CAG 202
ADVANCED COST ACCOUNTING - IV
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Msharashtra
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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
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Dr. B. R. Ambedkar University
Muaaffarpur, Bihar
Dr. Suhas Mahajan
Ex-Professor
Ness Wadia College of Commerce
Pune
Dr. V. V. Morajkar
Ex-Professor
B.Y.K. College, Nashik
Dr. Mahesh Kulkarni
Ex-Professor
B.Y.K. College, Nashik
Dr. J. F. Patil
Economist Kolhapur
Dr. Ashutosh Raravikar
Director, EDMU,
Ministry of Finance
New Delhi
Dr. A. G. Gosavi
Professor
Modern College, Shivaji Nagar, Pune
Dr. Madhuri Sunil Deshpande
Professor
Swami Ramanand Teerth Marathwada
University, Nanded
Dr. Prakash Deshmukh
Director (I/C)
School of Commerce & Management
Y.C.M.O.U., Nashik
Dr. Parag Saraf
Chartered Accountant Sangamner
Dist. AhmedNagar
Dr. S. V. Kuvalekar
Associate Professor and
Associate Dean (Training)(Finance )
Dr. Surendra Patole
Assistant Professor
School of Commerce & Management
National Institute of Bank Management ,
Y.C.M.O.U., Nashik
Pune
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Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
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Y.C.M.O.U., Nashik
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CONTENTS
Topic 1
Unit 1
Techniques of Costing
Budgets and Budgetary Control
1-12
1.0 Introduction of Costing Techniques 1.1 Unit Objectives 1.2 Budget, Budgeting and Budgetary Control
1.2.1 Meaning and definitions of Budget, Budgeting and Budgetary Control 1.2.2 Objectives of budgeting
1.2.3 Functions of budgeting 1.2.4 Advantages of budgeting 1.2.5 Disadvantages of budgeting 1.3
Summary 1.4 Key Terms 1.5 Questions 1.6 Further Reading
Unit 2
Budgets and Budgetary Control (Budgetary Control Organisation,
Types of budgets and Budgeting Process)
13-28
2.0 Introduction 2.1 Unit Objectives 2.2Budgetary control organisation 2.3 Different types of budgets 2.4
Types of functional budgets 2.5 Budgeting process 2.6 Revenue Budgets 2.7 Cash Budget 2.8 Zero Base
Budgeting (ZBB) 2.9 Difference between Traditional Budgeting and Zero Base Budgeting 2.10 Key
Terms 2.11 Summary 2.12 Questions 2.13 Further Reading
Unit 3
Budgets and Budgetary Control (Illustrations on preparation of
Budgets)
29-76
3.0 Introduction 3.1 Unit Objectives 3.2 Illustrations on preparation of budgets 3.2.1 Sales Budget 3.2.2
Production Budget 3.2.3 Production Cost Budget 3.2.4 Purchase Budget 3.2.5 Cash Budget 3.2.6 Flexible
Budget 3.3 Summary 3.4 Key Terms 3.5 Exercises 3.6 Further Reading
Unit 4
Marginal Costing
77-90
4.0 Introduction 4.1 Unit Objectives 4.2 Marginal Costing 4.2.1 Meaning and definitions of marginal cost
and marginal costing 4.2.2 Features of marginal costing 4.3 Distinction between Absorption Costing and
Marginal Costing 4.4 Importance of Marginal Costing 4.5 Meaning of various concepts used in marginal
costing 4.6 Summary 4.7 Key Terms 4.8 Questions 4.9 Further Reading
Unit 5
Marginal Costing (Important Concepts, Advantages and Limitations)
91-114
5.0 Introduction 5.1 Unit Objectives 5.2 Important concepts in Marginal costing 5.2.1 Concept of
Contribution 5.2.2 Profit Volume Ratio 5.2.3 Cost, volume and profit (CVP) Analysis 5.2.4 Concept of
key factor 5.2.5 Break-even point 5.2.6 Margin of safety 5.2.7 Break-even Analysis and break -even chart
5.3 Uses of Marginal costing 5.4 Limitations of Marginal costing 5.5 Key Terms and important formulae
5.6 Summary 5.7 Questions 5.8 Further Reading
Unit 6
Marginal Costing (Illustrations)
115-136
6.0 Introduction 6.1 Unit Objectives 6.2 Illustration on Marginal Costing 6.3 Summary 6.4 Exercises
Unit 7
Standard Costing (Introduction to Standard Costing)
137-148
7.0 Introduction 7.1 Unit Objectives 7.2 Historical Costing and its Limitations 7.3 Definition and meaning
of various concepts 7.4 Features of Standard Costing 7.5 Objectives of Standard Costing 7.6 Standard
Cost and Estimated Cost 7.7 Standard Costing and Budgetary Control 7.8 Advantages of Standard Costing
7.9 Limitations of Standard Costing 7.10 Summary 7.11 Key Terms 7.12 Questions 7.13 Further Reading
Unit 8
Standard Costing (Types of Standard and Variance Analysis)
149-174
8.0 Introduction 8.1 Unit Objectives 8.2 Pre-requisites to Standard Costing 8.3 Setting Standard 8.3.1
Types of Standards 8.3.2 Setting the Standards 8.4 Standard Material Cost 8.5 Standard Labour Cost 8.6
Standard Overheads 8.7 Problem in Setting Standard Costs 8.8 Variance Analysis 8.9 Different Types of
Variances 8.9.1 Material Variances 8.9.2 Labour Variances 8.9.3 Overhead Variances 8.9.4 Sales
Variances 8.10 Key Terms 8.11 Summary 8.12 Questions 8.13 Further Reading
Unit 9
Standard Costing (Illustrations on Computation of Variance)
175-246
9.0 Introduction 9.1 Unit Objectives 9.2 Illustration on Standard Costing 9.2.1 Material Variances 9.2.2
Labour Variances 9.2.3 Material and Labour Variances 9.2.4 Overhead Variances 9.2.5 Sales Variances
9.3 Summary 9.4 Exercises 9.5 Further Reading
Unit 10 Uniform Costing and Inter-firm Comparison
247-262
10.0 Introduction 10.1 Unit Objectives 10.2 Meaning and definition of Uniform Costing 10.3 Organisation
for Uniform Costing. 10.4 Pre-requisites for introduction of Uniform Costing 10.5 Uniform Cost Manual
10.6 Advantages of Uniform Costing 10.7 Limitations of Uniform Costing 10.8 Inter-firm comparison
10.8.1 Meaning 10.8.2 Pre-requisites for introduction 10.8.3 Advantages 10.8.4 Limitations 10.9
Summary 10.10 Key Terms 10.11 Questions 10.12 Further Reading
Unit 11 Activity Based Costing
263-290
11.0 Introduction 11.1 Unit Objectives 11.2 Activity Based Costing 11.2.1 Meaning and Definitions 11.2.2
Activity Based Costing Frame Work 11.3 Stages in Activity Based Costing 11.4 Purposes and Benefits
11.4.1 Purposes of Activity Based Costing 11.4.2 Benefits of Activity Based costing 11.5 Classification of
Activities 11.6 Traditional Costing and Activity Based Costing System 11.7 Accounting treatment in Activity
Based Costing 11.8 Cost Drivers 11.8.1 Types of Cost Driver 11.8.2 Selection of a Suitable Cost Driver
11.9 Illustrations 11.10 Summary 11.11 Key Terms 11.12 Questions 11.13 Further Reading
Unit 12
Cost Control and Cost Reduction
291-312
12.0 Introduction 12.1 Unit objectives 12.2 Cost Control 12.2.1 Steps involved in Cost Control 12.2.2
Control of Labour, Material and Overheads 12.2.3 Advantages of Cost Control 12.3 Cost Reduction 12.4
Distinction between Cost Control and Cost Reduction 12.5 Areas in which Cost Reduction Campaign or
activity can be undertaken 12.5.1 Cost Reduction techniques 12.5.2 Major problems in Cost Reduction
programme 12.6 Value Analysis 12.6.1 Procedure followed in Value Analysis 12.6.2 Benefits of Value
Analysis 12.7 Productivity 12.7.1 Meaning and definition 12.7.2 Productivity Measurement 12.7.3
Efficiency measures to improve productivity 12.7.4 Measures to improve productivity 12.8 Illustrations
12.9 Key terms 12.10 Questions & Exercises. 12.11 Further Reading
Unit 13
Target Costing
313-330
13.0 Introduction 13.1 Unit Objectives 13.2 Target Costing 13.2.1 Meaning and Concept 13.2.2 Definitions
13.2.3 Target Costing and Standard Costing 13.3 Origin of Target Costing 13.4 Features of Target Costing
13.5
Difference between Traditional Cost Management Approach and Target Costing Approach 13.6
Advantages of Target Costing 13.7 Limitations of Target Costing 13.8 Specimen Illustrations 13.9
Summary 13.10 Key Terms 13.11 Questions
INTRODUCTION
This book of self - instructional material is based on the syllabus for the
subject Advanced Cost Accounting (M.Com : CAG 202). This book is written on
the basis of the revised syllabus prescribed for the M.Com students of Yashwantrao
Chavan Maharashtra Open University, Nashik from June, 2015.
This book contents 13 Units and they deal with the techniques of costing
and some new trends such as Activity Based Costing and Target Costing. The
Book is written in simple language by the authors with the hope that the students
will be able to follow and understand the information easily. The theoratical
information about the techniques and the practical illustrations on the use of the
techniques should help the students in understanding the techniques of costing
properly. The information is supported by charts, tables and graphs at the appropriate
stages to enable the students to understand it easily. Theory questions, objective
type questions and sufficient exercises provided at the end of each Unit should
help the students to find out how far they have understood the information.
The authors will welcome any valuable suggestion from the teachers and
the students for improvement in the book.
The authors and editors are grateful for the guidance and co-operation
provided by the authorities of Yashwantrao Chavan Maharashtra Open University,
Nashik.
Editor
Authors
Topic 1
Techniques of Costing
Unit 1
Budgets and Budgetary Control
Unit 2
Budgets and Budgetary Control (Budgetary
Control Organisation, Types of budgets and
Budgeting Process)
Unit 3
Budgets and Budgetary Control (Illustrations on
preparation of Budgets)
Unit 4
Marginal Costing
Unit 5
Marginal Costing (Important Concepts,
Advantages and Limitations)
Unit 6
Marginal Costing (Illustrations)
Unit 7
Standard Costing (Introduction to Standard
Costing)
Unit 8
Standard Costing (Types of Standard and
Variance Analysis)
Unit 9
Standard Costing (Illustrations on Computation
of Variance)
Unit 10
Uniform Costing and Inter-firm Comparison
Unit 11
Activity Based Costing
Unit 12
Cost Control and Cost Reduction
Unit 13
Target Costing
Unit 1
Budgets and Budgetary Control
Budgets and Budgetary Control
Structure
1.0
Introduction of Costing Techniques
1.1
Unit Objectives
1.2
Budget, Budgeting and Budgetary Control
1.2.1
Meaning and definitions of Budget, Budgeting and Budgetary Control
1.2.2
Objectives of budgeting
1.2.3
Functions of budgeting
1.2.4
Advantages of budgeting
1.2.5
Disadvantages of budgeting
1.3
Summary
1.4
Key Terms
1.5
Questions
1.6
Further Reading
1.0
NOTES
Introduction of Costing Techniques
The costing techniques are generally considered as a basic requirement for
many of the planning, control and decision-making activities a manager has to
carry out in his work. These techniques provide useful insights and guidelines for
internal managerial tasks and purposes. For the purpose of Cost Control, costs
should be pooled into separate variable and fixed totals. Separation of variable
and fixed costs supports the use of standards, budgets and responsibility reporting
to help management in controlling costs. Management requires knowledge of cost
behaviour under various operating conditions and business decisions. The
identification and classification of costs as either fixed or variable, with semivariable expenses properly sub-divided into their fixed and variable components,
provides useful framework for the accumulation and analysis of costs and also for
taking decisions. Budgeting acts as a tool for both planning and control. Standard
Costing is also an important tool in planning, operating and controlling of a business
enterprise. On the other hand the technique of Variable Costing, also known as
Marginal Costing, provides more useful information to management for deciding
pricing policies and other important decision-making. Thus, costing techniques of
budgeting and budgetary control, standard costing and marginal costing give
significant contribution to management decision-making in different areas. In this
and subsequent Units we will consider detailed information about these three
techniques.
Advanced Cost Accounting - IV
1
Budgets and Budgetary Control
1.1
Unit Objectives
After studying the information provided in this Unit, you should be able to :-
•
Understand meanings and definitions of budget, budgeting and budgetary
control; and
•
Understand objectives, advantages and disadvantages of budgeting.
NOTES
1.2
Budget, Budgeting and Budgetary Control
1.2.1 Meaning and definitions of Budget, Budgeting and
Budgetary Control
A) Budget :
Meaning :
With growing complexity of business problems, new tools, techniques and
procedures came to be evolved to aid managers in handling these problems
effectively. Budget is one such managerial tool employed to chart future course
of action and to co-ordinate and control business operations so that financial
objectives are accomplished.
Budget is a short-term plan expressed in monetary terms, prepared and
approved prior to a defined period of time, usually showing planned income to be
generated and/or expenditure to be incurred during that period and the capital to
be employed to achieve a given objective. It is a plan containing the strategies to
be pursued during the budget and is prepared before the commencement of the
budget period.
Thus, plan is expressed mainly in financial terms, but also at times it
incorporates many non-financial quantitative measures as well.
Thus, Budget is a written statement of plan which shows the policy and
programme to be followed in future. It spells out goals laid down in advance by
the top management for the business as a whole and for different departments as
well as plan of operations. It is a statement of planned allocation of resources
expressed in financial or numerical terms.
2
Advanced Cost Accounting - IV
The term Budget refers to a statement showing the quantities and monetary
values, relating to specific period prepared in advance and indicating the future
policy to be pursued by the organisation. Precisely, it is a plan of operation expressed
in monetary terms covering a stipulated period. Policies are relatively clear
guidelines or criteria for managerial decision-making, on major or day-to-day
matters. The Budget portrays a particular course of action contemplated by the
management in carrying on the business. Generally speaking, these Budgets are
formulated on the basis of the forecasts prepared in the light of the past and the
present achievements. They are prepared to accomplish the desired objectives or
goals. They serve as tools by means of which the management is able to obtain all
the facts required for efficient management of the business.
Budgets and Budgetary Control
Definition :
i) Cecil Gillespie defines Budget as “a plan of operations, integrated and
co-ordinated, comprising all phases of business activities and summarised
to show the financial results of carrying out the plan”.
NOTES
ii) George R. Terry has defined Budget as, “an estimate of future needs
arranged according to an orderly basis, covering some or all the activities
of an enterprise for a definite period of time”.
iii) The Institute of Cost and Management Accountants, UK defines Budget
as, “a financial and/or quantitative statement, prepared and approved prior
to a defined period of time of the policy to be pursued during that period for
the purpose of attaining a given objective, it may include income, expenditure
and the employment of capital”.
B) Budgeting :
Meaning :
One of the primary objectives of management accounting is to provide
necessary information to the management for planning and control. Budgeting
acts as a tool for both planning and control. It is a formal process of financial
planning using estimated financial and accounting data.
Definition :
The National Association of Accountants USA defines Budgeting as, “the
process of planning all flows of financial resources into, within and from an entity
during some specified period”.
Budgeting is the process of designing, implementing and operating budgets.
It is the managerial process of budget planning and preparation, budgetary control
and the related procedures. Budgeting is the highest level of accounting in terms
of future which indicates a definite course of action and not merely reporting. It is
an integral part of such managerial policies as long-route planning, cash flow,
capital expenditure and project management.
Budgeting and Forecasting :
It must be remembered that budgeting is not forecasting. It is true that
budgeting does not involve some sort of forecasting particularly in the area of
sales budget. But the process is physically one of detailed analysis and planning
not merely prognosticating future results. Forecasting is a process of predicting
the future state of world in connection with those aspects of the world which are
relevant to and likely to affect on future activities. Any organised business cannot
avoid anticipating or calculating future conditions and trends for the framing of its
future policy and decision. Forecasting is concerned with probable events whereas
budgeting relates to planned events. Budgeting should be preceded by forecasting,
but forecasting may be done for purpose other than budgeting.
Advanced Cost Accounting - IV
3
Budgets and Budgetary Control
NOTES
Check Your Progress
Give Definitions and explain
meaning of the following
terms :a) Budget,
b) Budgeting, and
Thus, in forecasting an estimate of what is likely to happen, is made whereas
budgeting is the process of stating policy and programme to be followed in future.
Further, forecasting does not connote any sense of control while budgeting is a
tool of control since it represents actions which can be shaped according to will so
that it can be suited to the conditions which may or may not happen.
In sum, Budget is an operating and financial plan spelling out a target
which the management seems to attain on the basis of the forecasts made. A
Forecast denotes some degree of flexibility while a budget denotes a definite
target. The term ‘Budgeting’ refers to the process of preparing the budgets. The
purpose of Budgeting is to assess the extent of success of the management in
their planning and the actions to be launched in case of deviations. The Budget
system is both a “plan” as well as a “control” since it invariably includes in its fold
“Budgetary Control”.
c) Budgetary Control
C) Budgetary Control :
Budgetary Control is the process of laying down in monetary and
quantitative terms what exactly has to be done and how exactly it has to be done
in future and ensuring that actual results do not diverge from the planned course.
Thus, Budgetary Control is concerned with the comparison of the actuals with
the targets and reporting the results of the comparison. The budget reports form
the basis for action.
Definition :
Floyd H. Rowland and William H. Bann have defined Budgetary
Control as, “a tool of management used to plan, carry out and control the
operations of business. As a further explanation it establishes pre-determined
objectives and provides the basis for measuring performance against these
objectives”.
1.2.2 Objectives of Budgeting
The overall purpose of Budgeting is to plan different phases of business
operations, co-ordinate activities for different departments of the firm and to ensure
effective control over it. To accomplish this purpose, a Budget aims at attaining
the following objectives:
4
Advanced Cost Accounting - IV
i)
To prognosticate the firm’s future sales, promotion cost and other expenses
in order to reach desired amount of income and minimize the possibility of
business losses.
ii)
To anticipate the firm’s future financial condition and the future need for
funds to be employed in the business with a view to keeping the firm solvent.
iii)
To decide the composition of capitalisation in order to ensure availability of
funds at reasonable cost.
iv)
To indulge in planning for the future in conformity with good business
practice.
v)
To iron out seasonal fluctuations in production by developing new strategy
of “fill-in” products and thereby accomplishing one phase of economic
planning.
vi)
To ensure co-ordination among different departments in an organisation
such as production, marketing, finance and administration, through
consultation among the heads of the departments and mutual agreements
on policy.
vii)
To improve the operational efficiency of the divisions, departments and
cost centres of a plant.
viii)
To impose adequate and satisfactory norms of performances over the
various activities of the unit, to ensure that the valuable assets and resources
of the enterprise are utilized most efficiently and effectively.
ix)
To forecast operational activities as well as financial position and accordingly
acquire and allocate resources required for such operational activities.
x)
To provide a firm assurance of earning capacity of the unit on the capital
invested so as to achieve long term stability.
xi)
To eliminate wastes of all kinds to improve economy and efficiency and to
obtain the targeted income as planned.
xii)
To aid in obtaining better control over inventory, turnover as well as cash, to
ensure economical use of capital.
xiii)
To enlist the co-operation and commitment of organisational members to
the achievement of the predetermined goals of the organisation.
Budgets and Budgetary Control
NOTES
1.2.3 Functions of budgeting
An effective budgeting system is vital to the success of a business firm.
Without a fully co-ordinated budgeting system, management cannot know the
direction business is taking. Budgeting is needed in organisations to perform the
following functions indicated in the figure :i) Budget and Planning :
The first step in planning is defining a company’s broad aims and objectives.
After the broad objectives have been defined, strategies to achieve the desired
goals are formulated and tentative schedules set up. The budget is a detailed
schedule of the proposed combination of the various factors of production which
is the most profitable for the ensuing period. It is formal planning framework that
provides specific deadlines to achieve departmental objectives and contributes
towards the overall objectives of an organisation. A budget incorporates expected
performance and present managerial targets. These targets guide the business
operations and help in overcoming problem and analysing the future. Budgeting
influences strategies which tend to change if conditions or managerial objective
change such as changing product lines. Thus, budgeting influences the formulation
of all business strategies and subsequently assists business managers in executing
such strategies.
Advanced Cost Accounting - IV
5
Budgets and Budgetary Control
Planning
NOTES
Budget
is needed to
perform
the functions
Control and
Performance
Evaluation
Co-ordination
Communitcation
Fig. 1.1 : Functions of Budgeting
ii) Budget and Co-ordination :
Co-ordination is a managerial function under which all factors of production
and all departmental activities are balanced and integrated to achieve the objectives
of the organisation. Budget helps management to co-ordinate in the following
ways :
a)
The existence of a well-laid plan is the major step towards achieving coordination. Executives are forced to think of the relationships among individual
operations, and the company as a whole.
b)
Budgets help to restrain the empire building efforts of executives. Budgets
broaden individual thinking by helping to remove unconscious biases on the
part of engineers, sales and production officers.
c)
Budgets help to search out weaknesses in the organisational structure. The
formulation and administration of budgets isolate problems of communication,
of fixed responsibility and of working relationships.
iii) Budget and Communication :
Communication is an important and continuous activity of management.
Sound and effective communication process is an essential pre-requisite for the
success of any business organisation.
It is necessary in an efficient organisation that all people be informed about
the objectives, policies, programmes and performances. They should have a clear
understanding of the aims and objectives and the part that they are to play in goal
attainment. This is made possible through their participation in the budgeting process.
Budgets inform each manager of what others have agreed to do. They also inform
managers of the resources available to achieve objectives and targets.
