LECTURE NOTES

ON

STRATEGIC MANAGEMENT
ACCOUNTING

MBA III Semester

Dr. J. S. V. GOPALA SARMA

Professor
Department of MBA.

MASTER OF BUSINESS ADMINISTRATION

INSTITUTE OF AERONAUTICAL ENGINEERING
(Autonomous)
DUNDIGAL, HYDERABAD – 500043
 STRATEGIC MANAGEMENT ACCOUNTING SYLLABUS
UNIT – I

MANAGEMENT ACCOUNTING VS COST ACCOUNTING:

Objectives, advantages and limitations of management accounting and cost accounting, Role of accounting
information in planning and control, cost concepts and managerial use of classification of costs, the
management process and accounting, cost analysis and control: direct and indirect expenses, allocation and
apportionment of overheads, calculation of machine hour rate, introduction to activity based costing and
life cycle costing.

UNIT – II

COSTING FOR SPECIFIC INDUSTRIES:

Unit costing, job costing, cost sheet and tender sheet and process costing and their variants, treatment of
normal losses and abnormal losses, inter process profits, costing for byproducts and equivalent production,
introduction, application of marginal costing in terms of cost control, profit planning, closing down a plant,
dropping a product line, charging general and specific fixed costs, fixation of selling price.

UNIT – III

MAKE OR BUY DECISIONS:

Key or limiting factor, selection of suitable product mix, desired level of profits, diversification of products,
closing down or suspending activities, level of activity planning.

Break even analysis: application of breakeven point for various business problems, inter firm comparison:
need for inter firm comparison, types of comparisons, advantages.
UNIT – IV

BUDGETARY CONTROL:

Budget, budgetary control, steps in budgetary control, flexible budget, different types of budgets: sales
budget, cash budget, production budget, master budget, performance budgets, material vs. purchase
budgets, zero based budgeting, introduction to cost audit and management audit.

UNIT – V

STANDARD COSTING:

Standard cost and standard costing, standard costing vs. budgetary control, standard costing vs. estimated
cost, standard costing and marginal costing analysis of variance, material variance, labor variance, Sales
and Profit variance. Case studies.
 UNIT-I
MANAGEMENT ACCOUNTING Vs. COST ACCOUNTING
COST ACCOUNTANCY:

This is the widest of all the terms. It is applications of costing and cost accounting
principles, methods and techniques to the science, art and practice of cost control and
ascertainment of profitability.

According to the Institute of Cost and Management Accounts, London, “cost

accountancy is the application of costing and cost accounting principles, methods,
techniques etc., to the science, art and practice of cost control, cost audit and
ascertainment of profitability.”

COST ACCOUNTING:
It is a formal system of accounting for costs by means of which costs of products and
services are ascertained and controlled.

COSTING:

Costing is the classifying, recording and appropriate allocation of expenditure for the
determination of costs of products or services.

The techniques and processing of ascertainment of costs is known as costing. The

technique in costing consists of principles and rules which govern the procedure of
ascertaining costs of products or services. This technique is dynamic and changes
with time.

DEFINITIONS OF MANAGEMENT ACCOUNTING:

According to Anglo-American Council on Productivity: “Management Accounting is
the presentation of accounting information in such a way as to assist management in
creation of policy and day-to-day operation of an undertaking.”

According to Robert N.Anthony, “Management Accounting is concerned with

accounting information that is useful to management.”

According to Brown and Howard, “The essential aim of management accounting

should be to assist management in decision making and control.”

In the words of J.Batty, “Management Accounting is the term used to describe the
accounting methods, systems and techniques which coupled with special knowledge
and ability, assist management in its task of maximizing profits and minimizing
losses.”
 According to T.G.Rose, “Management Accounting is the adaptation and analysis of
accounting information and its diagnosis and explanation in such a way as to assist
management.”

FINANCIAL ACCOUNTING
Accounting is the wider term and includes recording, classifying and summarizing of
business transactions in terms of money, the preparation of financial reports, the
analysis and interpretation of these reports for the information and guidance of
management.

According to the American Institute of Certified Public Accounts, “ Financial

Accounting as the art of recording, classifying and summarizing in a significant
manner in terms of money transactions and events which in part, at least of financial
character and interpreting the results thereof”

American Accounting Association defines accounting as “ the process of

identifying, measuring and communicating economic information to permit informed
judgments and decisions by users of the information

According to Smith and Ashburne,

“Accounting is the science of recording and classifying business transactions and

events, primarily of financial character and art of making significant summaries,
analysis and interpretations of those transactions and events and communicating the
results to persons who must make decisions or form judgements”.

According to committee on terminology of American Institute of Certified Public

Accountants (AICPA),

“Accounting is the art of recording, classifying and summarizing in a significant

manner and in terms of money transactions and events which are in part, at least of
financial character and interpreting the results thereof.”

Differences between Financial Accounting and Management

Accounting
Point of Difference Financial Accounting Management Accounting
1. Objective Its main objective is to Its main objective is to help
provide information in the management in
the form of profit and formulation of policies and
loss account and balance plans.
sheet to varies interested
parties such as
shareholders, creditors,
bankers, investors,
debenture holders,
government etc.
 It covers only that It considers both qualitative
2. Scope information which can be information and other
measured in terms of information.
money.
3. Nature It is concerned almost It represents predetermined
exclusive with historical and as well as post
records i.e., transactions determined information.
which have already
Taken place.
4. Subject Matter It portrays the position of It is concerned with the
the business as a whole. activities of different units,
It assesses the results of departments and cost centres.
the whole business.

5. Focus Financial accounting It takes into account the past

reports reveal what had events only to the extent they
happed in the past. affect the future position.
6. Precision In financial accounting In management accounting no
all transactions are emphasis is given to actual
recorded with actual figures. Sometimes
amounts. There is no approximate figures are
room for use of considered more useful than
appropriate figures. actual figures to know the
trends of the business.
7. Statutory The preparation of It is optional. It is upto the
Obligation financial accounting is a management whether to instal
statutory obligation. it or not.
Financial statements
should be prepared in the
formats prescribed by
law.
8. Accounting It is governed by No such set of accounting
principles generally accepted principles and conventions
accounting principles and are followed in management
conventions. accounting.
9. Reporting Financial statements Reports prepared under
prepared under financial management account are
accounts are useful to useful for internal
outsiders like creditors, management only.
bankers, debenture
holders etc.
10. Period Financial accounts are It supplies needed
prepared for a particular information to the
period of time. management from time to
time thought the year.
11. Communication Promt And Quick In this, immediate and prompt
communication of communication of data is
information and keeping very much required.
upto date are not desired
in financial accounting.
 12. Audit Financial statements such It cannot be audited. As it not
as profit and loss account based on actual figures. It is
and balance sheet are not possible to get the
subject to verification. management accounts
Under companies Act audited.
Auditing is compulsory
for financial accounting.
13. Publication As per companies Act Statements and reports
1956, every registered prepared under management
company should publish accounting are meant only for
it’s final statements for internal management only.
the benefit of public. A Hence, they are not
copy of the same should published.
be filled with registrar of
companies.

Classification of Cost for Managerial Use

The Cost may be classified in various ways to serve different purposes. Some of the
important classifications are as under:

They are

1. By elements

2. As direct or indirect

3. By functional divisions

4. By departments

5. By product

6. As variable, semi-variable and fixed costs.

7. As expenditure being capital or revenue.

The Cost may be classified into eight categories on the basis of managerial Decisions.
They are

1. Marginal cost

2. Out of pocket costs

3. Differential cost

4. Sunk cost
5. Imputed or notional costs

6. Opportunity cost.

7. Replacement cost.

8. Avoidable and Unavoidable cost

1. Marginal Cost:

Marginal cost is the total of variable costs i.e., prime cost plus variable overheads.

It is based on the distinction between fixed and variable costs.

Fixed costs are ignored and only variable costs are taken into consideration for
determining cost of products and value of work-in-progress and finished goods.

2. Out of Pocket Costs:

This is that portion of the costs which involves payment to outsiders i.e., gives rise to
each expenditure as opposed to such costs as depreciation, which do not involve any
cash expenditure. Such costs are relevant for price fixation during recession or when
make or buy decision is to be made.

3. Differential Cost:

The change in costs due to change in the level of activity or pattern or method of
production is known as differential cost. If the change increases the cost, it will be
called incremental cost. If there is decrease in cost resulting from decrease in output,
the difference is known as decremental cost.

4. Sunk Cost:

A sunk cost is an irrecoverable cost and is caused by complete abandonment /

rejection / leaving of a plant. It is written down value of the abandoned plant less its
salvage value. Such costs are not relevant for decision-making and are not affected by
increase or decrease in volume / size. Thus, expenditure which has taken place and is
irrecoverable in a situation, is treated as sunk cost. For taking managerial decisions
with future implications, a sunk cost is an irrelevant cost.

If a decision has to be made for replacing the existing plant, the book value of the
plant less salvage value(if any) will be a sunk cost and will be irrelevant cost for
taking decision of the replacement of the existing plant.

5. Imputed Costs or Notional Costs:

Imputed costs or notional costs have the same meaning.

The American equivalent term of the British term ‘notional cost’ is imputed cost.
These costs are notional in nature and do not involve any cash outlay.

The Charted Accountants, London defines notional cost as “ the value of a benefit
where no actual cost is incurred.”

Even though such costs do not involve any cash outlay but are taken into
consideration while making managerial decisions.

Examples of such costs are: notional / unreal rent charged on business premises
owned by the proprietor, interest on capital for which no interest has been paid.

When alternative capital investment projects are being evaluated it is necessary to

consider the imputed interest on capital before a decision is arrived as to which is the
most profitable project.

6. Opportunity Cost:

It is the maximum possible alternative earning that might have been earned if the
productive capacity or services had been put to some alternative use. In simple words,
it is the advantage, in measurable terms which has been foregone due to not using the
facility in the manner originally planned.

For example, if an owned building is proposed to be used for a project, the likely rent
of building is the opportunity cost which should be taken into consideration while
evaluating the profitability of the project.

Similarly, if the fixed deposit in a bank is withdrawn for financing a new project, the
loss of interest on such fixed deposit is the opportunity cost.

7. Replacement Cost:

It is the cost at which there could be purchase of an asset or material identical to that
which is being replaced or revalued.

It is the cost of replacement at current market price.

8. Avoidable and Unavoidable Cost:

Avoidable costs are those which can be eliminated if a particular product or

department, with which they are directly related, is discontinued.

For example, salary of the clerks employed in a particular department can be

eliminated, if the department is discontinued.

Unavoidable cost is that cost which will not be eliminated with the discontinuation of
a product or department.

For example, salary of factory manager or factory rent cannot be eliminated even if a
product is eliminated.
COST ANALYSIS

Cost Accounting
As compared to the financial accounting, the focus of cost accounting is different. In
the modern days of cut throat competition, any business organization has to pay
attention towards their cost of production. Computation of cost on scientific basis and
thereafter cost control and cost reduction has become of paramount importance.
Hence it has become essential to study the basic principles and concepts of cost
accounting. These are discussed in the subsequent paragraphs.
Cost :- Cost can be defined as the expenditure (actual or notional) incurred on or
attributable to a given thing. It can also be described as the resources that have been
sacrificed or must be sacrificed to attain a particular objective. In other words, cost is
the amount of resources used for something which must be measured in terms of
money. For example – Cost of preparing one cup of tea is the amount incurred on the
elements like material, labour and other expenses; similarly cost of offering any
services like banking is the amount of expenditure for offering that service. Thus cost
of production or cost of service can be calculated by ascertaining the resources used
for the production or services.
Costing :- Costing may be defined as ‘the technique and process of ascertaining
costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and
appropriation of expenses for the determination of cost of products or services and for
the presentation of suitably arranged data for the purpose of control and guidance of
management. It includes the ascertainment of every order, job, contract, process,
service units as may be appropriate. It deals with the cost of production, selling and
distribution. If we analyze the above definitions, it will be understood that costing is
basically the procedure of ascertaining the costs. As mentioned above, for any
business organization, ascertaining of costs is must and for this purpose a scientific
procedure should be followed. ‘Costing’ is precisely this procedure which helps them
to fi nd out the costs of products or services.
Cost Accounting :- Cost Accounting primarily deals with collection, analysis of
relevant of cost data for interpretation and presentation for various problems of
management. Cost accounting accounts for the cost of products, service or an
operation. It is defined as, ‘the establishment of budgets, standard costs and actual
costs of operations, processes, activities or products and the analysis of variances,
profitability or the social use of funds’.
Cost Accountancy :- Cost Accountancy is a broader term and is defined as, ‘the
application of costing and cost accounting principles, methods and techniques to the
science and art and practice of cost control and the ascertainment of profitability as
well as presentation of information for the purpose of managerial decision making.’
If we analyze the above definition, the following points will emerge,
A. Cost accounting is basically application of the costing and cost accounting principles.
B. This application is with specific purpose and that is for the purpose of cost control,
ascertainment of profitability and also for presentation of information to facilitate
decision making.
 C. Cost accounting is a combination of art and science; it is a science as it has well defi
ned rules and regulations, it is an art as application of any science requires art and it is
a practice as it has to be applied on continuous basis and is not a onetime exercise.

OBJECTIVES OF COST ACCOUNTING

Objectives of Cost Accounting can be summarized as under

1. To ascertain the cost of production on per unit basis, for example, cost per kg, cost per
meter, cost per liter, cost per ton etc.
2. Cost accounting helps in the determination of selling price. Cost accounting enables
to determine the cost of production on a scientific basis and it helps to fi x the selling
price.
3. Cost accounting helps in cost control and cost reduction.
4. Ascertainment of division wise, activity wise and unit wise profitability becomes
possible through cost accounting.
5. Cost accounting also helps in locating wastages, inefficiencies and other loopholes in
the production processes/services offered.
6. Cost accounting helps in presentation of relevant data to the management which helps
in decision making. Decision making is one of the important functions of
Management and it requires presentation of relevant data. Cost accounting enables
presentation of relevant data in a systematic manner so that decision making becomes
possible.
7. Cost accounting also helps in estimation of costs for the future.

ESSENTIALS OF A GOOD COSTING SYSTEM:

For availing of maximum benefits, a good costing system should possess the following
characteristics.
1. Costing system adopted in any organization should be suitable to its nature and size of the
business and its information needs.
2. A costing system should be such that it is economical and the benefi ts derived from the
same should be more than the cost of operating of the same.
3. Costing system should be simple to operate and understand. Unnecessary complications
should be avoided.
4. Costing system should ensure proper system of accounting for material, labour and
overheads and there should be proper classification made at the time of recording of the
transaction itself.
5. Before designing a costing system, need and objectives of the system should be identified.
6. The costing system should ensure that the final aim of ascertaining of cost as accurately
possible should be achieved.
Certain Important Terms: It is necessary to understand certain important terms
used in cost accounting.

A. Cost Centre: Cost Center is defined as, ‘a production or service, function, activity or item
of equipment whose costs may be attributed to cost units. A cost center is the smallest
organizational sub unit for which separate cost allocation is attempted’. To put in simple
words, a cost center is nothing but a location, person or item of equipment for which cost
may be ascertained and used for the purpose of cost control. For example, a production
department, stores department, sales department can be cost centers. Similarly, an item of
equipment like a lathe, fork-lift, truck or delivery vehicle can be cost center, a person like
sales manager can be a cost center. The main object of identifying a cost center is to
facilitate collection of costs so that further accounting will be easy. A cost center can be
either personal or impersonal, similarly it can be a production cost center or service cost
centre. A cost center in which a specific process or a continuous sequence of operations is
carried out is known as Process Cost Center.

B. Profit Centre: Profit Center is defined as, ‘a segment of the business entity by which
both revenues are received and expenses are incurred or controlled’. (CEMA) A profit t
centre is any sub unit of an organization to which both revenues and costs are assigned.
As explained above, cost centre is an activity to which only costs are assigned but a profit
centre is one where costs and revenues are assigned so that profit t can be ascertained.
Such revenues and expenditure are being used to evaluate segmental performance as well
as managerial performance. A division of an organization may be called as profit center.
The performance of profit t centre is evaluated in terms of the fact whether the centre has
achieved its budgeted profits. Thus the profit t centre concept is used for evaluation of
performance.

Costing Systems : There are different costing systems used in practice. These are described
below.

A. Historical Costing :- In this system, costs are ascertained only after they are incurred
and that is why it is called as historical costing system. For example, costs incurred in
the month of April, 2007 may be ascertained and collected in the month of May. Such
type of costing system is extremely useful for conducting post-mortem examination of
costs, i.e. analysis of the costs incurred in the past. Historical costing system may not
be useful from cost control point of view but it certainly indicates a trend in the
behaviour of costs and is useful for estimation of costs in future.

B. Absorption Costing :- In this type of costing system, costs are absorbed in the product
units irrespective of their nature. In other words, all fixed and variable costs are
absorbed in the products. It is based on the principle that costs should be charged or
absorbed to whatever is being costed, whether it is a cost unit, cost center.
 C. Marginal Costing :- In Marginal Costing, only variable costs are charged to the
products and fi xed costs are written off to the Costing Profit and Loss A/c. The
principle followed in this case is that since fixed costs are largely period costs, they
should not enter into the production units. Naturally, the fixed costs will not enter into
the inventories and they will be valued at marginal costs only.
D. Uniform Costing :- This is not a distinct method of costing but is the adoption of
identical costing principles and procedures by several units of the same industry or by
several undertakings by mutual agreement. Uniform costing facilitates valid
comparisons betweenorganizations and helps in eliminating inefficiencies.

CLASSIFICATION OF COSTS / COST ANALYSIS

An important step in computation and analysis of cost is the classification of costs into
different types. Classification helps in better control of the costs and also helps
considerably in decision making. Classification of costs can be made according to the
following basis.

A. Classification according to elements: - Costs can be classified according to the

elements. There are three elements of costing, viz. material, labor and expenses. Total
cost of production/ services can be divided into the three elements to find out the
contribution of each element in the total costs.

B. Classification according to nature :- As per this classification, costs can be classified into
Direct and Indirect. Direct costs are the costs which are identifiable with the product unit
or cost centre while indirect costs are not identifiable with the product unit or cost centre
and hence they are to be allocated, apportioned and then absorb in the production units. All
elements of costs like material, labor and expenses can be classified into direct and
indirect.
They are mentioned below.

i. Direct and Indirect Material :- Direct material is the material which is identifiable withthe
product. For example, in a cup of tea, quantity of milk consumed can be identified,quantity of
glass in a glass bottle can be identified and so these will be direct materialsfor these products.
Indirect material cannot be identified with the product, for examplelubricants, fuel, oil, cotton
wastes etc cannot be identified with a given unit of productand hence these are the examples
of indirect materials.

ii. Direct and Indirect Labour :- Direct labour can be identified with a given unit of product
b for example, when wages are paid according to the piece rate, wages per unit can be
identified. Similarly wages paid to workers who are directly engaged in the production can
also be identified and hence they are direct wages. On the other hand, wages paid to workers
like sweepers, gardeners, maintenance workers etc are indirect wages as they cannot be
identified with the given unit of production.
iii. Direct and Indirect Expenses: - Direct expenses refer to expenses that are specifically
incurred and charged for specific or particular job, process, service, cost centre or cost unit.
These expenses are also called as chargeable expenses. Examples of these expenses are cost
of drawing, design and layout, royalties payable on use of patents, copyrights etc,
consultation fees paid to architects, surveyors etc. Indirect expenses on the other hand cannot
be traced to specific product, job, process, service or cost centre or cost unit. Several
examples of indirect expenses can be given like insurance, electricity, rent, salaries,
advertising etc. It should be noted that the total of direct expenses is known as ‘Prime Cost’
while the total of all indirect expenses is known as ‘Overheads’.

C. Classification according to behaviour: - Costs can also be classified according to their

behaviour. This classification is explained below.

i. Fixed Costs: - Out of the total costs, some costs remain fixed irrespective of changes in the
production volume. These costs are called as fixed costs. The feature of these costs isthat the
total costs remain same while per unit fixed cost is always variable. Examples ofthese costs
are salaries, insurance, rent, etc.

ii. Variable Costs: - These costs are variable in nature, i.e. they change according to the
volume of production. Their variability is in the same proportion to the production. For
example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total
Variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total
variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the
production. Another feature of the variable cost is that per unit variable cost remains same
while the total variable costs will vary. In the example given above, the per unit variable cost
remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct
materials, direct labour etc.

iii. Semi-variable Costs: Certain costs are partly fixed and partly variable. In other words,
they contain the features of both types of costs. These costs are neither totally fixed nor
totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs.
These costs are also called as ‘stepped costs’.

D. Classification according to functions: Costs can also be classified according to the

functions/ activities. This classification can be done as mentioned below:

i. Production Costs: All costs incurred for production of goods are known as production
costs.
ii. Administrative Costs: Costs incurred for administration are known as administrative
costs. Examples of these costs are office salaries, printing and stationery, office
telephone, office rent, office insurance etc.
iii. Selling and Distribution Costs :- All costs incurred for procuring an order are called
as selling costs while all costs incurred for execution of order are distribution costs.
 Market research expenses, advertising, sales staff salary, sales promotion expenses are
some of the examples of selling costs. Transportation expenses incurred on sales,
warehouse rent etc are examples of distribution costs.
iv. Research and Development Costs: In the modern days, research and development has
become one of the important functions of a business organization. Expenditure incurred
for this function can be classified as Research and Development Costs.

