Accounting For Management

Accounting for Management
S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: sn.selvaraj@yahoo.com Page 1

Semester I

UNIT IV COST ACCOUNTING
Cost Accounts Classification of Manufacturing Costs Accounting for
Manufacturing Costs Cost Accounting Systems: Job Order Costing Process
Costing Activity Based Costing Costing and the Value Chain Target Costing
Marginal Costing including Decision Making Budgetary Control & Variance
Analysis Standard Cost System

COST ACCOUNTS
Meaning of Cost: Costs that are usually considered an expense of the current period
may not be recorded as such because of special circumstances. Cost is the total spent
for goods or services including money, time and labor. Cost is the value of money that
has been used up to produce something, and hence is not available for use anymore.

Cost: It is the amount of resources given up in exchange for some goods or services.
The resources given up are expressed in monetary terms. Cost is defined as the
amount of expenditure (actual or notional) incurred on or attributable to a given thing
or to ascertain the cost of a given thing.

According to ICMA London, Cost is the amount of expenditure (actual or notional)
incurred on, or attributable to, a specified thing or activity or cost unit.

Expenses: Expenses are costs which have been applied against revenue of particular
accounting period in accordance with the principle of matching cost to revenue e.g.
cost goods-sold, office salaries of the period in which they are incurred.

Loss: It represents diminution in ownership equity other than from withdrawal of
capital for which no compensating value has been received e.g. destruction of property
by fire. Loss denotes sacrifice for which there is no corresponding return whereas
cost implies sacrifices for the sake of and accompanied by the securing of some other
value.

Meaning of Cost Accounting: Cost accounting is concerned with cost and therefore, it
is appropriate to understand the meaning of the term cost in a proper perspective. In
general cost means the amount of expenditure (actual or nominal) incurred on, or
attributable to a given thing. Its interpretation depends upon (a) the nature of the
business or industry and (b) the context in which it is used.

Meaning of Costing: Costing is a technique and process of ascertaining costs. This
technique consists of principles and rules which govern the procedure of ascertaining
the cost of products/services. The process of costing includes routines of ascertaining
cost by historical or conventional costing, standard costing or marginal costing.



According to Charles T Horngren, Cost Accounting is a quantitative method that
accumulates, classifies, summarizes and interprets information for three major
purposes: (i) Operational Planning and Control, (ii) Special Decision and (iii) Product
Decision.

Cost Concepts
A cost accountant is mainly concerned with the following cost concepts:
Concept of Objectivity: It is this concept gives direction to the activities relating
to cost finding, cost analysis, recording and cost reporting.
Concept of Materiality: This concept that stress accuracy must be tempered by
good judgment, if no distortion of product cost is likely to result.
Concept of Time Span: All assumptions relating to different cost exercise remain
valid only during related time span.
Concept of Relevant Range of Activity: Relevant range of activity represents the
span of volume over which the cost behavior is expected to remain valid.
Concept of Relevant Cost and Benefit: This concept is vital for decision-making
purposes.

Objectives of Cost Accounting
The main objectives of cost accounting can be summarized as follows:
To determining selling price
To determining and controlling efficiency
To facilitating preparation of financial and other statements
To Providing basis for operating policy

Elements of Cost
Mere knowledge of total cost cannot satisfy the needs of management. For proper
control and managerial decisions, management is to be provided with necessary data
to analyze and classify costs. For its purpose, the total cost is analyzed by elements of
cost i.e. by the nature of expenses. Strictly speaking and the broad elements of cost
are three i.e. Materials, Labour and Other expenses.

These elements of cost are further analyzed into different elements such as Direct
material, Indirect material, Direct labour, Indirect labour, Direct Expenses, Indirect
Expenses and Overheads.

CLASSIFICATION OF MANUFACTURING COSTS
The term manufacturing costs usually refers to material used, direct labour incurred,
and overhead incurred in a manufacturing business. Material used, direct labour and
manufacturing overhead at the time incurred are not expenses, rather they incurred
costs. In the manufacturing process, material labour, and overhead do not expire;
rather through manufacturing activity they become transformed from one type of
utility to another.



All costs related to production of goods are called manufacturing costs; they are also
referred to as product costs. The following are the classification of costs associated
with manufacturing.
(1) Direct Materials: Direct materials are those materials which can be identified in
the product and can be conveniently measured and directly charged to the
product. These materials directly enter the production and form a part of the
finished goods. Thus, the substance from which the product is made known as
material.

For example, timber in furniture making, cloth in dress making and bricks in
building a house. The following are normally classified as direct materials.

(a) All raw materials like jute in the manufacture of gunny bags, pig iron in
foundry and fruits in canning industry.
(b) Materials specifically purchased for a specific job, process or order like
glue for book binding, starch powder for dressing yarn etc.
(c) Parts or components purchased or produced like batteries for transistor-
radios and tyres for cycles.
(d) Primary packing materials like cartons, wrappings, cardboard boxes, etc.
used to protect finished product from climatic conditions or for easy
handling inside the factory.

Indirect Material: The materials which are not classified as direct materials are
called indirect materials. These materials are used for purposes ancillary to the
business and which cannot be conveniently assigned to specific physical units
is termed as Indirect Material. Indirect material may be used in the factory,
office or selling and distribution divisions. Consumable stores, oil and waste,
printing and stationery material, etc. are few examples of indirect materials.

(2) Direct Labour: All labour expended in altering the construction, composition,
confirmation or condition of the product. In simple words, it is that labour
which can be conveniently identified or attributed wholly to a particular job,
product or process or expended in converting raw materials into finished
goods. Wages of such labour are known as direct wages. Human effort is
needed for conversion of materials into finished goods, such human effort is
called labour.

Indirect Labour: Labour employed for the purpose of carrying out tasks
incidental to goods produced or services provided, is indirect labour. Wages of
store-keepers, foremen, time-keepers, directors fees, salaries of salesmen, etc.
are the examples of indirect labour costs. Indirect labour may relate to the
factory, office or selling and distribution divisions.

(3) Direct Expenses: All expenses which can be identified to a particular cost
centre and hence directly charged to the centre are known as direct expenses. In
other words, all expenses incurred specifically for a particular product, job are


called direct expenses. These are directly charged to the product. For
example, royalty, excise duty, hire charges of a specific plant and equipment
etc.

Indirect Expenses: These are expenses which cannot be directly, conveniently
and wholly allocated to cost centres or cost units. Examples of such expenses
are rent, lighting, insurance charges, etc.

(4) Overheads: Overheads may be defined as the aggregate of the cost of indirect
materials, indirect labour and such other expenses including services as cannot
conveniently be charged direct to specific cost units. Thus overheads are all
expenses other than direct expenses. The main groups into which overheads
may be sub-divided are (i) Manufacturing Overheads, (ii) Administration
Overheads, (iii) Selling and Distribution Overheads and (iv) Research and
Development Overheads.

By grouping the elements of cost, the following divisions of cost are obtained:
Direct material + Direct labour + Direct expenses = Prime cost
Prime cost + Factory overheads = Factory cost
Factory cost + Administrative overheads = Production cost
Production cost + Selling & Distribution overheads = Total cost (or)
Ultimate cost

Elements of Cost

Materials Labour Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Overheads

Production or Administration Selling
Distribution
Works Overheads Overheads Overheads
Overheads



ACCOUNTING FOR MANUFACTURING COSTS
A manufacturing firm maintains separate inventory accounts to accumulate product
costs associated with inventories at various stages of completion.

Raw Materials Inventory Account
The raw materials inventory account includes the cost of raw materials
purchased but not yet transferred to the factory floor; the manufacturing firm
records purchases of raw materials as debits to the raw materials inventory
account.
When the manufacturer physically transfers raw materials to the factory floor,
it also transfers the cost of the raw materials from raw materials inventory
account to the work-in-process inventory account.
It records this transfer as a credit to the raw material inventory account for the
cost of the raw materials transferred and a debit to the work-in-process
inventory account.
The balance in raw materials inventory is the cost of raw materials on hand in
the storeroom or warehouse.

Work-in-Process Inventory Account
The work-in-process inventory account accumulates the cost of raw materials
transferred to the factory floor, the cost of direct labour used in production, and
manufacturing overhead costs.
At the completion of the manufacturing process, the firm physically transfers
completed units from the factory floor to the finished goods storeroom.
It also transfers the product costs of those completed units to finished goods
inventory.
The firm credits the work-in-process inventory account for the manufacturing
costs assigned to the finished units transferred to the finished goods storeroom
and debits the finished goods inventory account.

Finished Goods Inventory Account
The finished goods inventory account measures the total manufacturing cost of
units completed but not yet sold.
The sale of manufactured goods to customer results in a transfer of their cost
from the finished goods inventory account to cost of goods sold, an expense
reducing net income and ultimately retained earnings.
The journal entry is a debit to cost of goods sold and a credit to finished goods
inventory.

Presentation of Manufacturing and Non-Manufacturing Costs in Financial Statements
Distinguish between manufacturing and non-manufacturing costs in critical because
the category determines where a cost will appear in the financial statements. All
manufacturing costs (direct material, direct labor and manufacturing overhead) are
attached to inventory as an asset on the balance sheet until the goods are sold. Till


then the costs are transferred to cost of goods sold on the income statement as an
expense.

As noted earlier, non-manufacturing costs are also called period costs; because they
are expensed on the income statement in the time period in which they are incurred.
Remember that the terms manufacturing cost and product cost are interchangeable, as
are the terms non-manufacturing cost and period cost.

Costs and Timing of when the Costs are Expensed
Manufacturing Costs
(also called product costs)
Non-Manufacturing Costs
(also called period costs)
1) Direct Materials 1) Selling
2) Direct Labor 2) General and Administrative
3) Manufacturing Overhead
Timing of Expense: Costs are
expensed when goods are sold.

Timing of Expense: Costs are
expensed in the time period incurred.

COST ACCOUNTING SYSTEMS:
An accounting system is a formal means of gathering and communicating data to aid
and coordinate collective decision in the light of overall goals or objectives of an
organization. The accounting system is the major quantitative information system in
almost every organization. Cost accounting is a formal means of gathering, measuring,
analyzing, and reporting cost data to aid management in coordinating collective
decisions in the achievement of the overall goals of an organization.

Need for Cost Accounting System
An effective accounting system provides information for two broad purposes:
1) The accumulation of cost data for external reporting.
2) The collection of quantitative data for internal use by management in carrying-
out its functions of planning, control, decision-making and the formulation of
overall policies.

Components of a Cost Accounting System
(a) An input measurement basis.
(b) An inventory valuation method.
(c) A cost accumulation method.
(d) A cost flow assumption.
(e) A capability of recording inventory cost flows at certain intervals.



Figure: Five Parts of a Cost Accounting System

Objectives of Cost Accounting System
To arrive at the cost of production every unit and develop cost standards
To indicate to the management any inefficiencies and the extent of various
forms of waste
To reveal sources of economies in production
To provide actual figures of cost for comparison with estimates
To present comparative cost data for different periods
To record the relative production results of each unit of plant and machinery

Factors of Consideration of Cost Accounting System
1) Objectives
2) Organizational Structure
3) Technical Aspect
4) Nature of product
5) Cooperation of staff
6) Collection of data
7) Standardization of forms
8) Control system
9) Methods and techniques of costing

Cost Accounting System
Input
Measurement
Basis
Inventory
Valuation
Method
Cost
Accumulation
Method
Cost Flow
Assumption
Recording
Interval
Capability
Pure
Historical
Full
Absorption
Throughput
Direct
(Variable)
Normal
Historical
Standard
Activity
Based
Hybrid
Backflush
Process
Job Order Specific
Identification
FIFO
Weighted
Average
Perpetual
Periodic


JOB ORDER COSTING
Job costing is the method of costing used to determine the cost of non-standard jobs
carried out according to customers specifications. In this method cost units are
separately identified and are costed individually. This method is also known by other
names, such as Job Order Costing, Specific Order Costing, Terminal Costing and
Production Order Costing. Here the idea is that each order placed with the firm for the
manufacture of a product, or for doing a job for a customer in accordance with his
specifications is different from the other.

For example, if Mr.A goes to the printers and asks him to print invitation cards for his
marriage, the card will be prepared according to his specifications, and the Invitation
card of Mr.X will not suit him. So the printing of the card Mr.A and Mr.Xs card are
two different jobs, which can be termed as two separate cost units and which are to be
costed individually. Job costing is applicable to job printers, engineers, furniture
makers, builders, contractors, hardware and machine manufacturing industries,
repairing shops, etc.

Job costing is employed in the following cases:
Where the production is against the order of the customer or jobs are executed
for different customers according to their specifications.
Where each job needs special treatment and no two orders are necessarily alike.
Where there is no uniformity in the flow of production from one department to
another.
Where the work-in-progress differs from period to period on the basis of the
number of jobs in hand.

Job Order Costing is used in:
1. Paper Boxes
2. Wooden Furniture
3. Toys and Novelties
4. Cooking Utensils
5. Caskets
6. Pianos
7. Locomotives
8. Office Machine Equipment
9. Luggage
10. Printing press

Characteristics of Job Costing
Custom Made Production
Unique Nature of Work
Work Flow Structure Predetermined
Difference in Work-in-Progress
Accumulation of Cost
Ascertaining of Cost
Short Duration of Work
Valid for all Industry

Objectives of Job Costing
Cost of each job/order is ascertained separately. This helps in finding out the
profit or loss on each individual job.


It enables the management to know those jobs which are more profitable and
those which are unprofitable.
It provides a basis for determining the cost of similar jobs undertaken in future.
It thus helps in future production planning.
It helps the management in controlling costs by comparing the actual costs with
the estimated costs.

Job Costing Procedure
The following steps are taken in jobs costing:
Figure: J ob Costing Procedure

Job Number: When an order has been accepted, an individual job number must be
assigned to each job so that separate jobs are identifiable at all stages of production.
Assignment of job numbers also facilitates reference for costing purposes in the ledger
and is conveniently short for use on various forms and documents.
Production Order: The production control department then makes out a Production
Order thereby authorizing to start work on the job. Several copies of the production
order are prepared, the copies often being in different colors to distinguish between
them more easily. These copies are passed on to the following:
All departmental foremen concerned with the job
Storekeeper for issuance of materials
Tool room for an advance notification of tools required

Production Order
Name of the Customer Job No. ..
Date of Commencement . Date ...
Date of Completion . Bill of Material No
Special Instructions ..... Drawing attached Yes/No..
Quantity Description Machines to be
used
Tools Required

(Signature) .
Production authorized by:
Head of Production Control Dept.
Figure: Production Order for J ob
Job Number
Production Order
Job Cost Sheet


Job Cost Sheet: The unique accounting document under job costing is the job cost
sheet. Receipt of production order is the signal for the cost accountant to prepare a job
cost sheet on which he will record the cost of materials used and the labor and
machine time taken. Each concern has to design a job cost sheet to suit its needs. Job
cost sheet are not prepared for specified periods but they are made out for each job
regardless of the time taken for its completion. However, material labor and overhead
costs are posted periodically to the relevant cost sheet.

The materials, labor and overhead to be absorbed into jobs are collected and recorded
in the following way:
i. Direct Materials
ii. Direct Wages
iii. Direct Expenses
iv. Overheads

A simple proforma of job cost sheet is given below.

Job Cost Sheet
Customer .. Job No...
Date of Commencement... Date of Completion. .
Material Cost Labor Cost Factory Overhead
(Absorbed)
Date Material
Req.No.
Amount
(Rs.)
Date Hours Rate
(Rs.)
Amount
(Rs.)
Dept. Hours Rate
(Rs.)
Amount
(Rs.)

Total Total Total
Profit/Loss (Rs.) Cost Summary Rs.
Price Quoted
.
Less: Cost
.
Profit/Loss
.
Material
Labor
Prime Cost
Factory overhead
Works cost
Administrative overhead
Cost of production
Selling and distribution overhead
Total cost

Figure: J ob Cost Sheet



Problem: Forge Machine Works collects its cost data by the job order cost
accumulation procedure. For Job 642, the following data are available:

Direct Materials Direct Labor
9/14 Issued Rs.1,200 Week of September 20 180 hours @ Rs.6.20/hr
9/20 Issued 662 Week of September 26 140 hours @ Rs.7.30/hr
9/22 Issued 480

Factory overhead applied at the rate of Rs.3.50 per direct labor hour. You are required
to prepare (a) the appropriate information on a job cost sheet and (b) the sales price of
the job, assuming that it was contracted with a mark-up of 40% of cost.

Solution
Forge Machine Works
Job Order Cost Sheet Job 642
Direct Materials Direct Labor Applied Factory Overhead
Date
Issued
Amount
(Rs.)
Date
(week
of)
Hours Rate
(Rs.)
Cost
(Rs.)
Date
(week
of)
Hours Rate
(Rs.)
Cost
(Rs.)
9/14
9/20
9/22
1,200
662
480
9/14
9/20

180
140
6.20
7.30
1,116
1,022
9/14
9/20

180
140
3.50
3.50
630
490
Total 2,342 Total 2,138 Total 1,120

Sales Price of Job 642, contracted with a mark-up of 40% of cost
Particulars Amount (Rs.)
Direct Materials
Direct Labor
Applied Factory Overhead

Total Factory Cost
Mark-up 40% of Cost
Sales Price
2,342
2,138
1,120

5,600
2,240
7,840

Completion of Jobs
When jobs are completed, the cost is transferred to cost of sales account. The total
cost of jobs completed during each period is set against the sales to determine the
profit or loss for the period.