6
Advanced Cost Accounting - IV
iv) Budget and Control and Performance Evaluation :
Budgets and Budgetary Control
Budgeting is needed in control and performance evaluation in the following
manner :
a)
When a budget is being formulated, departments analyse their plans for the
future and submit estimates as per their requirements, justifying each of
their demands by demonstrating a need.
b)
After budgets of different departments have been reviewed and approved
they become targets that set desirable limits on spending.
c)
At the end of the budget period, a comparison of actual expenditures with
budget expenditure is made as a means of judging performances and fixing
responsibility for deviations.
NOTES
Budgets are the basis of performance evaluation in an organisation as they
reflect realistic estimates of acceptable and expected performance.
1.2.4 Advantages of Budgeting
Budgeting plays an important role in the effective use of resources and
achieving overall organisational goals. It helps managements in the allocation of
responsibility and authority, and analysis of variances between budgets and actual
results so that corrective action may be taken. Budgeting has the following
advantages :
i)
Budgeting compels and motivates management to make an early and timely
study of its problems. It generates a sense of caution and care, and adequate
study among managers before decisions are made by them.
ii)
Budgeting provides a valuable means of controlling income and expenditure
of a business as it is a “plan for spending”. It regulates the spending of
money and shows up losses, waste and inefficiency emerging from
performances, thus making it possible for corrective action to be taken
promptly.
iii)
Budgeting provides a tool through which managerial policies and goals are
periodically evaluated, tested and established as guidelines for the entire
organisation.
iv)
Budgeting helps in directing capital and other resources into the most
profitable channels. It provides a means of ensuring that capital employed
is kept at a minimum level consistent with the level of activity planned and
that it is usefully employed; at the same time it ensures that maximum
output is obtained.
v)
As the budget figures are quantified, a measure of precision is injected into
the performance of various activity units. Performance evaluation becomes
more objective and rational.
vi)
Budgeting gives planning a reality and sense. It enables the enterprise to
clarify the goals and policy in operational and realistic terms.
Advanced Cost Accounting - IV
7
Budgets and Budgetary Control
NOTES
8
Advanced Cost Accounting - IV
vii)
The goal of budgeting is to minimise wastages of all kinds and make proper
and fuller utilisation of the assets and resources of the business concern so
as to achieve efficiency and profitability. Budgetary control directs enterprise
activity towards maximisation of efficiency, productivity and profitability.
viii)
Budgetary control establishes a clear linkage and balance between the inputs
such as assets, resources and time and the output in the form of production,
performance and profits.
ix)
It also forces the management to provide adequate and timely considerations
to all factors before reaching important decisions. The fact that plans and
objectives are being put down in black and white for all to see results needs
more careful consideration. The active participation of the management of
all levels in shaping the desired goals and the plans for achieving them has
definitely healthy effect on interest, enthusiasm and morale. Such personnel
factors enhance spirit de crops and productivity benefits. Furthermore, active
participation of the management in the planning function makes them aware
of the necessity of inter-department co-operation.
x)
The budget system provides an integrated picture of the firm’s operations
as a whole. It enables the manager of each division to see the relation of his
part of the enterprise to the totality of the firm. A production decision to
alter the level of work-in-progress inventories can be traced through the
entire budget system to show its effects on the firm’s overall profitability.
xi)
Through budgeting the management substitutes a rational plan for snap
decisions based upon intuition or ‘hunch’. This will certainly result in most
efficient utilisation of resources. The financial handicaps of over or under
investment in the various assets can be held to a minimum.
xii)
Budgets permit the business to plan its framing in an orderly and economical
fashion and to predict more accurately when, for how long and in what
amounts funds will be needed.
xiii)
With the help of budgeting system the management can remove the cloud
of uncertainty that exists in many enterprises among lower levels of
management relative to basic policies and objectives.
xiv)
With the help of budgeting system the top management can pinpoint efficiency
or inefficiency of different divisional and sub-divisional heads and ask for
remedial steps.
xv)
Budgeting keeps management informed in advance of conformance or lack
of conformance to predetermined plans, objectives and policies. For this
purpose, a comprehensive budgeting programme provides for comparison
of actual performance against predetermined plans and objectives. This
discrepancy in operations of the firm is detected and timely action is taken
to remedy the situation before the same goes out of hand.
xvi)
Careful forecast of cash flow makes possible the avoidance of many
difficulties and indeed serious financial embarrassment. Probable sources
of difficulty can often be skirted or completely eliminated by appropriate
adjustments in operating policies.
Budgets and Budgetary Control
xvii) Budgeting helps in eliminating all sorts of wastage in different departments.
Closer control of production costs, inventory and general administrative
expenses can be exercised.
xviii) Budget aids the management in obtaining funds from financial institution
because it will provide the latter an insight into the problems of operation,
the plans of the firm and an understanding of its financial requirements.
NOTES
1.2.5 Disadvantages of Budgeting
The foregoing discussion of advantages of budgeting should not give us an
impression that it is a foolproof managerial technique devoid of any limitations. As
a matter of fact, budgeting suffers from serious drawbacks and lack of appreciation
of these drawbacks has entailed failures of budgetary programmes in several
instances.
The main drawbacks of budgeting are as under :
i)
Lack of Absolute Accuracy :
Since budgets are projections, they are based on various assumptions and
parameters. Budget estimates are, therefore, devoid of absolute accuracy.
Nevertheless, degree of inaccuracy inherent in estimates can be reduced
with the help of modern forecasting techniques. The strength and weakness
of the budgetary programme depends, to a large measure, on the accuracy
with which the basic estimates are made. In using budget estimates it is
necessary to employ considered judgement in interpreting and using the
results.
ii)
Danger of Rigidity :
In many instances the management has mistakenly regarded budget
estimates as the rigid dictates of policy and business operations are
performed according to the original estimates. In adopting budgetary
programme management should not forget that business situations can never
be static and accordingly, budget techniques must continually be adapted to
incorporate changing conditions within the concern.
iii)
Prohibitive Cost :
The cost involved in installation as well as maintenance of the budgetary
system becomes too heavy and only large sized concerns can afford to
install if for reaping the benefits. Small concerns can ill afford to install such
a system, as there should be some correlation between the cost of the
system and the benefits obtained from it.
iv)
Impersonal Approach :
There is an erroneous impression that the budget system alone leads to
Advanced Cost Accounting - IV
9
Budgets and Budgetary Control
NOTES
success and guarantees future profits. There is no doubt that the budgets
inject a sense of clarity, direction and purpose in the activities of the
organisation, it is highly imperative that the business activity should be
conducted with impersonal approach supplemented with proper management
and administration.
v)
Check Your Progress
i)
What is ‘budgeting’ ? What
are the objectives of
budgeting ?
ii) Explain, in brief, various
functions which
are
performed by budgeting in
a business concern.
iii) Define
the
term
‘budgeting’. Mention the
advantages
and
disadvantages of budgeting.
1.3
Advanced Cost Accounting - IV
Summary
Budgets and Budgetary Control is one of the techniques of costing used for
assisting the management in its functions of planning and control. A budget is a
‘financial and/or quantitative statement prepared and approved prior to a defined
period of time, of the policy to be pursued during that period for the purpose of
attaining a given objective, it may include income, expenditure and employment of
capital’. The process used for designing, implementing and operating budgets is
known as ‘budgeting’. Budgetary Control is the process of laying down in monetary
and quantitative terms what exactly has to be done and how exactly it has to be
done in future and to ensure that the actual results do not diverge from the planned
results. In Budgetary Control at specific stages actual results are compared with
the budgeted results and if there is difference between the two, its causes are
found out and instructions for taking corrective action are given by those who are
responsible for exercising the budgetary control. Budgeting performs the functions
of planning, co-ordinating, communicating and evaluating the performance.
1.4
10
Mere preparation of budget does not suffice the purpose unless the
management at all levels feel the responsibility for achieving the departmental
goals laid down in the budget. A continuous budget consciousness is
necessary if benefits of budgeting are to be reaped. The management must
have hold on budgeting and therefore, different levels of management must
participate in the programme.
Key Terms
i)
Budget : Budget is a financial and/or a quantitative statement, prepared
and approved prior to a defined period of time, of the policy to be pursued
during that period for the purpose of attaining a given objective.
ii)
Budgeting : It is the process of planning, designing, implementing and
operating budgets.
iii)
Budgetary Control : Budgetary Control is a tool for management used to
plan, carry out and control the operations of business. Actual results are
compared with budgeted objectives and variations between the two is noted
and action is taken to eliminate or minimise the variations.
1.5
Questions
Budgets and Budgetary Control
I - Theory Questions :
(1)
Define the term budget, budgeting and budgetary control. Briefly state the
meaning you understand from these three terms.
(2)
Define the term ‘budgeting’. Explain the objectives of budgeting.
(3)
Explain the functions performed by budgeting in a business enterprise.
(4)
What is meant by budgeting ? Briefly explain the advantages and
disadvantages of budgeting.
(5)
Explain the importance of budgets and budgetary control as a technique of
costing.
NOTES
II - Multiple Choice Questions :
(1)
Which of the following statement is ‘wrong’ ?
(a) budgeting is not forecasting.
(b) budgeting relates to planned events.
(c) budgeting is the process of operating budgets.
(d) budgeting is not an integral part of managerial policies.
(2)
A forecast denotes some degree of ----------- while a budget denotes a
definite target.
(a) accountability
(b) adaptability
(c) authority
(d) flexibility
(3)
Match the pairs.
Group I
Group II
(a) Budget
(i)
performance of accuracy.
(b) Budgetary control
(ii)
predicting the future.
(c) Budgeting
(iii)
process of operating budgets.
(d) forecasting
(iv) comparison of actual with targets.
(v)
Control business operations.
Ans : (a) - (v), (b) - (iv), (c) - (iii), (d) - (ii).
Advanced Cost Accounting - IV
11
Budgets and Budgetary Control
(4)
Budget is written statement of ----------- which shows the policy and
programme to be followed in future.
(a) plan
(b) income
(c) expenditure
(d) forecasting.
Ans. : (1 - d), (2 - d), (4 - a).
12
Advanced Cost Accounting - IV
Unit 2
Budgets and Budgetary Control
(Budgetary Control Organisation,
Types of Budgets and Budgeting
Process)
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
Structure
2.0
Introduction
2.1
Unit Objectives
2.2
Budgetary control organisation
2.3
Different types of budgets
2.4
Types of functional budgets
2.5
Budgeting process
2.6
Revenue Budgets
2.7
Cash Budget
2.8
Zero Base Budgeting (ZBB)
2.9
Difference between Traditional Budgeting and Zero Base Budgeting
2.10 Key Terms
2.11 Summary
2.12 Questions
2.13 Further Reading
2.0
Introduction
In order to use the technique of budgets and budgetary control it becomes
necessary to establish a budgetary control organisation which takes up the
responsibility of deciding the types of budgets which are necessary for the business
enterprise, decides the period for which the budgets should be prepared, gets the
budgets prepared and approves them and keeps control an implementation of the
budgets so that the actual results will be same as the budgeted results or as near
to the budgeted results as possible. Information about the budgetary control
orgonisation and about the various types of budgets is provided in this Unit.
Advanced Cost Accounting - IV
13
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
2.1
Unit Objectives
After studying the information given in this Unit, you should be able to :•
Know the budgetary control organisation ;
•
Know how different types of budgets are classified;
•
Understand the budgeting process;
•
Understand the details to be considered and used in each type of budget;
and
•
Know Zero Base Budging and how it differs from traditional budgeting.
2.2
Budgetary Control Organisation
Budgets provide relevant control information to the management for the
future decisions and actions. With the budgetary system in existence control of
performance and evaluation of results become more purposeful and goal-oriented.
The budgetary system should be organised for maximising the benefits of such a
system. A budget centre is invariably located without the framework of the
organisation. Budget center must be clearly demarketed to facilitate the formation
of various budgets with the help of the heads of the departments concerned. A
‘chart of accounts’ in conformity with budget centres should be so maintained as
to facilitate recording and analysis of information required for the operation of the
‘feed back’ for the management. An organisation chart highlighting the functional
responsibilities of each member of the management team helps a member to
know his position in the organisational hierarchy vis-a-vis his relationship to other
members. Each official in the organisation knows precisely whom he should obey
and whom he can command in the day-to-day administration. A specimen of the
organisation chart is given below :
14
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
Budgetary Control : Organisation Chart
Mangaging Director
Budget Committee
NOTES
Budget Officer
Production
Manager
Sales
Manager
Production
(Production Budget
Plant and Equipment
Budget, Repairs and
Maintenance Budget)
Advertising
(Advertising
Budget, Sales
Budget)
Sales
Purchase
Officer
Secretary
Staff
Welfate
Personnel
(Labour
Budget)
Research
Purchase
(Purchase Budget
Materials Budget)
Staff
Manager
Stores and
Stocks
Shipping and
Transport
Manager
Transport,
Deliveries,
Packing
(Transport
Budget)
Accounts Finance
(Administratiion,
Expenses Budget,
Finance Budget)
Statistics
Fig. 2.1 : Organisational Chart of Budgetary Control
2.3
Different Types of Budgets
There may be different types of budgets depending upon the various bases
adopted by a firm. Four principal bases adopted generally by organisations are :
(A) Classification According to Time :
Based on time factor budgets can be classified into three types, such as longterms budgets, short-term budgets and current budgets.
i) Long-term Budgets :
These budgets are related to planning the operations of an organisation for
a period of 5 to 10 years. They are usually expressed in physical quantities.
Advanced Cost Accounting - IV
15
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
ii) Short-term Budgets :
These budgets are drawn usually for a period of one or two years. They
are usually quantified and expressed in monetary terms.
iii) Current Budgets :
NOTES
These budgets cover a period of one month or more and the short term
budgets are modified according to current conditions or prevailing situations.
(B) Coverage :
According to this basis, budgets can be categorized in terms of various activities
in the organisation . Budgets prepared for individual activities are called ‘Functional
Budgets’ All these activities have to be consolidated to know their total effect on
the organisation. A consolidated statement based on the functional budgets is termed
as ‘Master Budget’. A master budget consists of a projected income statement
(planned operating budget) and a projected balance sheet (financial budget) showing
the organisation’s objectives and proposed ways of achieving them.
(C) Classification According to Flexibility :
Budgets based on flexibility can be divided into fixed budgets and flexible budgets.
i) Fixed Budget :
This sets the targets in rigid terms. These budgets which are also known as
static budgets, are usually prepared for one year period, in advance. The fixed
budgets can be revised in the light of the changing circumstances. But the rigidity
and control over costs and expenses would be lost in such cases. These static
budgets are prepared where sales can be accurately forecast such that costs and
expenses in relation to the budgeted sales can be accurately determined.
ii) Flexible Budgets :
This budget is resorted to by all business concerns where sales forecasts
for the future could not be effected with certainty. The figures range from the
lowest to the highest possible percentage of operating activity in relation to the
standard operating performance. But the figures are adaptable to any given set of
operating conditions.
(D) Nature of Activity :
Business activity involves two processes, viz. creation of the infrastructure
for doing the business; and actually carrying out of the operations. Therefore,
planning is done for both kinds of activities. Depending on the nature of the activities,
budgets can, therefore, be grouped into capital and Revenue Budgets
‘Capital Budget’ is a statement of estimated receipts and expenditure to
be incurred on creation of manufacturing facilities, repair facilities etc.
16
Advanced Cost Accounting - IV
‘Revenue Budget’ involves the formulation of targets and the allied process
in respect of routine functions, viz. sales, production, finance and other allied
activities.
2.4
Types of Functional Budgets
When budgets are classified on the basis of functions they are called
functional budgets. They correspond and remain co-terminous with a particular
function of the business. They are integrated with master budget of the business.
The number of the functional budgets depends on the size and the nature of the
business concern. The functional budgets which are commonly found in a business
concern are as follows :
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
a) Sales Budget :
This represents the forecast of the total sales classified according to types
of products, salesmen and the geographic locations. The sales budget holds the
key for the success of all other budgets and hence, great care and caution are
taken at the time of formulation of this budget ensuring accuracy in the estimated
figures.
b) Selling and Distribution Cost Budget :
It relates to estimates of cost of selling and distribution of goods. This is
prepared on the basis of past experience taking into consideration a variety of a
factors such as future trends, economic conditions and competition.
(c) Production Budget :
This represents a forecast based on sales and production capacity. When
the budget is expressed in terms of physical quantity, it is called production budget.
But when the same is expressed in financial terms covering direct materials, direct
labour and expenses - fixed, variable and semi-variable - it becomes production
cost budget. This enables the management to minimise the cost of production and
maximise the output. This also forms the most important part of the budgetary
control system.
(i)
Materials Cost Budget shows expected cost of materials required for
budgeted production and sales purpose. Determination of material cost involves
quantities to be used and the rate per unit. The task of determining the quantities
required is that of the Production engineering department while the purchase
department has the responsibility of deciding the rate.
(ii) Labour Cost Budget prognosticates the direct labour cost expected to be
spent on carrying into effect the targeted production. Preparation of this budget
requires information regarding the time required to do one unit of work and the
wages to be paid for it.
(iii) Overhead Budget is a statement of expected overheads (comprising fixed
and variable overheads) which the firm will have to incur during the budget period.
This budget is prepared on the basis of the centres of overhead forecasts of all the
departments of the firm.
Once material cost budget, labour cost budget and overhead budget are
under preparation, a full production cost budget can be drawn. This budget is
generally presented in the form of a Cost Sheet.
Advanced Cost Accounting - IV
17
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
(d)
Materials Budget :
This is a by-product of Production Budget. This is expressed in terms of
physical quantities and values of materials to be issued from the stores for production
purpose. This budget ensures that right materials of right quantity and quality are
procured.
(e)
Labour Budget :
This represents the utilisation of labour force employed in productive activity.
The standard time required for production by employees of various skills is fairly
estimated.
(f)
Cash Budget :
This represents the sum total of the requirements of cash in respect of
various functional budgets and of estimated cash receipts for a stipulated period.
(g)
Research Budget :
This includes the salaries of the research assistants and technical expenses
of the research department. This concerns improvement in the quality of the
products or introduction of new products.
(h)
Plant Utilisation Budget :
This includes the plant and machinery requirements to meet the budgetary
production within the stipulated period. Various schedules are prepared indicating
the available load in each department expressed in standard hours or units.
(i)
Administrative Expenses Budget :
This comprises the salaries and expenses of the administrative office and
management for the stipulated period. All administrative expenses such as staff
salaries including that of directors and managing director and expenses of office
management like rents, insurance, lighting, etc. are all included in this budget.
(j)
Capital Budget :
This represents forecast of the total financial outlay on acquisition of fixed
assets such as plant and machinery, building and furniture and fixtures as also of
different sources of capital required. The budget period, contemplated in this
case which differs from that of other budgets, is a fairly long period.
(k)
Master Budget :
The final integration of all functional budgets by the accountant provides
the master budget. This reflects the estimated profit and loss account, for the
future period and balance sheet at the end thereof. Summarized figures are indicated
for each item in the budget. This portrays the overall plan for the budget period.
This highlights information relating to sales, production, direct and indirect cost,
profits and appropriation of profits.
18
Advanced Cost Accounting - IV
2.5
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
Budgeting Process
The Budgeting Process usually begins when managers receive top
management’s economic forecasts and marketing project objectives for the coming
year, alongwith a time-table stating when budgets must be completed. The forecasts
and objectives provided by top management represent guidelines within which
departmental budgets are prepered.
Once separate budgets for sales, production, finance and other activities have
been prepared and finalized and the targeted sales, cost of sales, expenses are
determined, the targeted profit and loss account and balance sheets are drawn.
These statements together are known as Master Budget.
The Budgeting Process is indicated in the following figure :
Check Your Progress
i)
What is the organisation
created for using Budgetary
Control ?
ii) What are the types of
budgets?
iii) Give a list of budgets
included under Functional
Budgets.
SELLING AND
DISTRIBUTION
COST BUDGET
SALES BUDGET
PRODUCTION BUDGET
ADMINISTRATION
OVERHEADS
COST
COST BUDGET
PRODUCTION
MATERIAL
COST
LABOUR
COST
RESEARCH AND
DEVELOPMENT
BUDGET
OVERHEAD
COST
CAPITAL
EXPENDITURE
BUDGET
CASH
MASTER BUDGET
BUDGET
BUDGETED PROFIT
AND LOSS ACCOUNT
BUDGETED
BALANCE SHEET
Fig. 2.2 : Budgeting Framework
Advanced Cost Accounting - IV
19
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
2.6 Revenue Budgets :
The components of Revenue Budgets are shown in following figure :
Revenue Budgets
NOTES
Principal
Secondary or
Summary
Budget
Subsidiary Budget
Budgets
Earnings
Expenses
Working
Expenses
or
Budget
Capital
Behaviour
Budget
Budget
Budget
Analysis
(activity
(over all)
Income
P&L
wise)
Budget
Turnover
& Gross
Margins
Budget
Demand
Manpower
Analysis
Planning
or
& Personnel
Forecast
Budget
Other
Income
Budget
Distribution
Expenses
Budget
2
Direct
Selling
Expenses
Budget
1
2
+
+
Total
Marketing
Expenses
Budget
1
4
a
c
+
b
+
Semi-variable
Expenses
b
20
Advanced Cost Accounting - IV
Other
Marketing
Services
Budget
4
3
+
V
Ex aria
pe bl
ns e
es
a
Promotion
Expenses
Budget
3
N
o
Ex n-va
pe ria
ns bl
es e
c
Order
Booking
&
Gross
Profit
Budget
P&L
Fig. 2.3 : Components of Revenue Budgets
Principal Budgets
Principal Budget is that factor the extent of whose influence must first be
assessed in order to ensure that functional budgets are reasonably capable of
fulfilment.
