CHAPTER 9

JOINT AND BY-PRODUCT COSTING

AT A GLANCE
IN THIS CHAPTER
By-product is generally referred to one or more products
AT A GLANCE with relatively less in value but produced in common
process in joint products production.

AT A GLANCE
SPOTLIGHT By-product is treated similar to normal loss as its scrap
value is deducted from joint cost.
1. By-Products
The products manufactured simultaneously by common
2. Joint Products process or processes and each product has significance
3. Distinguishing between Joint and controlled by management.
products and by-products In volume method of joint product, equal cost per unit is
allocated to each product with assumption that all
4. Methods of allocating joint cost
products receive same benefits from joint cost.
5. Comprehensive Examples
Sales value at split-off method is used to allocate the joint
cost on the basis of sales value. This method is used where
STICKY NOTES

SPOTLIGHT
joint products have sales value at split off point.
Net realizable value method is used on products which
require further processing, before these are sold. These
joint products have no sales value at split off point and
joint cost is allocated on the basis of net realizable value of
each joint product.

STICKY NOTES

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1. BY-PRODUCTS
1.1 Concept and definition of By-products
The products manufactured from common production process for joint products and relatively insignificant in
value are known as by-products. While producing joint products from common process, there might be another
product or products which have insignificant value as compared to joint products. In simple words, it is treated
as wastage from common process which can be sold as scrap. In pursuance to produce main products, by-
products are produced as unavoidable result and has negligible sales value.
1.2 Examples of by-product
Examples of by-products in different manufacturing entities are given below.
 During the process of sugar refining, a by-product “Sugar beet molasses” are produced. This by-product can
AT A GLANCE

be used as fodder for animals or is used in some foods for flavouring and colouring.
 While processing fruit juice and other related beverages, few by-products are also produced. These are fruit
pulp, seeds and peels, and these can be used in cosmetic industry for their medicine properties.
 Ethylene is another example of by-product, which is related with petroleum refinery. This by-product is
essential in polythene based products like plastic products.
1.3 Accounting treatment of by-products
Normal accounting treatment of by-products is simple and similar to treatment of normal loss as discussed in
chapter 7 earlier. The scrap value of by-product is deducted from joint cost, before allocating to joint products.
Joint cost is not allocated to by-products, but it is reduced by sales value of by-products. However, it can be
recognized as other income but in this case, joint cost is not allocated to by-products.
SPOTLIGHT

Treatment of proceeds of sale Measurement of by-product in joint process account

As other income No cost is allocated to the by product.
As a deduction from joint process costs (this is By-product is measured at scrap value (the accounting
the most commonly used method). treatment is very similar to that used for normal loss).

 Example 01:
AB Limited produces two joint products viz. Product A and Product B from common process. As
consequence of production of two main products, one by-product X is produced which can be
sold at Rs. 8 per unit.
During the month of December, 2020 total joint cost of Rs. 600,000 is incurred including direct
STICKY NOTES

and indirect cost. 6,000 units were produced in joint process.

The treatment of by-product is enumerated as under.
1. The sales value of Rs. 48,000 (6,000 x 8) of by-product X is recognized as other income
and joint cost of Rs. 600,000 is allocated to joint products A and B.
2. The sales value of Rs. 48,000 (6,000 x 8) of by-product X is deducted from joint cost and
remaining joint cost of Rs. 552,000 (600,000 – 48,000) is allocated to joint products A
and B.
 Example 02:
RS manufacturing company is engaged in production of chemicals in common process. At end of
process, Chemical K was resulted as by-product. RS manufacturing company deducts the sales
value of by-product from cost of main products.
In the month of November 2020, 5,000 liters of by-product Chemical A was produced. The liquid
is converted into solid waste and 10 liters is converted into 7 kg, which can be sold at Rs. 25 per
kg.
The scrap value of Chemical A (solid waste) of Rs. 87,500 (5,000 x 7/10 x 25) is deducted from
joint cost, before allocation it to joint products.

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2. JOINT PRODUCTS
2.1 Definition of joint products
In some manufacturing processes, two or more different products are produced and both are main products,
termed as joint products. Joint product costs can be defined as:
 Joint products are two or more products generated simultaneously, by a single manufacturing process or
series of processes using common input, and being substantially equal in value
Until the joint products are produced in the manufacturing process, they cannot be distinguished from each
other. The same input materials and processing operation produces all the joint products together.
Each joint product has a substantial sale value relative to each other joint product. An increase in one product’s
output will bring about an increase in other products quantity, not necessarily in the same proportion.

AT A GLANCE
2.2 Examples of joint products
The examples of joint products manufactured from common process are given below.
Oil industry produces gasoline, fuel oil, lubricants, paraffin, coal tar, asphalt and kerosene oil as joint products
from common process with crude oil.
Production of butter, cream and cheese from Milk.