Problem
The following is the budget of ABC Engineering Corporation for the year 2008.
Particulars Rs.
Factory overheads
Direct Labor Cost
Direct Labor Hours
Machine Hours
62,000
98,000
1,55,000
50,000

(a) From the above figures, prepare the overhead application rates, using the
following methods: (i) Direct labor hour; (ii) Direct labor cost and (iii)
Machine hour.
(b) Prepare a comparative statement of cost, showing the result of application of
each of the above rates to Job Order 333 from the under mentioned data:
Particulars Rs.
Direct Material Cost
Direct Labor Wages
Direct Labor Hours
Machine Hours
45.00
50.00
40.00
30.00

Solution
(a)
(i) Direct Labor Hour Rate = 62,000 / 1,55,000 = Re.0.40
(ii) Direct Labor Cost = (62,000 / 98,000) 100 = 63.27%
(iii) Machine Hour Rate = 62,000 / 50,000 = Rs.1.24

(b)
Comparative Statement of Cost
Basis of Overhead
Absorption
Direct
Labor
Hours
Direct
Labor Cost
Machine
Hours
Direct Material Cost
Direct Labor Cost
Overhead Cost
Total Cost
45.00
50.00
16.00
111.00
45.00
50.00
31.63
126.63
45.00
50.00
37.20
132.20

Advantages of Job Costing
It provides a detailed analysis of cost of materials, wages and overheads
classified by functions, departments and nature of expenses which enable
management to determine the operating efficiency of the different factors of
production, production centers and the functional units.
It enables the management to ascertain which of the jobs are more profitable
than the others, which are less profitable and which are incurring losses.


It provides a basis for estimating the cost of similar jobs taken up in future and
thus helps in future production planning.
Determination of predetermined overhead rates in job costing necessitates the
application of a system of budgetary control of overheads with all its
advantages.
Identification of spoilage and defectives with the respective production orders
and departments may enable the management to take effective steps in
reducing these to the minimum.
The detailed cost records of the past years are used for statistical purposes in
the determination of the trends of cost of the different types of jobs and their
relative efficiencies.

Disadvantages of Job Costing
It involves a great deal of clerical work in recording daily the cost of materials
issued, wages expended and overheads chargeable to each job or work order
which adds to the cost of cost accounting and also increases the chances of
errors.
Determination of overhead rates may involve budgeting of overhead expenses
and the bases of overhead apportionment and absorption but unless such
budgeting is complete i.e. extended to material, labor and expenses, its
advantages are considerably reduced.
Job costing is a historical costing which ascertains the cost of a job or product
after it has been manufactured. It does not facilitate control of cost unless it is
used with standard or estimated costing.
The costs compiled under job costing system represent the cost incurred under
actual conditions of operation. The system does not have any scientific basis to
indicate what the cost should be or should have been, unless standard costing is
employed.
In case of inflation, comparison of cost of a job for one period with that of
another becomes meaningless. Distortion of cost occurs even when the batch
quantities are different.

PROCESS COSTING
Process costing is a method of costing applied to industries where the material has to
pass through two or more processes for being converted into a finished product. This
method is used in the manufacture of chemical products, soap, vegetable oil, paints,
varnishes etc., where the production is continuous and the products has to pass from
one process to the other until completion.

Process costing is an accounting methodology that traces and accumulates direct costs,
and allocates indirect costs of a manufacturing process. Costs are assigned to products,
usually in a large batch, which might include an entire months production.
Eventually, costs have to be allocated to individual units of product. It assigns average
costs to each unit, and is the opposite extreme of Job costing which attempts to
measure individual costs of production of each unit. Process costing is a type of


operation costing which is used to ascertain the cost of product at each process or
stage of manufacture.

According to the Terminology of CIMA defines process costing as the costing
method applicable where goods or services result from a sequence of continuous or
repetitive operations or processes. Costs are arranged over the units produced during
the period.

Process costing is mostly used in industries produce the following:
(1) Textile Mills (7) Food processing
(2) Leather (8) Soap making
(3) Chemical works (9) Sugar works
(4) Steel Mills (10) Baby foods
(5) Paper manufacture (11) Paint
(6) Cement manufacture (12) Chemical products

Characteristics of Process Costing
Costs Flow from one Process to Another
Equivalent Production Computation
Average Unit Cost Computation
Normal and Abnormal Losses
Work in Process at Year End
Emergence of More than one Product
Homogenous Products
Uniformed Output
Saleable Output

Application of Process Costing
Process costing is used by those firm which manufacture articles of uniform standards.
These firms manufacture articles on a continuous flow basis. Manufacturing
operations or process is continuous when the arrangement of plant and machinery is
such that the production of an item of standard nature continues for a long period of
time without any stoppages.

Under the following conditions, process costing can be followed:
1) Production of single product
2) Processing of a single product for a certain period
3) Production of several products of a standard design in the same plant
4) Division of a factory into separate operations or process

Recording of Costs under Process Costing
The factory is divided into distinct process or operations and an account is kept for
each process, to which are debited all costs of materials, labor and overhead.
Material: Raw materials required for each process are drawn from stores by the
issue of material requisitions. Where materials are issued in bulk, the
department-in-charge of the process should intimate the quantity of such


materials consumed during a particular period. With the help of these data,
costs of raw materials are debited to the process concerned.
Labor: Wages paid to workmen and supervisory staffs engaged in particular
process are allocated to the process. Where workers are engaged in more than
one process, the gross wages are distributed to different process on the basis of
time spent.
Direct Expenses: Expenses such as cost of electricity, depreciation and hire
charges of equipment are determined easily for each process and allocated to
the process concerned.
Overhead: Where expenses are incurred for two or more processes the total of
such expenditure may be apportioned to different processes on suitable basis.
Sometimes overhead is recovered is recovered at predetermined rate based on
direct wages, prime costs, etc.

Steps in Process Costing
The key document in a typical process costing system is the production cost report,
prepared at the end of each period for each production process or department. The
production cost report summarizes the number of physical units and equivalent units
of a department, the cost incurred during the period and the cost assigned to both units
completed and transferred out and ending work-in-process inventories.

The preparation of a production cost report includes the five steps as follows:
Step 1: Analyze Flow of Physical Units:
Step 2: Calculate Equivalent Units:
Step 3: Determine Total Costs to Account:
Step 4: Compute Unit Costs:
Step 5: Assign Total Manufacturing Costs:

Companies generally divide the five-step production cost report into three parts:
1) Production Quantity I nformation: It includes Step1 Analyze flow of physical
units and Step2 Calculate equivalent units.
2) Unit Cost Determination: It includes Step3 Determine total costs to account
for and Step4 Compute equivalent unit cost.
3) Cost Assignment: It includes Step5 Assign total manufacturing cost (total cost
accounted for)

Problem: A product passes through three distinct processes to completion. These
processes are numbered respectively 1, 2 and 3. During the week ended 31
st
January,
1000 units are produced. The following information is obtained:
Direct Costs Process1 Process2 Process3
Materials
Labor
Direct Expenses
6,000
5,000
1,000
3,000
4,000
200
2,000
5,000
1,000
The indirect expenses for the period was Rs.2,800 apportioned to the process on the
basis of labor cost. Prepare process accounts showing total cost and cost per unit.


Solution
Process1 Account
Output: 1000 Units
Particulars Per
Unit
Total
(Rs)
Particulars Per
Unit
Total
(Rs)
To Materials
To Labor
To Direct expenses
To Indirect expenses
6
5
1
1
6,000
5,000
1,000
1,000
By Output transferred
to Process2
13 13,000
13 13,000 13 13,000

Indirect Expenses as a % of Labor = 2,800 100
5,000 + 4,000 + 5,000

= (2,800 / 14,000) 100 = 20%

Process2 Account
Output: 1000 Units
Particulars Per
Unit
Total
(Rs)
Particulars Per
Unit
Total
(Rs)
To Process1 (transfer)
To Materials
To Labor
To Direct expenses
13.00
3.00
4.00
0.20
0.80
13,000
3,000
4,000
200
800
to Process3
21 21,000
21 21,000 21 21,000

Process3 Account
Output: 1000 Units
Particulars Per
Unit
Total
(Rs)
Particulars Per
Unit
Total
(Rs)
To Process2 (transfer)
To Materials
To Labor
To Direct expenses
21
2
5
1
1
21,000
2,000
5,000
1,000
1,000
to finished stock
30 30,000
30 30,000 30 30,000

Finished Stock Account
Particulars Units Rs. Particulars Units Rs.
To Process3
(1,000 Units)
30 30,000 By Closing Stock 30 30,000



Methods of Process Costing
There are mainly two methods of process costing:
1) Weighted Average Method
2) First-in-First-out Method

Weighted Average Costing Method: The weighted average process-costing method
assigns the average equivalent unit cost of all work done to date (regardless of when it
was done) to equivalent units completed and transferred out, and to equivalent units in
ending inventory. The weighted average cost is simply the average of various
equivalent unit costs entering the work-in-process account.

Steps involved in Weighted Average Costing Method
Step 1: Physical Flow of the Units:
Step 2: Equivalent Units of Production:
Step 3: Costs to be Accounted for:
Step 4: Cost per Equivalent Unit:
Step 5: Costs Accounted for:

Problem: The following figures related to single industrial process:
Opening stock (10,000 units):
Material 2,250
Wages 650
Overhead 400
Units introduced (40,000 units):
Material 9,250
Wages 4,600
Overhead 3,100

3,300

16,950
During the period 30,000 units were completed and 20,000 units remained in process.
The degree of completion of closing stock or WIP as: Material 100% ; Labor 25% ;
Overhead 25%. Make the necessary computations and prepare Process Account by
using average method.

Solution

Statement of Equivalent Production
Input units Particulars Output
units
Equivalent Production
Material Labour and
overhead
10,000

40,000

50,000
Opening work-in-progress
Units started and finished
(40,000 20,000)
Closing work-in-progress

10,000

20,000
20,000
50,000
10,000

20,000
20,000
10,000

20,000
5,000
Equivalent units 50,000 35,000



Statement of Cost
Cost
Element
(A)
Opening
cost (Rs.)
(B)
Cost put in
(Rs.)
(C)
Total cost
(A+B)
(D)
Equivalent
production
units
(CD)
Cost per
unit
(Rs.)
Materials
Wages
Overhead
2,250
650
400
9,250
4,600
3,100
11,500
5,250
3,500
50,000
35,000
35,000
0.23
0.15
0.10
Total cost per unit 0.48

Statement of Evaluation
Particulars Rs.
Cost of finished gods
Closing work-in-progress:
Materials (100% complete)
Labor (25% complete)
Overheads (25% complete)
Cost of Closing WIP
30,000 @ Rs.0.48

20,000@ Rs.0.23
5,000@ Rs.0.15
5,000@ Rs.0.10

14,400

4,600
750
500
5,850

Process Account
Particulars Units Rs. Particulars Units Rs.
To Opening WIP
To Material
To Wages
To Overhead
10,000
40,000
3,300
9,250
4,600
3,100
By Completed and
transferred
By Closing work-in-
process
30,000

20,000
14,400

5,850
50,000 20,250 50,000 20,250

FIFO (First-In-First-Out) Costing Method: The First-In-First-Out process-costing
method assigns the cost of the earliest equivalent units available (starting with the
equivalent units in beginning work-in-process inventory. This method assumes that
the earliest equivalent units in work-in-process Assembly accounts are completed
first.

The First-In-First-Out method computes an average cost that is separate for the current
period from the beginning inventory. FIFO method gives satisfactory results when
prices of materials, rates of wages and overheads are relatively stable.

Steps involved in First-in-First-out Costing Method
Step 1: Physical Flow of the Units:
Step 2: Equivalent Units of Production:
Step 3: Costs to be Accounted for:
Step 4: Cost per Equivalent Unit:
Step 5: Costs Accounted for:



Problem: From the following information, calculate equivalent production.
Opening work-in-progress (30% complete)
Put into the process during the month
Transferred to next process
Closing work-in-progress (40% complete)
2,000 units
20,000units
18,000 units
4,000 units

Solution
Particulars Equivalent
Units
Opening work-in-progress
(70% unfinished work 2000 units)

No. of units introduced and completed during the
month:
Units put into process 20,000
Less: Units not completed 4,000

Closing stock-work done (4000 40%)
Equivalent production

The above calculation may be made by the following
alternative method:
Units completed during the month
Add: Closing stock-work done (4000 40%)

Less: Opening stock-work already done (200030%)

Equivalent production

1,400

16,000

1,600
19,000

18,000
1,600
19,600
600
19,000

FIFO Method versus Weighted Average Cost Method
Point of Reference First-in-First-out (FIFO)
Method
Weighted Average Cost Method
Equivalent Units Equivalent units show the work
which has been done in the
present period.
Equivalent units represent the
work performed till date; this is
inclusive of the work which has
done in the previous period on
the opening work in progress of
present period.
Units Completed There is a difference in the
accounting treatment between
units which are carried forward
from the previous period and
units which are completely
processed in the present period.
No distinction is maintained
between units completed from
opening work in progress or
units started during the present
period.
Cost of Completed
Units
The cost of completed units is
the aggregate of: Cost of
The calculation of the cost of
completed units is done by


opening work in progress +
Present cost which have been
apportioned to opening work in
progress + Present cost of units
completely processed in the
present period.
multiplying the units completed
by cost per unit.
Cost per Equivalent
Unit
Cost per equivalent unit = Cost
incurred in the present period
Equivalent units
Cost per equivalent unit = Cost
incurred to date Equivalent
units

Advantages of Process Costing
o Use for Comparison
o Simple and Easy
o Use for Control
o Accurate Cost Allocation
o Standard Process

Disadvantages of Process Costing
Historical Cost
Error in Average Cost
Problem of Apportionment
Inaccurate WIP
Inaccurate Average Costs

Distinction between Job Order Costing and Process Costing
Basis of Distinction Job Order Costing Process Costing
Specific Orders Job is performed against specific
orders
Production is continuous
Nature Each job may be different Product is homogeneous and
standardized
Cost Centre The cost center is a job The cost center is a process
Cost Ascertainment Costs are collected and
ascertained for each job
separately
Costs are collected and
ascertained for each process
separately
When costs are
calculated?
Job costs are calculated only
when a job is completed
Process costs are calculated at
the end of each period
WIP There may or may not be work-
in-process
There is always some work in
process because of continuous
production
Degree of Control Higher degree of control is
required because of
homogeneous jobs
Lower degree of control is
required because of
homogeneous products and
standardized process
Transfer There are usually no transfers
from one job to another unless
there is some surplus work.
The output of one process is
transferred to another process as
input.



ACTIVITY BASED COSTING
Activity Based Costing system is used to determine product costs for special
management reports. This system is ordinarily used as a supplement to the companys
usual costing system. Activity Based Costing (ABC) is a costing model that identifies
activities in an organization and assigns the cost of each activity resource to all
products and services according to the actual consumption by each activity.

The CIMA Official Terminology defines ABC as Cost attribution to cost units on the
basis of benefit received from indirect activities, for example: ordering, setting up,
assuring quality.

According to Horngren, ABC is a system that focuses on activities as fundamental
cost objects and utilizes cost of these activities as building blocks or compiling the
costs of other cost objects.

Activity Based Costing is only a generic approach and it can be a part of both order
costing system and a process costing system. ABC is an accounting methodology that
assigns costs to activities rather than products or services. This enables resources and
overhead costs to be more accurately assigned to products and services that consume
them.

Figure: Activity Based Costing Model

Resource
Drivers

Direct Direct
Tracing Tracing

Activity
Cost Drivers

Characteristics of Activity Based Costing
Activity based costing increases the number of cost pools used to accumulate
overhead costs.
The number of pools depends upon the cost driving activities.
Direct
Materials
Direct
Labor
Overhead
PRODUCTS
Activity
Cost Pools


Instead of accumulating overhead costs in single company-wise pool or
departmental pools, the costs are accumulated by activities.
It charges overhead costs to different jobs or products in proportion to the cost
driving activities in place of a blanket rate based on direct labor cost or direct
hours or machine hours.
It improves the traceability of the overhead costs, which results in more
accurate unit cost data for management.
Identification of cost during activities and their causes not only help in
computation of more accurate cost of a product but also eliminate non-value
added activities.
The elimination of non-value added activities would drive down the cost of the
product.

In designing an ABC system, there are six essential steps, as listed in the following:
1. Identify, define and classify activities and key attributes.
2. Assign the cost of resources to activities.
3. Assign the cost of secondary activities to primary activities.
4. Identify cost objects and specify the amount of each activity consumed by
specific cost objects.
5. Calculate primary activity rates.
6. Assign activity costs to cost objects.

Basic Steps of Activity Based Costing
The ABC system can be established in an organization by taking several steps as
follows:

Core Areas of Activity Based Costing
In order to correctly associate cost with products and services, ABC assign cost to
activities based on their use of resources. It then assign cot to cost objects, such as
Identifying Major Activities
Assigning Cost to Activity Cost Centers
Selecting Cost Drivers for Allocating Cost to
Cost Drivers
Allocating the Cost of an Activity to Cost
Objects on the Basis of Cost Driver Rates
Identifying Activities and Cost Drivers


product or customers, based on their use of activities. ABC can track the flow of
activities in organization by creating a link between the activity (resource
consumption) and the cost object.

The flow is characterized through four core areas:
1) Cost Object: It is an item for which cost measurement is required for example a
product or a customer.

2) Activities: These consist of the aggregate of different tasks and are concerned with
functions associated with cost objects. There are two types of activities.
i) Support Activities: Support activities are, for example, schedule production,
set up machine, purchase materials, inspect items, customer orders, supplier
records etc.
ii) Production Process Activities: Under the production process activity
machine products and assembled products are included within this production
process.

Activity cost centers are sometimes, similar to cost centers used under
traditional costing system. In case the purchasing department and purchasing
activity both the treated as cost centers, the support activity cost center also
become identical to cost centers taken under traditional costing system.

3) Cost Pool: It is another name given to a cost center and therefore, an activity cost
center may also be termed as an activity cost pool.

4) Cost Drivers: The causes of incurrence of overhead cost are known as cost driver. A
cost driver is a factor the change, of which results in a consequential change in the
total cost of a related cost. If it changes, it brings a change in the level of total cost of
the related cost object.

Following are some of the examples of cost drivers:
i) Machine setups
ii) Purchase orders
iii) Quality inspectors
iv) Production orders
v) Engineering change orders
vi) Shipments
vii) Materials receipts
viii) Inventory movements
ix) Maintenance requests
x) Scrap / reword orders
xi) Machine time
xii) Power consumed
xiii) Miles driven
xiv) Computer-hours logged
xv) Beds occupied
xvi) Flight-hours logged

The activity cost drivers can broadly be classified into following three
categories:
i) Transaction Driver: For example, the purchase order processed, customer
order processed, inspections performed and the set-ups undertaken, all
count the number of times an activity is performed.


ii) Duration Drivers: Mean the amount of time required to perform an
activity. Examples of duration drivers are set-up hours and inspection
hours.
iii) I ntensity Drivers: It refers to drivers which directly charge for the
resources used each times as activity is performed. Duration drivers
establish an average hourly rate of performing an activity while intensity
drivers involve direct charging based on the actual activity resource
relevant to a product.