E. Classification according to time: Costs can also be classified according to time. This
classification is explained below:

i. Historical Costs: These are the costs which are incurred in the past, i.e. in the past
year, past month or even in the last week or yesterday. The historical costs are ascertained
after the period is over. In other words it becomes a post-mortem analysis of what has
happened in the past. Though historical costs have limited importance, still they can be
used for estimating the trends of the future, i.e. they can be effectively used for predicting
the future costs.

ii. Predetermined Cost: These costs relating to the product are computed in advance of
production, on the basis of a specification of all the factors affecting cost and cost data.
Predetermined costs may be either standard or estimated. Standard Cost is a
predetermined calculation of how much cost should be under specific working conditions.
It is based on technical studies regarding material, labour and expenses. The main
purpose of standard cost is to have some kind of benchmark for comparing the actual
performance with the standards. On the other hand, estimated costs are predetermined
costs based on past performance and adjusted to the anticipated changes. It can be used in
any business situation or decision making which does not require accurate cost.

F. Classification of costs for Management decision making: - One of the important

functions of cost accounting is to present information to the Management for the purpose
of decision making. For decision making certain types of costs are relevant. Classification
of costs based on the criteria of decision making can be done in the following manner:

Marginal Cost: Marginal cost is the change in the aggregate costs due to change in the
volume of output by one unit. For example, suppose a manufacturing company produces
10,000 units and the aggregate costs are Rs. 25,000, if 10,001 units are produced the
aggregate costs may be Rs. 25,020 which means that the marginal cost is Rs. 20.
Marginal cost is also termed as variable cost and hence per unit marginal cost is always
same, i.e. per unit marginal cost is always fixed. Marginal cost can be effectively used for
decision making in various areas.

II. Differential Costs: Differential costs are also known as incremental cost.

III. Opportunity Costs: It is the value of benefit sacrificed in favour of an alternative

course
 of action. It is the maximum amount that could be obtained at any given point of time if a
resource was sold or put to the most valuable alternative use that would be practicable.
Opportunity cost of goods or services is measured in terms of revenue which could have
been earned by employing that goods or services in some other alternative uses.

IV. Relevant Cost: The relevant cost is a cost which is relevant in various decisions of
management. Decision making involves consideration of several alternative courses of
action. In this process, whatever costs are relevant are to be taken into consideration. In
other words, costs which are going to be affected matter the most and these costs are called
as relevant costs. Relevant cost is a future cost which is different for different alternatives.
It can also be defined as any cost which is affected by the decision on hand. Thus in
decision making relevant costs plays a vital role.
V. Replacement Cost: This cost is the cost at which existing items of material or fixed
assets can be replaced. Thus this is the cost of replacing existing assets at present or at a
future date.
VI. Abnormal Costs: It is an unusual or a typical cost whose occurrence is usually not
regular and is unexpected. This cost arises due to some abnormal situation of production
Abnormal cost arises due to idle time, may be due to some unexpected heavy breakdown
of machinery. They are not taken into consideration while computing cost of production or
for decision making.

VII. Controllable Costs: - In cost accounting, cost control and cost reduction are extremely
important. In fact, in the competitive environment, cost control and reduction are the key
words. Hence it is essential to identify the controllable and uncontrollable costs.
Controllable costs are those which can be controlled or influenced by a conscious
management action. For example, costs like telephone, printing stationery etc can be
controlled while costs like salaries etc cannot be controlled at least in the short run.
Generally, direct costs are controllable while uncontrollable costs are beyond the control of
an individual in a given period of time.
VIII. Shutdown Cost: These costs are the costs which are incurred if the operations are
shut down and they will disappear if the operations are continued. Examples of these costs
are costs of sheltering the plant and machinery and construction of sheds for storing
exposed property. Computation of shutdown costs is extremely important for taking a
decision of continuing or shutting down operations.
IX. Capacity Cost: These costs are normally fixed costs. The cost incurred by a company
for providing production, administration and selling and distribution capabilities in order to
perform various functions. Capacity costs include the costs of plant, machinery and
building for production, warehouses and vehicles for distribution and key personnel for
administration. These costs are in the nature of long-term costs and are incurred as a result
of planning decisions.
X. Urgent Costs: These costs are those which must be incurred in order to continue
operations of the firm. For example, cost of material and labour must be incurred if
production is to take place.
 COST ANALYSIS AND COST CONTROL

INTRODUCTION TO COST CONTROL:

Cost Control has been defined as the guidance and regulation by execution action of
the costs of operating and under taking. It is regarded as an important derivative of
cost accounting is inseparably connected with cost control with the help of cost data.

CLASSIFICATION OF COST CONTROL:

1. Physical cost control – control over production and distribution.

2. Managerial cost control- the use of cost data for regulating current operations.
3. Mechanics cost control-the accounting techniques which are involved in providing for
cost control.

STEPS IN COST CONTROL:

1. Target should be set up for expenses and performance.

2. The actual expenses and production performances should be measured periodically.
3. Actual cost should be compared with the targets with a view to find out the
deviations.
4. Variations if any should be analysed by cases.
5. Corrective actions should be taken to eliminate the variations.
Cost control is essential for a manufacturing organization because, it aims at guiding
the actual costs towards the line of targets regulates the actual if they deviate from
targets. This guidance and regulation is done by a management action. A suitable cost
control system helps in maintaining expected return on capital employed, increasing
productivity of men, machines and other resources, fixing a reasonable price for
customers and increasing the economic stability of the manufacturing organization.

DIRECT AND INDIRECT EXPENSES

Direct expenditure also known as chargeable expenses includes all such expenditure
other than expenses on direct material and labour that can be directly identified with
cost unit examples of direct expenses are architect or surveyors fees. Cost of drawings
and patterns, royalty, repairs and maintenance of plant obtained on hire etc.

Indirect expenses are also called overhead. They are also referred to as on cost. They
include material, indirect labour and other expenses, which cannot be directly charged
to specific cost units. The overheads can be divided into three categories.

1. Factory Overheads:
Factory overheads include all indirect expenses, which are connected with
manufacturing of a product. When they are allocated to different cost units they are
referred to as factory on cost or works on cost. Examples of factory overheads are
salary of factory manager, supervisor’s salary, factory rent and rates and factory
insurance etc.
2. Administrative Overheads:
Administrative overheads include all indirect expenses relating to enter price. They
are also called as office overheads or office on cost. They include expenses incurred
towards formulation of policies, planning and controlling the functions and
motivating the personnel of organization.

3. Selling and Distribution Overheads:

Selling and distribution overheads are indirect expenses connected with marketing
and sales. Selling expenses are incurred in securing and retaining customers. Salaries
and commission of sales managers and salesmen, training expenses, cost of samples,
catalogues, price lists, exhibition and demonstrating expenses, market research
expenses and expenses incurred on entertaining customers. Distribution expenses are
expenses incurred in ensuring that the products are available at all potential points of
sale. They include expenses on handling the products from the time they are placed in
the Warehouse until they reach their destination. Examples of distribution overheads
are cost of warehousing, packing and loading charges etc.

ACTIVITY BASED COSTING

Activity based costing is the method for estimating the resources required to operate
an organization’s business processes, produce its products and serve its customers.

Characteristics of ABC Costing:

Simple traditional distinction made between fixed and variable cost is not enough
guide to provide quality information to design a cost system.
The more appropriate distinction between cost behaviour patterns are volume related,
diversity related and time related.
Cost drivers need to be identified.

BENEFITS OF ACTIVITY BASED COSTING:

1. Identify the most profitable customers, products and channels.

2. Identify the least profitable customers, products and channels.
3. Determine the true contributors to and detractors from financial performance.
4. Accurately predict costs, profits and resources requirements associated with
changes in production volumes, organizational structure and costs of resources.
5. Easily identify the root causes of poor financial performance.
6. Track costs of activities and work processes.
7. Equip managers with cost intelligence to stimulate improvements.
8. Facilitate a better Marketing Mix.
9. Enhance the bargaining power with the customers.
10. Achieve better positioning of products.
LIMITATIONS OF ACTIVITY BASED COSTING:

1. Allocation:

Not all costs have been appropriated activity or resource consumption cost
drivers. Some costs require allocations to departments and pre-cuts based on
arbitrary volume measures because finding the activity that causes because
finding the activity that causes the cost is impractical. Eg. Faculty sustaining
costs such as cost of information system, factory manager’s salary, factory
insurance etc.

2. Omission of costs:

Product or service costs identified by ABC System are likely to not include all
costs associated with the product or service. Product or service costs typically do
not include costs for such activities as marketing, advertising, research and
development and product engineering even though some these costs can be
traced to individual products or services. Product costs do not include these costs
because generally accepted accounting principles (GAAP) for financial reporting
requires them to be treated as period costs.

3. Expense and Time:

An ABC System is not cost free and is time consuming to develop and
`implement. For firms of organizations that have been using a traditional volume
based costing, installing a new ABC System is likely to be very expensive.
Furthermore, like most innovative management or accounting system. ABC
usually requires a year or longer for successful development and implementation.

LIFE CYCLE COSTING

Life cycle costing is also called whole life costing is technique to establish the
total cost of ownership. It is a structured approach that addresses all the elements
of this cost and can be used to produce a spend profile of the product or services
over its anticipated life span.

The results of an LCC analysis can be used to assist management in the decision
making process where there is a choice of options. The accuracy of LCC analysis
diminishes as it projects further into the future, so it is most valuable as a
comparative tool when long term assumptions apply to all the opinions and
consequently have the same impact.

LCC is a system that tracks and accumulates the actual costs and revenues
attributable to cost object from its invention to its abandonment. It involves
tracing cost and revenues on a product by product basis over several calendar
periods.
LIFE CYCLE COST:

Life cycle cost are incurred both ;

i) `Product and services from design stage through development to market

launch, production and sale and their eventual withdrawal from market and
ii) Fixed costs i.e., capital equipment.
The component elements of a product cost over iots life cycle should include:
 Acquisition cost- costs of research design, testing. Production,
construction or purchase in case of capital equipment.
 Product distribution-transport and handling.
 Maintenance cost-cost as customer service, field maintenance and in
factory maintenance.
 Operation cost-the costs incurred in operations such as energy costs and
various faculty and other utility costs.
 Training- operators and maintenance trainin g.
 Retirement and disposal-cost at the end of product ‘s life or life of capital
equipment.

BENEFITS OF LCC ANALYSIS:

1. Option Evaluation:

LCC techniques allow evaluation of competing proposals on the basis of life costs.
LCC analysis is relevant to most service contracts and equipment purchasing
decisions.

2. Improved Awareness:

Application of LCC techniques provides management with an improved awareness

of the factors that drive cost and resources the required by the purchase. It is
important that the cost drives are identified so that most of management effort is
applied to the most cost effective area of purchase. Additionally awareness of the
cost drives will also highlight areas in existing items which would benefit from
management involvement.

3. Improved Forecasting:

The application of LCC technique allows the full cost associated with a
procurement to be estimated more accurately. It leads to improved decision making
at all levels for example major investment decesions or establishment of cost
effective support policies. Additionally, LCC analysis allows more accurate
forecasting of future expenditure to be applied to long-term costing assessment.

4 Performance Trade off against cost:

In purchasing decisions cost is not the only factor to be considered when assessing
the opinions. There are other factors such as the overall fit against the requirement
 and the quality of goods and the levels of service to be provided. LCC analysis
allows for a cost trade-off to be made against the varying attributes of the
purchasing options.

. LIFE CYCLE COSTING AND MANAGEMENT COTROL:

When life cycle costing is used for capital investment appraisal. the aim of life cycle
management then switches to control i.e., monitoring actual life cycle costs and
comparing them with the expected costs. Control action might consists of action to
reduce costs of existing asset, but it will also include

i) Action to improve the design or specifications for future capital purchases and
ii) Action to improve the life cycle costing techniques that are being used so that
future capital asset purchase decision will be better.

.
 UNIT-II
COSTING FOR SPECIFIC INDUSTRIES
1. JOB COSTING
As mentioned in the above paragraph, the methods of costing are used to ascertain the cost of
product or service offered by a business organization. There are two principle methods of
costing. These methods are as follows:

I] Job Costing
II] Process Costing

Other methods of costing are the variations of these two principle methods. The variations of
these methods of costing are as follows.

I] Job Costing: Batch Costing, Contract Costing, Multiple Costing.

II] Process Costing: Unit or Single Output Costing, Operating Costing, Operation Costing
The Job Costing and its variations are discussed in detail in the following paragraphs:

I] Job Costing: This method of costing is used in Job Order Industries where the production
is as per the requirements of the customer. In Job Order industries, the production is not on
continuous basis rather it is only when order from customers is received and that too as per
the specific cautions of the customers. Consequently, each job can be different from the other
one. Method used in such type of business organizations is the Job Costing or Job Order
Costing. The objective of this method of costing is to work out the cost of each job by
preparing the Job Cost Sheet. A job may be a product, unit, batch, sales order, project,
contract, service, specific program or any other cost objective that is distinguishable clearly
and unique in terms of materials and other services used. The cost of completed job will be
the materials used for the job, the direct labour employed for the same and the production
overheads and other overheads if any charged to the job.

Features of Job Costing:

1) It is a specific order costing

2) A job is carried out or a product is produced is produced to meet the specifi c
requirements of the order.
3) Job costing enables a business to ascertain the cost of a job on the basis of which
quotation for the job may be given.
4) While computing the cost, direct costs are charged to the job directly as they are
traceable to the job.
5) Indirect expenses i.e. overheads are charged to the job on some suitable basis.
 6) Each job completed may be different from other jobs and hence it is diffi cult to have
standardization of controls and therefore more detailed supervision and control is
necessary.
7) At the end of the accounting period, work in progress may or may not exist.

Methodology used in Job Costing:

As discussed above, the objective of job costing is to ascertain the cost of a job that is
produced as per the requirements of the customers. Hence it is necessary to identify the costs
associated with the job and present it in the form of job cost sheet for showing various types
of costs. Various costs are recorded in the following manner.
1. Direct Material Costs: Material used during the production process of a job and identified
with the job is the direct material. The cost of such material consumed is the direct material
cost. Direct material cost is identifiable with the job and is charged directly. The source
document for ascertaining this cost is the material requisition slip from which the quantity of
material consumed can be worked out. Cost of the same can be worked out according to any
method of pricing of the issues like first in first out, last in first out or average method as per
the policy of the organization. The actual material cost can be compared with standard cost to
find out any variations between the two. However, as each job may be different from the
other, standardization is difficult but efforts can be made for the same.
2. Direct Labour Cost: This cost is also identifiable with a particular job and can be worked
out with the help of ‘Job Time Tickets’ which is a record of time spent by a worker on a
particular job. The ‘job time ticket’ has the record of starting time and completion time of the
job and the time required for the job can be worked out easily from the same. Calculation of
wages can be done by multiplying the time spent by the hourly rate. Here also standards can
be set for the time as well as the rate so that comparison between the standard cost and actual
cost can be very useful.
3. Direct Expenses: Direct expenses are chargeable directly to the concerned job. The
invoices or any other document can be marked with the number of job and thus the amount of
direct expenses can be ascertained.
4. Overheads: This is really a challenging task as the overheads are all indirect expenses
incurred for the job. Because of their nature, overheads cannot be identified with the job and
so they are apportioned to a particular job on some suitable basis. Pre determined rates of
absorption of overheads are generally used for charging the overheads. This is done on the
basis of the budgeted data. If the predetermined rates are used, under/over absorption of
overheads is inevitable and hence rectification of the same becomes necessary.
5. Work in Progress: On the completion of a job, the total cost is worked out by adding the
overhead expenses in the direct cost. In other word, the overheads are added to the prime
cost. The cost sheet is then marked as ‘completed’ and proper entries are made in the
finished goods ledger. If a job remains incomplete at the end of an accounting period, the
total cost incurred on the same becomes the cost of work in progress. The work in progress at
the end of the accounting period becomes the closing work in progress and the same becomes
the opening work in progress at the beginning of the next accounting period. A separate
account for work in progress is maintained in the books of business concern..

Advantages of Job Costing:

The following are the advantages of job costing.

1. Accurate information is available regarding the cost of the job completed and the
profits generated from the same.
2. Proper records are maintained regarding the material, labor and overheads so that a
costing system is built up.
3. Useful cost data is generated from the point of view of management for proper control
and analysis.
4. Performance analysis with other jobs is possible by comparing the data of various
jobs. However it should be remembered that each job completed may be different
from the other.
5. If standard costing system is in use, the actual cost of job can be compared with the
standard to find out any deviation between the two.
6. Some jobs are priced on the basis of cost plus basis. In such cases, a profit margin is
added in the cost of the job. In such situation, a customer will be willing to pay the
price if the cost data is reliable. Job costing helps in maintaining this reliability and
the data made available becomes credible.

Limitations of Job Costing:

Job costing suffers from certain limitations.
These are as follows.
i. It is said that it is too time consuming and requires detailed record keeping. This
makes the method more expensive.
ii. Record keeping for different jobs may prove complicated.
iii. Inefficiencies of the organization may be charged to a job though it may not be
responsible for the same.
In spite of the above limitations, it can be said that job costing is an extremely useful method
for computation of the cost of a job. The limitation of time consuming can be removed by
computerization and this can also
reduce the complexity of the record keeping.

INTER-PROCESS PROFITS

The output of one process is transferred to the subsequent process at cost price. However
sometimes, the transfer is made at cost + certain percentage of profit. This is done when each
process is treated as a profit centre. In such cases, the difference between the debit and credit
side of the process account represents profit or loss and is transferred to the Profit and Loss
Account. The stocks at the end and at the beginning contain an element of unrealized profits,
which have to be written back in this method. If the profit element contained in the closing
inventory is more than the profit element in the opening inventory, profit will be overstated
and vice versa. Profit is realized only on the goods sold, thus to obtain the actual profit the
main task would be to calculate the profit element contained in the inventories. In order to
compute the profit element, in closing inventory and to obtain the net realized profit for a
period, three columns have to be shown in the ledger for showing the cost, unrealized profit
and the transfer price.

Costing / Accounting for by-products

By-products are jointly produced products of minor importance and do not have separate
costs until the split off point. They are not produced intentionally but are emerging out of the
manufacturing process of the main products. The following methods are used for accounting
of by-products. The methods are broadly divided into Non-Cost Methods and Cost Methods.

Non-Cost Methods: The following methods are included in this category.

Other income or miscellaneous income method: Under this method, sales value of by-
products is credited to the Profit and Loss Account and no credit is given in the cost accounts.
The credit to the profit and loss account is treated as other income or miscellaneous income.
No effort is made for ascertaining the cost of the product. No valuation of inventory is made
and all costs and expenses are charged to the main product. This is the least scientific method
and is used where the sales value of the by-product is negligible.

II. Total sales less total cost: Under this method, sales value of by-product is added to the
sales value of the main product. Further the total cost of the main product including the cost
of the by-product is deducted from the sales revenue of the main product and by-product. All
costs and expenses are charged to the main product.

III. Total cost less sales value of by-product: In this method, the total cost of production is
reduced by the sales value of the by-product. This method seems to be more acceptable
because like waste and scrap, by-product revenue reduces the cost of major products.

IV. Total cost less sales value of by-products after setting off selling and distribution
overheads of by-products: Sales value of the by-product minus the selling and distribution
overheads of by-product is deducted from the total cost. Selling and distribution overheads
are charged against by-products actually sold.
V. Reverse cost method: This method is based on the view that the sales value of the by-
product contains an element of profit. It is agreed that this element of profit should not be
credited to the profit and loss account. The cost of by-product is arrived at by working
backwards. Selling price of the by-product is deflated by an assumed gross profit margin.
Thus under this method, sales value of the by-product is first reduced by, an estimated profit
margin, selling and distribution expenses and then the post split off costs and then the cost of
the main product is thus reduced by this net figure.
Cost Methods: The following methods are included in this category.

I. Replacement or opportunity cost method: If the by-products are consumed actively, they
are valued at the opportunity cost method or replacement cost method. This means the cost
which would have been incurred had the by-product been purchased from outside. For
example, biogases, which is one of the main by-product of sugar industry and which is used
for the factory as a fuel in the boiler is valued at the market value, i.e. the price that would
have been paid if it would have been purchased from outside.

II. Standard cost method: Under this method, the by-product is valued at the standard cost
determined for each product. The standard cost may be based on technical assessment.
Standard cost of the by-product is credited to the process account of the main product.
Accordingly, the cost control of main product can be exercised effectively.

III. Joint cost proration: Where the by-product is of some signifi cance, it is appropriate that
the joint costs should be apportioned between the main products and by-products on a most
suitable and acceptable method. Thus in this method, no distinction is made between the joint
product and by-product. Industries, where the by-products are quite important, use this
method. For example, in a petroleum refinery, gas was earlier considered as a by-product.
Now it has assumed the importance like petrol, diesel etc. and is being treated as joint
product. Accordingly, the joint cost is prorated between the joint product and the by-product.

2. PROCESS COSTING
Process costing is probably the most widely used method of costing. It is used in mass
production industries producing standard products such as cement, sugar, steel, oil refining
etc. In such industries goods produced are identical and processes are standardized. In these
industries, for manufacturing a product, the raw material has to pass through several distinct
stages of manufacture in a predetermined sequence. Each such stage of manufacture is called
a”process”.

The goods produced are identical and all factory processes are standardized.

Method of cost ascertainment in such industries is known as process costing in which costs
are compiled for each process by preparing a separate account of such process.

CHARACTERISTICS OF PROCESS COSTING

1. The production is continuous and the final product is the result of a sequence of processes.

2. Costs are accumulated by processes.

3. The products are standardized and homogeneous.

4. The cost per unit produced is the average cost which is calculated by dividing the total
process cost by the number of units produced.

5. The finished product of each but last process becomes the input for the next process in
sequence and that of the last process is transferred to the finished goods stock.