SPOTLIGHT
STICKY NOTES

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3. JOINT PRODUCTS AND BY-PRODUCTS DISTINGUISHED

The main points of distinction between joint products and by-products are apparent from the following.
 Joint products are of equal values and importance while by-products are relatively small in economic value.
 Joint products are produced simultaneously while by-products are produced incidentally in the
manufacturing of main products.
 Joint products are crucial to the commercial viability of an organization, whereas by-products are not.
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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4. METHODS OF ALLOCATING JOINT COST

The costs of the common process that produces the joint products are common costs. In order to calculate a cost
for each joint product, these common costs must be shared (apportioned) between the joint products. The
common costs of the process must be apportioned between the joint products on a fair basis, in much the same
way that overhead costs are apportioned between cost centers.
One of the following three methods of apportionment is normally used:
 Physical Measures Method: Common costs are apportioned on the basis of the total number of units
produced. The cost per unit is the same for all the joint products. (This is also described as the physical
quantities basis).
 Sales value at the split-off point basis: Common costs are apportioned on the basis of the sales value of the
joint products produced, at the point where they are separated in the process (the ‘split off point’).

AT A GLANCE
 Net realizable value (sales value less further processing costs basis): Common costs are apportioned on
the basis of their eventual sales value after they have gone through further processing to get them ready for
sale.
 Example 03:
During the month of July, the NV Company processes a basic raw material through a
manufacturing process that yields three products – products X, Y and Z. There were no opening
inventories and the products are sold at the split-off point without further processing. Company
uses physical measurement method for allocating the joint costs.
In the month of July, joint costs of Rs. 600,000 was incurred and 40,000 units, 20,000 units and
60,000 units of product X, Y and Z were produced.

SPOTLIGHT
The joint costs allocated to each product is computed as under.

Calculation of per unit cost of each product

Joint cost (A) 600,000
Production Units
Product X 40,000
Product Y 20,000
Product Z 60,000
Total units produced (B) 120,000

STICKY NOTES
Unit cost (A/B) 5.00

Joint costs allocated to each product Rupees

Product X (40,000 x 5) 200,000
Product Y (20,000 x 5) 100,000
Product Z (60,000 x 5) 300,000

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 Example 04:
The Tracy Company manufacturers joint products X and Y as well as by-product Z. Cumulative cost
data for the period show Rs. 204,000 incurred in refining department. Costs are assigned to X and Y
by volume method. Additional data is given below.
Products Units Rs.
Product X 8,000
Product Y 10,000
Product Z (Sales price of Rs. 4.80 per unit) 2,000 9,600
Joint cost allocated to all joint and by-products is given below.
AT A GLANCE

Calculation of per unit cost of each product Rupees

Joint cost 204,000
Cost assigned to by-product Z (2,000 x 4.80) (9,600)
Joint cost to be allocated to main products (A) 194,400
Production Units
Product X 8,000
Product Y 10,000
Total units produced (B) 18,000
Unit cost (A/B) 10.80
SPOTLIGHT

Joint costs allocated to each product Rupees

Product X (8,000 x 10.80) 86,400
Product Y (10,000 x 10.80) 108,000
Product Z 9,600
Total Joint cost allocated 204,000

 Example 05:
STICKY NOTES

The Buildon Company produces three joint products, Buildon, Buildeze and Buildrite. Total joint
production cost for November 2020 was Rs. 216,000.
The units produced and unit sales prices at the split off point were.

Products Units Unit sales

price Rs.
Buildon 6,000 22.00
Buileze 8,000 12.50
Buildrite 10,000 12.80

Company is using “sales value at split off method” for allocating the joint cost to all joint products.

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Allocation of the joint production cost, using sales value at split off, is given below.

Products Units Unit sales Total Sales % of sales Joint cost

Produced price Rs. value Rs. value to allocated
total Rs.
Buildon 6,000 22.00 132,000 36.66667% 79,200
Buileze 8,000 12.50 100,000 27.77778% 60,000
Buildrite 10,000 12.80 128,000 35.55556% 76,800
360,000 216,000
 Example 06:
The Star Company manufactures three joint products from a single raw material. A summary of

AT A GLANCE
production costs shows:

Products
S K A Total
Output in kilograms 80,000 200,000 160,000 440,000
Selling price per kilogram Rs. 0.75 1.00 1.50

Products
S K A Total
Production costs:

SPOTLIGHT
Materials - - - 90,000
Direct labour Rs. 3,000 20,000 30,000 80,000
Variable production overheads Rs. 2,000 10,000 16,000 45,000
Fixed productin overheads Rs. 15,000 34,000 30,000 115,000

All separable costs have been assigned to products but the joint cost has not been allocated. All
of the year’s output was sold.
Gross profit for each product, after allocating the joint cost by sales value method, is calculated
as under.