The cost driver for business functions viz. Research and Development and
Customer Service are as below:
Business Functions
Cost Drivers
Research and Development
Numbers of research products
Personnel hours on a project
Technical complexities of projects
Customer Services
Number of service calls
Number of products services
Hours spent on servicing products

Advantages of Activity Based Costing
It helps understanding the behavior of overhead costs and their relationship to
products, services, customers and market segments.
It helps to allocate the resources to those activities that will increase the
shareholders vale.
It links profitability analysis to operational decisions.
It ensures that the cost of non-value added activities is visible to management.
It provides the right information for performance measurement because it
focuses on activities rather than resources.
The understanding of the cost driver for each activity gives better control over
the factors that cause costs.
It provides accurate information on profit margin and performance
measurement for profit measurement.
It gives business an opportunity to improve their competitive position through
better informations.

Disadvantages of Activity Based Costing
It is essentially not the panacea for all ills.
It absorbs a lot of resources.
Too much emphasis on customer viability can lead to problems such as cheaper
products and therefore, potentially lower sales.
It may lead to weaker customs segmentation.
It takes no account of opportunity cost.


Difference between Activity Based Costing and Traditional Costing
Basis ABC Costing Traditional Costing
Cost Pools ABC systems accumulate
costs into activity cost pools.
These are designed to
correspond to the major
activity or business processes.
By design, the costs in each
cost pool are largely caused
by a single factor the cost
driver.
Traditional costing systems
accumulate costs into facility-
wide or departmental cost
pools. The costs in each cost
pool are heterogeneous they
are costs of many major
processes and generally are
not caused by a single factor.
Allocation Bases ABC systems allocate costs to
products, services, and other
cost objects from the activity
cost pools using allocation
bases corresponding to cost
drivers of activity costs.
Traditional systems allocate
costs to products using
volume-based allocation
bases; units, direct labor input,
machine hours and revenue
dollars.
Hierarchy of Costs Allows for non-linearity of
costs within the organization
by explicitly recognizing that
some costs are not caused by
the number of units produced.
Generally estimates all of the
costs of an organization as
being driven by the volume of
product or service delivered.
Cost Objects Focuses on estimating the
costs of many costs objects of
interest: units, batches,
product lines, business
process, customers, and
suppliers
Focuses on estimating the cost
of a single cost object unit of
product or service.
Decision Support Because of the ability to align
allocation bases with cost
drivers, provides more
accurate information to
support managerial decisions.
Because of the inability to
align allocation bases with
cost drivers, leads to over-
costing and under-costing
problems.
Cost Control By providing summary costs
of organizational activities,
ABC allows for prioritization
of cost- management efforts.
Cost control is viewed as a
departmental exercise rather
than a cross functional effort.
Cost Relatively expensive to
implement and maintain.
Inexpensive to implement and
maintain.



COSTING AND THE VALUE CHAIN
The value chain framework is an approach for breaking down the sequence (chain) of
business functions into the strategically relevant activities through which utility is
added to products and services. Value chain analysis is undertaken in order to
understand the behavior or costs and the sources of differentiation.

According to CIMA Official Terminology, Value analysis is defined as A systematic
interdisciplinary examination of factors affecting the cost of a product or service in
order to devise means of achieving the specified purpose most economically at the
required standard of quality and reliability.

Value chain analysis is relevant for most businesses, but especially those engaging in
two key types of activities:
1) Vertically Integrated Activities: Vertically integrated businesses engage in all
the activities necessary to convert raw materials into a final product. Value
chain analysis helps identify which activities a company performs relatively
efficiently. This analysis is especially useful when a company can substantially
improve or outsource low-return activities.
2) Activities Susceptible to Technological Change: Technology causes value
chains to disintegrate and allows companies to specialize in a narrow set of
activities. Vertically integrated companies that rely on a handful of activities
for their profitability are at risk from specialized companies that perform that
activity better.

Value Chain Approach / Framework
The framework of value-chain provides guidance for a systematic internal analysis of
the firms existing or potential strengths and weakness. Systematic desegregation of a
firm into certain distinct activity categories enables the strategies to identify the key
internal factors, for closer examination, as potential sources of competitive advantage.

There are, for most business enterprises, two broad categories of value activities:
Primary activities and Support activities. The former includes activities connected
with the physical creation of the firms product or service, its marketing and delivery,
and provision of after-sale support. The support activities are those, which provide
inputs or infrastructure for primary activities to be performed.

O
r
g
a
n
i
z
a
t
i
o
n
a
l

A
c
t
i
v
i
t
i
e
s

Firm Infrastructure (e.g. finance, planning)
M
A
R
G
I
N

Human Resource Management
Technology Development
Procurement
Inbound
Logistics
Operations
(management)
Outbound
Logistics
Marketing
and Sales
After Sales
Services
Operational Activities
Figure: Value Chain Framework


Steps in Value Chain Analysis
Value chain analysis can be broken down into a three sequential steps:
1. Break down a market/organization into its key activities under each of the
major headings in the model.
2. Assess the potential for adding value via cost advantage or differentiation or
identify current activities where a business appears to be at a competitive
disadvantage.
3. Determine strategies built around focusing on activities where competitive
advantage can be sustained.

Operational Activities (Primary Activities)
Based on technological and strategic distinctness, the operational activities are
generally divisible into five basic categories as follows:
1) I nbound Logistics:
2) Operations:
3) Outbound Logistics:
4) Marketing and Sales:
5) Service:

Organizational Activities (Support Activities)
Support activities, which provide the infrastructure of primary activities, are also
required to be identified by isolating them on the basis of technological and strategic
distinctiveness. Four categories of organizational activities are generally distinguished
as follows:
1) Procurement
2) Technology Development
3) Human Resource Management
4) Firm Infrastructure

Cost Advantage and the Value Chain
A firm may create a cost advantage either by reducing the cost of individual value
chain activities or by reconfiguring the value chain. A cost analysis can be performed
by assigning costs to the value chain activities. The costs obtained from the
accounting report may need to be modified in order to allocate them properly to the
value creating activities.

Porter identified ten cost drivers related to value chain activities.
1) Economies of scale
2) Learning
3) Capacity Utilization
4) Linkages among activities
5) Interrelationship among
business units
6) Degree of vertical integration
7) Timing of market entry
8) Firms policy of cost or
differentiation
9) Geographic location
10) Institutional factors (regulation,
union activity, taxes, etc)



TARGET COSTING
Target costing a pricing method used by firms. It is defined as a cost management
tool for reducing the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design.

According to Cooper, Target Costing is a disciplined process for determining and
realizing a total cost which a proposed product with specified functionality must be
produced to generate the desired profitability at its anticipated selling price in the
future.

Concept of Target Costing
Target Costing as it has been developed in Japan, was invented by Toyota in 1965.
Thus, the use of target costing has a long tradition at Toyota. At Toyota, they talk
about cost control, i.e. influencing product costs during the design phase and keeping
the running costs as low as possible. Reducing cost through continuous improvement,
cost kaizen, is becoming relatively less important, because the efforts made
throughout the company will inevitably lead to fewer opportunities to cut costs.

Target Costing is built on a comprehensive set of cost planning, cost management and
cost control instruments which are aimed primarily at the early stages of product and
process design in order to influence product cost structures resulting from the market-
derived requirements. The targets costing process requires the cost orient co-
ordination of all product related functions.

Principles of Target Costing
Target costing can best be described as a systematic process of cost management and
profit planning. The six key principles of target costing are:
1) Price-Led Costing: Market prices are used to determine allowable or target
costs. Target costs are calculated using a formula similar to the following:
Market Price Required Profit Margin = Target Cost
2) Focus on Customers: Customer requirements for quality, cost, and time are
simultaneously incorporated in product and process decisions and guide cost
analysis. The value (to the customer) of any features and functionality built into
the product must be greater than the cost of providing those features and
functionality.
3) Focus on Design: Cost control is emphasized at the product and process design
stage. Therefore, engineering changes must occur before production begins,
resulting in lower costs and reduced time-to-market for new products.
4) Cross-Functional Involvement: Cross-functional product and process teams are
responsible for the entire product from initial concept through final production.
5) Value-Chain Involvement: All members of the value chain e.g. suppliers,
distributors, service providers, and customers are included in the target costing
process.
6) Life-Cycle Orientation: Total life-cycle costs are minimized for both the
producer and the customer. Life-cycle costs include purchase price, operating
costs, maintenance, and distribution costs.


Objectives of Target Costing
1) The fundamental objective of target costing is to enable management to use
proactive cost planning, cost management, and cost reduction practices
whereby costs are planned and managed out of a product and business early in
the design and development cycle, rather than during the latter stages of
product development and product.
2) Identify the cost at which the product must be manufactured as if it is to earn its
profit margin at its expected target selling price.
3) Break the target cost down to its component level and have the suppliers find
way to deliver the components they sell at the set target prices while still
making adequate returns.
4) Target costing is intended to get managers thinking ahead and comprehensively
about the cost and other implications of the decisions they made.
5) Target costing is as much a significant business philosophy as it is a process to
plan, manage, and reduce costs.
6) It emphasizes understanding the markets and competition; it focuses on
customer requirements in terms of quality, functions and delivery, as well as
price etc.

Characteristics of Target Costing
1) Target costing is a market-driven strategy and process.
2) Target cost is then calculated by subtracting the desired profit margin from this
target price.
3) The target cost is treated as an independent variable that must be satisfied along
with other customer requirements rather than the result of design decisions
(dependent variable).
4) Target costing is a simple, straightforward process than can have significant
impact on the health and profitability of business.
5) Its mostly logical, disciplined common sense that can be imbedded into a
companys existing procedures and processes.
6) Target costing is a disciplined process that uses data and information in a
logical series of steps to determine and achieve a target cost for the product.
7) Target costing is an integration of economic objectives and technological
knowledge.

Basic Process of Target Costing
Define the Product This step answers the fundamental questions of What are you
selling?, To whom?, What do they want it to do?.
Set the Product Second stage addresses the issue of What will they pay for it?
What should it cost to produce?
Achieve the Product It is concerned with How can we get there? Are we getting
there?
Maintaining Competitive Cost It deals with How can we stay ahead?


Steps of Target Costing
The following ten steps are required to install a comprehensive target costing
approach within an organization.

Advantages of Target Costing
o Proper Delivery
o Minimizing Product-Line Complexity
o Selecting Appropriate Product and Process Technologies
o Lowering Design Churn (Mix) Late in the Innovation Process
o Creative Competitive Future
o Eliminating Cost Overruns

Disadvantages of Target Costing
Misuse of the Technique
Stress on the Design Team
Take Long Time
Too Many Opinions
Re-orient Thinking
Establish Target Price
Determine Target Cost
Balance Target Cost
Establish Target Costing Process
Brainstorm and Analyze
Establish Product Cost
Use Tools
Reduce Indirect Cost
Measure Results and Maintain
Foucs


MARGINAL COSTING INCLUDING DECISION MAKING
Marginal cost is the cost of producing an additional unit of output or service. It is not
a system of costing like process or job costing, but it has been designed simply as an
approach to the presentation of accounting information. It adjudges profitability of an
enterprise by carefully studying the impact of the range of costs according to their
respective nature.

Marginal costing is the ascertaining of marginal costs, by differentiating between
fixed costs and variable costs and of the effect on profit of changes in volume or type
of output.

The Institute of Cost and Management Accountants, London, has defined Marginal
Costing as the ascertainment of marginal costs and of the effect on profit of changes
in volume or type of output by differentiating between fixed costs and variable costs.

To ascertain the marginal cost, we need the following elements of cost:
(a) Direct materials
(b) Direct labor
(c) Direct expenses and
(d) Total variable overheads.

That is,
Marginal Cost = Prime Cost + Total Variable Overheads
(or)
Marginal Cost = Total Cost Fixed Cost

Thus, Marginal costing, we can say it as, direct costing, differential costing,
incremental costing and comparative costing. Batty defines Marginal Costing as, a
technique of cost accounting which pays special attention to the behavior of costs with
changes in the volume of output.

For Example: Variable cost 800 @ Rs.50/- = Rs.40,000/-
Fixed cost = Rs.10,000/-
Total cost = Rs.50,000/-

If the production is increased by 10 units, then accordingly the cost varies:
Variable cost 810 @ Rs.50/- = Rs.40,500/-
Fixed cost = Rs.10,000/-
Total cost = Rs.50,500/-
Less: Total cost of 800 units = Rs.50,000/-

** Marginal cost of one unit = Rs.500/10 = Rs.50/-
Marginal cost = Increase in total cost / Increase in total units


Main Features of Marginal Costing
1. Marginal costing is a technique which is used in conjunction with other
methods of costing (process or job).
2. Fixed and variable costs are kept separate at every state.
3. As fixed costs are period costs, they are excluded from product cost and only
variable costs are considered as the cost of the product.
4. The difference between the contribution and fixed costs is the net profit or loss.
5. Cost-volume-profit relationship if fully employed to reveal the state of
profitability at various levels of activity.

Advantages of Marginal Costing
Simple to Operate and Easy to Understand
Removes complexities of Under-Absorption of overheads
Helps Management in Production Planning
No possibility of Fictitious Profit by Over-Valuing Stocks
Facilitates Calculation of Important Factors
Aid to Management
Facilitates the Study of Relative Profitability
Complimentary to Standard Costing and Budgetary Control
Helps in Cost Control
Profit Planning

Advantages of Marginal Costing
o Segregation into Fixed and Variable A Difficult Task
o Ignores Fixed Overheads
o Not Appropriate for Job/Contract Costing
o Assumption Regarding Behavior of Costs
o Problems in regard to Under or Over-Absorption
o Unable to Fix Selling Prices
o Useful Only in Short Profit Planning and Decision-Making
o Non-Recognition from Government Authorities

Absorption Costing and Marginal Costing
Absorption costing is the practice of charging all costs, both fixed and variable to
operations, process or products. In marginal costing, only variable costs are charged
to production.

The Institute of Cost and Management Accountants (U.K) defines it as, the practice
of charging all costs, both variable and fixed to operations, processes or products.
This explains why this technique is called full costing. Administrative, selling and
distribution overheads as much form part of total cost as prime cost and factory
burden.



Problem:
The monthly cost figures for production in a manufacturing company are:
Variable Cost Rs.1,20,000
Fixed Cost Rs. 35,000
Total Cost Rs.1,55,000

Normally monthly sales figure is Rs.2,00,000
Actual sales figures for three separate months are:
I Month II Month III Month
Rs.2,00,000 Rs.1,65,000 Rs.2,35,000

Under a system of marginal costing stock are valued as:
Opening Stock Rs.84,000 Rs. 84,000 Rs.1,05,000
Closing Stock Rs.84,000 Rs.1,05,000 Rs. 84,000

I f the marginal costing technique were not used stock would be valued as follows:
Opening Stock Rs.1,08,500 Rs.1,08,500 Rs.1,35,625
Closing Stock Rs.1,08,500 Rs.1,35,625 Rs.1,08,500

Prepare two tabulation, side-by-side, to summarize these results for each of the three
months, basing one tabulation on marginal cost and the other tabulation alongside on
absorption cost theory.

Marginal Costing Absorption Costing
I Month
I I
Month
I I I
Month
I Month
I I
Month
I I I
Month
Rs. Rs. Rs. Rs. Rs. Rs.
Opening Stock
Variable Cost
Fixed Cost
Total
Less: Closing Stock
Cost of Sales
Sales
Contribution
Less: Fixed Cost
Profit
Margin % on Sales
Profit on Sales
84,000
1,20,000
---
2,04,000
84,000
1,20,000
2,00,000
80,000
35,000
45,000
40%
22.5%
84,000
1,20,000
----
2,04,000
1,05,000
99,000
1,65,000
66,000
35,000
31,000
40%
18.8%
1,05,000
1,20,000
-----
2,25,000
84,000
1,41,000
2,35,000
94,000
35,000
59,000
40%
25%
108,500
1,20,000
35,000
2,63,500
1,08,500
1,55,000
2,00,000
45,000
----
45,000
22.5%
22.5%
1,08,500
1,20,000
35,000
2,63,500
1,35,625
1,27,875
1,65,000
37,125
----
37,125
22.5%
22.5%
1,35,625
1,20,000
35,000
2,90,625
1,08,500
1,82,125
2,35,000
52,875
----
52,875
22.5%
22.5%



Distinction Between Marginal Costing And Absorption Costing
Absorption Costing Marginal Costing
1. All costs fixed and variable are
charged to Product.
2. Profit = Sales Cost of Goods Sold
3. It does not reveal the cost volume
profit Relationship.
4. Closing inventories are valued at full
cost. Absorption costing reveals more
profit since the inclusion of fixed costs in
inventories.
5. Costs are included in the products, this
leads to over or under-absorption.
1. Only variable costs are charged to
products; fixed costs are transferred to
P& L Account.
2. Contribution margin = S VC and
Profit = Contribution FC
3. Cost Volume Profit relationship is an
important part of marginal costing.
4. Closing inventories are valued at
variable cost. Marginal costing reveals
less profit when compared to absorption
cost.
5. Fixed costs are not included in the
product; it will not lead to the problem of
under-absorption.

Marginal Cost Equations
Sales = Variable Cost + Fixed Cost Profit or Loss
Sales Variable Cost = Fixed Cost Profit or Loss
Sales Variable Cost = Contribution
Contribution = Fixed Cost + Profit

From the above equations we can understand that in order to earn profit, the
contribution must be more than the fixed cost. To avoid any loss, the contribution
must be equal to fixed cost.

Decision Making Under Marginal Costing System
Marginal Costing is an extremely valuable technique with the management. The cost
volume-profit relationship has served as a key to locked storehouse of solutions to
many situations. It enables the management to tackle many problems which are faced
in the practical business. All the introduction of marginal cost principles does is to
give the management a fresh and perhaps a refreshing, insight into the progress of
their business.

