MODULE 1

PROCESS COSTING

Meaning and Definition: There are certain industries in which one or more products are
manufactured in a continuous flow or on mass production basis. The raw material passes
from process to process until the finished product comes out. Similarly, the output of the
first process becomes the raw material of the second process and the output of the second
process becomes the raw material of the third process and so on, until the finished product is
obtained. The method of process costing is applied in such industries.
According to CIMA, “process costing is that form of operation costing where
standardised goods are produced”.

Features of process costing

 The production is divided into various stages (processes) and each process is carried out
by separate cost centre or department.
 The production is continuous and the final product is the result of a sequence of
operations.
 The output of one process becomes the input of another process.
 Production of a particular product may give rise to joint or by products.
 The cost of production per unit is the average cost which is obtained by dividing the
total process cost by the total no of units manufactured.
 There may arise normal loss, abnormal loss and abnormal gain which are treated
separately.
 Work in progress and the concept of equivalent units will arise.
 The finished products are identical units, which require the same amount of material,
labour and overhead per unit.
Industries suitable for process costing
 Metallurgical industries like iron and steel. Copper etc.
 Food processing industries like chocolates, biscuits etc.
 Chemical industries like oil, soap, perfumes, medicines etc.
 Other industries like textile mills, paper mills, paint manufacturing etc.
Objectives of process costing
 To ascertain the cost of production of each process.
 To identify and account for normal loss, abnormal loss and abnormal gain occurring
during the course of production.
 To account for joint products and by products.
 Difference between job costing and process costing

Job costing Process costing

Production is against specific orders. Production is not against orders and continuous
in nature.

Costs are determined for each job separately. Costs are computed for each process.

Production of non-standardised and un Production of standardised and identical

identical items is undertaken in accordance products is undertaken.
with the instructions of the customers.

As the job as a whole is considered as a single As there are series of processes employed, the
unit, there is no transfer of one part of job to cost of one process is transferred to the other
another. process

Work in progress may or may not occur in the There is usually work in progress, since the
beginning or at the end production is continuous in nature.

Cost control becomes difficult due to the On account of continuous and uninterrupted
intermittent nature of production. production, cost control is comparatively
easier.
There is no joint or by products. Production may give rise to joint or by
products.
Costs are computed when a job is complete. Costs are calculated at the end of each process.

Advantages of process costing

 It is easy to compute the cost of each department or process periodically at short
intervals.
 More economical than job costing.
 Cost control is more effective since production is continuous.
 Expenses can be separately allocated to each stage of production.
Disadvantages of process costing
 Since process costs are average costs, they are not always accurate.
 Costs accumulated at the end of the period are only historical costs.
 Computation of average cost becomes difficult when more than one type of product is
manufactured.
 There is lack of precise and commonly accepted criterion for the allocation of joint costs
among different types of products.

Elements of process costing are direct materials, direct labour, direct expenses and
overheads
 Format of process account
Process 1 A/c
Particulars Units Amount Particulars Units Amount
To direct materials By normal loss

To direct labour By abnormal loss

To direct expenses By process II a/c

(output
To factory overheads transferred to
next process)

Process II A/c
Particulars Units Amount Particulars Units Amount
To process I (cost of By normal loss
output transferred
from process I)

To direct materials

To direct labour

To direct expenses
By process III a/c
To factory overheads or finished stock a/c

1. A product has to pass through P, Q, R processes for completion. During a month, 1000
units were produced for which the following was the expenditure.
P Q R
Materials 2500 5000 2500
Labour 12500 10000 7500
Direct expenses 1250 1500 2500

There was a common expenditure of Rs.15000 which was to be allocated on the basis of
direct wages. Raw materials worth Rs.15000 were issued to process P. Prepare the
process accounts and finished stock account.
 Process loss or wastage
The process loss or wastage may be divided into two: normal loss and abnormal loss
Normal loss: It is the quantity of wastage which is unavoidable and is bound to take place.
It cannot be avoided though efforts can be made to minimise it. Normal loss generally arises
on account of the nature of materials used or the nature of the manufacturing process
involved. The extent of normal loss can be ascertained on the basis of past experience.
Normal output (units) = Total input (units) – Normal loss (units)

Normal loss a/c

Particulars Units Amount Particulars Units Amount
To process I a/c By cash( sale of
wastage)

