absorbed by the number of direct labour hours.

The following formula can be used for its calculation:

Overhead Rate = Production Overhead / Direct Labour Hours

Suitability:

This method is most suitable where manual labour is engaged in the factory.

Advantages:

1. This method gives full consideration to time factor.
2. This is not affected by the methods of wage payment (i.e., time rate or piece rate method)
3. This method gives accurate results.

Disadvantages:

1. This method requires additional clerical work and separate records are necessary for recording direct labour hours.
2. This method is not desirable where machines are used to a great extent.

Prime Cost Percentage Rate:

This method is based on the assumption that both materials and labour give rise to factory overheads and thus total of the two i.e., material and labours should be taken as the base for absorption of factory overheads. In other words, this method is a combination of the material cost and labour cost methods.

Under this method overhead rate is calculated by dividing the production overheads by Prime Cost.

Overhead Rate = ( Factory Overheads/Prime Cost) * 100

Suitability:

This method is suitable where direct material cost and direct labour cost are equally important and overheads are related to both.

Advantages:

1. It is simple to understand and easy to operate.
2. Information regarding materials and wages are readily available and there is no need to keep separate account for them.
3. This method gives satisfactory result because it takes into account direct material cost and direct labour cost.

Disadvantages:

1. Under this method, equal importance is given to both material cost and labour cost, though most of the overheads are closely related to labour cost.
2. Where material cost is predominant element of cost, the method ignores time factor.

Direct Labour Cost Percentage Rate:

This is the oldest method of overhead absorption and still it is more popularly used. Under this method, the overhead to be absorbed is divided by direct labour cost and the quotient is expressed in the form of percentage.

It is calculated with the help of following formula:

Overhead Rate = (Production Overhead/Direct Labour Cost) * 100

Suitability:

1. Where labour cost forms a high proportion to total cost of production.
2. Where skill of labour does not differ widely.
3. Where the wage rate does not fluctuate widely.

Advantages:

1. The method is simple to understand and easy to operate.
2. It gives stable results as labour rates are more constant than material prices.
3. Under this method special consideration is given to time factor, as higher the charge to a job for wages, the longer will have been the time spent on that job.
4. This method can be adopted with advantage where rates of workers are same, where workers are more or less of equal skill and where uniform types of works are performed.

Disadvantages:

1. This method is not suitable, where machines are used at a great extent.
2. As it ignores time factor, this method is not suitable in those industries where piece rate system of wage payment is adopted.
3. Where the work is done by both skilled and unskilled workers, the method is not suitable. If works are done by unskilled workers overheads incurred will be more.
4. No distinction is made between work done by skilled and unskilled workers.
5. It also does not distinguish between production of hand workers and that of machine workers. Machines give rise to certain overheads like depreciation, power etc. which should be charged only to the work done on machines.

Percentage on Direct Material Cost:

Under this method, the amount of overheads to be absorbed by cost unit is determined by the cost of direct materials consumed in producing it. This rate is ascertained by dividing the total overheads by the total cost of direct materials consumed in the department and multiplied by 100.

Overhead Rate = (Production/Factory Overheads/ Direct material Consumed) * 100

Suitability:

1. Where only one variety of the product is manufactured.
2. Where the materials used are common for different jobs or process or products.
3. Where the prices of the raw materials remain stable.
4. Where material costs constitute highest proportion to total cost.

Advantages:

1. This method is simple and easy to operate because cost of direct materials is readily available and no additional records are required to be maintained for this purpose.
2. This method gives fairly accurate rates where material prices do not fluctuate widely and where output is uniform.

Disadvantages:

1. Most of the factory overheads are not directly related to direct materials cost. So the method is not logically correct and hence gives misleading results.
2. This method fails to take into account the jobs performed by skilled and unskilled workers. A job which is performed by unskilled workers requires more amount of overheads. This method also fails to distinguish the jobs done by manual labour and machines.
3. This method does not take time factor into account. Most of the overheads are related to time element. A job which requires a longer period to complete may need more of overheads than a job which is completed in a shorter period of time.
4. This method is quite illogical and inaccurate because overheads are in no way related to the cost of materials consumed. The amount of overheads does not change because the work is being done on copper instead of iron. Both metals are quite different in prices and by applying the same percentage for both will be obviously incorrect.

