Accounting for Managers/Management Accounting (Unit-3) by Dr. Abhay Singh Chauhan

Management Accounting –Nature and Scope
By
Dr. Abhay Singh Chauhan

It is the accounting which provides the necessary
information to the management for discharging its
functions of planning, organizing, directing and
controlling.
The American Accounting Association defines it as:
The application of appropriate techniques and
concepts in processing historical and projected
economic data of an entity to assist management in
establishing plans for reasonable economic
objectives and in the making of rational decisions
with a view towards achieving these objectives.
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Management Accounting helps in the
performance of the functions of planning,
organizing, directing and controlling in the
following ways :
 Provides data : Serves as a vital source of data for
management planning.
 Modifies data : The accounting data is properly
compiled and classified for e.g purchase figures
of different months may be classified product
wise, supplier wise and territory wise.
 Analyses and interprets data: The accounting
data is analyzed meaningfully for effective
planning and decision making. This done through
ratio analysis, trend projections etc.

 Serves as a means of communication : It provides a
means of communicating management plans
upwards, downwards and outwards through the
organization.
 Facilitates control : Helps in translating objectives into
goals which are to be attained in a timely and effective
manner. The attainment is made possible through
budgetary control and standard costing, which are an
integral part of management accounting.
 Uses qualitative information : It is not restricted to the
use of financial data. It uses qualitative information
also, which can be obtained from surveys, statistical
compilations , engineering records etc.

The scope of Management Accounting is vast and
includes nearly all aspects of business operations :
 Financial Accounting : Without a properly designed
financial accounting system, management can not
obtain full control of operations.
 Cost Accounting : Standard costing, marginal
costing, opportunity cost analysis and other cost
techniques play a useful role in operation and
control.
 Budgetary Control : Involves framing budgets,
comparison of actual with budgeted performance,
computing variances, finding their causes etc.

 Inventory Control : Involves inventory control from
the time of acquisition till the time of final
disposal.
 Statistical Methods : Graphs, charts and other
statistical methods make the information presented
more impressive and intelligible.
 Interim Reporting : Includes preparation of
monthly, quarterly, half-yearly statements and
reports.
 Taxation : Includes computation of income in
accordance with tax laws, filing of returns and
making tax payments.
 Internal Audit : Development of suitable internal
audit systems for internal control.

Management Accountant is the channel through which the
information, provided by management accounting,
flows effectively and efficiently to the management.
Functions of the Management Accountant:
 Planning : He has to establish, control and administer
an adequate plan for the control of operations.
 Controlling : Compare actual performance with
operating plans and standards and to interpret and
report the results to all levels of management and the
owners.
 Coordinating :He consults and coordinates with all
segments of management responsible for policy or
action.

 Designed to supply
information to external
parties like shareholders,
creditors etc. in the form
of Balance Sheet and P&L
Account.
 Portrays the position of
the business as a whole.
 It is a post mortem
analysis of past activity
and uses monetary
record of past events.
 Designed for providing
accounting information
for internal use by the
management.
 Directs its attention to
various divisions,
departments etc., and
reports their
performances.
 It is accounting for the
future. It supplies data
for present and future,
duly analyzed, based on
which decision making is
done.

Financial Accounting versus
Management Accounting (Contd.)
 Only such economic events
are considered which can be
described in monetary
terms.
 Information is usually
provided yearly. Of course
in some cases it may be
half-yearly/quarterly.
 Based on financial data and
therefore more objective in
nature.
 Non monetary events are
also considered e.g technical
innovations, changes in the
value of money etc.
 Information is provided
more frequently and at
shorter intervals, as per
management requirement.
 Based on judgment and
therefore more subjective in
nature.

 Planning : Formulation of policies, setting up of
goals and initiating necessary programmes for
attainment of the goals is done by making available
the relevant data and analysing it for decision
making.
 Controlling : Involves evaluation of actual
performance and taking remedial action in case of
variance through budgetary control, standard
costing etc.
 Coordinating : Involves interlinking of different
divisions of the enterprise in a way as to achieve
the objectives of the organization as a whole. Tools
are departmental budgets and reports.

