ACCOUNTING FOR MANAGERS

Course Code: MBA104

COURSE OBJECTIVE: -
The objectives of the subject is to give exposure to the students, about accounting
principles, techniques and their application in the business decision making process.
Syllabus:

UNIT- I Basics of Accounting, Meaning, Process of Accounting, System of Accounting. Basic

Accounting Principles, Classification of Accounts, Personal Account, Real Account, Nominal
Accounts. Accounting Process, Transactions in between the Real A/c, Journal Entries in
between the Accounts of two different Categories, Accounting Equation. Basics of Cost
Accounting, Meaning of Cost Accounting, Cost Classification, Costing Concepts. Cost Sheet,
Direct Cost Classification, Indirect Cost Classification, Stock of Raw Materials, Stock of Semi-
finished Goods, Stock of Finished Goods.

UNIT- II Corporate Financial Statements, Types & Nature of Financial Statements, Attributes & Uses
of Financial Statements, Limitations of Financial Statements.
Classification of Expenditure/Receipts, Capital and Revenue Expenditures, Capital and
Revenue Receipts, Cost of Goods Sold.
Tools of Financial Statement Analysis, Concepts, Objectives, Tools for Analysis and
Interpretation,
Comparative Financial Statements, Comparative (Income) Financial Statement Analysis,
Comparative Common-size Statement, Trend Analysis.

UNIT- III Ratio Analysis, Definition, Classification, Purposes & Utility of the Ratio Analysis, Limitations
of the Ratio Analysis, Short-term Solvency Ratios, Capital Structure Ratios, Profitability Ratios,
Return on Assets Ratio, Return on Capital Employed, Turnover Ratios, Fund Flow Statement,
Meaning & Objectives of Fund Flow Statement, Analysis, Steps, Methods of Fund Flow
Statement, Methods of Preparing Fund from Operations, Advantages & Limitations of Fund
Flow Statement, Cash Flow Statement, Meaning & Utility of Cash Flow Statement, Steps in
the Preparation of Cash Flow Statement,

UNIT- IV Cost Control Techniques, Standard Costing and Variance Analysis, Definition and Meaning
of Standard Costing, Standard Costing System, Concept of Variance Analysis, Classification of
Variances, Responsibility Accounting, Responsibility Centers, Controllability Concept,
Accounting Concepts, Advantages and Disadvantages of Responsibility Accounting.

UNIT- V Management Applications, Definition & Importance of Marginal Costing, Cost-Volume-Profit

(CVP) Analysis, Break-even Analysis, Application of Cost Volume Profit Analysis.

UNIT-1
What Is Accounting?
Accounting is the process of assessing, recording and communicating financial transactions.
Organisations and individuals do accounting to develop detailed understanding of their financial
situation. An accountant is a finance professional who facilitates this, for companies and clients, by
tracking their profits, losses, expenses and incomes.

Accountants are responsible for ensuring that their clients are made aware of their financial
performance and legal obligations. They help companies make financial plans for the future and
prepare budgets. The managerial staff of a company would often require an accountant's expertise to
make decisions regarding transactions and investments.

What Are The Three Fundamental Concepts Of Accounting?

Accruals concept
The accruals concept states that revenues can be recognised only when they are earned, and
expenses, when assets are used. This means that businesses do not require to go by cash value when
they recognise profits, losses and revenue. For example, if your company sells a product, the value of
that product would require to factor in additional costs like customer support and logistics, and not
just the cost of production. It is general practice among auditors to verify that a company's financial
statements are prepared following the accruals concept.
Going concern concept
In accounting, it is always assumed that a business remains in operation in future time periods.
Expenses and revenue may be pushed to future periods, depending on the situation. For example,
companies can defer debt amounts (or portions of it) to their next financial quarters, under the
assumption that they would be operational in the future. Without the going concern concept, all
potential future expenses would require to be accounted for in the current period and this can make
it difficult for businesses to function, especially if they rely on credit/loans to function.
Economic entity concept

The economic entity concept maintains that business transactions be kept separate from the business
owner's personal transactions. Auditors require to verify that there is no mixing of business and
personal transactions in a company's financial records. If any person, including the owner, uses
company funds for their own personal transactions, it is considered embezzlement of funds, which
has legal and professional ramifications.

What Are The Basics Of Accounting?

To understand the basics of accounting, it is important to look at its three main components and the
terminology related to these components. The basic components of accounting are:
Records
Companies require to identify a clear approach to record-keeping, before they begin the accounting
process. They require to set up some basic accounts in which to store information. Accounts fall into
the following classifications:

Assets: These refer to resources or items that the company owns. Assets have future economic value
that can be measured and can be expressed in monetary terms. Examples of a company's assets
include investments, cash, inventory, accounts receivable, land, supplies, equipment, buildings and
vehicles.

Liabilities: These refer to the legal financial obligations or debts that companies incur during business
operations. Liabilities can be limited or unlimited. They are settled over time through the transfer of
economic benefits such as money, services or goods. Recorded on the right side of a company's
balance sheet, liabilities include any payable amounts, loans, mortgages, earned premiums, deferred
revenues and accrued expenses.

Equity: Equity, also known as shareholder's equity, refers to the amount of money that a company is
required to return to its shareholders after all of its assets are liquidated and all of its debt is paid off.
Equity is calculated by subtracting a company's total assets to its total liabilities.

Expenses: Expenses refer to the costs of operations that businesses incur to generate revenue.
Common expenses include employee wages, payments to suppliers, equipment depreciation and
factory leases.

Revenue: Revenue refers to the income that a company generates from its normal business
operations. It includes deductions and discounts for returned products. Revenue is the gross income
figure from which costs are subtracted to determine net income.
Accounting Process

It is a very important step in which you examine the

source documents and analyze them. For example,
Collecting and Analyzing
1 cash, bank, sales, and purchase related documents.
Accounting Documents
This is a continuous process throughout the accounting
period.

On the basis of the above documents, you pass journal

entries using double entry system in which debit and
2 Posting in Journal
credit balance remains equal. This process is repeated
throughout the accounting period.

Debit and credit balance of all the above accounts

3 Posting in Ledger Accounts affected through journal entries are posted in ledger
accounts. A ledger is simply a collection of all accounts.
 Usually, this is also a continuous process for the whole
accounting period.

As the name suggests, trial balance is a summary of all

the balances of ledger accounts irrespective of
whether they carry debit balance or credit balance.
Since we follow double entry system of accounts, the
4 Preparation of Trial Balance
total of all the debit and credit balance as appeared in
trial balance remains equal. Usually, you need to
prepare trial balance at the end of the said accounting
period.

In this step, the adjustment entries are first passed

through the journal, followed by posting in ledger
accounts, and finally in the trial balance. Since in most
of the cases, we used accrual basis of accounting to
5 Posting of Adjustment Entries
find out the correct value of revenue, expenses, assets
and liabilities accounts, we need to do these
adjustment entries. This process is performed at the
end of each accounting period.

Taking into account the above adjustment entries, we

create adjusted trial balance. Adjusted trial balance is a
6 Adjusted Trial Balance
platform to prepare the financial statements of a
company.

Financial statements are the set of statements like

Income and Expenditure Account or Trading and Profit
& Loss Account, Cash Flow Statement, Fund Flow
Statement, Balance Sheet or Statement of Affairs
7 Preparation of Financial Statements
Account. With the help of trial balance, we put all the
information into financial statements. Financial
statements clearly show the financial health of a firm
by depicting its profits or losses.

All the different accounts of revenue and expenditure

of the firm are transferred to the Trading and Profit &
Loss account. With the result of these entries, the
8 Post-Closing Entries balance of all the accounts of income and expenditure
accounts come to NIL. The net balance of these entries
represents the profit or loss of the company, which is
finally transferred to the owner’s equity or capital.

Post-closing Trial Balance represents the balances of

Asset, Liabilities & Capital account. These balances are
9 Post-Closing Trial Balance
transferred to next financial year as an opening
balance.
Classification of Accounts in Accounting

 Personal Account

 Real Account

o Tangible Real Account

oIntangible Real Account

 Nominal Account

Personal Account
These accounts types are related to persons. These persons may be natural persons like Raj’s account,
Rajesh’s account, Ramesh’s account, Suresh’s account, etc.

These persons can also be artificial persons like partnership firms, companies, bodies corporate,
an association of persons, etc.

For example – Rajesh and Suresh trading Co., Charitable trusts, XYZ Bank Ltd, C company Ltd, etc.

There can be personal representative accounts as well.

For example – In the case of Salary, when it is payable to employees, it is known how much amount is
payable to each of the employee. But collectively it is called as ‘Salary payable A/c’.

Rule for this Account

Debit the receiver.
Credit the Giver.

For Example – Goods sold to Suresh. In this transaction, Suresh is a personal account as being a natural
person. His account will be debited in the entry as the receiver.

Real Accounts
These account types are related to assets or properties. They are further classified as Tangible real
account and Intangible real account.

Tangible Real Accounts

These include assets that have a physical existence and can be touched. For example – Building A/c, cash
A/c, stationery A/c, inventory A/c, etc.

Intangible Real Accounts

These assets do not have any physical existence and cannot be touched. However, these can be
measured in terms of money and have value. For Example – Goodwill, Patent, Copyright, Trademark,
etc.

Real Account Rules

Debit what comes into the business.

Credit what goes out of business.

For Example – Furniture purchased by an entity in cash. Debit furniture A/c and credit cash A/c.
 Nominal Account
These accounts types are related to income or gains and expenses or losses. For example: – Rent A/c,
commission received A/c, salary A/c, wages A/c, conveyance A/c, etc.

Rules
Debit all the expenses and losses of the business.
Credit the incomes and gains of business.
For Example – Salary paid to employees of the entity. Salary A/c will be debited when the expenses are
incurred. Whereas, when an entity receives any interest, discount, etc these are credited whenever these
are received by the entity.

