Essential Cost Accounting: Materials, Labour, and Overheads

Posted on May 12, 2026 in Other subjects

Managing Material Costs

In cost accounting, managing materials is a massive undertaking because materials often account for 50% or more of the total cost of production. Here is a breakdown of how costs are classified and how material inventory is managed.

1. Classification of Costs

Costs can be classified in several ways to help management understand their behavior and impact.

By Nature or Element

• Material: The cost of commodities supplied to an undertaking.
• Labor: The cost of remuneration (wages/salary) for employees.
• Expenses: The cost of services provided (e.g., rent, utilities).

By Traceability (Relation to Product)

• Direct Costs: Easily identified with a specific unit (e.g., leather for shoes).
• Indirect Costs (Overheads): Costs that cannot be traced to a single unit (e.g., factory lighting).

By Behavior (Relation to Volume)

• Fixed Costs: Remain constant regardless of production levels (e.g., rent).
• Variable Costs: Change in direct proportion to production (e.g., raw materials).
• Semi-variable: Part fixed and part variable (e.g., telephone bill).

2. Material Cost: Purchase, Storage, and Control

This is a cycle designed to ensure that the right materials are available at the right time without overspending.

The Purchase Procedure

1. Purchase Requisition: A department asks the purchasing office for materials.
2. Selection of Suppliers: Inviting quotations and choosing the best vendor.
3. Purchase Order: A formal contract sent to the supplier.
4. Receiving & Inspection: Checking the goods against the order for quality and quantity.

Storage and Control

Once received, materials are kept in a “store.” Control involves:

• Bin Cards: A quantitative record of receipts and issues kept in the storeroom.
• Store Ledger: A record kept in the accounts department showing both the quantity and value of materials.

3. Stock Levels

To avoid “over-stocking” (wasting capital) or “under-stocking” (stopping production), companies set specific levels:

• Re-order Level: The point at which a fresh order should be placed.
• Minimum Level: The safety stock that should always be available.
• Maximum Level: The upper limit beyond which stock should not exceed.
• Danger Level: Below minimum level; requires urgent action to prevent a shutdown.

4. Inventory Control Techniques

These techniques help prioritize which materials need the most attention.

ABC Analysis (Always Better Control)

Materials are divided into three categories based on value:

• A Items: Small in quantity (10%), but high in value (70%). Require strict control.
• B Items: Moderate in quantity and value (20% each).
• C Items: Large in quantity (70%), but low in value (10%). Require loose control.

Economic Order Quantity (EOQ)

EOQ determines the ideal order size that minimizes the total cost of ordering and carrying inventory. (Where A = Annual Consumption, O = Ordering Cost per order, C = Carrying cost per unit per year)

5. Methods of Pricing Material Issues

When materials are sent from the store to the production floor, they must be assigned a price. Since prices change over time, companies use different methods:

• FIFO (First-In, First-Out): Assumes the oldest materials are used first. Best for perishable items.
• LIFO (Last-In, First-Out): Assumes the most recently purchased materials are used first. This matches current costs with current revenues.
• Weighted Average Price: Total cost of stock divided by total quantity. It smooths out price fluctuations.
• Standard Price: Materials are issued at a pre-determined fixed price, regardless of actual purchase price.

Summary Table: Inventory Techniques

Labour Cost Management

In cost accounting, Labour represents the human effort—both physical and mental—required to convert raw materials into finished goods. Unlike materials, labor is a “perishable” resource; if a worker’s hour is not used today, it is lost forever.

1. Components of Labour Cost

Labour cost is more than just the base salary. It is divided into:

• Monetary Benefits: Basic wages, Dearness Allowance (DA), overtime pay, and bonuses.
• Fringe Benefits: Employer’s contribution to Provident Fund (PF), ESI, subsidized food, housing, and medical facilities.
• Direct Labour: Wages paid to workers directly involved in production (e.g., a carpenter).
• Indirect Labour: Wages for support staff (e.g., security guards, supervisors, cleaners).

2. Idle Time: Concept and Accounting

Idle Time occurs when workers are paid but are not productive. It is the difference between “Time Clocked In” and “Time Spent on Job.”

