Short Notes on important topics
TOPICS
Ch-1 Cost concepts and classification of cost: 1. Direct expenses
2. Pre – requisites for computation of accounts. 3. Installation of a cost system
4. Uniform costing 5. Profit centre
6. Supply chain analysis 7. Cost control
8. Cost reduction 9. Cost centre 10. Cost unit 11. Relevant cost
Ch-2 Material accounting: 1. Material transfer note 2. ABC analysis
3. Economic Order Quantity (EOQ) 4. Obsolescence in material accounting. 5. Perpetual inventory system
6. Treatment of scrap in cost accounting 7. VED analysis
8. Scrap, spoilage and defectives in engineering industries. 9. Just in Time Analysis.
10. FSND Analysis.
Ch-3 Labour accounting:
1. Labour turnover and its avoidable and unavoidable causes. 2. Job evaluation
3. Incentives to indirect worker 4. Accounting of idle time 5. Idle time
6. Idle capacity 7. Work measurement 8. Motion study
Ch-4 Overheads:
1. Administration overheads
2. Under and over absorbed overheads 3. Depreciation and obsolescence
Ch-5 Job /Batch /Contract costing: 1. Profit on incomplete contracts 2. Batch costing
3. Cost- plus- contract
4. Escalation clause in contract costing
Ch-6 Process costing, Joint and By products: 1. Equivalent production
2. Split off point 3. Joint cost 4. By product
5. Reverse cost method in by product cost accounting 6. Fundamental principle of process costing.
7. Inter process profit.
Ch-7 Operating costing:
1. Activities of operating costing
Ch-8 Integrated accounting system: 1. Integrated accounting system 2. Interlocking accounts
Ch-9 Reconciliation of cost and financial accounts: Ch-10 Marginal costing:
1. Margin of safety 2. Profit volume ratio 3. Break Even Analysis 4. Differential cost analysis 5. Angle of incidence
6. Differential cost in decision making 7. Relevant cost
8. Application of marginal costing in price fixing 9. Sensitivity analysis
10. Cost- plus- pricing
11. Marginal costing for decision making 12. Cost volume profit analysis
13. Managerial decision making 14. Absorption costing
3. Activity based costing 4. Activity based accounting 5. Cost driver
Ch-12 Budgetary control: 1. Principle budget factor 2. Flexible budget
3. Flexible budgeting
4. Budgetary control and its objectives 5. Zero base budgeting
6. Budget manual 7. Fixed budget
Ch-13 Standard costing: 1. Standard cost /costing 2. Budgeted cost
3. Labour rate variance 4. Labour efficiency variance 5. Ideal standard
6. Average standard 7. Attainable standard 8. Variance analysis
9. Fixed production overhead variance 10. Sales value volume variance
Ch-14 Transfer pricing:
1. Limitation of market based transfer pricing 2. Transfer pricing methods
Ch-15 Uniform costing / Inter firm comparison: 1. Inter firm comparison
“
A
” 1. Activity based costing:Activity Based Costing is a method of apportionment of indirect costs to products. The conventional method of apportionment of overheads to the products on the basis of either material cost or labour cost has been found to be inappropriate in many cases. ABC is a better but costlier method of apportionment of overheads. It is more rational but requires more time and resources.
In Activity Based Costing, the indirect costs are apportioned to the product on the basis of various activities which are used to produce the product.
The objectives of Activity Based Costing are discussed below:
To remove and refine the traditional costing system and bring more accuracy in the computation of costs of products and services.
To help in decision making by accurately computing the costs of products and services.
To identify various activities in the production process and further identify the value adding activities.
To distribute overheads on the basis of activities.
To focus on high cost activities.
To identify the opportunities for improvement and reduction of costs.
To eliminate non value adding activities.
Limitations:
Activity Based Costing is a complex system and requires lot of records and tedious calculations.
For small organizations, traditional cost accounting system may be more beneficial than ABC due to the simplicity of operation of the former.
Sometimes it is difficult to attribute costs to single activities as some costs support several activities.
There is a need of trained professionals who are limited in number.
This system will be successful if there is a total support from the top management.
Substantial investment of time and money is required for the implementation of this system.
1. Activity based Budgeting:
A budget is prepared in terms of money or quantities or both before the actual event.
Budget helps in planning for the future. It also helps in controlling as there is a continuous comparison of actual with budget. Any deviation between the two is identified for taking suitable action. Activity Based Budgeting involves identification of activities and dividing them in value adding and non value adding activities. The non value adding activities are eliminated in due course of time. Activity Based Budgeting, thus requires identification of activities of the organization, establishing the factors which cause costs, the cost drivers and then collecting the costs of the activities in cost pools. It uses the activity analysis to relate costs to activities. Identifies. It identifies cost improvement opportunities.
2. Activity Based Accounting:
and reporting of activity related costs rather than costs related to departmental or cost centers. It involves several activities like Activity Based Budgeting, Activities based Cost management based on activities, performance measurement of activity, reducing the costs through elimination of non value adding activities and also initiating innovative measure for reduction of costs.
3. Activity based Management:
The basic purpose of management is to ensure the optimum utilisation of resources in an effective and efficient manner. The ABM is a tool of management that involves analyzing and costing activities with the goal of improving efficiency and effectiveness. ABM focuses on managing the activities themselves. In Activity Based Costing resources are traced to the activities for the purpose of computing the costs while in Activity Based Management, resources are traced to activities for evaluation of the activities themselves. In other words, efforts are made to improve the activities further. Thus ABM is a set of actions that management can take to improve performance and profitability.
4. Angle of Incidence:
The angle between total cost line and sales line is known as Angle of Incidence. It indicates the rate of profit. If this angle is higher it is presumed that rate of profit on sale is higher. It can be easily seen that the angle of incidence can be raised either by raising the slope of sales line or by lowering the slope of total cost line or by both. (You must show it by drawing the break even chart. See also break even chart in subsequent chapters.)
5. Application of marginal costing in price fixing:
It is a general principal that the price should cover the total cost (Marginal costs + Fixed costs) as well as desired profit. In a competitive market, price is not determined by the individual concern but by the market forces. Thus, costing (particularly Marginal Costing) is helpful in price determination only in short term and monopoly conditions. The various aspects price policy are:
1. Normal Price : Price in the long-term should be as much as to cover total cost and desired profit. Thus the normal price should be: Normal Price = VC + C
2. Minimum Price : Normal price may not be useful (i) for new products (ii) when competition is high and the competitors are cutting prices (iii)proposition. In such situations, a manufacturer is generally faced with a problem of what should be the minimum price. Hence he must fix a price, which must cover at least total cost. This is known as Minimum Price.