(a) Revenue Earning or Income Budget :
(i)
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
Order booking and Gross Profit Budgets :
These budgets are specially applicable to industrial marketing or other such
situations where there is a distinct time lag between the booking of order and
effecting actual delivery and sales. This budget is a statistical budget and not an
accounting one.
(ii)
Turnover and Gross Margin Budgets :
This is the main revenue income budget and is in line with the financial
accounting definition of sales and gross margin. This budget has to be in conformity
with the order booking and gross margin. This Budget can be prepared productwise.
(iii)
Other Income Budgets :
This would cover income from scrap sales, commission on third party sales,
income out of after sales services beyond warranty period, commission on imports
and exports on behalf of others, recovery of bad debts, income from brand name,
non operating incomes etc.
(b) Marketing Expense Budgets :
(i)
Direct Selling Expense Budget :
This will cover direct expenses on salesmen such as salesmen’s commission,
salsmen’s stationery, salesman postage and telegram, bad debts etc.
(ii)
Distribution Expense Budgets :
This includes expenses on maintenance of sales depots and branches,
expenses on transportation of goods and expenses on outside transport and owned
transport housing expenses, licences and insurance and such other expenses related
to distribution.
(iii)
Promotional Expense Budget :
This covers all expenses connected with advertisement and sales promotion
including media advertisement, payments to advertising agencies and commerce.
However company’s prestige or image advertisement expenses should not be
included in this budget.
(iv)
Other Marketing Service Budgets :
These include all expenses relating to marketing director’s office, market
planning activities, marketing research and such other general marketing services.
This also includes budget for special sales (i.e. new areas being tapped, new lines
being introduced, special advertising campaign etc.)
Advanced Cost Accounting - IV
21
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
(v) Total Marketing Expenses Budget : This budget can be further classified
on the basis of cost behaviour approach viz. fixed, semi-fixed and variable costs.
This budget will includes all marketing expenses which are mentioned above (i.e.
i+ii +iii +iv as above ).
Secondary Budgets :
There are various types of subsidiary budgets intended to provide supporting
data and analysis is with regard to the framing of the principal budgets mentioned
above, including the various expenses budgets. Following are the examples of
various types of subsidiary budgets :
(a)
Working Capital Budget :
Initial working capital budget is prepared to show the expected fund during
the “take of” period or gestation period. This in turn helps in the determination of
interest cost to be included in the expense budget and also the budgeted “Return
on Investment” in the marketing operations.
(b)
Personnel Budget :
Personnel budget is prepared with reference to production budget. If wages
are paid according to piece rate systems in all the departments preparation of
personnel budget is comparatively easy, when payment are made according to
time rate or piece rate, cum time rate production in terms of ordinary units should
be converted into standard hours of production in different departments. In other
cases, requirements for skilled and unskilled labour time shall be budgeted. This
budget depends on the decisions taken by the management. While taking such
decisions the management attempts to meet simultaneously the goals of the
organisation and the needs and value of their employees.
(c)
Expense Behavioural Analysis :
This requires isolation of fixed, semi-fixed and variable expenses of marketing
operations. The expenses are grouped as : Variable, Semi-variable and Fixed. The
first is directly related with production, the second is partly related and third is
unrelated with level of activity. Apart from variability with production, likely change
in rate of expenses should be considered. If expenses for each department are to
be shown separately, expenses are to be departmentalised in the light of allocation
of factory over-heads. An analysis of expenses in this manner facilitates precise
estimates of various heads of expenses covered under expense budgets. It would
be obvious that expense behaviour analysis made and used at the time of preparing
budget not only puts the budget estimation on a sounder footing, but also helps in
reviewing the various budget estimates. It also forms a systematic basis for
subsequent comparison between budgeted expenses and actual expenses for the
purpose of effective control. As the main purpose of budgeting is control of
expenses by pin pointing responsibility, no useful purpose is served by allocating
expenses incurred under one responsibility over various departments which are
no control on them.
22
Advanced Cost Accounting - IV
(d)
Sales Forecasting or Demand Analysis :
Sales forecast may be made in different ways. Best result is achieved
when there is arrangement of ‘Market Research’. Market Research may be
conducted continuously by marketing research department or may be taken up
periodically with the help of specialized consultancy firms, when such services
are available. Whatever be the system followed, nature of the demand i.e. whether
local and restricted, whether it is within a state or national or international in
character, must be determined. The pattern of demand for different products, and
how it is affected by the substitutes, should be considered. In this connection how
price, design, quality and packing influence, consumer preference should be studied
in the context of price and of the products of the competitors. The type of customers
(i.e. whether one industry or group of industries, or whether public at large, or
particular sections of the public or any part of community etc.) require serious
study. The trend and seasonal influences in sales should be brought to light by
mathematical, statistical or other techniques. In short this analysis establish a
systematic basis for budgeting order bookings as well as turnover in respect of
scientific products or services.
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
Summary Budgets :
We have seen how each revenue budget is prepared. After budgeting all
business functions, the owner is obviously eager to know the summarised result of
these revenue budgets. This result may be net business profit or net business loss.
So all the revenue budgets along with the development and finance budgets have
to integrated and summary budget are to be prepared. These are actually
summerised profit and loss or revenue statement budgets, prepared separately for
each important division or activity group, and also for the orgonisation’s total
operations.
In short with the help of the above revenue budgets a summary budget is
prepared. A summary budget is a budget which is prepared from, and summarised,
all the functional budgets. The end products of Summary Budgets are :
(a)
The Budgeted Profit and Loss Account :
Summarising the budgeted income from the sales budget and the budgeted
costs from other functional budgets, a budgeted profit and loss account is
built up.
(b)
The Budgeted Balance-Sheet :
The summary budgets thus prepared are reviewed, re-adjusted and rebudgeted in order to get the maximum benefit from budgetary control. It
will be observed that once a summary is approved, it ceases to be merely a
plan, it becomes the target for the concern during the budget period to be
achieved by executive directions.
Advanced Cost Accounting - IV
23
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
2.7
Cash Budget
Cash Budget is the forecast of cash position for a particular period. Cash
Budget is prepared after all the functional budgets are prepared. Cash Budget is
important because unless there is liquid cash, the budgeted profit has no meaning.
Cash Budget is prepared either weekly or monthly.
Necessity of Cash Budget :
The necessity of preparing Cash Budget is as follows :
i)
To get the working capital easily from the banks and for smooth running of
the business.
ii)
To enable the top management to make necessary arrangements of cash in
case of emergency.
iii)
To invest excess cash.
iv)
To know the exact amount of cash required for the business.
Cash Budgeting helps the companies to plan for dividend and interest
payments. It also helps in ascertaining the cash requirements for future years.
When a company requires more long-term capital, cash budget helps in planning
for such long-term capital requirements. The management comes to know which
type of capital is required to be raised e.g. equity capital, or fixed deposits from
the public or loans from Banks and financial institutions. If there is no cash budgeting,
the management will have to run for finance and borrow from sources which are
more expensive.
2.8
Zero Base Budgeting (ZBB)
Zero Base Budgeting (ZBB) is a method of budgeting whereby all activities
are revaluated each time a budget is formulated and every item of expenditure in
the budget is fully justified. That is, ZBB involves starting from scratch or zero.
In Traditional Budgeting, departmental managers need justify only increases
over the prior year’s budget i.e. Incremental Budgeting. This implies that what is
already being spent is automatically sanctioned. Under the ZBB concept each
department’s functions are reviewed completely and all expenditures, rather than
only the increases, must be approved. Also, in some departments ascertainment
of budgeted costs is easier than the other departments. For example, in production
departments it is easier to determine costs of inputes to achieve a level of budgeted
output. But, in other departments such as accounts, personnel, research and
development, it is difficult to even identify the output, and therefore equally greater
difficult to determine the cost of input to sustain (unidentifiable) output.
Consequently, the budgets of previous year tend to be subjectively increased as
the next year’s budgeted expenditure. However, the previous year’s budgets be
inefficient and adjusting merely next year’s budgets to the previous year’s budget
24
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
may result in wastages. ZBB overcomes this problem, to a certain extend. ZBB
rejects the traditional view of annual budgeting as an incremental process which
takes into account current expenditure plus and estimate of next year’s expenditure
to arrive at the next budget. Instead, the projected expenditure for existing
programmes should start from base zero with each year’s budgets being compiled
as if the programmes were being launched for the first time.
NOTES
Zero Base Budgeting has been defined by Peter A. Phyrr as under, “Planning
and budgeting process which requires each manager to justify his entire budget
request in detail right from scratch. (Hence, the term zero-base) and shifts the
burden of proof to each manager to justify why he should spend any money at all.
The approach in term requires an in-depth analysis of all decision packages to be
evaluated on systematic and rational lines and also ranked in order of importance.
Zero Base Budgeting (ZBB) as a system of Budgeting was used by the US
Department of Agriculture for the year 1964. It was developed in its present form
by Peter A. Phyrr at the Taxes Instrument, USA. The Zero Base Budgeting
concept has been successfully implemented in a large number of U.S. organisations
including such giants as Taxes Instruments, Southern California, Edision, Xerox
and New York, Telephone Company .
Check Your Progress
i)
What is Cash Budget ?
ii) What do you understand
from the following terms :
a) Master Budget
b) Personnel Budget
c) Zero-base Budgeting
(ZBB)
Some departments of Government of India have recently introduced ZBB
with a view to making the system of budgetory control more effective.
2.9
Difference between Traditional Budgeting and
Zero-Base Budgeting
Basic difference between the Traditional or Incremental Budgeting and the
Zero-Base Budgeting may be realized from the following :
i)
A Traditional Budget is function-oriented but a Zero-Base Budget is
programme or project- oriented.
ii)
In case of Traditional Budgeting, the existing programmes or projects are
self-perpetuating for which no re-justification is required. Justification is
needed only for new programmes or projects. Zero-Base Budgeting
presenting that all programmes for projects whether on-going or new, must
be justified on the ground that they all compete for the same scarce
resources.
iii)
Traditional Budgeting views critically only the cost increases whereas the
Zero-Base Budgeting critically examines existing levels of expenditure, as
the level of expenditure approved for the last budget is not necessarily
acceptable for the current budget.
iv)
Traditional Budgeting is input-oriented i.e. resources required; Zero-Base
Budgeting is output- oriented i.e. results achieved.
Thus, the Traditional Budgeting techniques may be quite meaningless in the
present context when management must review to better utilisation of scarce
resources or to improve performance.
Advanced Cost Accounting - IV
25
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
2.10 Key Terms
(a) Fixed Budget : A fixed budget is a budget designed to remain unchanged
irrespective of the level of activity actually attained.
(b) Flexible Budget : A Flexible budget is a budget which, by recognising the
difference between fixed, semi-variable and variable costs is designed in relation
to the level of activity attained.
(c) Functional Budgets : Budgets which relate to the individual functions in an
organisation are known as Functional Budgets. For example, purchase budget,
sales budget, production budget, cash budget etc.
(d) Master Budget : It is a consolidated summary of the various functional
budgets.
(e) Long-term Budgets : The budgets which are prepared for periods longer
than a year are called long-term budgets.
(f) Short-term Budgets : Budgets which are prepared for period less than a
year are known as short-term budgets.
(g) Basic Budgets : A budget which remains unaltered over a long period of
time is called basic budget
(h) Current Budgets : A budget which is established for use over a short period
of time and is related to the current conditions is called current budget.
2.11 Summary
26
Advanced Cost Accounting - IV
In those organisations which use the technique of budgeting and budgetary
control, a budgetary control organization is required to be established. In such
organisation managing director is at the top and budget committee and budget
officer work under him. All heads of the departments are included in the budgetary
control organisation. Preparation of budgets for their departments and getting
approval for the budget is the work performed by the heads of departments.
Obtaining information regarding implementation of the budgets and keeping control
to see that budgeted objectives are realized through actual performance is the
task to be performed by the budgetary control organisation. There are different
types of budgets depending upon the basis selected for classification of budgets.
Time, coverage, flexibility and nature of activity are the four bases used for
classification of budgets. When time is used as basis for classification, there are
three types of budgets - long term, short term and current budgets. When coverage
is used as a basis, the budgets are prepared for different activities carried out and
so these budgets are called ‘Functional Budgets’. Fixed budget and flexible budget
are the two types of budgets according to flexibility as a basis for classification.
As per nature of activity as a basis for classification of budgets there are capital
budget and revenue budgets. Budgeting process is required to be followed for
budgeting. Top management provides guidelines by stating economic forecasts
and marketing project objectives and in the light of these guidelines and the time
table provided for completing the budgets, the departmental budgets are prepared
by the heads of the various departments. After considering these budgets the top
management approves them and on the basis of sales budget, production budget,
production cost budget, budgets for various expenses and cash budget budgeted
profit and loss account and budgeted balance-sheet is prepared. These statements
together are known as Master Budget. Zero Base Budgeting is different from the
traditional budgeting. In ZBB every item is revaluated and every expenditure in
the budget is fully justified whereas in traditional budgeting only increase over the
previous year’s budget is required to be justified. Zero Base Budgeting starts
from scratch or zero while traditional budgeting is ‘incremental budgeting’.
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
NOTES
2.12 Questions
1)
Explain the budgetary control organisation
2)
Which are the basis used for classification of budgets ? State the types of
budgets according to each of these basis for classification of budgets.
3)
Explain in brief the types of budgets when ‘time’ is used as a basis for
classification of budgets.
4)
What is meant by ‘functional budgets’ ? Explain any four functional budgets
5)
What is ‘fixed budget’? How a flexible budget differs from ‘fixed budget’ ?
Which of these two budgets is more useful in your opinion?
6)
Explain budgeting process followed in an organisation
7)
What is meant by Zero Base Budgeting ? What are the differences between
‘Traditional Budgeting’ and Zero Base Budgeting ?
8)
Write notes on :
a) Cash Budget.
b)
Master Budget.
c)
Basic Budget.
Multiple Choice Questions
(1)
A consolidated Statement based on the functional budgets is termed as -------(a) Master Budget
(b) Short-term Budget
(c) Long-term Budget
(d) Cash Budget
Advanced Cost Accounting - IV
27
Budgets and Budgetary Control
(Budgetary Contol Organisation,
Types of Budgets & Budgeting
Process)
(2)
Match the pairs.
A Group (Classification)
NOTES
‘B’ Group (Type)
(a) Time
(i) Budgetary Control
(b) Flexibility
(ii) Capital Budget
(c) Coverage
(iii) Functional Budget
(d) Nature of Activity
(iv) Fixed Budget
(v) Short-term Budget
Ans. : (a) - (v), (b) - (iv), (c) - (iii), (d) - (ii).
(3)
Which of the following statement is ‘wrong’.
(a) Sales budget is a Functional Budget.
(b) Production budget is a Functional Budget.
(c) Selling and Distribution Cost Budget is a Functional Budget.
(d) Flexible Budget is a Functional Budget.
(4)
Which of the following is a right statement
(a) Capital budget is a type of flexible budget.
(b) Revenue budget is a type of flexible budget.
(c) Current budget is a type of flexible budget.
(d) Fixed budget is a type of flexible budget.
Ans :- (1 - a), (3 - d), (4 - d)
2.13 Further Reading
28
Advanced Cost Accounting - IV
i)
‘Advanced Cost Accounting’ - Nigam and Sharma.
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad
iii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B.K. Bhar.
Unit 3
Budgets and Budgetary Control
(Illustrations on preparation of
Budgets)
NOTES
Structure
3.0
Introduction
3.1
Unit Objectives
3.2
Illustrations on preparation of budgets
3.2.1
Sales Budget
3.2.2
Production Budget
3.2.3
Production Cost Budget
3.2.4
Purchase Budget
3.2.5
Cash Budget
3.2.6
Flexible Budget
3.3
Summary
3.4
Key Terms
3.5
Exercises
3.6
Further Reading
3.0
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Introduction
In unit 2, we have studied theoretical information about various types of
budgets which are prepared in a business concern. In this unit we are going to
study how these budgets are actually prepared and how the given information is
to be used for preparation of these budgets.
3.1
Unit Objectives
After studying the illustrations provided in this Unit you should be able to :
•
Prepare Sales Budget;
•
Prepare Production Budget;
•
Prepare Production Cost Budgets;
•
Prepare Purchase Budget;
Advanced Cost Accounting - IV
29
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
•
Prepare Cash Budget; and
•
Prepare Flexible Budget.
3.2
Illustrations on preparation of Budgets
Usually Sales Budget is the basic budget for majority of business
organisations. Therefore in the illustrations provided on preparation of budgets,
illustrations on Sales Budget are provided first. Then illustrations on production
budget, production cost budgets, purchase budget, cash budget and flexible budget
are given. For all the important budgets sufficient number of illustrations are
provided.
3.2.1 Sales Budget
ILLUSTRATION 1
Titan Ltd., Talegaon has estimated the sales of three products O, P and Q.
Following are the particulars of the three products.
Product
Quantities
O
P
Q
5,000 units
10,000 units
15,000 units
Selling price per unit
1,500
2,000
2,500
Prepare a Sales Budget.
SOLUTION
In the books of Titan Ltd., Talegaon
Sales Budget for the year ended period .......
Product
Budgeted Sales
Units
Selling Price
Per unit
Value of Sales
O
5,000
1,500
75,00,000
p
10,000
2,000
2,00,00,000
Q
15,000
2,500
3,75,00,000
Total
30,000
-
6,50,00,000
ILLUSTRATION 2
United Brew Ltd., Ulhasnagar sells its products in two regions i.e. Mumbai
and Thane of the two products and X and Y The budgeted sales for the six months
ended 30th June 2012 in each of the areas i.e. Mumbai and Thane are follows:
30
Advanced Cost Accounting - IV
Mumbai
Thane
X
2,000 Units
Y
1,000 Units
X
1,500 Units
Y
1,200 Units
The actual sales for the period ended 30th June 2012 were as follows:
Mumbai
Thane
X
2,500 Units
Y
1,100 Units
X
1,600 Units
Y
1,200 Units
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
The budgeted selling price and the actual price per unit were the same
which are as below :
For
X
8 per Unit
Y
5 per Unit
From the market survey report it is found that the sales of both the products
can be increased over the budgeted units of 30th June 2012 for the next six months
ending 31-12-2012 as given below.
Mumbai
Thane
X
by 500 Units
Y
by 200 Units
X
by 100 Units
Y
by 80 Units
Prepare Sales Budget for six months for the period ended 31st December
2012. Also prepare the budgeted and actual sales for the period ended 30th June
2012.
Advanced Cost Accounting - IV
31
SOLUTION
In the books of United Brew Ltd., Ulhasnagar
Budget
31-12-2012
Budget
30-06-2012
Actual
30-06-2012
Region Product Quantity Rate Amount Quantity Rate Amount Quantity Rate Amount
Units
Mumbai
Thane
Units
Units
X
2,500
8
20,000
2,000
8
16,000
2,500
8
20,000
Y
1,200
5
6,000
1,000
5
5,000
1,100
5
5,500
Total
3,700
-
26,000
3,000
-
21,000
3,600
-
25,500
X
1,600
8
12,800
1,500
8
12,000
1,600
8
12,800
Y
1,280
5
6,400
1,200
5
6,000
1,200
5
6,000
Total
2,880
-
19,200
2,700
-
18,000
2,800
-
18,800
X
4,100
8
32,800
3,500
8
28,000
4,100
8
32,800
Y
2,480
5
12,400
2,200
5
11,000
2,300
5
11,500
Total
6,580
-
45,200
5,700
-
39,000
6,400
-
44,300
ILLUSTRATION 3
Voltas Ltd., Vashi sell two products X and Y. The following estimates are
given for the year 2012.
Sales Budgets (Units)
Particulars
1st Quarter IInd Quarter IIIrd Quarter IVth Quarter
Product X
1,00,000
1,40,000
90,000
1,20,000
Product Y
90,000
1,20,000
1,00,000
1,10,000
Product X is sold @ 100 per units, while product Y is sold @ 200 per
unit. The Company incurs selling and distribution expenses @ 3% of the sales
value. Bad debts amounts to 1% of the sales value.
You are required to prepare a Sales Budget for the year 2012.
32
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of Voltas Ltd., Vashi
Sales Budget for the year 2012
(
in thousands)
1 st
II nd
IIIrd
IVth
Quarter Quarter QuarterQuarter
Particulars
Product X
Total
NOTES
10,000
14,000
9,000
12,000
45,000
18,000
24,000
20,000
22,000
84,000
Total Sales 28,000
38,000
Product Y
(+)
29,000 34,000 1,29,000
Less : Selling and
Distribution Expenses
840
1,140
870
1,020
3,870
280
380
290
340
1,290
1,120
1,520
1,160
1,360
5,160
Net Sales 26,880
36,480
@ 3% of Sales value
Bad Debts
@ 1% of Sales value
(+)
27,840 32,640 1,23,840
ILLUSTRATION 4
Wimco Ltd., Wardha manufactures two types of cement known as ‘Black’
and ‘White’. The cement is sold in the three states of Rajastan, Harayana and
Punjab through stock dealers. From the following data relating to budget period
ended on 30th June 2012 and the adjoining information, you are required to prepare
a Sales Budget for 6 months period beginning from 1st July and ending on 31st
December 2012.
Commodity
Territories
Rajastan
Punjab
Harayana
Budgeted Actual Budgeted Actual Budgeted Actual
Black Cement
25,000
24,000
20,000
18,000
10,000
10,000
White Cement
15,000
12,000
10,000
10,000
5,000
4,500
Total
40,000
36,000 30,000 28,000
15,000 14,500
Other Informations :
i)
The construction activity is expected to go up by 10% and accordingly the
Advanced Cost Accounting - IV
33
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
demand in all states expect in Punjab, is likely to increase in the budget,
period. The Sales Department visualises a decrease in sales by 5% in Punjab.
ii)
The company has decided to appoint few more dealers in Rajasthan and it
forecasts an additional sales of 5,000 bags of black cement through the
new dealers.
iii)
With a vigorous advertisement campaign, the demand in Harayana for
both Black and White cement is likely to increase by 20% in addition to the
10% as pointed out above.
iv)
The company expects to make direct supplies to local bodies in the States
of Rajasthan and Harayana. It hopes to sell 2,000 bags of black cement in
each of these states.
v)
Adequate production facilities exist and there is no limiting factors.
vi)
The selling price per bag is estimated as
cement respectively.