Marginal Costing helps the management in decision-making in respect of the
following vital areas:
Cost Control
Fixation of Selling Price
Closure of a Department or
Discontinuing a Product
Selection of a Profitable Product
Mix
Profit Planning
Decision to Make or Buy
Decision to Accept a Bulk Order
Introduction of New Product
Choice of Technique
Evaluation of Performance
And Decision Making
Maintaining a Desired Level of
Profit
Level of Activity Planning
Alternative Methods of Production
Introduction of Product Line


PROFIT VOLUME RATIO (P/V RATIO)
Profit volume ratio, which is popularly known as P/V Ratio, expresses the relationship
of contribution to sales. Another name for this ratio is contribution-sales ratio or
marginal-income ratio or variable-profit ratio. The ratio, expressed as a percentage,
indicated the relative profitability of different products.

The formula for computing the P/V Ratio is:
P/V Ratio = Contribution [C/S]
Sales
(or)
= Fixed Cost + Profit [F+P/S]
Sales
(or)
= Sales Variable Cost [SV/S]
Sales

It can be expressed in percentage. Normally, this ratio is expressed in percentage.
When we know the P/V ratio, B.E.P. can be calculated, by using the formula:

B.E.P. (Sales Volume) = Fixed Cost [F / PV Ratio]
P/V Ratio

The profit of the business can be increased by improving P/V ratio. As such
management will make efforts to improve the ratio. A higher ratio means greater
profitability and vice versa. So management will increase the P/V Ratio:
(a) by increasing sales price per unit.
(b) by decreasing variable cost
(c) by increasing the production of products.

P/V ratio is very important in decision-making. It can be used for the calculation of
B.E.P. and in problems regarding profit sales relationship.

1. B.E.P. = Fixed Cost [F / PV Ratio]
P/V Ratio

2. Fixed Cost = B.E.P * P/V ratio
3. Sales required in units to maintain a desired profit
= Fixed Cost + Desired Profit [F+P / PV Ratio]
P/V Ratio

= Required contribution
New contribution per unit

4. Contribution = Sales*P/V ratio
5. Variable Costs = Sales (1P/V ratio)


Problem
Marginal Cost Rs.2400
Selling Price Rs.3000
Calculate P/V ratio.

Solution
P/V ratio = Contribution / Sales * 100
= (3000-2400) / 3000*100
= 600 / 3000*100

Problem
The sales turnover and profit during two periods are as under:
Period I = Sales Rs.20 lakhs; Profit Rs.2 lakhs
Period II = Sales Rs.30 lakhs; Profit Rs.4 lakhs
Calculate P/V ratio.

Solution
P/V ratio = Change in Profit / Change in Sales *100
= 2,00,000 / 10,00,000 *100
= 20%

Problem
The following data are obtained from the records of a company:
First Year Second Year
Sales Rs.80,000 Rs.90,000
Profit Rs.10,000 Rs.14,000
Calculate the break-even point.

Solution
B.E.P. (Sales) = Fixed Cost
P/V ratio

P/V ratio = Change in Profit / Change in Sales *100
= 4000 /10,000 *100
= 40%

Fixed Cost = Contribution Profit

Contribution = Sales * P/V ratio
= 80,000 * 40% = 32,000

= 32,000 10,000 = 22,000

B.E.P. (Sales) = 22,000 = Rs.55,000
40%


Break-Even Point Analysis
The break-even point and break-even chart are two by-products of break-even
analysis. In a narrow sense, it is concerned with the break-even point and in a broad
sense it is concerned with break-even chart. Break-even analysis is also known as
cost volume profit analysis. This analysis is a tool of financial analysis whereby the
impact on profit of the changes in volume, price, costs and mix can be estimated with
reasonable accuracy. Break-even point is equilibrium point or balancing point of no-
profit no-loss. This is a point at which loss ceases and profit begins. This is a point
where income is exactly equal to expenditure.

Break-even point
Break-even point is a point where the total sales are equal to total cost. In this point
there is
no profit or loss in the volume of sales. The formula to calculate break-even point is:

B.E.P. (in units) = Total Fixed Cost
Contribution per unit
(or)
= Fixed Cost
Selling price per unit Variable cost per unit

Problem
From the following particulars calculate the break-even point:
Variable cost per unit Rs.12
Fixed expenses Rs.60,000
Selling price per unit Rs.18

Solution


Selling price Variable cost = Contribution
Rs.18 Rs.12 = Rs.6


= Rs.60,000 / Rs.6 = 10,000 units

B.E.P. Sales = 10,000*Rs.18 = Rs.1,80,000


Margin of Safety
Margin of Safety is an important concept in Marginal Costing Approach. A total sale
minus the sales at break-even point is known as the Margin of Safety (M/S). That is
Margin of Safety is the excess of normal or actual sales over sales at break-even point.
In other words, sales over and above break-even sales are known as Margin of Safety.
The Margin of Safety refers to the amount by which sales revenue can fall before a
loss is incurred. That is, it is the difference between the actual sales and sales at the
break-even point.

Break-even point can be compared to a Red Signal Point. If the Margin of Safety is
large, it is a sign of soundness of the business and vice versa. The Margin of Safety
serves as a guide, is a reliable indicator of the business strength and soundness.
Margin of Safety can be expressed in absolute sales amount or in percentage. High
Margin of Safety indicates the soundness of a business because even with substantial
fall in sale or fall in production, some profit shall be made. Small margin of safety on
the other hand is an indicator of the weak position of the business and even a small
reduction in sale or production will adversely affect the profit position of the business.

Margin of Safety can be increase by:
(a) Decreasing the fixed cost;
(b) Decreasing the variable cost;
(c) Increasing the selling price;
(d) Increasing output and sales;
(e) Changing to a product mix that improves P/V Ratio.

Margin of Safety = Actual Sales Sales at BEP

(or) = Profit / PV ratio
(or) = Profit / Contribution

As a percentage = Margin of Safety *100
Total Sales

Problem: From the following details find out (a) Profit Volume Ratio, (b) B.E.P., (c)
Margin of Safety.
Rs.
Sales 1,00,000
Total Costs 80,000
Fixed Costs 20,000
Net Profit 20,000

Solution
(a) P/V Ratio = Sales Variable expenses * 100
Sales
= 1,00,000 60,000 * 100 = 40%
1,00,000


(b) B.E.P. = Fixed Cost = 20,000 *100 = Rs.50,000
P/V Ratio 40

(c) Margin of Safety = Profit = 20,000 *100 = Rs.50,000
P/V Ratio 40

(or)

Margin of Safety = Actual Sales Sales at BEP
= 1,00,000 50,000 = Rs.50,000

Problem
The following information was obtained from a Company in a certain year:
Sales Rs.1,00,000
Variable Cost Rs. 60,000
Fixed Cost Rs. 30,000

Find the P/V Ratio, Break-even Point and Margin of Safety.

Solution
P/V Ratio = S V *100 = 1,00,000 60,000 *100 = 40%
S 1,00,000

Break-Even Point = FC = 30,000 = Rs.75,000
P/V Ratio 40%

Margin of Safety = Profit = 10,000 = Rs.25,000
P/V Ratio 40%

(or) = Sales Break-Even Sales
= 1,00,000 75,000 = Rs.25,000

Sales Mix Decision
Presuming that fixed costs will remain unaffected, decision regarding sales/production
mix is taken on the basis of the contribution per unit of each product. The product
which gives the highest contribution should be given the highest priority and the
product whose contribution is the least, should be given the least priority. A product
giving a negative contribution should be discontinued or given up unless there are
other reasons to continue its production.



Problem
Following information has been made available from the cost records of United
Automobiles Ltd., manufacturing spare parts.
Direct Materials Per unit
X Rs.8
Y Rs.6
Direct Wages
X 24 hours @ 25 paise per hour
Y 16 hours @ 25 paise perhour
Variable Overheads 150% of direct wages
Fixed Overheads (total) Rs.750
Selling Price
X Rs.25
Y Rs.20

The directors want to be acquainted with the desirability of adopting any one of the
following alternative sales mixes in the budget for the next period.
(a) 250 units of X and 250 units of Y
(b) 400 units of Y only
(c) 400 units of X and 100 units of Y
(d) 150 units of X and 350 units of Y

State which of the alternative sales mixes you would recommend to the management.

Solution
MARGINAL COST STATEMENT (PER UNIT)
Particulars Products
X Y
Rs. Rs.
Direct Materials 8 6
Direct Wages 6 4
Variable Overheads 9 6
Marginal Cost 23 16
Contribution 2 4
Selling Price 25 20



SELECTION OF SALES ALTERNATIVE

(a) 250 units of X and 250 units of Y
Contribution:
Product X 250 units*2 Rs. 500
Product Y 250 units*4 Rs.1000
Rs.1500
Less: Fixed Overheads Rs. 750
Profit Rs. 750
(b) 400 units of Y only
Contribution:
Profit Rs. 850

(c) 400 units of X and 100 units of Y
Contribution:
Product Y 100 units*4 Rs. 400
Rs.1200
Profit Rs. 450

(d) 150 units of X and 350 units of Y
Contribution:
Rs.1700
Profit Rs. 950

The alternative (d) is most profitable since it gives the maximum profit of Rs.950.

BUDGETARY CONTROL & VARIANCE ANALYSIS
Budget is a detailed plan of operations for some specific future period. It is an
estimated prepared in advance of the period to which it applies. It acts as a business
barometer as it is a complete programme of activities of the business for the period
covered.

According to George R Terry, A Budget is an estimate of future needs arranged
according to an orderly basis, covering some or all of the activities of an enterprise for
definite period of time.



According to Crown and Howard, A budget is a pre-determined statement of
management policy during a given period which provides a standard for comparison
with the results actually achieved.

Features of Budget
One Years Duration
Estimation of Business Units Profit Potential
Appraisal of Performance
Monetary Terms
Alteration of Approved Budget under Specified Conditions
Review and Approval by a Higher Authority
Managerial Commitment

The following are the essentials of a budget:
(a) It is prepared in advance and is based on a future plan of activities.
(b) It relates to a future period and is based on objectives to be attained.
(c) It is a statement expressed in monetary and physical units prepared for the
implementation of policy formulated by the management.
(d) It expresses largely in financial terms, of managements plans for operating and
financing the enterprise during specific periods of time.

Budgeting
Budgeting is the most common, useful and widely used standard device of planning
and control. Budgeting or Planning has become the primary function of management
these days. Most of the planning relates to individual situations and individual
proposals. However, this has to be supplemented and reinforced by overall periodic
planning followed by continuous comparison of the actual performance with the
planned performance.

Estimate, Forecast and Budget
An estimate is predetermination of future events either on the basis of simple
guess work or following scientific principles.
Forecast is an assessment of probable future events.
Budget is based on the implications of a forecast and related to plan events.

Budgeting Control
The budgetary control has now become an essential tool of the management for
controlling costs and maximizing profit. Budgeting control is applied to a system of
management and accounting control by which all operations and output are forecasted
as far ahead as possible and actual results when known are compared with budget
estimates.

According to CIMA, London, defines budgetary control as the establishment of
budgets relating to the responsibilities of executives to the requirements of a policy
and the continuous comparison of actual with budgeted result either to secure by


individual action the objectives of that policy or to provide a firm basis for its
revision.

The Essentials of Budgetary Control are:
(a) Establishment of budgets for each function and section of the organization.
(b) Executive responsibility in order to perform the specific tasks so that objectives
of the enterprise may be attained.
(c) Continuous comparison of the actual performance with that of the budget so as
to know the variations from budget and placing the responsibility of executives
for failure to achieve the desired result as given in the budget.
(d) Taking suitable remedial action to achieve the desired objective if there is a
variation of the actual performance from the budgeted performance.
(e) Revision of budgets in the light of changed circumstances.

Objectives of Budgetary Control
1. Planning
2. Co-ordination
3. Control

Types of Budgets
There are several types of budgets such as Fixed Budget, Flexible Budget, Long Term
Budget, Short Term Budget, Current Budget, Zero Base Budget, etc.
Fixed budget remains unchanged irrespective of the level of activity actually
attained.
Flexible budget is designed to change in accordance with the level of activity.
Long term budget is prepared for the period of 5 to 10 years
Short term budget is prepared for the period of 1 to 2 years
Current budget is prepared for the period of few months and weeks
Zero base budget (ZBB) is equalizing the expenditure with budgeted figures
and to control the cost. No previous figure is to be taken as a base figure for
adjustments and each activity is to be examined afresh.

Classification of Budget

On the Basis of Time On the Basis of Function On the Basis of Flexibility

Long-term Short-term Current
Budget Budget Budget

Operating Financial Master Fixed Flexible
Budget Budget Budget Budget Budget



Classification According to Time
In terms of time, the Budget can broadly be classified into four categories:
(a) Long-term Budget: A budget designed for a long period, generally for a period
of 5 to 10 years, is termed as a Long-term Budget. These budgets are
concerned with planning of the operations of a firm over a considerably long
period of time. They are generally prepared in in terms of physical quantities.
(b) Short-term Budget: These budgets are designed for a period generally not
exceeding 5 years. They are generally prepared in physical as well as in
monetary units.
(c) Current Budgets: These budgets cover a very short period, say, a month or a
quarter. They are essentially short-term budgets adjusted to current conditions
or prevailing circumstances.

Classification According to Function
These budgets are, therefore, also termed as Functional Budgets.
The following are the usual operational budgets.
1) Sales Budget: The budget forecasts total sales in terms of quantity, value,
items, periods, areas, etc.
2) Production Budget: The budget is based on Sales Budget. It forecasts quantity
of production in terms of items, periods, areas, etc.
3) Cost of Production Budget: The budget forecasts the cost of production.
Separate budgets are prepared for different elements of costs.
4) Purchase Budget: The budget forecasts the quantity and value of purchase
required for production. It gives quantity-wise, money-wise and period-wise
information about the materials to be purchased.
5) Personnel Budget: The budget anticipates the quantity of personnel required
during a period for production activity. This may be further split up between
direct and indirect personnel budgets.
6) Research Budget: The budgets relates to the research work to be done for
improvement in quality of the products or research for new products.

The following are the usual financial budgets.
1) Capital Expenditure Budget: The budget provides a guidance regarding the
amount of capital that may be required for procurement of capital assets during
the budget period.
2) Cash Budget: The budget is a forecast of the cash position by time period for a
specific duration of time. It states the estimated amount of cash receipts and
the estimation of cash payments and the likely balance of cash in hand at the
end of different periods.

The following is the usual master budget.
Master Budget: It is a summary budget incorporating all functional budgets in capsule
form. It interprets different functional budgets and covers within its range the
preparation of projected income statement and projected balance sheet.



Classification According to Flexibility
On the basis of flexibility, budgets can be divided into two categories:
(1) Fixed Budget: A budget prepared on the basis of a standard or a fixed level of
activity is called a fixed budget. It does not change with the change in the level of
activity. It is rigid budget and is drawn on the assumption that there will be no change
in the budgeted level of activity.
(2) Flexible Budget: A budget designed in a manner so as to give the budgeted cost of
any level of activity is termed as a flexible budget. Flexible budget gives different
budgeted costs for different levels of activity. This budget is prepared and applicable
to those industries where the level of activity during the year varies from period to
period, either due to the seasonal nature or variation in demand.

Distinction between Fixed Budget and Flexible Budget
The following are the main differences between these two budgets:
Point of
Distinction
Fixed Budget Flexible Budget
Flexibility
It is inflexible and does not
change with the actual volume
of output achieved
It is flexible and can be
suitably
re-casted quickly according to
level of activity attained.
Condition
It assumes that conditions
would remain static
It is designed to change
according to changed
conditions
Classification of
costs
Costs are not classified
according to their variability.
Costs are classified according
to the nature of their variability
Comparison
Comparison of actual and
budgeted performance cannot
be done.
Comparison of actual and
budgeted performance can be
done
Forecasting
It is difficult to forecast
accurately the results in it.
It clearly shows the impact of
various expenses of the
business.
Budget
Only one budget at a fixed
level of activity is prepared and
all conditions will remain
unaltered.
Series of budgets are prepared
at different levels of activity.
Ascertainment of
costs
It is not possible to ascertain
cost correctly at different
levels.
Costs can be easily ascertained
at different levels of activity
Tool for cost
control
It has limited application and is
ineffective as a tool for cost
control.
It has more application and can
be used as a effective tool for
cost control.
Fixation of prices
and submission of
tenders
If the budgeted and actual
activity levels vary, the correct
ascertainment of costs and
fixation of prices becomes
difficult.
It helps in fixation of price and
submission of tenders due to
correct ascertainment of costs.


SALES BUDGET
Sales budget is the most important budget and of primary importance. It forms the
basis on which all the other budgets are built up. This budget is a forecast of quantities
and values of sales to be achieved in a budget period. Every effort should be made to
ensure that its figures are as accurate as possible because this is usually the starting
budget. The Sales Manager should be made directly responsible for the preparation
and execution of the budget.

The sales budget may be prepared according to products, sales territories, types of
customers, salesmen etc. In the preparation of the sales budget, the sales manager
should take into consideration the following factors:
Past sales figures and trends
Salesmens estimates
Plant capacity
Availability of raw material and other supplies
General trade prospects
Orders in hand
Seasonal fluctuations
Financial aspect
Adequate return on capital employed
Competition
Miscellaneous considerations (advertising, government policies etc.)

The sales manager after taking into consideration the above factors, should prepare the
sales budget in terms of quantities and amount and the sales estimates must be
analyzed for products periods and territories. The sales budget should include an
estimate of selling and distribution costs in addition to an estimate of the total
proceeds.

The specimen of the sales budget is given as under:
Division: SALE BUDGET Year:
Area Production
For the Year Per Month
Quantity
kgs.
Rate
Per kg.
Value
Rs.
Quantity
kgs.
Value
Rs.
North
Marie
Good day
Bourbon

Total
South
Marie
Coco-cream
Orange cream

Total
East
Horlicks
Bourbon
Good day

Total


West
Marie
Good day
Bourbon

Total
Total
Marrie
Good day
Horlicks
Bourbon
Coco-cream
Orange cream

Total

A sales forecast may be just a guess of sales without taking into consideration
production capacity and may lack any objective to control the actual performance. On
the other hand, estimate of the sales given in the sales budget is not mere guess; it is
based on the plant capacity, availability of materials, labour and working capital and
many other considerations. It is capable of being achieved; thus, it is amenable to
control.