Minimum Price = VC + F
3. Quotation Price or Depression Price : Under some special circumstances price may be fixed at below cost too. One situation may be to meet out severe competition in Quotation Pricing. Such price must cover all variable costs and should yield some amount of contribution. Similarly, during depression, slump or trade recession, goods cannot be sold at normal price or minimum price due to lack of demand. If no sales are made, fixed cost may not be recovered and loss will be equal to fixed costs. Under this situation too, profitability can be improved by fixing a price equal to variable cost plus some portion of fixed overheads.
4. Special Price (Accepting Special Offer / Order/ Exploring New Market): Sometimes
price below costs. Normally, such offer should be rejected, because total cost will not be recovered. But if there is sufficient unutilized capacity and special offer may be met by producing extra units without increasing the existing total capacity, then decision should be based on the marginal cost rather than total cost, because extra production would not involve any increase in fixed cost; only the marginal costs of extra units of production become relevant point to be considered. The guiding principle is:
When price > Marginal Cost, accept the order. When price < Marginal Cost, reject the order.
5. Price Changes : In connection with profit planning, quantity sold, marginal cost, fixed cost and price are pillars of profit and profitability. Price changes may involve hike in price as well as reduction in price. In both the cases, quantity sold will also be affected depending upon the degree of elasticity of demand for production, which in turn may affect the profit position. Therefore, a careful analysis of the possible change in demand must be made and its probable impact on profit should be estimated through the techniques of marginal costing.
6. Absorption costing: Under absorption costing:
1. Costs are classified as direct and indirect, direct costs are those costs which can be directly attached or identified with the product and hence charged directly. Indirect costs i.e. overheads are first identified and collected and then apportioned to the product units on some suitable basis.
2. The closing stock of finished goods under absorption costing is valued at total cost, i.e. fixed and variable.
3. The fixed overhead absorption may create some problems like over/under absorption. This happens because of the overhead absorption rate which is pre determined.
4. Due to the inventory valuation, which is done at the full cost, the costs relating to the current period are carried forward to the subsequent period. This will distort the cost of production. 5. The total cost of production is charged to the product without distinguishing between the fixed
and variable components. The selling price is thus fixed on the basis of total costs.
7. Administration overheads:
Administration cost is the cost of running the administration of a firm.. Though these functions are not directly related to production, selling and distribution, they facilitate these functions. The expenditure incurred for carrying out these functions is called as ‘Administration Overheads’. Examples are, general office expenses, office salaries, office lighting, audit fees.
TREATMENT IN COST ACCOUNTS:
There are three methods of treatment of administrative overheads in cost accounts:
2) Apportionment to manufacturing and selling divisions: Under this method, administration overheads are divided between manufacturing and selling divisions on some suitable basis. The main logic behind this method is that, many experts believe that there are only two functions of a business firm and these are production and selling and other functions like administration are auxiliary functions. Therefore the administration overheads should be merged with manufacturing and selling divisions. The ultimate effect of this method is that the administration overheads lose their identity. The main criticism of this method is that administration is an equally important function of an undertaking and its merger with other functions on some basis does not show the correct picture. Similarly as the administrative overhead lose its identity; it is difficult to control the same.
3) Separate functional element of cost: Under this method, administration overhead is considered as separate charge to the cost to make and sell. The assumption under this method is that administration is a separate function. Accordingly, the cost of sales analysis sheet is prepared to show the manufacturing cost and is ultimately charged to the particular job or order.
CONTROL OF ADMINISTRATION OVERHEADS: Administration overheads are mostly fixed in nature. They can also be termed as ‘policy cost’ as they arise out of a policy. Due to these reasons, the administrative costs are fixed in nature and are uncontrollable. However control on these costs can be exercised through preparation of budgets and use of standard costing. A budget can be developed for these costs and actual costs can be compared with the budget. Responsibility accounting principles can also be followed to control these overheads.
8. ABC Analysis : (also called Pareto analysis)
Normal principal of inventory control is that the cost of control should not be more than the cost of the item itself. ABC analysis is a method of inventory control where attention is given to items according to their value and not as per their quantities. It is not a control technique but it provides a sound basis to decide where more control is required.
It is based on the principle of '' vital few, trivial many' or 'high value low volume'. In this technique, the items of inventory are classified according to the value of items. Materials are classified as A, B and C according to their value.
The ‘A’ items constitute roughly about 5-10% of the total items while its value may be about 80% of the total value of the inventory.
Items in class ‘B’ constitute intermediate position. These items may be about 20-25% of the total items while the usage value may be about 15% of the total value.
Items in class ‘C’ are the most negligible in value, about 65-75% of the total quantity but the value may be about 5% of the total usage value of the inventory.
The numbers given above are just indicative, actual numbers may vary from situation to situation. The principle to be followed is that the high value items should be controlled more carefully while items having small value though large in numbers can be controlled periodically.
The ABC analysis resembles to Pareto analysis of Vilfredo Pareto of Italy, who observed that the 80% of total wealth is in the hands of 20% of the people.
Advantages of ABC analysis :
1. Gives an idea of selective control so that effort can be concentrated only where it is required. 2. It reduces clerical and administrative costs or expenses of managing inventory.
For A Class items : (i) very strict control (ii) very low safety stock (iii) controlled by senior manager. For B Class items ;(i) Moderate control (ii) some safety stock (iii) controlled by middle level of management. You can write for C class items.
Accounting treatment of Idle Time costs: Please see Idle time.
“B
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1. Batch costing:
Batch costing is used where units of a product are manufactured in batches and used in the assembly of the final product. Thus components of products like television, radio sets, air conditioners and other consumer goods are manufactured in batches to maintain uniformity in all respects. Batch number is given to each batch manufactured and accordingly the cost is worked out. A batch cost sheet is prepared to show the total cost of the batch. One of the important aspects of batch type production is to decide the batch size. If product is produced in large quantities, the impact of the setting up cost will be lower as the setting up cost is fixed per batch. But on the other hand if the production quantity is large, the inventory carrying cost will be high as more inventory will have to be carried over in the store. The carrying cost of the inventory includes cost of storage, risk of pilferage, spoilage, obsolescence and interest on the investments blocked in the inventories. Therefore the size of the batch should not be either too small or too large. On the basis of a tradeoff between large size and small size, an appropriate size of the batch should be decided. This batch size is known as Economic Batch Quantity.