1. Estimates and Actuals:

The cost can be computed either on actual or estimated basis. Since cost accounts are meant to function as a control device it will be appropriate to adopt estimated costing or preferably standard costing system while preparing cost accounts. Estimates or standards can be nearer to the actuals but in most cases, they cannot be the same. This necessarily means that the profit shown by the cost accounts is bound to be different from the profit shown by the financial accounts.

Following are some of the important items the costs of which may be different in financial books and costing books:

(a) Direct Materials:

The estimated or standard cost of the direct materials purchased or consumed in the production process may be different from the actual costs. This difference will be due to change in price or quantity or both.

(b) Direct Labour:

The estimated or standard cost of direct labour may be different from the actual costs because of differences in wage rates or hours of work or both. Sometimes, workers might have to be paid more due to increased dearness allowance, pay revision, bonus etc. This will cause difference between the profits shown by the two sets of books.

(c) Overheads:

In cost accounts the recovery of overheads is generally based on estimates while in financial accounts the actual expenses incurred are recorded. This results in under-or over-recovery of overheads.

The under-recovery or over-recovery of overheads may be carried forward to the next period or may be charged by a supplementary rate (positive or negative) or transferred to costing Profit and Loss Account. In case the under-recovery or over-recovery of overheads has been carried forward to the next period, the profit as shown by the costing books will be different from the profit as shown by the financial books. Such variation may be due to over-or-under charging of factory, office or selling and distribution overheads.

(d) Depreciation:

Different methods of charging depreciation may be adopted in cost and financial books. In financial books depreciation may be charged according to fixed installment method or diminishing balance method etc. while in cost accounts machine hour rate or any other method may be used. This is also an item of overheads and may be one of the reasons of difference between the overheads charged in financial accounts and overheads charged in cost accounts.

Abnormal Gains and Losses:

Abnormal gains or losses may completely be excluded from cost accounts or may be taken to costing profit and loss account. In financial accounts such gains and losses are taken to profit and loss account. As such, in the former case costing profit/loss will differ from financial profit/loss and adjustment will be required. In the latter case, there will be no difference on this account between costing profit or loss and financial profit or loss.

Therefore, no adjustment will be required on this account. Examples of such abnormal gains and losses are abnormal wastage of materials e.g., by theft or fire etc., cost of abnormal idle time, cost of abnormal idle facilities, exceptional bad debts, abnormal gain in manufacturing through processes (when actual production exceeds normal production).

The need for reconciliation will not arise in case of a business where Integral or Integrated Accounting System is in use as there will be only one set of books both for financial and costing records. But where there are separate sets of books, reconciliation is imperative.

2. Items Included in Cost Accounts Only:

There are certain notional items which are excluded from the financial accounts but are charged in the cost accounts:

(i) Charge in lieu of rent where premises are owned.

(ii) Depreciation on an asset even when the book value of the asset is reduced to a negligible figure.

(iii) Interest on capital employed in production but upon which no interest is actually paid (this will be the case when the firm decides to include interest in the overheads).

The above items will reduce the profits in Cost Accounts as compared to that in Financial Accounts.

3. Items Included in Financial Accounts Only:

There are certain items which are included in the Financial Accounts but not in the Cost Accounts.

These include the following:

(a) Appropriation of profits e.g., provision for taxation, transfer to reserves, goodwill, preliminary expenses written off.

(b) Purely financial charges e.g., losses on sale of investments; penalties and fines, expenses on transfer of company’s office.

(c) Purely financial incomes e.g., interest received on bank deposits, profits made on the sale of investments, fixed assets, transfer fees received etc.

4. Valuation of Stocks:

(a) Raw materials: In financial accounts stock of raw materials is valued at cost or market price, whichever is less, while in cost accounts stock can be valued on the basis of FIFO or LIFO or any other method. Thus, the figure of stock may be inflated in cost or financial accounts.

(b) Work-in-progress: Difference may also exist regarding mode of valuation of work-in-progress. It may be valued at prime cost or factory cost or cost of production. The most appropriate mode of valuation is at factory cost in cost accounts. In financial accounts work-in-progress may be valued after considering a part of administrative expenses also.