Problem
A manufacturing company submits the following figures of product X for the first
quarter of 2009.
Sales (in units) January 50,000
February 40,000
March 60,000
Selling price per unit Rs.100

Target of 1
st
Quarter 2010
Sales quantity increase 20%
Sales price increase 10%

Prepare sales budget for the first quarter of 2010.

Solution
SALES BUDGET
for the first quarter of 2010
Month Units Price per unit (Rs) Value (Rs)
January 60,000 110 66,00,000
February 48,000 110 52,80,000
March 72,000 110 79,20,000
Total 1,80,000 1,98,00,000



PRODUCTION BUDGET
Production budget is a forecast of the total output of the whole organization broken
down into estimates of output of each type of product with a scheduling of operations
(by weeks and months) to be performed and a forecast of the closing finished stock.
This budget may be expressed in quantitative (weight, units etc) or financial (rupees)
units or both. This budget is prepared after taking into consideration the estimated
opening stock, the estimated sales and the desired closing finished stock of each
product.

Suppose, if the estimated opening stock of product X is 2,000 units and the estimated
sales is 15,000 units and the closing stock of the product is 2500 units the estimated
production will be 15,000 + 2500 + 2000 (Sales + Closing stock opening stock) =
15,500 units. The Works Manager is responsible for the total production budget and
the departmental managers are responsible for the departmental production budget.

The material, labour and plant requirements should be ascertained to have the desired
production to meet the sales programme. The sales and the production budget are
inter-dependent because production budget is governed by the sales budget and the
sales budget is largely determined by the production capacity and by production costs.

The specimen pro-forma of production budget is given below:
PRODUCTION BUDGET
Department: Production Year:
Months
Quanti
ty of
sales
Add
Quantity
of
closing
stock
Total
Quantity
Required
Less
Quantit
y of
Openin
g Stock
Producti
on Units
to be
Complet
ed
Add
Equivalent
Units in
Closing
Work-in-
progress
Less
Equivalen
t Units in
Opening
Work-in-
progress
Total
Equiva
lent
Units
to be
Compl
eted
January
February
March
April
May
June
July
August
September
October
November
December
TOTAL



Problem (Production Budget)
A manufacturing company submits the following figures relating to Product X for the
first quarter of 2010.
Sales Targets: January 60,000 units
February 48,000 units
March 72,000 units

Stock position: 1
st
January 2010 (% of January 2001 sales) 50%
31
st
March 2010 40,000 units
End January & February 50%
(% of subsequent months sales)

You are required to prepare production budget for the first quarter of 2010.

Solution
PRODUCTION BUDGET FOR THE 1
ST
QUARTER OF 2010
Month Sales (units) closing stock
(units)
Opening stock
(units)
Production
(units)
January 60,000 24,000 30,000 54,000
February 48,000 36,000 24,000 60,000
March 72,000 40,000 36,000 76,000
Total 1,90,000

COST OF PRODUCTION BUDGET
After determining the volume of output the cost of procuring the output must be
obtained by preparing a cost of production budget. This budget is an estimate of cost
of output planned for a budget period and may be classified into
(a) Material cost budget,
(b) Labour cost budget and
(c) Overhead budget (cost of production includes material, labour and
overheads).

(a) Material Budget: In drawing up the production budget, one of the first requirements
to be considered is material. As we know, materials may be direct or indirect. Thus,
material budget deals with the requirement and procurement of direct materials.
Indirect materials are dealt with under the works overhead budget.

Materials budget can be classified into material requirement budget and material
procurement purchase budget. The material requirement budget gives information
about the quantity of material required during the budget period to attain the
production target. Material requirement budget takes into consideration the inventory
of materials and the materials on order at the beginning of a budget period and the
anticipated inventory of materials and the materials to be on order on the closing date
of the budget period.


Problem (Material Budget)
Draw up a Material Requirement Budget from the following information:
Estimated sales of a product are 40,000 units. Each unit of the product requires 3 units
of material A and 5 units of material B.
Estimated opening balances at the commencement of the next year:
Finished product - 5000 units
Material A - 12,000 units
Material B - 20,000 units
Material on order
The desirable closing balances at the end of the next year:
Finished product - 7000 units
Material on order

Solution
Estimated production during the next year is not given in the question. It is
calculated as follows:
Estimated production = Expected sales + Desired closing stock of
finished goods Estimated opening stock of
finished goods
= 40,000 units + 7,000 units 5,000 units
= 42,000 units

MATERIAL REQUIREMENT BUDGET
(Quantitative)
Material A
Units
Material B
Units
Material required to meet the production target:
Material A @ 3 units for 42,000 finished units
Material B @ 5 units for 42,000 finished units
Desiring closing balances of materials at the end
of the budget period
Estimated units of materials to be on order at the
end of the budget period

1,26,000

15,000

8,000

2,10,000

25,000

10,000

Less: Estimated opening balances of materials at
the beginning of the period
1,49,000

12,000
2,45,000

20,000

Less: Estimated units of materials at the
beginning of the budget period
1,37,000

7,000
2,25,000

11,000
1,30,000 2,14,000


(b) Direct Labour Budget: This budget gives an estimate of the requirement of direct
labour essential to meet the production target. This budget may be classified into
labour requirement budget and labour recruitment budget. The labour requirement
budget is developed on the basis of requirement of the production budget given and
detailed information regarding the different classes of labour.

In preparing the labour cost budget, the question of overtime should not be overlooked
because workers are to get higher rates of wages if they work on overtime. Regular
overtime should be avoided by engagement of additional workers and extension of
plant.

Problem (Direct Labour Budget)
P Limited manufactures two products using one grade of labour. Shown below is an
extract from the companys working papers for the next periods budget:
Product A Product A
Budgeted production (units) 3,480 4,000
Standard hour allowed per product 5 4

Budgeted wage rate Rs.8 per hour. Overtime premium is 50% and is payable, if a
worker works for more than 40 hours a week. There are 90 direct workers.

The target productivity ratio (or efficiency ratio) for the productive hours worked by
the direct workers in actually manufacturing the production is 80%; in addition the
non-productive downtime is budgeted at 20% of the productive hours worked. There
are twelve 5 days weeks in the budget period. Calculate the wages budget for direct
workers showing hours required and wages paid.

Solution
DIRECT WORKERS WAGES BUDGET
(Showing hours required and wages paid)
Product A Product B Total
Budget production in units
Standard hours for budgeted production
3,480
17,400
4,000
16,000

33,400
Standard hours for budgeted production at target efficiency ratio (A)
33,400 hours (100/80)
Add: Normal productive down time (20% 41,750 hours)
41,750

8,350
Total labour hours required
Less: Normal labour hours (90 workers 12 weeks 5 days 8
hours)
50,100
43,200
Difference (overtime) 6,900
Wages for normal hours (43,200 Rs.8)
Overtime wages (6,900 Rs.12)
3,45,600
82,800
Total wages
4,28,400



(c) Manufacturing Overheads Budget: This budget gives an estimate of the works
overhead expenses to be incurred in a budget period to achieve the production target.
The budget includes the cost of indirect materials, indirect labour and indirect works
expenses. The budget may be classified into fixed cost, variable cost and semi-
variable cost. It can be broken into departmental overhead budget to facilitate control.

Problem (Manufacturing Overheads Budget): Prepare a manufacturing overhead budget and
ascertain the manufacturing overhead rates at 50% and 70% capacities. The following
particulars are given at 60% capacity:
Variable overheads: Rs.
Indirect Material 6,000
Indirect Labour 18,000
Semi-variable overheads:
Electricity (40% fixed) 30,000
Repairs and Maintenance (20% variable) 3,000
Fixed overheads:
Depreciation 16,500
Insurance 4,500
Salaries 15,000
Total overheads 93,000
Estimated direct labour hours 1,86,000 hours.

Solution: MANUFACTURING OVERHEAD BUDGET AND ASCERTAINMENT OF
OVERHEAD RATES
Items 50%
Capacity
60%
Capacity
70%
Capacity
Variable overheads:
Indirect Material
Indirect Labour
Semi-variable overheads:
Electricity
Repairs and maintenance
Fixed overheads:
Depreciation
Insurance
Salaries
Total overheads (a)
Estimated direct labour hours (b)
Overhead rate [(a) (b)]
Rs.
5,000
15,000

27,000
2,900

16,500
4,500
15,000
85,900
1,55,000
Re.0.55
Rs.
6,000
18,000

30,000
3,000

16,500
4,500
15,000
93,000
1,86,000
Re.0.50
Rs.
7,000
21,000

33,000
3,100

16,500
4,500
15,000
1,00,100
2,17,000
Re.0.46
Notes: Electricity: At 60% electricity cost is Rs.30,000 of which Rs.12,000 (i.e. 40% of
Rs.30,000) is fixed and Rs.18,000 variable. The variable portion of the electricity cost is
Rs.15,000 (i.e. [(18000/60)50] at 50% capacity and Rs.21,000 (i.e. [(18000/60)70] at
70% capacity. To this variable portion, the fixed portion of Rs.12,000 should be added to get
the electricity cost.
Repairs and Maintenance: At 60% capacity repairs and maintenance cost is Rs.3,000 of which
Rs.2,400 (i.e. 80% of Rs.3,000) is fixed and Rs.600 is variable. The variable portion at 50%
is Rs.500 (i.e. [(600/60)50] and Rs.700 (i.e. [(600/60)70] at 70% capacity. To this
variable, the fixed portion of Rs. 2,400 should be added to obtain repairs and maintenance
cost.


MASTER BUDGET
The Master Budget is consolidated summary of the various functional budgets. It has
been defined as as summary of the budget schedules in capsule form made for the
purpose of presenting in one report the highlights of the budget forecast. The
definition of this budget given by Chartered Institute of Management Accountant,
England, is as follows:
The summary budget incorporating its components functional budgets and
which is finally approved adopted and employed.

The master budget is prepared by the budget committee on the basis of co-ordinated
functional budgets and becomes the target for the company during the budget period
when it is finally approved by the committee. This budget summarizes functional
budgets to produce a Budgeted Profit and Loss Account and a Budgeted Balance
Sheet as at the end of the budget period.

Advantages of the master budget are as follows:
1. A summary of all functional budgets in capsule form is available in one report.
2. The accuracy of all the functional budgets is checked because the summarized
information of all functional budgets should agree with the information given
in the master budget.
3. It gives an overall estimated profit position of the organization for the budget
period.
4. Information relating to forecast balance sheet is available in the master budget.

This budget is very useful for the top management because it is usually interested in
the summarized meaningful information provided by this budget.

Steps in the Preparation of the Master Budget
As indicated above, a Master Budget incorporates all functional Budgets and includes
the preparation of a projected income statement and a balance sheet. The following
steps are, therefore, required for preparing a Master Budget:
(1) The preparation of the Sales Budget is the basic starting point for the
preparation of the Master Budget. The sales budget is prepared after taking
into account a number of factors. Number of units likely to be sold for each
month, the prices at which they are likely to be sold and the composition of
cash and credit sales in total sales.
(2) The preparation of the production budget is the next step. The quantity of
production will be estimated on the basis of the following formula. Quantity to
be produced = Quantity to be sold + Desired Closing Stock Estimated
Opening Stock. In case of a trading concern, the quantity to be purchased can
also be estimated on the basis of the formula given above. The value of
purchases can be found out by multiplying the quantity to be purchased with
the estimated purchasing cost per unit.


(3) Cost of production budget is the third step in preparation of the Master Budget.
The cost of production will be estimated by estimating the cost of different
elements of costs.
(4) The preparation of the cash budget is the next important step. The budget will
be helpful in estimating the cash inflows from different sources such as issue of
shares, debentures, long-term loans, debtors, etc.
(5) The above steps from 1 to 4 will be helpful in providing information for
preparing the budget or projected income statement.
(6) On the basis of the last years balance sheet and the information collected by
taking steps 1 to 5, the budgeted or projected balance sheet for the business will
be prepared. This will be the final step in preparation of a Master Budget.

The Master Budget may be in the following form:
MASTER BUDGET
Period:
Normal Capacity: Budgeted Capacity:
Particulars
Product A Product B Product C Total
Rs. Rs. Rs. Rs.
Sales
Less: Factory Cost of sales

Gross Profit
Less: Operating Expenses:
Administration
Selling & Distribution
Research & Devlpt.
Financial

Operating Profit
Add: Other Income

Net Profit before Tax
Less: Provision for Taxation

Net Profit
Less: Appropriations

Balance of Profit
Assets:
Fixed assets
Current assets

Total Capital Employed
Less: Outsiders Liabilities
Current liability
Long-term liability

Shareholders Fund
Ratios:
1. Profit / Turnover
2. Profit / Capital employd
3. Sales/Capital employed
4. Current Assets /
Current Liabilities
(current ratio)
5. Quick Assets /
Current Liabilities
(liquid ratio)



Problem:
A Glass Manufacturing company requires you to calculate and prepare the master
budget for the next year from the following information.
Sales:
Toughened glass Rs.3,00,000
Bent toughened glass Rs.5,00,000
Direct material cost 60% of sales
Direct wages 20 workers @ Rs.150 per month.
Factory Overheads:
Indirect labour:
Works manager Rs.500 per month
Foreman Rs.400 per month
Stores and spares 2 on sales

Depreciation on machinery Rs.12,600
Light and power Rs.5000
Repairs and maintenance 10% on sales
Sundries 10% on direct wages
Administration, Selling and Distribution expenses Rs.14,000 per year.

Solution:
MASTER BUDGET
for the period ending on .
Rs. Rs.
Sales (as per sales budget)
Toughened glass . Units @ Rs.
Bent toughened glass . Units @ Rs.

Less: Cost of Production (as per cost of prodn. budget)
Direct Materials . Units @ Rs.
Direct Wages . Units @ Rs.
Prime Cost
Less: Factory Overhead: Variable:
Stores and Spares (2 on sales) 20,000
Light and Power 5,000
Repairs and Maintenance 8,000

Less: Factory Overhead: Fixed:
Works Managers salary 6,000
Foremans Salary 4,800
Depreciation 12,600
Sundries 3,600
Works Cost
Gross Profit
Less: Administration, Selling &Distribution Overheads
Net Profit

4,80,000
36,000
5,16,000

33,000

27,000

3,00,000
5,00,000
8,00,000

5,76,000
2,24,000
14,000
2,10,000


FLEXIBLE AND FIXED BUDGETS
Problem: The expenses budgeted for production of 10,000 units in a factory is
furnished below:
Per unit (Rs.)
Materials 70
Labour 25
Variable Factory Overheads 20
Fixed Factory Overheads (Rs.1,00,000) 10
Variable Expenses (Direct) 5
Selling Expenses (10% fixed) 13
Distribution Expenses (20% fixed) 7
Administrative Expenses (Fixed Rs.50,000) 5
Total cost of sales per unit 155

You are required to prepare a budget for the production of 6000 units and 8,000 units.

Solution
FLEXIBLE BUDGET
Particulars
Output 6000 units Output 8000 units
Per unit
Rs.
Amount
Rs.
Per unit
Rs.
Amount
Rs.
Production Expenses:
Material
Labour
Direct Variable Expense
Prime Cost
Factory Overheads:
Variable overheads
Fixed overheads
Works Cost
Administrative Expenses fixed
Cost of Production
Selling Expenses:
Fixed 10% of Rs.13
Variable 90% of Rs.13
Distribution Expenses:
Fixed 20% of Rs.7
Variable 80% of Rs.7
Total Cost of Sales

70.00
25.00
5.00
100.00

20.00
16.67
136.67
8.33
145.00

2.17
11.70

2.33
5.60
166.80

4,20,000
1,50,000
30,000
6,00,000

1,20,000
1,00,000
8,20,000
50,000
8,70,000

13,000
70,200

14,000
33,600
10,00800

70.00
25.00
5.00
100.00

20.00
12.50
132.50
6.25
138.75

1.63
11.70

1.75
5.60
159.43

5,60,000
2,00,000
40,000
8,00,000

1,60,000
1,00,000
10,60,000
50,000
11,10,000

13,000
93,600

14,000
44,800
12,75,400



Problem
Excellent Manufacturers can produce 4000 units of a certain product at 100%
capacity. The following information is obtained from the books of accounts.
August, 2001 September, 2001
Units produced 2800 3600
Rs. Rs.
Repair and maintenance 500 560
Power 1,800 2,000
Shop labour 700 900
Consumable stores 1,400 1,800
Salaries 1,000 1,000
Inspection 200 240
Depreciation 1,400 1,400

The rate of production per hour is 10 units. Direct material cost per unit is Re.1 and
direct wages per hour is Rs.4. You are required to
a) Compute the cost of production at 100%, 80% and 60% capacity showing the
variable, fixed and semi-fixed items under the flexible budget; and
b) Find out the overhead absorption rate per unit at 80% capacity.

Solution:
(a) COST OF PRODUCTION UNDER FLEXIBLE BUDGET
I tem
Capacity
100% 80% 60%
Units
Production hours @ 10 units per hour

Direct Material
Direct Wages
Prime Cost
Production Overhead Variable:
Shop Labour
Consumable Stores
Semi-Variable:
Power
Repair & Maintenance
Inspection
Fixed:
Depreciation
Salaries
Total Overheads
Cost of Production
Cost of Production per unit
4000
400
Rs.
4,000
1,600
5,600

1,000
2,000

2,100
590
260

1,400
1,000
8,350
13,950
3.49
3200
320
Rs.
3,200
1,280
4,480

800
1,600

1,900
530
220

1,400
1,000
7,450
11,930
3.73
2400
240
Rs.
2,400
960
3,360

600
1,200

1,700
470
180

1,400
1,000
6,550
9,910
4.13

(b) Total Overhead at 80% for 3200 units Rs.7,450 i.e. Rs.2.33 per unit should the
overhead absorption rate.