 Organizing : The whole organization is divided into
suitable profit or cost centres. Internal control and
internal audit for each of these centres helps in
organizing and establishing a sound business
structure.
 Motivating : Periodical departmental profit & loss
accounts, budgetary reports etc. help in
ascertaining which employee to reward and which
to penalize.
 Communicating : Involves transmission of data ,
results etc to insiders as well as outsiders. This
function is facilitated by developing a suitable
system of reporting which highlights the relevant
facts.

Management Accounting uses various tools to
discharge its duty towards management : The
important tools are:
 Financial Statement Analysis
 Funds Flow Analysis
 Cash Flow Analysis
 Costing Techniques including Marginal,
Differential, Standard and Opportunity Costing
 Budgetary Control
 Management Reporting

Cost Accounting –
Meaning and Scope.

 Cost Accounting is concerned with recording,
classifying and summarizing costs for
determination of costs of products or services
;planning, controlling and reducing such costs
and furnishing information to management for
decision making.
 According to Chartered Institute of Management
Accountants, London, cost accounting is ‘the
process of accounting for costs from the point at
which the expenditure is incurred or committed
to the establishment of its ultimate relationship
with cost units. In its widest sense, it embraces
the preparation of statistical data , the
application of cost control methods and the
ascertainment of the profitability of the activities
carried out or planned.’

Cost accounting provides useful data for both internal and
external reporting. Internal report presents details of
cost information regarding cost of specific products
or services while external reports contain cost data in
a summarized and aggregate form.
To satisfy requirements of both internal and external
reporting, the following activities are undertaken by
cost accounting :
 Cost Determination for specific product or activity.
 Cost Recording
 Cost Analysis : concerned with the critical evaluation
of cost information to assist the management in
planning and controlling the business activities.
 Cost Reporting :Concerned with reporting cost data
both for internal and external reporting purposes.

 Aims at safeguarding the
interest of the business, its
proprietors and others
connected with it.
 Financial Accounts are
prepared according to
some accepted accounting
concepts and conventions.
 Reveals the profit of
business as a whole
 Prepared and submitted
usually at the end of the
accounting period.
 Provides information
useful to outsiders, hence
high degree of accuracy
 Renders information for
guidance of the
management for proper
planning, operational
control & decision making.
 Maintenance of cost
records are voluntary and
there are no statutory
forms regarding their
presentation.
 Reveals the profit made on
each product, job or
process.
 Prepared more frequently,
sometimes even weekly.
 Provides information
useful to insiders, degree
of accuracy is less.3/27/2020By Dr. Abhay Singh Chauhan 16

Management Accounting has a wider scope as
compared to cost accounting. Cost Accounting
deals primarily with cost data while management
accounting involves the consideration of both
costs and revenue. Management accounting is an
all inclusive accounting information system which
covers financial accounting, cost accounting and
all aspects of financial management. But it is not
a substitute for other accounting functions. It
involves a continuous process of reporting cost,
financial and other relevant data in an analytical
and informative way to the management.

The term Cost Accountancy has a wider meaning as
compared to the term cost accounting. According to
CIMA, London, cost accountancy means ‘the application
of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost
control. It includes the presentation of information
there from, for the purpose of managerial decision
making’. Cost accountancy is thus the science, art and
practice of the cost accountant.
Cost Accountancy includes the following:
 Cost Accounting : It is the process of accounting for
costs.
 Costing : It is the technique and process of ascertaining
costs.
 Cost Control
 Cost Reduction
 Cost Audit: It is the verification of cost accounts and a
check on the adherence to the cost accounting plan.

i. Ascertainment of cost : Involves computation of
cost incurred
ii. Estimation of costs : As compared to ‘what has
been the cost’ it emphasizes on ‘what is likely to
be the cost’ or ‘what should be the cost’.
iii. Cost Control : Involves i) determination of standard
costs and ii) analyzing the cause of variations
between standard and actual cost.
iv. Cost Reduction
v. Determining selling price
vi. Facilitating preparation of financial and other
statements: A developed cost accounting system
provides immediate information regarding stock of
raw materials, work-in-progress and finished
goods. This helps in speedy preparation of
financial statements.
vii. Provides basis for operating policy: ex. make or
buy, Shut down or operate at loss etc.