Categories of Idle Time

1. Normal Idle Time: Unavoidable time losses inherent in the production process (e.g., time taken to walk from the factory gate to the machine, machine setup time, or tea breaks). Accounting: Treated as an indirect cost and charged to Factory Overheads.
2. Abnormal Idle Time: Avoidable time losses due to inefficiency (e.g., power failure, machine breakdown, or strikes). Accounting: Charged directly to the Costing Profit & Loss Account so it doesn’t inflate product costs.

3. Overtime: Accounting and Control

Overtime is work performed beyond the normal scheduled hours, usually paid at a higher rate.

• Accounting Treatment:
  • If requested by a customer for an urgent job: Charged directly to that specific Job.
  • If due to general production pressure: Charged to Factory Overheads.
  • If due to abnormal causes (e.g., flood/fire): Charged to Costing P&L.
• Control: Management must require prior authorization for overtime and investigate if it is being used to cover up inefficiencies during regular hours.

4. Methods of Wage Payment & Incentive Plans

A good wage system should balance worker motivation with cost-effectiveness.

Basic Methods

• Time Rate System: Payment is based on time spent (e.g., ₹500 per day). Quality is high, but there is no incentive for speed.
• Piece Rate System: Payment is based on units produced (e.g., ₹10 per shirt). Speed is high, but quality may suffer.

Incentive Plans

These plans provide a “bonus” for time saved or high efficiency.

5. Labour Turnover

Labour Turnover is the rate at which employees leave an organization and are replaced by new ones. High turnover is expensive because it involves recruitment and training costs.

Causes of Turnover

• Personal: Retirement, family issues, or better opportunities elsewhere.
• Unavoidable: Seasonal nature of the business or illness.
• Avoidable: Low wages, poor working conditions, lack of promotion, or bad management.

Measurement (The Formulas)

1. Separation Method: (Number of separations / Average number of workers) × 100
2. Replacement Method: (Number of replacements / Average number of workers) × 100
3. Flux Method: (Separations + Accessions / Average number of workers) × 100

Cost Tip: To control labor turnover, companies often conduct Exit Interviews to find the “Avoidable Causes” and improve their retention strategies.

Overhead Accounting

Overheads are the total of all indirect costs (Indirect Material + Indirect Labour + Indirect Expenses). Because they cannot be traced to a single unit of production, they must be systematically distributed.

1. Overhead Accounting Process

A. Collection and Classification

Overheads are collected from various sources (invoices, stores requisitions, payroll) and classified by:

• Function: Production, Administration, Selling, and Distribution.
• Behavior: Fixed, Variable, and Semi-variable.

B. Allocation vs. Apportionment

• Allocation: Directly charging an overhead to a specific department (e.g., salary of a supervisor who only manages the “Welding” department).
• Apportionment: Sharing “common” costs among multiple departments using a logical basis (e.g., dividing Rent based on the floor area occupied by each department).

C. Primary vs. Secondary Distribution

1. Primary Distribution: Allocating and apportioning overheads to all departments (both Production and Service).
2. Secondary Distribution: Re-distributing the costs of Service Departments (like Maintenance or Canteen) to Production Departments.

2. Absorption of Overheads

Absorption is the process of charging the accumulated overheads to the final products. The most common method for machine-heavy industries is the Machine Hour Rate (MHR).

Machine Hour Rate (MHR)

MHR is the cost of running a machine for one hour. It includes:

• Standing Charges: Fixed costs (Rent, Insurance, Lighting).
• Machine Expenses: Variable costs (Power, Fuel, Depreciation, Repairs).

3. Standard Costing and Variance Analysis

Standard Costing is a control technique that compares Standard Costs (what it should cost) with Actual Costs (what it did cost). The difference is called a Variance.

Types of Variances

• Material Variances:
  • Price Variance: Buying at a higher/lower price than expected.
  • Usage Variance: Using more/less material than the standard.
• Labour Variances:
  • Rate Variance: Paying a different wage rate.
  • Efficiency Variance: Workers taking more/less time than planned.

Suggested Readings

If you are looking for academic depth or preparing for university exams, these are the gold-standard texts:

1. Cost Accounting: Principles and Practice by M.N. Arora
2. Cost Accounting by Jawahar Lal and Seema Srivastava
3. Principles and Practice of Cost Accounting by Ashish K. Bhattacharyya
4. Cost Accounting: A Managerial Emphasis by Horngren, Datar, and Rajan