Where, A =Annual requirements of the product S =Setting up cost per batch
C =Carrying cost per unit of inventory per annum.
2. By product:
The term ‘ products’ is sometimes used synonymously with the term ‘minor products’. The by-product is a secondary by-product, which additionally results from the manufacture of a main by-product. By products are also produced from the same raw material and same process operations but they are secondary results of operation. The main difference between the joint product and by- product is that there is no intention to produce the by-product while the joint products are produced intentionally. The sales value of bye products are considerably less than the that of main product.
3. Budget manual:
A budget manual is the list of directions given for the preparation and presentation of budgets of all categories. It also contains the accountability and responsibility of the persons involved in preparation and presentation of budgets.
The budget manual thus is a schedule, document or booklet, which contains different forms to be used, procedures to be followed, budgeting organization details, and set of instructions to be followed in the budgeting system. It also lists out details of the responsibilities of different persons and the managers involved in the process.
A typical budget manual contains the following:
Internal lines of authorities and responsibilities.
Functions of the budget committee including the role of budget officer.
Budget period
Principal budget factor
Detailed program of budget preparation
Accounting codes and numbering
Follow up procedures.
4. Budgetary control:
The written form of forecasts made in respect of various functional activities of a business is called budget. When this budget is used to evaluate the actual performance or results, it is termed as ‘Budgetary Control’. If we view the control function as to involve fixing targets, recording actual and continuous comparison of actual with targets with a view to report for action.
Characteristics of budgetary control are:
a. Preparation of budgets either in physical terms and/or monetary terms in respect of production, sales, distribution and finance in pursuance of goals, objectives, etc. set by the management. b. Comparison of actual results with the budgeted results. The difference between the two is
invariably called as ‘budget variance’ and a report styled as ‘Budget Performance and Variation Report’ is generally prepared and submitted.
c. Revision of budgets in the light of changed circumstances. d. Institutions of corrective and remedial actions.
Objectives of budgetary control are: i. To control departmental activities.
ii. To help in systematic planning of production and in formulation of policies and provide basis of judgment to executives.
iii. To determine from time to time the amount of money needed for production.
iv. To control direct and indirect expenses by limiting the changes of wastage and by limiting the allowable expenses for different departmental heads.
v. To compare the pre-planned targets with the amount of actual expenses. vi. To control the income and expenses of production functions.
vii. To pre-determine the capital expenditures of the concern. viii. To control research and development activities.
ix. To provide machinery for centralized control, where decentralized function is essential.
x. To determine the responsibility of departmental heads or executives and to make them efficient.
5. Break Even Analysis:
Break even analysis attempts to study the revenue and costs in relation to sales volume of a business unit and to determine that point where sales revenue just equals to total cost. This level of activity is generally termed as Break Even Point (BEP). Production level below the BEP will result into loss, while production above BEP will result in profits.
Break Even point can also be shown on the graph paper as follows:
Explanation: On horizontal axis, production and sales volume is shown while on the vertical axis, sales and costs in amount are shown.
Assumptions of Break Even Point: The concept of break even point is based on the following Assumptions:
Production and sales are the same, which means that as much as is produced is sold out in the market. Thus there is no inventory remaining at the end.
Fixed cost remains same irrespective of the production volume.
Variable cost varies with the production. It changes in the same proportion that of the production. Hence it has a linear relationship with the production. In other words, variable cost per unit remain the same.
Selling price per unit remains same irrespective of the quantity sold.
Limitation of Break Even Point:
It helps in decision making regarding production level however this is based on the assumption that the variable cost per unit, sales price per unit and the fixed cost remains the same. If there is any change in these variables, the BEP will give misleading results.
“c
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1. Cost Driver:-
disposed off in time, the reason being the staff in the stores is not trained properly in this area. Managers have to address this cost driver to correct the root cause of this problem and take proper action. Activity Based Costing is based on the belief that activities cause costs and therefore a link should be established between activities and product. The cost drivers thus are the links between the activities and the cost.
Some functions and their cost drives are as follows :
1. R & D : (i) no. of projects (ii) persons in projects or (iii) hours in project. (You may think some more)
2. Marketing : (i) no. of advertisements (ii) no. of samples distributed (iii) no. of sales executives 3. Customer service : (i) no. of customers visited (ii) no. of deliveries (iii) hours spent with him.
2. Cost volume profit analysis:
Cost volume profit analysis is an attempt to measure the effect of changes in volume, cost, selling price and product mix on profits. Marginal costs are closely connected with volume and vary directly and proportionately with variations in volume. On the other hand, fixed costs remain constant and are not affected by the change in volume of production. Thus, the amount of profit on the sale of a product depends upon volume of production and its costs. When an effort is made to establish this relationship, that process is known as “Cost Volume Profit Analysis”.
3. Cost plus Contracts:
This type of contract is generally adopted when the probable cost of contract cannot be ascertained in advance with reasonable accuracy. In this type of contract, the contractor receives his total cost plus a profit, which may be a percentage of cost. These types of contracts give protection to the contractor against fluctuations in profits as he is guaranteed about his profit irrespective of the actual costs. However in order to avoid any dispute in future, it is always advisable to specify the admissible costs in advance.
This type of contract is usually made for (i) production of specifically designed aircraft, ship etc (ii) for urgent works (iii) for defense works.
Salient features of cost plus contracts:
1. Suitable where estimates of material and labour can not be estimated with reasonable accuracy.
2. Suitable when contract is likely to take long duration to complete;
3. Suitable when prices of material, labour and other components of contract are not steady and predictable.
4. The client is allowed to inspect and scrutinize the books, records and other documents of the contractors at all times.
Advantages :
1. The work can be started immediately without any formal agreement between the two. The drawings, designs and other specifications may be decided at a later stage.
2. Very handy in case of emergency where cost is not very important like floods, epidemics, time bound commitments etc.
3. Big documentation is not required. Disputes regarding escalation of prices do not arise. Disadvantages :
2. Contractor does not care about the costs rather he is more interested that the total cost should go up as his commission is based on the amount spent by him.