To the Management:
 Aids in price fixation
 Costing makes comparison possible.
 Provides data for periodical profit and loss account.
 Wastages are eliminated: Cost of the article can be
known at every stage and hence it is possible to check
various forms of waste.
 Aids in determining and enhancing efficiency: Losses
due to wastage are minimized thus enhancing
efficiency.
 Helps in Inventory Control
 Helps in determining break even point:
Break Even Point = Fixed Costs / Contribution per unit
where, Contribution = Selling price – Variable cost.

vii. Helps in determining the level of output for a
desired profit :
Level of Output = (Fixed Cost + Desired Profit)/
Contribution
per unit
viii. It helps in periods of trade depression and
competition: In periods of depression, a firm may
have to sell its product even below the total cost.
While deciding whether to shut down or sell, the
firm should keep operating as long as the fixed
costs are being recovered.
To the Employees:
Workers are benefited indirectly through increase
in consumer goods and directly through
continuous employment and larger remuneration.

Practical Difficulties
 Lack of Support from Top Management: This
due to resistance to the additional work
involved. The difficulty can be overcome by
instilling a sense of cost consciousness in the
minds of the top management.
 Resistance from the existing staff : They
should be explained that the costing system
would not replace but strengthen the existing
system and open to them new areas of
development.
 Non-cooperation at other levels
 Heavy Costs: Unnecessary sophistication and
formalities should be avoided .

Main Considerations
 The product : Nature of product determines
the type of costing system to be adopted e.g a
product requiring high value of material
content requires an elaborate system of
material control.
 The organization :The existing organization
should be disturbed as little as possible.
 The objective : The objective and information
that the management wants to acquire should
also be cared for while adopting a costing
system.
 The technical details : The system should be
adopted after a detailed study of the technical
aspect of the business.
 Informative and simple
 Elastic : Should be capable of adapting to
changing requirements of the business.

 Determining cost and analyzing income: Analyses
and classifies costs according to different cost
elements viz. material, labour and expenses.
Advises the management about the profitability or
otherwise of each job, product or process.
 Providing cost data for planning and control:
Collects, classifies and presents in appropriate
form, suitable data to the management for
planning and controlling the operations of the
business.
 Undertaking special cost studies for managerial
decision making : Studies regarding -
i. Introduction of new products, replacement of
manual labour with machines etc.
ii. Make or buy decisions, accepting orders below
cost etc.
iii. Expansion plans, Utilization of idle capacity etc.
iv. Installation of cost audit system

Relationship of Cost department with other
departments is summarized below :
 Manufacturing Department : Cost Accounting
department is concerned with ascertaining,
controlling and reducing costs of each of the
manufacturing departments.
 Research and Design Department: Cost
department provides information to decide
whether a particular design or result of the
research activity should be accepted or
rejected.
 Personnel Department :Cost department
prepares the wages abstract on the basis of
the information provided by the time or job
cards maintained by the personnel
department.

 Finance and Accounts Department: This
department has to depend heavily on cost
accounting department for preparing various
budgets, cash flow statement, income statements
etc.
 Marketing Department: This department provides
information regarding the price at which the
product should be positioned in the market.
Information about the cost of the product is pre
requisite for this.
 Public relations Department : Cost accounting
department provides information regarding the
costs of the products manufactured, wages paid to
employees and the profitability of different
products or processes. This information definitely
improves the relations between the company and
different sections of the public.

In this chapter you have studied :
 Meaning of Cost Accounting
 Differentiation of Cost Accounting from Financial
Accounting and Management Accounting
 Objectives and Importance of Cost Accounting
 Difficulties and problems involved in the
installation of a costing system.
 Functions of a Cost Accountant
 Interrelationship between Cost Accounting
department and other departments.

 The term cost refers to the amount of resources
given up in exchange for some goods or services.
The resources so given up are always expressed
in terms of money. According to CIMA, London,
the term cost in general means, ‘ the amount of
expenditure ( actual or notional ) incurred on or
attributable to a given thing or activity.
 Cost refers to the total resources foregone, which
may or may not bring matching economic
benefits. In the former case, it will be termed as
an expense while in the latter case it will be
termed as a loss. Both the expense and loss are
charged to the P & L account while deferred cost
or unexpired cost is shown as an asset in the
Balance Sheet.