COST ACCOUNTING

Introduction
Accounting can no longer be considered a mere language of business. The need for maintaining
the financial chastity of business operations, ensuring the reliability of recorded experience
resulting from these operations and conducting a frank appraisal of such experiences has made
accounting a prime activity along with such other activities as marketing, production and
finance. Accounting may be broadly classified into two categories – accounting which is meant
to serve all parties external to the operating responsibility of the firms and the accounting, which
is designed to serve internal parties to take care of the operational needs of the firm. The first
category, which is conventionally referred to as “financial accounting”, looks to the interest of
those who have primarily a financial stake in the organisation‟s affairs – creditors, investors,
employees etc. On the other hand, the second category of accounting is primarily concerned with
providing information relating to the conduct of the various aspects of a business like cost or
profit associated with some portions of business operations to the internal parties viz.,
management. This category of accounting is divided into “management accounting” and “cost
accounting”. This section deals with cost accounting.

Cost- Cost is a foregoing, measured in monetary terms, incurred or potentially to be incurred to

achieve a specific objective. Cost can be termed as the amount of resources given up in exchange
for some goods or services.

Costing- The technique and process of ascertaining costs is known as Costing.

Cost Accountancy- Cost Accountancy includes, Costing and Cost Accounting. Cost
Accountancy is the application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the ascertainment of profitability.
 Meaning of Cost Accounting
Cost accounting developed as an advanced phase of accounting science and is trying to make up
the deficiencies of financial accounts. It is essentially a creation of the twentieth century. Cost
accounting accounts for the costs of a product, a service or an operation. It is concerned with
actual costs incurred and the estimation of future costs. Cost accounting is a conscious and
rational procedure used by accountants for accumulating costs and relating such costs to specific
products or departments for effective management action. Cost accounting through its marginal
costing technique helps the management in profit planning and through its another technique i.e.
Standard costing facilitates cost control. In short, cost accounting is a management information
system which analyses past, present and future data to provide the basis for managerial decision
making.
Definitions-

The Institute of Cost and Works Accountants, London defines cost accounting as,

“Cost Accounting is the technique and process of ascertainment of cost”

The Institute of Cost and Works Accountants, India defines cost accounting as,

“The technique and process of ascertainment of costs. Cost accounts the process of accounting for
costs, which begins with the recording of expenses or the bases on which they are calculatingand
ends with the preparation of statistical data.”
Thus, the process of accounting for cost from the point at which expenditure incurs or commit to
the establishment of its ultimate relationship with cost centers and cost units. In its wider usage, it
embraces the preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of activities carry out or plan.

In other words, cost accounting may be defined as the body of concepts, methods, techniques and
procedures used to compute analyses or estimate the cost, profitability and performance of
individual product, services or departments and other segments of an enterprise.

Nature and Characteristics of Cost Accounting

The nature and main characteristics of cost accounting are as follows:

(i) Specialised Branch of Accounting: Cost accounting is a specialised branch of accounting

which covers collection, classification, recording, apportionment, determination and control
ofcost. Though it is based on double entry system but has its own concepts and conventions
also.
(ii) Art and Science Both: Cost accounting is a science because it has its own principles and
rules, which are followed on regular basis and in a systematic manner. It is also an art because
itsprinciples and techniques are used in solving the business problems through cost data.
(iii) Recognised as a Profession: As cost accounting is a specialised branch of knowledge, it is
recognised as a profession also. The Institute of Cost and Works Accountants of India provides
professional assistance to cost accountants and frames the rules for their professional and
approach.
 (iv) Determination of various Components of Total Cost: It ascertains cost of products and
services through the process of accumulation, classification, analysis and recording. The
elements of cost include (a) material, (b) labour and, (c) expenses. The main function of this
system is to determine total cost and cost per unit. It also determines the cost of incomplete
workor job in case if the work remains uncompleted.

(v) Application of Statistical Data of Computing Profit and Cost: The extensive use of
system involves application of statistical data, control methods and techniques and
determining profitability. The statistical data are helpful in preparation of cost sheet,
coststatement, various cost accounts and are used for the purpose of cost comparison.
(vi) Helpful to Management: This system provides information and measures for control
andguidance for various levels of management.

Scope of Cost Accounting

The scope of cost accounting is very broad. An organisation having an effective cost accounting
system helps the management in performance of their responsibilities in an efficient and
effective manner. In brief, cost accounting covers the following aspects:

a. Classification of Cost: The cost classification is the process of grouping costs according to
their characteristics. In this context the cost can be classified according to elements, functions,
nature, controllability, normality and relevance to decision-making.

b. Cost Recording: After cost classification, cost transactions are recorded in various ledger
accounts.

c. Cost Allocation: It includes allotment of whole items of cost to cost centres or cost units
according to pre-determined basis.

d. Cost Determination: It is also called as „cost measurement‟ and it means computation of cost
of individual products, services, departments or other segments of an enterprises. It can be done
by preparing cost sheet or statement of cost. Production account can also be prepared for this
purpose.

e. Cost Control: It is an important aspect of cost accounting and for this purpose various
techniques such as standard costing, budgetary control, inventory control, quality control, etc.
can be adopted.

f. Cost Comparison: It refers to comparison of current cost with previous cost or cost of similar
other concerns.

g. Cost Reporting: It means communication of cost data on regular basis which may be used by
management for decision-making or which are made available to government or some outside
agencies.

h. Cost Reduction: It means permanent and genuine reduction in per unit cost of produced or
services rendered.

i. Cost Analysis: It involves the estimation of relationship between costs and various
determinants of costs.

j. Cost Audit: It means an examination of the appropriateness of the cost accounting system
adopted by the business and effectiveness of its implementation.
Function of Cost Accounting
The main functions or objects of cost accounting are as follows:

a. Cost ascertainment: The primary objective of cost accounting is to determine the cost of
production of every unit, job, operation, process, department or service. The technique of
ascertaining cost is known as „Costing‟. In order to determine cost, all the expenses are
accumulated, classified and analysed. It not only determines the cost at completion stage but also
determines cost at various stages of production.
b. Cost control: Cost control is one of the important functions of cost accounting. To measure
the efficiency of the organisation or of the cost centres, the various operations involved in the
manufacture of products are to be carefully studied. Budgets and standards for the consumption
of materials, use of labour, and for expending the overhead are to be set and compared with
actual performances. The variances arising out of the comparison so made tell the tale whether
the cost is within control or not.
c. Cost reduction: Cost reduction refers to real or genuine savings through permanent reduction
in cost of a product or service without impairing the quality and affecting its purpose for which it
was intended to be used. In the competitive market situations, it is utmost important for the
organisations to look for activities and search for new technology through research and
development activities that can reduce the cost of a product. Cost reduction can be attainable in
almost all the areas of business activities. The area covered for cost reduction are like
product design, plant layout, production methods, material substitution, reduction in wastages,
innovation marketing strategies, purchasing and material control etc.
d. Ascertainment of profitability: It is the object of cost accounting to ascertain the profit
making capacity of that activity planned or being carried out and to compare the actual profits
made with their profitabilities. Difference is analysed and efforts are made to earn the maximum
profit as per capacity.
e. Determination of selling price: The supply price or the tender price of a product depends
upon its total cost plus a margin of profit which the businessman wants to make depending upon
the inter-play of factors of demand and supply. Cost accounting provides detailed information
about the composition of total cost for the determination of the selling price. It also provides
information to decide the extent to which the prices can be reduced to meet the challenge arising
out of competition, by differentiating the costs into variable and fixed cost. Similarly, in
the event of depression or recession, the cost accountant can guide as to which expenses can be
curtailed, to reduce the cost of production and thus to decide the minimum selling price.
 f. Providing a basis for business policy and decision-making: The objective of cost accounting
is to help the management in the formulation of business policy and in decision-making.
The gross-profit analysis, the cost-volume-profit relationship, the break-even point of sales, and
the differential costing method, etc., help the management in profit-planning and in deciding
crucial matters like : (a) introduction or discontinuance of a product; (b) utilization of idle plant
capacity; ( c) selection of most profitable sales-mix; (d) dumping of goods in a foreign market at
a cheaper price; (e) make or buy; (f) purchase of new plant or continuance with the old plant at
the of heavy repairs, etc.
g. Compliance to statutory requirements: The Central Government, under Section 209(1) (d)
of the Companies Act, has made it compulsory for 47 industries to maintain cost accounts. Thus
compliance to statutory requirements is also one of the objectives of cost accounting.
Cost Centre- Any unit of cost accounting selected with a view to accumulating all cost under
that unit is known as Cost Centre. The unit may be a product, service, division, department,
section, a group of plant and machinery, a group of employees of several units. E.g. production
department, service department.

Classification of Cost Centre- Process cost centre, Production cost centre, Service cost centre,
Impersonal cost centre, Personal cost centre and Operation cost centre.

Distinction between Financial Accounting and Cost Accounting

Though there is much common ground between financial accounting and cost accounting and
though in fact cost accounting is an outgrowth of financial accounting yet the emphasis differs.
Firstly financial accounting is more attached with reporting the results of business to persons
other than internal management – government, creditors, investors, researchers, etc. Cost
accounting is an internal reporting system for an organisation‟s own management for decision
making. Secondly financial accounting data is historical in nature and its periodicity of reporting
is much wider. Cost accounting is more concerned with short-term planning and its reporting
period much lesser than financial accounting. It not only deals with historic data but also is
futuristic in approach. Thirdly, in financial accounting the major emphasis in cost classification
is based on the type of transaction e.g. Salaries, repairs, insurance, stores, etc. But in cost
accounting the major emphasis is on functions, activities, products, processes and on internal
planning and control and information needs of the organisation.

Utility of Cost Accounting

 A properly installed cost accounting system will help the management in the following ways:

1- The analysis of profitability of individual products, services or jobs.

2- The analysis of profitability of different departments or operations.

3- It locates differences between actual results and expected results.

4- It will assist in setting the prices so as to cover costs and generate an acceptable level of profit.
5- Cost accounting data generally serves as a base to which the tools and techniques of
management accounting can be applied to make it more purposeful and management oriented.

6- The effect on profits of increase or decrease in output or shutdown of a product line or

department can be analysed by adoption of efficient cost accounting system.