Abnormal loss: It is defined as the loss in excess of the predetermined (normal) [Link] may
occur due to unexpected or abnormal conditions such as carelessness of workers, accident,
substandard materials etc.
Abnormal output (units) = normal output (units) - actual output (units)
Cost of abnormal loss = Cost of normal output x Abnormal loss in units
Normal output in units
Or
=Total process cost - Scrap value of normal loss x Abnormal loss in units
Input in units – Normal loss in units

Abnormal loss a/c

Particulars Units Amount Particulars Units Amount
To process I a/c By cash( sale of
wastage)
By costing
profit and loss
a/c

Abnormal gain: when the actual process loss is less than the normal loss or when the actual
output is more than the normal expected output, it gives rise to abnormal gain. It may arise
due to exceptionally good quality of materials, exceptionally high degree of efficiency on
the part of workers etc.
Abnormal gain in units = actual output (units) – normal output (units)
Value of abnormal gain = = Cost of normal output x Abnormal loss in units
Normal output in units
Or
= Total process cost-scrap value of normal loss x Abnormal gain in units
Input in units – Normal loss in units

Abnormal gain a/c

Particulars Units Amount Particulars Units Amount
To normal loss By process a/c
a/c

To costing profit
and loss a/c

2. 10000 units have been issued to Process X at a cost of Rs.20000. the other expenses are
as follows:
Rs.
Materials 12,000
Labour 16,000
Factory 5,000
expenses

From past experience it is ascertained that wastage incurred in the process is 2% of input
and it realises Rs.50 per 100 units. The actual output of process is 9,800 units. Prepare
process X a/c and normal loss a/c.
3. In process A, 100 units of raw materials were introduced at a cost of Rs.1,000. the other
expenditure incurred by this process was Rs.600. of the units introduced 10% is normally
lost in the course of manufacturing and they possess a scrap value of Rs.3 each. The
output of process A was only 75 units. Prepare process A a/c and abnormal loss a/c.

4. In process B, 75 units of a commodity was transferred from process A at a cost of

Rs.1,308. the additional expenses incurred by the process were Rs.202. Normal loss is
20% of the units introduced. Scrap value is Rs.4 per unit. The output was 70 units.
Prepare process a/c and abnormal gain a/c.

5. The product of a company passes through 3 processes X, Y and Z. normal loss incurred
for each process is: X =2% Y =5% Z =10%
 The loss has some scrap value. The scrap of process X and Y is sold at Rs.5 per 100
units and that of process Z at Rs.20 per 100 units. The following information is
additionally obtained:

X Y Z
Materials 6,000 4,000 2,000
Labour 8,000 6,000 3,000
Manufacturing 1,000 1,000 1,500
expenses
20,000 units have been issued to process X at a cost of Rs.10,000. the output of each
process has been as under.
Process X – 19,500 units Process Y – 18,800 units Process Z – 16,000 units
Prepare process accounts, finished stock a/c, normal loss , abnormal loss and gain a/c.

6. From the following data prepare the process accounts

Process A Process B
Materials consumed 12,000 6,000
Direct labour 14,000 8,000
Manufacturing expenses 4,000 4,000
Input in units 10,000 -
Input in value 10,000 -
Output in units 9,400 8,300
Normal wastage 5% 10%
Value of normal wastage(per 100 units) 8 10

7. A product has to pass through 3 processes X, Y and Z. the normal wastage of the 3
processes are 2%, 5% and 10% respectively which are to be calculated on the number of
units that enter into each process. The scrap value of wastage of 3 processes is Rs.10,
Rs.40 and Rs. 20 per 100 units respectively. Following are the additional details.
X Y Z
Materials 12,000 4,000 4,000
Labour 8,000 6,000 6,000
Manufacturing 2,000 4,000 2,000
expenses
20,000 units were put into process X at a cost of Rs.16,000. the output of each process
has been: X = 19,600 units, Y = 18,400 units and Z = 16,700 units. Prepare process
accounts, normal loss a/c, abnormal loss a/c and abnormal gain a/c.
8. From the following figures, show the cost of 3 processes of manufacture. The product of
each process is passed on to the next process immediately on completion.
 Process Process Process
A B C

Materials and wages 30400 12000 29250

Works on cost 5600 5250 6000
Production in units 36000 37500 48000
Stock(units from preceding process on 1.07.14) - 4000 16500
Stock(units from preceding process on - 1000 5500
31.07.14)