Workings:
Calculation of semi-variable overheads:
Power Difference in capacity Difference in overhead (Rs.)
20% 200
1% 10
At 80% variable cost is 80*Rs.10 = Rs.800 and fixed cost is Rs.1,100.

In the same way it can be calculated for 100% and 60% capacity. Same way may be
followed for repair and maintenance and inspection.

CASH BUDGET
Cash budget makes a provision for a minimum cash balance which will be available at
all times. In general, this balance should be equal to one months operating expenses
plus some provision for contingencies. The minimum balance of cash will help in
tiding over adverse conditions of a minor nature. Meanwhile, management can make
alternative arrangement for additional cash.

Cash (or Financial) Budget: This budget gives an estimate of the anticipated receipts
and payments of cash during the budget period. Therefore, this budget is divided into
two parts, one showing the estimated cash receipts on account of cash sales, credit
collections and miscellaneous receipts and the other showing the estimated
disbursement on account of cash purchases, amount payable to creditors, wages
payable to workers, indirect expenses payable, income tax payable, budgeted capital
expenditure etc. In short, every factory which affects the receipts and payments of
cash is taken into account in the preparation of this budget.

Thus, a cash budget is a summary statement of the firms expected cash inflows and
outflows over a projected time period. In other words, cash budget involves a
projection of future cash receipts and cash disbursements over various time intervals.

Functions of a Cash Budget
A cash budget helps the management in:
a. Determining the future cash needs of the firm;
b. Planning for financing of those needs; and
c. Exercising control over cash and liquidity of the firm.

The overall objective of a cash budget is to enable the firm to meet all its
commitments in time and at the same time prevent accumulation of unnecessary large
balance with it.

Methods of preparing a Cash Budget
A cash budget can be prepared by any of the following methods:
1. Receipts and Payments Method
2. Adjusted Profit and Loss Account Method
3. Balance Sheet Method


Advantages of Cash Budget
The following are the main advantages preparing cash budget:
(a) It provides an opportunity to review the cash flow of future period as
realistically as possible and make sure that cash is available for revenue and
capital expenditure.
(b) Where adequate amount of cash is not likely to be available during certain
periods e.g. when payment of bonus, dividend, tax, etc.
(c) If large surplus of cash is likely to result during certain periods then it will be
possible to plan most profitable investment of these funds.
(d) Preparation of a cash budget by a company will help to plant its cash position
in such a way the maximum seasonal discounts can be availed of.
(e) The importance of cash budget may be more in some trades than in others e.g.
in trades where there are wide seasonal fluctuations or where long contracts are
undertaken.

Problem:
On 30
th
September 2001, the balance sheet of Mano Ltd., (retailer) was as under:
Rs. Rs.
Equity shares of Rs.10 each fully paid 20,000 Equipment (at cost) 20,000
Reserves 10,000 Less: Depreciation 5,000
Trade Creditors 40,000 15,000
Proposed Dividend 15,000 Stock 20,000
Trade Debtors 15,000
Balance at Bank 35,000
85,000 85,000
The company is developing a system of forward planning on 1
st
October 2001 it
supplies the following information:
Month Sales(Rs.) Purchases (Rs.)
Credit Cash Credit
September, 2001 (actual) 15,000 14,000 40,000
October, 2001 (budget) 18,000 5,000 23,000
November, 2001 (budget) 20,000 6,000 27,000
December, 2001 (budget) 25,000 8,000 26,000
i. All trade debtors are allowed one months credit and expected to settle
promptly. All trade creditors are paid in the months following delivery.
ii. On 1
st
October, 2001, all equipment were replaced at a cost of Rs.30,000.
Rs.14,000 was allowed in exchange for the old equipment and a net payment of
Rs.16,000 was made.
iii. The proposed dividend will be paid in December, 2001.
iv. The following expenses will be paid:
(a) Wages Rs.3,000 per month (b)Administration Rs.1,500 per month
(c) Rent Rs.3,600 for the year up to 30
th
September, 2002 (to be paid in
October, 2001).
You are required to prepare a Cash Budget for the month of October, November and
December, 2001.


Solution
CASH BUDGET
I tems
2001
October November December

Opening balance of bank (overdraft)
Cash Inflows:
From cash sales of current month
From credit sales of previous month
Total Receipts (A)
Cash Outflows:
Creditors for purchase of the preceding
month
Equipment
Wages
Administration
Rent
Dividend
Total Payments (B)
Closing Balance (Overdraft) (A B)
Rs.
35,000

5,000
15,000
55,000

40,000
16,000
3,000
1,500
3,600
---- --
64,100
(9,100)
Rs.
(9,100)

6,000
18,000
14,900

23,000
-----
3,000
1,500
-----
------
27,500
(12,600)
Rs.
(12,600)

8,000
20,000
15,4000

27,000
----
3,000
1,500
----
15,000
46,500
(31,100)

(i) Cash Budget under Receipts and Payments Method
In case of this method the cash receipt from various sources and cash payment to
different agencies are estimated. The Receipts and Payments may be divided into two
specific categories as follows:
1. Receipts: (a) Capital and (b) Revenue
2. Payments: (a) Capital and (b) Revenue

The Capital receipts would be:
The proceeds of issue of shares or debentures or loans to be raised
The sale proceeds of long-term investments or fixed assets.
The Revenue receipts would be:
The amount receivable on cash sale of goods or services
The amount receivable from investments
Other business receipts like commission, income from investments, etc.
The Capital Payments would include:
Redemption of redeemable preference shares
Payment of long-term loans
Purchase of fixed assets
The Revenue payments would include:
Payments for materials supplied
Payment of wages
Payments of overheads
Other payments like interest on loans and income tax, etc.
Payment of dividends


In the opening balance of cash of a period, the estimated cash receipts are added and
the estimated cash payments are deducted to find out the closing balance. This will
become the opening balance of cash for the next period.

Problem: Prepare a Cash Budget for the months of May, June and July, 2008 on the
basis of the following information:
(1) Income and Expenditure Forecasts:
Months
Credit
Sales
(Rs.)
Credit
Purchases
(Rs.)
Wages
(Rs.)
Manufg.
Expenses
(Rs.)
Office
Expenses
(Rs.)
Selling
Expenses
(Rs.)
March
April
May
June
July
August
60,000
62,000
64,000
58,000
56,000
60,000
36,000
38,000
33,000
35,000
39,000
34,000
9,000
8,000
10,000
8,500
9,500
8,000
4,000
3,000
4,500
3,500
4,000
3,000
2,000
1,500
2,500
2,000
1,000
1,500
4,000
5,000
4,500
3,500
4,500
4,500

(2) Cash balance on 1
st
May, 2008 Rs.8,000
(3) Plant costing Rs.16,000 is due for delivery in July, payable 10% on delivery
and the balance after 3 months.
(4) Advance Tax of Rs.8,000 each is payable in March and June
(5) Period of credit allowed by supplier is 2 months and allowed to customers is 1
month.
(6) Lag in payment of manufacturing expenses month.
(7) Lag in payment of office and selling expenses one month.

Solution
CASH BUDGET
Particulars
May 2008
Rs.
J une 2008
Rs.
J uly 2008
Rs.
Opening Balance
Estimated Cash Receipts:
Debtors (Credit Sales)

Estimated Cash Payments:
Creditors (Credit Purchases)
Wages
Manufacturing Expenses
Office Expenses
Selling Expenses
Plant payment on delivery
Advance Tax
Total
Closing Balance
8,000

62,000
70,000

36,000
10,000
3,750
1,500
5,000
----
----
56,250
13,750
13,750

64,000
77,750

38,000
8,500
4,000
2,500
4,500
----
8,000
65,500
12,250
12,250

58,000
70,250

33,000
9,500
3,750
2,000
3,500
1,600
-----
53,350
16,900


Notes:
a) Opening balance for June has been written after finding closing balance for May, and
for July after finding the closing balance for June.
b) Since the period of credit allowed to customers is one month, the payments for credit
purchases in March shall be made in May and so on.
c) Since the period of credit allowed by suppliers is two months, the payment for credit
purchases in March shall be made in May and so on.
d) One-half of the manufacturing expenses of April and one-half of those of May shall
be paid
in May , i.e. ( of Rs.3,000) + ( of Rs.4,500) i.e. Rs.3,750 and so on.
e) Office and Selling Expenses of April shall be paid in May and so on.

(ii) Cash Budget under Adjusted Profit and Loss Account Method
In case of this method the cash budget is prepared on the basis of opening cash and
bank balances, projected profit and loss account and the balances of the various assets
and liabilities. Cash from operations is taken, as not the profit figure as shown by the
P&L account, but the figure of profit as adjusted in the light of non-cash items such as
depreciation, loss on sale of capital assets, preliminary expenses written off from P&L
a/c etc.

Since these items do not affect cash position though they have been charged to the
profit and loss account, they are added back to the profit or deducted from loss, as the
case may be. Likely issue of new shares realization from the sale of fixed assets or
raising long-term loans, are taken as other sources of cash. Similarly, likely
redemption of preference shares, payment of long-term loans, purchase of fixed assets,
payment of dividends, etc. are taken as applications of cash.

Moreover, increase in current liabilities such as creditors, bills payable, prepaid
expenses, etc. will mean less investment in these assets, therefore, and they will be all
taken as sources of cash. Decrease in current liabilities or increase in current assets on
the same basis, will mean decrease in cash resources.

Problem
The following data are available and you are required to prepare a Cash Budget
according to adjusted profit and loss method.
BALANCE SHEET
as on 31
st
December 2006
Liabilities Rs. Assets Rs.
Shares Capital
General Reserve
Profit and Loss Account
Creditors
Bills Payable
Outstanding Rent
1,00,000
20,000
10,000
50,000
10,000
2,000

1,92,000
Premises
Machinery
Debtors
Closing Stock
Bills Receivable
Prepaid commission
Bank
50,000
25,000
40,000
20,000
5,000
1,000
51,000
1,92,000


PROJECTED TRADING, PROFIT AND LOSS ACCOUNT
for the year ending 31
st
December 2007
Particulars Rs. Particulars Rs.
To Opening Stock
To Purchases
To Octroi
To Gross Profit c/d

To Interest
To Salaries
To Depreciation
(10% on premises and mach)
To Rent 6,000
Less: Last years
Outstanding 2,000
4,000
Add: Outstanding 1,000

To Commission 3,000
Add: Last years
Prepaid 1,000
To Office Expenses
To Advertisement Expenses
To Net Profit c/d

To Dividends
To Additional to Reserve
To Balance c/d
20,000
1,50,000
2,000
43,000
2,15,000

3,000
6,000
7,500

5,000

4,000
2,000
1,000
19,500
48,000

8,000
4,000
17,500
29,500
By Sales
By Closing Stock

By Gross Profit b/d
By Sundry Receipts

By Balance of Profit
from last year
By Net Profit b/d
2,00,000
15,000

2,15,000

43,000
5,000

48,000

10,000
19,500
29,500

Closing balance of certain items: Share Capital Rs.1,20,000; 10% Debentures
Rs.30,000; Creditors Rs.40,000; Debtors Rs.60,000; Bill Payable Rs.12,000; Bills
Receivable Rs.4,000; Furniture Rs.15,000; Plant Rs.50,000 (both these assets are to be
purchased by the end of the year)


Solution:
CASH BUDGET
Rs. Rs.
Opening Balance as on 1
st
January, 2007
Add: Net Profit for the year
Depreciation
Decrease in Bills Receivable
Increase in Bills Payable
Issue of Share Capital
Issue of Debentures
Decrease in Prepaid Commission
Decrease of Stock

Less: Purchase of Plant
Purchase of Furniture
Increase of Debtors
Decrease of Creditors
Decrease in Outstanding Rent
Dividend Paid
Closing Balance as on 31
st
December 2007

19,500
7,500
1,000
2,000
20,000
30,000
1,000
5,000

50,000
15,000
20,000
10,000
1,000
8,000

51,000

86,000
1,37,000

1,04,000
33,000

(iii) Cash Budget under Balance Sheet Method
In case of this method at the end of each period a projected balance sheet is drawn up
setting out the various assets and liabilities except cash and bank balances. The
balancing figure would be the estimated closing cash/bank balance. Thus, under this
method, closing balances other than cash/bank will have to be found out first to be put
in the budgeted balance sheet. This can be done by adjusting the anticipated
transactions of the year in the opening balance. This method is not recommended.

Problem: From the given data obtained from X Company Ltd. You are required to
prepare a Cash Budget according to Balance Sheet Method.

BALANCE SHEET
as on 31
st
December 2006
Shares Capital
General Reserve
Creditors
Bills Payable
Outstanding Rent
1,00,000
20,000
10,000
50,000
10,000
2,000

1,92,000
Premises
Machinery
Debtors
Closing Stock
Bills Receivable
Prepaid commission
Bank
50,000
25,000
40,000
20,000
5,000
1,000
51,000
1,92,000



PROJECTED TRADING, PROFIT AND LOSS ACCOUNT for the year ending 31.12.2007
Particulars Rs. Particulars Rs.
To Opening Stock
To Purchases
To Octroi
To Gross Profit c/d

To Interest
To Salaries
To Depreciation
(10% on premises and mach)
To Rent 6,000
Less: Last years
Outstanding 2,000
4,000
Add: Outstanding 1,000

To Commission 3,000
Add: Last years
Prepaid 1,000
To Office Expenses
To Advertisement Expenses
To Net Profit c/d

To Dividends
To Additional to Reserve
To Balance c/d
20,000
1,50,000
2,000
43,000
2,15,000

3,000
6,000
7,500

5,000

4,000
2,000
1,000
19,500
48,000
8,000
4,000
17,500
29,500
By Sales
By Closing Stock

By Gross Profit b/d
By Sundry Receipts

By Balance of Profit from
last year
By Net Profit b/d
2,00,000
15,000

2,15,000

43,000
5,000

48,000

10,000
19,500
29,500
Closing balance of certain items: Share Capital Rs.1,20,000; 10% Debentures
Rs.30,000; Creditors Rs.40,000; Debtors Rs.60,000; Bill Payable Rs.12,000; Bills
Receivable Rs.4,000; Furniture Rs.15,000; Plant Rs.50,000 (both these assets are to be
purchased by the end of the year)

Solution:
BUDGETED BALANCE SHEET as on 31
st
December 2007
Shares Capital
10% Debentures
General Reserve
Creditors
Bills Payable
Outstanding Rent
1,20,000
30,000
24,000
17,500
40,000
12,000
1,000

2,44,500
Premises 50,000
Less: Depreciation 5,000
Machinery 25,000
Less: Depreciation 2,500
Furniture
Debtors
Bills Receivable
Plant
Closing Stock
Bank (balancing figure)

45,000

22,500
15,000
60,000
4,000
50,000
15,000
33,000
2,44,500


VARIANCE ANALYSIS
Variance is the difference between actual costs and standard costs during an
accounting period. It refers to variation of actual results with planned results. Variance
analysis is a systematic process which analyses and interprets the variances. It refers
to the break-down of total variances of different components.

Standard cost is predetermined estimate of cost to manufacture a single unit or a
number of units of a product during a future period. Actual costs are compared with
these standard costs. The deviation of actual from the standard is called Variance.
The difference between the actual cost and the standard cost is known as the cost
variance.

According to Terminology of CIMA, Variance is The difference between planned,
budgeted or standard cot and actual costs (similarly in respect of revenue).

The term Variance has been derived from the verb to vary meaning to differ. In
cost accounting, variance means deviation of the actual cost from the standard cost.

Variance analysis is the process of analyzing variances by sub-dividing the total
variance in such a way that management can assign responsibility for off-standard
performance. Variance analysis is a tool to measure performances and based on the
principle of management by exception. In variance analysis the attention of
management is drawn not only to the monetary value of unfavourable and favourable
managerial performance but also the responsibility and causes for the same.

The most significant contribution of standard costing to the science and art of
management is the presentation of variances. As a matter of fact, without
determination and analysis of variances, standard costing is meaningless.

Favorable and Un-favorable Variances
The main purpose of Standard Costing is the computation and analysis of variance. A
variance is the difference between the actual cost and standard cost. A variance may
be favorable or un-favorable and controllable or uncontrollable

When the actual cost is less than the standard cost, it is known as favorable or
credit variance. The effect of favorable variance increases the profit.
When the actual cost is more than the standard cost, it is known as unfavorable
or debit variance. It refers to deviation to the loss of the business.

Controllable and Uncontrollable Variances
Variances may be controllable or uncontrollable upon the controllability of the factors
casing variances. Calculation of variances indicates to management whether cots are
under control or not.



Controllable variance refers to a deviation caused by such factors which could
be influenced by the executive action. For example: excess usage of materials,
excess time taken by a worker, etc.
Uncontrollable variance is due to the factors beyond the control of the
department. For example: the wage rate is increased due to strike, Govt.
restriction, change in market price, etc.

Computation of Variances
The computation and analysis of variance are the objectives of standard costing. The
causes of variances are necessary to find remedial measures; and therefore a detailed
study of variance analysis is essential. Variances can be found out with respect to all
the elements of cost, i.e. direct material, direct labour and overheads.

In other words, the total cost variance is split into its component parts on the basis of
elements and each element is further subdivided to locate the responsibility of
variance. The following are the common variances which are calculated by the
management. Sub-divisions of variances really give detailed information to the
management in order to control the cost.
1. Material Cost Variances
2. Labour or Wages Variances
3. Overhead Cost Variances (a) Variable (b) Fixed
4. Sales Variances.

MATERIAL LABOUR OVERHEAD SALES PROFIT VARIANCES

MATERIAL VARIANCES
In case of materials, the following may be the variances:
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage or Quantity Variance
(d) Material Mix Variance
(e) Material Yield Variance

(a) Material Cost Variance (MCV): It is the difference between the standard cost of
materials allowed (as per the standards laid down) for the output achieved and
the actual cost of materials used. Thus it may be expressed as:

Material Cost Variance = Standard Cost of Materials for Actual Output
Actual Cost of Materials Used
(or)
Material Cost Variance = Material Price Variance + Material Usage or
Quantity Variance
(or)
Material Cost Variance = Material Price Variance + Material Mix Variance
+ Material Yield Variance


In order to calculate material cost variance, it is necessary to know:
1. Standard quantity of materials which should have been required to produce
actual output. Standard quantity of materials = Actual Output Standard
Quantity of Materials per unit.
2. Standard price per unit of materials.
3. Actual quantity of materials used.
4. Actual price per unit of materials.