6. The sequence of operations or processes is specific and pre-determined.

7. Some loss of materials in processes (due to chemical action, evaporation etc.,) is

unavoidable.

8. Processing of raw materials may give rise to the production of several products.

9. These several products produced from the same raw material may be termed as joint
products or by-products.

ADVANTAGES OF PROCESS COSTING

The following are the main advantages of process costing:

1. It is possible to determine process costs periodically at short intervals.

2. Unit cost can be computed weekly or even daily if overhead rates are used on

Pre-determined basis.

3. It is simple and less expensive to find out the process cost.

4. It is possible to have managerial control by evaluating the performance of each Process.

5. It is easy to allocate the expenses to processes in order to have accurate costs.

6. It is easy to quote the prices with standardization of process. Standard costing can be

established easily in process type of manufacture.

DISADVANTAGES OF PROCESS COSTING

The following are the main disadvantages of Process Costing.

1. Costs obtained at the end of the accounting period are only of historical value and are not
very useful for effective control.

2. Work- in- progress is required to be ascertained at the end of an accounting period for
calculating the cost of continuous process. Valuation of work- in-progress is generally done
on estimated basis which introduces further inaccuracies in total cost.

3. Where different products arise in the same process and common costs are prorated to
various cost units. Such individual products’ costs may be taken as only approximation and
hence not reliable but may be taken as the best.
4. There is a wide scope of errors while calculating average costs. An error in one average
cost will be carried through all processes to the valuation of work in process and finished
goods.

5. The computation of average cost is more difficult in those cases where more than one type
of products are manufactured and a division of cost elements is necessary.

PROBLEMS ON COST SHEET

Single or Output Costing:

Q1. Prepare a cost sheet and calculate the percentage of works expenses of office
expenses to direct wages and the percentage office expenses to works cost from the
following

1 Stock of raw materials 1-1-2010 30,500

2 Stock of finished goods 1-1-2010 20,400
3 Stock of raw materials 31-1-2010 48,500
4 Stock of finished goods 31-1-2010 10,000
5 Purchase of raw materials 25,000
6 stock of work in progress 1-1-2010 8,000
7 stock of work in progress 31-1-2010 9,000
8 Sales 95,000
9 Direct wages 20,400
10 Factory expenses 10,500
11 Office expenses 5,400
12 Selling & Distribution expenses 6,300
Solution: Cost sheet at the month ended 31-1-2010

Particulars I.C O.C

opening stock of raw materials 30,500
Add: Purchase of raw materials 25,000
55,500
Less: closing stock of materials 48,500
COST OF MATERIAL CONSUMED 7,000
Add: direct wages 20,400
PRIME COST 27,400
Add: factory Overheads 10,500
37,900
Add: opening stock in WIP 8,000
45,900
Less: closing stock in WIP 9,000
FACTORY/ WORKS COST 36,900
Add: office overheads 5,400
COST OF PRODUCTION 42,300
Add: opening stock of finished goods 20,400
62,700
Less: closing stock of finished goods 10,000
COST OF GOODS SOLD 52,700
Add: Selling & distribution overheads 6,300
TOTAL COST 59,000
Profit 36,000
SALES 95,000

i) Calculation of percentage of works expenses to direct wages

office expenses 10,500

% of office expenses = x 100 = x100 = 51.47%
works cost 20,400

ii) Calculation of % of office expenses to work cost

office expenses 5,400

% of office expenses = x 100 = x100 = 14.63%
works cost 36,900

Detailed cost sheet:

Q2. Prepare a cost sheet for the month ended from the following information.

Particulars Amout
1 Opening stock of material 50,000
2 Purchases 20,000
3 Carriage inwards 40,000
4 Octroi& custom charges 6,000
5 Closing stock of raw material 10,000
6 Productive wages 8,000
7 Chargeable expenses/direct expenses 2,000
8 Indirect material 6,000
9 Indirect wages 4,000
10 Leave wages 5,000
11 Overtime premium 8000
12 Fuel & power 2,000
13 Coal & coke 4,000
14 Factory rent 6,000
15 Factory insurance 4,000
16 Factory lighting 6,000
17 Supervision 5,000
18 Canteen & welfare 4,000
19 Haulage 6,000
20 Work salaries 10,000
21 Drawing off salaries 5,000
22 Gas & water 1,000
23 Laboratory expenses 7,000
24 Internal transport expenses 1,000
25 Sale & scrap 5,000
26 Opening stock of WIP 10,000
27 Closing stock of WIP 5,000
28 Office salaries 20,000
29 Directors fees 10,000
30 Depreciation on office furniture 5,000
31 Subscription to trade journals 2,000
32 Establishment charges 3,000
33 Legal charges 6,000
34 Postage & telegram 4,000
35 Audit fee 3,000
36 Opening stock of finished goods 10,000
37 Closing stock of finished goods 6,000
38 Advertisement 4,000
39 Showroom expenses 6,000
40 Bad debts 5,000
41 Carriage outwards 6,000
42 Counting house salaries 10,000
43 Warehouse rent 4,000
44 Expenses of sales branches 6,000
45 Sales 3,00,000
46 Provision for bad debts 10,000
47 Interest paid 5,000
48 Donations 20,000
49 Income tax paid 5,000
50 Cash discount 7,000

Sol: DETAILED COST SHEET

Particulars I.C O.C

opening stock of materials 50,000
Add: Purchases 20,000
Add: carriage inwards 5,000
Add: octrai& custom charges 6,000
81,000
Less: closing stock of materials 10,000
COST OF MATERIAL
CONSUMED 71,000
Add: productive wages 8,000
Add: chargeable expenses 2,000
10,000
PRIME COST 81,000
Add: factory Overheads
indirect material 6,000
leave wages 5,000
indirect wages 4,000
overtime premium 8,000
fuel & power 2,000
cole& coke 4,000
factory rent 6,000
factory insurance 4,000
Supervision 5,000
canteen expenses 4,000
Haulage 6,000
work salaries 10,000
drawing of salaries 5,000
gas & water 1,000
laboratory expenses 7,000
internal transport expenses 1,000
84,000
Less: sale of scrap 5,000
79,000
Add: opening stock in WIP 10,000
89,000
Less: closing stock in WIP 5,000
 84,000
FACTORY/ WORKS COST 1,65,000
Add: office overheads
office salaries 20,000
directors fees 10,000
depreciation on office furniture 5,000
subscription to trade journals 2,000
establishment charges 3,000
legal charges 6,000
postage & telegram 4,000
audit fees 3,000
COST OF PRODUCTION 53,000
Add: opening stock of finished goods 10,000
63,000
Less: closing stock of finished goods 6,000
57,000
COST OF GOODS SOLD 2,22,000
Add: Selling & distribution overheads
Advertisement 4,000
showroom expenses 6,000
bad debts 5,000
carriage outwards 6,000
counting house salaries 10,000
warehouse rent 4,000
expenses of sales branches 6,000
41,000
TOTAL COST 2,63,000
profit 37,000
SALES 3,00,000

TENDER SHEET PROBLEM:

Q. E ltd. company furnishes the following information for 10,000units of a product

manufactured during the year 2007

Materials 90,000
Direct wages 60,000
Power & consumable stores 12,000
Indirect wages 15,000
Factory lighting 5,500
Cost of rectification of defective work 3,000
Clerical salaries & management expenses 33,500
Selling expenses 5,500
Sale of scrap 2,000
 Repairs & depreciation on P&M 11,500

Other information:

1. Net selling price was 31.60p.u sold & all units were sold
2. As from 1-1-2008, the selling price was reduced to Rs.31 p.u. It was estimated that
production could be increased in 2008 by 50% due to spare capacity.
3. Rates for materials & direct wages will increase by 10%.
You are required to prepare

i. Cost sheet for the year 2007 showing various elements of cost per unit
ii. Estimated cost sheet & profit for 2008 assuming that 15,000 will be produced and
sold during the year 2008 and factory overheads will be recovered as a % of direct
wages and office &selling overheads as a percentage of works cost.
Sol: Cost sheet of E ltd. Company for the year 2007 (10,000 units)

Particulars Unit rate O.C

Materials (90000/10,000) 9.00 90,000
Direct wages 6.00 60,000
PRIME COST 15.00 1,50,000
Add: factory Overheads
power & consumable stores 1.2 12,000
indirect wages 1.5 15,000
factoy lighting 0.55 5,500
cost of defective work 0.3 3,000
plant & depreciation 1.15 11,500
19.7 1,97,000
Less: sale of scrap 0.2 2,000
FACTORY/ WORKS COST 19.5 1,95,000
Add: office overheads
clerical staff salaries 3.35 33,500
OFFICE COST 22.85 2,28,500
Add: Selling & distribution overheads 0.55 55,000
TOTAL COST 23.4 2,34,000
profit 8.2 82,000
SALES 31.6 3,16,000
i. Calculation of factory overheads rates on direct wages

factory O.H 45,000

x 100 = x100 = 75%
direct wages 60,000

ii. Calculation of office & selling O.H on works cost

 office O.H 5,500+33,500
x 100 = x100 = 20%
works cost 1,95,000

Tender sheet for 15,000 units

Particulars Unit rate O.C

Materials 9.90 1,48,500
Direct wages 6.60 99,000
PRIME COST 16.50 2,47,500
Add: factory Overheads
75% of direct wages 4.95 74,250
FACTORY/ WORKS COST 21.45 3,21,750
Add: office and selling & distribution overheads
20% of works cost 4.29 64,350
TOTAL COST 25.74 3,86,100
profit 5.26 78,900
SALES 31.00 4,65,000

PROBLEMS ON PROCESS COSTING

MODEL 1: When Abnormal and normal wastages are not given in the problem

Q1. Prepare process accounts and calculate total cost of production from the following

Process
Particulars X Y X
Materials 2,250 750 300
Labour 1,200 3,000 900
DIRECT EXPENSES
Fuel & Power 300 200 400
Carriage 200 300 100
Work Overheads 1,890 2,580 1,875

Indirect expenses of Rs. 1,275 should be apportioned on the basis of Direct wages

Sol: Calculation of Indirect Wages to X,Y,Z in the ratio of Direct Labour (4:10:3) :

X process share indirect wages : 1275 x (4÷17) = 300

Y process share indirect wages : 1275 x (10÷17) = 750

Z process share indirect wages : 1275x (3÷17) = 225

Dr Process X Account Cr

Particulars Amount Particulars Amount

To materials 2,250 By transfer to process Y 6,140
To labour 1,200
To fuel & power 300
To carriage 200
To work overheads 1,890
To indirect expenses 300
6,140 6,140

Dr Process Y Account Cr

Particulars Amount Particulars Amount

To transfer from process X 6,140 By transfer to process Z 13,720
To materials 750
To labour 3,000
To fuel & power 200
To carriage 300
To work overheads 2,580
To indirect expenses 750
13,720 13,720
Dr Process Z Account Cr

Particulars Amount Particulars Amount

To transfer from process Y 13,720 By stock of finished good
17,520
To materials 300 (BIF)
To labour 900
To fuel & power 400
To carriage 100
To work overheads 1,875
To indirect expenses 225
17,520 17,520

MODEL 2: When normal loss is given in problem

Q2. Prepare process accounts A & B from following information

Process
Particulars A B
Materials (50 units) 50 --
Expenses 30 --
 5 units valued at 2 units valued at
Normal Loss Rs. 1.25 Rs. 3.50

Sol:

Dr Process A account Cr

Particulars Units Amount Particulars Units Amount

By normal loss (5x1.25) 5
To materials 50 50 1.25
By transfer to process B a/c 45
To expenses -- 30 78.75

50 80 50 80

Dr Process B account Cr

Particulars Units Amount Particulars Units Amount

By normal loss 2
To transfer from process A 45 79 3.5
By finished goods 43
75.25

45 79 45 78.75

MODEL 3: When Normal and Abnormal wastages/losses are given

Q3. A product passes 3 process A,B& C. The normal wastage of each process is as
follows:

Process Normal loss Wastage sold

A 3% 25 paise per unit

B 5% 50paise p.u

C 8% 1 rupee p.u
10,000 units were issues to process A on 1-Apr-2004 at a cost of Rs.1 per unit. The other
costs were given as follows

A B C
Sundry material 1,000 1,500 500
Labour 5,000 8,000 6,500
Direct expenses 1,050 1,188 2,009
Actual output ( in units) 9,500 9,100 8,100
Prepare process accounts assuming that no opening and closing stocks, also prepare
abnormal wastage gain account.

Sol:

Dr Process A a/c Cr

Amoun
Particulars Units Amount Particulars Units t
By normal loss @ 3%
300
To units introduced 10,000 10,000 of output 75
To material -- 1,000 By abnormal loss 200 350
By transfer to process B
To labour cost -- 5,000 a/c 9,500 16,625
To direct expenses -- 1,050
10,000 17,050 10,000 17,050

Working Notes: Calculation of the value of abnormal wastage of 200 units in process A

Dr Value - Cr Value
x abnormal wastage
Dr units - Cr units

17,050-75
x 200 =350/-
10,000-300
Dr Process B a/c Cr

Amoun
Particulars Units Amount Particulars Units t
To transfer from process By normal loss @ 5%
475
A a/c 9,500 16,625 of output 238
To material -- 1,500 By abnormal loss - -
By transfer to process C
To labour cost -- 3,000 a/c 9,100 27,300
To direct expenses -- 1,188
To abnormal gain 75 225
9,575 27,538 9,575 27,538
Working Notes: Calculation of the value of abnormal gain of 75 units in process B

Dr Value - Cr Value
x abnormal wastage
Dr units - Cr units

27,313-238
x 75 = 225/-
9,500 - 475

Dr Process C a/c Cr

Amoun
Particulars Units Amount Particulars Units t
To transfer from process By normal loss @ 8%
728
B a/c 9,100 27,300 of output 728
To material -- 500 By abnormal loss 272 1,156
By transfer to finished
To labour cost -- 6,500 goods 8,100 34,425
To direct expenses -- 2,009
9,100 36,309 9,100 36,309

Working Notes: Calculation of the value of abnormal loss of 272 units in process C

Dr Value - Cr Value
x abnormal wastage
Dr units - Cr units

36,309-728
x 272 = 1,156/-
9,100-728

Dr Abnormal loss a/c Cr

Amoun
Particulars Units Amount Particulars Units t
By sale of
To process A a/c 200 350 wastage
To process C a/c 272 1,156 process A 200 50
Process C 272 272
By
profit&loss
a/c - 1,184
472 1,506 472 1,506
Dr Abnormal wastage a/c Cr

Particulars Units Amount Particulars Units Amount

To sale value in process B 75 38 By process B a/c 75 225
To P&L a/c - 187
75 225 75 225

Applications [Merits] of Marginal Costing

Marginal costing is a very useful technique of costing and has great potential for management
in various managerial tasks and decision- making process. The applications of marginal
costing are discussed in the following paragraphs:

1) Cost Control: One of the important challenges in front of the management is the control of
cost. In the modern competitive environment, increase in the selling price for improving the
profit margin can be dangerous as it may lead to loss of market share. The other way to
improve the profit is cost reduction and cost control. Cost control aims at not allowing the
cost to rise beyond the present level. Marginal costing technique helps in this task by
segregating the costs between variable and fixed. While fixed costs remain unchanged
irrespective of the production volume, variable costs vary according to the production
volume. Certain items of fixed costs are not controllable at the middle management or lower
management level. In such situation it will be more advisable to focus on the variable costs
for cost control purpose. Since the segregation of costs between fixed and variable is done in
the marginal costing, concentration can be made on variable costs rather than fixed cost and
in this way unnecessary efforts to control fixed costs can be avoided.

2) Profit Planning: Another important application of marginal costing is the area of profit
planning. Profit planning, generally known as budget or plan of operation may be defined as
the planning of future operations to attain a defined profit goal. The marginal costing
technique helps to generate data required for profit planning and decision-making. For
example, computation of profit if there is a change in the product mix, impact on profit if
there is a change in the selling price, change in profit if one of the product is discontinued or
if there is a introduction of new product, decision regarding the change in the sales mix are
some of the areas of profit planning in which necessary information can be generated by
marginal costing for decision making. The segregation of costs between fixed and variable is
thus extremely useful in profit planning.
Desired sales = Fixed Cost + Desired Profit
P /V Ratio
3), Key Factor Analysis: The management has to prepare a plan after taking into
consideration the constraints if any, on the various resources. These constraints are also
known as limiting factors or principal budget factors as discussed in the topic of ‘Budgets and
Budgetary Control’. These key factors may be availability of raw material, availability of
skilled labour, machine hours availability, or the market demand of the product. Marginal
costing helps the management to decide the best production plan by using the scarce
resources in the most beneficial manner and thus optimize the profits. For example, if raw
material is the key factor and its availability is limited to a particular quantity and the
company is manufacturing three products, A, B and C. In such cases marginal costing
technique helps to prepare a statement, which shows the amount of contribution per kg of
material. The product, which yields highest contribution per kg of raw material, is given the
priority and produced to the maximum possible extent. Then the other products are taken up
in the order of priority. Thus the resultant product mix will yield highest amount of profi t in
the given situation.

4. Decision Making: Managerial decision-making is a very crucial function in any

organization. Decision – making should be on the basis of the relevant information. Through
the marginal costing technique, information about the cost behaviour is made available in the
form of fi xed and variable costs. The segregation of costs between fi xed and variable helps
the management in predicting the cost behaviour in various alternatives. Thus it becomes
easy to take decisions. Some of the decisions are to be taken on the basis of comparative cost
analysis while in some decisions the resulting income is the deciding factor. Marginal costing
helps in generating both the types of information and thus the decision making becomes
rational and based on facts rather than based on intuition. Some of the crucial areas of
decision-making are mentioned below.
_ Make or buy decisions
_ Accepting or rejecting an export offer
_ Variation in selling price
_ Variation in product mix
_ Variation in sales mix
_ Key factor analysis
_ Evaluation of different alternatives regarding profi t improvement
_ Closing down/continuation of a division
_ Capital expenditure decisions.

5. Break Even Point

The concept of ‘Break Even Point’ is extremely important for decision making in various
areas. This concept is based on the behaviour of costs, i.e. fixed cost and variable costs. As
discussed earlier, fixed costs are those costs that remain constant irrespective of the changes
in the volume of production. On the other hand, variable costs are the costs that vary with the
level of production. While fixed cost per unit is always variable, variable cost per units is
always fixed. In addition to these two types of costs, there are semi variable costs that are
partially fixed and partially variable. Semi variable costs thus have the features of both types
of costs. They remain fixed up to a certain level of production and after crossing that level,
they become variable. The Break Even Point is a level of production where the total costs are
equal to the total revenue, i.e. sales. Thus at the breakeven level, there is neither profit nor
loss. Production level below the break-even-point will result into loss while production above
break-even point will result in profits.

6. Closing down a plant / Shutdown Decision

A factory may have to case operation for sometime due to various reasons such as labour
troubles, material shortage, major break down, market depression etc., this shut down may be
of temporary nature and operations are renewed when the situation improves. Shut down
costs are classified as follows:
1. Costs incurred on suspension of operations. These include cost of notifying customers
about shut down , retrenchment and lay off costs etc.
2. Costs incurred during continued shut down such as cost of care and custody of plant
and machinery and other equipment etc.
3. Costs incurred on remaining operations after shut down e.g., cost of recruiting and
training new workers time lag in packing up production and sales , additional
promotional costs etc.
7. Dropping a product line/ Discontinuance of a product Line:
Another type of decision making in multi-product firm is regarding the dropping of a product
line. The following factors should be considered before taking a decision about the dropping
of a product line.
1. The contribution given by the product, this contribution is the different from profit.
Profit is arrived at after deducting fixed cost from contribution. Fixed costs are
apportioned over different products on some reasonable basis which may not be very
much correct. Hence contribution gives a better idea about the profitability of a
product as compared to profit.
2. The capacity utilization i.e., whether the firm is working with full capacity or below
normal capacity. In case a firm is having idle capacity, the production of any product
which can contribute toward the recovery of fixed cost can be justified.
3. The availability of product to replace the product which the firm wants to discontinue
and which is already accounting for a significant proportion of the total capacity.
4. The long-term prospects the market for the product.
5. The effect on sale of other products. In some cases, dropping down of one product
may result in heavy decline in sales of other products affecting the overall
profitability of the firm.

8. Charging General and Specific Fixed Costs:

Sometimes it is observed that general fixed cost is apportioned to departments or for
products. This may be done for ascertainment of total cost but will not be prudent for
decision making. Any apportionment of general fixed cost s may give misleading
 results. However, where fixed costs are specific. The same may be taken into
consideration as a relevant cost.

9. Fixation of Selling Price:

Although the prices are more controlled by market conditions and other economic
factors than by decisions of management yet fixation of selling prices is one of the
most important functions of management. This function is to be performed
 Under normal conditions
 In times of competition
 In times of trade depression.
 In accepting additional orders for utilising idle capacity.
 In exporting and exploring new markets.
 Selling price below the Marginal cost.
 When a new product is introduced into the market.
 When foreign market is to be explored to earn foreign exchange.
 When the concern has already purchased large quantities of material.
 At the time of closure of the business.
 When the sales one product at a price below the marginal cost will be pushed
up the sales of other profitable products.
 When employees cannot be retrenched.
 When the goods are perishable in nature.
 UNIT-III
MAKE OR BUY DECISIONS
MARGINAL COSTING

INTRODUCTION OF MARGINAL COSTING:

Marginal Costing is not a method of costing like job, batch or contract costing. It is in fact a
technique of costing in which only variable manufacturing costs are considered while
determining the cost of goods sold and also for valuation of inventories. In fact this technique
is based on the fundamental principle that the total costs can be divided into fixed and
variable. While the total fixed costs remain constant at all levels of production, the variable
costs go on changing with the production level. It will increase if the production increases
and will decrease if the production decreases. The technique of marginal costing helps in
supplying the relevant information to the management to enable them to take decisions in
several areas. In this chapter, the technique of marginal costing is explained in detail.