3. The final designs are not ready, changes in drawings may occur in any stage resulting in more costs and time delays.
4. Cost Allocation:
Allocation is the process by which cost items are charged directly to a cost unit or cost center. For example, electricity charges can be allocated to various departments if separate meters are installed, depreciation of machinery can be allocated to various departments as the machines can be identified with the departments. Thus allocation is a direct process of identifying overheads to the cost units or cost center. Cost allocation is also known as cost assignment, cost identification or cost allotment.
5. Cost
Apportionment:-Wherever possible, the overheads are to be allocated. However, if it is not possible to charge the overheads to a particular cost center or cost unit, they are to be apportioned to various departments on some suitable basis. This process is called as ‘Apportionment’ of overheads. For example, if separate meters are provided in each department, the electricity expenses can be allocated to various departments. However if separate meters are not provided, electricity expenses will have to be apportioned to the departments on some suitable basis like number of light points. A statement showing the apportionment of overheads is called as ‘Primary Distribution Summary’ of overheads.
6. Cost center:
A cost center is nothing but a location, person or item of equipment for which cost may be ascertained and used for the purpose of cost control. Cost Center is defined as, ‘a production or service, function, activity or item of equipment whose costs may be attributed to cost units. The main object of identifying a cost center is to facilitate collection of costs so that further accounting will be easy. A cost center can be either personal or impersonal, similarly it can be a production cost center or service cost center. A cost center in which a specific process or a continuous sequence of operations is carried out is known as Process Cost Center.
7. Cost unit:
Cost unit may be defined as “a quantitative unit of product or service in relation to which costs are determined”.
This ascertainment is done through means of costing process viz. allocation, apportionment and absorption. Cost unit differ from industry to industry. It can be expressed as cost per thousand bricks, cost per passenger- kilometer, cost per patient, cost per ton etc.
8. Cost control:
Cost control implies various actions taken in order to ensure that the cost do not rise beyond a particular level
It means keeping the expenses within limits or control. Cost control has the following features:
Cost control is a continuous process. It involves setting standards and budgets for deciding targets of different expenses and constant comparison of actual the budgeted and standards.
It also involves, timely cost control reports showing the variances between standard and actual performance.
Motivating and encouraging employees to accomplish budgetary goals is also one of the essential aspects of cost control.
Actually cost control not only means monetary limits on cost but it also involves optimum utilization of resources or performing the same job at same cost.
9. Cost Reduction:
Cost Reduction refers to permanent reduction in cost of a product or service without impairing the quality and affecting its purpose for which it was intended to be used. In the competitive market situations, it is utmost important for the organizations to look for activities and search for new technology through research & development activities that can reduce the cost of a product. The goal of cost reduction can be achieved in two ways, first is reducing the cost per unit and the second one is increasing productivity. Reducing wastages, improving efficiency, searching for alternative materials, and a constant drive to reduce costs, can effect cost reduction.
1.
Difference between cost control and cost reduction :
Particulars
Cost Control
Cost Reduction
Meaning Cost should not go beyond certain
point, limit or standard.
It is permanent decrease in the unit cost of goods and services, without reduction in quality.
Emphasis Past performance is the standard
from which control will be measured.
Present performance is the standard from where reduction in future will be achieved. Past performance is not considered.
Approach Set norms are generally followed. New norms are identified.
Focus It is short term review with focus
on controlling or reducing cost in a particular period.
It is long term approach with focus on permanent reduction in cost per unit.
Function It is corrective function. It is preventive function.
“d”
2. Differential Cost Analysis: (See also relevant cost)
When decision is required among many alternatives, differential cost analysis is good tool to help the manager to take decision. In this analysis, all the costs related to a particular option, are taken, added up and compared. Normally, the option giving the minimum total cost is selected for adoption. With reference to level of output, differential cost is the difference in total costs for two levels of output. When a decision has to be made involving increase or decrease of n units of output, the difference in costs between two policies may be considered to be the cost really incurred on account of these n units of business. This may be called the differential costs of a given amount of business. It is important in decision making when:
the decision requires introduction of a new line or increase in level of activity with the increase in plant capacity.
the decision is of long term nature.
The differential cost analysis is not relevant cost analysis. If the salary of manager is same in all the options, it will become irrelevant in relevant cost analysis. All items which are same among the alternatives are not considered in relevant cost analysis. On the contrary, all related items are considered in differential cost analysis whether they are same or not same, among the alternatives. It may be noted that differential cost analysis and relevant cost analysis will favour the same option.
3. Depreciation and Obsolescence: (See also Obsolescence)
Depreciation is defined as “The decrease in the value of a fixed asset due to use and/or the lapse of time”. Depreciation arises due to the wear and tear of the asset and it is the result of two factors, i.e. usage and lapse of time. Generally, both the factors go together. There are several methods of calculating depreciation. Two main methods are given below;
i. Straight line method: The value or cost of asset is distributed equally over the life of asset. Here the rate remains fixed for each year. Value is total cost less residual value.
ii. Reducing balance method: Here the rate of depreciation is the same throughout, but depreciation is calculated on the balance of the assets remaining after charging depreciation each year.
Obsolescence is defined as “The loss in the value of assets due to some factors other than time''. The condition of the asset is good but it is no longer useful. Audio cassettes or video cassettes are some examples.
Causes of Obsolescence:
i. To bring into use a new and improved machine. So the old one is discarded.
ii. The product which a machine produces, may be in demand in the market. If that product is discontinued, the machine becomes obsolete.
iii. If it is thought to give a better design and get-up to the product due to change in fashion, or out of three products, viz., A,B,C it is decided to divert the resources of ‘C’ product to the production of ‘A’ and ‘B’ products, for reasons of economy, the machine producing unwanted product would become obsolete.
4. Direct expenses:
Direct expense represents that part of cost which is other than material and labour. It is basically cost of facilities or services which are used as helps to the production. These are also called 'chargeable expenses'.
Direct expenses are those expenses (other than material and labour) which can be directly associated with a particular job, process, service, cost center or cost unit. These expenses are also called as chargeable expenses. Examples of these expenses are cost of drawing, design and layout, royalties’ payable on use of patents, copyrights, Fees of architects etc. They form part of prime cost. They do not physically form part of the final product like material cost.
In a factory, expenses that can be directly linked to production department also can be clubbed as direct expenses. Examples are power and electricity charges based on the meter reading in the production department. These are absorbed into prime cost.
“e”
1. Escalation clause:
Escalation clause in a contract provides that if during the period of execution of a contract, the prices of materials, rates of labour or other items of contract rise beyond a specified limit, the contractor would be compensated for such rise in a predetermined manner.