9. The Bengal chemical com ltd produced three chemicals during the month of January
2017 by three consecutive processes. In each process, 2% of the total weight put in is lost
and 10% is scrap from which process 1 and 2 realises Rs.100 per tonne and from process
3 Rs.20 per tonne. The product of 3 processes is dealt with as follows:
Process 1 Process 2 Process 3
Raw material ₹ 120000 ₹ 28000 ₹ 107840
(1000 tons) (140 tons) (1348
tons)
Wages ₹ 20500 ₹ 18520 ₹15000
Overhead ₹ 10300 ₹ 7240 ₹ 3100
Passed to next process 75% 50%
Passed to warehouse for sale 25% 50% 100%

Prepare process accounts, showing the cost per tonne of each product.

10. On the basis of the following information, prepare process accounts and a statement of
profit
Process 1 Process 2 Process 3
Raw materials used 1000 tons - -
Cost per ton(Rs.) 200 - -
Manufacturing expenses(Rs.) 87500 34500 10710
Loss in weight 5% 10% 20%
Scrap(sales price Rs.50/ton) 50 ton 30 ton 51 ton
Sales price/ton(Rs.) 350 500 800
Management expenses were Rs.17500 and selling expenses were Rs.10000. of the
output of process 1 and of the output of process 2 are transferred to next process and
the balance are sold. The entire output of process 3 is sold.

11. The product of a chemical factory passes through two different processes. From past
experiences, it is ascertained that normal loss is: process A 2% process B 10%.The
scrap value in process A and B is Rs.25 and Rs.50 per 100 units respectively. 10000 units
of raw materials were introduced in process A in April at a cost of Rs.16000. the
following information is further available:
 Process A Process B
Indirect materials(Rs.) 16000 5000
Direct labour(Rs.) 9000 8000
Direct expenses(Rs.) 8200 1500
Output in units 39000 36500
Finished stock in units
April 1 6000 5000
April 30 5000 8000
Value of stock/unit on 1st April(Rs.) 1.2 1.6

The stock is valued and transferred to next process at weighted average cost. Prepare
process cost accounts.

Joint products and By-products

In some industries, two or more products are simultaneously produced in the same process.
Such products may be joint products, by products or co products.
Joint products
They refer to a group of individual products of significant relative sales value
simultaneously produced from the same raw materials. The basic features of joint products
are:
a. These products cannot be produced separately.
b. These are obtained from the common manufacturing process and common raw
materials.
c. These products carry almost equal economic importance or sales value.
d. They require further processing after the point of separation.
e. No product can be called as a main product.
Oil refining is the typical example of joint products. In the process of refining oil, joint
products such as kerosene, fuel oil, wax, tar etc. are obtained from crude petroleum. Other
examples are milk, butter, cream etc. obtained in dairies and copper, silver etc. obtained
from same ore.
According to ICMA, joint products are defined as “two or more products separated in the
course of processing, each having a sufficiently high saleable value to merit recognition as
a main products”.
By products
It is a secondary or subsidiary product which emerges as a result of manufacturing of the
main products. It is the residual material which is incidentally obtained from the production
of main products and has relatively small value. The basic features of by products are:
a. They are produced incidental to the main products.
 b. Their value is very low compared to the main product.
c. They can be sold immediately after separation without further processing.
d. They emerge from the same basic raw materials.
e. They are produced simultaneously from a common process.
In case of sugar industry, the production of sugar is accompanied by bagasse and molasses.
Other examples include saw-dust, off-cuts etc. from wood working and sulphur, bitumen
etc. from oil refining process.

Co-products
They are those products that are produced together but not from the same materials and from
the same process. For example, in a bakery, bread, cakes, pastry and biscuits of various types
produced.

Difference between joint products and by products

Joint products By products

Joint products are comparatively of equal Their value is very low compared to the
importance. main products.

There is no product to be designated as There will always be at least one main

main product. product.

They should undergo further processing They can be sold immediately after
after separation before they are sold. separation.

Each joint product is a major product line. By products are incidental products with
negligible value.

It has greater importance. It has lesser importance.

Accounting for joint costs (Methods of apportionment of joint costs)

a. Average unit cost method: An average cost is arrived at for all the products without
calculating separately the cost of each joint product. The joint processing cost incurred
up to the point of separation is divided by the number of units produced to get the
average cost per unit. The cost per unit is multiplied by the number of each joint product
to get the cost of each joint product.