(c) Finished goods: Under financial accounts, stock of finished goods is valued at cost or market price whichever is lower. In cost accounts, finished stock is generally valued at total cost of production. If the circumstances warrant, prime cost or factory cost may also be taken as the basis for valuing the stock of finished goods.

Thus, mode of valuation of stocks gives rise to different results in the two sets of books. Greater valuation of opening stocks in cost accounts means less profit as per cost accounts and vice versa. Greater valuation of closing stocks in cost accounts means more profit as per cost accounts and vice versa.

1. Stores Ledger:

Stores department will maintain a record called ‘stores ledger’ in which a separate folio is kept for each individual item of stock. It records not only the quantity details of stock movements but also record the rates and values of stock movements.

With the information available in the store’s ledger, it is easier to ascertain the value of any stock item at any point of time. The minimum, maximum and reorder levels of stock are also mentioned for taking action to replenish the stock position.

2. Bin Card:

A ‘bin card’ indicates the level of each particular item of stock at any point of time. It is attached to the concerned bin, rack or place where the raw material is stored. It records all the receipts of a particular item of materials and its issues. It gives all the basic information relating to physical movements. It is a record of receipts, issues and balance of the quantity of an item of stock handled by a store.

3. Material Return Note:

If materials received from the stores are not of suitable quality or if there is surplus material remaining with the department, they are returned to stores with a note called ‘material return note’ evidencing return of material from department to stores.

4. Material Transfer Note:

If materials are transferred from one department or job to another within the organization, then material transfer note should be raised. It is a record of the transfer of materials between stores, cost centres or cost units showing all data for making necessary accounting entries.

5. Stores Requisition Note:

It is also called ‘materials requisition note’. When Production or other departments requires material from the stores it raises a requisition, which is an order on the stores for the material required for execution of the work order. This note is signed by the department in-charge of the concerned department. It is documents which authorize the issue of a specified quantity of materials.

6. Goods Received Note (GRN):

Once the inspection is completed, GRN is prepared by the stores department, and copies of GRN is sent to the purchasing department, costing department, accounts department and production department, which initiated purchase requisition.

7. Material Inspection Note:

When materials are delivered, a supplier’s carrier will usually provide a document called ‘delivery note’ or ‘delivery advice’ to confirm the details of materials delivered. When materials are unloaded, the warehouse staff check the material unloaded with the delivery note. Then the warehouse staff prepares a Materials Receipt Note, a copy of which is given to the supplier’s carrier as a proof of delivery.

After receiving the materials the Inspection Department thoroughly inspects whether the quality of material is in accordance with the purchase order and the quality of material received and it prepares a note called ‘material inspection note’, copies of which are sent to the supplier and stores department.

8. Purchase Order:

If the Purchase Requisition received by the Purchasing Department is in order then it will call for tenders or quotations from the suppliers of materials. It will send enquiries to prospective suppliers giving details of requirement and requesting details of available materials, prices, terms and delivery etc. Quotations will then be compared and will place order with those suppliers who will provide the necessary goods at competitive prices.

9. Bill of Materials:

Bill of Materials is a comprehensive list of materials, with specifications, material codes and quantity of each material required for a particular job, process or production unit. It will also include the details of substitute materials. It is prepared by the engineering or planning department for submission of quotation and after the receipt of work order. It is a method of documenting materials required for execution of the specified job work.

Bill of Material acts as an authorization to the Stores Department in procuring the materials and the concerned department in material requisition from the stores. It is an advance intimation to the concerned departments of the job, work order to be completed.

Advantages:

(a) It acts as a guide in planning the execution of job, process or product units by documenting all materials required for that specified work.

(b) It is a base for action to be initiated by the Stores Department in placing the purchase requisition with the purchase department.

(c) The information mentioned in the bill of materials act as a standard with which any deviation can be detected and remedial measures are taken if deviations take places.

(d) It is a good control measure on material cost.

(e) The material cost to be charged to a particular unit, job or process can easily be determined beforehand.

(f) It helps in submission of tenders and quotations.

(g) It is a planning exercise for the proposed production or work.

(h) It serves as an advance intimation to stores department about the raw material requirement.