In order to protect the contractor from the rise in the price, an escalation clause may be inserted in the contract. As per this clause, the contract price is increased proportionately if there is a rise in input costs like material, labor or overheads. The condition that may be laid down is that the contractor will have to produce a proof regarding the rise in the price.
The object of this clause is to protect the interests of both the parties, the contractor is protected against the price rise while the client is protect against the use of inferior quality of material when the price rises. However, the escalation clause does not cover that part of increase in costs which is caused due to inefficiency or wrong estimation.
Conversely, the de-escalation clause may also be provided for adjustment of price falls.
2. Equivalent production:
It may happen that at the end of a particular period, there may be some incomplete units in the process. Further the degree of completion of the opening work in progress and closing work in progress may be different. These incomplete units will create problems in finding out the cost per unit, as all the units will not have the same degree of completion. In such cases, the equivalent units will have to be worked out for the incomplete units. The concept of equivalent units states that 2 units, each complete 50% will be treated as equivalent to 1 completed unit. This concept will have to be implemented for solving the problem of incomplete units. For this, degree of completion will have to be ascertained for each element of cost, i.e. material, labor and overheads.
The following methods of pricing are used for valuing the equivalent units.
First In First Out Method [FIFO ] : In this method, the assumption is that the incomplete units from the opening stock are completed first and then the units introduced in the process are completed. The objective of the first in first out method is to value the inventory at the current costs.
Average Method: Process costs are sometimes computed on the basis of average costs. Where degree of completion of opening work in progress is not given, average method is used. The average process cost is obtained by adding the cost of opening work in progress in the cost of units introduced in the process during the current period and dividing this total cost by total equivalent units obtained by adding the number of units completed and equivalent units of the closing work in progress of each element, material, labor and overheads. The main object of average method is to even out the fluctuations in prices and hence is used when the prices fluctuate widely during a particular period.
Weighted Average Method: If a manufacturing unit is manufacturing two or more products, which are quite dissimilar to each other, weighted average method is used. Under this method, weighted average is computed and used in valuation of the incomplete units.
3. Economic Order Quantity (EOQ):
to incur certain costs at the time of order. These costs include costs like handling and transportation costs, stationery costs, costs incurred for inviting quotations and tenders etc. The more is the frequency of order, the more are these costs.
On the other hand, there are certain costs that are called as carrying costs. The cost of carrying the inventory is the real out of pocket cost associated with having inventory on hand, such as warehouse charges, insurance, lighting, losses due to handling, spoilage, breakage etc, and another important component of carrying cost is the amount of interest lost due to the investment in the inventory. Carrying costs will go on increasing if the quantity of material in inventory goes on increasing. Both, the carrying costs and the ordering costs are variable costs, however their behavior is exactly opposite of each other. If orders are more frequent, ordering costs will go on increasing but as the material ordered will be in less quantity, the carrying costs will decrease. On the other hand, if numbers of orders are reduced, the quantity per order will increase and the carrying cost will
increase. The ordering cost will come down due to reduction of number of orders. In this situation, the most desirable quantity to be ordered is that quantity at which both, the ordering costs and carrying costs will be minimum. This quantity is called as ‘Economic Order Quantity’. This quantity can be calculated with the help of the following formula:
Where,
U =Annual demand /annual consumption in units O =Cost of placing and receiving an order
IC =Carrying cost per unit per annum
The Economic Order Quantity is an important concept as it guides the Purchase Manager regarding the quantity to be purchased of a particular material. However, this concept is based on some assumptions.
These assumptions are as follows.
•The concerned material will be available all the time without any difficulty. •The price of the material will remain constant.
•Ordering cost and carrying costs are variable.
•Impact of quantity discounts on the prices is negligible.
“f
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1. Fundamental principles of process costing:
Process Costing is also a method of costing which is used in those industries where the production is in continuous process, i.e. the output of one process becomes the input of the subsequent process and so on till the final product emerges from the last process. This method is employed where it is not possible to trace the items of prime cost to a particular order because its identity is lost in the continuous production.
The principles of process costing are:
1) The production is in continuous flow and is uniform. All units coming out as finished products are uniform with each other in all respects.
2) The product is manufactured in a continuous flow and hence individual units lose their identity.
3) The unit cost is obtained by dividing the total cost for a particular period by the total output. This is the average cost of the product units.
4) Cost per process is ascertained and cost of each process is transferred to the subsequent process until the finished product emerges.
5) In a particular process normal and abnormal losses emerge. Normal loss is a loss, which is inevitable in any process and thus cannot be avoided or controlled. Any loss, which, Is over and above, the normal loss is called as abnormal loss and is to be accounted for separately. Abnormal gain and abnormal loss are to be accounted for in the process cost accounts. 6) Sometimes each process may be treated as profit center and so while transferring the cost from one process to another, a percentage of profit is added in the cost of that process. This is known as inter process profit and needs to be accounted for in the process cost accounts.
7) Though the cost per unit is computed by dividing the total cost by the number of units, there can be a problem on incomplete units at the end of a particular accounting period. In such cases equivalent units have to be worked out for computing the cost per unit.
2. Fixed budget:
According to CIMA, a fixed budget is a budget designed to remain unchanged irrespective of the level of activity actually attained. A fixed budget shows the expected results for only one level of activity. Once the budget has been determined, it is not changed even if the level of activity is changed.
When budgets are prepared for a fixed or standard volume of activity, they are called static or fixed budgets. FB is used as an effective tool of cost control. Such a budget is helpful for fixed expenses. It is also called static budget.
3. Flexible budget:
Flexible budgets are not fixed or rigid budgets. When budgets are designed for different volumes and levels of any activity, they are called flexible budget. In the case of such budgets, revenues and costs targets are set in respect of different levels of activity even from zero to hundred percent of production volume. This helps a lot to change revenues and costs targets for the actual level of activity and thus makes the comparison of budgeted and actual performances more logical and scientific.
The method of preparation and presentation of flexible budget is called flexible budgeting. Flexible budget may be prepared in the following situations :
New business : New business has typical nature, it may be difficult to forecast the demand of a product accurately.
Uncertain environment : Demand, supply of raw materials, prices and customer habits and attitudes are uncertain.
Limiting factor analysis :When certain factors of market or of production are uncertain, the preparation of flexible budget for different levels may help in taking decisions.