STICKY NOTES
Products
S K A Total
-------------------Rupees------------------
Sales 60,000 200,000 240,000 500,000
(80,000x0.75/200,000x1/160,000x1.50)
Less: Cost of sales:
Direct labour (3,000) (20,000) (30,000) (53,000)
Variable production overheads (2,000) (10,000) (16,000) (28,000)
Fixed production overheads (15,000) (34,000) (30,000) (79,000)
Joint cost allocated W-1 (20,400) (68,000) (81,600) (170,000)
(40,400) (132,000) (157,600) (330,000)
Gross profit 19,600 68,000 82,400

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W-1 Allocation of Joint cost

Products Units Unit sales Total Sales % of sales Joint cost

Produced price Rs. value Rs. value to allocated
total Rs. W-2
S 80,000 0.75 60,000 12% 20,400
K 200,000 1.00 200,000 40% 68,000
A 160,000 1.50 240,000 48% 81,600
500,000 170,000

W-2 Calculation of Joint Cost

AT A GLANCE

Description Rupees
Materials 90,000
Direct labour (80,000 – 3,000- 20,000 – 30,000) 27,000
Variable production overheads (45,000- 2,000- 10,000- 16,000) 17,000
Fixed production overheads (115,000- 15,000- 34,000- 30,000) 36,000
Total joint cost to be allocated 170,000

 Example 07:
Two joint products JP1 and JP2, are produced from a common process.
SPOTLIGHT

During March, 8,000 units of materials were input to the process. Total costs of processing (direct
materials and conversion costs) were Rs. 135,880.
Output was 5,000 units of JP1 and 3,000 units of JP2.
JP1 has a sales value of Rs. 40 per unit when it is output from the process and can be sold for
Rs.120 per unit after further processing costs of Rs.25 per unit.
JP2 has a sales value of Rs. 55 per unit when it is output from the process and can be sold for
Rs.80 per unit after further processing costs of Rs.15 per unit.
Joint costs allocation under all of the above mentioned methods, is calculated as under.
STICKY NOTES

Volume/ Physical measurement method

Output Units
JP1 5,000
JP2 3,000
8,000

Costs: Rs.
JP1: 5,000 units/8,000 units  Rs.135,880. 84,925
JP2: 3,000 units/8,000 units  Rs.135,880. 50,955
135,880

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These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 84,925
JP2 3,000 50,955
8,000 135,880 8,000 135,880
Sales value at point of split off, assuming no further processing is required and products
are sold at split off point.
Sales value Rs.
JP1 (5,000 units  Rs. 40) 200,000

AT A GLANCE
JP2 (3,000 units  Rs. 55) 165,000
365,000
Costs: Rs.
JP1: Rs. 200,000/ Rs. 365,000  Rs.135,880. 74,455
JP2: Rs. 165,000/ Rs. 365,000  Rs.135,880. 61,425
135,880
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.

SPOTLIGHT
Processing cost 8,000 135,880 JP1 5,000 74,455
JP2 3,000 61,425
8,000 135,880 8,000 135,880
Net realizable value at the point of split off

NRV value Rs.

JP1 (5,000 units  Rs. 120  Rs. 25) 475,000
JP2 (3,000 units  Rs. 80  Rs. 15) 195,000
670,000

STICKY NOTES
Costs: Rs.
JP1: Rs. 475,000/Rs. 670,000  Rs.135,880. 96,333
JP2: Rs. 195,000/Rs. 670,000  Rs.135,880. 39,547
135,880
These costs would be recorded in the process account as follows.
Process account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 96,333
JP2 3,000 39,547
8,000 135,880 8,000 135,880

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 CHAPTER 11: STANDARD COSTING CAF 3: CMA

1. USING AND DERIVING STANDARD COSTS

1.1 Standard cost
A standard cost is a predetermined unit cost based on expected level of activity. A standard cost has two
components: first standard and second cost. Standard is defined as norm and whatever is considered normal can
generally be adopted as standard. A standard is expectation of usage of material in quantities, utilization of time
of labour and percentage of plant capacity to be used. In order to complete standard cost, expected costs are
assigned to it like expected cost of material per unit, expected rate per hour etc.
Standard costs of products are usually restricted to production costs only, not administration and selling and
distribution overheads.
Overheads are normally absorbed into standard production cost at an absorption rate per direct labour hour,
AT A GLANCE

depending company is using absorption costing.