DEFINITIONS OF MARGINAL COSTING:

Marginal Cost is defined as, ‘the change in aggregate costs due to change in the volume of
production by one unit’. For example, if the total number of units produced are 800 and the
total cost of production is Rs.12, 000, if one unit is additionally produced the total cost of
production may become Rs.12, 010 and if the production quantity is decreased by one unit,
the total cost may come down to Rs.11, 990. Thus the change in the total cost is by Rs.10 and
hence the marginal cost is Rs.10. The increase or decrease in the total cost is by the same
amount because the variable cost always remains constant on per unit basis. Marginal Costing
has been defined as, ‘Ascertainment of cost and measuring the impact on profits of the
change in the volume of output or type of output. This is subject to one assumption and that is
the fixed cost will remain unchanged irrespective of the change.’ Thus the marginal costing
involves firstly the ascertainment of the marginal cost and measuring the impact on profit of
alterations made in the production volume and type. To clarify the point, let us take a simple
example, suppose company X is manufacturing three products, A, B and C at present and the
number of units produced are 45 000, 50 000 and 30 000 respectively p.a. If it decides to
change the product mix and decides that the production of B is to be reduced by 5000 units
and that of A should be increased by 5000 units, there will be impact on profits
and it will be essential to measure the same before the final decision is taken. Marginal
costing helps to prepare comparative statement and thus facilitates the decision-making. This
decision is regarding the change in the volume of output. Now suppose if the company has to
take a decision that product B should not be produced at all and the capacity, which will be
available, should be utilized for A and B this will be change in the type of output and again
the impact on profi t will have to be measured. This can be done with the help of marginal
costing by preparing comparative statement showing profits before the decision and after the
decision. This is subject to one assumption and that is the fi xed cost remains constant
irrespective of the changes in the production. Thus marginal costing is a very useful
technique of costing for decision-making.

PROBLEM ON MARGINAL COSTING:

Company X is producing 1 00 000 units. The variable cost per unit is Rs.5 and the fixed
costs are Rs.5, 00,000. If we work out the total cost per unit, it will be variable cost + fixed
cost per unit [at present level of production] that means, the total cost will be Rs.5 + Rs.5 =
Rs.10. But as per the technique of marginal costing, the variable cost only i.e. Rs.5, will be
charged to the production while the fixed cost of Rs.5, 00, 000 will not be charged to the cost
of production, it will be charged to the Costing Profit and Loss Account. Thus the selling
price of the product will be fixed on the basis of variable costs of Rs.5 per unit. This may
result in charging the price below the total cost but producing and selling a large volume of
the product will cover the fixed costs. Suppose, in the above example, selling price is Rs.9,
which covers the variable cost but not the total cost, efforts of the company will be to
maximize the volume of sales and through the margin between the selling price and variable
cost, cover the fixed cost. The difference between the selling price of Rs.10 per unit and the
variable cost of Rs.5 per units is the margin, which is called as ‘Contribution’. The
contribution margin in this case is Rs.5 per unit. If the company is able to produce and sell,
say, 1 50 000 units it will earn a total contribution of Rs.5 _ 1 50 000 units = Rs.7, 50, 000
which will cover the fixed costs and earn profits. However if the company is not able to sell
sufficient number of units, it will incur a loss. The concept of break-even point which is
discussed in detail later in this chapter is based on the same calculation.
Determination of marginal costing is the first basic principle of marginal costing. Marginal
cost is the additional cost of the production of additional unit. The marginal cost to an
economist means the cost of producing one additional unit of output and in this cost fixed
costs may be included. In cost accounting and management accounting marginal cost means
only variable expenses and it excludes the fixed cost. Hence it can be said that marginal cost
means additional variable cost to produce one more unit.

FEATURES OF MARGINAL COSTING:

1. Marginal costing is a technique of costing which is used in conjunction with other
methods of costing like process or job costing.
2. Only marginal costs i.e., variable costs are charged to products. These include direct
material, direct labour, direct expenses and variable over heads.
3. Fixed costs are treated as period costs and are directly charged to profit and loss
account for the period for which they are incurred. They are not charged to products.
4. The finished goods and work-in-progress are valued at marginal cost.
 5. In marginal costing prices are determined on the basis of marginal cost plus
contribution.
6. Profitability of departments and products is determined with reference to their
contribution margin.
7. Fixed costs remain constant irrespective of level of activity.
8. Cost-volume-profit relationship is fully employed to reveal the state of profitability at
various levels of activity.
9. It high lights the effect of costs on the level of output planned.
10. Break-even point is the prime component of marginal costing technique.

ADVANTAGES OF MARGINAL COSTING:

i) Simply to operate and easy to understand:

Marginal costing is a simple technique. It is very simple to operate and easy to

understand. It is constant in nature. Complications involved in allocation, apportionment and
absorption of overheads are avoided.

ii) Cost control:

In marginal costs are divided into fixed and variable costs. Variable costs are
always controllable. Thus greater control may be exercised over these costs. Further,
effective control on fixed costs becomes easier by treating them as a whole in the
determination of profit.

iii) Helps Management in Decision making:

This technique helps the management in taking various decisions. Marginal

costing is more useful in taking decisions like price fixation, make or buy, introduction of
new product line, selection of product mix etc.

iv) Relationship of net income with sales:

Marginal costing system establishes direct relationship of net income with the
sales. The marginal contribution technique provides a better and more logical basis for the
fixation of sales prices with intending profits.

v) Treatment of Overheads simplified:

It reduces the degree of over or under recovery of overheads due to separation of

fixed overheads from production cost.

vi) Helps in preparing Flexible Budget:

Marginal costing facilitates the preparation of flexible budget by differentiating

variable costs and fixed costs. It also helps in the evaluation of performance of responsible
personnel.
 vii) Stock Valuation:

Marginal costing inventory is valued at variable cost. Thus, unrealized profits are not taken
into account. Under this method stock valuation will be uniform and realistic.

viii)Aid to profit planning:

Marginal costing technique provides data relating to cost-volume-profit relationship. This

facilitates profit planning in future.

Xi) Helps in pricing:

Marginal costing is very helpful in fixation of selling price of products under various
conditions. It gives a better and more logical base for ths fixation of sales price as well as for
tendering contracts when the business is at low level.

x) Profitability Appraisal:

Marginal costing helps the management in evaluating the profitability of alternative

operations.

LIMITATIONS OF MARGINAL COSTING:

i) Practical Difficulty In Dividing Cost:

. The whole concept of marginal costing is based on the classification of total

cost into fixed and variable cost which is very difficult task. In marginal costing semi-
variable and semi-fixed costs are not considered.

ii) Time Factor Ignored:

Marginal costing technique does not attach much importance to time factor. If
time taken for completing two different jobs is not the same, costs will naturally will be
higher for the job which has taken longer time. Though marginal cost may the same for the
both jobs.

iii) Improper basis of pricing:

Marginal costing gives impression that as long as the price is more than the
marginal cost of production is profitable. But it may result in over all losses. In long run the
price without covering total cost will not yield profit to the firm.

iv) Not suitable to all industries:

Marginal costing technique is not suitable to all types of industries. For example
in capital intensive industries fixed cost like depreciation is more. If fixed costs are ignored
proper results cannot be ascertained. With the increase of automation the scope of marginal
costing is decreasing.

v) Fluctuations in Profits:
 Marginal costing technique cannot be applied in industries where there is large
stock of work-in-progress. As fixed overheads are not included in the value of stock , firm
will get losses in some years. This results in wide fluctuations in profits.s

vi) Difficulty in fixation of price:

Under marginal costing, selling price is fixed on the basis of contribution. In case of cost plus
contract is very difficult to fix price.

vii) Under or over absorption:

application of variable overheads depends on estimate and not on actual as such there may be
under or absorption.

viii)Full claim cannot be claimed:

Since stock is valued at marginal cost, in case of fire full amount of loss cannot be recovered
from the insurance company.

Xi) Not suitable for external reporting:

This technique is not suitable for external reporting viz., for tax authorities, where marginal
income is not considered to be taxable profit.

X) Significance Lost:

In capital intensive industries fixed costs occupy major portion in the total cost. But marginal
costs cover only variable costs. As such, it loses its significance in capital intensive
industries.

x) Full information is not given:

Marginal costing does not explain reasons for increase in production or sales.

1. MAKE OR BUY DECISION

A firm may make some products; parts or tools or sometimes it may buy the same thing from
outside. The management must decide which is profitable. In taking such a make or buy
decision marginal costing technique helps the management.

Make or buy decisions become necessary when utilized production facilities exist and the
product being produced has a component, which can either be made in the factory itself or
purchased from outside market.

While deciding to make or buy, the cost comparison should be made between the marginal
cost of manufacture and price at which the product or component could be obtained from
outside. It is profitable to the firm to buy the component from others only when the supplier’s
price is less than the marginal cost. Fixed costs are excluded on the assumption that they have
been already recovered.
Factors that influence make or Buy Decision:

In a make or buy decision, the following cost and non-cost factors must be
considered specifically

Cost Factors

a) Availability of plant facility.

b) Quality and type of item which effects the production schedule.
c) The space required for production of item.
d) Any special machinery or equipment required.
e) Any transportation involved due to the location of the product i.e., the feeder point.
f) Cost of acquiring special know-how required for the item.

2. KEY FACTOR OR LIMITING FACTOR

The limiting factor which prevents an enterprise from earning unlimited profit is known as
the key factor. Usually this limiting factor is sales. A concern may not be able to sell as much
as it can product. Sometimes a concern cancels all it produces but production is limited due to
the shortage of material, lower plant capacity or capital. In such a case, decision has to be
taken the choice of the product whose product is to be increased, reduced or stopped. The key
factor is also called as limiting factor or principle budge factor.

When there is no limiting factor, the choice of the product will be on the basis of the highest
P/V Ratio. But when there is scarce or limited resources selection of the product will be on
the basis of contribution per unit of scarce factor of production. When a limiting is in
operation , the contribution per unit of such a factor should be the criterion to judge the
profitability of a product. When two or more limiting factors are in operation simultaneously,
it is necessary to take all of them into consideration to determine the profitability. When the
material is in short supply, profitability is determined by contribution per kg, when labour
shortage is there profitability is measured contribution per labour hour.

3. SELECTION OF A SUITABLE PRODUCT MIX

When a factory manufactures more than one product, a problem is faced by the management
as to which product mix gives the maximum profits. The best product mix is that which
yields the maximum contribution.

 The best product mix is that which yields the maximum contribution.
 The products which give the maximum contribution are to be retained and their
production should be increased.
 The products which give comparatively less contribution should be reduced or close
down altogether.
 The effect of sales mix can also be seen by comparing the P/V Ratio and Breakeven
point.
  The new sales mix will be favourable if it increases P/V Ratio and reduces the
breakeven point.

4. DIVERSIFICATION OF PRODUCTS
Sometimes it becomes necessary for a concern to introduce a new product or products
in order to utilize the idle capacity or to capture a new market or for other purposes.
General fixed costs will however, be charged to the old product / products.
 In order to decide about the profitability of the new product, it is assumed that the
manufacture of the new product will not increase fixed costs of the concern.
 If the price realized from the sale of such product is more than its variable cost of
production it is worth trying.
 If the data is presented under absorption costing method, the decision will be
wrong.
 If with the introduction of new product, there is an increase in the fixed costs, then
such specific increase in fixed costs must be deducted from the contribution for
making any decision.
 General fixed costs will be charged to the old products.

5. CLOSING DOWN ALL SUSPECTING ACTIVITIES

The deduction to close down or suspend its activities will depend whether products
are making contribution towards fixed costs or not. i.e., whether the contribution is
more than the difference in fixed costs by working at normal operations and when the
plant or product is closed down or suspended.
If the business is closed down
 They may be certain fixed costs which could be avoided.
 There will be certain expenses which will have to be incurred at the time of
closing the operations like redundancy payments, necessary maintenance of
the plant or overhauling of plant on reopening training of personal etc.
 Such costs are associated with closing down of the business and must be taken
into consideration before taking any decision.

Applications of BEP for various business problems:

1. MAKE OR BUY DECISION

A firm may make some products; parts or tools or sometimes it may buy the same thing from
outside. The management must decide which is profitable. In taking such a make or buy
decision marginal costing technique helps the management.

Make or buy decisions become necessary when utilized production facilities exist and the
product being produced has a component, which can either be made in the factory itself or
purchased from outside market.
While deciding to make or buy, the cost comparison should be made between the marginal
cost of manufacture and price at which the product or component could be obtained from
outside. It is profitable to the firm to buy the component from others only when the supplier’s
price is less than the marginal cost. Fixed costs are excluded on the assumption that they have
been already recovered.

FACTORS THAT INFLUENCE MAKE OR BUY DECISION :

In a make or buy decision, the following cost and non-cost factors must be
considered specifically

Cost Factors

1. Availability of plant facility.

2. Quality and type of item which effects the production schedule.
3. The space required for production of item.
4. Any special machinery or equipment required.
5. Any transportation involved due to the location of the product i.e., the feeder point.
6. Cost of acquiring special know-how required for the item.

Every business process need planning to select, plan, analyse and reengineering and it is
essence of operating management. One of the common used quantitative method is process
selection is break –even analysis. This helps in identifying what volume of sales and
production can make it profit. Process planning involve major issues such as make or buy
decision. This make or buy decision refer to a decision such as which components are
purchased and which components are manufactured . management is usually confronted with
the problem of decision of make or buy of any item. This problem can be solve by a large
extent through break-even chart.

6,000

4,000

2,000

1,000 2,000 3,000 4000

2. PRICING DECISION:
Break-even point is valuable analytical tool to recognize and interpret its results. For
management it is useful in pricing determination, expenses control and profitability.
Changing the price of a product would change the total revenue function of the business and
this would affect the break-even point and the margin of safety. These factors need to be
considered along with market-based factors such as the demand for the product.

3. SALES MIXING DECISION:

Altering the sales mix in a multi-product environment would tend to alter the total revenue
function of the business and also the variable cost function. This would affect the break-even
point and margin of safety but by explaining the effects of different sales mixes it is possible
to consider their effect on the profitability of the business and this will facilitate decisions
regarding the sales mix.

4. PRODUCTION CAPACITY PLANNING:

We have seen that the cost and revenue relationship do not apply indefinitely but only within
the relevant range. As activity is expanded it will eventually be constrained by shortage of
one of the factors of production and this factor is known as the limiting factor. While this
limitation can be overcome in the long term. In short term maximum profits can be made by
maximising contribution per unit of the limiting factor.

The limiting factor is the major constraint on organizational activity. Here we will merely
state that C.V.P. Analysis can facilitate an understanding of the effect upon profit of the
limiting factor.

BREAK EVEN ANALYSIS

When we use in broad sense, break-even analysis is used to determine probable profit /loss at
any given level of production or sales. It also helps to determine the amount or volume of
sales to earn a desired amount of profit.

Break Even Analysis refers to analysis of the break-even point(BEP).

The BEP is defined as no profit or no loss point. Why is it necessary to determine the BEP
when there is neither profit nor loss? It is an important because it denotes the minimum
volume of production to be undertaken to avoid losses. In other words, it points out how
much minimum to be produced to see the profits. It is a technique for profit planning and
control and therefore is considered a valuable managerial tool.

Break-even analysis is defined as analysis of costs and their possible impact on revenues and
volume of the firm. Hence, it is also called the cost-volume-profit analysis. A firm is said to
attain the BEP when its total revenue is equal to total cost ( TR=TC). Total cost comprises
fixed cost and variable cost. The significant variables on which the BEP is based are fixed
cost, variable cost and total revenue. The study of cost-volume-profit relationship is often
referred as Break Even Analysis. The Break Even Analysis is interpreted in two senses. In
its narrow sense, it is concerned with finding out Break Even Point. Break Even Point is the
point at which total revenue is equal to total cost. It is the point of no profit , no loss. In its
broad sense, BEP determines the probable profit at any level of production.

ASSUMPTIONS OF BREAK EVEN ANALYSIS:

1. Costs can perfectly be classified into fixed and variable costs.

2. Selling price per unit remains constant in spite of competition or change in the volume
of production. It does not consider the price discounts or cash discounts.

3. Volume of sales and volume of production are equal(All the goods produced are
sold). Hence there is no closing stock/ unsold stock.

4. There is only one product available for sale. In case of multi product firm, the product
mix / Sales mix remains constant.

5. Fixed costs remain constant at all levels of output.

6. Variable cost fluctuates /varies proportionally with volume of production.

7. There is no opening or closing stock.

8. There will be no change in operating efficiency.

9. The volume of output or production is the only factor which affecting/influencing the

cost.

10. There will be no change in general price level.

SIGNIFICANCE / IMPORTANCE/ADVANTAGES OF BREAK-EVEN ANALYSIS

1. Information provided by Break-Even Chart can be understood more easily than those
contained in profit and Loss Account and the cost statement.

2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals
how changes in the profit. So it helps management in decision-making.

3. It is very useful for forecasting costs and profits for a long-term planning and growth.

4. The Break Even Chart discloses profits at various levels of production.

It serves as very useful tool for cost control.

6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break Even Chart presents the different elements in the costs i.e., direct
material, direct labour, fixed overheads and variable overheads.

Break-even analysis is also a valuable tool

 to as certain the profit on a particular level of sales volume or a given capacity of

production.

 to calculate sales required to earn a particular desired level of profit.

 to compare the product lines, sales area, methods of sale for individual company.

 to compare the efficiency of the different firms.

 to decide whether to add a particular product to the existing product line or drop one
from it.

 to decide to ‘make or buy’ a given component or spare part.

 to decide what promotion mix will yield optimum sales.

 to assess the impact of changes in fixed cost, variable cost or selling price on BEP and
profits during a given period.

LIMITATIONS OF BREAK-EVEN ANALYSIS

Break-even analysis has certain underlying assumptions which form its limitations.

1. Break-even point is based on fixed cost, variable cost and total revenue. A change in
one variable is going to affect the BEP.

2. All costs cannot be classified into fixed and variable costs. We have semi-variable
costs also.

3. In case of multi product firm, a single chart cannot be of any use. Series of charts
have to be made use of.

4. It is based on fixed cost concept and hence holds good only in the short-run.

5. total cost and total revenue lines are not always straight as shown in the figure. The
quantity and price discounts are the usual phenomena affecting the total revenue line.

6. Where the business conditions are volatile/ unstable BEP cannot give stable results.

7. Break-even chart represents only cost volume profits. It ignores other considerations
such as capital amount, marketing aspects and effect of government policy etc., which
are necessary in decision making.

8. It is assumed that sales, total cost and fixed cost can be represented as straight lines.
In actual practice, this may not be so.
 9. It assumes that profit is a function of output. This is not always true. The firm may

increase the profit without increasing output.

10. A major drawback of Break Even Chart(BEC) is its inability to handle production

and sale of multiple products.

11. It is difficult to handle selling costs such as advertisement and sales promotion in

BEC.

12. It ignores economies of scale in production.

13. Fixed costs do not remain constant in the long run.

14. Semi-variable costs are completely ignored.

15. It assumes production is equal to sale. It is not always true because generally there may

be opening stock.

16. When production increases variable cost per unit may not remain constant but may

reduce on account of bulk buying etc.

17. The assumption of static nature of business and economic activities is a well-known

defect of Break Even Chart (BEC).

INTER-FIRM COMPARISIONS
Meaning of Inter-firm comparison:
Inter-Firm comparison is a technique, which studies the performances, efficiencies, costs and
profits of various concerns in an industry with help of exchange of information in order to
have a relative comparison. It involves the process by bringing together a number of identical
firms and collecting their business figures and statistics through a neutral organization in
which the participating firms repose their full confidence.

The figures under comparison may relate to:

1. Financial results viz., the position of assets, liabilities, profit, capital employed etc.,
expressed in terms of financial ratios.
2. Cost structure of the products viz., material cost, labour cost and overhead cost etc.,
expressed in terms of cost ratios.
3. Physical and operational performance such as output or operation per man-hour,
expressed in terms of productivity ratios, percentages and so on.
Need for Inter-firm comparison:

Progressive management, the world over has always asked itself the question how is my
company performing in comparison to that of others? The published trading and profit and
loss accounts and balance sheets along with annual reports provide scanty data for purposeful
study and assessment of the performance of a company.

The figures from these reports just indicate in a general way, the profitability, stability,
solvency and growth of an organization, but they do not throw light on whether a company
has really made the optimum use of all the available resources in men, materials etc. It is the
inter-firm comparison that provides the management with a vivid comparative picture of how
its operating performance, financial results and product cost structure compare with those of
other firms of similar size, nature, industry or trade.

Requirement (prerequisites) of Inter-firm comparison Scheme:

The following are the main requirements while installing a scheme of inter-firm
comparisons:.

1. Adoption of uniform costing:

There must be a sound system of uniform costing in the firm where inter-firm comparison
scheme is to be implemented. A uniform manual should also be prepared and distributed
among the member units to enable the function of the system efficiently.

2. Organization Responsible:

An organization must be established to run the system efficiently and for better results firms
of different sizes in an industry should become member of the organization.

3. Information to be collected:

The nature of information to be collected from the participating firms depends upon the needs
of the management, comparative importance of the information and the efficiency of the
central body responsible for the collection of the information.