Distinction between Costing and Cost Accounting

Costing is the technique and process of ascertaining costs. It tries to find out the cost of doing
something, i.e., the cost of manufacturing an article, rendering a service, or performing a
function. Cost accounting is a broader term, in that it tries to determine the costs through a
formal system of accounting (unlike costing which can be performed even through informal
means). Stated precisely, cost accounting is a formal mechanism by means of which costs of
products and services are ascertained and controlled. The institute of cost and management
accountants, U.K. defines cost accounting as: the application of accounting and costing
principles, methods and techniques in the ascertainment of costs and the analysis of savings
and/or excesses as compared with previous experience or with standards. It, thus, includes three
things:

1. Cost Ascertainment: finding out the specific and precise total and unit costs of products
and services.
2. Cost Presentation: reporting cost data to various levels of management with a view to
facilitate decision making.
3. Cost Control: this consists of estimating costs for production and activities for the future,
and keeping them within proper limits. Budgets and standards are employed for this
purpose.

Cost accounting also aims at cost reduction, i.e., achieving a permanent and real reduction in cost
by improving the standards. Cost accountancy is a comprehensive term that implies the
`application of costing and cost accounting principles, methods and techniques to the science, art
and practice of cost control‟. It seeks to control costs and ascertain the profitability of business
operations.
 Classification of Cost In the process of cost accounting, costs are arranged and rearranged in
various classifications. The term „classification‟ refers to the process of grouping costs according
to their common characteristics. The different bases of cost classification are:
 by nature or elements (materials, labour and overheads)

 by time (historical, pre-determined)

 by traceability to the product (direct, indirect)

 by association with the product (product, period)

 by changes in activity or volume (fixed, variable, semi-variable)

 by function (manufacturing, administrative, selling, research and development, pre-production)

 by relationship with the accounting period (capital, revenue)

 by controllability (controllable, non-controllable)

 By analytical/decision-making purpose (opportunity, sunk, differential, joint, common,imputed,

out-of-pocket, marginal, uniform, replacement)
 by other reasons (conversion, traceable, normal, avoidable, unavoidable, and total).

Elements of Cost
The elements of costs are the essential part of the cost. There are broadly three elements of cost,
as explained below:

(A) Material
The substance from which the produce is made is called material. It can be direct as well
as indirect.

I) Direct Material: it refers to those materials which become an integral part of the final product
and can be easily traceable to specific physical units. Direct materials, thus, include:

1. All materials specifically purchased for a particular job or process.

2. Components purchased or produced.

3. Primary packing materials (e.g., carton, wrapping, card-board boxes etc.).

4. Material passing from one process to another.

II) Indirect Material: all materials which are used for purpose ancillary to the business and which
cannot conveniently be assigned to specific physical units are known as `indirect materials‟. Oil,
grease, consumable stores, printing and stationery material etc. are a few examples of indirect
materials.

(B) Labour
In order to convert materials into finished products, human effort is required. Such human effort
is known as labour.

Labour can be direct as well as indirect.

I) Direct Labour: It is defined as the wages paid to workers who are engaged in the production
process and whose time can be conveniently and economically traceable to specific physical
units. When a concern does not produce but instead renders a service, the term direct labour or
wages refers to the cost of wages paid to those who directly carry out the service, e.g., wages
paid to driver, conductor etc. Of a bus in transport service.

II) Indirect Labour: Labour employed for the purpose of carrying out tasks Incidental to goods
produced or services provided is called indirect labour or indirect wages. In short, wages which
cannot be directly identified with a job, process or operation, are generally treated as indirect
wages. Examples of indirect labour are: wages of store-keepers, foremen, supervisors, inspectors,
internal transport men etc.

(C) Expenses
Expenses may be direct or indirect.

I) Direct Expenses: These are expenses which can be directly, conveniently and wholly
identifiable with a job, process or operation. Direct expenses are also known as chargeable
expenses or productive expenses. Examples of such expenses are: cost of special layout, design
or drawings, hire of special machinery required for a particular contract, maintenance cost of
special tools needed for a contract job, etc.

II) Indirect Expenses: Expenses which cannot be charged to production directly and which are
neither indirect materials nor indirect wages are known as indirect expenses. Examples are rent,
rates and taxes, insurance, depreciation, repairs and maintenance, power, lighting and heating
etc.

The above elements of cost may be shown as follows:

Element of cost
 a. Direct/indirect Materials

b. Direct/indirect labour

c. Direct/indirect expenses

1. Overheads

The term overheads includes, indirect material, indirect labour and indirect expenses, explained
in the preceding paragraphs. Overheads may be incurred in the factory, office or selling and
distribution departments/ divisions in an undertaking. Thus overheads may be of three types:
factory overheads, office and administrative overheads and selling and distribution overheads.
This classification of overheads may be shown thus:

Classification of

Overheads Overheads

Direct Overheads

Factory Overheads - Indirect

Office Overheads - Indirect

Selling and distribution Overheads - Indirect

2. Cost Classification by Time

On the basis of the time of computing costs, they can be classified into historical and pre-
determined costs.

I) Historical Costs: These costs are computed after they are incurred. Such costs are
available only after the production of a particular thing is over.
II) Pre-Determined Costs: These costs are computed in advance of production on the
basis of a specification of all factors influencing cost. Such costs may be:
1. Estimated costs: estimated costs are based on a lot of guess work. They try to
ascertain what the costs will be based on certain factors. They are less accurate as
only past experience is taken into account primarily, while computing them.
2. Standard costs: standard costs is a pre-determined cost based on a technical
estimate for material, labour and other expenses for a selected period of time and for a
prescribed set of working conditions. It is more scientific in nature and the object is to
find out what the costs should be.
 3.Cost Classification by Traceability
As explained previously, costs which can be easily traceable to a product are called direct costs.
Indirect costs cannot be traced to a product or activity. They are common to several products
(e.g., salary of a factory manager, supervisor etc.) And they have to be apportioned to different
products on some suitable basis. Indirect costs are also called `overheads‟.

4.Cost Classification by Association with Product

Costs can also be classified (on the basis of their association with products) as product costs and
period costs.

1. Product Costs: product costs are traceable to the product and include direct material, direct
labour and manufacturing overheads. In other words, product cost is equivalent to factory cost.

2. Period Costs: period costs are charged to the period in which they are incurred and are treated
as expenses. They are incurred on the basis of time, e.g., rent, salaries, insurance etc. They
cannot be directly assigned to a product, as they are incurred for several products at a time
(generally).

5. Cost Classification by Activity/Volume

Costs are also classified into fixed, variable and semi-variable on the basis of variability of cost
in the volume of production.

1. Fixed Cost:

Fixed cost is a cost which tends to be unaffected by variations in volume of output. Fixed cost
mainly depends on the passage of time and does not vary directly with the volume of output. It is
also called period cost, e.g., rent, insurance, depreciation of buildings etc. It must be noted here
that fixed costs remain fixed upto a certain level only. These costs may also vary after a certain
production level.

2. Semi-Variable Cost:

These costs are partly fixed and partly variable. Because of the variable element, they fluctuate
with volume and because of the fixed element; they do not change in direct proportion to output.
Semi-variable or semi-fixed costs change in the same direction as that of the output but not in the
same proportion. For example, the expenditure on maintenance is to a great extent fixed if the
output does not change significantly. Where, however, the production rises beyond a certain
limit, further expenditure on maintenance will be necessary although the increase in the
expenditure will not be in proportion to the rise in output. Other examples in this regard are:
depreciation, telephone rent, repairs etc.

3. Variable Cost:
 Cost which tends to vary directly with volume of outputs is called `variable cost‟. It is a direct
cost. It includes direct material, direct labour, direct expenses etc. It should be noted here that the
variable cost per unit is constant but the total cost changes corresponding to the levels of output.
It is always expressed in terms of units, not in terms of time.

6. Cost Classification by Function

On the basis of the functions carried out in a manufacturing concern, Costs can be classified into
four categories:

1. Manufacturing/Production Cost: it is the cost of operating the manufacturing division of an

enterprise. It is defined as the cost of the sequence of operations which begin with supplying
materials, services and ends with the primary packing of the product.

2. Administrative/Office Cost: it is the cost of formulating the policy, directing the organisation
and controlling the operations of an undertaking, which is not directly related to production,
selling, distribution, research or development. Administration cost, thus, includes all office
expenses: remuneration paid to managers, directors, legal expenses, depreciation of office
premises etc.

3. Selling Cost: selling cost is the cost of seeking to create and stimulate demand e.g.,
advertisements, show room expenses, sales promotion expenses, discounts to distributors, free
repair and servicing expenses, etc.

4. Distribution Cost: it is the cost of the sequence of operations which begins with making the
packed product, available for despatch and ends with making the reconditioned returned empty
package, if any, available for re-use. Thus, distribution cost includes all those expenses
concerned with despatching and delivering finished products to customers, e.g., warehouse rent,
depreciation of delivery vehicles, special packing, loading expenses, carriage outward, salaries of
despatch clerks, repairing of empties for re-use, etc.

5. Research and Development Cost: It is the cost of discovering new ideas, processes, and
products by experiment and implementing such results on a commercial basis.

6. Pre-Production Cost: Expenses incurred before a factory is started and expenses involved in
introducing a new product are preproduction costs. They are treated as deferred revenue
expenditure and charged to the cost of future production on some suitable basis.

7. Cost Classification by Relationship with Controllability

On the basis of controllability, costs can be classified as controllable or uncontrollable.

1. Controllable Cost: A cost which can be influenced by the action of a specified member of an
undertaking is a controllable cost, e.g., direct materials, direct labour etc.
 2. Uncontrollable Cost: A cost which cannot be influenced by the action of a specified member
of an undertaking is an uncontrollable cost, e.g., rent, rates, taxes, salary, insurance etc. The term
controllable cost is often used in relation to variable cost and the term uncontrollable cost in
relation to fixed cost. It should be noted here that a controllable cost can be controlled by a
person at a given organisation level only. Sometimes two or more individuals may be involved in
controlling such a cost.

8. Cost Classification by Decision-Making Purpose

Costs may be classified on the basis of decision-making purposes for which they are put to use,
in the following ways:

1. Opportunity Cost: It is the value of the benefit sacrificed in favour of choosing a particular
alternative or action. It is the cost of the best alternative foregone. If an owned building, for
example, is proposed to be used for a new project, the likely revenue which the building could
fetch, when rented out, is the opportunity cost which should be considered while evaluating the
profitability of the project.