NOTES
60 and 100 for black and white
SOLUTION
In the books of Wimco Ltd., Wardha
Sales Budget for the six months ended 31-12-2012
Territories
For 1th Jan. to 30th June 2012
Black Cement
34
White Cement
Budgeted
Actuals
(Bags)
(Bags)
(Bags)
Rajasthan
25,000
24,000
Punjab
20,000
Harayana
Total
For 1th July to 31st Dec. 2012
Black
White
Black
White
(Bags)
(Bags)
(Bags)
( )
( )
15,000
12,000
33,400
13,200
20,04,000
13,20,000
18,000
10,000
10,000
17,100
9,500
10,26,000
9,50,000
10,000
10,000
5,000
4,500
15,000
5,850
9,00,000
5,85,000
55,000
52,000
30,000
Advanced Cost Accounting - IV
Budgeted Actuals
26,500 65,500
28,550 39,30,000 28,55,000
Statement of Sales Forecast (Bags)
Rajastan
Punjab
Harayana
Particulars
Black
White
Black
White
Black
White
Present sale
24,000
12,000
18,000
10,000
10,000
4,500
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
Increase due to
construction activity
(10% of existing)
(+) 2,400 (+)1,200
-
-
(+)1,000 (+) 450
Estimated decrease
for punjab (5%)
-
-
(-)900
(-)500
-
-
(+)5,000
-
-
-
-
-
-
-
-
-
(+)2,000 (+)900
(+)2,000
-
-
-
(+)2,000
-
33,400
13,200
17,100
9,500
15,000
5,850
Additional Sale by
new dealers
Increase due to
massive advertising
campaign (20%of
existing)
Direct supplies
Total
ILLUSTRATION 5
Yashwant Traders, Yeowatmal sells two products viz. Bee and Dee. The
following are the estimates regarding sales during 2012.
Particulars
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
Total
Units
Units
Units
Units
Units
Product-Bee
9,000
23,000
30,000
8,000
70,000
Product-Dee
8,500
7,500
5,500
8,500
30,000
Both the products are sold on seasnol basis. Product Bee tends to sell
better in summer while Product-Dee sells better in winter. Product-Bee is sold @
10 per unit whereas Product-Dee @ 20 per unit. Past experiences reveal that
the firm is unable to realise 1% of their total sales value and spends 2% of it for
carriage and 3% of it for advertising purposes. Prepare a Sales Budget for the
year 2012 incorporating the above mentioned information.
Advanced Cost Accounting - IV
35
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of Yashwant Traders, Yeowatmal
Sales Budget for the year 2012
Particulars
First Quarter Second Quarter Third Quater Fourth Quarter Total
Actual Sales :
i) Product Bee
@
2,30,000
3,00,000
80,000
7,00,000
1,70,000
1,50,000
1,10,000
1,70,000
6,00,000
2,60,000
3,80,000
4,10,000
2,50,000
13,00,000
2,600
3,800
4,100
2,500
13,000
5,200
7,600
8,200
5,000
26,000
7,800
11,400
12,300
7,500
39,000
10 per unit
ii) Product Dee@
90,000
20 per unit
(+)
 Total Sales Value
(A)
Less : Selling and Distribution Expenses
i) Bad Debts @ 1% of Total Sales Value
ii) Carriage Outward @ 2 % of Total Sales value
iii) Advertisement
@ 3% of Total Sales Value
 Total Expenses
(B)
15,600
22,800
24,600
15,000
78,000
 Total Sales (A-B)
(C)
2,44,000
3,57,000
3,85,400
2,35,000
12,22,000
3.2.2 Production Budget
This Budget is prepared after the sales budget because the sales to be
made are estimated in the sales budget so that how much quantity should be
produced can be known. Thus, a production budget is one which is an estimate for
the quantities of goods to be purchased during the budget period. It is expressed
either in units or standard hours. The following factors should be taken into
consideration while preparing the production budget.
i)
Forecast of sales
ii) Requirement of stock to be maintained
iii) Plant capacity
iv) Spares and components to be purchased
v) Make or buy decision
vi) Production cycle
vii) Production policy of management
36
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Production budget can be drawn in the following way :
Products
Particulars
Unit A
Sales
Add : Closing Stock
Less : Opening stock
(+)
(-)
Production
Unit B
.....
.....
.....
.....
.....
.....
.....
.....
.....
.....
NOTES
An analysis of the above factors will suggest the amount of goods that can
be produced within the factory. If the calculated production is less than the budgeted
sales, then the firm will not be in a position to maintain the sales budget and earn
sufficient profits for which potential exists. In such a situation, the firm should
explore the following possibilities before taking a final decision on production budget.
Can the inventory level be reduced ? Can the plant utilization capacity be
increased or additional plant installed to fill the gap ?
ILLUSTRATION 1
OCL India Co. Ltd., Osmanabad had budgeted sales as under :
Months in 2012-13
Black Cement
White Cement
July
5,000
2,000
August
10,000
4,000
September
12,000
5,000
Octomber
15,000
6,000
November
13,500
5,000
December
10,000
6,550
January
12,000
5,000
77,500
33,500
The company maintains inventory equal to half of the sales for next month
and there is no work-in-progress at the end of any month.
Prepare the Production Budget for the half year ending on 31-12-2012.
Advanced Cost Accounting - IV
37
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of OCL India Co. Ltd., Osmanabad
Production Budget for the half year ending 31-12-2012
Product Y
July
August
Sept.
Oct.
Nov.
Dec.
5,000
10,000
12,000
15,000
13,500
10,000
5,000
6,000
7,500
6,750
5,000
6,000
10,000
16,000
19,500
21,750
18,500
16,000
2,500
5,000
6,000
7,500
6,750
5,000
7,500
11,000
13,500
14,250
11,750
11,000
2,000
4,000
5,000
6,000
5,000
6,550
2,000
2,500
3,000
2,500
3,275
2,500
4,000
6,500
8,000
8,500
8,275
9,050
1,000
1,000
2,500
3,000
2,500
3,275
3,000
5,500
5,500
5,500
5,775
5,775
Black Cement
Budgeted Sales
Add : Closing Inventories
(50% of next month)
(+)
Less : Opening Inventories
(-)
Budgeted Production
White Cement
Budgeted Sales
Add : Closing Inventory
(+)
(50% of next month)
Less : Opening Invventory
(-)
Budgeted Production
ILLUSTRATION 2
Padmini Ltd., Pandharpur estimates its sales quarterwise as under :
1st Quarter
IInd Quarter IIIrd Quarter IVth Quarter Vth Quarter
(Units)
(Units)
(Units)
(Units)
(Units)
1,00,000
1,20,000
1,32,000
1,44,000
1,68,000
The Opening Stock of the 1st quarter was 20,000 unit. The company has
decided to keep Closing Stock equal to 1/12th of the sales of the next quarter.
Show what should be the production in each quarter for the current year.
SOLUTION
38
Advanced Cost Accounting - IV
i)
Note that there are four quarters in a year. The Vth quarter is shown of the
next year for calculation of the Closing Stock. Hence, in the Production
Cost Budget only 4 quarters should be taken.
ii)
The Closing Stock of each quarter becomes the Opening Stock of the next
quarter.
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
In the books of Padmini Ltd., Pandharpur
Production Budget (Units) for the quarter ended..........
Particulars
Sales
Add : Closing Stock
(+)
Less : Opening Stock
(-)
 Estimated Production
1 st
II nd
IIIrd
IVth
Units
Units
Units
Units
1,00,000
1,20,000
1,32,000
1,44,000
10,000
11,000
12,000
14,000
1,10,000
1,31,000
1,44,000
1,58,000
20,000
10,000
11,000
12,000
90,000
1,21,000
1,33,000
1,46,000
NOTES
3.2.3 Production Cost Budget
This budget is prepared after the Production Budget. This budget shows
the details of the estimated costs which are required to be incurred as per the
quantities shown in the production budget. The details include materials cost, labour
cost, and overheads. The overheads again include variable, semi-variable and
fixed costs. The costs are classified and analysed according to the products or
departments.
The production cost budget depends upon :
i) Production Budget ii) Estimated increase in wages, salaries and expenses
iii) Estimated increase/ decrease in the price of raw materials and other supplies.
Proforma of the Production Cost Budget :
Production Cost Budget
Particulars
Periods
Department Total
Units to be produced as per production budget
Costs :
i)
Direct Material
.....
.....
ii)
Direct Labour
.....
.....
iii)
Direct expenses
.....
......
iv)
Factory Overheads
.....
......
.....
.....
.....
.....
.....
.....
.....
.....
• Variable
• Semi-Variable
• Fixed

Total
v)
Production Cost
(+)
.....
Advanced Cost Accounting - IV
39
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ILLUSTRATION 1
Rajdoot Co. Ltd., gives the following production costs.
Particulars
NOTES
Direct Material Cost
1,50,000
Direct Labour Cost
80,000
Factory Overheads :
Variable
Fixed
50,000
(+) 25,000
75,000
The estimates made by the Production Manager for the next year about the
various changes are as below :
a)
Production will rise by 10%.
b)
There will be decrease in labour cost by 2% due to the more efficiency of
the labourers.
c)
Direct material price will increase by 5%.
Draw a Production Cost Budget.
SOLUTION
Working Notes :
i)
Calculation of Revised Direct Material Cost :
Actual Cost
1,50,000
Add : Increase in cost as production
will rise by 10% of 1,50,000
(+)
15,000
1,65,000
Add : Increase in cost as material
price will increase by 5% of

40
Advanced Cost Accounting - IV
1,65,000
Revised Direct Material Cost
(+)
8,250
1,73,250
ii)
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Calculation of Revised Direct Labour Cost :
Actual Cost
80,000
Add : Increase in cost as production
will raise by 10% of
80,000
(+)
8,000
NOTES
88,000
Less : Decrease in cost as labour
cost will decrease by 2% of
88,000
(-)
 Revised Direct Labour Cost
1,760
86,240
In the books of Rajdoot Co. Ltd.,
Production Cost Budget for the year ended....
Particulars
Direct Material
Add :
Direct Labour
(+)
Prime Cost
Add :
Revised Budget
1,50,000
1,73,250
80,000
86,240
2,30,000
2,59,490
50,000
55,000
25,000
25,000
3,05,000
3,39,490
Factory Overheads :
i) Variable
ii) Fixed

Original Budget
(+)
Total Cost
ILLUSTRATION 2
The information has been made available from records of Siemens India
Ltd., Solapur for the last six months of 2012 and of only the sales of January 2013
in respect of product A.
i)
The units to be sold in different months are :
2012
Units
July
1,100
September
1,700
November
2,500
January
2,000
August
1,100
October
1,900
December
2,300
Advanced Cost Accounting - IV
41
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ii)
There will be no work-in Progress at the end of any month.
iii)
Finished units equal to half of sales for the next month will be in Stock
at the end of every month (including June).
iv)
Budgeted Production and Production Cost for the year ending 31-12-2012.
NOTES
Production (Units)
22,000
Direct Material per unit
10
Direct Wages per units
4
Total Factory Overheads apportioned to product
88,000
Prepare :
A)
A Production Budget for each of the last six months of 2012
B)
A Summarised production cost budget for the same period.
SOLUTION
In the books of Siemens India Ltd., Solapur
A) Production Budget for six months ended 31-12-2012
Particulars
July August Sept.
Oct.
Nov.
Dec.
Sales (in units)
1,100
1,100
1,700 1,900 2,500 2,300
550
850
950 1,250 1,150 1,000
1,650
1,950
2,650 3,150 3,650 3,300
550
550
Add : Closing Stock i.e. half of
sales for the next
month
(+)
Less:Opening Stock i.e. last
months Closing Stock (-)
 Production in units
850
950 1,250 1,150
1,100 1,400 1,800 2,200 2,400 2,150
B) Production Cost Budget for six months ended 31-12-2012
Production for six months (July to December, 2012 )
July + Aug. + Sept. + Oct. + Nov. + Dec.
= (1,100+1,400+ 1,800 + 2,200 +2,400 +2,150 units) = 11,050 units
Particulars
Direct Materials @
Add : Direct Wages @
10 per unit
4 per unit
Add : Factory Overheads (88,000 x 1/2 )
42
Advanced Cost Accounting - IV
Total Production Cost
1,10,500
(+)
44,200
(+)
44,000
1,98,700
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
3.2.4 Purchase Budget
Illustrations
ILLUSTRATION 1
In Motherson Co. Ltd., Matunga the Sales Executive expects to sale 60,000
units of Water Cooler for the year 2012. The Production Manager has estimated
the requirements of raw materials as : A - 4 units, B - 6 units for producing one
water cooler. The opening and closing balances of the finished goods and raw
materials estimated are as follows :
Item
Opening balance at the
Closing balance at the
beginning of the next year
end of the next year
units
units
A
10,000
11,000
B
15,000
17,000
8,000
11,000
Finished goods
NOTES
Prepare a Purchase Budget showing the quantities of materials to be
purchased.
SOLUTION
First we have to prepare the Production Budget and from this we can
estimate the purchases and draw the Purchases Budget as shown below.
In the Books of Motherson Co. Ltd., Matunga
Production Budget for the year 2012
Add :
Particulars
Units
Estimated Sales for the year
60,000
Closing balance (estimated)
(+)
11,000
71,000
Less :
Opening balance (estimated)
Estimated Production
(-)
8,000
63,000
Advanced Cost Accounting - IV
43
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
Purchase Budget for the year 2012
Particulars
Annual requirement of Materials
Material A
Units
Material B
Units
2,52,000
3,78,000
11,000
17,000
2,63,000
3,95,000
10,000
15,000
2,53,000
3,80,000
A : 63,000 x 4 units
B : 63,000 x 6 units
Add : Stock to be maintained at the end
of the year
(+)
Less : Stock at the beginning
of the year
(-)
Quantity to be purchased
ILLUSTRATION 2
Nashik Soap Factory, Nashik Road uses the combination of two materials
X and Y which constitute 75% and 25% of the total output in units. They estimate
a sale of 500 quintals of soaps during the month of July 2012. The estimates for
the opening and closing stocks are as follows :
Particulars
Opening Stocks
Quintals
Closing Stocks
Quintals
X
100
140
Y
80
300
Finished Goods
70
90
The expected purchase price of the two materials are :
X : . 600 per quintal
Y : .500 per quintal
Prepare : Production Budget, Material Consumption Budget and Purchase
Budget (showing cost) for the month ended 31st July 2012.
44
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the Books of Nashik Soap Factory, Nashik Road
Production Budget for the month ended 31-7-2012
Add :
Particulars
Quintals
Estimated Sales
500
Closing Stock of finished goods
(+)
NOTES
90
590
Less :
Opening Stock of finished goods

(+)
70
Estimated Production
520
Material Consumption Budget for the month ended 31-7-2012
Particulars
Materials consumption for estimated
X
Y
390
130
390
130
production distributed in the radio of 75% : 25%
[ i.e. 520 Quintals x 3:1]
Purchase Budget for the month ended 31-7-2012
Particulars
X
Y
390
130
140
300
530
430
100
80
430
350
( )
600
500
( )
2,58,000
1,75,000
Materials required for production
Add :
Less :
Costing Stock
(+)
Opening Stock
(-)
Materials to be purchased
Purchase price per quaintal
Cost (X : 430 x
(Y : 350 x

Total Cost
500 )
600 )
4,33,000
Advanced Cost Accounting - IV
45
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
3.2.5 Cash budget
Methods of Preparing Cash Budget :
NOTES
There are three methods of preparing the cash budgets. viz, Receipts and
Payments Method, Adjusted Profit and Loss Method, The Balance Sheet Method.
Usually, the Receipt and Payments method is used for short-term cash
budget. The other two methods as mentioned above are used for long-term cash
budgets.
Receipt and Payments Method :
According to this method, Cash Budget includes all the cash receipts whether
they are on revenue account or capital account. Similarly, all expected capital and
revenue expenditures are brought in a cash budget. The accruals i.e. income
earned but not received and expenditure due but not paid are excluded from the
cash budget. Thus, a cash budget is a sort of cash account which records cash
receipts and cash payments and shows expected cash balance at the end of the
budget period. The informations for cash budget are derived from other budgets.
For example, the sales budget will provide the amount of sales and the receipts
from sales and realization from debtors can be estimated by taking into account
the terms of sales. The raw materials purchase budget, labour budget and overheads
budget will provide information relating to payments for raw materials, wages and
overhead charges. The management can forecast payments on account of capital
expenditure, tax, dividend etc. The difference of cash receipts and cash payments
for a period is either positive or negative, which is carried to next period.
In this method, all the cash receipts which are expected and all the cash
payments which are expected to be made are taken into account. Thus, the cash
balance will represents the difference between the total cash receipts expected
(including the opening cash balance) and total cash payments to be made.
The following are the sources and application of cash.
Sources :
i)
From customers (debtors). This can be ascertained from the Sales Budget.
The terms and conditions of sale, lag in payments and other factors should
be considered while estimating the cash receipts.
ii)
Cash receipts from other sources viz. Dividends received interest on
investments, rent received, sale of investments, sale of fixed assets etc.
Applications :
46
Advanced Cost Accounting - IV
i)
Cash payments for purchase of raw materials, payment of wages and other
expenses are estimated from the various budgets viz. Purchase budgets
personnel budget and overhead/ expenses budget. The suppliers credit period,
term and conditions of purchases cash discount allowed, lag in payment of
wages, etc. should be considered.
ii)
Cash payment for capital expenditure can be ascertained from the capital
expenditure budget.
iii)
Cash payments for dividends, income tax etc.
ILLUSTRATION 1
Prepare a Cash Budget for the three months ended 31-3-2013 from the
following particulars relating to Bharat Forge Co. Ltd., Bangalore.
2012-2013
Months
Credit Sales
Purchases
Wages
NOTES
November
1,00,000
80,000
5000
December
90,000
70,000
6000
1,00,000
4,500
January
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
1,10,000
February
60,000
95,000
5,500
March
80,000
1,30,000
7000
40% off the credit sales will be realised in the month following the sales
and the remaining 60% in the second month following. The creditors will be paid
in the month following the purchases. Interest of 5,000 will have to be paid in
the month of February, 2013. Income-tax of 15,000 will have to be paid in the
month of March, 2013 Wages are paid in the same month. The opening balance of
cash as on 1-1-2013 was 20,000.
SOLUTION
In the Books of Bharat Forge Ltd., Bangalore
Cash Budget for the three months ending 31-3-2013
Particulars
Cash Balance Opening
January February
(A)
March
20,000
41,500
29,000
36,000
44,000
24,000
Add Receipts :
1) Collection from debtors
(a) 40% of Credit Salesone month credit
(b) 60% 0f Credit Salestwo months credit
(+)
60,000
54,000
66,000
 Actual Receipts
(B)
96,000
98,000
90,000
 Total Receipts (A+B)
(C) 1,16,000 1,39,500 1,19,000
Less Payment :
1) Creditors for purchases one month credit
70,000
1,00,000
95,000
2) Interest
-
5,000
-
3) Income-tax
-
-
15,000
4,500
5,500
7,000
4) Wages
(+)
 Total Payments
(D)
74.500 1,10,500 1,17,000
(-)
Cash Balance Closing (C-D)
(E)
41,500
29,000
2,000
Advanced Cost Accounting - IV
47
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
ILLUSTRATION 2
Cadbury India Ltd., Cochin wants to avail overdraft facility with Bank of
India for the period October-December 2012 for meeting the orders. From the
following particulars prepare a cash budget and find out the amount of overdraft
facility required.
2012
Credit Sales
Purchases
Wages
Months
July
1,30,000
1,60,000
14,000
August
2,10,000
1,55,000
15,000
September
2,20,000
1,80,000
18,000
October
3,00,000
3,20,000
15,000
November
1,50,000
2,20,000
17,000
December
1,50,000
3,50,000
16,000
The credit sales are realised as below :
•
50% of the amount in the second month following, and balance 2 months
or
•
50% of the amount in the third month following the sales 3 months or
The creditors for purchases are paid in the month following the month of
purchase.
The bank pass book showed a balance in the Current Account as on 30th
September 2012 10,000.
48
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of Cadbury India Ltd., Cochin
Cash Budget for the three months ending 31-12-2012
Particulars
October
November
December
NOTES
Cash at Bank Opening :
(A)
(+) 10,000
(-) 15,000
(-) 1,37,000
1,05,000
1,10,000
1,50,000
Add Receipts :
1) Collection from Debtors
(a) 50% of Credit Sales- two
months credit
(b) 50% of Credit Sales-three
months credit
(+)
65,000
1,05,000
1,10,000

(B)
1,70,000
2,15,000
2,60,000
1,80,000
2,00,000
1,23,000
15,000
17,000
16,000
Actual Receipts
(+)

Total Receipts (A +B ) (C)
Less Payments :
1) Wages
2) Creditors purchases one
month credit
(+)
1,80,000
3,20,000
2,20,000

(D)
1,95,000
3,37,000
2,36,000
Total Payments
(-)
Cash at Bank Closing(C - D)(E) (-) 15,000
(-)1,37,000 (-) 1,13,000
ILLUSTRATION 3
Denso Ltd., Delhi wishes to arrange overdraft facility with its bankers during
the period April to June 2012 when it will be manufacturing mostly for stock.