4.Method of Collection and Presentation of Information:

The time and the firm in which the information is to be submitted by the member units must
be decided in advance. The various statistical tools for the purpose of collection of data, it’s
editing, classification, presentation, drawing conclusions and inferences can be used. Ratio
analysis for measuring profitability, efficiency and productivity can also be used.

Types of comparisons:
The following three types of comparisons made for this purpose.

1. Comparison of Management Ratio:

 The management ratios are those which are linked to sales, profits, and assets of the
business. These ratios are not meant to provide management in a nutshell with
comparative picture of its operating performance.
2. Comparison of Cost Ratios:
Management may not be satisfied with the ratios calculated in. they would like to go a
step further to make inter-firm comparison more meaningful and to find out how they
are doing in relation to others as regards the cost of production.
3. Comparison of Technical Data:
This type of comparison will be of special interest to industries working in highly
competitive economics. It is visualized that technical comparison will be in the realm
of quality of materials used, their utilization, process involved machinery used and
certain other technical aspects of production. The following are the main ratios, which
are calculated for this purpose:
1. Quality of Raw Material consumed
Man Hours or Machine Hours
2. Cost of Raw Material consumed
Man Hours or Machine Hours
3. Cost of Scrap
Cost of Raw Material Consumed
4. Quality of Scrap
Cost of Raw Material Consumed
5. Quality of Scrap
Quality of Raw Material Consumed
6. Quantity produced
Man Hours or Machine Hours
7. Cost of Rejected material
Cost of production

8. Cost of reworking
Cost of production

9. Loss of Process
Cost of Material
10. Idle time hours
Total Available time

11. Overtime Hours

Man Hours

12. Cost of Idle Time

Direct Labour Cost
13. Power Units Consumed
Machine Hours
 14. Total cost of production
Man Hours or Machine Hours
15. Quality of Scrap
Cost of Raw Material Consumed

16. Cost of Machine Maintenance

Cost of Production

17. Cost of maintenance of other factory assets

Cost of Production

Advantages of Inter- Firm Comparisons:

Inter-firm comparison is nothing more than learning. It is for the management that inter-firm
comparison has been evolved as a Inter-firm comparison:

1. It encourages managerial efficiency in the organization by technique in industry. The

following are the main advantages of pointing out the spots of inefficiencies and thus
brings stability in the cost structure and presentation of information.
2. It creates cost consciousness among the participating firms and they are cautious in
this respect at all levels of management.
3. It helps the member firms to reduce their costs in case their costs are more as
compared to other firms.
4. It increases the productivity by locating the weaknesses and in economies.
5. It provides useful information to management of every member unit to make proper
decisions.
6. It helps the government, regulatory agencies and researchers in getting useful data and
information to improve policies and conducting depth studies and research.

IMPORTANT PROBLEMS FROM BREAK EVEN ANALYSIS

1. You are required to compute (i) Break Even Point (Rs.) (ii) Margin of Safety (MOS)
iii) Margin of Safety Ratio (iv) Sales at a Profit of Rs.10,000 from the following
information:

Sales Rs. 3,00,000 ; Variable Cost Rs.2,00,000 ; Fixed Cost Rs. 70,000;

Profit Rs. 30,000.

Solution: Break-Even Point (Rs.) = Fixed cost / P/V Ratio

P/V Ratio = (Contribution / Sales ) X 100

Contribution= Sales – Variable cost

 = 3,00,000-2,00,000 = Rs. 1,00,000

P/V Ratio = ( Contribution / Sale)X100

= (1,00,000/ 3,00,000) x 100 = 33.33 % or 1/3

i) Break-Even Point = Fixed Cost / P/V Ratio

=70,000 / 1/3 = 70,000 X 3/1 = Rs.2,10,000
ii) Margin of Safety = Actual sales – Break-Even Sales
= 3,00,000-2,10,000 = Rs.90,000
iii) Margin of Safety Ratio = (MOS / Sales) X 100
= (90,000 / 3,00,000) X 100 = 30%
iv) Sales required to earn a desired profit of Rs.10,000 will be
Estimated Sales = (Fixed cost + Desired profit) / P/V Ratio
= (70,000+10,000) / 1/3 = 80,000 X 3/1 = Rs.2,40,000

2. You are required to compute (i) Break Even Point (Rs.) (ii) Margin of
Safety(MOS) (iii) Margin of Safety Ratio (iv) Sales at a Profit of Rs.10,000
from the following information:

Sales Rs. 3,00,000 ; Variable Cost Rs.2,40,000 ; Fixed Cost Rs. 30,000;

Profit Rs. 30,000

Solution: Break-Even Point (Rs.) = Fixed cost / P/V Ratio

P/V Ratio = (Contribution / Sales) X 100

Contribution= Sales – Variable cost = 3,00,000-2,40,000 = Rs. 60,000

P/V Ratio = (60,000/ 3,00,000) x 100 = 20 %

i) Break-Even Point (Rs.) = 30,000 / 20% = 30,000 X 100/20 = Rs.1,50,000

ii) Margin of Safety = Actual sales – Break-Even Sales
= 3,00,000-1,50,000 = Rs.1,50,000
iii) Margin of Safety Ratio = (MOS / Sales) X 100
= (1,50,000 / 3,00,000) X100 = 50%
iv) Sales required to earn a desired profit of Rs.10,000 will be
Estimated Sales = (Fixed cost + Desired profit) / P/V Ratio
= (30,000+10,000) / 20%
= 40,000 X 100 /20 = Rs.2,00,000

3. You are required to compute (i) P/V Ratio ( ii) Break Even Point (Rs.)

iii) Sales required to earn a Profit of Rs.4,50,000 from the following:

Fixed Expenses Rs.90,000

Variable Cost per Unit

Direct Materials Rs. 5 per unit

Direct Labour Rs. 2 per unit

Direct Overheads 100 % of Direct Labour.

Selling Price per Unit Rs.12

SOLUTION: Contribution per unit = Selling price per unit – variable cost per unit

= 12 – (5+2+2) = 12-9 = Rs.3

i) P/V Ratio = (Contribution Per unit/ Selling price per unit) X 100

= (3/ 12) X 100 = 25%

ii) Break-Even Point (Rs.) = Fixed Expenses / P/V Ratio

= 90,000 / 25% = 90,000 X 100/25 = Rs.3,60,000

iii) Sales required to earn a profit of Rs.4,50,000

Estimated sales = (Fixed Cost + Desired Profit)/ P/V Ratio
= (90,000+4,50,000) / 25%
= 5,40,000 X 100/25 = Rs.21,60,000

4. You are required to calculate i) P/V Ratio (ii) B.E.P (in Rs.) (iii) B.E.P (in units)
(iv) Margin of Safety from the following:

Total Sales Rs.3,60,000; Selling price per unit Rs.100;

Variable cost per unit Rs.50;

Fixed Cost Rs.1,00,000.

SOLUTION:

Contribution per unit = Selling price per unit- Variable cost per unit.

= 100 – 50 = Rs.50

i) P/V Ratio = (Contribution per unit / Selling price per unit) X 100
=( 50/100)X 100 = 50%
ii) Break-Even Sales (in Rs.) = Fixed cost / P/V Ratio
= 1,00,000 / 50% = 1,00,000 X 100/50=Rs.2,00,000
iii) Break-Even Sales (in Units) = Fixed Cost / Contribution per unit
= 1,00,000 / 50 = 2,000 units
iv) Margin of Safety = Actual Sales – Break Even Sales
= 3,60,000- 2,00,000 = Rs.1,60,000
5. You are required to compute

(i) Break Even Point (Rs.) (ii) Sales required to earn a Profit of Rs.20,000

(iii) Profit when sales are Rs.1,25,000 from the following

Information:

Years Sales (Rs.) Profit (Rs.)

2000 1,00,000 15,000
2001 1,20,000 23,000

SOLUTION:

(i) P/V Ratio = (Change in Profit / Change in Sales)X 100

Change in profit = Current year Profit – Last year profit

= 23,000 – 15,000 = Rs.8,000

Change in Sales = Current year sales- Last year Sales

= 1,20,000-1,00,000 = Rs.20,000

P/V Ratio = (8,000/ 20,000) X 100 = 40%

(i) Fixed Cost = (Current Year sales X P/V Ratio)- Current year Profit
= (1,20,000 X 40/100)-23,000
= 48,000-23,000 = Rs.25,000
(ii) Break-Even Point (Rs.) = Fixed Cost / P/V Ratio
= 25,000 / 40% = 25,000 X 100/40 = Rs.62,500

(iii) Sales required to earn a profit of Rs.20,000

Estimated Sales = (Fixed Cost + Desired Profit) / P/V Ratio
= (25,000 +20,000) / 40%
= 45,000 X 100/40 = Rs.1,12,500
The sales required to earn a profit of Rs.20,000 will be Rs.1,12,500

(iv) Profit at an estimated sales of Rs.1,25,000

Estimated Profit = (Desired Sales X P/V Ratio)- Fixed Cost
= (1,25,000 X 40%) – 25,000
= 50,000-25,000 = Rs.25,000
The profit at an estimated sales of Rs.1,25,000 will be Rs.25,000

6. The Sales Turnover and profit during two years were given as follows:
 Years Sales (Rs.) Profit (Rs.)
2003 1,40,000 15,000
2004 1,60,000 20,000
You are required to calculate the following:

i) Break Even Point (Value)

ii) Sales required to earn a profit of Rs.40,000
iii) Profit when Sales are Rs.1,20,000.

SOLUTION:

(i) P/V Ratio = (Change in Profit / Change in Sales)X 100

Change in profit = Current year Profit – Last year profit

= 20,000 – 15,000 = Rs.5,000

Change in Sales = Current year sales- Last year Sales

= 1,60,000-1,40,000 = Rs.20,000

P/V Ratio = (5,000/ 20,000) X 100 = 25%

Fixed Cost = (Current Year sales X P/V Ratio)- Current year Profit

= (1,60,000 X 25 /100)-20,000

= 40,000-20,000 = Rs.20,000
(ii) Break-Even Point (Rs.) = Fixed Cost / P/V Ratio
= 20,000 / 25% = 20,000 X 100/25 = Rs.80,000

(iii) Sales required to earn a profit of Rs.40,000

Estimated Sales = (Fixed Cost + Desired Profit) / P/V Ratio
= (20,000 +40,000) / 25%
= 60,000 X 100/25 = Rs.2,40,000
The sales required to earn a profit of Rs.40,000 will be Rs.2,40,000.

(iv) Profit at an estimated sales of Rs.1,20,000

Estimated Profit = (Desired Sales X P/V Ratio)- Fixed Cost
= (1,20,000 X 25%) – 20,000
= 30,000-20,000 = Rs.10,000
The profit at desired sales of Rs.1,20,000 will be Rs.10,000.

7. The Sales Turnover and profit during two years were given as follows:

Years Sales (Rs.) Profit (Rs.)/Loss

(Rs.)
2009 38,000 -2,400
2010 65,000 3,000
You are required to calculate the following:

i) Break Even Point (Value)

ii) Sales required to earn a profit of Rs.5,000
iii) Profit/Loss when Sales are Rs.46,000.

SOLUTION:

(i) P/V Ratio = (Change in Profit / Change in Sales)X 100

Change in profit = Current year Profit – Last year profit

= 3,000 – (-2,400) = 3,000 +2,400 =Rs.5,400

Change in Sales = Current year sales- Last year Sales

= 65,000-38,000 = Rs.27,000

P/V Ratio = (5,400/ 27,000) X 100 = 20%

Fixed Cost = (Current Year sales X P/V Ratio)- Current year Profit

= (65,000 X 20 /100)-3,000

= 13,000-3,000 = Rs.10,000
(ii) Break-Even Point (Rs.) = Fixed Cost / P/V Ratio
= 10,000 / 20% = 10,000 X 100/20 = Rs.50,000

(iii) Sales required to earn a profit of Rs.5,000

Estimated Sales = (Fixed Cost + Desired Profit) / P/V Ratio
= (10,000 +5,000) / 20%
= 15,000 X 100/20 = Rs.75,000
The sales required to earn a profit of Rs.40,000 will be Rs.75,000.

(iv) Profit /Loss at an estimated sales of Rs.46,000

Estimated Profit / Loss = (Desired Sales X P/V Ratio)- Fixed Cost
= (46,000 X 20%) – 10,000
= 9,200-10,000 = -Rs.800
The Loss at a desired sales of Rs.46,000 will be Rs.800.

8. The Sales Turnover and Total cost during two years were given as follows:

Years Total Sales (Rs.) Total Cost (Rs.)

2008 42,500 38,700
2009 39,200 36,852
You are required to calculate the following:

i) Break Even Point (Value)

ii) Sales required to earn a profit of Rs.6,000
iii) Profit when Sales are Rs.47,500.

SOLUTION:

Profit for 2009= Current year sales – Current year Total cost

= 39,200 – 36,852 = Rs. 2,348

Profit for 2008=Last year sales – Last year Total cost

= 42,500 – 38,700 = Rs.3,800

Change in sales = Current year sales – Last year sales

= 39,200 – 42,500 = -3,300

Change in Profit = Current year profit – Last year profit

= 2,348-3,800 = -1,452

i) P/V Ratio = (Change in Profit / Change in sales)X 100

= (-1452 / -3,300) X 100 = 44%
Fixed Cost = (Last year Sales X P/V Ratio)- Last Year Profit.
= (42,500 X 44%) – 3,800
= 18,700-3,800 = 14,900

(ii) Break-Even Sales = Fixed Cost / P/V Ratio

= 14,900 / 44% = 14,900 X 100/44 = Rs.33,863.64 = Rs.33,864

(iii) Sales required to earn a profit of Rs.6,000

Estimated Sales = (Fixed Cost + Desired Profit) / P/V Ratio

= (14,900 + 6,000) / 44%

= 20,900 X 100 / 44 = Rs.47,500
The Sales required to earn a profit of Rs.6,000 will be Rs.47,500

(iv) Profit when sales are Rs.47,500

Estimated Profit = (Desired Sales X P/V Ratio)- Fixed Cost

= (47,500 X 44%) -14,900
= 20,900- 14,900 = Rs.6,000
The profit at sales of Rs.47,500 will be Rs.6,000.
 UNIT-IV
BUDGETARY CONTROL
Introduction of Budgetary Control:
Budgetary control is the process of determining various budgeted figures for
the enterprises for the future period and then comparing the budgeted figures with the
actual performance for calculating variances, if any. First of all budgets are prepared
and then actual results are recorded. The comparison of budgeted and actual figures
will enable to find out discrepancies and take remedial measures at a proper time. The
budgetary control is a continuous process which helps in planning and co-ordination.
It provides a method of control too. A budget is a means and budgetary control is the
end-result.

Definitions of Budgetary Control:

According to Brown and Howard, “Budgetary control is a system of controlling
costs which includes the preparation of budgets, co-coordinating the department and
establishing the responsibilities, comparing the actual performance with the budgeted
(standard performances) and acting upon results to achieve maximum profitability.”

Wheldon characterizes budgetary control as “planning in advance of various

functions of a business so that the business as a whole is controlled.”

J.Batty defines budgetary control as “A system which uses budgets as a means of

planning and controlling all aspects of producing and/or selling commodities and
services.”

According to Welsch, “Budgetary control involves the use of budget and budgetary
reports, throughout the period to co-ordinate, evaluate and control day-to-day
operations in accordance with the goals specified by the budget.”

Advantages of Budgetary Control:

1. Maximisation of profit: The budgetary control aims at the maximization of profits
of enterprise. To achieve this aim, a proper planning and co-ordination of different
functions is undertaken. There is a proper control over various capital and revenue
expenditures. The resources are put to the best possible use.
2. Co-ordination: The working of different departments and sectors is properly co-
ordinated. The budgets of different departments have a bearing on one another. The
co-ordination of various executives and subordinates is necessary for achieving
budgeted targets.

3. Specific Aims: The plans, policies and goals are decided by the top management.
All efforts are put together to reach the common goal of the organization. Every
department is given a target to be achieved. The efforts are directed towards
achieving some specific aims. If there is no definite aim then the efforts will be
wasted in pursuing different aims.

4. Tool for Measuring Performance: By providing targets to various departments,

budgetary control provides a tool for measuring managerial performance. The
budgeted targets are compared to actual results and deviations are determined. The
performance of each department is reported to the top management. This system
enables the introduction of management by exception.

5. Economy: The planning of expenditure will be systematic and there will be

economy in spending. The finances will be put to optimum use. The benefits
derived for the concern will ultimately extend to industry and then to national
economy. The national resources will be used economically and wastage will be
eliminated.

6. Determining weaknesses: the deviations in budgeted and actual performance will

enable the determination of weak spots. Efforts are concentrated on those aspects
where performance is less than the stipulated.

7. Corrective Action: The management will be able to take corrective measures

whenever there is a discrepancy in performance. The deviations will be regularly
reported so that necessary action is taken at the earliest. In the absence of budgetary
control system the deviations can be determined only at the end of the financial
period.

8. Consciousness: It creates budget consciousness among the employees. By fixing

targets for the employees, they are made conscious of their responsibility.
Everybody knows what he is expected to do and he continues with his work
uninterrupted.

9. Reduces Costs: In the present day competitive world budgetary control has a
significant role to play. Every business man tries to reduce the cost of the
production for increasing sales. He tries to have those combinations of products
where profitability is more.

10. Introduction of Incentive scheme: Budgetary control system also enables the
introduction of incentive schemes of remuneration. The comparison of budgeted and
actual performance will enable the use of such schemes.
Limitations of Budgetary Control:
1. Uncertain future: The budgets are prepared for the future period. Despite best
estimates made for the future, the predictions may not always come true. The
future is always uncertain and the situation which have to be prepared on the basis
of certain assumptions. The future uncertainties reduce the utility of budgetary
control.

2. Budgetary Revisions Required: Budgets are prepared on the assumptions that

certain conditions will prevail. Because of future uncertainties, assumed conditions
may not prevail necessitating the revision of budgetary targets. The frequent
revision of targets will reduce the value of budgets and revisions involve huge
expenditure too.

3. Discourages Efficient Persons: Under budgetary control system the targets are
given to every person in the organization. The common tendency of people is to
achieve the targets only. There may be some efficient persons who can precede the
targets but they will also feel contented by reaching the targets. So budgets may
serve as constraints on managerial initiatives.

4. Problem of Co-ordination: The success of budgetary control depends upon the

co-ordination among different departments. The performance of one department
affects the results of other departments. To overcome the problem of co-ordination
a Budgetary Officer is needed. Every concern cannot afford to appoint a Budgetary
Officer. The of co-ordination among different departments results in poor
performance.

5. Conflict among Different Departments: Budgetary Control may lead to conflict

among functional departments. Every departmental head worries for his
department goals without thinking of business goal. Every department tries to get
maximum allocations of funds and this raises a conflict among different
departments.

6. Depends upon Support of Top Management: Budgetary control system depends

upon the support of top management. The management should be enthusiastic for
the success of this system and should give full support for it. If at any time there is
a lack of support from top management then this system will collapse.
Differences between Fixed Budget and Flexible Budget:
Fixed Budget:

According to ICWA London, “Fixed budget is a budget which is designed to

remain unchanged irrespective of the level of activity actually attained.” Fixed
budgets are suitable under static conditions. If, sales, expenses and costs can be
forecasted with greater accuracy then this budget can be advantageously used.”

Flexible Budget

A Flexible budget consists of a series of budgets for different levels of

activities. It therefore, varies with level of activity attained. A flexible budget is
prepared after taking into consideration unforeseen changes in the conditions of the
business. A flexible budget is defined as a budget which by recognizing the difference
between fixed , semi-fixed and variable cost is designed to change in relation to the
level of activity.

The Flexible budgets will be useful where level of activity changes from time
to time. When the forecasting of the demand is uncertain and the undertaking operates
under conditions of shortage of materials, labour etc., then this budget will be more
suited.

Differences between Fixed Budget and Flexible Budget

Basis of Fixed Budget Flexible Budget

Distinction

1.Rigidity A fixed budget remains the A flexible budget is recast to suit

same irrespective of changed the changed circumstances.
situations. It remains inflexible Suitable adjustments are made if
even if volume of business is the situation so demands.
changed.

2.Conditions A fixed budget assumes that This budget is changed if the

conditions will remain constant. level of activity varies.

3.Cost In fixed budgets costs are not The costs are studied as per their
Classification classified according to their nature. i.e.,fixed, variable and
nature. semi-variable.

4.Change in If the level of activity changes The budgets are redrafted as per
Volume then budgeted and actual results the changed volume and a
cannot be compared because of comparison between budgeted
change in basis. and actual figures will be
possible.
5. Forecasting Forecasting of accurate results Flexible budgets clearly show the
is difficult. impact of expenses on operations
and it helps in making accurate
forecasts.

6.Cost Under changed circumstances The costs can be easily

ascertainment costs cannot be ascertained. ascertained under different levels
of activity. This helps in fixing
prices.

BUDGETS AND BUDGETARY CONTROL

Introduction
The first important task in front of the management is to have clearly defined
objectives. Objectives are short term as well as long term and they should be defi ned
in clear terms. It is necessary to prepare a comprehensive plan to transform these
objectives into reality and planning without controlling will not be effective and hence
there is a need of effective control system. While planning helps an organization to
work systematically towards achieving the objectives, controlling helps to review the
progress made and to monitor whether the work is progressing as per the plan or not.
Budgeting is one such technique that helps in planning as well as controlling. It is a
technique of cost accounting with the twin objectives of facilitating planning and
ensuring controlling. Various aspects of budgets and budgetary control, the types of
budgets and the preparation of the same are discussed in detail in this chapter.