2. Sunk Cost: A cost which was incurred or sunk in the past and is not relevant for decision-
making is a sunk cost. It is only historical in nature and is irrelevant for decision-making. It may
also be defined as the difference between the purchase price of an asset and its salvage value.

3. Differential Cost: The difference in total costs between two alternatives is called as differential
cost. In case the choice of an alternative results in increase in total cost, such increase in costs is
called `incremental cost‟. If the choice results in decrease in total costs, the resulting decrease is
known as decremental cost.

4. Joint Cost: Whenever two or more products are produced out of one and the same raw material
or process, the cost of material purchased and the processing are called joint costs. Technically
speaking, joint cost is that cost which is common to the processing of joint products or
byproducts upto the point of split-off or separation.

5. Common Cost: Common cost is a cost which is incurred for more than one product, job
territory or any other specific costing object. It cannot be treated to individual products and,
hence, apportioned on some suitable basis.

6. Imputed Cost: This type of cost is neither spent nor recorded in the books of account. These
costs are not actually incurred (hence known as hypothetical or notional costs) but are considered
while making a decision. For example, in accounting, interest and rent are recognized only as
expenditure when they are actually paid. But in costing, they are charged on a notional basis
while ascertaining the cost of a product.

7. Out-Of-Pocket Cost: It is the cost which involves current or future expenditure outlay, based
on managerial decisions. For example a company has its own trucks for transporting goods from
 one place to another. It seeks to replace these by employing public carriers of goods. While
making this decision, management can ignore depreciation, but not the out-of-pocket costs in the
present situation, i.e., fuel, salary to drivers and maintenance paid in cash.

8. Marginal Cost: It is the aggregate of variable costs, i.e., prime cost plus variable overheads.

9. Replacement Cost: It is the cost of replacing a material or asset in the current market.

What is a cost sheet?

A cost sheet is a statement that shows the various components of total cost for a product and shows
previous data for comparison. You can deduce the ideal selling price of a product based on the cost
sheet.
A cost sheet document can be prepared either by using historical cost or by referring to estimated
costs. A historical cost sheet is prepared based on the actual cost incurred for a product. An estimated
cost sheet, on the other hand, is prepared based on estimated cost just before the production begins.

Importance and objectives of cost sheet

Cost sheets help with a number of essential business processes:

1. Determining cost: The main objective of the cost sheet is to obtain an accurate product cost. It

gives you both the total cost and cost per unit of a product.

2. Fixing selling price: In order to fix the selling price of a product, you need to create a cost sheet so

you can see the details of its production cost.

3. Cost comparison: It helps the management compare the current cost of a product with a previous

per unit cost for the same product. Comparing the costs helps management take corrective measures

if costs have increased.

4. Cost control: The cost sheet is an important document for a manufacturing unit, as it helps in

controlling production costs. Using an estimated cost sheet aids in monitoring labour, material and

overhead costs at each step of production.

5. Decision-making: Some of the most important decisions management makes are based on the cost

sheet. Whenever a business needs to produce or buy a component, or quote prices for its goods on a

tender, managers refer to the cost sheet.

UNIT-2
What Is Financial Statement Analysis?

Financial statement analysis is the process of analyzing a company’s financial

statements for decision-making purposes. External stakeholders use it to
understand the overall health of an organization and to evaluate financial
performance and business value. Internal constituents use it as a monitoring tool
for managing the finances.

How to Analyze Financial Statements

The financial statements of a company record important financial data on every
aspect of a business’s activities. As such, they can be evaluated on the basis of
past, current, and projected performance.

In general, financial statements are centered around generally accepted

accounting principles (GAAP) in the United States. These principles require a
company to create and maintain three main financial statements: the balance
sheet, the income statement, and the cash flow statement. Public companies have
stricter standards for financial statement reporting. Public companies must follow
GAAP, which requires accrual accounting.

Private companies have greater flexibility in their financial statement preparation

and have the option to use either accrual or cash accounting.

Several techniques are commonly used as part of financial statement analysis.

Three of the most important techniques are horizontal analysis, vertical analysis,
and ratio analysis. Horizontal analysis compares data horizontally, by analyzing
values of line items across two or more years. Vertical analysis looks at the
vertical effects that line items have on other parts of the business and the
business’s proportions. Ratio analysis uses important ratio metrics to calculate
statistical relationships.

Types of Financial Statements

Companies use the balance sheet, income statement, and cash flow statement to
manage the operations of their business and to provide transparency to their
stakeholders. All three statements are interconnected and create different views of
a company’s activities and performance.

Balance Sheet
The balance sheet is a report of a company’s financial worth in terms of book
value. It is broken into three parts to include a company’s assets, liabilities,
and shareholder equity. Short-term assets such as cash and accounts receivable
can tell a lot about a company’s operational efficiency; liabilities include the
company’s expense arrangements and the debt capital it is paying off; and
shareholder equity includes details on equity capital investments and retained
earnings from periodic net income. The balance sheet must balance assets and
liabilities to equal shareholder equity. This figure is considered a company’s book
value and serves as an important performance metric that increases or decreases
with the financial activities of a company.
Income Statement
The income statement breaks down the revenue that a company earns against the
expenses involved in its business to provide a bottom line, meaning the net profit
or loss. The income statement is broken into three parts that help to analyze
business efficiency at three different points. It begins with revenue and the direct
costs associated with revenue to identify gross profit. It then moves to operating
profit, which subtracts indirect expenses like marketing costs, general costs, and
depreciation. Finally, after deducting interest and taxes, the net income is
reached.

Basic analysis of the income statement usually involves the calculation of gross
profit margin, operating profit margin, and net profit margin, which each divide
profit by revenue. Profit margin helps to show where company costs are low or
high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company’s cash flows from
operating activities, investing activities, and financing activities. Net income is
carried over to the cash flow statement, where it is included as the top line item for
operating activities. Like its title, investing activities include cash flows involved
with firm-wide investments. The financing activities section includes cash flow
from both debt and equity financing. The bottom line shows how much cash a
company has available.

limitations of financial statements

Financial Statements are very useful to an organization but still, they suffer from the following
limitations:

1. Historical Data: Financial Statements are prepared on the basis of historical cost. Since the
purchasing power of money is changing, the values of assets and liabilities shown in financial
statement do not reflect current market situation.
2. Assets may not realise: Accounting is done on the basis of certain conventions. Some of the
assets may not realize the stated values, if the liquidation is forced on the company. Assets
shown in the balance sheet reflect merely unexpired or unamortised cost.
3. Bias: Financial statements are the outcome of recorded facts, accounting concepts and
conventions used and personal judgments, made in different situations by the accountants.
Hence, bias may be observed in the results, and the financial position depicted in financial
statements may not be realistic.
4. Aggregate Information: Financial statements show aggregate information but not detailed
information. Hence, they may not be help the users in decision-making much.
5. Vital Information Missing: Balance sheet does not disclose information relating to loss of
markets, and cessation of agreements, which have vital bearing on the enterprise.
6. No Qualitative Information: Financial statements contain only monetary information but not
qualitative information like industrial relations, industrial climate, labour relations, quality of
work, etc.
7. They are Only Interim Reports: Profit and loss account discloses the profit/loss for a specified
period. It does not give an idea about the earning capacity over time similarly, the financial
position reflected in balance sheet is true at that point of time, the likely change on a future
date is not depicted.

Tools of Analysis of Financial Statements :

The most frequently used tools of financial analysis are as follows :

 Comparative Statements: These are the statements depicting the financial position and
profitability of an enterprise for the distinct timeframe in a comparative form to give a notion
 about the position of 2 or more periods. It usually applies to the 2 important financial
statements, namely, statement of profit and loss and balance sheet outlined in a comparative
form. Comparative figures signify the direction and trend of financial position and operating
outcomes. This type of analysis is also referred to as ‘horizontal analysis’.
 Common Size Statements: Common size statements are the statements which signify the
association of distinct items of a financial statement with a generally known item by depicting
each item as a % of that common item. Such statements allow an analyst to compare the
financing and operating attributes of 2 enterprises of distinct sizes in a similar industry. This
analysis is also referred to as ‘Vertical analysis’.
 Cash Flow Analysis: It refers to the analysis of the actual movement of cash into and out of an
establishment. The flow of cash into the trading concern is called cash inflow or positive cash
flow and the flow of cash out of the enterprise is known as negative cash flow or cash outflow.
The difference between the outflow and inflow of cash is the net cash flow. Hence, it compiles
the reasons for the changes in the cash position of a trading concern between dates of 2
balance sheets.
 Ratio Analysis: It characterizes the vital association which exists between several items of a
B/S (balance sheet) and a statement of P&L of an enterprise. As a method of financial analysis,
accounting ratios compute the comparative importance of the single items of the position and
income statements. It is feasible to evaluate the solvency, efficiency, and profitability of an
enterprise via the method of ratio analysis.

Classification of Receipts

CLASSIFICATION OF RECEIPTS
What are Receipts?

A receipt is a written acknowledgement of the transfer of something valuable from one party to
another. In addition to the receipts that are normally given to customers by vendors and service
providers, receipts are also given in business-to-business entities as well as stock market transactions.
However, receipts are classified into two types. They are:

 Revenue receipts
 Capital receipts

Revenue Receipts

Revenue receipts are those receipts that do not lead to a claim on the government. They are hence
termed non-redeemable. They are classified into tax and non-tax revenues. Tax revenues, a vital
component of revenue receipts, have been bifurcated into direct taxes (personal income tax) and
enterprises (corporation tax), indirect taxes like customs duties (taxes imposed on commodities
imported into and exported out of India), excise taxes (duties levied on commodities manufactured
within the nation), and service taxes.

Other direct taxes such as gift tax, wealth tax, and estate duty (now eradicated) have never brought a
large amount of revenue, hence they are known as paper taxes.

Capital Receipts

The government also gets money in terms of loans or from the sale of its assets. Loans must be given
back to the agencies from which they have borrowed. Hence, they establish liability. The sale of
government assets, such as the sale of shares in Public Sector Undertakings (PSUs) that is known as
Public Sector Undertakings disinvestment, minimises the total amount of financial assets of the
government.

