Unit 3: Reconciliation & methods of costing
Cost Accounting notes · PTU syllabus (BCOM 201-18)
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Unit summary
Cost and financial accounts usually show different profits — and the reasons must be reconciled. This unit covers the need for reconciliation and the reasons for differing profits, the preparation of reconciliation statements, and the main methods of costing — process costing, contract costing, and marginal costing with cost-volume-profit analysis basics.
After this unit you can
- Explain the need for reconciliation and the reasons for differing profits
- Prepare a reconciliation statement
- Prepare process accounts with normal and abnormal losses and contract accounts
- Explain marginal costing and calculate P/V ratio, break-even point and margin of safety
PTU syllabus topics
- Need for reconciling cost and financial accounts
- reasons for differing profits
- preparation of reconciliation statements
- process costing
- contract costing
- marginal costing and cost-volume-profit analysis basics
Contribution
Sales − variable cost
P/V ratio
Contribution / Sales × 100
Break-even sales
Fixed cost / P/V ratio
Margin of safety
Actual sales − break-even sales
Sales for target profit
(Fixed cost + target profit) / P/V ratio
Topic 1
Reconciliation of cost and financial accounts
When cost and financial accounts are kept separately (non-integrated system), the profits differ and must be reconciled to check arithmetical accuracy and reliability.
Reasons for differing profits
Items only in financial accounts
Interest received, dividends, profit on sale of assets, fines, donations, losses on sale of investments, goodwill written off
Items only in cost accounts
Notional rent, notional interest on capital
Under- or over-absorption of overheads
Overheads charged differently
Different stock valuation
FIFO in costing vs lower of cost and NRV in financial
Different depreciation methods
Machine hour vs written-down value
Topic 2
Preparing the reconciliation statement
- 1Start with profit as per cost accounts
- 2Add
Incomes only in financial books, over-absorbed overheads, expenses only in cost books, excess opening stock in cost books, excess closing stock in financial books
- 3Less
Expenses only in financial books, under-absorbed overheads, incomes only in cost books
- 4Result
Profit as per financial accounts
Example
Profit per cost accounts ₹50,000. Interest received ₹2,000 (only financial); factory overheads under-absorbed ₹3,000; donation ₹1,000 (only financial); notional rent ₹4,000 charged in cost accounts. Financial profit = 50,000 + 2,000 − 3,000 − 1,000 + 4,000 = ₹52,000.
Exam tip
When starting with costing profit, ask: "Does this item make financial profit higher?" If yes — add; if no — deduct.
Topic 3
Process costing
Process costing is used where production passes through successive processes and the output of one process becomes the input of the next (chemicals, textiles, oil refining, paper).
- Normal loss: expected, unavoidable loss — cost absorbed by good units; scrap value credited to the process.
- Abnormal loss: loss above normal — valued at the cost of good units and transferred to the Abnormal Loss A/c.
- Abnormal gain: actual loss less than normal — debited to the process and credited to Abnormal Gain A/c.
Cost per unit of normal output
(Total cost − Scrap value of normal loss) ÷ (Input − Normal loss units)
Value of abnormal loss
Abnormal loss units × Cost per unit of normal output
Example
Input 1,000 units costing ₹20,000; normal loss 10% (scrap ₹2 per unit); actual output 850. Normal loss = 100 units (scrap ₹200). Cost per unit = (20,000 − 200) ÷ 900 = ₹22. Abnormal loss = 50 units × 22 = ₹1,100. Output transferred = 850 × 22 = ₹18,700.
- Equivalent production: WIP converted into completed units for computing cost per unit.
- Joint products and by-products: products obtained from the same process; joint costs apportioned (physical units, sales value).
Topic 4
Contract costing
Contract costing is used by builders and contractors for large, long-duration jobs (roads, buildings, bridges). Each contract is a cost unit; a separate Contract Account is prepared.
- Work certified: value of work approved by the architect/engineer; work uncertified: completed but not yet certified (at cost).
- Retention money: portion of the certified amount withheld by the contractee as security.
- Notional profit = Work certified + Work uncertified − Cost of work to date.
| Stage of completion | Profit taken to P&L |
|---|---|
| Less than 25% | Nil |
| 25% to 50% | 1/3 × Notional profit × Cash received ÷ Work certified |
| 50% to 90% | 2/3 × Notional profit × Cash received ÷ Work certified |
| Near completion (over 90%) | Estimated total profit × Work certified ÷ Contract price (and similar formulae) |
- Losses are recognised in full immediately (prudence).
Exam tip
Under AS-7 / Ind AS 115, revenue is recognised on the percentage-of-completion method — mention that the fractional rules are traditional costing conventions.
Topic 5
Marginal costing and CVP basics
Marginal costing is the ascertainment of marginal costs and the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs (CIMA). Only variable costs are charged to products; fixed costs are written off against contribution.
Contribution
Sales − Variable cost = Fixed cost + Profit
P/V ratio
Contribution ÷ Sales × 100
Break-even point (units)
Fixed cost ÷ Contribution per unit
Break-even point (sales)
Fixed cost ÷ P/V ratio
Margin of safety
Actual sales − BEP sales = Profit ÷ P/V ratio
Sales for desired profit
(Fixed cost + Desired profit) ÷ P/V ratio
Example
Selling price ₹50, variable cost ₹30, fixed cost ₹40,000, sales 3,000 units. Contribution = ₹20 per unit; P/V ratio = 40%. BEP = 40,000 ÷ 20 = 2,000 units (₹1,00,000). Margin of safety = ₹1,50,000 − ₹1,00,000 = ₹50,000. Profit = 50,000 × 40% = ₹20,000.
Fixed costs
Period costs, charged against contribution
Included in product cost
Stock valuation
At variable cost
At full cost
Profit when production > sales
Lower
Higher
Use
Short-term decisions
External reporting
- Break-even chart shows total cost, total sales and the BEP; the angle of incidence between sales and total cost lines indicates profitability.
- Decisions using marginal costing: make or buy, accept a special order, key (limiting) factor, shut down, product mix, pricing in recession.
Key terms
- Reconciliation statement
- Statement explaining the difference between cost and financial profits
- Abnormal loss
- Loss in excess of normal expected loss
- Notional profit
- Value of work done less cost of work to date
- Contribution
- Sales minus variable cost
- Break-even point
- Level of sales where total revenue equals total cost
Quick revision
- Reasons for difference: financial-only items, cost-only items, under/over-absorption, stock and depreciation differences.
- Process costing: normal loss absorbed; abnormal loss/gain at normal cost per unit.
- Contract costing: notional profit, profit fractions 0, 1/3, 2/3.
- Marginal costing: contribution, P/V ratio, BEP, margin of safety.
- Profit = Margin of safety × P/V ratio.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Why is reconciliation of cost and financial accounts necessary?
- Q2.Give four items appearing only in financial accounts.
- Q3.Distinguish normal and abnormal loss.
- Q4.What is retention money?
- Q5.What is P/V ratio?
- Q6.Define margin of safety.
Long-answer questions
- Q1.Explain the reasons for differences between cost and financial profits and prepare a reconciliation statement.
- Q2.Explain process costing with treatment of normal and abnormal loss and abnormal gain.
- Q3.Explain contract costing and the recognition of profit on incomplete contracts.
- Q4.Explain marginal costing and the uses of CVP analysis.
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