Age of the inventory indicates the duration of inventory in the organization. It shows the moving position of inventory during the year. This analysis divides the items of inventory into four categories in the descending order of their usage rate as follows:
‘F’ stands for fast moving items and stocks of such items are consumed in a short span of time. Stock of fast moving items must be observed constantly and replenishment orders be placed in time to avoid stock out position.
‘S’ indicates slow moving items, existing stock of which would last for two years or so. These items must be reviewed carefully before eliminating them.
‘N’ means normal moving items and such items are exhausted over a period of time, i.e. say one year. The order levels and quantities for such items should be on the basis of a new estimate of future demand to minimize the risks of a surplus stock.
‘D’ stands for dead stock which means that there will not be any further demand for the same. It is necessary to identify these items and if there cannot be any alternative use for the same, should be eliminated.
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1. Integrated accounting system:
When the books relating to financial accounts and cost accounts are integrated in one book it is called Integrated accounting system. It is a single book keeping system, which contains both financial and cost accounts. The need for reconciliation between the profits shown by cost accounts and financial accounts is eliminated totally as only one set of books of accounts is maintained.
The benefits of integrated accounting system are as follows:
1) As only one set of accounting records is kept, the need for reconciliation between the profits shown by the two records is eliminated.
2) The duplication of work is eliminated, thus the cost of operating this system is reduced.
3) This method is simple to understand and easy to operate. Unnecessary complications are eliminated.
4) Cost data can be available promptly and regularly.
5) There is a cross checking of various figures in cost as well as financial accounts. This ensures accuracy of figures of cost and financial data.
6) Use of mechanized accounting methods can be made.
Cost and Financial Accounts are said to be interlocked, when independent set of books are maintained for each of them. These accounts are interlocked through control accounts maintained in the two sets of books. Cost Ledger Control Account is maintained in the financial books and a General Ledger Adjustment Account is maintained is costing books. In this manner, connection between the two sets of books is maintained.
2. Idle time:
Idle time does not simply mean that the workers are sitting idle. The plant, machines, equipments and other accessories also become idle during that period, and the fixed cost continues to be incurred. As such idle time need to be reduced as far as possible.
department, the cost should be charged to the overheads of that department and absorbed in the production cost of that department.
The Normal but uncontrollable idle time is one arising due to time lost between the factory and place of work, between one job and the other, time lost in setting the machine, tea breaks etc. the cost of this type should be charged to the job at an higher labour rate.
The idle time which is beyond control, is an abnormal one. Idle times due to strikes, lock-outs, long spell of electric failure or machine breakdown, fire, flood, storm etc. are of abnormal nature.
The time when the worker does not work and remains idle, is the idle time. So the idle time cost represents the wages paid for the time lost. The following are its causes:
Lack of proper planning: Proper planning ensures smooth and uniform production. If the workers do not have material at the right time, or the machines are not kept fit for working, the time goes waste. Sometimes, delay in the previous process delays the operations of the following process.
Carelessness in supervision: If the foreman of a department does not take his duty seriously, the labour working under him also becomes careless and spoils time in the idle way.
Confrontation between labour and management: The confrontation between labour and management arising from any cause, waste time in discussions, dialogues, strikes, etc. and the wages paid, if any, for this period form the idle time cost.
Economic factors: Trade depression or severe competition lowers the production, and so labour remains effectively unutilized.
Other reasons: the electricity may fail or the machine may breakdown for some or more time. They make labour to remain idle for the time being. The time lost between one job and the other are the normal causes leading to idle time.
3. Idle capacity:
Expenses incurred on account of loss in capacity usage is known as idle capacity cost. If a plant has capacity to produce 2,000 articles, but it produces only 1,500 articles only as the demand is limited in the market, the idle capacity is 500 articles. Idle time is a part of idle capacity, as due to idle capacity, idle time does arise. Where idle capacity arises due to abnormal causes, such as, trade depression, recession etc., and the plant remains unutilized for a long time, the idle capacity is known as idle facility. Idle facility means that the factory has the facilities of plant, machines etc., but these facilities are lying unused.
4. Incentive schemes for Indirect workers:
It is difficult to determine standards for the output of indirect workers and it is difficult to measure the actual output of these workers. As such, they are generally from incentives benefits. But a careful thought would reveal that it is necessary to provide incentive to them for the following reasons:
a.) Indirect workers are as good participants in manufacture as the direct workers are. Any slackness in their service may not help the direct labour to achieve their targets.
b.) Denial of bonus to indirect workers, while direct workers are paid, causes discontentment and unrest.
1.) It creates team spirit in the workers.
2.) Efficiency in the important services like plant repairs, store services, power, transport etc. is very much called for. This efficiency cannot only be maintained but improved.
3.) The cost of production is reduced.
Incentive Methods- Suggestions: We can divide the indirect workers into two groups: (i) Those who work directly with direct workers, and
(ii) Those who provide general services.
To the workers of first category, like internal workers, checkers, like maintenance workers, canteen workers, sweepers etc., and bonus is suggested on a wider basis, such as output of the whole factory.
5. Interlocking accounts: See under integrated accounts.
6. Inter firm comparison:
Inter firm comparison is the comparison between two firms (or some firms) which are operating under the same industry. It can also be used when two departments under the same organization are compared.
Thus, it is a technique of evaluation and is based upon comparison of productivity, efficiency, cost, profit as yardstick among the different business units in a same industry.
The scheme of the internal comparison consists of two phases –
a. Voluntary collection and exchange of information concerning costs, prices, profits, productivity and overall efficiency among the participating firms engaged in a similar types of the operation. b. Making systematic inter firm comparison of the available data for the purpose of improvement
in efficiency and indicating the weaknesses and the strong points.
7. Inter process profits:
Sometimes, while transferring the cost of one process to the subsequent one, some percentage of profit is added in it. This is called as inter process profits. This is done when a process is treated as profit center. In such cases, unrealized profit is to be computed and shown separately. The stocks at the end and at the beginning contain an element of unrealized profits, which have to be written back in this method. If the profit element contained in the closing inventory is more than the profit element in the opening inventory, profit will be overstated and vice versa. Profit is realized only on the goods sold, thus to obtain the actual profit the main task would be to calculate the profit element contained in the inventories.
8. Installation of a cost system:
The following factors should be taken into consideration while designing a costing system:
1. Size of the firm: As the size of the firm and its business grows, the volume and complexity of the cost data also grows. In such situation, the cost accounting system should be capable of supplying such information.