Likewise, when the government sells an asset, it is understood that its earnings from that asset will
vanish in the future. Hence, these receipts can be debt establishing or non-debt establishing. All the
receipts of the government that establish liability or minimise financial assets are known as capital
receipts. When the government takes loans, it means that these loans will have to be given back and
interest will have to be financed on these loans in the future.

CLASSIFICATION OF EXPENDITURE

Expenditure is referred to as the act of spending time, energy or money on something. In economics,
it means money spent on purchasing any goods or services.

There are two categories of expenditures which are:

1. Revenue Expenditures
 2. Capital Expenditures

Revenue Expenditures

Revenue expenditures are the expenditures incurred for the basis other than the creation of physical
or financial assets of the central government. These are associated with the expenses incurred for the
normal operations of the government divisions and various services, interest payments on debt
sustained by the government, and grants given to state governments and other parties (even though
some of the endowments might be meant for the creation of assets).

Budget documents allocate total expenditure into plan and non-plan expenditures.

Non-plan expenditure, the more significant component of revenue expenditure, covers a broad
degree of general, economic, and social services of the government. The main objects of a non-plan
expenditure are interest payments, defence services, subsidies, salaries, and pensions.

Capital Expenditures

There are the expenditures of the government that result in the creation of physical or financial
assets, or depletion in financial liabilities. This incorporates expenditure on the investment of
building, land, equipment, machinery, investment in shares, and loans and advances by the central
government to state and union territory governments, Public Sector Undertakings (PSUs), and other
parties.

Capital expenditure is also classified as plan and non-plan in the budget documents. A plan capital
expenditure, like its revenue equivalent, is associated with central plan and central assistance for
state and union territory plans. A non-plan capital expenditure covers different general, social, and
economic services furnished by the government.

The Medium-term Fiscal Policy Statement sets a 3-year rolling target for specific fiscal indicators and
examines whether revenue expenditure can be financed through revenue receipts on a sustainable
basis and how productively capital receipts market borrowings are being consumed.

The Fiscal Policy Strategy Statement sets the preferences of the government in the fiscal sector,
examining current policies and justifying any deviation in important fiscal measures. The
Macroeconomic Framework Statement assesses the prospects of the economy for the GDP growth
rate, the fiscal balance of the central government, and external balance.
What Is Trend Analysis?

Trend analysis is a technique used in technical analysis that attempts to predict future stock price
movements based on recently observed trend data. Trend analysis uses historical data, such as price
movements and trade volume, to forecast the long-term direction of market sentiment.
Understanding Trend Analysis
Trend analysis tries to predict a trend, such as a bull market run, and ride that trend until data
suggests a trend reversal, such as a bull-to-bear market. Trend analysis is helpful because moving
with trends, and not against them, will lead to profit for an investor. It is based on the idea that what
has happened in the past gives traders an idea of what will happen in the future. There are three
main types of trends: short-, intermediate- and long-term.

A trend is a general direction the market is taking during a specified period of time. Trends can be
both upward and downward, relating to bullish and bearish markets, respectively. While there is no
specified minimum amount of time required for a direction to be considered a trend, the longer the
direction is maintained, the more notable the trend.
Trend analysis is the process of looking at current trends in order to predict future ones and is
considered a form of comparative analysis. This can include attempting to determine whether a
current market trend, such as gains in a particular market sector, is likely to continue, as well as
whether a trend in one market area could result in a trend in another. Though a trend analysis may
involve a large amount of data, there is no guarantee that the results will be correct.

UNIT-3

What Is Ratio Analysis?

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational
efficiency, and profitability by studying its financial statements such as the balance sheet and
income statement. Ratio analysis is a cornerstone of fundamental equity analysis.

Types of Ratio Analysis

The various kinds of financial ratios available may be broadly grouped into the following six silos,
based on the sets of data they provide:
1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-term debts as they become due,
using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio,
and working capital ratio.

2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets,
equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by
paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include:
debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios
These ratios convey how well a company can generate profits from its operations. Profit margin,
return on assets, return on equity, return on capital employed, and gross margin ratios are all
examples of profitability ratios.

4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and
liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio,
inventory turnover, and days' sales in inventory.

5. Coverage Ratios
Coverage ratios measure a company's ability to make the interest payments and other obligations
associated with its debts. Examples include the times interest earned ratio and the debt-service
coverage ratio.

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E
ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict
earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of
companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered
undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former
may trend upwards in the future, while the latter may trend downwards until each aligns with its
intrinsic value.

Numerator
Liquidity Ratios
Denominator
Current assets
Current ratio =
Current liabilities

Cash + marketable securities + net receivables

Quick (acid-test) ratio =
Current liabilities
 Cash + marketable securities
Cash ratio =
Current liabilities
CFO
CFO ratio =
Average current liabilities
365 X Quick ratio numerator
Defensive interval =
(Cash burn rate) Projected expenditures (= COGS + Other
operating expenses except depreciation)

Working capital = Current assets – Current liabilities

Numerator
Activity Ratios
Denominator
Net sales
Receivable turnover =
Average net trade receivables
365
Average receivables collection day =
Receivable turnover
Cost of goods sold (COGS)
Inventory turnover =
Average total inventory
365
Average days inventory in stock =
Inventory turnover
COGS + change in inventory = Purchases
Payables turnover =
Average accounts payable
365
Average days payables outstanding =
Payables turnover
Operating cycle = Receivables collection days + Inventory holding days

Net trade cycle or cash cycle = Operating cycle - Average days payables outstanding
Net sales
Working capital turnover =
Average working capital
Net sales
Fixed asset turnover =
Average net fixed assets
Net sales
Asset turnover =
Average total assets

Numerator
Profitability Ratios
Denominator
Net income
Return on equity (ROE) =
Average total shareholders’ equity
 Net Income + Interest expense * (1-tax rate)
Return on assets (ROA) =
Average total assets
NOPAT = EBIT * (1- tax rate)
Return on invested capital (ROIC) =
(See Course Note for details)
Average invested capital
Net sales – COGS = Gross margin
Gross profit margin on sales =
Net sales
EBIT
Operating Margin =
Net sales
Net income
Net profit margin on sales =
Net Sales
CFO
Cash return on assets =
Average total assets
Net income less preferred dividends
Earnings per share (EPS) =
Weighted common shares outstanding
Market price of stock
Price earnings ratio (P-E) =
Earnings per share

Numerator
Solvency Ratios
Denominator

Total debt
Debt to total assets =
Total assets

Total debt
Debt to equity =
Total shareholders’ equity
Total (average) assets
Financial leverage =
Total (average) shareholders’ equity
EBIT
Times interest earned (TIE) =
Interest expense

Meaning of Cash Flow

Cash flow refers to the outflow and inflow of cash or cash equivalents in an organization in a specific
period. Cash flow is recorded in the cash flow statement, which is one of the most important financial
statements in accounting.

There are many sources of cash flow in an organisation which may be categorized as:
 1. Cash Flows from Operating activities: It represents the movement of cash from the core
operations of a business
2. Cash Flows from Investment Activities: It represents the flow of cash due to purchase or sale
of an asset or any other investment activities for the business
3. Cash flow from financing activities: It involves changes in the flow of cash involving selling or
paying off financial instruments such as the issuance of debt, issuing shares and debentures or
repayment of debt

Meaning of Fund Flow

Fund flow refers to the working capital of the company, and a fund flow statement is prepared to
visualize the changes in working capital of the company over a period of time. Investors use the fund
flow information to determine where capital needs to be invested.

There are two types of inflow of funds in a business

1. Funds generated by the business operations

2. Long term funds raised by issuing shares or sale of fixed assets.

Cash Flow Fund Flow

Definition

Cash flow is based on the concept of outflow and inflow Fund flow is based on the concept of changes in
of cash and cash equivalents during a particular period working capital over a period of time

What is calculated?

Cash from the operations is calculated Fund from the operation is calculated.

What it shows

It shows the short term position of the business It shows the position of the business in the long term

Purpose
To show the movement of cash during the beginning and To show the changes in the financial position of
end of an accounting period business between previous and current accounting
periods

Discloses

Inflows and Outflows of cash Source and application of the available funds

Accounting Basis

Cash Basis of accounting Accrual basis of accounting

Part of Financial Statement

Yes No

Used for

Cash Budgeting Capital Budgeting

UNIT-4

STANDARD COSTING

Standard:
 According to Prof. Erie L. Kolder, “Standard is a desired attainable objective, a
performance, a goal, a model”.

Standard Cost:
Standard cost is a predetermined estimate of cost to manufacture a single unit or a number of units
during a future period.
The Chartered Institute of Management Accountants, London, defines “Standard Cost” as,
“a pre-determined cost which is calculated from management‟s standards of efficient operation
and the relevant necessary expenditure. It may be used as a basis for price fixing and for cost
control through variance analysis”.

Standard Costing:
According to the Chartered Institute of Management Accountants, London Standard Costing is
“the preparation and use of Standard Cost, their comparison with actual costs, and the analysis of
variances to their causes and points of incidence”.
The study of standard cost comprises of:
1. Ascertainment and use of standard costs.
2. Comparison of actual costs with standard costs and measuring the variances.
3. Controlling costs by the variance analysis.
4. Reporting to management for taking proper action to maximize the efficiency.

Objectives of Standard Costing

1. The objectives of standard costing technique are as follows:
2. To provide a formal basis for assessing performance and efficiency.
3. To control costs by establishing standards and analyzing of variances.
4. To enable the principle of „management by exception‟ to be practiced at the detailed
operational level.
5. To assist in setting budgets
Advantages of Standard Costing
A good standard costing system results in the following advantages:

 The setting of standards should result in the best resources and methods being used and
thereby increase efficiency.
 Budgets are compiled from standards.
 Actual costs can be compared with standard costs in order to evaluate performance
 Areas of strengths and weakness are highlighted.
 It acts as a form of feed forward control that allows an organization to plan the
manufacturing inputs required for different levels of output.
 It acts as a form of feedback control by highlighting performance that did not achieve the
standard set.
 It operates via the management by exception principle where only those variances (i.e.
Differences between actual and expected results) which are outside certain tolerance
limits are investigated, thereby saving managerial time and maximizing managerial
efficiency.
 The process of setting, revising and monitoring standards encourages reappraised of
methods, materials and techniques thus leading to cost control as an immediate effect and
to cost reduction as a long term effect.