 From a joint process, products A, B and C are obtained, the joint cost being
Rs.150000. the units of the joint products were: A 3200, B 2500 and C 1800.
 Apportion the joint costs among the products according to the average unit cost
method.

b. Physical unit method: The physical volume of materials found in the joint products at
the point of separation is taken as the basis of apportionment of joint costs. Any loss
arising during processing is also apportioned on the same basis.

 A Dairy company produces the following products using 10000 litres of milk at
Rs.30/litre from a common process. Apportion the joint costs among the products
on the basis of physical unit method.

Kgs
Butter 7000
Cheese 2400
Cream 104
Ghess 96

c. Survey method (point value method): This method is on the presumption that joint costs
cannot be allocated satisfactorily by considering any one single factor. Therefore
management carries on extensive survey for collecting information of all factors involved
from the commencement of production to the final stage of sale. It may conduct survey on
volume, selling price, technical aspects etc. Here joint costs are apportioned on the basis of
the point value or percentages assigned to each product according to its relative importance.

 In a timber industry three grades of timber namely A, B and C are obtained at split
off point of cutting operation at a cost of Rs.62000. The units of three grades
obtained are 600 units, 400 units and 200 units of A, B and C respectively. Technical
estimates show that weight of 6, 5 and 3 be assigned to each grade A, B and C
respectively. Show a statement showing apportionment of joint costs.

d. Contribution margin method: Joint costs are divided into variable cost and fixed cost. The
variable costs are apportioned over the joint products on the basis of the units produced.
Sales minus variable costs give the contribution ratio which is then used to apportion the
fixed costs.

 Three products A, B and C are produced from a common process. The total cost up
to the split off point is Rs.23300- fixed cost Rs.3300 and variable costs
[Link] quantity of output produced and sold are 100kg, 60kg and 40kg of
A,B and C for Rs.140, Rs.130 and Rs.120 per kg. Apportion the joint cost among the
products A, B and C under contribution margin method.
e. Standard cost method: Joint cost is apportioned among joint products on the basis of
pre-determined standard cost for each joint product. This helps to compare the actual
with the standard and measures the efficiency.

f. Market value method: Under this method, the products are made to bear a proportion of
the joint cost on the basis of their ability to bear the same which depends upon the
expected market price of the [Link] is more scientific since the market price
necessarily depends upon the quality and grade of production. The market values vary on
the basis of point of valuation. Hence, the different methods under market value are:

1. Market value at the point of split off: When market value of each joint product is
known at the point of separation, the joint cost is apportioned in the proportion of these
values. The market value for the purpose may be either market value per unit or the
amount of market value of the entire units of each joint product.

 From a joint process, 400 units of joint product X and 600 units of joint product Y
are obtained with market values of Rs.40/unit of X and Rs.20/unit of Y. the cost of
joint processing is Rs.21000. apportion the joint costs on the basis of selling price
and sales amount.

2. Market value after further processing: Application of this method is easy as the
selling price of each finished product will be readily available. From the sales value of
each joint product, the post-split off cost of respective product is deducted and on the
basis of values obtained, the joint cost is apportioned.

 The joint cost of manufacturing 1000 units of A, 2000 units of B and 3000 units of C
is Rs.24000. The selling price of products A, B and C are Rs.5, Rs.4 and Rs.3
respectively. The product do not require any further processing costs after split-off
point. You are required to apportion the joint costs on sales price basis and on sales
value basis.

 From a joint process, 500 units of product X, 300 units of Y and 200 units of product
Z are obtained which have market values of Rs.40, Rs.50 and Rs.30 per unit
respectively. The post-split off costs were Rs.5000 for X, Rs.500 for Y and Rs.1000
for Z. the joint costs amounted to Rs.18000. Apportion the joint costs among the
products.

g. Reverse cost method or net value method: Joint product costs are apportioned to
different products on the basis of the estimated cost at the separation point. The estimated
cost at the separation point is ascertained by deducting from the sales value of each joint
product, the estimated net profit, selling and distribution expenses if any and the
subsequent processing costs after separation.
1. A factory produces three products A, B and C which originates from a common process.
The actual joint costs are:
Material Rs.10200
Labour Rs. 11500
Overheads Rs.7500

Subsequent expenses are as follows.

A B C

Material ( Rs.) 2500 1200 1400

Labour ( Rs.) 1900 1600 2000
Overhead ( Rs.) 1500 900 1050
Selling prices( Rs.) 30000 20000 15000
Estimated profit on sales 40% 30% 25%

Prepare a statement showing the apportionment of joint costs over different products.