Material : Substance from which the product is made.
It can further be divided as :
 Direct Material : All material which becomes an
integral part of the finished product and which
can be assigned to specific physical units ex.
i. All material components specifically purchased,
produced or requisitioned from the stores
ii. Primary packing material (carton, wrapping,
cardboard box)
iii. Purchased or partly produced components.
 Indirect Material: All material which is used for
purpose ancillary to the business and which can
not be assigned to specific physical units ex.
Consumable stores, oil and waste, printing and
stationery material etc.

Labour : Conversion of Material into finished goods
requires human effort which is called labour. It
can further be subdivided as :
 Direct Labour : Labour which takes an active and
direct part in the production of a particular
commodity. It is specifically and conveniently
traceable to specific products.
 Indirect Labour : Labour employed for the
purpose of carrying out tasks incidental to goods
or services provided. It does not alter the
construction, composition or condition of the
product. It can not be traced to specific units of
output ex. wages for store keeper, foremen, time
keepers, directors’ fee, salaries for sales men etc.

Expenses : Any other cost besides material and labour is
termed as expense.
 Direct Expense : Expenses which can be directly,
conveniently and wholly allocated to specific cost
centers ex. hire of special machinery for a particular
contract, cost of defective work incurred in
connection with a particular job.
 Indirect Expense : Expenses which can not be directly,
conveniently or wholly allocated to specific cost
centres or cost units ex. rent, insurance, salaries etc.
Overheads : All indirect costs ( material, labour and
expenses ) are overheads. May be subdivided as :
 Factory Overheads : They include
i. Indirect material used in factory such as lubricants,
oil,

consumable store etc.
ii. Indirect labour ex. salary for gatekeeper , time keeper
etc.
iii. Indirect expenses ex. factory rent, factory insurance
etc.
 Office & Administration Overheads: They include:
i. Indirect material used in office ex. printing and
stationery.
ii. Indirect labour ex. salaries payable to office manager,
clerks.
iii. Indirect expenses ex. office rent, office insurance etc.
 Selling and Distribution Overheads : They include :
i. Indirect material used ex. packing material, printing
and stationery etc.
ii. Indirect labour ex. salaries of salesmen, sales manager
etc.
iii. Indirect expenses ex. rent, insurance, advertising
expenses etc.

 Prime Cost : Also known as basic, first or flat cost.
Prime Cost =Direct material + Direct Labour + Direct
Expenses
The term ‘ Direct Material’ means the cost of direct material
consumed, which equals : Opening Stock + Purchases –
Closing Stock
 Factory Cost : Also called Works cost or manufacturing
cost.
Factory Cost = Prime Cost + Factory Overheads.
Adjustment for Scrap : In case certain materials ( before
being used ) are found to be defective and hence sold,
the value of materials used should be reduced by the
cost of such materials
Adjustment for Work-in-progress :Work-in progress means
units which are not yet complete but on which some
work has been done. Generally such goods bear a
proportionate part of factory overheads, apart from raw
material & direct wages. Thus, opening and closing stock
of work-in progress is kept in mind while computing
works cost of goods manufactured.

 Office Cost : Also known as administrative cost or
cost of production.
Office Cost = Factory Cost + Office and
Administration Overheads.
Office & Administration overheads are included on the
presumption that they relate solely to production.
The amount of office and administration overheads
relating to sales are a part of selling overheads and
must have already been included in them
Adjustment for Finished Goods :
Cost of production of goods sold = Cost of production +
Opening Stock of Finished Goods – Closing Stock of
Finished Goods.
 Total Cost or Cost of Sales:
Cost of Sales = Cost of Production of goods sold +
Selling and distribution overheads.

According to CIMA, London cost sheet is ‘ a document which
provides for the assembly of the estimated detailed cost
in respect of a cost centre or a cost unit’.
Cost Sheets may be of the following two types :
 Historical Cost Sheet: Prepared periodically and after the
costs have been incurred.
 Estimated Cost Sheet: Prepared before the actual
commencement of production. The estimation process is
repeated at regular intervals. The estimates are
compared with the actual costs so that costs can be
effectively controlled.
Importance of Cost Sheet:
 Ascertainment of Cost
 Controlling Costs
 Fixation of Selling Price
 Submitting of tenders: Preparation of an estimated cost
sheet about relevant product or job facilitates this.