A typical standard cost card includes the following:
Rs.
Direct materials:
Material A: X litres at Rs. X per litre X
Material B: X kilos at Rs. X per kilo X
X
Direct labour:
Skilled labour: X hours at Rs. X per hour X
SPOTLIGHT

Unskilled labour: X hours at Rs. X per hour X

X
Variable production overheads: X hours at Rs. X per hour X
Fixed production overheads: X hours at Rs. X per hour X
Standard cost of one unit of product X
 Example 01:
ABC company provides the following data for preparation of standard cost of Product M01.
1. Product M01 requires two kg of material J and three liters of material K.
STICKY NOTES

2. Standard price of material J and material K are Rs. 16 per kg and Rs. 7 per liter respectively
3. 90 minutes of unskilled labour and 45 minutes of skilled labour are required to produce one
unit of M01.
4. Standard labour rate of skilled and unskilled labour is Rs. 60 and Rs. 30 per hour respectively.
5. Variable production overheads are absorbed at Rs. 15 per labour hour.
6. Budgeted fixed production overhead are estimated at Rs. 600,000 and budgeted level of
activity are 50,000 skilled labour hours. Fixed production are absorbed on basis of skilled
labour hours.
The standard cost card of Product M01, is prepared as under.
Rs.
Direct materials:
Material J: 2 kg at Rs. 16 per kg 32
Material K: 3 liters at Rs. 7 per liter 21
53.00

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Rs.
Direct labour:
Skilled labour: 45 minutes at Rs. 60 per hour (45/60 x 60) 45.00
Unskilled labour: 90 hours at Rs. 30 per hour (90/60 x 30) 45.00
90.00
Variable production overheads: 135 minutes at Rs. 15 per hour (135/60 x 15) 33.75
Fixed production overheads: 45 hours at Rs. 12 per skilled labour hour
(45/60 x 12) whereas FOAR/hour = (600,000/50,000) 9.00
Standard cost of one unit of product 185.75
1.2 Standard costing

AT A GLANCE
Standard costing involves the establishment of predetermined estimates of the costs of products or services, the
collection of actual costs and the comparison of the actual results with the predetermined estimates. The
predetermined costs are known as standard costs and the difference between standard and actual is known as
variance.

Features of standard costing

 It is comprehensive system in which inventories are recorded at standard cost. For example, standard cost
card shows material price is Rs. 4.20 per kg, but actually purchased at Rs. 4.25 per kg. In standard costing,
we will record the Material inventory at standard cost i.e. Rs. 4.25.
 Standard costing is a control technique that reports variances by comparing actual costs to pre-set standards
so facilitating action through management by exception.
 The reasons for such variances are highlighted to judge whether these are due to controllable or

SPOTLIGHT
uncontrollable factors.
 Corrective action is taken to avoid such variances in future.
Standard costing may be used with either a system of absorption costing or a system of marginal costing.

When is standard costing appropriate?

Standard costing can be used in a variety of situations.
 It is most useful when accounting for homogenous goods produced in large numbers, when there is a degree
of repetition in the production process.
 A standard costing system may be used when an entity produces standard units of product or service that
are identical to all other similar units produced.

STICKY NOTES
 Standard costing is usually associated with standard products, but can be applied to standard services too.
A standard unit should have exactly the same input resources (direct materials, direct labour time) as all other
similar units, and these resources should cost exactly the same. Standard units should therefore have the same
cost.

Who sets standard costs?

Standard costs are set by managers with the expertise to assess what the standard prices and rates should be.
Standard costs are normally reviewed regularly, typically once a year as part of the annual budgeting process.
 Standard prices for direct materials should be set by managers with expertise in the purchase costs of
materials. This is likely to be a senior manager in the purchasing department (buying department).
 Standard rates for direct labour should be set by managers with expertise in labour rates. This is likely to be
a senior manager in the human resources department (personnel department).
 Standard usage rates for direct materials and standard efficiency rates for direct labour should be set by
managers with expertise in operational activities. This may be a senior manager in the production or
operations department, or a manager in the technical department.

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 Standard overhead rates should be identified by a senior management accountant, from budgeted overhead
costs and budgeted activity levels that have been agreed in the annual budgeting process.

1.3 The purposes of standard costing

Standard costing systems are widely used because they provide cost information for variety of purposes and
these are given below.
 It provides prediction of future costs that can be used for decision making purposes.
 Standard costing system provides challenging target in order to motivate the individuals.
 It assists in setting budgets and evaluates the managerial performance. Variances are calculated and reasons
are identified, to measure the manager performance.
 It is very useful technique which promotes possible cost reduction.
AT A GLANCE

When there are large adverse variances, this might indicate that actual performance is poor, and control action
is needed to deal with the weaknesses.
When there are large favorable variances, and actual results are much better than expected, management should
investigate to find out why this has happened, and whether any action is needed to ensure that the favorable
results continue in the future.