Definitions of Budget:

To begin with, let us try to understand the definitions of budget and budgetary control.
Budget has been defined by CIMA U.K. as, ‘A financial and/or quantitative statement
prepared prior to a defined period of time, of the policy to be pursued during that
period for the purpose of achieving a given objective.’ If we analyze the definition,
the following features of budget emerge.

I. A budget is a statement that is always prepared prior to a defined period of time.

This means that budget is always prepared for future period and not for the past. For
example, a budget for the year 2008-09 regarding the sales will be prepared in the
year 2007-08. Another important point is that the time for which it is prepared is
certain. Thus a budget may be prepared for next 3 years/1 year/ 6 months/1 month or
even for a week, but the point is that the time frame for which it is prepared is certain.
It cannot be prepared for indefinite period of time.
 II. Budget is prepared either in quantitative details or monetary details or both. This
means that budget will show the planning in terms of rupees or in quantity or both.
For example, a production budget will show the production target in number of units
and when the target units are multiplied by the anticipated production cost, it will be a
production cost budget that is expressed in terms of money Similarly purchase budget
is prepared in quantity to show the anticipated purchases in the next year and when
the quantity is multiplied by the expected price per unit, it will become a purchase
cost budget that is expressed in monetary terms. Some budgets are prepared only in
monetary terms, for example, cash budget, capital expenditure budget etc.

III. Every organization has well defined objectives, which are to be achieved in a
particular span of time. It is of paramount importance that there should be systematic
efforts to bring them into reality. As a part of these efforts, it is necessary to formulate
a policy and it is reflected in the budget. Thus if a firm has to launch a massive drive
for recruitment of people, this policy will be reflected in the manpower planning
budget as well as other relevant budgets. Thus the policy to be pursued in future for
the purpose of achieving well-defined objectives is reflected in the budget.
Budgetary Control is actually a means of control in which the actual results are
compared with the budgeted results so that appropriate action may be taken with
regard to any deviations between the two.

Budgetary control has the following stages .

1. Developing Budgets: The first stage in budgetary control is developing various

budgets. It will be necessary to identify the budget centre in the organization and
budgets will have to develop for each one of them. Thus budgets are developed for
functions like purchase, sale, production, manpower planning as well as for cash,
capital expenditure, machine hours, labour hours and so on. Utmost care should be
taken while developing the budgets. The factors affecting the planning should be
studied carefully and budgets should be developed after a thorough study of the same.

2. Recording Actual Performance: There should be a proper system of recording the

actual performance achieved. This will facilitate the comparison between the budget
and the actual. An efficient accounting and cost accounting system will help to record
the actual performance effectively.

3. Comparison of Budgeted and Actual Performance: One of the most important

aspects of budgetary control is the comparison between the budgeted and the actual
performance. The objective of such comparison is to find out the deviation between
the two and provide the base for taking corrective action.

4. Corrective Action: Taking appropriate corrective action on the basis of the

comparison between the budgeted and actual results is the essence of budgeting. A
budget is always prepared for future and hence there may be a variation between the
budgeted results and actual results. There is a need for investigation of the same and
take appropriate action so that the deviations will not repeat in the future.
Responsibilities can be fixed on proper persons so that they can be held responsible
for any such deviations.

Objectives of Budgeting

An effective budgeting system plays a crucial role in the success of a business

organization. The budgeting system has the following objectives, which are of
paramount importance in the overall efficiency and effectiveness of the business
organization. These objectives are discussed below:

1. Planning: Planning is necessary for doing any work in a systematic manner. A

well- prepared plan helps the organization to use the scarce resources in an effi cient
manner and thus achieving the predetermined targets becomes easy. A budget is
always prepared for future period and it lays down targets regarding various aspects
like purchase, production, sales, manpower planning etc. This automatically facilitates
planning.

2. Co-ordination: For achieving the predetermined objectives, apart from planning,

coordinated efforts are required. Budgeting facilitates coordination in the sense that
budgets cannot be developed in isolation. For example, while developing the
production budget, the production manager will have to consult the sales manager for
sales forecast and purchase manager for the availability of the raw material.
Production budget cannot be developed in isolation. Similarly the purchase and sales
budget as well as other functional budgets like cash, capital expenditure, manpower
planning etc cannot be developed without considering other functions. Hence the
coordination is automatically facilitated.

3. Control: Planning is looking ahead while controlling is looking back. Preparation of

budgets involves detailed planning about various activities like purchase, sales,
production, and other functions like marketing, sales promotion, manpower planning.
But planning alone is not sufficient. There should be a proper system of controlling
which will ensure that the work is progressing as per the plan. Budgets provide the
basis for such controlling in the sense that the actual performance can be compared
with the budgeted performance. Any deviation between the two can be found out and
analyzed to ascertain the reasons behind the deviation so that necessary corrective
action can be taken to rectify the same. Thus budgeting helps immensely in
controlling function.
Benefits of Budgeting:

Budgeting plays an important role in planning and controlling. It helps in directing the
scarce resources to the most productive use and thus ensures overall efficiency in the
organization. The benefits derived by an organization from an effective system of
budgeting can be summarized as given below:

I. Budgeting facilitates planning of various activities and ensures that the working of
the organization is systematic and smooth.

II. Budgeting is a coordinated exercise and hence combines the ideas of different
levels of management in preparation of the same.

III. Any budget cannot be prepared in isolation and therefore coordination among
various departments is facilitated automatically.

IV. Budgeting helps planning and controlling income and expenditure so as to achieve
higher profitability and also act as a guide for various management decisions.

V. Budgeting is an effective means for planning and thus ensures suffi cient
availability of working capital and other resources.

VI. It is extremely necessary to evaluate the actual performance with predetermined

parameters. Budgeting ensures that there are well-defined parameters and thus the
performance is evaluated against these parameters.

VII. As the resources are directed to the most productive use, budgeting helps in
reducing the wastages and losses.

(Steps involved in the Preparation for) Essentials of Budgetary

Control

A budgetary control is extremely useful for planning and controlling as described

above. However, for getting these benefits, sufficient preparation should be made. For
complete success, a solid foundation should be laid down and in view of this the
following aspects are of crucial importance.

I. Budget Committee: For successful implementation of budgetary control system,

there is a need of a budget committee. In small or medium size organizations, the
budget related work may be carried out by the Chief Accountant himself. Due to the
size of the organization, there may not be too many problems in implementation of
the budgetary control system. However, in large size organization, there is a need of a
budget c committee consisting of the chief executive, budget officer and heads of
main departments in the organization. The main functions of the budget committee
are to get the budgets prepared and then scrutinize the same, to lay down broad
policies regarding the preparation of budgets, to approve the budgets, to suggest for
revision, to monitor the implementation and to recommend the action to be taken in a
given situation.

II. Budget Centres: Establishment of budget centres is another important pre-requisite

of a sound budgetary control system. A budget centre is a group of activities or a
section of the organization for which budget can be developed. For example,
manpower planning budget, research and development cost budget, production and
production cost budget, labour hour budget and so on. Budget centres should be
defined clearly so that preparation becomes easy.

III. Budget Period: A budget is always prepared prior to a defined period of time.
This means that the period for which a budget is prepared is decided in advance. Thus
a budget may be prepared for three years, one year, six months, one month or even for
one week. The point is that the period for which the budget is prepared should be
certain and decided in advance. Generally it can be said that the functional budgets
like sales, purchase, production etc. are prepared for one year and then broken down
on monthly basis. Budgets like capital expenditure are generally prepared for a period
from 1 year to 3 years. Thus depending upon the type of budget, the period of the
same is decided and it is important that it is decided well in advance.

IV. Preparation of an Organization Chart: There should be an organization chart

that shows clearly defined authorities and responsibilities of various
executives. The organization chart will defi ne clearly the functions to be performed
by each executive relating to the budget preparation and his relationship with other
executives. The organization chart may have to be adjusted to ensure that each budget
center is controlled by an appropriate member of the staff.

V. Budget Manual: A budget manual is defi ned by ICMA as ‘ a document which

sets out the responsibilities of the person engaged in, the routine of and the forms and
records required for budgetary control’.
The budget manual thus is a schedule, document or booklet, which contains different
forms to be used, procedures to be followed, budgeting organization details, and set of
instructions to be followed in the budgeting system. It also lists out details of the
responsibilities of different persons and the managers involved in the process. A
typical budget manual contains the following.
_ Objectives and managerial policies of the business concern.
_ Internal lines of authorities and responsibilities.
_ Functions of the budget committee including the role of budget offi cer.
_ Budget period
_ Principal budget factor
_ Detailed program of budget preparation
_ Accounting codes and numbering
_ Follow up procedures.
VI. Principal Budget Factor or Key Factor: A key factor or a principal budget factor
[also called as constraint] is that factor the extent of whose infl uence must fi rst be
assessed in order to prepare the functional budgets. Normally sales is the key factor or
principal budget factor but other factors like production, purchase, skilled labor may
also be the key factors. For example, a company has production capacity to produce
30,000 tones per annum but if the sales forecast tells that the market can absorb only
20,000 units, there is no point in producing 30,000 units. Thus the sale is the key
factor in this case. On the other hand, if the company has capacity to produce 30,000
units and the market has the capacity to absorb the entire production which means that
sales is not the key factor but if raw material is available in limited quantity so that
only 25,000 units can be produced, the raw material will become the key factor. The
key factor puts restrictions on the other functions and hence it must be considered
carefully in advance. So continuous assessment of the business situation
becomes necessary. In all conditions the key factor is the starting point in the process
of preparation of budgets. A typical list of some of the key factors is given below:

_ Sales: Consumer demand, shortage of sales staff, inadequate advertising

_ Material: Availability of supply, restrictions on import

_ Labor: Shortage of labor

_ Plant: Availability of capacity, bottlenecks in key processes

_ Management: Lack of capital, pricing policy, shortage of efficient executives, lack

of know- how, faulty design of the product etc.

VII. Establishment of Adequate Accounting Records: It is essential that the

accounting system should be able to record and analyze the transactions involved. A
chart of accounts or accounts code should be maintained which may correspond with
the budget centres for establishment of budgets and finally control through budgets.

Types of Budgets

Budgets can be classified as per the following basis.

On the basis of Area of Operation

A. Functional Budgets
B. Master Budget
 On the basis of Capacity Utilization
A. Fixed Budget
B. Flexible Budgets

On the basis of Time

A. Short Term
B. Medium Term
C. Long Term

On the basis of Conditions

A. Basic Budget
B. Current Budget
These budgets are discussed in detail in the following paragraphs.
_ Classification according to Area of Operation
A. Functional Budgets: The functional budgets are prepared for each function of the
organization. These budgets are normally prepared for a period of one year and then
broken down to each month. The following budgets are included in this category.
_ Sales Budget: A Sales Budget shows forecast of expected sales in the future period
[the period is well-defined] and expressed in quantity of the product to be sold as well
as the monetary value of the same. A Sales Budget may be prepared product wise,
territories/area/country wise, customer group wise, salesmen wise as well as time wise
like quarter wise, month wise, weekly etc. The following factors are taken into
consideration while preparing a sales budget.
_ Analysis of past sales: Analysis of sales for the last 5-10 years will provide valuable
information like the long term trend, seasonal trends, cyclical fl uctuations and other
relevant information like customer preference analysis, shift in demand, competition
and other environmental factors. This information can be used to predict the likely
future demand of the product.
_ Estimates given by the sales staff: Sales staff of the business organization works in
the field and hence they know the market situation very well. They have very close
interaction with the market and are in a better position to know the demand pattern
and other such trends.
However, care is to be taken that the subjective element in the sales estimates given
by the sales staff should be eliminated to arrive at a realistic sales forecast.
_ Market Potential Analysis: Marketing Research helps any business organization to
collect the data regarding markets, demand pattern, customer preferences, market
potential and other factors like economic factors and environmental factors. From this
analysis, market potential can be worked out which will be used in the sales budget.
_ Dependent Factor: Demand of a product is dependent upon certain factors. For
example, the demand for petrol and diesel is dependent on the number of vehicles
plying though the
roads. Analysis of such dependent factor will help to prepare the sales forecast which
can be used in the sales budget.
Production Budget / Material Purchase Budget:
 This budget shows the quantity of materials to be purchased during the coming year.
For the preparation of this budget, production budget is the starting point if it is the
key factor. If the raw material availability is the key factor, it becomes the starting
point. The desired closing inventory of the raw materials is added to the requirement
as per the production budget and the opening inventory is subtracted from the gross
requirements. This budget is prepared in quantity as well as in the monetary terms and
helps immensely in planning of the purchases of raw materials. Availability of storage
space, financial resources, various levels of materials like maximum, minimum, re-
order and economic order quantity are taken into consideration while preparing this
budget. A separate material utilization budget may also be prepared as a preparation
of material purchase budget.
Cash Budget:
A cash budget is an estimate of cash receipts and cash payments prepared for each
month. In this budget all expected payments, revenue as well as capital and all
receipts, revenue and capital are taken into consideration. The main purpose of cash
budget is to predict the receipts and payments in cash so that the firm will be able to
find out the cash balance at the end of the budget period. This will help the firm to
know whether there will be surplus cash or
deficit at the end of the budget period. It will help them to plan for either investing
the surplus or raise necessary amount to finance the deficit. Cash Budget is prepared
in various ways, but the most popular form of the same is by the method of Receipt
and Payment method.
Other Functional Budgets:
In addition to the budgets discussed above, the following are other functional budgets.

Direct Labor Budget: The labor budget estimates the labor required for smooth and
uninterrupted production. The labor budget shows the number of each type or grade of
workers required in each period to achieve the budgeted output, budgeted cost of such
labor, period wise and period of training necessary for different types of labor.
_ Factory Overhead Budget: This budget is prepared for planning of the factory
overheads to be incurred during the budget period. In this budget the overheads
should be shown department wise so that responsibility can be fi xed on proper
persons. Classification of factory overheads into fixed and variable components
should also be shown in this budget.
_ Administrative Overhead Budget: This budget covers the administrative costs for
non-manufacturing business activities. The administrative overheads include expenses
like offi ce expenses, offi ce salaries, directors’ remuneration, legal expenses, audit
fees, rent, interest, property taxes, postage, telephone, telegraph etc. These expenses
should be classifi ed properly under different headings to determine the
responsibilities regarding cost control and reduction.
_ Capital Expenditure Budget: Capital expenditure is incurred with a long - term
perspective and with the objective of augmenting the earning capacity of the fi rm in
the long run. Capital expenditure results in either acquisition of fi xed asset or
permanent improvement in the existing fi xed assets. Another important feature of
 capital expenditure is that the amount involved is very heavy and the decision to incur
capital expenditure is not reversible. Hence a careful planning is required before
decision to incur capital expenditure is taken. In the budget of capital expenditure,
apart from the planning of incurring the expenditure, evaluation of the same is also
shown. This budget therefore becomes extremely crucial as it not only plans the
expenditure but also evaluates the same and helps in arriving at a decision.
_ Manpower Planning Budget: This budget shows the requirement of manpower in the
budget period. The categories in which manpower is required are also shown in this
budget. The requirement of manpower depends on the expansion plans of the
organization and also on the expected separations during the budget period.
_ Research and Development Cost Budget: This budget is one of the important tools
for planning and controlling research and development costs. It helps management in
planning the research and development activities well in advance and also about the
fairness of the expenditure. Research and development is one of the important
activities of any firm and hence proper planning and coordination is required for
effectiveness of the same. This budget also helps to plan the requirement of necessary
staff for carrying out research and development.
B. Master Budget: All the budgets described above are called as ‘Functional Budgets’
that are prepared for planning of the individual function of the organization. For
example, budgets are prepared for Purchase, Sales, Production, Manpower Planning,
and so on. A Master Budget which is also called as ‘Comprehensive Budget’ is a
consolidation of all the functional budgets. It shows the projected Profit and Loss
Account and Balance Sheet of the business organization. For preparation of this
budget, all functional budgets are combined together and the relevant fi gures are
incorporated in preparation of the projected Profit and Loss Account and Balance
Sheet. Thus Master Budget is prepared for the entire organization and not for
individual functions.

_ Fixed and Flexible Budgets: The fi xed and fl exible budgets are discussed in detail
in the following paragraphs.
_ Fixed Budgets: When a budget is prepared by assuming a fixed percentage of
capacity utilization, it is called as a fixed budget. For example, a firm may decide to
operate at 90% of its total capacity and prepare a budget showing the projected profit
or loss at that capacity. This budget is defined by The Institute of Cost and
Management Accountants [U.K.] as ‘ the budget which is designed to remain
unchanged irrespective of the level of activity actually attained. It is based on a single
level of activity.’ For preparation of this budget, sales forecast will have to be
prepared along with the cost estimates. Cost estimates can be prepared by segregating
the costs according to their behaviour i.e. fixed and variable. Cost predictions should
be made element wise and the projected profit or loss can be worked out by deducting
the costs from the sales revenue. Actually in practice, fixed budgets are prepared very
rarely. The main reason is that the actual output differs from the budgeted output
significantly. Thus if the budget is prepared on the assumption of producing 50, 000
units and actually the number of units produced are 40, 000, the comparison of actual
 results with the budgeted ones will be unfair and misleading. The budget may reveal
the difference between the budgeted costs and actual costs but the reasons for the
deviations may not be pointed out. A fi xed budget may be prepared when the
budgeted output and actual output are quite close and not much deviation exists
between the two. In such cases, maximum control can be exercised between the
budgeted performance and actual performance.

_ Flexible Budgets: A flexible budget is a budget that is prepared for different levels of
capacity utilization. It can be called as a series of fixed budgets prepared for different
levels of activity. For example, a budget can be prepared for capacity utilization levels
of 50%, 60%, 70%, 80%, 90% and 100%. The basic principle of flexible budget is
that if a budget is prepared for showing the results at say, 15, 000 units and the actual
production is only 12, 000 units, the comparison between the expenditures, budgeted
and actual will not be fair as the budget was prepared for 15, 000 units. Therefore a
flexible budget is developed for a relevant range of production from 12, 000 units to
15, 000 units. Thus even if the actual production is 12, 000 units, the results will be
comparable with the budgeted performance of 12, 000 units. Even if the production
slips to 8, 000 units, the manager has a tool that can be used to determine budgeted
cost at 9, 000 units of output. The flexible budget thus, provides a reliable basis for
comparisons because it is automatically geared to changes in production activity.
Thus a flexible budget covers a range of activity, it is flexible i.e. easy to change with
variation in production levels and it facilitates performance measurement
and evaluation.
_ While preparing flexible budget, it is necessary to study the behavior of costs and
divide them in fixed, variable and semi variable. After doing this, the costs can be
estimated for a given level of activity.
_ It is also necessary to plan the range of activity. A firm may decide to develop
flexible budget for activity level starting from 50% to 100% with an interval of 10%
in between. It is necessary to estimate the costs and associate them with the chosen
level of activity.
_ Finally the profit or loss at different levels of activity will be computed by comparing
the costs with the revenues.

Classification of Budgets According to Time: According to this classifi cation,

budgets are divided in the following categories.
o Short Term Budget: Any budget that is prepared for a period up to one year is
known as Short Term Budget. Functional budgets are normally prepared for a period
of one year and then it is broken down month wise.
o Medium Term Budget: Budget prepared for a period 1-3 years is Medium Term
Budget. Budgets like Capital Expenditure, Manpower Planning are prepared for
medium term.
o Long Term Budgets: Any budget exceeding 3 years is known as Long Term
Budgets. Master Budget is normally prepared for long term. In the modern days due
to uncertainty, very few budgets are prepared for long term.
 ZERO BASE BUDGETING

_ Zero Base Budgeting: Zero Base Budgeting is method of budgeting whereby all
activities are revaluated each time budget is formulated and every item of expenditure
in the budget is fully justified. Thus the Zero Base Budgeting involves from scratch or
zero.
Zero based budgeting [also known as priority based budgeting] actually emerged in
the late 1960s as an attempt to overcome the limitations of incremental budgeting.
This approach requires that all activities are justified and prioritized before decisions
are taken relating to the amount of resources allocated to each activity. In incremental
budgeting or traditional budgeting, previous year’s figures are taken as base and based
on the same the budgeted fi gures for the next year are worked out. Thus the previous
year is taken as the base for preparation of the budget. However the main limitation of
this system of budgeting is that an activity is continued in the future only because it is
being continued in the past. Hence in Zero Based Budgeting, the beginning is made
from scratch and each activity and
function is reviewed thoroughly before sanctioning the same and all expenditures are
analyzed and sanctioned only if they are justified. Besides adopting a ‘Zero Based’
approach, the Zero Based Budgeting also focuses on programs or activities instead of
functional departments based on line items, which is a feature of traditional
budgeting. It is an extension of program budgeting. In program budgeting, programs
are identified and goals are developed for the organization for the particular program.
By inserting decision packages in the system and ranking the packages, the analysis is
strengthened and priorities are determined.

_ Applications of Zero Based Budgeting: The following stages/steps are involved in

the application of Zero Based Budgeting.

 Each separate activity of the organization is identifi ed and is called as a decision

package. Decision package is actually nothing but a document that identifi es and
describes an activity in such a manner that it can be evaluated by the management and
rank against other activities competing for limited resources and decide whether to
sanction the same or not.

 It should be ensured that each decision package is justifi ed in the sense it should be
ascertained whether the package is consistent with the goal of the organization or not.

 If the package is consistent with the overall objectives of the organization, the cost of
minimum efforts required to sustain the decision should be determined.

 Alternatives for each decision package are considered in order to select better and
cheaper options.
  Based on the cost and benefit analysis a particular decision package/s should be
selected and resources are allocated to the selected package.