Limitations of Standard Costing

Standard costing suffers from the following limitations:

1. A lot of input data is required which can be expensive.

2. Unless standards are accurately set any performance evaluation will be meaningless.
3. Uncertainty in standard costing can be caused by inflation, technological change,
economic and political factors, etc. Standards therefore need to be continually updated
and revised.
4. The maintenance of the cost data base is expensive.
5. Setting of standards involves forecasting and subjective judgments with inherent
possibilities of error and ambiguity.
6. Standard costing cannot be adopted in the firms which do not have uniform and standard
production programme.
7. It is very difficult to predict controllable and uncontrollable variances.

Budgetary Control and Standard Costing

The systems of budgetary control and standard costing have the common objective of
controlling business operations by establishing pre-determined targets, measuring the actual
performance and comparing it with the targets, for the purposes of having better efficiency and of
reducing costs. These two systems are said to be interrelated but they are not inter-dependent. The
budgetary control system can function effectively even without the system of standard costing in
operation but the vice-versa is not true. Usually, the two are used in conjunction with each other
to have most fruitful results. The distinction between the two systems is mainly on account of the
field or scope and technique of operation.
Both standard costing and budgetary control aim at maximum efficiency and managerial control.
Budgetary control and standard costing have the common objective of controlling business
 operations by establishing pre-determined targets, measuring the actual performance and
comparing it with the targets, for the purposes of having better efficiency and of reducing costs.
The two systems are said to be interrelated but they are not inter-dependent. The budgetary
control system can function effectively even without the system of standard costing in operation
but the vice-versa is not possible.

Standard Costing as a Controlling Technique

It is essential for management to have knowledge of costs so that decision can be effective.
Management can control costs on information being provided to it. The technique of standard
costing is used for building a proper budgeting and feedback system. The uses of standard costing
to management are as follows.

Variance Analysis
The difference between the standard cost and the actual cost is known as „cost variance‟. If
actual cost is less than the standard cost, the variance is favorable. If the actual cost is more than
the standard cost, the variance is unfavorable. A favorable variance indicates efficiency, while an
unfavorable one denotes inefficiency. However, mere knowledge of these variances would not be
useful for ensuring cost control. These have to be thoroughly analyzed so as to find out the
contributory factors. It would then be possible to find out whether the variances are amenable to
control or not. The term „variance analysis‟, thus, may be defined as „the resolution into
constituent parts and the explanation of variances‟.

1. Formulation of Price and Production Policies

Standard Costing acts as a valuable guide to management in the fixation of price and formulation
production polices. It also assists management in the field of inventory pricing, product, product
pricing profit planning and also in reporting to top management.

2. Comparison and Analysis of Data

Standard Costing provides a stable basis for comparison of actual with standard costs. It brings out
the impact of external factors and internal causes on the cost and performance of the concern. Thus,
it helps to take remedial action.

3. Cost Consciousness
 An atmosphere of cost consciousness is created among the staff. Standard costing also provides
incentive to workers for efficient performance.

4. Better Capacity to Anticipate

An effective budget can be formulated for the future by laving price knowledge of the deviations
of actual costs from standard costs. Data are available at an early stage and the capacity to
anticipate about changing conditions is developed.

Setting the Standard

While setting standard cost for operations, process or products, the following preliminaries must
be gone through:
1. Establish Standard Committee comprising Purchase Manager, Personnel Manager, and
Production Manager. The Cost Accountant coordinates the functions.
2. Study the existing costing system, cost records and forms in use.
3. A technical survey of the existing methods of production should be undertaken.
4. Determine the type of standard to be used.
5. Fix standard for each element of cost.
6. Determine standard costs of r each product.
7. Fix the responsibility for setting standards.
8. Account variances properly.
9. Ascertain the deviations by comparing the actual with standards.
10. Take necessary action to ensure that adverse variances are not repeated.

Determination of Standard Costs

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

(a) Establishment of cost centre. For fixing responsibility and defining the lines of authority,
cost centre is necessary. “A cost centre is a location, person or item of equipment (or group
of these) for which costs may be ascertained and used of the purpose of cost control”. With
the help of cost centre, the standards are prepared and the variances are analyzed.

(b) Classification and codification of accounts. Accounts are classified according to different
items of expenses under suitable heading. Each heading may be given codes and symbols.
Coding is useful for speedy collection and analysis.

(c) Types of standards. The different types of standards are given below:
 (i) Basic standard. It is fixed and unaltered for an indefinite period for forward planning.
According to I.C.M.A London, it is “an underlying standard from which a current
standard can be developed”. From this basic standard, changes in current standard
and actual standard can be measured.

(ii) Current standard. It is a short-term standard, as it is revised at regular intervals.

I.C.M.A. London refers to it as “a standard which is established for use over a short
period of time and is related to current conditions”. This standard is realistic and
helpful to business. It is useful for cost control.

(iii) Normal standard. It is an average standard, and is based on normal conditions which
prevail over a long period of a trade cycle. I.C.M.A defines it as “the averagestandard
which, it is anticipated, can be attained over a future period of time, preferably long
enough to cover one trade-cycle”. It is used for planning and decision making during
the period of trade cycle to which it is related. It is very difficult to apply in practice.

(iv) Ideal standard. I.C.M.A. defines it as “the standard which can be attained under the
most favorable condition possible”. It is fixed and needs a high degree of efficiency,
best possible conditions of management and performance. Existing conditions and
conditions capable of achievement should be taken into consideration. It is difficult to
attain this ideal standard.

(v) Expected standard. It is a practical standard. I.C.M.A defines it as, “the standard
which, it is anticipated, can be attained during a future specified budget period”. For
setting this standard, due weightage is given for all the expected conditions. It is more
realistic than the ideal standard.

(d) Setting the standards. After choosing the standard, the setting of standard is the work of the
standard committee. The cost accountant has to supply the necessary cost figures and co-
ordinate the activity committee. He must ensure that the setting standards are accurate.
Standards cost is determined for each element of the following costs.
(i) Direct Material cost. Standard material cost is equal to the standard quantity multiplied by
the standard price. The setting of standard costs for direct materials involves

(a) Standard Material Quantity. For each product or part or the process, mechanical
calculation or mechanical analysis is made. The allowance for normal wastage or loss
must be fixed very carefully. Similarly, where different kinds of materials are used as
a mix for a process, a standard material mix is determined to produce the desire
quality product.

(b) Standard Material Price. Setting of material standard price is done by the cost
accountant and the purchase manager. The current standard is the desirable and
effective for fixing the price. Normally one year is the period for fixation of standard
price. If there are more fluctuations in prices, then revision of standard price is
necessary. Before fixing the standard, the following points must be considered:
Prices of materials in stock
 Price quoted by suppliers
Trade and cash discounts received
Future prices based upon statistical data
Material price already contracted

(ii) Setting standard for Direct Labour. The standard labour cost is equal to the standard
time for each operation multiplied by the standard wage rate. Setting of standard cost of
direct labour involves:
(a) Fixation of standard time
(b) Fixation of standard rate
(a) Fixation of standard time: Standard time is fixed by time or motion study or past
records or test runs or estimates. Labour time is fixed by the work study engineer.
While fixing standard time, normal ideal time is allowed for fatigue, normal delays
or other contingencies.

(b) Fixation of standard rate. With the help of the personnel manager, the accountant
determines the standard rate. Fixation of standard rate is influenced by (i) Union‟s
policy (ii) Demand for labour (iii) Policy the be followed. (iv) Method of wage
payment.

(iii) Setting standard for Overhead. Overheads are divided into fixed, variable and semi-
variable. Standard overhead rate is determined on the basis of past records and future trend
of prices. It is calculated for a unit or for an hour.
Standard variable overhead rate=
Standard variable overhead for the budget Period

Budgeted production units or budgeted hours for the budgeted period (or some other base)

Standard fixed overhead rate=

Standard overheads for the budget period

Budgeted production units or budgeted hours for the budgeted period (or some other base)

Revision of Standards
Standard cost may be established for an indefinite period. There are no definite rules for
the selection for a particular period. If the standards are fixed for a short period, it is expensive and
frequent revision of standards will impair the utility and purpose for which standard is set.
At the same, if the standard is set for a longer period, it may not be useful particularly in
the days of high inflation and large fluctuations of rates in case of materials and labour.
Standards have to be revised from time to time taking into consideration changing
circumstances. The circumstances may change on account of technical innovations, changed
market conditions, increase or decrease in plant capacity, developing new products or giving up
 unprofitable production lines. If variations from actual occur in practice, they may be due to
controllable or uncontrollable causes. Standards should be revised only on account of those causes
which are beyond the control of the management. Changes in product design, supply of labour and
material, changes in market conditions for a long period, trade or cyclical variations would impel
the management to revise the standards. The objective, while comparing the actual performance
with the standard performance and revising standards, is to facilitate better control over costs and
improve the overall working and profitability of the organization.
Apart from the above, basic standards are revised in the course of time under the following
circumstances, when:
1. There are permanent changes in the method of production –designs and specifications.
2. Plant capacity is changed
3. There is a large variation between the standard and the actual.
4.
Budgetary Control and Standard Costing
The systems of budgetary control and standard costing have the common objective of
controlling business operations by establishing pre-determined targets, measuring the actual
performance and comparing it with the targets, for the purposes of having better efficiency and of
reducing costs. These two systems are said to be interrelated but they are not inter-dependent. The
budgetary control system can function effectively even without the system of standard costing in
operation but the vice-versa is not true. Usually, the two are used in conjunction with each other
to have most fruitful results. The distinction between the two systems is mainly on account of the
field or scope and technique of operation.

Budgeting Standard costing

1.Budgetary control is concerned 1. Standard Costing is related with
with the operation of the business the control of the expenses and
as a whole and hence its more hence it is more intensive
extensive

2. Budget is a projection of financial 2. Standard cost is the projection of

accounts cost accounts

3. It does not necessarily involve 3. It requires standardization of

standardization of products. products.