2. The joint costs of three products X, Y and X are Material Rs.6000, Labour Rs.5000 and
Overhead Rs.4500 respectively. The subsequent expenses are as follows:

X Y Z

Material ( Rs.) 1000 800 900

Labour ( Rs.) 1200 700 850
Overhead ( Rs.) 1300 500 750
Selling prices( Rs.) 21000 10000 9000
Estimated profit on sales 50% 30% 33.33%

Prepare a statement showing the apportionment of joint costs over different products.

3. Joint cost of Products A, B and C are : Materials Rs.100000, Labour Rs.18000 and OH
Rs.8000 respectively. Compute share of joint costs based on the given data.
Additional Information
A B C
Sales value 100000 70000 60000
Estimated profit on sales 20% 30% 40%
Subsequent expenses 10000 9000 6000
 Accounting for by-products

There are two methods for accounting by-products: Non-cost method and Cost method
Non-cost method (Sales value method): Costs are not assigned to by products but income
or revenue arising from the sale of by -product is credited to P and L A/c or to the Main
Product A/c. Following are the types of non-cost method:
a. Crediting the sales value of by product to other income (other income method): It is used
when the sales value of by-product is very small. Here sales value of by product is
treated as other income and credited to P & L A/c. If by product is not sold and is kept in
stock, its value for Balance sheet purpose shall be taken as nil.

b. By-product sales added to main product sales: Sales value of by-product is added to the
sales of the main product and profit or loss is computed by deducting the total cost from
the combined sales figures of main product and by product. By-product in hand, has no
value for Balance sheet purpose.

c. By-product value deducted from total cost: Sales value of by-product is deducted from
the total cost of the main product.

d. Selling and distribution expenses incurred for selling the by-product is deducted from
the sales value of the by-product and the net sales value is deducted from the total cost
of the main product.

e. Subsequent costs and the selling and distribution cost of the by-products are deducted
from the sales value of by-product and the net amount so arrived is deducted from the
total cost of the main product.

f. Reverse cost method: Net estimated cost of the by-product is calculated by deducting
from its sales value, the following:
- estimated profit on by-product,
- selling and distribution expenses of by product and
- costs incurred for further processing of by-product after the split-off point.
The estimated cost of the by-product is credited to the main product a/c to find out its cost.
1. The Kerala Chemical Ltd. Is engaged in the production of a Chemical X and in the
course of manufacturing, a by-product Y is produced, which after a separate process has
a commercial value. For the month of July 2016, the following are the summarised
costing data.
Joint expenses (Rs.) Separate expenses (Rs.)
X Y
Material 19200 7360 780
Labour 11700 7680 2642
Overhead 3450 1500 544
 The output of the month was 143 tonnes of X and 49 tonnes of Y and the selling price of
Y is Rs.280/tonne. Assume that profit on Y is estimated at 50% of the selling price,
prepare an account showing the cost of X /tonne.

2. Prepare an account showing the cost per kg of the main product Alpha and by-product
Beta from the following.
Joint expenses (Rs.) Separate expenses (Rs.)
Alpha Beta
Material 10000 6000 500
Labour 7000 5000 2000
Overhead 2500 1500 600

Quantities produced during the period: Alpha - 100 kgs Beta – 50 kgs
The selling price of Beta was Rs.120/kg on which the profit earned was estimated at 30%.
3. In manufacturing the main product A, a company processes the resulting waste material
into two by product B1 and B2. Using revise costing method of by-products, prepare a
comparative profit and loss statement of 3 products from the following data.
Total joint cost up to separation point was Rs.68000
A B1 B2
Sales( all production) 164000 16000 24000
Cost after separation - 4800 7200
Estimated net profit % on sales - 20% 30%
Estimated selling expenses as % of sales value 20% 20% 20%

Cost methods: Following are the main cost methods

a. Replacement cost (opportunity cost) method: The by-product is valued at a cost
which would have been incurred had it been purchased from outside. This method is
followed when the by-product is used as input in the production process. Opportunity
cost is that cost which would have been incurred by the company had the by-product
been purchased from an outside supplier.

b. Standard cost method: By-products are valued at a standard rate determined for each
by product and credited to process account. The standard cost may be on technical
estimates or the average price over a period of time. The standard cost should be revised
now and then to give effect to change in actual cost.

c. Joint cost method: By-products are given due recognition and joint cost is apportioned
among joint products and by products using physical unit or market value method.
 Equivalent production

The problem of work-in-progress in process industries is very important. In a continuous

process, there must be some WIP at the beginning and at the end of a period and the degree
of completion of closing WIP may be different from degree of completion of opening WIP.
The problem in valuation of WIP can be solved by calculating Equivalent production. It
represents the production of a process expressed in terms of completed units.