_ Benefits from Zero Based Budgeting: ZBB was fi rst introduced by Peter A. Pyhrr, a
staff control manager at Texas Instruments Corporation, U.S.A. He developed this
technique and implemented it for the first time during the year 1969-70 in Texas in the
private sector and popularized its wider use. He wrote an article on ZBB in Harvard
Business Review and later wrote a book on the same. The ZBB concept was first applied
in the State of Georgia, U.S.A. when Mr. Jimmy Carter was the Governor of the State.
Later after becoming the President of U.S.A. Mr. Carter introduced and implemented the
ZBB in the country in the year 1987.
ZBB has a wide application not only in the Government Departments but also in the
private sector in a variety of business. In India, the ZBB was applied in the State of
Maharashtra in 80s and early 90s. Benefits from ZBB can be summarized in the following
manner.

1. ZBB facilitates review of various activities right from the scratch and a detailed cost
benefit study is conducted for each activity. Thus an activity is continued only if the
cost benefit study is favorable. This ensures that an activity will not be continued
merely because it was conducted in the previous year.

2.A detailed cost benefit analysis results in efficient allocation of resources and
consequently wastages and obsolescence is eliminated.
3. A lot of brainstorming is required for evaluating cost and benefits arising from an
activity and this results into generation of new ideas and also a sense of involvement of
the staff.
4. ZBB facilitates improvement in communication and co-ordination amongst the staff.
5. Awareness amongst the managers about the input costs is created which helps the
organization to become cost conscious.
6. An exhaustive documentation is necessary for the implementation of this system and it
automatically leads to record building.

_Limitations of Zero Based Budgeting: The following are the limitations of Zero Based
Budgeting.
1. It is a very detailed procedure and naturally if time consuming and lot of paper work is
involved in the same.
2. Cost involved in preparation and implementation of this system is very high.
3. Morale of staff may be very low as they might feel threatened if a particular activity is
discontinued.
4. Ranking of activities and decision-making may become subjective at times.
5. It may not advisable to apply this method when there are non- financial considerations,
such as ethical and social responsibility because this will dictate rejecting a budget claim on
low ranking projects.
_ Performance Budgeting: It is budgetary system where the input costs are related to the
performance i.e. the end results. This budgeting is used extensively in the Government and
Public Sector Undertakings. It is essentially a projection of the Government activities and
expenditure thereon for the budget period. This budgeting starts with the broad classification
of expenditure according to functions such as education, health, irrigation, social
welfare etc. Each of the functions is then classified into programs sub classified into activities
or projects. The main features of performance budgeting are as follows.

_ Classification into functions, programs or activities

_ Specification of objectives for each program
_ Establishing suitable methods for measurement of work as far as possible.

_ Fixation of work targets for each program. Objectives of each program are ascertained
clearly and then the resources are applied after specifying them clearly. The results expected
from such activities are also laid down. Annual, quarterly and monthly targets are determined
for the entire organization. These targets are broken down for each activity centre. The next
step is to set up various productivity or performance ratios and finally target for each program
activity is fixed. The targets are compared with the actual results achieved. Thus the
procedures for the performance budgets include allocation of resources, execution of the
budget and periodic reporting at regular intervals. The budgets are initially compiled by the
various agencies such as Government Department, public undertakings etc. Thereafter these
budgets move on to the authorities responsible for reviewing the performance budgets. Once
the higher authorities decide about the funds, the amount sanctioned is communicated and the
work is started. It is the duty of these agencies to start the work in time, to ensure the regular
fl ow of expenditure, against the physical targets, prevent over runs under spending and
furnish report to the higher authorities regarding the physical progress achieved. In the final
phase of performance budgetary process, progress reports are to be submitted periodically to
higher authorities to indicate broadly, the physical performance to be achieved, the
expenditure incurred and the variances together with explanations for the variances.

PROBLEM ON PRODUCTION BUDGET

Production (in units) = sales – opening stock + closing stock

Problem No.1: Prepare a production budget for each month and summarized production cost
budget for 6 months ending 31-12-2005 from the following data of product X.

i. Units to be sold for different months as follows:

July 2005 1,100

Aug 2005 1,100
Sept 2005 1,700
Oct 2005 1,900
Nov 2005 2,500
 Dec 2005 2,300
Jan 2006 2,000

ii. There will be no work in progress at the end of any month.

iii. Finished units equal to half of the sales for the next month will be in stock at the end
of each month including june 2005.
iv. Budgeted or standard production and production cost for the year ending 31-12-2005
are given as follows
Standard production ------ 22000units
Direct material Rs.10p.u
Direct labour Rs..4p.u
Total factory overheads apportioned to the products is rs.88000.

Solution : Production budget for 6 months from July to December 2005

Months
Particulars Total units
july aug sept oct Nov Dec
Estimated sales 1,100 1,100 1,700 1,900 2,500 2,300 10,600
Less: opening
stock( half of the
current month
sales) 550 550 850 950 1,250 1,150 5,300
550 550 850 950 1,250 1,150 5,300
Add: closing
stock (half of
next month
sales) 550 850 950 1,250 1,150 1,100 5,750
1,100 1,400 1,800 2,200 2,400 2,150 11,050

Production cost budget for 6 months ending 31-12-2005

Particulars unit rate Amount

Material cost (11,050x10) 1,10,500
Labour cost (11,050x4) 44,200
Factory O.H (11,050x4) 44,200
TOTAL COST OF PRODUCTION 1,98,900
 PROBLEM ON CASH BUDGET

Problem No. 2 A company is expecting to have rs.32,000 cash in hand on 1-4-2005 and it request you to
prepare cash budget for 3 months i.e; april to june 2005. The following information is supplied to you.

Months Sales Purchases Wages Expenses

Feb 70,000 44,000 6,000 5,000
Mar 80,000 56,000 9,000 6,000
April 96,000 60,000 9,000 7,000
May 1,00,000 68,000 11,000 9,000
June 1,20,000 62,000 14,000 9,000

Other information:

i. 2months credit is allowed by suppliers.

ii. 25% of sales if for cash and 1 month credit is allowed to customers.
iii. Delay in the payment of expenses & wages for one month.
iv. Income tax of re.28,000 paid in june 2005.

Solution: Cash budget for 3 months from April – june 2005

2005
Particulars
April May June
Balance b/d 32,000 57,000 1,87,000
Add: Cash Receipts
Cash sales (25%) 24,000 25,000 30,000
Cash received from debtors (75% of
previous month) 60,000 72,000 75,000
Total ash available 1,16,000 1,54,000 1,87,000
Less: Cash payments
cash paid to creditors 44,000 56,000 60,000
payment of wages 9,000 9,000 11,000
payment of expenses 6,000 7,000 9,000
income tax paid - - 28,000
Total payments 59,000 72,000 1,08,000
Closing balance of cash 57,000 82,000 79,000

PROBLEM ON FLEXIBLE BUDGET:

Problem No.3: The following information at 50% of capacity is given. Prepare a flexible
budget and farecast profit/loss at 60%, 70% and 90% capacities.

Expenses @ 50% capacity

Fixed expenses
Salaries 50,000
Rent & rates 40,000
Depreciation 60,000
 Admin expenses 70,000

Variable expenses
Direct material 2,00,000
Labour 2,50,000
Other expenses 40,000

Semi-variable expenses
Repairs 1,00,000
Indirect labour 1,50,000
Other expenses 90,000
Other information:

i. It is estimated that fixed expenses will remain constant at all capacities.

ii. Semi-variable expenses will not change between 45% & 60% , capacity will raise
by 10% between 60% & 75% and further increase of 5% when capacity crosses
75%
iii. Estimated sales of various capacities are given as follows:
At 60% capacity sales will be 11,00,000
At 70% capacity sales will be 13,00,000
At 90% capacity sales will be 15,00,000.

Solution: FLEXIBLE BUDGET

levels of capacity
Particulars
50% 60% 70% 90%
Fixed expenses
salaries 50,000 50,000 50,000 50,000
rent &rates 40,000 40,000 40,000 40,000
depreciation 60,000 60,000 60,000 60,000
admin expenses 70,000 70,000 70,000 70,000
Variable expenses
direct material 2,00,000 2,40,000 2,80,000 3,60,000
labour 2,50,000 3,00,000 3,50,000 4,50,000
other expenses 40,000 48,000 56,000 72,000
Semi-variable expenses
repairs 1,00,000 1,00,000 1,10,000 1,15,000
indirect labour 1,50,000 1,50,000 1,65,000 1,72,500
other expenses 90,000 90,000 99,000 1,03,500
TOTAL COST - 11,48,000 12,80,000 1,49,300
profit/loss - -48,000 20,000 7,000
SALES - 11,00,000 13,00,000 15,00,000
U
 NIT-V
STANDARD COSTING

Definitions of Standard Costing:

1. According to Backer and Jocobsen, “Standard cost is the amount of firm thinks a
product or operation of a process for a period of time should cost, based upon certain
assumed conditions of efficiency, economic conditions and other factors”.
2. According to Brown and Howard, standard costing may be defined as “a technique of
cost accounting which compares the standard cost of each product or service with
actual cost to determine the efficiency of the operation so that any remedial action
may be taken immediately.”
3. According to The Terminology of Cost Accountancy defines Standard costing as “the
preparation and use of standard costs, their comparison with actual costs, and the
analysis of variance to their causes and points of incidence”.
4. According to London Institute of Cost and Works Accounts, standard costing as “an
estimate cost, prepared in advance of production or supply correlating a technical
specification of material and labour to the price and wage rates estimated for a
selected period of time within a prescribed set of working conditions”.

Significance of Standard Costing:

1. Measuring Efficiency:
Standard costing is a yardstick for measuring efficiency. The comparison of
actual cost with standard costs enables the management to evaluate performance of
various cost centres. In the absence of standard costing system actual costs of
different periods may be compared to measure efficiency. It is not proper to compare
costs of different periods because circumstances of both the periods may be different.
Moreover, a decision about base period with which the comparison is to be made is
also difficult to be made. Standard costing gives targets with which actual
performance can be compared.
2. Formulation of Production and Price Policy:
Standard costing is helpful in formulating production policies. The standards
are set by studying all existing conditions. It becomes easy to formulate production
plans by taking into account standard costs. It is also helpful for finding prices of
various products. In case tenders are to be submitted or prices are to be quoted in
advance then standard costing produces necessary data for price fixation.
3. Determination of Variance:
By comparing actual costs with standard costs variances are determined.
Management is able to spot out the place of inefficiencies. It can fix responsibility for
deviation in performance. It is possible to corrective actions/ measures earliest. A
regular check on various expenditures is also ensured by standard costing system.
4. Reduction of work:
In historical costing, records are maintained for determining costs. Standard
costing reduces clerical work to a considerable extent and management is supplied
with useful information. In this system only necessary information will be recorded
and superfluous data are avoided. The report presentation is simplified and only
required information is presented in such a form that management is able to interpret
the information easily and useful.
5. Management by Exception:
With the use of standard costing, the targets of different individuals are fixed.
If the performance is according to predetermined standards then there is nothing to
worry. The attention of management is drawn only when actual performance is less
than the budgeted performance. Management by exception means that everybody is
given a target to be achieved and management need not supervise each and
everything. The responsibilities are fixed and everybody tries to achieve his targets. If
the things are not going as per targets then management need not bother. Management
devotes its time to other important things. So management by exception is possible
only when targets of work can be fixed. Standard costing enables the determination of
targets.
6. Facilitates Cost Control:
Every costing system aims at cost control and cost reduction. Standard costing
helps in achieving these aims. The standards are being constantly analysed and an
effort is made to improve efficiency. Whenever a variance occurs the reasons are
studied and immediate corrective measures are undertaken. The action taken in
spotting weak points enables cost control system.
7. Eliminating Inefficiencies:
The setting of standard for different elements of cost requires a detailed study
of different aspects. The standards are differently set for manufacturing,
administrative and selling expenditure. Improved methods are used for setting these
standards. The determination of manufacturing expenses will require time and motion
study for labour and effective control devices for materials etc. Similar studies will be
needed for finding other expenses. All these studies will make it possible to eliminate
inefficiencies at different steps. The whole effort will give an improved costing
system and will enable better service to the consumer.
8. Helpful in Taking important Decisions:
Standard costing provides useful information to the management in taking
important decisions. The problem created by inflation, rising prices etc. can be
effectively tackled with the help of standard costing. It can also be used to provide
incentive plans for employees, etc
Limitations of Standard Costing:

1. Standard costing cannot be used in those concerns where non-standard products are
produced. If the production is undertaken according to customer’s specifications then
each job will involve different amount of expenditure. Under such circumstances it is
not possible to set up standards for every job. Standard costing can be used only in
those concerns where standard products are manufactured.
2. The process of setting up standards is a different task as it requires technical skill. The
time and motion study is required to be undertaken for this purpose. These studies
require a lot of time and money.
3. There are no inset circumstances to be considered for fixing standards. The conditions
under which standards are fixed do not remain static. With the change circumstances
the standards are also to be revised. The revision of standards is a costly affair. In
case the standards are not revised the same become impracticable.
4. This system is expensive and small concerns may not afford to bear the cost. For
small concerns the utility from this system may be less than the cost involved in it.
5. The fixing of responsibility is not an easy task. The variances are to be classified into
controllable and uncontrollable variances. The responsibility can be fixed only for
controllable variances. The determination of controllable and uncontrollable variances
will be a problem. The variances may be controllable at one point of time and may
become uncontrollable at another point of time. The problem is faced whenever a
responsibility is to be fixed.
6. The industries liable for frequent technological changes will not be suitable for
standard costing system. The change in production process will require a revision of
standard. A frequent revision of standard will be costly. So this system will not be
useful for industries where methods and techniques for production are fast changing.

3Q. Distinguish between Standard Costing and Budgetary

Control.
Differences between Standard Costing and Budgetary Control.
Point of Standard Costing Budgetary Control
Difference
1. Concept In standard costing, unit In budgetary control the
concept is used. The standard budgets are prepared for the
cost is fixed for one product concern as a whole. In
and different standards are budgetary control total
used for different products. concept is used. The whole
concern is taken as one unit
for budgets. The actual
figures for the whole
concern are compared with
predetermined budgeted
figures. In case of
 Government, the budgets
are fixed for the whole
country or state.
Standard costs are fixed on the The budgets are fixed on
2. Basis basis of technical information. the basis of past records
Standard costs are planned and future expectations.
costs and these are expected in
future.
3. Scope Standards are set up for The scope of budgetary
expenditures only and control is much wider than
therefore, for manufacturing the scope of Standard
departments standards are set costing. Budgets are
for different elements of cost prepared for incomes,
i.e, material, labour and expenditure and other
overheads. activities. Budgets are
prepared for different
functional departments
such as purchase, sale,
production, finance and
personal department. One
budget is known as Master
budget.
4. Emphasis In standard costing the In budgetary control, the
standards are set and an targets of expenditure are
attempt is made to achieve set and these targets cannot
these standards. The emphasis be exceeded. In this system
is on achieving the standards. the emphasis is on keeping
Actual costs may be more than the expenditures within the
standard costs and there can be budgeted figures.
no such thing in budgetary
control.
5. Objective Budgets are set on the basis of The standards are related to
present level of efficiency what management wants to
while standard costs are based achieve.
on the standards set by the
management.
6. Relationship Standard costing is related to Budgetary control is related
cost accounts. to financial accounts.
7. Use Standard costing control be Budgets are used for
used for forecasting purposes forecasting purposes. The
only. forecasts about income,
expenses and costs are
based on historical figures
and expected changes in
future.
8. Variance In standard costing variances Budgetary control deals
are calculated for different with total variances only.
Analysis elements of cost i.e., material, The variance may be
labour and overheads. In calculated for different
standard costing variances are departments or for the
 studied according to their concern as a whole.
causes. An independent study
is possible for determining
causes of variances and it will
be very helpful for cost control
purpose.
9. Elements Standard costing cannot be The budgetary control
used partially; it will have to system can be applied
be used wholly. The standards partly or wholly. Budgets
will have to be set for all may be prepared for some
elements of cost. departments and may not
be prepared for all
departments. If a concern is
interested in preparing
production budget only. It
is free to do so.

Standard Cost is defined as, ‘a pre-determined cost which is calculated from

management’s standard of efficient operation and the relevant necessary expenditure. It may
be used as a basis for price fixation and for cost control through variance analysis.’ [CIMA –
UK] Standard Costing is defi ned as, ‘preparation and use of standard costs, their comparison
with actual costs and analysis of variances into their causes and points of incidences.’ [CIMA
– UK] From the defi nitions given above, the following features of standard cost and standard
costing emerge. Meaning of both the terms will be clearer by going through carefully
these features.

Features of Standard Cost and Standard Costing

The following are the features of standard cost:

 Standard cost is a pre planned or pre-determined cost. This means that the standard
cost is determined even before the commencement of production. For example, if a
firm is planning to launch a product in the year 2009, the standard cost of the same
will be determined in the year 2008.
 Standard cost is not an estimated cost. There is a difference between saying what
would be the cost and what should be the cost. Standard cost is a planned cost and it is
a cost that should be the actual cost of production.
 It is calculated after taking into consideration the management’s standard of efficient
operation. Thus standard cost fixed on the assumption of 80% efficiency will be
different from what it will be if the assumption is of 90% efficiency.
 Standard cost can be used as a basis for price fixation as well as for exercising control
over the cost.
Standard Costing is a technique of costing rather than a method and has
the following features:

 Standard costing involves setting of standards for various elements of cost. Thus
standards are set for material costs, labour costs and overhead costs. Setting of
standard is the heart of standard costing and so this work is done very carefully.
Setting of wrong standards will defeat the very purpose of standard costing. Standards
are not only set for costs, but also for sales and profits. The objective behind setting of
standards is to have a basis for comparison between the standard performance and the
actual performance.
 Another feature of standard costing is to continuously record the actual performance
against the standards so that comparison between the two can be done easily.
 Standard costing ensures that there is a constant comparison between the standards
and actual and the difference between the two is worked out. The difference is known
as variance’ and it is to be analysed further to find out the reasons behind the same.
 After the ascertaining of the variances, analyzing them to find out the reasons for the
variances and taking corrective action in order to ensure that the variances are not
repeated, are the two important actions of management. Thus standard costing helps
immensely in evaluation of performance of the organization.
 Estimated costs should not be confused with standard costs. Though both of them are
future costs, there is a fundamental difference between the two. Estimated cost is
more or less a reasonable assessment of what the cost will be in future while on the
other hand, standard cost is a pre planned cost in the sense it denotes what the cost
ought to be. Estimated costs are developed on the basis of projections based on past
performance as well as expected future trends. Standard costs are pre determined in a
scientific manner through technical analysis regarding the material consumption and
time and motion study for determining labour requirements. Estimated costs may not
help management in decision making as they are not scientifically pre determined
costs but standard costs are decided after a comprehensive study and analysis of all
relevant factors and hence provide reliable measures for product costing, product
pricing, planning, co-ordination and cost control as well as reduction purposes. Under
estimated costing, the cost is estimated in advance and is based on the assumption
that costs are more or less free to move and that what is made is the best estimate of
the cost. Under standard costing, a cost is established which is based on the
assumption that cost will not be allowed to move freely but will be controlled as far as
possible so that the actual cost will be close to the standard cost as far as possible and
any variation between the standard and actual cost will be capable of reasonable
explanation.
 VARIANCE ANALYSIS

Computation of Variances

After setting the standards and standard costs for various elements of cost, the next important
step is to compute variances for each element of cost. Variance is the difference between the
standard cost and the actual cost. In other words it is the difference between what the cost
should have been and what is the actual cost. Element wise computation of variances is given
in the following paragraphs.

A] Material Variances: In the material variances, the main objective is to fi nd out the
difference between the standard cost of material used for actual production and actual cost of
material used. Thus the main variance in this category is the cost variance, which is thereafter
broken down into other variances. These variances are given below.

1) Material Cost Variance:

As mentioned above, this variance shows the difference between the standard cost of
material consumed for actual production and the actual cost. The following formula is
used for computation of this variance.
Material Cost Variance:
Standard Cost of Material Consumed for Actual Production – Actual Cost
If the actual cost of material consumed is less than the standard cost of material
consumed, the variance is ‘favourable’, otherwise it is adverse.
2) Material Price Variance:
One of the reasons for difference between the standard materialcost and actual
material cost is the difference between the standard price and actual price.Material
Price Variance measures the difference between the standard price and actual price
with reference to the actual quantity consumed. The computation is as shown below:
Material Price Variance: Actual Quantity [Standard Price – Actual Price]
3) Material Quantity [Usage] Variance:
This variance measures the difference between the standard quantity of material
consumed for actual production and the actual quantity consumed and the same is
multiplied by standard price. The computation is as shown below.
Material Quantity [Usage] Variance:
Standard Price [Standard Quantity – Actual Quantity]
The total of Price Variance and Quantity Variance is equal to Cost Variance
Material Cost Variance = Material Price Variance + Material Quantity Variance.

Problem No.1. Calculate Material Variances from the following details.