10. Purchase Requisition:

CIMA defines Purchase Requisition as “an internal instruction to a buying office to purchase goods or services. It states their quantity and description and elicits a purchase order”.

The manager in-charge of Purchase Department should obtain requisition from the Stores in- charge, departmental head or similar person requiring goods before placing orders on suppliers. If the present stock run down to the reorder level, then the stores department send a Purchase Requisition to Purchase Department, authorizing the department to order further stock.

Perpetual inventory system provides a running balance of cost of goods available for sale and cost of goods sold. Under this system, no purchases account is maintained because inventory account is directly debited with each purchase of merchandise. The expenses that are incurred to obtain merchandise inventory increase the cost of merchandise available for sale. These expenses are, therefore, also debited to inventory account. Examples of such expenses are freight-in and insurances etc. Each time the merchandise is sold, the related cost is transferred from inventory account to cost of goods sold account by debiting cost of goods sold and crediting inventory account.

Perpetual inventory is a method of accounting for inventory that records the sale or purchase of inventory immediately through the use of computerized point-of-sale systems and enterprise asset management software. Perpetual inventory provides a highly detailed view of changes in inventory with immediate reporting of the amount of inventory in stock, and accurately reflects the level of goods on hand. Within this system, a company makes no effort at keeping detailed inventory records of products on hand; rather, purchases of goods are recorded as a debit to the inventory database. Effectively, the cost of goods sold includes such elements as direct labor and materials costs and direct factory overhead costs.

A perpetual inventory system is a method of inventory management that records real-time transactions of received or sold stock through the use of technology generally considered a more efficient method than a periodic inventory system.

A perpetual inventory system is distinguished from a periodic inventory system, a method in which a company maintains records of its inventory by regularly scheduled physical counts.

The perpetual inventory system is a more robust system than the periodic inventory system, which is where a company undertakes regular audits of stock to update inventory information.  These audits include regular physical inventory counts on a scheduled and periodic basis. The major difference between perpetual and periodic inventory systems is that the former has a system that updates inventory information in real-time while the latter uses a more manual process.

Perpetual inventory systems in the past were not widely used, as it was difficult to record and process the large amounts of data quickly and accurately.

In recent years, however, the technology capability has increased and has improved business and accounting practices, inventory tracking systems can now be managed through the use of computers and scanners, perpetual inventory tracking has become less burdensome.

Perpetual vs. Periodic Inventory Systems

Most small and medium-sized companies use the periodic inventory system, which involves scheduled inventory audits throughout every year. In most cases, periodic inventory counts are conducted a few times per year or even at the end of every month.

The primary issue that companies face under the periodic inventory system is the fact that inventory information is not up to date, and may be unreliable. This means that managers don’t have accurate demand forecasts or inventory levels to ensure that stockouts don’t occur.

Perpetual inventories are the solution to such an issue, giving accurate and updated information about inventory levels, COGS, allows them to check on discrepancies in real-time.

Since the periodic inventory system is only updated occasionally, managers never have current and accurate financial information to base their purchasing or manufacturing decisions on.

Perpetual inventory systems fix this problem. As soon as an inventory transaction takes place, it is entered into the system and inventory balances and costs are updated automatically. Managers can use current inventory reports any time because the system always keeps a real time balance of inventory.

The early years of the European Monetary System (EMS) were marked by uneven currency values and adjustments that raised the value of stronger currencies and lowered those of weaker ones. After 1986, changes in national interest rates were specifically used to keep all the currencies stable.

The early 90s saw a new crisis for the European Monetary System (EMS). Differing economic and political conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from the European Monetary System (EMS) in 1992. Britain’s withdrawal reflected and foreshadowed its insistence on independence from continental Europe, later refusing to join the eurozone along with Sweden and Denmark.

Meanwhile, efforts to form a common currency and cement greater economic alliances were ramped up. In 1993, most EC members signed the Maastricht Treaty, establishing the European Union (EU). One year later, the EU created the European Monetary Institute, which later became the European Central Bank (ECB).

At the end of 1998, most EU nations unanimously cut their interest rates to promote economic growth and prepare for the implementation of the euro. In January 1999, a unified currency, the euro, was born and came to be used by most EU member countries. The European Economic and Monetary Union (EMU) was established, succeeding the European Monetary System (EMS) as the new name for the common monetary and economic policy of the EU.