Equivalent production = actual no of units in process of manufacture X percentage of work

completed

Steps in equivalent production

- Compute the equivalent production of opening WIP by taking into account the
degree of work to be done on it during that current period.
- No of units introduced and completed during the current period will be computed by
deducting the closing WIP from the units introduced in the process during the
current period.
- Equivalent production of closing WIP is ascertained by taking into account the no of
units of closing WIP and the degree of work completed on them.
- Equivalent production calculated as above, will be aggregated to ascertain the total
output in terms of equivalent production or equivalent units

1. In process X 1000 units were introduced. The normal loss was estimated @ 5% of
input. At the end of the month 230 units were incomplete. Finished units were 720.
The stage of completion is as follows: Calculate equivalent production units.

Material 75% complete

Labour 50% ”
Overhead 50% ”

2. In process P 1000 units were introduced. The normal loss was estimated @ 10% of
input. At the end of the month 300 units were incomplete. Finished units were 550.
The stage of completion is as follows:

Material 75% complete

Labour 50% ”
Overhead 50

Calculate equivalent production units.

3. Input of materials – 10000 units. Normal loss was estimated @ 8% of input. Closing
WP was 900 units, material 70% complete and labour and overheads 30% complete.
8700 units were transferred to next process. Compute equivalent production.
 4. The following data are available in respect of Process A for the month of April 2016.

Opening WIP 900 units

Degree of completion Material 80%, Labour and OH
60%
Input of materials during the 6000 units
month
Closing WIP 700 units
Degree of completion Material 70%, Labour and OH
60%
Units transferred to next process 6200 units
Compute equivalent production for the month of April 2016.

Inter-process profits

In process costing, the usual practice is to transfer the output of each process to the next
process and from the last process to the finished stock account at actual cost price. But in
some of the manufacturing concerns, the transfer of output from one process to another and
from last process to finished stock account, is made at cost plus a certain percentage of
profit which is known as transfer price or inflated price. But it may create accounting
problem. Therefore, inter process profit included in the stock should be eliminated as this
profit is not yet realised. The cost of stock in each process and finished stock account shall
be calculated as follows:

Cost of stock = Total of cost column x value of stock

Total of total column

The element of unrealised profit included in the value of stock shall be ascertained as
follows:

Amount of unrealised profit = Value of stock – Cost of stock

The amount of unrealised profit shall be debited to P&L A/c and credited to Reserve for
Unrealised Profit in order to ascertain the actual process profit. Thus the actual amount of
profit can be calculated as follows:

Actual profit = Apparent profit from process – Unrealised profit included in closing
stock
1. A product passes through two processes A and B, output of process A is transferred to
process B at cost plus 25% profit and the output of process B is similarly transferred to
finished stock account at cost plus 25% profit. The following information was further
available:
Process Process
A B
Materials 8000 24000
Wages 12000 16000
Closing 4000 12000
stock
( valued at
prime cost)
Out of the finished stock, a portion remained at hand valued at Rs.18000 and the
balance sold for Rs.58000. Prepare the process and finished stock account. Also
calculate the amount of reserve that should be made in respect of unrealised profit.

2. A product passes through 3 processes A, B and C. the output of process A and B is

charged to the next process to give a profit of 25% on cost, while the output of process C
is charged to finished stock account which gives process C at a profit of 25% on cost.

Process Process Process

A B C
Materials 14000 21000 7000
Wages 21000 14000 28000
Closing 7000 14000 21000
stock
Out of the finished stock, a portion remained at hand valued at Rs.14000 and the
balance sold for Rs.126000. Prepare the process and finished stock account. Also
calculate the amount of reserve that should be made in respect of unrealised profit.