Standard quantity of materials for producing 1 unit of finished product ‘P’ is 5 kg.
The standard price is Rs.6 per kg. During a particular period, 500 units of ‘P’ were
produced.Actual material consumed was 2700 kg at a cost of Rs.16, 200.
Solution:
 I] Material Cost Variance = Standard Cost of Materials – Actual Cost
500 units _ 5 kg _ Rs.6 – Rs.16, 200
Rs.15, 000 – Rs.16, 200 = Rs.1, 200 [A]
II] Material Price Variance = Actual Quantity [Standard Price – Actual Price]
2, 700 [Rs.6 – Rs.6] = Nil
III] Material Quantity Variance = Standard Price [Std. Qty – Actual Qty]
Rs.6 [2500 – 2700] = Rs.1, 200 [A]
Reconciliation
Material Cost Variance = Material Price Variance + Material Quantity Variance.
Rs.1200 [A] = Rs. Nil + Rs.1, 200 [A]

4) Material Mix Variance:

In case of several products, two or more types of raw materials are mixed to produce
the fi nal product. In such cases, standard proportion of mixture is decided in advance.
For example, in manufacturing one unit of product ‘P’, material A and B may have to
be mixed in a standard proportion of 3:2. This is called as a standard mix. However,
when the actual production begins, the actual proportion of mix may have to be
changed due to several reasons like non-availability of a particular material etc. In
such cases material mix variance arises. The mix variance is computed in the
following manner.
• Material Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual
Mix

5) Material Yield Variance:

In any manufacturing process, some unavoidable loss always takes place. Thus if the
input is 100, output may be 95, 5 units being normal or unavoidable loss. The normal
loss is always anticipated and taken into consideration while determining the standard
quantity. Yield variance arises when the actual loss is more or less than the normal
loss. The computation of yield variance is as given below.
• Material Yield Variance = SYR [Actual Yield – Standard Yield]
SYR = Standard Yield Rate, i.e. standard cost per unit of standard output.
Reconciliation: Quantity Variance = Mix Variance + Yield Variance.

B] Labour Variances: Like the material variances, labour variances arise due to the
difference between the standard labour cost for actual production and the actual labour cost.
The following variances are computed in case of direct labour.
1) Labour Cost Variance:
This variance is the main variance in case of labour and arises due to the difference
between the standard labour cost for actual production and the actual labour cost. The
following formula is used for computation of this variance.
Labour Cost Variance = Standard Labour Cost for Actual Production – Actual Labour
Cost
This variance will be favourable is the actual labour cost is less than the standard labour
cost and adverse if the actual labour cost is more than the standard labour cost.
2) Labour Rate Variance:
One of the reasons for labour cost variance is the difference between the standard rate of
wages and actual wages rate. The labour rate variance indicates the difference between the
standard labour rate and the actual labour rate paid. The formula for computation is as
under.
Labour Rate Variance: Actual Hours Paid [Standard Rate – Actual Rate]
This variance will be favourable if the actual rate paid is less than the standard rate. The
labour rate variance is that portion of direct labour cost variance, which is due to the
difference between the labour rates.
3) Labour Efficiency Variance:
It is of paramount importance that efficiency of labour is measured. For doing this, the
actual time taken by the workers should be compared with the standard time allowed for
the job. The standard time allowed for a particular job is decided with the help of time
and motion study. The efficiency variance is computed with the help of the following
formula.
Labour Effi ciency Variance = Standard Rate [Standard Hours for Actual Output – Actual
Hours worked]
This variance will be favourable is the actual time taken is less than the standard time.
4) Labour Mix Variance or Gang Composition Variance:
This variance is similar to the material mix variance and is computed in the same manner.
In doing a particular job, there may be a particular combination of labour force, which may
consist of skilled, semi skilled and unskilled workers. However due to some practical diffi
culties, this composition may have to be changed. How much is the loss caused due to this
change or how much is the gain due to this change is indicated by this variance. The
computation is done with the help of the following formula.
Labour Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix.
5) Labour Yield Variance:
This variance indicates the difference between the actual output and the standard output
based on actual hours. In other words, a comparison is made between the actual
production achieved and the production that should have been achieved in actual number
of working hours. The variance will be favourable is the actual output achieved is more
than the standard output. The computation is done in the following manner.
Labour Yield Variance = Average Standard Wage Rate Per Unit [Actual Output –
Standard
Output]
6) Idle Time Variance:
This variance indicates the loss caused due to abnormal idle time. While fixing the
standard time, normal idle time is taken into consideration. However if the actual idle time
is more than the standard/normal idle time, it is called as abnormal idle time. This variance
will be always adverse and will be computed as shown below.
Idle Time Variance = Abnormal Idle Time X Standard Rate.
C] Overhead Variances: The overhead variances show the difference between the standard
overhead cost and the actual overhead cost. In case of direct material and direct labour
variances, there is no question of dividing them into fixed and variable as the direct material
and direct labour costs are variable. However, in case of overheads, it is necessary to divide
them into fixed and variable for computation of variances. We will take up the fixed overhead
variances first and then the variable overhead variances. The fixed overhead variances are
discussed in the following paragraphs.
I] Fixed Overhead Variances: The following variances are computed in case of fixed
overheads.
A. Fixed Overhead Cost Variance: This variance indicates the difference between the
standard fixed overheads for actual production and the actual fixed overheads incurred.
Actually this variance indicates the under/over absorbed fixed overheads. If the actual
overheads incurred are more than the standard fixed overheads, it indicates the under
absorption of fixed overheads and the variance is favourable. On the other hand, if the actual
overheads incurred are more than the standard fixed overheads, it indicates the over
absorption of fixed overheads and the variance is adverse. The following formula is used for
computation of this variance.
Fixed Overhead Cost Variance: Standard Fixed Overheads for Actual Production – Actual
Fixed Overheads.
B. Fixed Overhead Expenditure/Budget Variance: This variance indicates the difference
between the budgeted fixed overheads and the actual fixed overhead expenses. If the actual
fixed overheads are more than the budgeted fixed overheads, it is an adverse variance as it
means overspending as compared to the budgeted amount. On the other hand, if the actual
fixed overheads are less than the budgeted fixed overheads, it is a favourable variance. This
variance is computed with the help of the following formula.
Fixed Overhead Expenditure Variance: Budgeted Fixed Overheads – Actual Fixed
Overheads
C] Fixed Overheads Volume Variance: This variance indicates the under/over absorption of
fixed overheads due to the difference in the budgeted quantity of production and actual
quantity of production. If the actual quantity produced is more than the budgeted one, this
variance will be favourable but it will indicate over absorption of fi xed overheads. On the
other hand, if the actual quantity produced is less than the budgeted one, it indicates adverse
variance and there will be under absorption of overheads. The formula for computation of
this variance is as shown below:
Fixed Overhead Volume Variance: Standard Rate [Budgeted Quantity – Actual Quantity]
Reconciliation I = Fixed Overhead Cost Variance = Expenditure Variance + Volume
Variance
D] Fixed Overhead Efficiency Variance: It is that portion of volume variance which arises
due to the difference between the output actually achieved and the output which should have
been achieved in the actual hours worked. This variance will be favourable it the actual
production is more than the standard production in actual hours. The formula for computation
of this variance is as follows:
Fixed Overhead Efficiency Variance: Standard Rate [Standard Production – Actual
Production]
E] Fixed Overhead Capacity Variance: This variance is also that portion of volume variance,
which arises due to the difference between the capacity utilization, i.e. the capacity actually
utilized and the budgeted capacity. If the capacity utilization is more than the budgeted
capacity, the variance is favourable, otherwise it will be adverse. The formula is as follows:
Fixed Overheads Capacity Variance: Standard Rate [Standard Quantity – Budgeted
Quantity]
Reconciliation II = Volume Variance = Efficiency Variance + Capacity Variance
F] Fixed Overhead Revised Capacity Variance: This variance indicates the difference in
capacity utilization due to working for more or less number of days than the budgeted one.
The computation of this variance is done by using the following formula.
Fixed Overhead Revised Capacity Variance = Standard Rate [Standard Quantity – Revised
Budgeted Quantity]
G] Fixed Overheads Calendar Variance: This variance indicates the difference between the
budgeted quantity of production and actual quantity of production achieved arising due to the
difference in the number of days worked and budgeted. The formula for computation of this
variance is as follows.
Fixed Overheads Calendar Variance = Standard Rate [Budgeted Quantity – Revised
Budgeted
Quantity]
II] Variable Overhead Variances: The following variances are computed in case of variable
overheads.
A] Variable Overhead Cost Variance: This variance indicates the difference between the
standard variable overheads for actual overheads and the actual overheads. The difference
between the two arises due to the variation between the budgeted and actual quantity. The
formula for the computation of this variance is as follows:
Variable Overhead Cost Variance = Standard Variable Overheads for Actual Production
– Actual Variable Overheads.
B] Variable Overheads Expenditure Variance: This variance indicates the difference
between
the standard variable overheads to be charged to the standard production and the actual
variable overheads. If the actual overheads are less than the standard variable overheads,
the variance is favourable, otherwise it is adverse. The formula for the computation is as
follows:
Variable Overhead Expenditure Variance = Standard Variable Overheads for Standard
Production – Actual Variable Overheads.
C] Variable Overheads Efficiency Variance: It indicates the efficiency by comparing
between the output actually achieved and the output that should have been achieved in the
actual hours
worked. [Standard Production] This variance will be favourable if the actual output achieved
is more than the standard output. The formula for computation is given below:
Variable Overheads Efficiency Variance: Standard Rate [Standard Quantity – Actual
Quantity]
Important note: All the formulae mentioned above are with reference to the quantity.
All overhead variances can also be computed with relation to number of hours. In one
of thIs illustrations, this is demonstrated.

PROBLEM ON OVERHEDS

From the following information extracted from the books of a manufacturing company,
calculate Fixed and Variable Overhead Variances.
Particulars Budgeted Actual
Production – Units 22, 000 24, 000
Fixed Overheads Rs.44, 000 Rs.49, 000
Variable Overheads Rs.33, 000 Rs.39, 000
Number of Days 25 26
Number of man hours 25, 000 27, 000

Solution:
A] Fixed Overhead Variances:

I] Fixed Overhead Cost Variance: Standard Fixed Overheads for Actual Production – Actual
Fixed Overheads = Rs.48, 000 – Rs.49, 000 = Rs.1, 000 [A]
Note: Standard fi xed overheads for actual production = Actual Production 24, 000 X
standard rate Rs.2 [Rs.44, 000 budgeted fi xed overheads / 22, 000 budgeted production =
Rs.2]

II] Fixed Overhead Expenditure Variance: Budgeted Fixed Overheads – Actual Fixed
Overheads = Rs.44, 000 – Rs.49, 000 = Rs.5, 000 [A]

III] Fixed Overhead Volume Variance: Standard Rate [Budgeted Quantity – Actual
Quantity] =
Rs.2 [22, 000 – 24, 000] = Rs.4, 000 [F]
The variance is favourable as the actual quantity produced is more than the budgeted
quantity.
Reconciliation I = Cost Variance = Expenditure Variance + Volume Variance
Rs.1, 000 [A] = Rs.5, 000 [A] + Rs.4, 000 [F]

IV] Fixed Overhead Efficiency Variance: Standard Rate [Standard Quantity – Actual
Quantity] = Rs.2 [23, 760 – 24, 000] = Rs.480 [F]
Note: Standard quantity of production is in reference to actual number of hours. If 22, 000
units are produced in 25, 000 hrs [standard hours], in actual 27, 000 hours, 23, 760 units
should have been produced. When number of days and number of hours, both are given, the
standard quantity is always to be computed in relation to the actual hours. However, if only
number of days is given, the standard quantity will have to be computed in relation to number
of days.
V] Fixed Overhead Capacity Variance: Standard Rate [Standard Quantity – Budgeted
Quantity] = Rs.2 [23, 760 – 22, 000] = Rs.3, 520 [F]
Reconciliation II = Volume Variance = Efficiency Variance + Capacity Variance
Ra.4, 000 [F] = Rs.480 [F] + 3, 520 [F]
VI] Fixed Overhead Revised Capacity Variance = Standard Rate [Standard Quantity –
Revised Budgeted Quantity] = Rs.2 [23, 760 – 22, 880] = Rs.2 X 880 = Rs.1760 [F]
Note: Standard quantity is computed as shown in the Efficiency Variance. Revised Budget
Quantity is computed as: in 25 days, the production is 22, 000 so in 26 days the revised
quantity is 22, 880 units.

VII] Fixed Overhead Calendar Variance: Standard Rate [Revised Budgeted Quantity –
Budgeted Quantity] = Rs.2 [22, 880 – 22, 000] = Rs.2 X 880 = Rs.1, 760 [F]
Reconciliation III = Capacity Variance = Revised Capacity Variance + Calendar Variance =
Rs.3, 520 [F] = Rs.1760 [F] + Rs.1760 [F]

I] Cost Variance: Standard Variable Overheads for Actual Production – Actual Variable
Overheads:
Rs.36, 000 – Rs.39, 000 = Rs.3, 000 [A]
Note: Standard Variable Overheads for Actual Production = Standard Rate Per Unit X Actual
Production Units = Rs.1.5 [Budgeted variable overheads Rs.33, 000 /Budgeted production
units
22, 000 = Rs.1.5] X 24, 000 units = Rs.36, 000

II] Expenditure Variance: Standard Variable Overheads for Standard Production – Actual
Variable Overheads: Rs.1.5 X 23, 760 – Rs.39, 000 = Rs.3360 [A]

III] Efficiency Variance: Standard Rate [Standard Quantity – Actual Quantity]

Rs.1.5 [23, 760 – 24, 000] = Rs.360 [F]

STEPS INVOLVED IN STANDARD COSTING

The technique of standard costing involves the determination of cost beforehand. The cost is
based on technical information after considering the impact of current conditions. Cost
ascertainment is not based on a guess work. The impact of possible factors on cost is studied
before setting the standards. The standards are set as per existing conditions of work. The
standard costs subdivided into standards for materials, labour and overheads. The subdivision
of standards will be useful for cost control. The actual costy is recorded, when it incurred.
The standard cost is compared with the actual cost. The difference between these two costs is
known as variance. The variances are calculated element-wise. The management can take
corrective measures to set the things right.

From the above discussions it is clear that the standard costing involves the following steps:

1. The determination of standard cost.

2. The recording of actual cost.
 3. The comparison between standard cost and actual cost.
4. The finding out of variance.
5. The reporting of variance so as to find out inefficiency and take necessary corrective
actions/ measures.

STANDARD COSTING Vs ESTIMATED COSTS

Both the standard costing and estimated costs are used to determine price in advance.
The purpose of both systems is to control cost. The same accounting principles are used in
standard cost and estimated cost. The points of difference between standard cost and
estimated cost are discussed as under:

1. Estimated costs are based on historical accounting. It is an estimate of what the

cost will be. It is a cost of guess work or reasonable estimate for the costs in
future. On the other hand standard costs are based on scientific analysis and
engineering studies. Standard costing determines what the cost should be.

2. Standard costs are used as a device for measuring efficiency. The standards are
determined and a comparison of standard with actual costs enables to determine
the efficiency of the concern. Estimated costs cannot be used to determine
efficiency. It only determines the expected costs. An effort is made that estimated
cost should almost be near to actual costs.
3. The purpose of determining estimated costs is to find out selling price in advance
to take a decision whether to produce or to make and also to prepare financial
budgets. Estimated costs do not serve the purpose of cost control. On the other
hand standard costs are helpful in cost control. The analysis of variance enables to
take corrective measures, if necessary.
4. Standard costs are not easily changed. The standards are set in such a way that
small changes in conditions do not require a change in standards. Estimated costs
are revised with the changes in conditions. They are made realistic by
incorporating changes in prices. Standard costs are more realistic than estimated
costs.

5. Estimated costs are used by the concern using historical costing. Standard costing
is used by those concerns which use standard costing system. Standard costing is
aprt of cost accounting process while estimated costs are statistical in nature and
as such may not become a part of accounting.

PROBLEMS ON MATERIAL VARIANCE

1. From the following data calculate various material variances

Materials Std.Qty(units) Std.Price(Rs.) Actual Actual

Qty(units) Price(Rs.)
A 80 8.00 90 7.50
B 70 3.00 80 4.00
 150 170
SOLUTION:

1. Material Cost Variance = (Std.Qty X Std.Price)-(Actual Qty. X Actual Price)

A = (80 X 8)- (90X7.50) = 640-675 = -Rs.35
B = (70 X 3) – (80 X 4) = 210-320 = -Rs.110
Total MCV = Rs.145
2. Material Price Variance = A.Q ( Std.Price-Actual Price)
A = 90 ( 8-7.50) = 90 X 0.50 = Rs.45
B = 80 ( 3-4) = 80 X1 = - Rs.80
Total M.P.V= - Rs. 35
3. Material Usage Variance = Std. Price (Std.Qty –Actual Qty)
A = 8 ( 80-90) = 8 X -10 = - Rs.80
B = 3 ( 70-80 ) = 3 X -10 = -Rs. 30

Total MUV= -Rs.110

4. Material Mix Variance =

Total weight of Actual Mix X Std.Cost of Std.Mix – Std. cost of Actual Mix

Total Weight of Std. Mix

170/150 X 80X8+70X3 _ (90X8 + 80X3)

= 963.3 – 960 = Rs.3.3 Favourable

PROBLEM ON LABOUR VARIANCE

2. From the following data you are required to compute various Labour variances.
Budgeted Labour composition for producing 100 articles
20 Men @ Rs.1.25 per hour for 24 hours.
30 Women @Rs.1.10 per hour for 30 hours.
Actual Labour composition for producing 100 articles
25 Men @ Rs.1.50 per hour for 24 hours.
25 Women @Rs.1.20 per hour for 25 hours.
Compute ( i) Labour Cost Variance ( ii) Labour Rate Variance (iii) Labour Efficiency
variance (iv) Labour Mix Variance.

1. Labour Cost Variance = Std. Labour Cost- Actual Labour Cost

Men = (20 x25x 1.25)- (25x24x1.50) = 625-900 = -Rs.275
Women =(30 x30x 1.10) – (25 x25x 1.20) = 990-750 = Rs.240
Total LCV = -Rs.35

2. Labour Rate Variance = Actual Time ( Std. Rate-Actual Rate)

 Men = 600 ( 1.25-1.50) = 600 X -0.25 = -Rs.150.00
Women = 625 ( 1.10-1.20) = 625X-0.10 = - Rs.62.50
Total L.R.V= - Rs.212.50
3. Labour Efficiency Variance = Std. Rate ( Std. Time –Actual Time)
Men = 1.25( 500-600) = 1.25 X -100 = - Rs.125
Women = 1.10 ( 900-625 ) = 1.10 X 275 = Rs. 302.50

Total L.E.V = Rs.177.50

4. Labour Mix Variance =

Total Time of Actual Lab. Mix X Std.Cost of Rev.Std.Mix – Std. cost of Actual Lab. Mix

Total Time of Std. Lab. Mix

1,225/1400 X 20x25x1.25+30x30X1.10 - (25x24x1.25 + 25x25X1.10)

= 1,225 / 1400 x (625+990) - 750+687.50

= 1,225 / 1400 x1615 -1,437.50 = 1,413.12 – 1,437.50 = Rs.24.38 unfavourable.

PROBLEM ON SALES VARIANCE

12. From the following particulars calculate all sales variances according to ( A) Profit
Method (B) Value Method

Product Standard Actual

Qty Cost per Price per Qty Cost per Price per
(Units) unit(Rs.) unit (Units) unit(Rs.) unit
X 3,000 10.00 12.00 3,200 10.50 13.00
Y 2,000 15.00 18.00 3,200 10.50 17.00

SOLUTION:

A) UNDER PROFIT METHOD:

1. Total Sales Margin Variance = Actual profit – standard profit
= 12,800 – 12,000 = Rs.800
2. Sales Margin Variance due to Selling price =
Actual Qty. of sales ( Actual Sale price per unit- budget sales price per unit)
X = 3,200 X (13-12) = 3,200 X1 = Rs.3,200
 Y= 1,600 X (17-18) = 1,600 X -1 =-Rs.1,600

TOTAL SMV = Rs.1,600

3. Sales Margin Variance due to Volume =

Std. profit per unit ( Actual Qty. of Sales- Budgeted Qty. of sales)
X = 2 (3,200-3,000) = 2 X 200= Rs.400
Y= 3 (1,600-2,000) = 3 X -400 =-Rs.1,200

TOTAL SMV = - Rs.800

4. Sales Margin Variance due to sales mix =

Std. profit per unit (Actual Qty. of Sales- Budgeted proportion for Actual sales)
X = 2 (3,200-2,880) = 2 X 320= Rs.640
Y= 3 (1,600-1,920) = 3 X -320 =-Rs.960

TOTAL SMV = - Rs.320

5. Sales Margin Variance due to Sales Qty.=

Std. profit per unit ( Std. proportion for Actual sales - Budgeted Qty. of sales)
X = 2 (2,880-3,000) = 2 X -120= -Rs.240
Y= 3 (1,920-2,000) = 3 X -80 = -Rs.240

TOTAL SMV = - Rs.480

UNDER VALUE METHOD:

1. Sales Value Variance = Actual value of sales – Budgeted value of sales

= 68,800 – 72,000 = -Rs.3,200
2. Sales price variance = Actual Qty of sales (Actual price –Budgeted price)
X = 3,200 (13-12) = 3,200 X 1 = Rs.3,200
Y = 1,600 (17-18 ) = 1,600 x -1 = -Rs.1,600
Total = Rs.1,600
3. Sales Volume Variance = Std.Price ( Actual Qty of sales – Budgeted Qty. of sales
X = 12 ( 3,200 -3,000) = 12 x 200 = Rs.2,400
Y = 18 ( 1,600 – 2,000) = 18 x -400 = -Rs.7,200
Total = - Rs.4,800
4. Sales Mix Variance = Std. Value of Actual Mix – Std value of Revised Std. Mix
= 67,200 – 69,120 = -Rs.1,920
5. Sales Qty. Variance = Std. Selling Price – (Rev. sales Qty- Budgeted Qty. of sales)
X = 12 ( 2,880 – 3,000) = -Rs. 1,440
Y = 18 ( 1,920 – 2,000) = - Rs.1,440
Total = -Rs.2,880