Variances and controllability

The principle of controllability should be applied in any performance management system.
When variances are used to measure the performance of an aspect of operations, or the performance of a
manager, they should be reported to the manager who is:
 responsible for the area of operations to which the variances relate, and
SPOTLIGHT

 able to do something to control them.

The reasons of the variances are further analysed into controllable and uncontrollable factors. The managers are
accountable for any material controllable variance, means his performance is measured on these bases.
On the contrary, it is also unreasonable to make a manager accountable for performance that is outside his
control, and for variances that he can do nothing about.
1.4 Deriving a standard cost
A standard variable cost of a product is established by building up the standard materials, labour and production
overhead costs for each standard unit. This will be the standard cost in marginal costing system.
STICKY NOTES

In a standard absorption costing system, the standard fixed overhead cost is a standard cost per unit, based on
budgeted data about fixed costs and the budgeted production volume.

Deriving the standard cost of materials

These are based on product specifications and derived from intensive study of input quantity. This study should
include most suitable material for each product after keeping in view the product design and processes. On above
study, the standard quantity for each material for different products is established.
Standard price information is obtained from procurement and purchase department. It is based on assumption
that purchase and procurement department has made reasonable search for suppliers and price is based on most
competitive price, at required quality.

Deriving the standard cost of labour

In order to set the labour standard, it is vital that activities should be analysed by different operation, after
conducting the comprehensive study and implementing time and motion study. It helps to determine standard
time required to produce one unit.

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The standard rate per hour information is taken from human resource department, and it is based on contract
made with employees, if already hired. Otherwise, market analysis should be carried out to gather information
about cost of labour.
Deriving the standard cost of production overheads
The procedure for establishing standard manufacturing overhead rates for purpose of determination of overhead
absorption rate, is similar as discussed in chapter 3. Separate rates for fixed and variable production overheads
are determined in order to make better planning and control.
Selection of base for absorption of production overheads is of great immense. As we know that increase or
decrease in activity level, might largely affect overhead absorption rate, therefore, comprehensive study should
be taken place, before selection of base.
1.5 Types of standard & their behavioural aspects

AT A GLANCE
Standards are predetermined estimates of unit costs but how is the level of efficiency inherent in the estimate
determined? Should it assume perfect operating conditions or should it incorporate an allowance for waste and
idle time? The standard set will be a performance target and if it seen as unattainable this may have a detrimental
impact on staff motivation. If the standard set is too easy to attain there may be no incentive to find
improvements.
There are four types of standard, and any of these may be used in a standard costing system. One of the purposes
of standard costing is to set performance standards that motivates employees to improve performance. The type
of standard used can have an effect on motivation and incentives. The types of standards and their behavioural
aspects are given below:
Ideal standards.
These assume perfect operating conditions. No allowance is made for wastage, labour inefficiency or machine

SPOTLIGHT
breakdowns. Standard cost in ideal standard represents minimum cost, as compared to other standards. The
ideal standard cost is the cost that would be achievable if operating conditions and operating performance were
perfect. In practice, the ideal standard is not achieved.
Ideal standards are unlikely to be achieved. They may be very useful as long term targets and may provide senior
managers with an indication of the potential for savings in a process but generally the ideal standard will not be
achieved. Consequently, the reported variances will always be adverse. Employees may be becoming de-
motivated when their performance level is always worse than standard and they know that the standard is
unachievable.
Attainable standards.
These assume efficient but not perfect operating conditions. An allowance is made for waste, break down and

STICKY NOTES
inefficiency. However, the attainable standard is set at a higher level of efficiency than the current performance
standard, and some improvements will therefore be necessary in order to achieve the standard level of
performance.
Attainable standards are the most likely to motivate employees to improve performance as they are based on
challenging but attainable targets. It is for this reason that standards are often based on attainable conditions.
However, a problem with attainable standards is deciding on the level of performance that should be the target
for achievement.
Current standards.
These are based on current working conditions and what the entity is capable of achieving at the moment.
Current standards do not provide any incentive to make significant improvements in performance, and might be
considered unsatisfactory when current operating performance is considered inefficient.
Current standards may be useful for producing budgets as they are based on current levels of efficiency and may
therefore give a realistic guide to resources required in the production process. However current standards are
unlikely to motivate employees to improve their performance, unless there are incentives for achieving
favourable variances (for achieving results that are better than the standard), such as annual cash bonuses.