(b) Material Price Variance (MPV): It is that portion of the material cost variance
which is due to the difference between the standard cost of materials used for
the output achieved and the actual cost of materials used. In other words, it can
be expressed as:

Material Price Variance: Actual! Usage (Standard Unit Price Actual Unit
Price)
Here, Actual Usage = Actual quantity of materials (in units) used
Standard Unit Price = Standard price of material per unit
Actual Unit Price = Actual price of material per unit

(c) Material Usage (or Quantity) Variance (MQV): It is that portion of the material
cost variance which is due to the difference between the standard quantity of
materials specified for the actual output and the actual quantity of materials
used. It may be expressed as:
Material Usage Variance:
Standard Price per unit (Standard Quantity Actual Quantity)

(d) Material Mix Variance (MMV): It is that portion of the material usage variance
which is due to the difference between standard and the actual composition of a
mixture. In other words, this variance arises because the ratio of materials
being changed from the standard ratio set. It is calculated as the difference
between the standard price of standard mix and standard price of actual mix.

In case of material mix variance, two situations may arise:
i) Actual weight of mix and the standard weight of mix do not differ. In such as
case, material mix variance is calculated with the help of the following
formula:
Standard Unit Cost (Standard Quantity Actual Quantity)
(or)
Standard Cost of Standard Mix Standard Cost of Actual Mix

ii) Actual weight of mix differs from the standard weight of mix. In such case,
material mix variance is calculated as follows:
Total Weight of Actual Mix St. Cost of (Revised) St. Mix St.
Total Weight of (Revised) St. Mix Cost of
Actual Mix


The formula is necessitated to adjust the total weight of standard mix to the total
weight of actual mix which is more or less than the weight of standard mix.

(e) Material Yield Variance (MYV): it is that portion of the material usage variance
which is due to the difference between the standard yield specified and the
actual yield obtained. This variance measures the abnormal loss or saving of
materials. This variance is particularly important in case of process industries
where certain percentage of loss of materials is inevitable. If the actual loss of
materials differs from the standard loss of materials, yield variance will arise.
Yield variance is also known as scrap variance. This loss may result in the
following two situations.
(i) When standard and actual mix do not differ. In such a case, yield
variance is calculated with the help of the following formula:
Yield Variance = Standard Rate (Actual Yield Standard Yield)
Where,
Standard Rate = Standard Cost of Standard Mix
Net St. Output (i.e. Gross output St. Loss)

(ii) When actual mix differs from standard mix. In such a case, formula for
the calculation of yield variance is almost the same. But since the weight
of actual mix differs from that of the standard mix, a revised standard
mix is to be calculated to adjust the standard mix in proportion to the
actual mix and the standard rate is to be calculated from the revised
standard mix as follows:
Formula for yield variance in such a case is:
Yield Variance = Standard Rate (Actual Yield Revised
Standard Yield)
Standard Rate = Standard Cost of Revised Standard Mix
Net Standard Output

Problem: The standard material required to manufacture one unit of product X is 10
kg. and the standard price per kg. of material is Rs.2.50. The cost accounts records,
however, reveal that 11,500 kg. of material costing Rs.27,600 where used for
manufacturing 1,000 units of product X. Calculate Material Variances.

Solution
Standard price of material per kg. = Rs.2.50
Standard usage per unit of product X = 10 kg.
Therefore,
Standard usage of an actual output of 1000 units of product X = 100010kg =
10000 kg.
Actual usage of material = 11,500 kg.
Actual cost of materials = Rs.27,600
Therefore,
Actual price of material per kg. = Rs.27,600 / 11500 = Rs.2.40


Standard Cost of Material Actual Cost of Material
(or)
(Standard Usage Standard Rate) (Actual Usage Actual Rate)
= (10,000 kg Rs.2.50) (11,500 Rs.2.40)
= Rs.25000 Rs.27600 = Rs.2,600 Adverse.

Actual Usage (Standard Unit Price Actual Unit Price)
= 11,500 kg. (Rs.2.50 Rs.2.40) = Rs.1,150 Favourable

(c) Material Usage Variance
Standard Unit Price (Standard Usage Actual Usage)
= Rs.2.50(10,000 kg. 11,500 kg.) = Rs.3,750 Adverse.

Verification
Material Cost Variance = Material Price Variance + Material Usage Variance
Rs.2,600 Adverse = Rs.1,150 Fav. + 3,750 Adverse
= Rs.2,600 Adverse.

Problem: From the following particulars calculate (i) Total Material Cost Variance;
(ii) Material Price Variance; and (iii) Material Usage Variance.
Materials Standard Actual
Units Price (Rs.) Units Price (Rs.)
A 1010 1.0 1080 1.2
B 410 1.5 380 1.8
C 350 2.0 380 1.9

Solution: Workings:
Materials Standard Cost Actual Cost
Units Price
(Rs.)
Total
(Rs.)
Units Price
(Rs.)
Total
(Rs.)
A 1010 1.0 1,010 1080 1.2 1,296
B 410 1.5 615 380 1.8 684
C 350 2.0 700 380 1.9 722
2,325 2,702

Standard Cost of Material Actual Cost of Material
(or)
(Standard Quantity Standard Unit Cost) (Actual Quantity Actual Unit
Cost)
= Rs.2,325 Rs.2,702 = Rs.377 Adverse.



Actual Quantity (Standard Unit Price Actual Unit Price)
Material A: 1,080 units (Re.1.0 Rs.1.20) = Rs.216 Adverse
Material B: 380 units (Re.1.5 Rs.1.80) = Rs.114 Adverse
Material C: 380 units (Re.2.0 Rs.1.90) = Rs. 38 Favourable
Total Material Price Variance = Rs.292 Adverse

(c) Material Usage Variance
Standard Unit Price (Standard Quantity Actual Quantity)
Material A: Re.1(1,010 units 1,080 units) = Rs.70 Adverse
Material B: Re.1.5(410 units 380 units) = Rs.45 Favourable
Material C: Re.2(350 units 380 units) = Rs.60 Adverse

Total Material Usage Variance = Rs.85 Adverse

Verification
Material Cost Variance = Material Price Variance + Material Usage Variance
Rs.377 Adverse = Rs.292 Rs.85
= Rs.377 Adverse.

Problem
From the following information, calculate the materials mix variance.
Materials Standard Actual
A 200 units @ Rs.12 160 units @ Rs.13
B 100 units @ Rs.10 140 units @ Rs.10

Due to shortage of material A, it was decided to reduce consumption of A by 15% and
increase that of material B by 30%.

Solution
Revised Standard Mix is:
Material A: 200 units 15% of 200 = 170 units
Material B: 100 units + 30% of 100 = 130 units

Material Mix Variance:
Standard Unit Cost (Revised Standard Quantity Actual Quantity)
Material A: Rs.12(170 units 160 units) = Rs.120 Favourable
Material B: Rs.10(130 units 140 units) = Rs.100 Adverse
Material Mix Variance = Rs. 20 Favourable



LABOUR VARIANCES
Labour variances can be analyzed as follows:
(a) Labour Cost Variances (LCV)
(b) Labour Rate (of Pay) Variance (LRV)
(c) Total Labour Efficiency Variance (TLEV)
(d) Labour Efficiency Variance (LEV)
(e) Labour Idle Time Variance (LITV)
(f) Labour Mix Varaince or Gang Composition Variance (LMV or GCV)
(g) Labour Yield Variance or Labour Efficiency Sub-variance (LYV or LESV)
(h) Substitution Variance.

(a) Labour Cost Variance: It is the difference between the standard cost of labour
allowed for the actual output achieved and the actual cost of labour employed. It is
also known as wages variance. This variance is expressed as:
Labour Cost Variance = Standard Cost of Labour Actual Cost of Labour

(b) Labour Rate (of pay) Variance: It is that portion of the labour cost variance which
arises due to the difference between the standard rate specified and the actual rate
paid. It is calculated as follows:
Rate of Pay Variance = Actual Time Taken (Standard Rate Actual Rate)

(c) Total Labour Efficiency Variance: It is that portion of the labour cost variance which
arises due to the difference between the standard labour cost of standard time for
actual output and standard cost of actual time paid for. It is calculated as follows:
Total Labour Efficiency Variance
= Standard Rate(Standard Time for Actual Output Actual Time paid
for)
Total labour efficiency variance is calculated only when there is abnormal idle
time.

(d) Labour Efficiency Variance: It is that portion of the labour cost variance which
arises due to the difference between the standard labour hours specified for the output
achieved and the actual labour hours spent. It is expressed as:
Labour Efficiency Variance = Standard Rate(Standard Time for Actual
Output Actual Time worked)
Here standard time for actual output means time which should be allowed for the
actual output achieved. Actual time worked means actual labour hours spent minus
abnormal idle hours.

(e) Labour I dle Time Variance: It is calculated only when there is abnormal idle time. It
is that portion of labour cost variance which is due to the abnormal idle time of
workers. This variance is shown separately to show the effect of abnormal causes
affecting production like power failure, breakdown of machinery, shortage of
materials etc. While calculating labour efficiency variance, abnormal idle time is
deducted from actual time expended to ascertain the real efficiency of the workers.



Labour Idle Time Variance is expressed as:
Idle Time Variance = Abnormal Idle Time Standard Rate
Total Labour Cost Variance = Labour Rate of Pay Variance + Total Labour Efficiency
Variance
Total Labour Efficiency Variance = Labour Efficiency Variance + Labour Idle Time
Varinace

(f) Labour Mix Variance (or) Gang Composition Variance: It is like materials mix
variance and is a part of labour efficiency variance. This variance shows to the
management as to how much of the labour cost variance is due to the change in the
composition of labour force. It is calculated as follows:
(i) If there is no change in the standard composition labour force and total time
expended is equal to the total standard time, the formula is:
Labour Mix Variance = Standard Cost of Standard Composition (for
actual time taken) Standard Cost of Actual Composition (for actual
time worked)

(ii) If the standard composition labour force is revised due to shortage of a
particular type of labour and the total time expended is equal to the total
standard time, the formula is:
Labour Mix Variance = Standard Cost of Revised Standard Composition
(for actual time taken) Standard Cost of Actual Composition (for
actual time worked)

(iii) If the actual time of labour differs from the total standard time of labour,
the formula is: LMV =
Total Time of Actual Labour Composition Standard Cost of
Total Time of Standard Labour Composition Standard Composition
Standard Cost of
Actual Composition

(iv) If the standard is revised and the total actual time of labour differs from the
total standard time of labour, the formula is:
Total Time of Actual Labour Composition Standard Cost of
Total Time of Revised Standard Labour Revised
Std.Composition Composition
Standard Cost of Actual
Composition

(g) Labour Yield Variance: It is like materials yield variance and arises due to the
difference between yield that should have been obtained by actual time utilized on
production and actual yield obtained. It can be calculated as:
Standard Labour Cost per unit [Actual Yield in units Standard Yield in units
expected
from the actual time worked on production]



(h) Substitution Variance: This is a variance in labour cost which arises due to
substitution of labour when one grade of labour is substituted by another. This is
denoted by difference between the actual hours at standard rate of standard worker
and the actual hours at standard rate of actual worker. This can be denoted as under:
Substitution Variance
= (Actual Hours Standard Rate for Standard Worker)
(Actual Hours Standard Rate for Actual Worker)

Problem
Calculate variances from the following data:
Standard Actual
Number of men employed 100 9
Output in units 5000 4800
Number of working days in a month 20 18
Average wages per month Rs.200 Rs.198

Solution
First, we calculate standard rate, actual rate, standard time and actual time which are
not directly given in the problem.
Standard wages per man per month = Rs.200
Standard working days in a month = 20 days

Therefore,
Standard rate per day = Rs.200/20 = Rs.10
Actual wages per man per month = Rs.198
Actual working days in a month = 18 days
Actual rate per day = Rs.198/18 = Rs.11

Standard man days for an output of 5000 units = 100 20 = 2000 man days
Therefore, Standard man days for the actual output of 4800 units
=(2000/5000)4800 = 1920 man days

Actual man days = men working days = 90 18 = 1620 man days

(a) Labour Cost Variance
= Standard Cost of Labour Actual Cost of Labour

For 5000 units Standard cost of labour = 100 workers @ Rs.200 = Rs.20000
Therefore, for the actual output of 4800 units,
Standard cost of labour = (20000/5000) 4800 = Rs.19200

Actual Cost of Labour = 90 worker @ Rs.198 = Rs.17820

Therefore, LCV = Rs.19200 Rs.17820 = Rs.1380 Favourable



(b) Rate of Pay Variance
Actual Time (Standard Rate Actual Rate)
1620 man days (Rs.10 Rs.11) = Rs.1620 Unfavourable

(c) Labour Efficiency Variance
Standard Rate (Standard Time Actual Time)
Rs.10(1920 man days 1620 man days) = Rs.3000 Favourable

Problem
The original standard rate of pay in a factory was Rs.4 per hour. Due to settlement
with trade unions, this rate of pay per hour is increased by 15%. During a particular
period, 5000 actual hours were worked whereas work done was equivalent to 4400
hours. The actual labour cost was Rs.24000. Calculate Labour Variances.

Solution
Original standard rate per hour Rs.4.00
Current standard rate per hour (Rs.4 + 15% of Rs.4) Rs.4.60

(a) Rate of Pay Variance
= Actual time (Current standard rate Actual rate)
= 5000 hrs [Rs.4.60 Rs.24000/5000]
= Rs.23000 Rs.24000 = Rs.1000 Adverse

(b) Labour Efficiency Variance
= Current standard rate (Standard time Actual time)
= 4.60(4400 hrs 5000 hrs) = Rs.2760 Adverse

(c) Wages Revision Variance
= Standard labour cost of actual output at original standard rate
Standard Labour cost of actual output at current standard rate
(or)
= (Time allowed original standard time) (Time allowed Current
standard rate)
= (4400 hrs Rs.4) (4400 hrs Rs.4.60) = 2640 Adverse

(d) Total Labour Cost Variance
= Standard time Original standard rate Actual cost of labour
= 4400 hrs Rs.4 Rs.24000 = 6400 Adverse.

OVERHEAD VARIANCES
Overhead cost variance can be defined as the difference between the standard cost of
overhead allowed for the actual output achieved and the actual overhead cost incurred.
In other words, overhead cost variance is under or over absorption of overheads.



The formula for calculation is:
Overhead Cost Variance
= Actual output Standard overhead rate per unit Actual overhead cost
(or)
= Standard hours for actual output Standard overhead rate per hour Actual
overhead cost

Overhead cost variance can be classified as follows:
Variable Overhead Variance
Fixed Overhead Variance

(1) Variable Overhead Variance: It is the difference between the standard variable
overhead cost allowed for the actual output achieved and the actual variable overhead
cost. This variance is represented by expenditure variance only because variable
overhead cost will vary in proportion to production so that only a change in
expenditure can cause such variance.

It is expressed as:
Actual Output Standard Variable Overhead Rate Actual Variable
Overheads
(or)
Std. Hours for Actual Output Std. Variable Overhead Rate per hour Actual
Variable Overheads

Some accountants also find out variable overhead efficiency variance just like labour
efficiency variance. Variable overhead efficiency variance can be calculated if
information relating to actual time taken and time allowed is given. In such a case
variable overhead variance can be divided into two parts as given below.
(a) Variable Overhead Expenditure Variance
= Actual hours worked Standard variable overhead rate per hour
Actual variable overhead
(or)
= Actual hours (Standard Variable Overhead Rate per hour Actual
variable overhead rate per hour)

Variable overhead expenditure variance is calculated in the same way as labour rate
variance is calculated.

(b) Variable Overhead Efficiency Variance
= (Standard time for actual production Standard variable overhead rate
per hour)
(Actual hours worked Standard variable overhead rate per hour
(or)
= Standard variable overhead rate per hour (Standard hours for Actual
Production Actual hours)


Variable overhead efficiency variance resembles labour efficiency variance and is
calculated like labour efficiency variance.

Problem
From the following data, calculate variable overhead variances:
Budgeted Actual
Variable overhead Rs.250,000 Rs.260,000
Output in units 25,000 20,000
Working hours 1,25,000 1,10,000

Solution
Standard variable overhead per unit = Rs.250,000/25,000 = Rs.10
Standard variable overhead per hour = Rs.250,000/1,25,000 = Rs.2
Time allowed per unit of output = Rs.1,25,000/25,000 = Rs.5
hours

(a) Variable Overhead Expenditure Variance
= Actual hours worked Standard rate per hour Actual overhead
= 1,10000 Rs.2 Rs.2,60,000 = Rs.40,000 Adverse

(b) Variable Overhead Efficiency Variance
= (Standard time for actual production Standard variable overhead rate
per hour)
(Actual hours worked Standard variable overhead rate per hour
= (1,00,000 Rs.2) (1,10,000 Rs.2) = Rs.20,000 Adverse

Standard time for actual production = Time allowed for 20,000 units of actual
output @ 5 hours per unit i.e. 1,00,000 hours.

Total Variable Overhead Variance
= Actual output Standard rate per unit Actual overhead
= 20,000 Rs.10 Rs.2,60,000 = Rs.60,000 Adverse

(2) Fixed Overhead Variance: It is that portion of total overhead cost variance which is
due to the difference between the standard costs of fixed overhead allowed for the
actual output achieved and the actual fixed overhead cost incurred. The formula for
the calculation of this variance is:
Actual Output Standard Fixed Overhead Rate per unit Actual Fixed
Overheads.
(or)
Standard hours produced Standard Fixed Overhead Rate per hour Actual
Fixed Overheads.