4. Budgetary control can be adopted 4. It is not possible to operate this

in part also. system in parts
 5. Budgeting can be operated 5. Standard costing cannot exist

What is Responsibility Accounting?

Responsibility Accounting is management accounting where all the company’s management,

budgeting, and internal accounting are held responsible. The primary objective of responsibility
accounting is to hold responsible all the concerned departments of any particular function.
In this type of accounting system, responsibility is assigned on the basis of the knowledge and skills
of the individuals. The basic motive of responsibility accounting is to decrease the overall cost and
increase the overall profit. If the motives do not get fulfilled, the concerned people are held
accountable and answerable. Accountability is clearly defined under responsibility accounting, so
concerned people work more carefully as they are made answerable to their seniors, management,
and board of directors.

What are Responsibility Centers?

A responsibility center is a functional business entity that has definite objectives and goals,
dedicated personnel, procedures, and policies as well as the duty of generating a financial report.
Different types of responsibility centers are being set up under responsibility accounting and every
responsibility center has different goals assigned to them that they have to fulfill in order to
contribute to the overall growth of the organization. Some basic responsibility centers that all
organisations generally need are Cost center, Profit center, Revenue Center and Investment Center.
Types of Responsibility Centers

1. Cost Center
A cost center is responsible for cost control. The main objective of the cost center is to minimize
cost. The cost center’s prime work is to check the cost of an organisation and to limit the unwanted
expenditure that the company may acquire. Costs, in this respect, are basically classified as
controllable costs and non-controllable costs. Controllable costs are the costs that can be
controlled by the organization. Uncontrollable costs are the cost that the organization can not
control. The concerned center is made responsible and accountable for only controllable expenses.
So, it is important to distinguish between controllable costs and non-controllable costs. The
performance evaluation is done on the basis of the actual cost that occurred and the targeted cost.
Some types of costs centers are:
 Production Cost Center
 Personal Cost Center
 Service Cost Center
 Impersonal Cost Center
 Process Cost Center
 Operation Cost Center
2. Revenue Center
This center is basically inclined towards the generation of leads and subsequently increasing the
overall revenue of the firm. Company’s sales team is mainly held responsible for this. A revenue
center is judged solely on its ability to generate sales; it is not judged on the amount of costs
incurred. Revenue centers are employed in organisations that are heavily sales focused. Sales team
are trained to generate more leads and convert them. Trainings are set up for them and evaluation
of the personnel is made on the basis of the conversion rates.

3. Profit Center
A profit center refers to a center whose performance is measured in cost and revenue both. It
contributes to both revenue and expenses, resulting in profit and loss. Profit occurs when revenues
are more than costs and loss occurs when costs are more than profits. The profit center is
accountable for all the actions associated with the sale of goods and production. The principle
objective of a profit center is to generate and maximize profit by minimising the cost incurred and
increasing sales. The accomplishment of a profit center is estimated in terms of profit growth
during a definite period.

4. Investment Center
This center is held responsible for using the company’s assets in the most efficient way and
investing them in the best opportunities in order to increase returns. Companies evaluate the
performance of an investment center according to the revenues it brings in through investments
in capital assets. An investment center is sometimes called an investment division. Investment
centers are increasingly important for firms as financialization leads companies to seek profits from
investment and lending activities in addition to core production.
Features of Responsibility Accounting
1. Inputs and Outputs: Responsibility accounting majorly covers two most important aspects of
business i.e. costs and revenue. Costs can be identified as inputs and revenue can be identified as
outputs. Cost and revenue are the essence of the business and need a close watch.
2. Use of Budgeting: Budgeting involves planning and controlling inputs and outputs. Costs can be
identified as inputs and revenue can be identified as outputs. Under budgeting process, planned
stats of cost and revenue are set up and then compare with the actual cost and revenue and offset
the deviations.
3. Performance Reporting: Performance reports of all the responsibility centers are made properly
and reported to seniors for evaluation. Corrective measures are taken in case of deviations.
4. Identification of Responsibility Centers: Under responsibility accounting, various types of
responsibility centers are identified and operated to ensure the smooth running of various
functions of the organisation.
Objectives of Responsibility Accounting
1. Accountability: Responsibility Accounting makes concerned people accountable for the results.
Division needs to prepare the reports and send them to the manager. In this way, personnel takes
care of all the necessary things, as they know they have to give proper reports to the managing
authorities.
2. More Responsible Personnel: Responsibility Accounting makes the company’s personnel more
responsible for the organisation’s performance. Responsibility accounting ensures better results,
growth, proper documentation, effective and efficient personnel, and more accountable and
responsible employees.
3. Minimisation of Costs: Responsibility Accounting ensures the minimisation of costs at various
levels in order to avoid wastage of resources. A cost center ensures a cut in costs and makes the
overall cost system effective.
4. Maximisation of Profits: Under Responsibility Accounting, the main goal of the profit center is to
increase the profits of the organization over different periods of time, which improves the overall
financial position of the company.
5. Decentralisation: Responsibility Accounting decentralises power so that personnel will have a
sense of responsibility and belongingness to the organisation.

Advantages of Responsibility Accounting

1. System of Control: Responsibility Accounting sets up a system of control in a way that concerned
people are held responsible for their work and they are accountable to their seniors and
management regarding their performances.
2. Awareness: Responsibility accounting creates awareness in the workplace as the personnel has
to explain the deviation of their assigned responsibility center.
3. Better Results: As actual numbers are compared with the target numbers over the years,
management will know the reasons for the constant deviation and they can take corrective
measures carefully according to the needs of the organization.
4. Efficiency: Responsibility Accounting creates a sense of efficiency within individual employees as
their work and achievements will be reviewed.
5. Effective communication: Individual and company goals are established and communicated in
the best way.

Limitations of Responsibility Accounting :

While implementing the system of responsibility accounting, the following difficulties are likely
to be faced by the management :

1) Classification of Costs :
For responsibility accounting system to be effective, a proper classification
between controllable and non-controllable costs is a prime requisite. But practical
difficulties arise while doing so on account of the complex nature and variety of costs.

2) Inter-departmental Conflicts :
Separate departmental pursuits may lead to inter-departmental rivalry and it may be prejudicial
to the interest of the enterprise as a whole. Managers may act in the best interests of their own,
but not in the best interests of the enterprise.

3) Delay in Reporting :
Responsibility reports may be delayed. Each responsibility centre can take its own time in
preparing reports.
4) Overloading of Information :
Responsibility accounting reports may be overloading with all available information. This danger
is inherent in the system but with clear instructions by management as to the functioning of the
system and preparation of reports, etc., only relevant information flow in.

5) Complete Reliance Will Be Deceptive :

Responsibility accounting can't be relied upon completely as a tool of management control. It is
a system just to direct the attention of management to those areas of performance which
required further investigation.
 UNIT-5

MARGINAL COSTING
Marginal costing is a technique of costing. This technique of costing uses the concept `marginal
cost‟. Marginal cost is the change in the total cost of production as a result of change in the
production by one unit. Thus marginal cost is nothing but variable cost. In marginal costing
technique only variable costs are considered while calculating the cost of the product, while
fixed costs are charged against the revenue of the period. The revenue arising from the excess of
sales over variable costs is known as `contribution‟. Using contribution as a vital tool, marginal
costing helps to a great extent in the managerial decision making process. This unit deals with
the various aspects of marginal costing.

Marginal Costing is very important technique in solving managerial problems and contributing in
various areas of decisions. In this context profitability of two or more alternative options is
compared and such options is selected which offers maximum profitability along with fulfillment
of objectives of the enterprise.

Marginal costing - definition

Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product –“is its variable cost”. This is normally taken to be; direct labor,
direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as:
„the accounting system in which variable costs are charged to cost units and the fixed costs of the
period are written-off in full against the aggregate contribution. Its special value is in decision
making‟. (Terminology.)
The term „contribution‟ mentioned in the formal definition is the term given to the difference
between Sales and Marginal cost.
Thus, Marginal Cost = Direct Material + Direct Labor + Direct Expenses +
Variable Overheads

Marginal Cost
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total
marginal costs of a department or batch or operation. The meaning is usually clear from the
context.
Note- Alternative names for marginal costing are the contribution approach and direct costing.

Contribution
The difference between selling price and variable cost (or marginal cost) is known as
`contribution‟ or `gross margin‟. It may be considered as some sort of fund from out of which all
fixed costs are met. The difference between contribution and fixed cost represents either profit or
loss, as the case may be. Contribution is calculated thus:
Contribution = Selling Price – Variable Cost
= Fixed Cost + Profit or – Loss
It is clear from the above equation that profit arises only when contribution exceeds fixed costs. In
other terms, the point of „no profit no loss‟ will be at a level where contribution is equal to fixed
costs.

Marginal cost equation

 The algebraic expression of contribution is known as marginal cost equation. It can be expressed
thus:
S–V=F+P
S–V=C
C = F + P And In Case Of Loss
C=F–L
Where: S = Sales
V = Variable Cost
C = Contribution
F = Fixed Cost
P = Profit
L = Loss

Profit Volume Ratio (P/V Ratio)

The profitability of business operations can be found out by calculating the p/v ratio. It shows the
relationship between contribution and sales and is usually expressed in percentage. It is also known
as „marginal-income ratio‟, „contribution-sales ratio‟ or `variable-profit ratio‟. P/v ratio thus is
the ratio of contribution to sales, and is calculated thus:
Contribution
P/V Ratio = -------------------- 100
Sales

C S–V F+P
= or or
S S S

Variable Costs
=1-
Sales

The ratio can also be shown by comparing the change in contribution to change in sales, or change
in profit to change in sales. Any increase in contribution, obviously, would mean increase in profit,
as fixed expenses are assumed to be constant at all levels of production.
Change in Contribution
P/V Ratio =
Change in Sales
Change in Profit
=
Change in Sales

The importance of p/v ratio lies in its use for evaluating the profitability of alternative products,
proposals or schemes. A higher ratio shows greater profitability. Management should, therefore,
 try to increase p/v ratio by widening the gap between the selling price and the variable costs. This
can be achieved by increasing sale price, reducing variable costs or switching over to more
profitable products.