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Basic standards.
These are standards which remain unchanged over a long period of time. Variances are calculated by comparing
actual results with the basic standard, and if there is a gradual improvement in performance over time, this will
be apparent in an improving trend in reported variances.
Basic standards will not motivate employees to improve their performance as they are based on achievable
conditions at some time in the past. They are also not useful for budgeting because they will often be out of date.
In practice, they are the least common type of standard.
When there is waste in production, or when idle time occurs regularly, current standard costs may include an
allowance for the expected wastage or expected idle time. This is considered in more detail later.
 Example 02:
A company produces bookshelves. Each bookshelf requires three planks of wood. A box of wood
AT A GLANCE

contains 15 planks and costs Rs.45.

Currently 20% of wood is wasted during production. Management would like to reduce this
wastage to 10%.
Calculate a standard material cost for a bookshelf based on
a) Ideal conditions
Standard cost per plank = Rs.45/15 planks = Rs.3 per plank
Ideal standard: 3 planks  Rs.3 = Rs.9 per bookshelf
b) Current conditions
Current standard: 3/0.80 planks = 3.75 planks at Rs.3 = Rs.11.25 per bookshelf
c) Attainable conditions
SPOTLIGHT

Attainable or target standard: 3/0.9 = 3.33 planks at Rs.3 = Rs.10 per bookshelf

1.6 Reviewing standards

How often should standards be revised? There are several reasons why standards should be revised regularly.
Regular revision leads to standards which are meaningful targets that employees may be motivated to achieve
(for example, through incentive schemes).
Variance analysis is more meaningful because reported variances should be realistic.
In practice, standards are normally reviewed annually. Standards by their nature are long-term averages and
therefore some variation is expected over time. The budgeting process can therefore be used to review the
standard costs in use.
STICKY NOTES

 Example 03:
Makhdoom Limited makes and sells a single product, Product Q, with the following standard
specification for material, labour and production overheads. The information is related to
recently prepared standard cost card.
1. Direct material X and Y are used in the quantities of 12kg and 8 kg respectively. Current
price of material X is Rs. 40 per kg while material Y is Rs. 32 per kg.
2. It takes 20 hours of direct labour to produce one unit with standard direct labour rate of Rs.
10 per hour.
3. Annual sales/ production budget is 2,400 units evenly spread throughout the year. The
standard selling price is based on current price of Rs. 1,250 per unit.
4. The budgeted production overhead, all fixed, is Rs. 288,000 and expenditure is expected to
occur evenly over the year. Company’s policy is to absorb production overheads on direct
labour hours.
The senior management has gathered information and takes decisions for handling current
situation.

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a. Due to increase in competition, it is expected that sales price will decline by 6%. In order to
increase the production and sales volume, specific marketing campaign will be launched. It
is expected that volume of production and sales will increase by 10%.
b. The prices of material X is expected to increase by 3%. However, an agreement has been
made recently whereby 4% discount will be availed on purchase of material Y.
c. An agreement with trade union revealed that 8% increase in rate per hour will ensure 10%
savings in time for production in one unit.
d. Fixed production overhead, are expected to increase by 5% due to inflation.
Current and revised standard cost card, showing standard cost and profit per unit, is given below.

Current standard cost card and profit per unit Rs.

Direct materials:

AT A GLANCE
Material X: 12 kg at Rs. 40 per kg 480.00
Material Y: 8 kg at Rs. 32 per kg 256.00
736.00
Direct labour: 20 hours at Rs. 10 per hour 200.00
Fixed production overhead: [288,000/(2,400 x 20)] = 20 hours at Rs. 6 per 120.00
hour
Standard cost of production per unit 1,056.00
Selling price per unit 1,250.00

SPOTLIGHT
Standard gross profit per unit 194.00

Revised standard cost card and profit per unit Rs.

Direct materials:
Material X: 12 kg at Rs. 40 x 1.03 = 41.20 per kg 494.40
Material Y: 8 kg at Rs. 32 x 0.96 = 30.72per kg 245.76
740.16
Direct labour: 20 x 0.90= 18 hours at Rs. 10 x 1.08= 10.80 per hour 194.40

STICKY NOTES
Fixed production overhead: 18 hours at Rs. 6.36 per hour W-1 114.48
Standard cost of production per unit 1,049.04
Selling price per unit (1,250 x 0.94) 1,175.00
Standard gross profit per unit 125.96

W-1 Fixed production overhead rate per hour Rs.