2. Manufacturing Process: In some industries, there may be a continuous process of production while in some batch or job type of production may be in operation. A cost accounting system should be such that the manufacturing process is taken into consideration and cost data is collected accordingly.
3. Nature and Number of Products: If a single product is produced, all costs like material, labor and indirect expenses can be directly allocated to that product. But if more than one product is manufactured, the question of allocation and apportionment as well as absorption of indirect expenses arises and hence the cost accounting system should be designed accordingly as more complex data will be required.
4. Management Control Needs: The designing of a cost accounting system in a business organization is guided by the management control requirements. The costing system should supply data to persons at different levels in the organization to take suitable action in their respective areas.
5. Raw Materials: The nature of raw materials and the degree of waste therein influence the designing of costing system. There are some materials which have a high degree of spoilage. The costing system should be such that identification of spoilage, keeping records of materials, pricing of the issues etc are taken into consideration.
6. Organization Structure: The structure of the organization also plays a vital role in designing a costing system. The system should correspond to the hierarchy of the organization.
7. External Factors: External factors are also important in designing of a costing system. For example, Cost Accounting Record Rules have been mandatory for certain types of industries.
Practical Difficulties in Installation of Costing system :
The practical difficulties expected at the time of installation of costing system are given below:
o Top Management of an organization may not give necessary support and recognition to the costing system installed in an organization. Due to lack of support, this system may not give desired results.
o There may be resistance from existing accounting staff due to fear of losing job recognition and importance after the implementation of the system.
o Employees of other departments may not co-operate for installation of costing system due to fear of increase in workload or revealing of inefficiency.
o The foremen, supervisors, workers and other operating level staff may resent the introduction of costing system due to the fear on increasing of workload.
o Shortage of qualified and efficient staff may be another difficulty in installing and operating a costing system.
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1. Joint costs:
All costs incurred up to the split off point are termed as joint costs or pre separation costs. Costs incurred after the split off point are post separation costs and can be easily identified with the products. Joint costs occur in many industries like petroleum, flour mills, saw mills, dairy etc. When a process produces two or more products, such products may be called if all have equal importance. If a product is less important such product may be termed as bye product.
2. Just in Time Inventory:
JIT is based on zero inventory theory. It assumes that inventory is juts waste and should not be maintained at all. It requires highly mechanized systerm. This principle envisages that there should not be any intermediate stage like storekeeping. Material purchased from supplier should directly go to the assembly line, i.e.to the production department. There should not be any need of storing the material. The benefit of Just in time system are as follows:
Right quantities are purchased or produced at right time.
Cost effective production or operation of correct services is possible.
Inventory carrying costs are eliminated totally.
The stores function is eliminated and hence there is a considerable saving in the stores cost.
Losses due to breakage, wastage, pilferage etc are avoided.
The benefits can be obtained by giving more business to less number of suppliers who must have high quality of material and its delivery. The features of JIT are as follows :
Long term stable relationships with suppliers.
Alternative suppliers.
Simple purchase agreements.
Small but more number of deliveries.
3. Job evaluation:
Job evaluation is a technique of analysis and assessment of jobs to determine their value within the firm. It aims at providing a rational and equitable basis for differential salaries and wages for different classes of workers.
Job evaluation has the following objectives:
It helps in developing a systematic and rational wage structure as well as job structure.
Job evaluation aims at removing the controversies and disputes relating to salary between the employers and employees. Thus the employees and also the employer remain satisfied.
Another important objective of job evaluation is to bring fairness and stability in the wage and salary structure so as to ensure full cooperation of workers in implementing various policies of the employers.
Job evaluation discloses characteristics and conditions relating to different jobs. This is very useful at the time of recruiting of workers as only suitable workers can be
recruited.
Methods of job evaluation:
Ranking: The job or work characteristics are graded from the highest to the lowest in accordance with relative responsibility and skill.
Grading: Here the jobs are classified into number of grades or groups. A simple form of grading may be Unskilled, Semi-skilled and Skilled or it may be in the form of workers, supervisors, administrators. The value is attached to each job in accordance with work characteristics.
Weighting: A job requiring skill and good qualifications has to be attached a greater weight than the one of an unskilled type.
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1. Limitation of market based transfer pricing: See Transfer pricing 2. Labour turnover:
In every industry, workers leave their jobs and new workers have to be appointed to replace them. The ratio of replaced workers to the total number of workers is the Labour Turnover Ratio. If more workers leave the factory, the turnover would be high, and vice versa. A high turnover is a costly affair and must be avoided.
Measurement of labour Turnover:
The following methods are available to compare the labour turnover of the previous period with the current one:
Addition Method: Under this method, number of employees added during a particular period is taken into consideration for computing the labour turnover.
Labour Turnover =Number of additions / Average number of workers during the period X 100
Separations Method: In this method, instead of taking the number of employees added, number of employees left during the period is taken into consideration.
Labour Turnover =Number of separations / Average number of workers during the period X 100
Replacement Method: In this method neither the additions nor the separations are taken into consideration. The number of employees replaced is taken into consideration for computing the labour turnover.
Labour Turnover =Number of replacements / Average number of workers during the period X 100
Flux Method: Under this method labour turnover is computed by taking into consideration the additions as well as separations. The turnover can also be computed by taking
replacements and separations also.
Labour Turnover = [Number of additions +Number of separations] / Average number of Workers during the period X 100
Avoidable and Unavoidable causes of labour turnover:
Avoidable Causes:
Dissatisfaction with the job
Dissatisfaction with the working hours
Dissatisfaction with the working environment
Dissatisfaction with monetary and non monetary incentives
Relationship with colleagues
Relationship with the superiors like supervisors
Other reasons such as lack of facilities like insurance, absence of promotion chances, lack of proper training etc.
Unavoidable Causes: Personal betterment
Retirement
Death
Illness or accident
Change in locality
Termination
Marriage
National service
Other reasons like lack of residential facilities, family commitments, attitude etc.
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1. Margin of Safety: (See also break even chart)
Margin of safety is the difference between the actual sales and the breakeven sales. It indicates the volume of sales, which directly contributes to profit, as fixed costs have already been covered by Break-even point. The higher the safety margin the better it is.