Prepare a Cash Budget for the above period from the following cost data indicating
the extent of bank facilities the company will require at the end of each month.
Advanced Cost Accounting - IV
49
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
i)
NOTES
Cost Data :
2012
Months
Sales
Purchases
Wages
February
1,80,000
1,24,800
12,000
March
1,92,000
1,44,000
14,000
April
1,08,000
2,43,000
11,000
May
1,74,000
2,46,000
10,000
June
1,26,000
2,68,000
15,000
ii)
50% of Credit Sales are realised in the month following the sales and the
remaining 50% in the second month following. Creditors are paid in the
month following the month of purchases.
iii)
Cash at bank on 1st April 2012 estimated
25,000
SOLUTION
In the Books of Denso Ltd., Delhi
Cash Budget for the three months ending 30-6-2012
Particulars
Cash at Bank Opening
April
May
June
(A) (+) 25,000
(+) 56,000
(-) 47,000
96,000
54,000
87,000
Add Receipts :
1) Collection from Debtors
a) 50% of Credits Salesone month credit
b) 50% of Credit Saletwo months credit
(+)
90,000
96,000
54,000
 Actual Receipts
(B)
1,86,000
1,50,000
1,41,000
2,11,000
2,06,000
94,000
1,44,000
2,43,000
2,46,000
(+)
 Total Receipts (A+B)
(C)
Less Payments :
1) Payment to Creditors for Purchase
of Materials one month credit
2) Wages
(+)
11,000
10,000
15,000
 Total Payments
(D)
1,55,000
2,53,000
2,61,000
(-)
Cash at Bank Closing (C - D) (E) (+)56,000
50
Advanced Cost Accounting - IV
(-)47,000 (-)1,67,000
ILLUSTRATION 4
Eskay Ltd., Ernakulam wishes to prepare Cash Budget from January.
Prepare a cash budget for the first six months from the following estimated revenue
and expenses of 2012.
Months
Total Sales Materials
Wages
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Overheads
NOTES
Production
Selling and
Distribution
January
20,000
20,000
4,000
3,200
800
February
22,000
14,000
4,400
3,300
900
March
24,000
14,000
4,600
3,300
800
April
26,000
12,000
4,600
3,400
900
May
28,000
12,000
4,800
3,500
900
June
30,000
16,000
4,800
3,600
1,000
Cash balance on 1st Jan 2012 was 10,000. A new machine is to be installed
at 30,000 on credit to be repaid by two equal instalments in March and April
2012. Sales commission @ 5% on total sales is to be paid within the month following
actual sales. 10,000 being the amount of 2nd call may be received in March 2012.
Share premium amounting to 2,000 is also receivable with 2nd call.
•
Period of credit allowed by suppliers-2 months.
•
Period of credit allowed to customers-1month.
•
Delay in payment of overheads-1month.
•
Delay in payment of wages-1/2 month.
•
Assume cash sales to be 50% of total sales.
Advanced Cost Accounting - IV
51
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of Eskay Ltd., Ernakulam
Cash-Budget for six months ending 30th June, 2012
Particulars
Cash Balance - Opening
(A)
Jan.
Feb.
March
April
May
June
10,000
18,000
29,800
20,000
6,100
8,800
Add : Receipts
1.
Share 2nd Call
-
-
10,000
-
-
-
2.
Share Premium
-
-
2,000
-
-
-
3.
Cash Sales : 50% of Total Sales
10,000
11,000
12,000
13,000
14,000
15,000
4.
Collection from Debtors 50 % of Total Sales
-
10,000
11,000
12,000
13,000
14,000
1 month credit
 Actual Receipts
(B) 10,000 21,000 35,000 25,000 27,000 29,000
 Total Receipts (A+B)
(C) 20,000 39,000 64,800 45,000 33,100 37,800
Less : Payments
1.
Purchases of Machine
2.
Sales Commission @ 5% on Total Sales
3.
Payment to Suppliers for purchase of material
1,000
(2 months credit)
15,000
15,000
1,100
1,200
1,300
1,400
20,000
14,000
14,000
12,000
4.
Payment of Production Overheads (1 month credit)
3,200
3,300
3,300
3,400
3,500
5.
Payment of Selling and Distribution (1 month credit)
800
900
800
900
900
6.
Payment of Wages (1/2 month credit)
4,200
4,500
4,600
4,700
4,800
2,000
 Total Payment
(D)
Cash Balance Closing (C-D)
(E) 18,000 29,800 20,000
2,000
9,200 44,800 38,900 24,300 22,600
6,100
8,800 15,200
ILLUSTRATION 5
Summerised bellow are the income and expenditure forecasts for the month
of March to August 2012 of Flex Industries Ltd., Faridabad.
Month
Credit
Credit
Wages Manufact-
Sales Purchases
uring
Office
Selling
Expenses Expenses
Expenses
52
Advanced Cost Accounting - IV
March
60,000
36,000
9,000
4,000
2,000
4,000
April
62,000
38,000
8,000
3,000
1,500
5,000
May
64,000
33,000
10,000
4,500
2,500
4,500
June
58,000
35,000
8,500
3,500
2,000
3,500
July
56,000
39,000
9,000
4,000
1,000
4,500
August
60,000
34,000
8,000
3,000
1,500
4,500
You are given the following further information :
i)
Plant costing 16,000 is due for delivery in July 2012 payable 10% on
delivery and balance after three months.
ii)
Advance Tax of
iii)
Period of credit allowed
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
8,000 each is payable in March and June 2012.
NOTES
i) by suppliers 2 months and
ii) to customers one month
iv)
Lag in payment of manufacturing expenses half month.
v)
Lag in payment of all other expenses one month.
You are required to prepare a Cash Budget for three months starting on 1st
May, 2012 when there was a cash balance of 8,000.
SOLUTION
In the Books of Flex Industries Ltd., Faridabad
Cash-Budget for three months ended on 31-7-2012
Particulars
Cash Balance Opening
May
(A)
June
July
8,000
15,750
12,750
62,000
64,000
58,000
Add Receipts :
1) Collection from customers for
credit sales (1 month credit) (+)
 Actual Receipts
(B)
62,000
64,000
58,000
 Total Receipts (A+B)
(C)
70,000
79,750
70,750
1) Purchase of Plant
-
-
1,600
2) Advance-Tax
-
8,000
-
purchase (2 months credit)
36,000
38,000
33,000
4) Payment of Manufacturing
3,750
4,000
3,750
(1,500+2,250)
(2,250+1,750)
(1,750+2000)
8,000
10,000
8,500
1,500
2,500
2,000
5,000
4,500
3,500
(D)
54,250
67,000
52,350
Cash at Bank Closing (C-D)(E)
15,750
12,750
18,400
Less : Payments :
3) Payment to suppliers for credit
Expenses ( half month credit )
5) Wages (one month credit)
6) Office expenses
(one month credit)
7) Selling Expenses
(one month credit)
 Total Payments
Advanced Cost Accounting - IV
53
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ILLUSTRATION 6
From the following information relating to Gesco Ltd., Gurgaon prepare a
Cash Budget for half year ended 30-6-2012
2012
NOTES
Sales
Materials Wages
Months
January
Selling
Works
Manufacturing
Expenses Overheads Expenses
72,000
25,000
10,040
4,000
6,000
1,500
February 97,000
31,000
12,190
5,000
6,300
1,700
March
86,000
25,000
10,620
5,500
6,000
2,000
April
88,600
30,600
25,042
6,700
6,500
2,200
May
1,02,500
37,000
22,075
8,500
8,000
2,500
June
1,08,700
38,800
23,039
9,000
8,200
2,500
The Cash balance on 1-1-2012 is 2,500. Assume that 50% of the total
sales are cash sales. Assets are to be acquired in the month of February and April
2012 hence, provision should be made for the payment of 8,000 and 25,000
respectively for the same. An application has been made to the bank for the grant
of a loan of 30,000 and it is expected that it will be received in May, 2012. It is
also anticipated that a dividend of 35,000 will be paid in June. Debtors are
allowed one months credit whereas creditors, for goods or overheads, grant one
months credit. Sales commission @3% on total sales is to be paid in the same
month.
54
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of Gesco Ltd., Gurgaon
Cash-Budget for the six months ended on 30-6-2012
Particulars
Cash Balance - Opening
Jan.
(A)
Feb.
March
April
May
June
2,500
26,300
51,200
85,500
81,100
1,35,500
36,000
48,500
43,000
44,300
51,250
54,350
-
36,000
48,500
43,000
44,300
51,250
Add : Receipts
1. Cash Sales 50% of Total Sales
2. Collection from Debtors 50% of Total Sales
one months credit
3. Grant of Bank Loan
(+)
30,000
 Actual Receipts
(B) 36,000
 Total Receipts (A+B)
(C) 38,500 1,10,800 1,42,700 1,72,800 2,06,650 2,41,100
84,500
91,500
87,300 1,25,550 1,05,600
Less : Payments
1. Credit for purchase of materials
25,000
31,000
25,500
30,600
37,000
10,040
12,190
10,620
25,042
22,075
23,039
-
4,000
5,000
5,500
6,700
8,500
-
6,000
6,300
6,000
6,500
8,000
-
1,500
1,700
2,000
2,200
2,500
6. Purchase of Asset
-
8,000
25,000
-
-
7. Dividend
-
-
-
-
-
35,000
3,075
3,261
One months credit
2. Wages
3. Creditors for selling expenses
One months credit
4. Creditors for Works Overheads
One months credit
5. Creditors for Office on Cost
One months credit
8. Sales Commission @3%
on Total Sale
(+)
2,160
2,910
2,580
2,658
 Total Payments
(D) 12,200
59,600
57,200
91,700
(E) 26,300
51,200
85,500
81,100 1,35,500 1,23,800
Cash Balance Closing (C - D)
71,150 1,17,300
Advanced Cost Accounting - IV
55
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
3.2.6 Flexible Budget
ICMA London Terminology defines a flexible budget as,” one which
by recognising the difference between fixed, semi-fixed and variable costs, is
designed to change in relation to the level activity attained”. Thus, a Flexible
Budget is one which is designed to change according to the level actually achieved.
The budgeted figures can be changed according to the changing conditions. Hence
a Flexible Budget is just the opposite of a fixed budget. Thus it is more elastic.
practical and useful in the real life. These budgets are prepared for the purpose of
cost control.
Flexible Budgets are prepared in the following cases :
i)
Where the business depends upon some scarce material.
ii)
Where the exact demand cannot be estimated e.g. in new business.
iii)
Where the business depend upon nature e.g. rainfall.
iv)
In some business where the sales cannot be predicted.
v)
Where sufficient labour force is necessary for running the business
smoothly.
Preparation of Flexible Budgets :
Flexible budget can be prepared in the following manner :
At first a number of fixed budgets are prepared for each manufacturing
budget centre. Within the limits of these budget center. Within the limits of these
budgets, the flexible budgets are prepared. In Flexible budgets clear differences
are drawn between fixed, semi-fixed and variable costs.
There are three methods of preparing Flexible budgets viz. Tabular Method,
Charting Method, Ratio Method.
i)
Tabular Method :
In this method, a table is prepared wherein different capacities are shown in
horizontal columns and the budget, the budgeted figures are shown against
different capacities in the vertical columns. The expenses are recorded as
variable, semi-variable and fixed. Various capacity levels showing different
volumes of production are shown in the flexible budgets.
ii)
Charting Method :
In this method, the expenses are analysed according to their nature or
behavior i.e. variable, semi-variable and fixed. The budgeted expenses are
prepared and these are plotted on a graph paper against different levels of
activity. The budgeted expenses relating to the level of activity actually attained
can be read from this chart.
56
Advanced Cost Accounting - IV
iii)
Ratio Method :
If the activities of a company are standardised and the expenses are of
uniform nature, most of the expenses can be worked out as percentage
level of activity. The method is that the common cost are estimated. For the
normal production, i.e. the normal level of activity. From this we can work
out various ratios which show the relationships of each expenses with each
increase in the level of activity. Then the budgeted cost for any level of
activity can be ascertained by using these ratios.
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
Uses of Flexible Budget :
i)
It is more realistic and has great practical utility in the business.
ii)
The efficiency of the managers can be measured.
iii)
It helps to control the costs.
iv)
It is more realistic than a fixed budget because a fixed budget deals with
only one level of activity or condition.
v)
The figures in a flexible budget can be changed according to the change in
the volume of activity.
Advanced Cost Accounting - IV
57
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Proforma of Flexible Budget :
In the Books of a Company
FLEXIBLE BUDGET
Normal Activity Units :
NOTES
Capacity : %
Production
Units
-
-
-
%
-
-
-
Capacity
Particulars
Unit
Cost
A) Fixed Expenses
• Salaries
• Depreciation
• Insurance
• Rent
B) Variable Expenses
• Direct Material
• Direct Labour
• Direct Expenses
• Indirect Material/
Labour/Expenses
• Variable Overheads
C) Semi-variable Expenses
• Electricity
• Repairs and Maintenance
• Administrative Expenses
• Selling Expenses
• Distribution Expenses
58
Advanced Cost Accounting - IV
 Total Cost
(+)
Add : Profit
(+)
Less : Loss
(-)
 Sales
Total
Cost
Unit
Cost
Total
Cost
Unit
Cost
Total
Cost
ILLUSTRATION 1
The statement given below gives the Flexible Budget at 60% capacity of
Finolex Cable Ltd., Faizpur. Prepare a tabulated statement giving the budget figures
at 75% and 90% capacity where no indication has been given, make your own
classification of expenses between fixed, variable and semi-variable expenses.
Particulars
Prime Cost Materials
60% Capacity
60,000
Productive Wages
40,000
Rent
12,000
Indirect Materials
48,000
Insurance of Machinery
12,000
Indirect Labour
40,000
Repairs and maintenance (60% Fixed)
NOTES
1,60,000
Depreciation
Electric Power (40% Fixed )
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
8,000
20,000
Advanced Cost Accounting - IV
59
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the books of Finolex Cable Ltd., Faizpur
Flexible Budget
Normal Activity : Units
NOTES
Capacity : 60%
Production
Units
-
-
-
60
75
90
Total
Total
Total
Cost
Cost
Cost
i) Depreciation
60,000
60,000
60,000
ii) Rent
12,000
12,000
12,000
iii) Insurance of Machinery
12,000
12,000
12,000
Capacity
%
Particulars
A)
Fixed Expenses :
B) Variable Expenses :
i) Prime Cost Materials
1,60,000
2,00,000 2,40,000
ii) Productive Wages :
40,000
50,000
60,000
iii) Indirect Materials
48,000
60,000
72,000
iv) Indirect Labour
40,000
50,000
60,000
C) Semi-Variable Expenses
i) Electric Power
8,000
• Fixed-40%
3,200
3,200
3,200
3,200
• Variable-60%
4,800
4,800
6,000
7,200
12,000
12,000
12,000
8,000
10,000
12,000
ii) Repairs and Maintenance
• Fixed-60%
• Variable-40%
Total
60
Advanced Cost Accounting - IV
20,000
12,000
8,000
(+)
4,00,000
4,75,000 5,50,400
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ILLUSTRATION 2
The expenses budgeted for production at 100% capacity of Infosys Ltd.,
Islampur are given below :
Particulars
At 100% Capacity
Direct Materials
6,00,000
Variable Works Overheads
2,00,000
Basic Wages
2,00,000
Fixed Production Overheads
80,000
Productive Expenses-Marginal
40,000
Administrative Expenses -Rigid
40,000
Selling Overheads (10% Fixed)
1,20,000
Distribution on Cost (80% variable )
NOTES
60,000
Prepare a Flexible Budget for the production at 60% and 80% capacity
showing separately - i) Prime Cost, ii) Works Cost, iii) Cost of Production, iv)
Cost of Turnover.
Advanced Cost Accounting - IV
61
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the Books of Infosys Ltd., Islampur
Flexible Budget
Normal Activity : Units
NOTES
Capacity : 100%
Production
Capacity
Units
%
Particulars
Direct Materials
Add : Basic Wages
60
80
100
Total
Total
Total
Cost
Cost
Cost
3,60,000
4,80,000 6,00,000
1,20,000
1,60,000 2,00,000
Add : Productive Expenses-Marginal (+)
24,000
32,000
40,000
Prime Cost
5,04,000
6,72,000
8,40,000
(i)
Add : Factory Overheads
i) Variable Works Overheads
1,20,000
ii) Fixed Production Overheads (+)
1,60,000 2,00,000
80,000
80,000
ii)
7,04,000
9,12,000 11,20,000
Add : Administrative Expenses-Rigid (+)
40,000
40,000
Cost of Production
7,44,000
9,52,000 11,60,000
12,000
12,000
12,000
1,08,000
64,800
86,400 1,08,000
12,000
12,000
12,000
(+)
28,800
38,400
48,000
iv)
8,61,600
Works Cost
iii)
80,000
40,000
Add : Selling and Distribution Overheads
i) Selling Overheads -
• Fixed - 10%
• Variable -90%
1,20,000
ii) Distribution on Cost -
• Fixed - 20%
12,000
• Variable - 80%
48,000
Cost of Turnover
62
Advanced Cost Accounting - IV
12,000
60,000
11,00,800 13,40,000
ILLUSTRATION 3
From the following information relating to Castrol Ltd., Cochin prepare a
Flexible Budget at 60% and 80% capacity.
Particulars
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
70% Capacity
NOTES
A)
Variable Overheads :
•
Indirect Material
5,000
•
Indirect Labour
15,000
B)
Semi-Variable Overheads :
i)
Electricity
ii)
50,000
• Variable
60%
• Fixed
40%
Repair and Maintenance
5,000
• Variable
65%
• Fixed
35%
C) Fixed Overhead :
• Salaries to Staff
10,000
• Depreciation on Machines
14,000
• Insurance on Machines
Total
6,000
1,05,000
The company estimated the direct labour hours to be worked at 70% capacity
as 70,000 hours. Also calculate the overhead recovery rate at 60%, 70% and 80%
capacities.
Advanced Cost Accounting - IV
63
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
SOLUTION
In the Books of Castrol Ltd., Cochin
Flexible Budget
Normal Activity : Units
Capacity : 100%
NOTES
Production
capacity
Units
%
Particulars
60
70
80
Total
Total
Total
Cost
Cost
Cost
A) Variable Overheads :
i)
Indirect Material
ii) Indirect Labour
4,286
5,000
5,714
12,857
15,000
17,143
B) Semi-variable Overheads
i)
Electricity
50,000
• Variable - 60%
30,000
25,714
30,000
34,286
• Fixed - 40%
20,000
20,000
20,000
20,000
ii) Repairs and Maintenance
5,000
• Variable - 65%
3,250
2,786
3,250
3,714
• Fixed - 35%
1,750
1,750
1,750
1,750
i) Salaries to Staff
10,000
10,000
10,000
ii) Depreciation on Machines
14.000
14,000
14,000
6,000
6,000
6,000
C) Fixed Overheads :
iii) Insurance of Machines

(+)
Total Overheads
97,393 1,05,000 1,12,607
Calculation of Overhead
Recovery Rate on the basis of
Direct Labour Hours :
Total Overheads
=
Direct Labour Hours
97,393
1,05,000 1,12,607
=
=
=
60,000 Hrs 70,000 Hrs 80,000 Hrs
=
64
Advanced Cost Accounting - IV
1.62 = 1.50
= 1.41
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ILLUSTRATION 4
Activa Co, Ltd., Anand produces computer hardware. The estimated cost
per unit is as under :

Direct Material
15
Direct Wages
10
Direct Expenses
4
Variable Overhead
6
Total
NOTES
35
The fixed overheads are estimated at 1,00,000. The semi-variable overheads
are 50,000 at 100% capacity i.e. 10,000 units. The semi-variable expenses vary
in stages of 4,000 for each change in output of 1,000 units. Selling price per unit
is 70 You are required to prepare a Flexible Budget at 50%, 70%, 90% and
100% capacities and determine the profit at each level.
SOLUTION
In the Books of Activa Co., Anand
Flexible Budget
Normal Activity : 10,000 units
Capacity : 100%
Production
Capacity
Units
%
Particulars
5,000
50
7,000
70
Total
Cost
Direct Material
15.00
75,000 15.00
1,05,000 15.00
1,35,000 15.00
1,50,000
Add : Direct Wages
10.00
50,000 10.00
70,000 10.00
90,000 10.00
1,00,000
20,000
28,000
36,000
Prime Cost
4.00
(i) 29.00
Add : Variable Overheads
Add : Fixed Overheads
6.00
20.00
4.00
1,45,000 29.00
30,000
6.00
1,00,000 14.29
Total
Cost
Unit
Cost
10,000
100
Unit
Cost
Add : Direct Expenses (+)
Unit
Cost
9,000
90
4.00
2,03,000 29.00
42,000
6.00
1,00,000 11.11
Total
Cost
Unit
Cost
Total
Cost
4.00
40,000
2,61,000 29.00
2,90,000
54,000
6.00
60.000
1,00,000 10.00
1,00,000
Add : Semi-Variable
Overheads
(+)
Total Cost
(ii) 61.00
Add : Profit
(iii) (+)
Selling Price
6.00
9.00
30,000
5.43
38,000
5.11
46,000
5.00
50,000
3,05,000 54.72
3,83,000 51.22
4,61,000 50.00
5,00,000
45,000 15.28
1,07,000 18.78
1,69,000 20.00
2,00,000
70.00 3,50,000 70.00 4,90,000 70.00 6,30,000 70.00 7,00,000
Advanced Cost Accounting - IV
65
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ILLUSTRATION 5
The expenses for the production at 5,000 units at the 50% capacity in
Baroda Chemicals Ltd., Bhavnagar given as follow
Per Units
NOTES
Materials
50
Labour
20
Variable Overheads
15
Fixed Overheads (
50,000 )
10
Administrative Expenses (5% Variable )
10
Selling Expenses (20% Fixed)
6
Distribution Expenses (10% Fixed )
(+)
Total Cost of Sales Per Unit
5
116
You are required to prepare a budget for 70% and 90% production capacity.