The variance is further analyzed as under:


(a) Expenditure Variance: It is that portion of the fixed overhead variance which is
due to the difference between the budgeted fixed overheads and the actual fixed
overheads incurred during a particular period. It is expressed as:
Expenditure Variance = Budgeted Fixed Overheads Actual Fixed
Overheads
Expenditure Variance = Budgeted Hours Standard Fixed Overhead
Rate per hour Actual Fixed Overheads

(b) Volume Variance: It is that portion of the fixed overhead variance which arises
due to the difference between the standard cost of fixed overhead allowed for
the actual output and the budgeted fixed overheads for the period during which
the actual output has been achieved. This variance shows the over or under
absorption of fixed overheads during a particular period. If the actual output is
more than the budgeted output, there is over-recovery of fixed overheads and
volume variance is favourable and vice versa if the actual output is less than the
budgeted output. This is so because fixed overheads are not expected to
change with the change in output. This variance is expressed as:
Volume Variance = Actual Output Standard Rate Budgeted Fixed
Overheads
(or)
= Standard Rate (Actual output Budgeted output)
(or)
= Standard Rate per hour (Standard hours produced
Actual hours)

Standard hours produced means number of hours which should have been taken for
the actual output as per the standard lay down.

SALES VARIANCES
The analysis of variances will be complete only when the difference between the
actual profit and standard profit is fully analyzed. It is necessary to make an analysis
of sales variances to have a complete analysis of profit variance because profit is the
difference between sales and cost. Thus, in addition to the analysis of cost variances
i.e. materials cost variance, labour cost variance and overheads cost variance, an
analysis of sales variances should be made. Sales variances may be calculated in two
different ways. These may be computed so as to show the effect on profit or these may
be calculated to show the effect on sales value.

The first method of calculating sales variances is profit method of calculating sales
variances and the second method is known as value method of calculating sales
variances. Sales variances showing the effect on profit are more meaningful, so these
would be considered first.



Profit Method of Calculating Sales Variances
The sales variances according to this method can be analyzed as:
(1) Total Sales Margin Variances (TSMV)
Actual profit Budgeted profit
(or)
(Actual quantity of sales Actual profit per unit) (Budgeted quantity
of sales Budgeted profit per unit)

(2) Sales Margin Variance (SMV) due to Selling Price: It is that portion of total
sales margin variance which is due to the difference between the actual price of
quantity of sales effected and the standard price of those sales. It is calculated
as:
Actual quantity of sales (Actual selling price per unit Standard selling
price per unit)
(3) Sales Margin Variance (SMV) due to Volume: It is that portion of total sales
margin variance which arises due to the number of articles sold being more or
less than the budgeted quantity of sales. It is calculated as:
Standard profit per unit (Actual quantity of sales Budgeted quantity of
sales)

Sales margin variance due to volume can be divided into two parts:
(1) Sales margin variance due to sales mixture
(2) Sales margin variance due to sales quantities

Sales Margin Variance (SMV) due to Sales Mixture (SM): It is that portion of sales
margin due to volume which arises because of different proportion of actual sales mix.
It is taken as the difference between the actual and budgeted quantities of each product
of which the sales mixture is composed, valuing the difference of quantities at
standard profit. It is calculated as:

Standard profit per unit (Actual quantity of sales Standard proportion for
actual sales)
(or)
Standard profit Revised Standard Profit

Sales Margin Variance (SMV) due to Sales Quantities (SQ): It is that portion of sales
margin due to volume which arises because of difference between the actual and
budgeted quantity sold of each product. It is calculated as:

Standard profit per unit (Standard proportion for actual sales Budgeted
quantity of sales)
(or)
Revised Standard profit Budgeted Profit



Value Method of Calculating Sales Variances
Sales variances calculated according to the value method show the effect on sales
value and enable the sales manager to know the effect of the various sales efforts on
his overall sales value figures. Sales variances according to this method may be as
follows:

(1) Sales Value Variance (SVV): It is the difference between the standard value and
the actual value of sales effected during a period. It is calculated as:
Sales Value Variance = Actual Value of Sales Budgeted Value of
Sales

Sales value variance arises due to one or more of the following reasons:
Actual selling price may be higher or lower than the standard price. This
is expressed in sales price variance.
Actual quantity of goods sold may be more or less than the budgeted
quantity of sales. This is expressed in sales volume variance.
Actual mix of various varieties sold may differ from the standard mix.
This is expressed in sales mix variance.
Revised standard sales quantity may be more or less than the budgeted
quantity of sales. This is expressed in sales quantity variance.

(2) Sales Price Variance (SPV): It is that portion of sales value variance which
arises due to the difference between actual price and standard price specified.
The formula for the calculation of this variance is:
Sales Price Variance = Actual Quantity Sold (Actual Price Standard
Price)

(3) Sales Volume Variance (S.Vol.V): It is that portion of the sales value variance
which arises due to difference between actual quantity of sales and standard
quantity of sales. The variance is calculated as:
Sales Price Variance = Standard Price (Actual Quantity of Sales
Budgeted Quantity of Sales)
Sales volume variance can be divided into two parts:
(a) Sales mix variance (SMV): It is a part of sales volume variance and arises due
to the difference in the proportion in which various articles are sold and the
standard proportion in which various articles were to be sold. It is calculated as:
Sales Mix Variance = Standard Value of Actual Mix Standard Value
of Revised Standard Mix

(b) Sales Quantity Variance (SQV): It is that part of sales volume variance which
arises due to the difference between revised standard sales quantity and
budgeted sales quantity. It is calculated as:
Standard Selling Price (Revised Standard Sales Quantity Budgeted
Sales Quantity)



Problem
From the following particulars calculate all sales variances according to (a) Profit
Method and (b) Value Method

Product
Standard Actual
Quantity
units
Cost
per unit
Price
per unit
Quantity
units
Cost
per unit
Price
per unit
X 3000 Rs.10 Rs.12 3200 Rs.10.50 Rs.13
Y 2000 Rs.15 Rs.18 1600 Rs.14.00 Rs.17

Solution
(A) Profit Method
1. Total Sales Margin Variance = Actual Profit Budgeted Profit
= Rs.12800 Rs.12000 = Rs.800 (F)

2. Sales Margin Variance due to Selling Price
= Actual Quantity of Sales (Actual sale price per unit Budgeted sales
price unit)
X = 3200(Rs.13 Rs.12) = Rs.3200 (F)
Y = 1600(Rs.17 Rs.18) = Rs.1600 (A)
1600 (F)

3. Sales Margin Variances due to Volume
= Standard Profit per unit (Actual quantity of sales Budgeted quantity
of sales)
X = Rs.2 (32003000) = Rs.400 (F)
Y = Rs.3 (16002000) = Rs.1200 (A)
800 (A)

4. Sales Margin Variances due to Sales Mix
= Standard Profit per unit (Actual Qty. of sales Std. proportion for
actual sales)
X = Rs.2 (32002880) = Rs.640 (F)
Y = Rs.3 (16001920) = Rs.960 (A)
320 (A)

5. Sales Margin Variances due to Sales Quantity
= Standard Profit per unit (Std. proportion for actual sales Budgeted
Qty. of sales)
X = Rs.2 (28803000) = Rs.240 (A)
Y = Rs.3 (19202000) = Rs.240 (A)
480 (A)

(B) Value Method
1. Sales Value Variance = Actual Value of Sales Budgeted Value of Sales
= Rs.68800 Rs.72000 = Rs.3200 (A)


2. Sales Price Variance
= Actual Quantity of Sales (Actual price Budgeted price)
X = 3200(Rs.13 Rs.12) = Rs.3200 (F)
Y = 1600(Rs.17 Rs.18) = Rs.1600 (A)
1600 (F)

3. Sales volume Variance
= Standard Price (Actual Qty. of sales Budgeted Qty. of sales)
X = Rs.12 (32003000) = Rs.2400 (F)
Y = Rs.18 (16002000) = Rs.7200 (A)
4800 (A)

4. Sales Mix Variance
= Std. Value of Actual Mix Std. Value of Revised Standard Mix
= Rs.67200 Rs.69120 = Rs.1920 (A)

5. Sales Quantity Variance
= Standard Selling Price (Revised Sales Qty. Budgeted Qty. of sales)
X = Rs.12 (28803000) = Rs.1440 (A)
Y = Rs.18 (19202000) = Rs.1440 (A)
2880 (A)

Working Table
Pro
du
ct
Budgeted Actual
Std.
Propn.
for
Actual
Sales
Std.
Value of
Actual
Mix
Std.
Value
of
Revis
ed
Std.
Mix
Qty.
(Units
)
Pri
ce
Value
Co
st
Pro
fit
Total
Profit
Qty.
(Unit
s)
Pri
ce
Value Cost Profit
Total
Profit
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Rs
.
Rs.
Rs
.
Rs
.
Rs.
Rs
.
Rs. Rs. Rs. Rs.
X 3000 12 36000 10 2 6000 3200 13 41600 10.50 2.50 8000
2880
(4800*3
/5)
38400
(3200*1
2)
34560
(2880*
12)
Y 2000 18 36000 15 3 6000 1600 17 27200 14.00 3.00 4800
1920
(4800*2
/5)
28800
(1600*1
8)
34560
(1920*
18)

Profit and Loss Variance
Profit or loss variance is defined as the difference between the budgeted profit (or
loss) and the actual profit (or loss). This will include the total of variances appropriate
to standard cost of sales, the sales margin variances and variances due to any change
which have not been included in standard cost of production.

Variance Analysis
Analysis of variances is most important step in standard costing. It is very important
tool for exercising cost control. Analysis of variances will help us in locating the
cause and person responsible for a particular type of variance as is illustrated below:


The analysis of variances should be reported to the management, so that corrective
action may be taken. Corrective action cannot be taken by the cost accountant it can
only be taken by the management.
Variance Possible Causes Person Responsible
Material Price
Variance
Changes in market price
Inefficient buying
Emergency purchases
Loss of discount
Non-availability of Std.
Qty.
Uncontrollable
Purchase Officer
Production Manager
Accounts Officer
Uncontrollable
Material Usage
Variance
Excessive wastage
Careless handling
Poor quality of material
Wrong specification
Wrong mixture of materials
Incorrect setting of
materials
Foreman
Storekeeper
Purchase Officer
Planning Engineer
Production Manager
Cost Accountant
Rate of Pay Variance Wrong grade of labour
General rise in wages
Overtime for urgent work
Foreman
Uncontrollable
Production/sales Manager
Labour Efficiency
Variance
Ineffective supervision
Poor quality of materials
Poor working conditions
Foreman
Purchase Officer
Personnel Manager
Idle Time Variance Shortage of materials
Break-down of machinery
Power failure
Time lost in getting
instruction
Purchase Officer
Maintenance Engineer
Electrical Engineer
Production Manager
Expenditure Variance Rise in general price level
Changes in production
methods
Ineffective control
Uncontrollable
Production Manager
Departmental Manager
Volume Variance Lack of orders
Ineffective supervision
Poor efficiency of
machinery
Poor efficiency of workers
More or less working days
Sales Manager
Departmental Manager
Maintenance Engineer
Foreman
Uncontrollable
Sales Price Variance Unexpected competition
Rise in general price level
Poor quality of products
Uncontrollable
Uncontrollable
Production Manager
Sales Volume Variance Unexpected competition
Ineffective sales promotion
Ineffective supervision and
control of salesmen
Uncontrollable
Publicity Manager
Sales Manager


STANDARD COST SYSTEM
Historical costing or actual costing is a system where costs are ascertained after they
are incurred. It is a postmortem of the costs. Historical cost does not help in finding
mistakes and inefficiencies, which all lead to variation in profit. Due to these
disadvantages and limitations of historical costing, the standard costing technique was
introduced in U.S.A. and in U.K. In India also standard costing is used widely and
recognized greatly.

Standard costing seeks to establish the cost of a product, operations or process under
standard operating conditions. The aim of standard cost is to eliminate the influence of
abnormal changes in prices. It is used as a guide for future decision and action over a
period of time. Standard Costing is an effective management tool for planning,
decision-making, coordinating and control of business. The object of standard cost is
to ascertain the quotation and determination of price policy. It is a technique of cost
control.

Definition
Standard: According to Prof.Eric L. Kohler, Standard is a desired attainable
objective, a performance, a goal, a model. Standard may be used to a predetermined
rate or a predetermined amount or a predetermined cost.

Standard Cost: I.C.M.A. Terminology defines, a predetermined cost, which is
calculated from management standards of efficient operations and the relevant
necessary expenditure. It may be used as a basis for price-fixing and for cost control
through variance analysis.

The other names for standard costs are predetermined costs, budgeted costs, projected
costs, model costs, measure costs, specification costs etc.

Standard Costing: I.C.M.A. Terminology defines, The preparation and use of standard
costs their comparison with actual costs and the analysis of variances to their caused
and points incidence.

Applications of Standard Costing
Standard costing is a very important managerial tool for cost control. The applications
and advantages of standard costing are summarized as follows.
1. It helps the management in formulating price and production policy.
2. It is a yardstick of performance. Standard costs are compared with actual costs
and the differences are analyzed and effective cost control is taken. Thus
reduction of cost is possible by increasing profits.
3. It reduces avoidable wastages and losses.
4. It facilitates to reduce clerical and accounting cost and managerial time.
5. It creates cost consciousness among the personnel, because the variance
analysis fixed responsibility for favourable or unfavourable performance.
6. Executives become more responsible, as it shows clearly who is responsible for
the cost centre.


7. By the variance analysis and reporting, the principle of management by
exception is facilitated. Management must concentrate their attention on
variations only.
8. It aids in budgetary control and in decision-making.
9. Opening stock and closing stock are valued at the standard price. This helps in
the preparation of Profit and Loss Account for short period say a week, a
month, etc.
10. It facilitates timely cost reports to management and a forward looking
mentality is encouraged at all levels of the management. It is a basis for the
implementation of an incentive system for the employees.

Applicability of Standard Costing
Standard costing is a control device. It is not a separate method of product costing.
Any activity of recurring nature is susceptible for setting standards. The standard-cost
process is mostly used to control the operating tasks. Manufacturing activities are
routine and frequent and therefore easy for establishing standards.

Industries where standardized and uniform work of repetitive nature is done are
suitable for introduction of standard costing. Standard costing system is of little use or
no use where work varies from job to job or contract to contract.

Setting the Standard
While setting standard cost for operations, process or products, the following
preliminaries must be gone through:
There must be Standard Committee similar to Budget Committee, in which
Purchase Manger, Personnel Manager and Production Manger are represented.
The Cost Accountant coordinates the functions of Standard Committee.
Study the existing costing system, cost records and forms in use. If necessary,
review the existing system.
A technical survey of the existing methods of production should be undertaken.
Determine the type of standard to be used.
Fix standard for each element of cost.
Determine standard costs for each product.
Fix the responsibility for setting standards.
Classify the accounts properly so that variances may be accounted for.
Comparison of actual costs with pre-determined standards to ascertain the
deviations
Action to be taken my management to ensure that adverse variances are not
repeated

Determination of Standard Costs
The following preliminary steps are to be considered before setting standards:
(a) Establishment of cost centre
(b) Classification and codification of accounts
(c) Types of standards
(d) Setting the standards


Standard Cost Card
When all the standard costs have been determined, a Standard Cost Card is prepared
for each production or service. The process of setting standards for materials, labour
and overheads results in the establishment of the standard cost for the product. Such a
cost card shows for a specified unit of production, quantity, quality and price of each
type of materials to be used, the time and the rate of pay of each type of labour, the
various operations the product would pass through, the recovery of overhead and the
total cost. The build-up of the standard cost of each item is recorded in Standard Cost
Card. These details serve as a basis to measure the efficiency against which actual
quantities and costs are compared. The type of standard cost card varies with the
requirements of individual firm; hence no uniform format can be prescribed.

Limitations of Standard Costing
Even though there are advantages of standard costing, there exist few disadvantages or
limitations of standard costing.
It is costly, as the setting of standard need high technical skills.
Keeping of up-to-date standard is a problem. Periodic revision of standard is a
costly thing.
Inefficient staff is incapable of operating this system.
Since it is difficult to set correct standards, it is difficult to ascertain correct
variance.
Industries, which are subject to frequent changes in technological process or
the quality of material or the character of labour, need a constant revision of
standard. But revision of standard is more expensive.
For small concern, standard costing is expensive.
It is difficult to apply this method where production takes more than one
accounting period. Standard costing may not be effective in industries which
deal in non-standardized products or job according to customers requirements.

Part A Questions
1. Define cost
2. What is cost accounting?
3. What are the different methods of costing?
4. What are elements of cost?
5. What is meant by overheads? What are the different types of overheads?
6. What is manufacturing cost?
7. What is job order costing?
8. What is process costing?
9. Define ABC
10. What is target costing?
11. What is marginal costing?
12. What is break-even point?
13. What is Margin of Safety?
14. Define budget
15. What is budgetary control?


16. Distinguish budget, budgeting and budgetary control.
17. What are fixed and flexible budgets?
18. What is a cash budget and what are the objectives of a cash budget?
19. What does variance analysis mean?
20. What is standard costing?

Part B Questions
1. Describe various methods of Cost Accounting system.
2. Explain the advantages and limitation of Job Order Costing.
3. Explain process costing.
4. Explain the differences between Job costing and Process costing.
5. Explain the features of Weighted Average Cost method and FIFO method.
6. Explain the pros and cons of ABC system.
Explain Advantages disadvantages of Marginal costing.
7. Explain in detail the applications of marginal costing technique in managerial
decision making.
8. Explain types of Budget.
9. Advantages & disadvantages of Budgetary control.
10. List out the various functional budgets and explain its objectives.
11. Distinguish between marginal costing and absorption costing.
12. Explain the advantages of standard costing.

Problems Production budget Flexible budget Sales budget Cash budget
************

Text Books & References:
1. M.Y.Khan & P.K.Jain, Management Accounting, Tata McGraw Hill, 2011.
2. R.Narayanaswamy, Financial Accounting A managerial perspective, PHI
Learning, New Delhi, 2011.
3. Jan Williams, Financial and Managerial Accounting The basis for business
Decisions, 13
th
edition, Tata McGraw Hill Publishers, 2010
4. Horngren, Surdem, Stratton, Burgstahler, Schatzberg, Introduction to
Management Accounting, PHI Learning, 2011.

Accounting For Management - Unit IV

Diunggah oleh

Informasi Dokumen

Judul Asli

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Accounting For Management - Unit IV

Diunggah oleh

Hak Cipta:

Format Tersedia

S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: sn.selvaraj@yahoo.com Page 1

Anda mungkin juga menyukai