Fixed, variable, Semi-variable and step costs:
Fixed Cost : A cost which tends to be unaffected by
variations in volume of output. Depend mainly on
passage of time and do not vary directly with
volume or rate of output ex. rent, insurance.
Variable Cost : the cost which varies directly in
proportion to every increase or decrease in the
volume of output or production ex. wages of
labourers, cost of direct material.
Semi- Variable Cost: The cost which does not vary
proportionately but simultaneously cannot remain
stationery at all times . Also called semi-fixed cost
ex. Depreciation, repairs.
Step up costs : Costs which remain fixed over a range of
activity and then jump to a new level as activity
changes. They are a type of semi variable costs.

Shut down and sunk costs:
Shut down Cost :If a plant is idle due to temporary
difficulties, certain fixed costs have to be incurred even if
no work is being done ex. rent, insurance of building,
depreciation etc. Such costs of the idle plant are known
as shut down costs.
Sunk Cost :Historical or past costs. Created by a decision that
was made in the past and cannot be changed by any
decision that will be made in the future ex. Investment in
building, plant and machinery. Such costs are irrelevant
for decision making.
Differential, Incremental or Decremental cost :
Differential Cost :Difference in total cost between two
alternatives.
Incremental Cost: increase in total cost as a result of choice of
alternative.
Decremental Cost : Decrease in total cost as a result of choice
of alternative.

Opportunity Cost: The advantage which has been foregone on
account of not using the facilities in the manner
originally planned. It is the alternative revenue foregone.
Ex. If an owned building is proposed to be utilized for
housing a new project plant, the likely revenue which the
building could fetch, is the opportunity cost.
Product Costs and Period Costs :
Costs which become part of the cost of the product rather
than an expense of the period in which they are incurred
are called ‘Product costs’. They are included in inventory
values. They can be fixed or variable ex. Cost of raw
material, direct wages.
Costs which are not associated with production are called ‘
Period costs’. They are treated as an expense of the
period in which they are incurred. They can be fixed or
variable ex. general administration costs, salesmen
salaries etc.

Cost Unit and Cost Centre :
Cost Unit : CIMA London, defines a unit of cost as, ‘ a unit of
quantity of product, service or time in relation to which
costs may be ascertained or expressed’. Unit selected
should be unambiguous, simple and commonly used ex:
i) Brick Kilns - per 1000 bricks made
ii) Electricity Companies - per unit of electricity generated
Cost Centre :According to CIMA London, cost centre means ,
‘a location, person or item of equipment ( or group of
these )for which costs may be ascertained and used for
the purpose of cost control’. Thus cost centre refers to
one of those convenient units into which the whole
factory organization has been appropriately divided for
costing purposes.

Cost Allocation and Cost Apportionment:
Cost allocation and cost apportionment are the two
procedures which describe the identification and
allotment of cost centres or cost units. Cost
allocation refers to , ‘ the allotment of whole items
of costs to cost centres or cost units’ while cost
apportionment refers to ‘ the allotment of
proportions of items of costs to cost centres or cost
units’. Thus the former involves the process of
charging direct expenditure to cost centres or cost
units while the latter involves the process of
charging indirect expenditure to cost centres or cost
units.

Costing has been defined as ‘ the technique and process of
ascertaining costs’. Various types of Costing :
 Job Costing : Used where the production is not highly
repetitive and consists of distinct jobs or lots. An
account is opened for each job and all appropriate
expenditure is charged thereto. Variants of Job costing :
i. Contract Costing : A contract is a big job , while job is a
small contract.
ii. Cost Plus Costing: In contracts where besides cost, an
agreed sum or percentage to cover overheads and profit
is paid to the contractor, the method is termed as
contract plus costing.
iii. Batch Costing : Where order jobs are arranged in
different batches after taking into account the
convenience of producing articles, batch costing is
employed. The unit of cost is batch or group of identical
products , instead of single job order or contract.