At 90% capacity costs of Materials will increase by 10% where as labour cost
will decrease by 5%.
SOLUTION
In the Books of Baroda Chemicals Ltd., Bhavnagar
Flexible Budget
Normal Activity : 5,000 units
Capacity : 50%
Production
Capacity
Particulars
Units
%
A) Fixed Expenses :
i) Fixed Overheads
B) Variable Expenses :
i) Materials
5,000
7,000
9,000
50
70
90
Unit Cost Total Cost Unit Cost Total Cost Unit Cost TotalCost
10.00
50,000
7.14
50,000
50.00
2,50,000
50.00
3,50,000
5.56
50,000
55.00
4,95,000
(50 + 10%
i.e. 5)
ii) Labour
20.00
1,00,000
20.00
1,40,000
19.00
1,71,000
(20 - 5%
i.e. 1)
iii) Variable Overheads
C) Semi-Variable Expenses :
i) Administrative Expenses
• Fixed
95 %
• Variable
5%
ii) Selling Expenses
• Fixed
20%
• Variable
80%
iii) Distribution Expenses
• Fixed
10%
• Variable
90%
 Total Cost of Sales
Advanced
Cost Accounting - IV
66
15.00
75,000
15.00
1,05,000
15.00
1,35,000
9.50
0.50
47,500
2,500
6.79
0.50
47,500
3,500
5.28
0.50
6,000
4,500
1.20
4.80
6,000
24,000
0.86
4.80
6,000
33,600
0.67
4.80
6,000
43,200
2,500
0.28
31,500
4.50
7,69,600 110.59
2,500
40,500
9,95,200
10.
9.50
0.50
6.
1.20
4.80
5.
0.50
4.50
0.50
2,500
0.36
4.50
22,500
4.50
116.00 5,80,000 109.95
ILLUSTRATION 6
Dabur Chemical Ltd., Delhi has given you the following information at 50%
capacity of the production of 5,000 units during the month of March, 2012.
Particulars
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Per Unit
Materials
50
Labour
30
Variable Overheads
20
Fixed Overheads ( 50,000 )
10
Administrative Overheads (90 % Fixed)
10
Selling Expenses ( 25% Fixed )
Distribution Expenses (20 % Fixed )
NOTES
8
(+)
5
Total Cost
133
You are required to prepare budgets at 60%, 70% and 80% capacity
presuming that at 80% capacity material cost will be less by 5% and variable
selling expenses will increase by 10%
SOLUTION
In the Books of Dabur Chemicals Ltd., Delhi
Flexible Budget
Normal Activity : 5,000 units
Capacity : 50%
Production
Capacity
Particulars
A)
i)
B)
i)
Units
%
Fixed Expenses :
Fixed Overheads
Variable Expenses :
Materials
5,000
50
Unit
Total
Cost
Cost
6,000
60
Unit
Total
Cost
Cost
7,000
70
Unit
Total
Cost
Cost
10.00
50,000
8.33
50,000
7.14
50,000
50.00 2,50,000
50.00
3,00,000
50.00
3,50,000
8,000
80
Unit
Total
Cost
Cost
6.25
50,000
47.50 3,80,000
( .50 - 5%
i.e. 2.50)
ii) Labour
iii)Variable Overheads
C) Semi-Variable Expenses :
i) Administrative Expenses
• Fixed
90 % 9.
• Variable 10 % 1.
ii) Selling Expenses
8.
• Fixed
25% 2.
• Variable 75% 6.
30.00 1,50,000
30.00
1,80,000
30.00
2,10,000
30.00 2,40,000
20.00 1,00,000
20.00
1,20,000
20.00
1,40,000
20.00 1,60,000
10.
9.00
1.00
45,000
5,000
7.50
1.00
45,000
6,000
6.43
1.00
45,000
7,000
5.62
1.00
45,000
8,000
2.00
6.00
10,000
30,000
1.67
6.00
10,000
36,000
1.43
6.00
10,000
42,000
1.25
6.60
10,000
52.800
( 6 + 10%
i.e. 6)
iii)Distribution Expenses
• Fixed
20% 1.
• Variable 80% 4.
 Total Cost
5.
1.00
5,000
0.83
5,000
0.71
5,000
5,000
4.00
20,000
4.00
24,000
4.00
28,000
4.00 32,000
133.00 6,65,000 129.33 7,76,000 126.71 8,87,000 122.84 9,82,000
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
ILLUSTRATION 7
Crysta Ltd., Cochin is currently working at 50% capacity and produces
1,000 units at a cost 180 per unit as per the details shown below.
Particulars
Per Unit
NOTES
Direct Material
100
Direct Labour
30
Factory Overheads (40% Fixed )
30
Administrative Overhead (50% Fixed)
20
The current selling price is
200 per unit.
At 60% capacity working, raw material cost increases by 2% and selling
price falls by 20%. At 80% capacity working, material cost increases by 5% and
selling price falls by 5%.
Estimate profits of the company at 60% and 80% capacity by preparing the
budgets and offer your critical comments.
SOLUTION
Production
Capacity
In the Books of Crysta Ltd., Cochin
Flexible Budget
Normal Activity : 1,000 units
Capacity : 50%
Units
1,000
1,200
1,600
%
50
60
80
Particulars
Unit Cost Total Cost Unit Cost Total Cost Unit Cost TotalCost
Direct Material
100.00
1,00,000
102.00
1,22,400
(100+2%
i.e. 2)
Add : Direct Labour
(+)
Prime Cost
i)
Add : Factory Overheads
30
• Fixed
40% 12
• Variable
60% 18
Add : Administrative Overheads 20
• Fixed
50% 10
• Variable
50% 10
(+)
 Total Cost
Add : Profits
ii)
iii)
(+)
Selling Price
105.00
1,68,000
(100+5%
i.e
5)
30.00
130.00
30,000
1,30,000
30.00
132.00
36,000
1,58,400
30.00
135.00
48,000
2,16,000
12.00
18.00
12,000
18,000
10.00
18.00
12,000
21,600
7.50
18.00
12,000
28,800
10.00
10.00
10,000
10,000
8.33
10.00
10,000
12,000
6.25
10.00
10.000
16,000
180.00
20.00
1,80,000
20,000
178.33
17.67
2,14,000
21,200
176.75
13.25
2,82,800
21,200
200.00
2,00,000
196.00
2,35,200
190.00
3,04,000
(200-2%
(200-5%
i.e.
i.e.
4)
10)
Comments :
After making critical analysis, it is suggested that production capacity should
not be increased as profit remain constant at 60% and 80% capacity level.
3.3
Summary
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
Preparation of various budgets is an important stage in the use of budgets
and budgetary control technique. An organisation has to decide which is its basic
budget and the basic budget is first prepared, analysed and approved so that all
other budgets can be prepared on the basis of the contents of the basic budget.
Sales budget is the basic budget for most of the business organisations; so sales
budget is prepared first and production budget, production cost budget and purchase
budget are prepared on the basis of the sales budget. Cash budget is an important
budget and it can be prepared by three different methods - receipts and payments
method, Adjusted profit and Loss Account method and Balance Sheet method.
Flexible budget is prepared when the level of activity is uncertain and if fixed
budget is prepared the actual results cannot be compared with the fixed budget
since the actual level of activity is different from the activity level used for
preparation of the fixed budget. In Flexible budget there are results/costs shown
for different levels of activity and the comparison of the actual results/costs can
be done with the budgeted results/costs for that level of activity; e.g. in flexible
budget the production costs are shown for 70%, 80%, 90% and 100% level of
activity. If actual level of production activity is 80%, the actual production costs
will be compared with production costs at 80% level shown in the flexible budget.
Such comparision becomes more realistic and helps in controlling the costs more
effectively.
3.4
Key Terms
i)
Basic Budget : Basic Budget is the budget on the basis of which all other
budgets are prepared. Basic Budget is prepared first, analysed and approved
and then other budgets are prepared. Generally ‘sales budget’ is the basic
budget.
ii)
Fixed Budget : It is a budget prepared by assuming a certain fixed capacity
at which the business enterprise will operate. It gives quantitative and/or
monetary information only for one level of activity.
iii)
Flexible Budget : Flexible budget provides quantitative and/or monetary
data for different levels of activity so that comparison of actual results with
the budgeted data for the actual level of working becomes possible and
budgetary control becomes more effective. For example, production cost
budget may be prepared for 50%, 60%, 80% and 100% capacity levels so
that if actual production takes place at 80% capacity, comparison of actual
production cost with production cost budgeted for 80% capacity can be
done.
Advanced Cost Accounting - IV
69
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
3.5
1)
NOTES
Exercises
The following Budget estimates are available from Monica Industries Ltd.,
Malegaon working at 50% capacity.
Variable Costs
50,000
Semi-variable Costs
25,000
Fixed Costs
10,000
You are required to prepare a budget for 80% capacity assuming that
semi-variable expenses increases by 10% for every 20% increases in capacity.
2)
In a factory, a cost center works at 60% capacity and the following overhead
expenses are incurred.
Particulars
Salary of Supervisor
2,000
Salary of Assistant Supervisor
1,000
Wages of Workers
5,000
Repairs of Machines
8,000
Spoiled work
2,500
Oils and Lubricants
2,000
Depreciation of machine
10,000
30,500
Prepare a Flexible Budget for 75%, 100% and 125% capacities.
3)
Kumaran Mohan Ltd., produces a consumer product. The estimate
costs per unit are given below :
Raw Material
500
Direct Labour
300
Factory Overhead
400 (30% fixed )
Administrative Overheads
200 (60% fixed )
Cost per unit
1,400
The selling price per unit is 1,800. At 50% capacity it produces
5,000 units. Find out the profits when it works at 60% and 80% capacity.
70
Advanced Cost Accounting - IV
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Notes
i)
The cost per unit of
1,400 is at 50% capacity.
ii)
At 60% capacity raw material cost increases by 3% and selling price falls
by 3%.
iii)
At 80% capacity raw material cost increases by 4% and selling price falls
by 5%.
NOTES
Draw a proforma of a Flexible Budget using imaginary figures for 50%,
60% and 70% capacity levels.
4)
Prepare a Production Budget for 3,000 and 2,000 capacities assuming
that administration expenses remain constant at all levels of output. The budgeted
expenses for production of 4,000 units are :
Particulars
Unit Cost
Raw Materials
80
Direct Labour
30
Variable Overheads
20
Fixed Overheads ( 80,000)
10
Variable Overheads (Direct)
4
Selling Expenses (10% Fixed)
15
Administration Expenses ( 40,000)
5
Distribution Expenses (25% Fixed)
6
170
5)
A company estimates the sales of 25,000 units of product for the year 2005.
The raw material to be required are A - 3 units and B - 4 units. The opening
and closing balances of finished goods and raw materials estimated are as
follows :
Items
Opening Balance at the
Closing Balance at the
beginning of the next year
beginning of next year
(Units)
(Units)
A
8,000
10,000
B
10,000
14,000
Finished goods
5,000
18,000
Prepare Purchase Budget showing the quantities of materials to be
purchased.
Advanced Cost Accounting - IV
71
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
6)
Rotex and Co. sells two products X and Y. The following are the estimates
for the year 2012.
Sales Budgets (Units)
Ist Quarter
IInd Quarter IIIrd Quartet
IVth Quarter
NOTES
Product X
50,000
60,000
40,000
1,10,000
Product Y
40,000
50,000
70,000
1,00,000
Product X is sold at 8 per units while Product Y is sold at 15 per unit.
The Company incurs Selling and Distribution Expenses @ 2% of the Sales
value. Bad debts amount to 1% of the Sales value.
Prepare a Sale Budget for the year 2012
7)
From the following particulars prepare a Cash Budget for January, February
and March 2012 in a tabular form.
2011-2012
Sales
Purchases
Wages Expenses
Octomber
1,00,000
50,000
15,000
6,000
November
90,000
45,000
19,000
5,000
December
80,000
40,000
24,000
7,000
January
85,000
42,500
22,000
5,000
February
95,000
50,000
18,000
6,000
March
90,000
45,000
20,000
5,000
Further Information :
72
Advanced Cost Accounting - IV
i)
5% of the puchases and 10% of the sales are for cash.
ii)
Credit allowed to customers is 1/2 months.
iii)
Creditors for purchases are paid following the month of puchases.
iv)
Wages are paid every 15 days.
v)
Opening Balance of cash as on 1st January 2012 is
8)
From the following particulars prepare a Cash Budget for the quarter
ended 30th June 2012.
15,000.
Actual
January
Budgeted
February
March
1,00,000
1,00,000
95,000
Purchases
50,000
45,000
48,000
50,000
45,000
30,000
Wages
30,000
25,000
28,000
30,000
25,000
20,000
4,000
5,000
5,000
8,000
6,000
4,000
Sales
Expenses
April
May
June
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
1,20,000 1,15,000 1,10,000
NOTES
Further Information :
i)
50% of the puchases and sales are for cash.
ii)
Debtors realised after one month.
iii)
Creditors paid after two months.
iv)
Payment of Wages made after one week.
v)
Expenses are paid after one month.
vi)
Rent of
vii)
Income-Tax payable in April
viii)
Cash balance as on 1st April 2012 was
9)
The following is the estimated data for six-months March 2012 to August
2012 of a company.
5,000 per month not considered in expenses.
Months Credit
2012
Credit
1,500.
1,500.
Wages Manufacturing
Sales Puchases
Expenses
Office
Selling
Expenses Expenses
March
50,000
35,000
9,000
5,000
1,500
1,500
April
54,000
39,000
8,500
4,000
2,000
4,000
May
58,000
32,000
9,500
4,500
3,500
4,500
June
50,000
35,000
8,000
3,000
1,000
3,500
July
55,000
38,000
7,900
5,500
1,500
4,500
August 60,000
36,000
8,200
4,400
2,500
4,000
Other information :
i)
A machine valued at 20,000 will be supplied in June 2012 when 20% will
have to be paid against delivery and the remaining balance to be paid after
4 months.
Advanced Cost Accounting - IV
73
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
NOTES
ii)
Credit Period...........
Allowed to customers........
1 month
Allowed by supplies..........
2 month
iii)
Tax to be paid in advance
10,000 in March 2012
iv)
Lag in payments ........ Manufacturing Expenses 15 days
............ All other Expenses 30 days
Prepare a Cash Budget for half year ended on 31st August 2012.
II- Multiple Choice Questions
(1)
Match the pairs.
Group ‘I’
Group ‘II’
(a) Principal Budget
(i) Revenue Budget
(b) Secondary Budget
(ii) Promotion Expenses Budget
(c) Summary Budget
(iii) Profit & Loss Budget
(d) Expenses Budget
(iv) Working Capital Budget
(v) Other Income Budget
Ans. : (a) - (v), (b) - (iv), (c) - (iii), (d) - (ii).
(2)
Cash Budget is prepared afterall ----------- budgets are prepared.
(a) longterm
(b) shortterm
(c) zero based
(d) functional
(3)
The ----------- budgeting has been successfully implemented in a large
number of US organiations
(a) zero based
(b) capital
(c) cash
(d) master
(4)
Salesman’s Commission is included in ---------(a) Promotional Expenses Budget
(b) Distribution Expenses Budget
74
Advanced Cost Accounting - IV
(c) Working Capital Budget
(d) Direct Selling Expenses Budget.
Ans. : (2 - d), (3 - a), (4 - d)
3.6
Budgets and Budgetary Control
(Illustration On Preparation Of
Budgets )
Further Reading
NOTES
i)
‘Advanced Cost Accounting’ - Nigam and Sharma
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B. K. Bhar.
Advanced Cost Accounting - IV
75
Unit 4
Marginal Costing
Marginal Costing
Structure
4.0
Introduction
4.1
Unit Objectives
4.2
Marginal Costing
4.2.1
Meaning and definitions of marginal cost and marginal costing
4.2.2
Features of marginal costing
4.3
Distinction between Absorption Costing and Marginal Costing
4.4
Importance of Marginal Costing
4.5
Meaning of various concepts used in marginal costing
4.6
Summary
4.7
Key Terms
4.8
Questions
4.9
Further Reading
4.0
NOTES
Introduction
Every manufacturing concern would like to increase its profits by increasing
volume of production and sales. But increase in volume of production also leads to
increase in production cost. Management of a concern is interested in knowing
how much increase in costs will take place when the volume of production is
increased by a certain quantity. All costs do not increase in the same proportion by
an increase in the quantity of production. Management, therefore, wants detailed
and accurate information about behaviour of all items of costs which will enable it
to take proper decision about increase in volume of production upto a certain level
where it can maximise the concern’s profit. Some costs increase or decrease
proportionately with increase or decrease in production volume whereas some
costs do not increase or decrease upto a certain limit with increase or decrease in
the volume of production and there are some items of costs which show
disproportionate increase or decrease with increase or decrease in the volume of
production respectively. The first type of costs are known as ‘variable costs’, the
second type of costs are known as ‘fixed costs’ and the third type of costs are
called ‘semi - variable or semi - fixed costs’. To provide information about the
behaviour of costs at different levels of output and to help the management in
taking proper decision about level of output, costing has a technique which is
called ‘marginal costing’. In this unit some basic information about marginal costing
is provided.
Advanced Cost Accounting - IV
77
Marginal Costing
4.1
Unit Objectives
After studying the information provided in this Unit you should be able to :
NOTES
•
Know meaning and definitions of marginal cost and marginal costing;
•
Know the features of the marginal costing;
•
Know how marginal costing differs from absorption costing;
•
Know certain concepts used in marginal costing;
Different terminologies used for Marginal Costing :
Marginal Costing which is otherwise known as ‘Variable Costing’ is used
as a tool for decision - making by the management. Marginal costing is also known
as ‘Direct Costing’ and this new concept is gaining wide popularity in the field of
accounting. Marginal Costing is a technique through which variable costs are
taken into account for the purpose of product costing, inventory valuation and
other important management decisions. The term ‘Marginal Costing’ is commonly
used in U. K. and other European countries while the same is denoted as ‘Direct
Costing’ or ‘Variable Costing’ in U. S. A.
Thus, Marginal Costing is also known as variable or direct or differential
costing. The term Marginal Costing seems to be inappropriate since it has an
exclusive meaning in economics. Under the above circumstance, the term ‘Variable
Costing’ seems to be more appropriate and acceptable.
4.2
Marginal Costing
Marginal Costing is an accounting technique which ascertains marginal cost
by differentiating between fixed or period costs and variable costs. This technique
aims to charge only those costs of the cost of the product that vary directly with
sales volumes. Those costs would be direct material, direct labour and factory
overhead expenses such as supplies, some indirect labour and power. The cost of
the product would not include fixed or non - variable expenses such as depreciation,
factory insurance, taxes and supervisory salaries.
4.3.1 Meaning and definitions of Marginal Cost and
Marginal Costing
78
Advanced Cost Accounting - IV
Marginal Cost is a term which has its origin in the subject of economics. In
economics, marginal cost means the cost incurred for the unit on the margin. The
difference between the total cost incurred for 100 units and 101 units is the marginal
cost because it is the cost incurred for producing the 101st unit. The difference in
total cost when one less unit is produced (i.e. when only 99 units are produced) is
also the marginal cost. According to the Chartered Institute of Management
Accountants, London, the term ‘marginal cost’ means “the amount at any given
volume of output by which aggregate costs are changed if the volume of output is
increased or decreased by one unit. In practice this is measured by the total variable
cost attributable to one unit.
In order to understand the concept of marginal cost it is necessary to know
the difference between ‘fixed costs’ and ‘variable costs’. Costs which are incurred
by a business concern can be divided in two categories, fixed costs and variable
costs. Those costs which do not change according to the volume of output but
which depend on the period are known as the fixed costs. Within a certain capacity
level of the business organisation the amount of a fixed cost remains constant and
dose not decrease or increase even if output is reduced or increased. A supervisor
who is paid on monthly basis receives the same amount of salary every month
even though the actual output in these months varies because his salary is related
to the time factor and not to the actual output in the month. Rent, insurance premium,
general lighting charges are also examples of the fixed costs.
Marginal Costing
NOTES
In case of variable costs the amount of expenditure is directly related to the
output and the variable cost varies in direct proportion to the increase or decrease
in the output. Direct material cost, direct labour cost, direct expenses and variable
overheads are the examples of the variable costs. In case of the variable costs the
amount of cost per unit of output remains constant and so the total variable cost
increases proportionately when there is increase in the output and decreases
proportionately when the output decreases. Some items of overheads show a
tendency to change but it is not a proportionate change. This is because a part of
such overhead is of fixed nature and the remaining part of it is of variable nature.
Therefore such costs are known as semi-fixed or semi-variable costs. The cost of
such semi - variable items is required to be divided into fixed cost and variable
cost and the amount of fixed cost is added to the amount of the fixed costs and
amount of variable cost is added to the amount of variable costs. The total amount
of variable costs is the marginal cost. Following illustration will help to understand
the concept of the marginal cost.
Illustration :
In PQR Company only one type of product is manufactured and sold. One
unit of the product requires direct material of 150, direct labour of 200, direct
expenses of
50. The fixed costs of the company for a week amount to 1800
and semi-variable costs for a week amount to 500 for an output of 10 units. Out
of the semi - variable costs 20% are fixed and remaining are variable.
Find out the marginal cost of a unit.
Answer
per unit
Direct Materials Cost
150
Direct Labour Cost
200
Direct Expenses
50
Variable Expenses
40
Marginal cost i. e. total variable cost
440
Advanced Cost Accounting - IV
79
Marginal Costing
The amount of variable expenses per unit are calculated as under :
Weekly amount of semi-variable expenses is 500 of this 20% is fixed and
80% is variable. So the variable amount is 80% of 500 = 400. Since the output
for the week is 10 units the amount of variable expenses
NOTES
400
=
=
10
40
In calculation of the marginal cost only variable costs are taken into consideration.
and the fixed costs of 1900 ( 1800 + 100 out of the semi-variable expenses)
are treated as the period costs.