Revised budgeted production overheads (288,000 x 1.05) 302,400
Revised production in units (2,400 x 1.10) 2,640
Revised direct labour hours (2,640 x 18) 47,520
Fixed production overhead rate per hour (302,400/ 47,520) 6.36

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2. ALLOWING FOR WASTE AND IDLE TIME

2.1 Materials wastage in standard costing
Waste is an unavoidable feature of some production processes. The actual amount of materials wasted may vary
from one period to another, but there may be a standard rate of wastage or a ‘normal’ rate of loss which is a
measure of the average rate of wastage or loss.
An allowance for expected loss can be included in a standard cost. The standard cost can be based on the expected
quantity of input materials required to produce one unit of output (which is the same principle as that used for
normal loss in process costing).
 Example 04:
A company manufactures a product in a process production system. There is some wastage in
AT A GLANCE

production, and normal loss is 10% of the number of units input to the process. One unit of raw
material is required to produce one unit of finished goods.
The standard price per unit of direct material is Rs.4.50 per unit.
a) If an ideal standard is used, and the standard does not provide for any loss in process,
standard direct material cost per unit of output would be as follows
Ideal standard
No loss; therefore, standard cost =
1 unit of direct materials at Rs.4.50 per unit of material = Rs.4.50 per unit of output.
b) If the standard cost allows for a loss of 10% of input materials in producing each unit of
SPOTLIGHT

output, then Standard Direct material cost per unit of output would be:
Attainable or current standard: allow for 10% loss
Standard input to produce one unit of = 1/0.9 units = 1.111 units.
Therefore, standard cost =
1.111 units of materials at Rs.4.50 per unit = Rs.5 per unit of output.
 Example 05:
A company produces sandwiches. Each sandwich requires two slices of bread and a loaf of bread
contains 24 slices. Each loaf of bread costs Rs.6. It is estimated that currently 20% of bread is
wasted. Management would like to reduce this wastage to 10%.
STICKY NOTES

Calculation of a standard material cost for a sandwich based on various conditions are given
below
a) Ideal conditions
Standard cost per slice of bread = Rs.6/24 slices = Rs.0.25 per slice
Ideal standard: 2 slices  Rs.0.25 = Rs.0.50
b) Current conditions
Current standard: 2/0.80 slices = 2.5 slices at Rs.0.25 = Rs.0.625
c) Attainable conditions
Attainable or target standard: 2/0.9 = 2.22 slices at Rs.0.25 = Rs.0.555.
Note that the current and attainable standard costs include an allowance for wastage, and a
materials usage variance will occur only if the actual wastage rate differs from the standard
wastage rate.

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Step VI Rank the products from in house manufacturing point of view. (In reversal order as
calculated in Step V)
Step VII Determination of units to be make and buy. (Optimal solution)
The above steps can be explained with the help of following example.
 Example 09:
Rizwan Manufacturing Company (RMC) is engaged in production of three products. Due to
increase in demand of products, the RMC is facing difficulties in producing all units. The
maximum machine hours available in the month of March 2021 are 50,000. The relevant data is
given in following table.

Product J Product S Product A

Maximum demand Units 6,000 8,000 10,000

AT A GLANCE
Machine hours per unit Hr/U 4 3 2
Variable production cost per unit Rs. 60 100 120
Cost to purchase per unit from
external supplier Rs. 90 120 140
The optimal solution relating to make or buy, is calculated as under.
As there is only one limiting factor given in question, no need to calculate and identify the limiting
factor.

Product J Product S Product A

Variable production cost per unit 60 100 120

SPOTLIGHT
Cost to purchase per unit from external
supplier (90) (120) (140)
Extra cost per unit, if bought (30) (20) (20)
Machine hours per unit 4 3 2
Extra cost per machine hours, if bought (7.50) (6.67) (10.00)
Ranking, if bought II I III
Ranking, if make first II III I
The product A should be produced first, but product S should be bought first. We should first
make units in house, and remaining units should be bought from external supplier. The optimal

STICKY NOTES
table is given as under.

Machine hours Units to make Units to buy

Available machine hours 50,000
Product A (10,000 x 2) (20,000) 10,000
30,000
Product J (6,000 x 4) (24,000) 6,000
6,000
Product S (Note) (6,000) 2,000 6,000

Note: After producing product A and J, only 6,000 machine hours are available. These hours can
be utilized in the production of product S, which requires 3 hours to product one unit. Therefore,
only 2,000 units of product S can be produced in house. The maximum demand of product S is
8,000 units, hence, remaining 6,000 units should be bought from external supplier.

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 Example 11:
Wombat Company makes four products, W, X, Y and Z. All four products are made on the same
machines, and the machine capacity for the year at Wombat’s factory is 3,500 hours. However, it
is able to obtain any of these products in unlimited quantities from a sub-contractor.
Budgeted data is as follows.

Product W X Y Z
Annual sales demand (units) 4,000 6,000 3,000 5,000
Rs. Rs. Rs. Rs.
Sales price per unit 15 20 18 17
Variable cost per unit, in-house manufacture 5 7 6 7

AT A GLANCE
Cost of external purchase (outsourcing) 8.0 11.8 10.5 11.0
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40

Which items should be produced in-house and which should be outsourced? The question would
require following calculations to reach the conclusion
The selling price for each product is higher than the variable cost of purchasing each product
externally; therefore, profit will be maximized by making the products in-house or purchasing
them externally, up to the full amount of the annual sales demand.