 Process Costing :If a product passes through different
stages, each distinct and well- defined, it is desirable to
know the cost of production at each stage. For this,
process costing is used, under which separate account is
opened for each process. Variants of process costing :
i. Operation Costing : This method is employed where
mass or repetitive production is carried out or where
articles have to be stocked in semi-finished stage. The
cost unit is an operation instead of a process.
ii. Unit Costing :Cost per unit of output is ascertained and
the amount of each element constituting such cost is
determined.
iii. Operating Costing :This method is employed where
expenses are incurred for providing services such as
those rendered by bus companies or railway companies.
The total expenses regarding operation are divided by
the appropriate unit and cost per unit is calculated.

 Marginal Costing : It is a technique of costing in
which allocation of expenditure to production is
restricted to those costs which arise as a result of
production i.e costs which vary with production.
 Direct Costing : It is the practice of charging all
direct costs to operations , processes of products,
leaving all indirect costs to be written off against
profits in the period in which they arise.
 Absorption or full costing : It is the practice of
charging all costs both variable and fixed to
operations, products or processes.
 Uniform Costing : It is the technique where
standardized principles and methods of cost
accounting are employed by a number of different
companies or firms.

 Historical Costing : It is the determination of cost by
actuals. It may be :
i. Post Costing : It means ascertainment of cost after
production is completed. It is done by analyzing the
financial accounts at the end of the period in such a way
as to disclose the cost of units which have been
produced.
ii. Continuous Costing : Cost is ascertained as soon as the
job is completed or even when the job is in progress.
This is done by charging to the job the actual
expenditure on material and wages, and estimated share
of overheads.
 Standard Costing : System under which :
i. Cost are predetermined on the basis of laid down
standards.
ii. Actual costs are compared with pre determined costs.
iii. Variances are found out as to their causes.
iv. Remedial measures including revision of standards, is
taken.

 Activity Based Costing : The technique which involves
identification of costs with each cost driving activity and
making it as the basis for apportionment of costs over
different products or jobs.
 Back Flush Costing :A cost accounting system which
focusses on the output of an organization and then
works back to attribute costs to stock and cost of sales.
Also termed as delayed costing or post-deduct costing .
This is because the costing of inventories is delayed
almost till the goods are sold.
 Life Cycle costing : According to CIMA London, it is the
‘practice of obtaining over their lifetimes, the best use of
physical assets at the lowest total cost to the entity’.
 Value Added Concept : It is a performance measure and
it reports the wealth generated by a business
undertaking over a period of time . It represents the sale
value ‘ less the cost of bought in goods and services
used in producing those sales’.

 The concept of cost
 Different elements of cost
 Different components of cost
 Classification of costs into different categories
 Differentiation between certain important terms
relevant to ascertainment of costs ex. cost centre
and cost unit
 Different methods, systems and techniques of
costing
 Meaning of certain innovative and emerging cost
concepts.

Inventories are unconsumed or unsold goods
purchased or manufactured. According to AS 2 (
revised ) inventories are assets :
 Held for sale in the ordinary course of business
 In the process of production for such sale or
 In the form of materials or supplies to be
consumed in the production process or in the
rendering of services.
Thus inventory includes stock of
i) Finished goods
ii) Work-in progress
iii) Raw materials and components.

 Determination of Income :
Gross profit is the excess of sales over cost of
goods sold.
Cost of Goods sold = Opening Inventory + Purchases
– Closing
Inventory
 Determination of Financial Position:
The inventory at the end of the period is to be
shown as a current asset in the Balance Sheet of
the business. In case the inventory is not valued
properly, the balance sheet will not disclose the
correct financial position of the business.

 Periodic Inventory System: The quantity and value
of inventory is found out only at the end of the
accounting period after having a physical
verification of the units in hand. No information
is provided regarding quantity and value of
materials in hand on a continuous basis. No
accounting is done for shrinkage, losses, theft
and wastage.
 Perpetual inventory System : Also known as
automatic Inventory System. It is ‘ A method of
recording inventory balances after every receipt
and issue to facilitate regular checking and to
avoid closing down for stock taking.’ Details
about quantity and value of stock are available on
a continuous basis.