The European Monetary System (EMS) was a multilateral adjustable exchange rate agreement in which most of the nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations in relative value. It was initiated in 1979 under then President of the European Commission Roy Jenkins as an agreement among the Member States of the EEC to foster monetary policy co-operation among their Central Banks for the purpose of managing inter-community exchange rates and financing exchange market interventions.

The EMS functioned by adjusting nominal and real exchange rates, thus establishing closer monetary cooperation and creating a zone of monetary stability. As part of the EMS, the ECC established the first European Exchange Rate Mechanism (ERM) which calculated exchange rates for each currency and a European Currency Unit (ECU): an accounting currency unit that was a weighted average of the currencies of the 12 participating states. The ERM let exchange rates to fluctuate within fixed margins, allowing for some variation while limiting economic risks and maintaining liquidity.

The European Monetary System lasted from 1979 to 1999, when it was succeeded by the Economic and Monetary Union (EMU) and exchange rates for Eurozone countries were fixed against the new currency the Euro. The ERM was replaced at the same time with the current Exchange Rate Mechanism (ERM II).

The European Monetary System (EMS) was created in response to the collapse of the Bretton Woods Agreement. Formed in the aftermath of World War II (WWII), the Bretton Woods Agreement established an adjustable fixed foreign exchange rate to stabilize economies. When it was abandoned in the early 1970s, currencies began to float, prompting members of the EC to seek out a new exchange rate agreement to complement their customs union.

The European Monetary System’s (EMS) primary objective was to stabilize inflation and stop large exchange rate fluctuations between European countries. This formed part of a wider goal to foster economic and political unity in Europe and pave the way for a future common currency, the euro.

Currency fluctuations were controlled through an exchange rate mechanism (ERM). The ERM was responsible for pegging national exchange rates, allowing only slight deviations from the European currency unit (ECU) a composite artificial currency based on a basket of 12 EU member currencies, weighted according to each country’s share of EU output. The ECU served as a reference currency for exchange rate policy and determined exchange rates among the participating countries’ currencies via officially sanctioned accounting methods.

The Structure of the Federal Reserve System is unique among all the assets within central banks, with both public and private aspects. It is described as “independent within the government” rather than “independent of government”.

The Federal Reserve System (also known as the Federal Reserve or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System

The Federal Reserve does not require public funding, instead it remits its profits to the federal government. It derives its authority and purpose from the Federal Reserve Act, which was passed by Congress in 1913 and is subject to Congressional modification or repeal.

Purpose

The primary declared motivation for creating the Federal Reserve System was to address banking panics. Other purposes are stated in the Federal Reserve Act, such as “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes”. Before the founding of the Federal Reserve System, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. Today the Federal Reserve System has responsibilities in addition to stabilizing the financial system.

Current functions of the Federal Reserve System include:

• To address the problem of banking panics
• To serve as the central bank for the United States
• To strike a balance between private interests of banks and the centralized responsibility of government
• To supervise and regulate banking institutions
• To protect the credit rights of consumers
• To manage the nation’s money supply through monetary policy to achieve the sometimes-conflicting goals of
• Maximum employment
• Stable prices, including prevention of either inflation or deflation
• Moderate long-term interest rates
• To maintain the stability of the financial system and contain systemic risk in financial markets
• To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
• To facilitate the exchange of payments among regions
• To respond to local liquidity needs
• To strengthen U.S. standing in the world economy

Composition

• The presidentially appointed Board of Governors (or Federal Reserve Board), an independent federal government agency located in Washington, D.C.
• The Federal Open Market Committee (FOMC), composed of the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents, which oversees open market operations, the principal tool of U.S. monetary policy.
• Twelve regional Federal Reserve Banks located in major cities throughout the nation, which divide the nation into twelve Federal Reserve districts. The Federal Reserve Banks act as fiscal agents for the U.S. Treasury, and each has its own nine-member board of directors.
• Numerous other private U.S. member banks, which own required amounts of non-transferable stock in their regional Federal Reserve Banks.
• Various advisory councils.