Product W X Y Z
Rs. Rs. Rs. Rs.

SPOTLIGHT
Variable cost per unit, in-house manufacture 5.00 7.00 6.00 7.00
Cost of external purchase (outsourcing) 8.00 11.80 10.50 11.00
Extra cost of outsourcing, per unit 3.00 4.80 4.50 4.00
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40
Extra cost of outsourcing, per machine hour saved Rs.12 Rs.9.60 Rs.15 Rs.10
Priority for outsourcing 3rd 1st 4th 2nd
Priority for in-house production 2nd 4th 1st 3rd

The cost-minimizing and profit-maximizing budget is as follows.

STICKY NOTES
Product Total variable cost
Units Machine hours
In-house production: Rs.
Y 3,000 900 18,000
W 4,000 1,000 20,000
Z (balance) 4,000 1,600 28,000
3,500
Outsource:
Z (1,000 x 11) 1,000 11,000
X (6,000 x 11.80) 6,000 70,800
Total variable cost 147,800

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 Example 19:
Stamba makes two components, A and B, for which costs in the next year are expected to be as
follows:

A B
Production (units) 30,000 20,000
Variable costs per unit: Rs. Rs.
Direct materials 6 5
Direct labour 3 9
Variable production overheads 1 3
AT A GLANCE

Variable production cost 10 17

Direct labour is paid Rs.12 per hour. There will be only 19,500 hours of direct labour time
available next year, and any additional components must be purchased from an external supplier.
Total fixed costs per annum are expected to be as follows:

Rs.
Incurred as a direct consequence of making A 40,000
Incurred as a direct consequence of making B 50,000
Other fixed costs 30,000
SPOTLIGHT

120,000
An external supplier has offered to supply units of A for Rs.12.50 and units of B for Rs.23.
a) Recommendation regarding whether Stamba should shut down internal production of
Component A or Component B and switch to external purchasing is given below.

Component A Component B
Rs. Rs.
Cost of making internally 10.0 17.0
STICKY NOTES

Cost of buying 12.5 23.0

Extra variable cost of buying 2.5 6.0
Quantities required next year 30,000 20,000
Total extra variable cost of buying 75,000 120,000
Fixed costs saved by closure 40,000 50,000
Net extra costs of buying 35,000 70,000

It appears that it would cost the company more each year to shut down internal
production of either component and switch to external purchasing.
b) Recommendation regarding the quantities that Stamba should make of the components,
and the quantities that it should buy externally, in order to obtain the required quantities
of both components at the minimum cost would be as follows.

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In addition, the total annual cost will be calculated below

Tutorial note. To answer part (b), you will need to consider that labour is a limiting
factor.
Production hours required hours
Component A (30,000  0.25 hours) 7,500
Component B (20,000  0.75 hours) 15,000
Total hours required 22,500
Total hours available 19,500
Shortfall 3,000
There are insufficient hours available to manufacture everything internally. Some

AT A GLANCE
components must be purchased externally.

Component A Component B
Rs. per unit Rs. per unit
Cost of making internally 10.0 17.0
Cost of buying 12.5 23.0
Cost saved by making 2.5 6.0
Hours required to make internally 0.25 hours 0.75 hours
(Rs.3/Rs.12 per hour: Rs.9/Rs.12 per hour)
Costs saved per hour by making Rs.10 Rs.8

SPOTLIGHT
(Rs.2.50/0.25 hours: Rs.6/0.75 hours)
It is better to make Component A internally than Component B.
Component Units Hours Cost/unit Cost
Rs. Rs.
A 30,000 7,500 10 300,000
B (balance) 16,000 12,000 17 272,000
Variable cost of internal manufacture 19,500 572,000
Cost of external purchase – balance
of units required 4,000 23 92,000

STICKY NOTES
Fixed costs 120,000
Total costs 784,000

c) Non-financial considerations relevant to make-or-buy decision are discussed below:

Risks of outsourcing work:
i. Supplier may produce items to a lower standard of quality.
ii. The supplier may fail to meet delivery dates and the buyer may dependent on the
supplier to commit onward delivery to its buyer. In case of buying of a component,
production process of the end-product may be held up by a lack of component.
Benefits of outsourcing work:
i. Outsourcing work will enable the management to focus all of its efforts on those
aspects of operation the entity does best.
ii. The external supplier may have specialist expertise which enables it to provide
outsourced products more efficiently and at a cheaper price.

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