Inventory should be valued at the lower of ‘ historical cost’
and ‘net realizable value’.
Historical Cost : It is the aggregate of cost of purchase,
cost of conversion and other costs incurred in
bringing the inventories to their present location and
conditions.
The various methods of assigning historical costs to
inventory and goods sold are as under:
i. Specific Identification Method: Each item of inventory
is identified with its cost. The total of various costs so
identified, constitutes the value of the inventory. This
technique of inventory valuation can only be adopted
by a company handling a small number of items. For
a large number of inventory items, it is nearly
impossible to identify the cost of each individual item.

ii. First In First Out ( FIFO ): It is assumed that the
material first received is the first to be issued or sold.
Thus the inventory at any point of time is presumed
to be composed of items most recently acquired.
Advantages: i) It values stock nearer to current market
price.
ii) It is based on cost, hence no unrealized profit enters
into the financial accounts of the company.
iii) The method id realistic since the normal procedure is to
utilize the material that has been longest in stock.
Disadvantages: i) Involves complicated calculations and
hence increases the possibility of clerical error.
ii) Comparison between different jobs using the same type
of material gets sometimes difficult. A job
commenced a few minutes after another job may have
to bear a different charge for material because the
first job completely exhausted the supply of material
of the particular lot.

iii. Last In First Out ( LIFO ): The last item of material
purchased is the first to be issued or sold. Hence,
inventory consists of items purchased at the
earliest cost.
Advantages :i) It takes into account the current
market conditions while valuing material issued
to different jobs or calculating the cost of goods
sold.
ii) The method is based on cost and hence no
unrealized profit or loss is made on account of
use of this method.
FIFO, LIFO and market fluctuations:
In periods of rising prices :FIFO will result in lower
cost of goods sold and higher closing stock of
inventory. Thus profits will be inflated and there
will be a higher tax liability. Using LIFO will result

In Periods of falling prices : FIFO will result in higher
cost of goods sold, lower profitability and lower
tax liability. Reverse will be the case if LIFO is
followed.
iv. Highest in First Out : Materials or goods
purchased at the highest prices are treated as
being first issued or sold, irrespective of the date
of purchase.
v. Base Stock method :Based on the contention that
each enterprise maintains a minimum quantity of
material in its stock. This base stock is deemed
to be created out of the first lot purchased and
therefore valued at this price and is carried
forward as a fixed price. Any quantity over and
above the base stock is valued in accordance with3/27/2020By Dr. Abhay Singh Chauhan 55

iv. Next in First Out :Issues are made at the price of
materials which has been ordered but not yet
received. The attempt is to value material issued
at a price which is nearest to market price.
v. Weighted Average Price Method: Based on the
assumption that once the material is put into a
common bin, it loses its separate identity. Hence
the inventory consists of no specific batch of
goods. It is priced on the basis of average prices
paid for the goods, weighted according to the
quantity purchased at each price.

Net Realizable Value :Net realizable value means ‘the
estimated selling price in the ordinary course of
business less costs of completion and less costs
necessary to be incurred in order to make the
sale’. Ascertainment of net realizable value and its
comparison with historical cost can be done using
any of the following methods :
i. Aggregate or total inventory method : The total
cost price of the different items of inventory is
calculated and compared with the total of net
realizable value of the different items of inventory.
Valuation is done at the price lower of the two.
ii. Group Method: Groups are formed of
homogenous items of inventory . The cost and net
realizable value of each group is ascertained. The
lower of the two is taken for inventory valuation.
iii. Item by Item method: The cost and net realizable
of each item is found out and valuation is done at3/27/2020By Dr. Abhay Singh Chauhan 57

If Inventory is taken on a date after the balance sheet
date: Ex. If the Balance Sheet is prepared on 31st
December 1991 and inventory is taken on 31st
January, 1992, the following adjustments will be
required:
Inventory as on 31st Jan, 1992
Less : Purchases made between 1st Jan, 1992 to
31st Jan, 1992
Less : Sales returns ( at cost price) 1st Jan 1992 to 31st
Jan 1992
Add: Sales ( at cost price ) 2nd Jan 1992 to 31st Jan
1992
Add: Purchase Returns 2nd Jan 1992 to 31st Jan 1992
Value of inventory as on 31st December 1991

 Definition of the term inventory
 The objectives of inventory valuation
 Different Inventory systems
 Different methods of Inventory valuation
 Valuation of Inventory for Balance Sheet purposes

Accounting for Managers/Management Accounting (Unit-3) by Dr. Abhay Singh Chauhan

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