3. Prepare inter process accounts.

Particulars Process Process Finished

1 2 stock
Opening stock 3000 3600 9000
Direct materials 6000 6300 Nil
Direct wages 4480 4500 Nil
Production OH 4200 1800 Nil
Closing stock 1480 1800 4500
Inter process profit Nil 600 3300
for opening stock
Output of process 1 is transferred to process 2 at 25% profit on transfer price and output
of process 2 is transferred to finished stock at 20%profit on transfer price. Sales were
Rs.56000. you are required to prepare process accounts and finished stock account.
4. There were 3 process. Output of process 2 is transferred to process 3 at 25% profit on
transfer price. Stock in process is valued at prime cost and finished stock has been
valued at price at which it is received from process 3.

Particulars Process Process Process Finished

1 2 3 stock
Opening stock 2500 13000 11000 26500
Direct materials 14000 22000 44000 Nil
Direct wages 10000 11000 55000 Nil
Production OH 12000 27500 28000 Nil
Closing stock 6000 6500 34000 35000
Profit on cost of 20% - 10% -
each processes
Inter process Nil 2000 3000 12000
profit for opening
stock

Sales during the period were Rs.900000. Prepare process accounts and finished stock
account
 TRANSFER PRICING

Meaning
In decentralised organisations, very often goods/services which are output of one division
may be transferred to another division as input for better control. In such a case there is a
need to set a price for the goods/services sold or transferred. Such a price which applies
solely to transactions between divisions within an organisation is called a transfer price. In
other words, it is the price that one sub unit( segment, department, division and so on) of an
organisation that charges for a product/service supplied to another sub unit of the same
organisation as it is only an internal transfer and not sale. Transfer price becomes a cost to
the buying division and a revenue to the selling division.

Objectives of transfer pricing

1. To evaluate current performance and profitability of each individual unit: When goods
are transferred from one department to another, the revenue of one department becomes
the cost of another and such inter transfer price affects the reported profit. It also can be
used to arrive at a valid measure of divisional profit for performance valuation purpose.
2. To assist in decision making: Correct transfer price will make the cost of both the units
realistic in order to take decisions relating to such problems as make or buy, sell or
process further, choice between alternative methods of production etc.
3. Full capacity utilisation: There may be certain divisions that have spare capacity. Such
divisions should be motivated to utilize their balance capacity in an optimal manner. The
focus is to optimise the profits of a firm over a short period of time, by stressing on
maximum utilisation of plant capacity.
4. To allocate the profits of a multi-national business: It can be used to allocate the profits
of a multi-national business to division operating in a particular country.
5. For accurate estimation of earnings on proposed investment decisions: When finance is
scarce and it is required to determine allocation of scarce resources to various divisions
of the concern, this technique is useful.

Criteria for setting transfer price

1. Goal congruence: Transfer prices should help in achieving the company’s goals and
objectives as a whole, thereby promoting goal congruence between divisions and
company as a whole.
2. Management effort: Transfer price should aid in accomplishing company’s strategies
and in the promotion of management efforts to achieve the same.
3. Segment performance evaluation: The TPS should facilitate the evaluation of
performance of individual sub-units and their respective heads.
4. Sub-unit autonomy: TP should promote autonomy of the sub-units in decision making
ie, to transact with outside agencies or with other sub-units of the company to maximise
their profits. Divisional autonomy should not be undermined.
 5. Motivation value: TPS should provide information that motivate divisional managers to
make good economic decisions

Methods of transfer pricing

There are various transfer pricing methods in use based on either (a) cost, (b) market
[Link] following are the important types of intra-company transfer price.

1. Cost price
According to this method, goods and services are transferred from one segment of the
company to another on the basis of unit cost of production of the transferring division. The
cost could either be taken to be the actual cost of production or the standard cost of
production. The advantage of these methods of transfer pricing is that it is very simple and
convenient to operate. But, it distorts the profit of the various responsibility centres in the
sense that the profit of the transferring centre shall be underestimated and that of the centre
to which transfer is made would be overestimated. In fact, this method of transfer pricing is
inappropriate for profit centre analysis.

2. Cost plus a normal mark-up

To overcome the short comings of the simple cost price method, many companies add to the
cost a margin of profit, say 15% of the cost, to determine the transfer price. Thus, in this
method, the buying division is charged the actual unit cost of production of the transferring
department. What so ever it may be, plus a mark-up for the profit. The merit of this method
is simplicity and convenience, but this methods is also not an appropriate method for profit
centre analysis as the inefficiencies of one department along with their costs are transferred
to another department.