Margin of Safety = Actual Sales – Break-even Sales
2. Managerial decision making:
Managerial decision making is a very crucial function in any organization. Decision making should be on the basis of relevant information. Through the marginal costing technique, information about the cost behavior is made available in the form of fixed and variable cost. The segregation of costs between fixed and variable helps the management in predicting the cost behavior in various alternatives. Thus it becomes easy to take decisions. Marginal costing helps in comparative cost analysis and thus the decision making becomes rational and based on facts rather than based on intuition. Some of the crucial areas of decision making are mentioned below:
Make or buy decisions.
Accepting or rejecting an export offer.
Variation in selling price.
Variation in product mix.
Variation in sales mix.
Key factor analysis.
Evaluation of different alternatives regarding profit improvement.
Capital expenditure decision.
3. Motion study:
Motion study aims at the elimination of unnecessary motions or the movements employed by the worker in the performance of his function. Every motion has an effect on the time consumed and causes fatigue to the worker. Minimum movement of men, machine and materials is necessary for better output and better efficiency. Motion study is conducted just for this purpose.
Motion study helps in proper scheduling of the operational functions, devising the proper factory lay-out, minimizing the organizational functions, and setting up standards with the help of Time study.
4. Marginal costing for decision making : (see also managerial decision making)
One additional unit of production is known as marginal unit, and the change in total cost on account of adding or subtracting one additional unit is known as marginal cost. However this one unit may be a product, a batch, an order, a stage of production, a process or even a department. The change in total costs for any change in volume of production is fully accounted for by variable cost. Thus marginal cost is sometimes described as variable cost. Variable cost consist of direct materials, direct labour, variable expenses and all variable overheads. In other words, marginal cost should be taken as equal to prime cost plus all variable overheads.
Marginal costing helps the management to determine the profitability of different units/ products of the concern and to identify the forces acting as bottlenecks in achieving the profit goal. It provides useful data and details for decision making particularly of short term nature.
Few managerial problems and areas of decisions, where marginal costing will be of immense help are:
1. Achieving profit target 2. Increase in level of activity
3. Dropping / introducing a new line or product. 4. Evaluation of sales promotional schemes 5. Market expansion
6. Pricing policy, etc.
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1. Operating costing:
This is method of costing to determine the cost of operations. When no items are produced but services are offered, this method is used to determine the cost of such services
The main objective of operating costing is to compute the cost of the services offered by the organization. It is also applied to the operations within the organization when one or more departments provide services to production department. For this, it is necessary to decide the unit operation cost in such cases. The next step is to collect and identify various costs under different headings.
Fixed or standing charges
Semi fixed or maintenance charges
Variable or running charges.
Five activities of operating costing are:
2. Electricity generation (per person per unit) 3. Hotels and canteens (per room per day) 4. Hospitals (per patient per day)
5. Educational institutions (per student per day)
2. Obsolescence in material costing:
Obsolescence is defined as “The loss in the value of assets due to some factors other than time''. The condition of the asset is good but it is no longer useful. Audio cassettes or video cassettes are some examples.
Causes of Obsolescence:
iv. To bring into use a new and improved machine. So the old one is discarded.
v. The product which a machine produces, may be in demand in the market. If that product is discontinued, the machine becomes obsolete.
vi. If it is thought to give a better design and get-up to the product due to change in fashion, or out of three products, viz., A,B,C it is decided to divert the resources of ‘C’ product to the production of ‘A’ and ‘B’ products, for reasons of economy, the machine producing unwanted product would become obsolete.
Obsolete materials become useless or obsolete due to change in the product, process, design or method of production. In the case of slow moving materials as well as non moving materials, capital remains blocked unnecessarily and also cost of storing continue to be incurred of these materials are kept in the store in excess of the requirements. Management should make proper investigations into slow moving and obsolete materials and try to minimize the capital investments in the same. It is necessary to have an efficient Management Information System which will enable to generate regular reports to examine the situations relating to these stocks so that the non-moving and obsolete stocks can be disposed off in time. Perpetual inventory system is also advised to detect the obsolete stock.
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1. Profit Volume Ratio:
It is also known as Contribution Ratio or Marginal Income Percentage. It is a ratio of Contribution to Sales. Here profit does not indicate profit but represents contribution. Similarly, volume does not signify the volume of sales but denotes value of sales. Since contribution is not affected by and fixed expenses. Profit-volume ratio remains constant for varying levels of production. PVR is expressed normally in percentage.
PV Ratio = C/S * 100
Advantages of PV Ratio (following problems can be solved):
A competitive study of the following items of facts can be made easier with the help of PVR: a.) Line of product.
b.) Individual factors. c.) Sales area.
Desired level of production, sales, profit etc.
Determining Price Policy and others managerial policies.
2. Profit on incomplete contract:
Several contracts take more time than one financial year before they are complete. The questions arises as to whether the profits on such contracts should be taken into consideration after the completion of the contract or whether a portion of the same should be taken into accounts every year on certain basis. If profit is taken into consideration after the completion of contracts and if in a single year several contracts are completed, the profits shown will be very high while in another year, if none of the contracts are completed, amount of profits shown will be very low. Thus there will be distortions in the amount of profits. Therefore it becomes necessary to compute the amount of profit on partly completed contracts and take credit of appropriate amount in the profit and loss account by using the following guidelines.
Value of certified work only should be taken into consideration while determining the profit. Value of work uncertified should not be taken into consideration.
In case of contracts which are less than 25% complete, no profits should be taken into consideration
and consequently no credit should be taken to Profit and Loss Account.
In case of contracts which are more than 25% complete, but less than 50% complete, the following
method should be used for computing the profit to be credited to the Profit and Loss Account.
1/3 X Notional Profit / Cash Received / Work Certified.
Notional profit is the difference between the value of work certified and cost of work certified. It is computed in the following manner.
Notional Profit =Value of work certified – [cost of work to date – cost of work completed but not certified ]
In case of contracts complete between 50% and 90% [more than 50% but less than 90%] the following method is used for computing the profit to be credited to the Profit and Loss Account.
2/3 X Notional Pro fi t X Cash Received / Work Certified
In case of contracts completed 90% or more than that, it is considered to be almost complete. In
such cases, the estimated total profit is first determined by deducting the total costs to date and additional expenditure necessary to complete the contract from the contract price. The portion of profit so arrived is credited to the Profit and Loss Account by using the following formula.
Method I :- Estimated Profit X Work Certified / Contract Price
Method II:- Estimated Pro fi t X Work Certified / Contract Price X Cash Received / Work Certified
Or Estimated Profit X Cash Received / Work Certified.
The method II is preferable to the first one.