Break-Even or Cost-Volume-Profit Analysis

Break-even analysis is a specific method of presenting and studying the inner relationship between
costs, volume and profits. (Hence, the name c-v-p analysis). It is an important tool of financial
analysis whereby the impact on profit of the changes in volume, price, costs and mix can be found
out with a certain amount of accuracy. A business is said to break even when its total sales are
equal to its total costs. It is a point of no profit or no loss. At this point contribution is equal to fixed
costs. Break-even point, can be calculated thus:

Fixed Cost
B.E.P. (In Units) =
Contribution Per Unit
Fixed Cost
=
Selling Price/Unit – Marginal Cost/Unit

Fixed Cost
B.E.P. (Sales) = --------------------------- X Selling Price/Unit
Contribution Per Unit
Fixed Cost
= X Total Sales
Total Contribution

FXS
Or =
S–V

Fixed Cost
Or =
Variable Cost Per Unit

Variable Cost Per Unit

1-
Selling Price Per Unit

Fixed Cost
Or =
P/V Ratio
 At break-even point the desired profit is zero. Where the volume of output or sales is to be
calculated so as to earn a desired amount of profit, the amount of desired profits has to be added
to the fixed cost given in the above formula.

Fixed Cost + Desired Profit

Units To Earn A Desired Profit = -------------------------------------
Contribution per Unit
Fixed Cost + Desired Profit
Sales to Earn a Desired Profit = ------------------------------------
P/V Ratio

Cash Break-Even Point

It is the level of output or sales where the cash inflow will be equivalent to cash needed to meet
immediate cash liabilities. To this end, fixed costs have to be divided into two parts (i) fixed cost
which do not need immediate cash outlay (depreciation etc.) And (ii) fixed cost which need
immediate cash outlay (rent etc.). Cash break-even point can be calculated thus:

Cash Fixed Costs

Cash Break-Even Point (Of Output) = -----------------------------------
Cash Contribution per Unit

Composite Break-Even Point

Where a firm is dealing with several products, a composite breakeven point can be calculated
using the following formula:

Cash Fixed Costs

Composite Break-Even Point (Sales) = ----------------------------
Composite P/V Ratio

Total Fixed Costs X Total Sales

Or =
Total Contribution
Total Contribution
Or = X 100
Total Sales

Margin of Safety
Total sales minus the sales at break-even point are known as the margin of safety. Lower break-
even point means a higher margin of safety. Margin of safety can also be expressed as a percentage
of total sales. The formula is:
 Margin of Safety = Total Sales – Sales at B.E.P.

Profit
Or =
P/V Ratio

Margin of Safety
Margin of Safety (%) = -------------------------- 100
Total Sales

Higher margin of safety shows that the business is sound and when sales substantially come down,
(but not below break even sales) profit might be earned by the business. Lower margin of safety,
as pointed out earlier, means that when sales come down slightly profit position might be affected
adversely. Thus, margin of safety can be used to test the soundness of a business. In order to
improve the margin of safety a business can increase selling prices (without affecting demand, of
course) reducing fixed or variable costs and replacing unprofitable products with profitable one.

Theory of Marginal Costing

The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA,
London is as follows:
In relation to a given volume of output, additional output can normally be obtained at less than
proportionate cost because within limits, the aggregate of certain items of cost will tend to
remain fixed and only the aggregate of the remainder will tend to rise proportionately with an
increase in output. Conversely, a decrease in the volume of output will normally be accompanied
by less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in the following two steps:

1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely,
if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of
Rs.3,000 and if by increasing the output by one unit the cost goes up to Rs.3,100, the marginal cost
of additional output will be Rs.100.

2. If an increase in output is more than one, the total increase in cost divided by the total increase in
output will give the average marginal cost per unit. It can be described as follows:
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed
and variable cost. In order to understand the marginal costing technique, it is essential to
understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost
of one more or one less unit produced besides existing level of production. In this connection, a
unit may mean a single commodity, a dozen, and a gross or any other measure of goods.
Example, if a manufacturing firm produces X unit at a cost of Rs.300 and X+1 unit at a cost of
Rs.320, the cost of an additional unit will be Rs.20 which is marginal cost. Similarly if the
 production of X-1 units comes down to Rs.280, the cost of marginal unit will be Rs.20 (300– 280).

The marginal cost varies directly with the volume of production and marginal cost per unit remains
the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable
overheads. It does not contain any element of fixed cost which is kept separate under marginal cost
technique.

Marginal costing may be defined as the technique of presenting cost data wherein variable costs
and fixed costs are shown separately for managerial decision-making. It should be clearly
understood that marginal costing is not a method of costing like process costing or job costing.
Rather it is simply a method or technique of the analysis of cost information for the guidance of
management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. In UK, marginal costing is a
popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing.
Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where
contribution is given by: Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution
goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).

In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost
(C = F). This is known as break even point.
The concept of contribution is very useful in marginal costing. It has a fixed relation with sales.
The proportion of contribution to sales is known as P/V ratio which remains the same under given
conditions of production and sales.

Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost
is charged to units of cost, while the fixed cost for the period is completely written off against the
contribution.

The term marginal cost implies the additional cost involved in producing an extra unit of output,
which can be reckoned by total variable cost assigned to one unit. It can be calculated as:

Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis of variability
into fixed cost and variable costs. In the same way, semi variable cost is separated.

Valuation of Stock: While valuing the finished goods and work in progress, only variable cost is
taken into account. However, the variable selling and distribution overheads are not included in
the valuation of inventory.

Limitations of Marginal Costing

Marginal costing has the following limitations:
 1. Difficulty in classification: In marginal costing, costs are segregated into Fixed and variable.
In actual practice, this classification scheme proves to be Superfluous in that, certain costs may
be partly fixed and partly variable and certain other costs may have no relation to volume of output
or even with the time. In short, the categorisation of costs into fixed and variable elements is a
difficult and tedious job.

2. Difficulty in Application: The marginal costing technique cannot be applied in industries where
large stocks in the form of work-in-progress (job and contracting firms) are maintained.

3. Defective Inventory Valuation: Under marginal costing, fixed costs are not included in the
value of finished goods and work in progress. As fixed costs are also incurred, these should form
part of the cost of the product. By eliminating fixed costs from finished stock and work-in-
progress, marginal costing techniques present stocks at less than their true value. Valuing stocks
at marginal cost is objectionable because of other reasons also:
1. In case of loss by fire, full loss cannot be recovered from the insurance company.
2. Profits will be lower than that shown under absorption costing and hence may be objected to by
tax authorities.
3. Circulating assets will be understated in the balance sheet.

4. Wrong Basis for Pricing: In marginal costing, sales prices are arrived at on the basis of
contribution alone. This is an objectionable practice. For example, in the long run, the selling price
should not be fixed on the basis of contribution alone as it may result in losses or low profits. Other
important factors such as fixed costs, capital employed should also be taken into account while
fixing selling prices. Further, it is also not correct to lay more stress on selling function, as is done
in marginal costing, and relegate production function to the background.

5. Limited Scope: The utility of marginal costing is limited to short-run profit planning and
decision-making. For decisions of far-reaching importance, one is interested in special purpose
cost rather than variable cost. Important decisions on several occasions depend on non-cost
considerations also, which are thoroughly discounted in marginal costing.
In view of these limitations, marginal costing needs to be applied with necessary care and
caution. Fruitful results will emerge only when management tries to apply the technique in
combination with other useful techniques such as budgetary control and standard costing.

Make or Buy Decision

„Make or Buy Decision‟ is a problem in respect of which management has to take decision
continuously, In this context, the management has to decide whether a certain product or
component should be made in the factory itself or bought from outside suppliers.
The nature of decision regarding make or buy may be of the following types:
(a) Stopping the production of the part and buying it from the market: A business co is already
making a part or component which is used in the business. Now due to some decision has to be
taken whether this part or component should be bought from the market additional requirement
due to increase in production of main factory should be made in factory or should be bought
from the market.
 In the case of a decision like stopping the production of the part or component and buying it from
market, it is to be remembered that there would not be additional fixed cost in case and only
marginal cost is the relevant factor to be considered. If the marginal cost is less than buying
price, additional requirement of the component should be met by making rather than buying.
Similarly, if buying price is less than marginal cost, it will be advantageous to purchase it from
the market.
(b) Stopping the purchase of a component and to produce it in own factory: The second aspect of
the problem of make or buy may be that a component or part thus far being purchased from the
market should be produced or made in factory or not. In this case, normally some extra
arrangement regarding space, labour, machine etc. will be required. This may involve capital
investment too. Some special overheads may also be necessary. If the decision for making
requires the setting up of a new and separate factory, separate supervisory staff may also be
needed. All these arrangements will require additional costs. As such, the price being paid to
outsiders should be compared with additional costs which will have to be incurred in the form of
raw materials, wages, salaries of additional supervisors, interest on capital investment,
depreciation on new machine, rent of premises etc. If such additional cost are less than the
buying price, the component should be manufactured and vice-versa.

Change in Product Mix

(b). Introducing a new line or department: The problem of introducing a new product or line
involves decision in two respects- whether a new product or line should be added to the existing
production or not, and if it should be introduced, then what should be the model or design or
shape of the new product. In other words, if new product can be produced in more than one
model, which model should be introduced? The marginal cost of new product in all its possible
models should be considered. It also possible that a portion of the cost of facilities relating to the
original production may be used for the purpose of producing new product.
(c). Selecting optimum product mix: When a company is engaged in a number of lines or
produts, there may arise a problem of selecting most optimum product mix which would
maximize the earnings. This problem becomes complicated, when one of the factors happens to
be limiting or key factors. Under such a situation, profitability will be improved only by
economizing the scarce resources. As pointed out earlier, contribution per unit of key factor is
the real index of profitability under such case. Thus, while deciding a profitable mix of products,
contribution per unit of key factor should be considered.

Shut-Down Decisions
Shut-down decisions may be of two types- closure of entire business and dropping a line or
product or department.
Closure of entire business: Sometimes, a business concern may not be in a position to carry out
its trading activities in an adequate volume due to trade recession or cut throat competition. As
such, the management of such business concern may be faced with a problem of suspending the
trading activities.
Shut-down point = Net escapable fixed cost / contribution per unit
Or
Shut-down point = Avoidable expenses / contribution per unit of raw materials