The total cost calculated for a week in which 10 units are produced will be
as under :-
Direct Materials Cost ( 150 × 10)
1,500
Direct Labour Cost ( 200 × 10)
2,000
Direct Expenses ( 50 × 10)
500
Variable Expenses ( 40 × 10)
400
Total Variable Cost
4400
Fixed Costs for the week
1900
Total cost
6300
If in the next week instead of 10 units 11 units are produced, the total cost
incurred will be :
Direct Materials Cost ( 150 × 11)
1,650
Direct Labour Cost ( 200 × 11)
2200
Direct Expenses ( 50 × 11)
550
Variable Expenses ( 40 × 11)
440
Total Variable Cost
4840
Fixed Costs for the week
1900
Total cost
6740
This shows that the total cost increases by 440 when one additional unit is
produced and this amount of 440 is the marginal cost i.e. the cost of the 11th unit
produced.
80
Advanced Cost Accounting - IV
Meaning of Marginal Costing
Marginal Costing is not a method of costing but it is a technique used in
costing for presenting cost data to the management in such a way that it can be
understood by it easily and can be used by the management for taking decisions.
Marginal Costing is defined by the Chartered Institute of Management Accountants
(CIMA), London, as “The accounting system in which variable costs are charged
to cost units and fixed costs of the period are written off in full against the aggregate
contribution. Its special value is in decision making”.
Marginal Costing
NOTES
I.C.M.A. defines Marginal costing as “The ascertainment of marginal cost
and of the effect on profit of changes in volume or type of output by differentiating
between fixed costs and variable costs.”
The technique of the marginal costing is based on the concept of marginal
cost. In marginal costing total variable cost of the product is regarded as the
product cost and the fixed cost amount is charged to the Costing Profit and Loss
Account of that period as the period cost. Profitability is decided on the basis of
the contribution available from each product or each department. Contribution
available from each type of product or each department is calculated by deducting
from the sales of each type of product or department the cost of sales (i.e. total
variable cost) of each type of product or each department. The technique of
marginal costing is, thus, different from the absorption costing. This difference is
explained in detail in this Unit at a later stage.
4.3.2 Features of Marginal Costing
1)
Marginal Costing is a technique of cost recording and reporting. It is not a
method of costing like job costing or process costing. It being a technique
can be used in any manufacturing unit irrespective of the method of costing
being used in the unit.
2)
In marginal costing all costs are grouped under two categories - fixed costs,
and variable costs, semi-fixed/semi-variable costs are also segregated into
fixed costs and variable costs by using a suitable method for such segregation.
3)
Variable costs also known as marginal costs are charged to products
produced in the period. Cost of products is calculated by adding direct
materials costs, direct labour cost, direct expenses and variable overheads.
4)
Fixed costs are treated as period costs and they are not charged to the
output produced during the period. So product cost does not include any
part of the fixed costs. Fixed costs are charged fully to the Costing Profit
and Loss Account prepared for the period in which the fixed costs are
incurred.
5)
Inventory of work-in-progress and finished products is valued only at the
Variable Costs.
6)
For calculating profit or loss the total fixed costs are deducted from the
total contribution available from different products and departments.
Advanced Cost Accounting - IV
81
Marginal Costing
7)
4.4
NOTES
Check Your Progress
i)
Explain meanings of
‘Marginal Cost’ and
‘Marginal Costing’.
ii) Define the term ‘marginal
costing’. What are other
terms used for marginal
costing ?
iii) Briefly explain the features
of marginal costing.
Information reported to the management through the use of marginal costing
technique helps the management in taking various important decisions.
Distinction between Absorption Costing and
Marginal Costing
1)
Absorption costing is also known as ‘total costing’ or ‘traditional costing’.
Under absorption costing all costs - variable as well as fixed - are charged to
products manufactured and inventories. The variable costs are charged on actual
basis and fixed overheads are charged by apportioning them by using a suitable
method which assures a proper charging of fixed overheads to the different
products manufactured or departments which have been benefitted by such costs.
Inventories of work-in-progress and finished products are also charged with the
fixed overheads. This results is carrying over some part of the fixed costs to the
next period.
In marginal costing variable costs are charged to products. Fixed costs are
treated as period costs and total amount of fixed costs is charged to Costing Profit
and Loss Account prepared for the period in which such production is done. No
part of fixed costs is included in the cost of products and inventories of work-inprogress or finished products. Valuation of inventory of work-in-progress and of
finished products is done at the variable costs per unit, Due to this the inventories
valuation under absorption costing is more than valuation of inventories shown
under marginal costing.
2)
Under absorption costing profitability is judged on the basis of profit available
from the products or departments and profit is calculated as the difference between
sales revenue and total costs of products or departments.
Under marginal costing profitability is judged on the basis of contribution
made by product or departments. Contribution is calculated as difference between
sales revenue of the product or department and marginal cost of the product or
department.
3)
Data provided to management under absorption costing may not be very
helpful for taking decision since the charging of fixed costs is done by apportioning
such costs using some arbitrary method. Also profit ascertainment under absorption
costing may be affected because of variation in the volume of opening inventory
and closing inventory in different periods. Managerial decision based on such
inaccurate data may not be proper decisions.
Under marginal costing product cost is calculated by considering only variable
costs of the product. Valuation of inventories is also done on the basis of variable
costs only. Profitability of different products or departments is decided on the
basis of contribution available from the products or the departments. Such
information is more reliable and it helps management to take decisions more
accurately.
82
Advanced Cost Accounting - IV
Following formats should help in understanding difference in calculation of
profit/loss under absorption costing and marginal costing :
Marginal Costing
Profit/Loss calculation under absorption costing
NOTES
Sales
........
Variable costs of manufacturing
........
Add : fixed Factory Overheads
........
Cost of goods manufactured
.........
Add : Opening stock of goods
........
Cost of goods available for sales
.........
Less : Closing stock of goods
.........
Cost of goods sold
.........
Over/Under absorption of Factory overheads
........
Cost of goods sold at actual
.........
Gross profit on sales (Sales-cost of goods sold at actual)
.........
Less : Administration and selling overheads
(Fixed + Variable)
........
Net income/loss for the period
.........
Advanced Cost Accounting - IV
83
Marginal Costing
Profit / Loss calculation under marginal costing
NOTES
Sales
........
Variable costs of manufacturing
........
Cost of goods manufactured
.........
Add : Opening stock of goods
........
Cost of goods available for sales
.........
Less : closing stock of goods
.........
Cost of goods sold
........
Contribution (Sales - cost of good sold )
........
Less : Fixed factory overheads
.........
Fixed administration and Selling overheads ........
Variable administration and Selling overheads
Net income/loss for the period
.......
........
........
Notes :
1)
Under absorption costing valuation of stock is done by including
fixed factory overheads while under marginal costing stock is valued at
variable costs only. Fixed Factory overheads are not considered in such
valuation.
2)
Under absorption costing fixed factory overheads are charged at predetermined rate and so the amount of under or over absorption is required
to be adjusted. Under absorbed fixed factory overheads are added and
over-absorbed fixed factory overheads are deducted from cost of goods
sold amount to find out cost of goods sold at actual. Under marginal costing
as stock valuation does not include Fixed Factory overheads, such adjustment
is not needed.
3)
Under absorption costing when gross profit on sales is more than the amount
of fixed and variable administration and selling overheads there is net income
and if gross profit on sales is less than the amount of fixed and variable
administration and selling overheads, there is net loss.
Under marginal costing when contribution is more than fixed factory
overheads + fixed and variable administration and selling overheads, there
is net income. If contribution is less than such overheads, there is net loss
for the period.
84
Advanced Cost Accounting - IV
4.5
Importance of the Marginal Costing
Marginal costing is extension of cost accounting methodology to the dynamics
of an economic situation. Any business may be conceived as an infinite series of
decisions and sections, of which each one throws its impact over a period of time
with diminishing emphasis. Thus, once a decision is taken and management action
is implemented at a given point of time, the resulting situation constitutes a datum
subject to room for correction for subsequent management decision and action.
From this point of view every decision reached and action taken at any given time
is marginal in character.
Marginal Costing
NOTES
It is generally recongnised that business decisions are made on the basis of
margins. It means emphasis has been shifted from absolute total cost to marginal
cost or differential cost in marking policy decisions such as,
i)
Whether the current rate of production should be continued or stepped up
or retarded?
ii)
Whether to produce certain requirements of the concern e.g. raw materials,
spare parts, capital equipment etc. within organization or to buy them from
outside?
iii)
Whether it would pay to reduce the prices of certain products during time
of trade depression to the point where such reduced price would cover
variable expenses through net total cost ?
In answering such questions the technique of Marginal Costing is used in
which emphasis is on the rate of change rather than overall changes. Marginal
Costing techniques aim at finding out the effect of changes in the levels of activity
on sales price and cost and consequently on profits.
Following are the different types of uses of Marginal Costing which
indicates the importance of Marginal Costing :
i)
Relative Profitability :
In case of Multi - Product and multi line of business activities, Marginal
Costing facilitates the study of relative profitability of different products. It
will show where the sales efforts should be concentrated.
ii)
Basis for Pricing :
Marginal Costing furnishes a better and more logical basis for fixation of
selling prices and tendering for contract particularly when business is dull.
iii)
Valuable adjunct to other techniques :
Marginal costing is valuable adjunct to budgeting and standard costing
techniques.
Advanced Cost Accounting - IV
85
Marginal Costing
iv)
Simple to Understand and Application :
Marginal Costing method is simple in application and it is easy for exercise
of cost control. It is more informative and simple to understand.
v)
Cost Analysis Possible :
Profit volume analysis is facilitated by the use of break - even charts and
profit - volume graphs, and so on.
vi)
Responsibility Accounting becomes more effective :
Responsibility accounting is more effective when based on marginal costing
because managers can identify their responsibilities more clearly when fixed
overheads is not charged arbitrarily to their departments or divisions.
vii)
Consistency :
The Marginal Cost per unit of output remains the same irrespective the
volume of output.
viii) Realistic Valuation of Stock :
In Marginal Costing stocks of finished goods and work-in-progress are valued
at their variable cost only. Therefore, it is more realistic and uniform. No
fictitious profit arises.
ix)
No under/Over absorption of overheads :
In Marginal Costing There is no question of allocation, apportionment or
absorptions of fixed overheads. Hence, the tedious method of their
accounting is eliminated.
x)
Facilitates Cost Control :
By separating the fixed and variable costs, marginal costing provides better
means of controlling costs.
xi)
Valuable aid to Management :
It helps the management with more appropriate information in taking vital
business decisions like make or buy, sub-contracting, export order pricing
under recession, of continue or discontinue a product / division / sales territory,
selection of suitable product mix etc.
xii)
Aid to Profit Planning :
The technique of Marginal Costing helps the management in profit planning.
The management can plan the volume of sales for earning a required profit.
86
Advanced Cost Accounting - IV
4.6
i)
Meaning of Various Concepts used in Marginal
Costing
Marginal Costing
Fixed Costs
Fixed Cost are those costs which do not vary with the change in the volume
of production upto a given range.
NOTES
Example : Rent and Insurance of Building, Plant and Machinery and
furniture etc.
ii)
Variable Costs
Variable Costs are those costs which vary in direct proportion to the volume
of production.
Example : Direct Material Costs, Direct Labour Costs, Direct Expenses
and Variable Overheads.
iii)
Semi-variable Costs
Semi -variable Costs are those costs of which one part remains fixed upto
a given range and other part various with the change in the volume of
production but not in the same proportion. For example an expenses may
not change if output is upto 50% capacity but may increase by 5% for
every 10% increase in input over 50% capacity but upto 80%.
Example : Telephone expenses of which hire part is fixed and charges for
calls are variable.
iv)
Contribution
It is a difference between the total sales value and total variable costs.
It is basically that portion of sales which remains after recovering variable
costs and is available towards fixed costs and profits.
v)
P/V Ratio
P/V. Ratio is the ratio of contribution to sales and is usually expressed as a
percentage.
vi)
Break Even Point
Break Even Point refers to that volume of operation as which total sales
revenue is just equal to total cost (i.e. fixed cost and variable cost).
It is the point at which there is neither profit nor loss.
It is the point at which contribution (i.e. sales - Variable costs) is just equal
to fixed costs.
vii)
Margin of Safety
Margin of Safety is the difference between actual sales and the Break
Advanced Cost Accounting - IV
87
Marginal Costing
Even Sales.
At any level of margin of safety, fixed costs are zero since fixed costs are
already recovered upto Break Even point.
At any level of margin of safely, the contribution (i.e. sales-variable costs)
is equal to profit since fixed costs are zero.
NOTES
viii) Break Even Analysis
Check Your Progress
i)
Break Even Analysis is a technique used for studying the relationship
between costs, volume and profit at different level of operations. It is called
cost-volume-profit Analysis (or CVP Analysis).
How Marginal Cost is
calculated ?
ii) What are main points of
distinction
between
‘absorption costing’ and
‘marginal costing’ ?
iii) Explain the following
concepts used in marginal
costing :
a) Fixed or Periodic Costs.
b) Variable Costs.
c) Contribution.
d) P/V Ratio
e) Break-even Point.
f) Margin of Safety.
iv) State the importance of
marginal costing by
pointing out the uses of
marginal costing.
4.6
Summary
Marginal costing is a technique of costing used for providing information
to the management of a concern by using which the management can take proper
decision about quantity to be produced and sold which will result in maximising the
concern’s profit. The technique of marginal costing is based upon the knowledge
that all costs do not behave in the same way with increase or decrease in the
output level. Some costs like direct materials cost, direct labour cost, direct expenses
and variable overheads show proportionate increase or decrease in cost with
increase of decrease in the quantity of output respectively. These costs are termed
‘Variable costs’. Some costs do not show any increase or decrease upto a certain
limit even if output level is increased or decreased. Such costs are termed as
‘Fixed Costs’ or ‘Period Costs’. Some costs show disproportionate change when
output is increased or decreased and such costs are termed as ‘Semi-variable’ or
‘Semi-fixed’ costs. Semi-variable costs are made up by mixture of fixed costs
and variable costs and in marginal costing they are required to be divided into
fixed costs and variable costs so that fixed portion of such costs can be added to
fixed costs and variable portion can be added to variable costs. In marginal costing
only variable costs are considered as product costs and fixed costs are treated as
periodic costs and charged to the Costing Profit and Loss Account prepared for
the period.
Marginal cost is a term taken from the subject of economics. Marginal cost
is the cost of the unit in the margin. So the difference in total cost which arises due
to increase or decrease of output by one unit is the amount or marginal cost.
Marginal cost is the variable cost of one unit produced more or one unit produced
less.
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Advanced Cost Accounting - IV
Marginal costing is different from traditional costing. In marginal costing
product cost is equal to variable costs i.e. direct materials cost, direct labour cost,
direct expenses and variable overheads. Fixed costs are not regarded as a product
cost. Therefore, in valuation of stock of finished goods and stock of work-inprocess only variable costs are taken into consideration whereas in traditional
costing the product cost is made up of variable costs plus fixed costs. In marginal
costing total amount of fixed costs is charged to the Costing Profit and Loss
Account prepared for the period in which the fixed costs were incurred.
Marginal Costing
Meaning of certain concepts which are used in Marginal Costing is given in
brief in this unit. Detailed information about these concepts will be provided in the
next unit.
4.7
Key Terms
i)
Fixed Costs : Fixed costs are the costs which do not change over a
reasonable period of time even when volume of production increases or
decreases.
ii)
Variable Costs : Variable costs change proportionately with increase or
decrease in the volume of production. [Per unit amount of variable costs
remain constant.]
iii)
Contribution : Contribution is the difference between sales value and
variable costs.
iv)
P/V Ratio : P/V Ratio (Profit Volume Ratio) is the ratio of contribution to
sales and indicates profitability of product.
v)
Break-even Point : It is the volume of operation at which total sales and
total costs (i.e. variable costs + fixed costs) become equal and so there is
neither profit nor loss at this volume.
vi)
Margin of Safety : Margin of safety is the difference between actual sales
and break-even point sales. A large margin of safety is desirable since it
provides a greater safety to the business enterprise.
4.8
NOTES
Questions
I - Theory Questions
1)
What is meant by ‘Marginal Cost’ and ‘Marginal Costing’? Explain, by
giving an example, how ‘Marginal Cost’ is calculated.
2)
Define the terms ‘marginal cost’ and ‘marginal costing’. Briefly state how
costs are considered and treated in Marginal Costing Technique.
3)
Define ‘Marginal Costing’. Explain important features of Marginal Costing.
4)
Differentiate between ‘Traditional Costing’ and ‘Marginal Costing’.
II - Multiple Choice Questions
1)
In orders to understand the concept of “Marginal Cost” it is necessary to
know the difference between ....... and .........
a) Fixed costs and Variable costs
Advanced Cost Accounting - IV
89
Marginal Costing
b) Material Cost and Labour Cost
c) Prime Cost and Distribution Cost
d) Profit and Margin.
NOTES
2)
Which statement of following is ‘wrong’.
a) Marginal Costing is not a method of costing.
b) Marginal Costing is a technique of costing.
c) Marginal Costing is used in manufacturing units.
d) Marginal Costing is a method of costing.
3)
Under marginal costing the profitability is judged on the basis of ...... made
by products or departments.
a) Cobtribution
b) Sales
c) Purchases
d) Ready
4)
Absorption Costing is also known as “........ “
a) Non-traditional Costing
b) Net Costing
c) Non performing Costing
d) Traditional Costing.
Ans, : (1 - a), (2 - d), (3 - a), (4 - d).
4.9
Further Reading
i) ‘Cost Accounting’ - Jawahar Lal
ii) ‘Advanced Cost Accounting’ - Nigam and Sharma
iii) ‘Theory and Practice of Cost Accounting’ - M. L. Agrawal
iv) ‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
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Advanced Cost Accounting - IV
Unit 5
Marginal Costing
(Important Concepts, Advantages
and Limitations)
Structure
5.0
Introduction
5.1
Unit Objectives
5.2
Important concepts in Marginal costing
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
5.2.1 Concept of Contribution
5.2.2 Profit Volume Ratio
5.2.3 Cost, volume and profit (CVP) Analysis
5.2.4 Concept of key factor
5.2.5 Break-even point
5.2.6 Margin of safety
5.2.7 Break-even Analysis and break -even chart
5.3
Uses of Marginal costing
5.4
Limitations of Marginal costing
5.5
Key Terms and important formulae
5.6
Summary
5.7
Questions
5.8
Further Reading
5.0
Introduction
In the use of marginal costing it is very important to understand certain
concepts. Meaning of these concepts has been provided in brief in Unit 4.
Explanation of these concepts is provided in this Unit. Also calculation of Breakeven point by using algebric method and by drawing Break-even chart is also
explained in this Unit. Uses of Marginal costing technique and limitations of the
Marginal costing technique are provided in this unit.
Advanced Cost Accounting - IV
91
Marginal Costing
(Important Concepts,
Advantages & Limitations)
5.1
Unit Objectives
After studying the information provided in this Unit you should be able to :
NOTES
•
Understand important concepts used in Marginal Costing;
•
Calculate Break-even point by using algebric method;
•
Prepare Break-even charts; and
•
Understand uses and limitations of Marginal Costing.
5.2
Important Concepts in Marginal Costing
In the technique of Marginal costing, there are some important concepts
which must be properly understood in order to use the technique of marginal
costing correctly.
These concepts are explained below :
5.2.1 Concept of contribution
Contribution is the difference between sales and variable costs. When there
is no opening or closing stock of goods the contribution is calculated as under
.......
Sales
Less : Variable Costs
Direct Material cost
.......
Direct Labour cost
.......
Direct Expenses
.......
Variable overheads
.......
Contribution
.......
........
Formula for contribution is C = S - V
Contribution is used for meeting the amount of Fixed Factory overheads,
Fixed and Variable Administration overheads and Fixed and Variable Selling and
Distribution overheads. After meeting these overheads if there remains a balance
of contribution it is shown as net profit. If contribution amount is not sufficient to
meet the above mentioned overheads the negative amount of contribution is net
loss amount.
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Advanced Cost Accounting - IV
When a business unit manufactures and sells more than one type of product,
contribution available from each type of the product is calculated separately and
then the contribution from each type of product is added together and the total
contribution is used to meet the fixed factory overheads, Fixed and variable
administration overheads and Fixed and variable selling and distribution overheads
incurred by the business unit during the period. Positive balance of contribution is
net profit and negative balance indicates net loss suffered by the business unit
during the period.
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
Profit = Contribution - Fixed Costs
P=C-F
Sales = Variable Costs + Fixes Costs + Profit
 S = VC + FC + P
Loss = Fixed costs - Contribution
[Generally, variable administration overheads and variable selling overheads
are treated as fixed costs and they are deducted along with fixed factory overheads
from contribution amount to calculate net profit / loss for the period. If variable
administration and variable selling overheads are included in calculation of total
variable or marginal costs, only fixed factory overheads, fixed administration
overheads and fixed selling overheads should be deducted from contribution
amount to find out net profit/net loss for the period]
Contribution is also known by other terms such as marginal contribution,
marginal income, marginal revenue, marginal balance and profit pick-up.
Role of Contributions :
In marginal costing, Contribution has greater significance. The justification
for contribution lies in the fact that when two or more products are manufactured
by a single unit, the apportionment of fixed cost to different products under marginal
costing is simplified. Contribution represents the difference between sales and
variable cost of sales and is often referred to as “Gross Margin” It can be
considered as some sort of fund from and out of which all fixed costs are to be
met. Again, the difference between contribution and fixed cost represents either
profit or loss as the case may be.