3. Incremental cost
Another method of transfer pricing in use by certain companies is the incremental cost of the
transferring division. Incremental cost can be computed in two ways depending upon the
circumstances. In case entire production is transferred to another division within the same
company, the increment cost will be the total of variable cost of transferring centre plus any
fixed costs which are directly attributable to that centre/division. The incremental cost so
calculated suffers from the same defects as that of cost price method. The second approach
may be used when goods and services are sold to outside customers as well as transferred
within the same company. In such a case, incremental cost may be taken as the opportunity
cost in the form of loss of revenue which the transferring division would have charged from
the outside customers. The second approach is similar to the market price basis and is more
useful for profit-centre analysis.

4. Shared profit relative to the cost

According to this method no price is charged for the intra-company transfers. Rather out of
the total sales revenue of the company the aggregate cost of various divisions is deducted to
find out the profit for the company as a whole; and then the profit is shared by the various
profit centres relative to the cost basis of each centre. Thus, in this method profit is shared
according to the cost of each division. The drawback of this method is that in efficiencies
are not evaluated, and hence, it is not an appropriate method for profit centre analysis.
5. Market price
In this method, the prices charged for intra-company transfers are determined on the basis of
market prices and not on the cost basis. There are three ways of computing the market price.
Firstly, the prevailing market price, after making adjustment for discounts and other selling
costs, may be taken as transfer price if there is an active market for goods and services
transferred between divisions of the same company. The main advantage of this method is
that it protects the profitability interest of both the divisions as the buying division is
charged what it has to otherwise pay to the outsiders, and the transferring division gets the
price which, in any case, it would have obtained from outsiders. Further, selling and
distribution costs as well as costs of bad debts are reduced and the transferring department
gets an assured market, whereas, the buying division is assured of regular and timely
deliveries. Secondly where active market-does not exist or where market price is not
available, cost plus a normal profit may be taken as a reasonable market price. But, then,
inefficiencies of one division will be transferred to another division. Thirdly, the company
could invite bids from the market so as to determine the market price. The lowest bid may
be accepted as the market price for the transfer; however, the problem may arise because of
false bidding or no bidding at all.

6. Standard price
Transfer prices can also be fixed on predetermined standard price basis. The standard price
may be determined on the basis of cost production and the prevailing market conditions.
Thus, division working at less than the desired efficiency will show lesser profits as
compared to the efficient division. However, difficulties may arise in fixing the standard
price agreeable to the different divisions.

7. Negotiated price
The intra-company transfer price can also be determined on the basis of negotiations
between the buying and the transferring division. Here determination of transfer price is
based on active participation, involvement, co-ordination and agreement of managers of
transferring and buying divisions. The price will be the mutually agreed price. Such as
pricing method will be advantages to both the divisions as well as the company as a whole.
However, this method could be used only when both the buying as well as transferring
divisions has alternative choice available with them.

Advantages:
- The buying division may purchase from outside sources, if the outside prices are lower than
internal division’s price.
- Buying and selling divisions are completely free to deal outside the company. This promotes
sub-unit autonomy and motivated managers.
- Managers can determine the appropriate transfer prices that satisfy the requirements of the
divisions and is in the best interest of the company as a whole.

Limitations:
- The agreed transfer price may depend on the negotiated skills and bargaining powers of the
managers involved. The final result may not be always optimal.
- Rather than agreement on transfer price, negotiations can lead to conflict between divisions
and may require top-management mediation.
- Negotiations are time-consuming for managers involved, when the number of transactions
and inter-dependencies are large.
8. Dual or Two-way Price
According to this method, the transferring division is allowed to give credit price, whereas,
the buying division is charged at a different price. It enables better evaluation of profit
centres and avoids conflicts among them on account of transfer prices. However, the total
profits of the various segments would differ from the actual profit of the company as a
whole. But, it poses no problems for the company as transfer prices are meant for internal
purposes of performance evaluation only.

Practical problems
1. A company fixes the inter-divisional transfer prices for its products on the basis of cost
plus an estimated return on investment in its divisions. The relevant portion of the
budget for the Division A for the year 2019-20 is given below.
Particulars Amount
Fixed assets 5,00,000
Current assets other than debtors 3,00,000
Debtors 2,00,000
Annual fixed cost for the division 8,00,000
Variable cost per unit of product 10
Budgeted volume of production per year (units) 4,00,000. Desired return on investment
28%. You are required to determine the transfer price for Division A.