The concept of ‘Contribution’ is of immense use in fixing the selling
prices, determining the break-even point, selecting the product mix for profit
maximisation and also ascertaining the profitability of the products, departments
etc.
The difference between the marginal cost of the various products
manufactured and their respective selling price is the contribution which each
product makes towards fixed or period costs and profit. According to Watter W.
Bigg, Contribution may be defined as the difference between sales value and the
marginal cost of sales, and no net profit arises until the contribution equals the
fixed overheads. When this level of output is achieved, the business is said to
break-even as neither profit nor loss occurs. Production in excess of that necessary
to break-even will result in a profit equivalent to the excess units multiplied by the
“contribution” per unit. Conversely, a loss is sustained if output is less than that
required to break-even amounting to the short-fall of units multiplied by the
Advanced Cost Accounting - IV
93
Marginal Costing
(Important Concepts,
Advantages & Limitations)
contribution”. Thus, contribution is the difference between product revenue and
variable cost of product. It represents the excess of sales over marginal cost
(variable cost) that is the amount to meet fixed cost and profit expectation of an
organisation. It can be calculated as under.
Contribution = Sales - Variable Cost
NOTES
Contribution (per unit) = Selling Price - Marginal Cost Per Unit
Contribution = Fixed Cost ± Profit/Loss
Suppose total sales revenue is 1,50,000, variable cost is 60,000 and sale
in term of units are 1,000 then contribution will be
Contribution
Contribution (per unit)
=
Sales - Variable Cost
=
1,50,000 - 60,000 = 90,000
=
150 -
=
90
60
Marginal Cost Equation :
(Relationship between Marginal Cost and Contribution)
The analysis of marginal cost statement and the contribution above reveals
that :
Sales (-) Marginal Cost = Contribution
Fixed cost (+) Profit = Contribution
By combining the above two equations, we get the fundamental marginal
cost equation.
Sales - marginal Cost = Fixes Cost ± Profit / Loss
The marginal cost equation has practical utility in the sense that if any three
factors of the above equation are known, the fourth can be easily computed.
Contribution and Profit :
A product sells at 50 has a variable cost of 30 and during the period
ended 30th June 2011, 2,000 units were sold. Fixed costs for that period amounted
to 25,000. The contribution and profit would be calculated, as shown in the
following table.
94
Advanced Cost Accounting - IV
Statement showing Contribution and Profit
Particulars
Unit Cost Total Cost
% of Sales
Marginal Costing
(Important Concepts,
Advantages & Limitations)
%
Selling Price
Less :Variable Costs
(-)
Contribution
Less :Fixed Costs
50
1,00,000
100
30
60,000
60
20
40,000
40
(-)
NOTES
25,000
Profit
15,000
From the above table it can be observed that the contribution goes towards
the recovery of the fixed overheads and profit. Marginal Costing is a technique
which can be used as part of the decision - making process to show the effect of
changes possible changes in demand and/or selling price and/or variable costs. It
can for example, be used to identify the most profitable projects, in make or buy
decision making or in deciding whether or not accept a special contract. Variable
Costs include only those costs which can be identified with and traced to products,
e.g. direct [about direct materials, direct labour, direct expenses and variable
overheads. The fixed costs are those which cannot be identified with and traced
to the products. They tend to vary more with time than output, and are treated as
period costs. This means that the fixed costs are not included in product costs.
They are simply written off, in total, against the total contribution, generated from
the sale of all the firms’s products, for the period in which they were incurred.
This treatment of fixed costs also means that because they are not included in
product costs they are not carried forward into the future as part of the valuation
of the stocks of work in progress and finished goods.
The following statement shows a multiple product environment
Particulars
Products
Contribution
A
B
C
D
Total
20
34
36
20
110
(-)
78
Less : Fixed Costs
Profit
32
A multi - product environment
EXAMPLE
Compute the amount of fixed cost from the information given below
Sales
:
2,40,000
Variable Cost
:
1,20,000
Profit
:
60,000
Advanced Cost Accounting - IV
95
Marginal Costing
(Important Concepts,
Advantages & Limitations)
SOLUTION
As per marginal costing equation
NOTES
S -V
=
FC + P
2,40,000 - 1,20,000
=
FC +
1,20,000
=
FC + .60,000
(-) FC
=
(-) FC
=
FC
=
60,000
60,000 - 1,20,000
(-)
60,000
60,000
5.2.2 Profit Volume Ratio (P/V Ratio)
The profit/volume ratio also knows as ‘contribution ratio’ or ‘marginal ratio’
expresses the relationship between contribution and sales. In other words, it is the
contribution per rupee of sales. The P/V ratio may be expressed as under.
Contribution
Contribution per unit
x 100 or
P/V Ratio =
Sales
x100
Selling price per unit
Contribution i.e. (FC + Profit)
Sales =
OR
P/V Ratio
Contribution = Sales x P/V Ratio
Since contribution is equal to sale minus (-) variable cost and also represents
the amount of fixed cost and profit expectations, therefore P/V Ratio can also be
expressed as.
Sales - Variable Cost
i)
P/V Ratio
=
Sales
Fixed Cost + Profit
ii)
P/V Ratio
=
Sales
As discussed earlier, the fixed cost remains constant in the short-term period
therefore any increase in contribution after the recovery of fixed cost would result
straight way in the increase of profit. Thus,
Change in profit or Change in Contribution
P/V Ratio
=
Change in the Sales
EXAMPLE
Compute : (i) P/V Ratio and (ii) Fixed Cost from the following information.
96
Advanced Cost Accounting - IV
Sales
:
1,50,000
Profit
:
15,000
Variable Cost
:
Marginal Costing
(Important Concepts,
Advantages & Limitations)
80%
SOLUTION
Sales
=
Variable cost
NOTES
1,50,000
=
80%
80
=
x
1,50,000 =
1,20,000
100
i) P/V Ratio
S -V
=
1,50,000 -
x 100 =
S
x 100 =20%
1,50,000
ii) Contribution
=
FC +P
30,000
=
FC + 15,000
(-) FC
=
(-) FC
=
(-) 15,000
FC
=
15,000
15,000 - 30,000
FC + P
iii) Sales =
1,20,000
15,000 +
15,000
=
P/V Ratio
x 100 =
1,50,000
20
Proof :
Sales
=
1,50,000
Less : V. C. (80%)
=
1,20,000
Contribution
=
30,000
Less : F.C.
=
15,000
Profit
=
15,000
EXAMPLE
Assuming that the cost structure and setting prices remains the same in period
(i) and (ii), find out the P/V Ratio.
Periods
Sales
Total Cost
I Quarter
2,80,000
2,50,000
II Quarter
3,20,000
2,80,000
Advanced Cost Accounting - IV
97
Marginal Costing
(Important Concepts,
Advantages & Limitations)
SOLUTION
Period
NOTES
Sales
Total Cost
Profit
I Quarter
2,80,000
2,50,000
30,000
II Quarter
3,20,000
2,80,000
40,000
P/V Ratio =
Change in profit
Change in Sales
x100 =
10,000
x 100 =25%
40,000
5.2.3 Cost, Volume and profit Analysis
Every business unit is established with a basic objective of earning profit.
So persons responsible for management of a unit have to formulate policies, take
decisions and exercise control in such a way that the business unit can earn profit
from its operations. Profit is affected by the following factors to whom management
has to pay proper attention :1)
Costs and their behaviour.
2)
Volume in terms of number of units or Sales Value.
3)
Sales revenue and selling price.
4)
Sales mix.
1)
Costs and expenses behave in different ways when the volume of production
and sales vary over a period of time. Costs and expenses are required to be
divided in two separate groups as variable costs and fixed costs. For this purpose
expenses which are of semi-variable nature are required to be segregated into
variable and fixed costs by using an appropriate method for such segregation. So
that variable part of such expenses can be included in the variable costs group and
fixed part can be included in fixed costs group. Variable costs are those costs
which vary proportionately and in the same direction as the variation (changes) in
volume. Since the per unit amount of variable costs remains constant total amount
of variable costs increases when volume increases and decreases when volume
decreases.
Fixed costs which are also termed as period costs remain constant in total
amount irrespective of any increase or decrease in the volume of output. Fixed
costs per unit show variation with change in volume of output. When volume of
output increases the per unit amount of fixed costs decreases and when volume
of output decreases per unit amount of fixed costs increases.
This behaviour of variable costs and fixed costs should be fully understood
by the management because it helps the management in understanding the changes
in amount of profits with changes in volume of output planned by it. It can decide
the minimum volume of output which will provide contribution margin which will
98
Advanced Cost Accounting - IV
be equal to total fixed costs so that the business unit will not suffer any loss, and
will break-even. To earn a certain amount of profit what should be the volume of
output can also be decided by the management. [It is important to know that fixed
costs remain constant upto a certain capacity level of operations. When the output
is increased beyond that level, even fixed costs increase and such increase in
fixed costs results in reducing the amount of profit.]
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
2)
Volume which may be measured in terms of number of units produced and
sold or in terms of sales value is second important factor which affects profit of a
business unit. Assuming that the business unit produces and sells only one type of
product marginal contribution available from that product will have to meet the
fixed costs incurred and the remaining amount of contribution is available as profit
to the business unit. Contribution per unit is the difference between selling price
per unit and variable cost per unit. When there is no change in the selling price and
variable cost, the contribution per unit remains unchanged and in such situation
profit can be maximised only by increasing the volume upto capacity level. This
happens because with increase in the volume of output and sale, total contribution
increases and since the fixed costs remain constant upto the capacity level profit,
which is calculated by deducting fixed costs from contribution, increases. So
management has to take proper decision about volume of output to earn the
expected or desired amount of profit.
3)
Sales revenue and selling price is the third factor on which the amount of
profit earned by a business unit depends. Sales revenue is the amount which is
calculated by multiplying number of units sold by selling price per unit. Difference
between sales revenue and variable cost is the contribution amount. Sales revenue
increases when selling price per unit is increased and decreases when selling
price per unit is reduced. Therefore management should fix the selling price of the
product at such level which will bring maximum amount of contribution to the
business unit. Usually every business unit has to face competition in the market
and so the management should fix the selling price of its product in such a way
that it can sell all units produced by it at that price.
4)
Sales mix is the factor which is required to be decided by those business
units which produce more than one type of product. When a business unit produces
three types of products A, B and C its management has to decide how many units
of A, B and C should be produced and sold to earn maximum amount of profit.
This proportion/ ratio of units of A, B and C products is known as sales mix.
Selling prices and variable costs of A, B and C products may not be same and so
the contributions available from each type of these products are used as a guide
by the management. Profitability of each type of product is calculated by considering
P/V ratio of each type of product using following formulae :P/V Ratio
Contribution
x 100
=
Sales
Sales - Variable Costs
x 100
=
Sales
Advanced Cost Accounting - IV
99
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
Product which has the highest P/v ratio should be produced and sold to the
maximum extent and product which has the lowest P/v ratio should be produced
and sold to the minimum extent. While following this general rule the management
should consider other factors like demand for the product, technical factors which
set limit on the production of a particular product, availability of material or labour
required for production of the product, etc. A proper sales - mix will result in
increasing the amount of profit earned whereas a wrong sales - mix may result in
suffering of a loss by the business unit.
From the information provided about the four factors above it becomes
clear that it is very important for the management of a business unit to understand
how they affect amount of profit that can be earned by the business unit. Variation
made in one factor affects other factors and thereby profit amount of the business
unit. Analysis of relationship existing among cost, volume and profit enables the
management to take proper decisions in respect of volume of output, fixation of
selling prices of products and sales - mix to be adopted.
5.2.4 Concept of Key Factor
While explaining the cost, volume and profit relationship it is stated that the
management of the business unit should try to maximise its profit by taking proper
decisions about volume of output, sales and selling price and it should produce and
sell maximum units of that product which shows highest P/V ratio. For doing this
the management should have no restrictions in obtaining the required material, in
getting labour required for production, no difficulties in creating required production
capacity and in selling the entire quantity of output produced by it. But these
assumptions are rarely fulfilled. Actually most of the business units have to face
the problem either in producing the expected quantity of the product or in selling
them in the market. The factors which restrict production or sales are known as ‘
key factors’. Limiting factor, governing factor and principal factor are the other
terms used to denote the key factor. In case of most of the business units ‘sales’
is the key factor which puts limit on the maximum number of units of products
which can be sold by them and they have to restrict the production upto that limit.
Some other factors which can be regarded as the key factor are as under :-
100 Advanced Cost Accounting - IV
1)
Availability of material needed for production.
2)
Labour hours are restricted because of non-availability of labourers
possessing the specific skill required for production of the product.
3)
Machine hours are restricted due to the plant capacity.
4)
Restriction placed on production by the Government.
5)
Inability to bring in additional capital for raising production capacity.
When such a key factor exists, the management has to take decision about
quantity to be produced of different products and also about the sales-mix to be
adopted with reference to the key factor. For this the profitability of each type of
product is calculated with reference to the key factor and following formulae is
used for that purpose :-
Marginal Costing
(Important Concepts,
Advantages & Limitations)
Contribution
Profitability of the product
=
Key Factor
Following illustration should help in understanding the calculation of
profitability and the quantity to be produced of each type of the product
A business unit produces and sells product X and product Y. Following
information is provided to you :-
Direct material used per unit
Material cost per kg
Product X
Product Y
3 kg
2 kg
50
Direct Labour Cost per unit
20
25
Direct Expenses per unit
5
4
Variable factory overheads per unit
5
6
Fixed overheads
NOTES
2000 per week
Selling price per unit
Maximum production possible per week
240
200
100 units
150 units
Assuming that the product X and product Y use the same material and
maximum 480 kg of material is available per week, find out the profitability in
terms of material for both products and work out the best sales mix for X and Y
which will give maximum profit to the business unit.
SOLUTION
1) Calculation of profit per unit for product X and product Y
Product X
A) Sales 240
Product Y
200
Variable cost per unit
Direct material cost
150
100
Direct Labour cost
20
25
Direct expenses
5
4
Variable factory overheads
5
6
180
135
60
65
B) Total variable cost per unit
Contribution per unit (A - B)
Advanced Cost Accounting - IV
101
Marginal Costing
(Important Concepts,
Advantages & Limitations)
Material is the Key Factor and Product X consumes 3kg material per unit
and Product Y consumes 2 kg material. Therefore profitability can be calculated
in terms of the material consumed per unit as under
Contribution
NOTES
Profitability
=
Material in kg
60
Profitability of Product X
=
=
20 per kg of material
=
32.50 per kg of material
3kg
65
Profitability of Product Y
=
2kg
Product Y shows more profitability per kg of material consumed and so
maximum possible production of Product Y should be done and remaining quantity
of material should be used for production of Product X. Maximum possible
production of Product Y is given as 150 units and so 150 x 2kg = 300 kg material
should be used for Product Y and remaining quantity of material 180 kg should be
used for producing Product X. As each units of Product X requires 3kg material
by using 180 kg material 60 units of Product X can be produced . Maximum profit
can be earned with the sales-mix of X 60 units and Y 150 units. This maximum
profit can be calculated as under :Product X
Selling price per unit
Product Y
Total
240
200
-
60
150
-
Sales revenue
14400
30000
44400
Less Marginal/Total Variable Cost
10800
20250
31050
3600
9750
13350
-
-
2000
Units produced and sold
Contribution
Less Fixed Costs for a week
Profit
11350
If instead of the sales mix of 60 units of X and 150 units of Y any other
sales-mix is adopted the amount of profit will reduce.
5.2.5 Break-even Point
102 Advanced Cost Accounting - IV
In marginal costing calculation of ‘break-even point’ occupies a significant
place. To break-even means to have contribution amount which is exactly equal
to the amount of fixed costs. In other words when the sales revenue becomes
equal to the total costs (made up of total variable cost plus total fixed costs) the
business unit is said to reach the break-even point or break-even position. By
deducting the total variable cost per unit from the sales value of the unit we obtain
the marginal contribution. This contribution is used to meet the fixed costs of the
business unit in the first instance. In the beginning total fixed costs amount is
larger than the amount of contribution and so the difference is the amount of loss.
As the number of units sold go on increasing the contribution amount also increases
and reduces the amount of loss. At a certain number of units the contribution
amount meets the remaining balance of the fixed costs and the amount of fixed
costs is fully met by the contribution. This quantity of unit is known as the breakeven point quantity. There is neither any profit nor any loss at the break even
point. After this point every additional unit sold provides profit because the
contribution available from that unit is not required for meeting fixed costs and so
such contribution becomes profit available to the business unit.
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
In marginal costing break-even point can be calculated in any of the following
ways :
Fixed Costs
B. E. P. (in units)
F
=
=
Contribution per unit
C
Fixed Costs
B. E. P. (in sales)
=
P/V Ratio
Total Fixed Costs
B. E. P. Sales value
=
Total variable cost
1Total sales value
Some times only sales and profits of a business unit for two consecutive
years are given and from this data Break-even point is asked to be calculated. In
such case P/V ratio of the business unit should be calculated first by using the
following formulae :Change in profit
P/V Ratio
x 100
=
Change in sales
Then using the P/v ratio, other items like variable costs, fixed costs for any
one year should be calculated and finally B. E. P. should be calculated by using
the formulae given below :
Fixed Costs
B. E. P.
=
P/V ratio
A business enterprise which has a break-even point at lower level has better
opportunity of earning more profit since by reaching the break-even point at lower
level of sales, the unit earns profit on the remaining quantity sold after the breakeven quantity. On the other hand a business unit which reaches break-even point
after selling a large quantity of product starts earning profit on units sold after the
break-even point and so it earns profit on the remaining quantity of product sold
and thus earns a small amount of profit.
Advanced Cost Accounting - IV
103
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
5.2.6 Margin of Safety
Margin of safety is difference between the actual sales and the sales at the
break-even point. Margin of safety calculated in this manner is the margin of
safety in sales value. Margin of safety can also be calculated in terms of quantity
or number of units. It is calculated as under :Margin of safety (in units)
=
Margin of safety in %
=
Actual units sold - units at break even point
BEP
x 100
1Sales
Margin of safety can also be calculated by using following formula :Profit
Margin of safety
=
P/V Ratio
A low margin of safety indicates that the business unit has a small buffer to
fall back upon and even a small reduction in the sales is likely to reduce the profits
of the business enterprise considerably and may bring it to the position of no profit
no loss. A business enterprise which has a large margin of safety is in a better
position to face the position of reduction in sales since it has a larger buffer to
absorb the shock of reduction in sales. In a break-even chart, the distance between
the break-even sales and the actual sales is the margin of safety.
5.2.7 Break-even Analysis and Break-even Chart
Break-even Analysis :Break-even analysis is the analysis of the factors which affect the amount
of profit available to a business enterprise. Amount of profit depends upon five
factors which consists of (1) selling price, (2) volume of sales, (3) unit variable
costs, (4) total fixed costs and (5) sales-mix i.e. the proportions in which different
products are produced and sold by the business enterprise. Analysis of each of
these factors enables the management of the enterprise to know how changes
made in these factors will affect the profit of the enterprise and such analysis
helps the management in taking decisions and planning the profit of the enterprise.
104 Advanced Cost Accounting - IV
Break-even analysis indicates to the management how changes made in
the selling price, volume of sales, variable costs per unit, total amount of fixed
costs and in the sales-mix of the various types of products produced and sold will
affect the profit of the enterprise. It also helps the management to understand at
which volume the enterprise reaches the break-even point and so reaches the
position of no-profit, no-loss and how any decrease and increase in the volume of
sales will reduce the profit or increase the profit or wipe-up the profit and result in
suffering loss by the enterprise. Effect on profit caused by increase or decrease
in the selling price per unit or variable cost per unit, or total fixed costs or proportion
of sales-mix can also be easily understood by the management by making use of
the break-even analysis and the management can take decisions and plan the
profit of the enterprise accordingly.
Marginal Costing
(Important Concepts,
Advantages & Limitations)
Assumptions of Break-even Analysis :For break-even analysis, following assumption are made :1)
All costs can be divided into two groups-variable costs and fixed costs.
2)
Variable costs change proportionately and in the same direction as the volume
of sales changes. Per unit amount of variable cost remains constant and
increase in the volume will cause proportionate increase in amount of total
variable costs and decrease in sales volume will cause proportionate decrease
in the total variable costs.
3)
Fixed cost remains constant at all volumes of sale and so increase in volume
of sales causes reduction in per unit amount of the fixed costs and decrease
in the sales volume causes increase in the per unit fixed costs [It should be
noted that the assumption that fixed costs remain constant is true only upto
a certain volume of production and sales. If volume is increased beyond
this limit even the fixed costs show a tendency to increase because of
additional infra-structure is required to be created for increase in production
and sales beyond a certain limit and due to this the fixed costs also increase.]
4)
Selling price unit remains the same at all levels of activity.
5)
Entire quantity produced is sold and the market can absorb the entire quantity
offered for sale.
6)
Production facilities and productivity per worker remain same.
NOTES
Break-even analysis is useful to the management in understanding the
relationship that exists among the factors on which the profit of a business
enterprise depends and in knowing how changes made in any of these factors will
affect the profit. This analysis is very useful in profit planning and exercising
control on the working of the business enterprise. Management is able to decide
the alternative options available to it for achieving a certain profit target and which
option would be more beneficial for the enterprise. Using the information provided
by the break-even analysis, the management is able to prepare flexible budget
showing the position of different types of costs, sales revenue and profit available
at different levels of operating.
Break-even Chart :When the information which becomes available from break-even analysis
is presented to the management in a graph or chart format, it becomes easy for
the management to understand the information. Such presentation is called as
‘break-even chart’ or ‘break-even graph’. A Break-even Chart can be prepared
in various ways and the simplest type of Break-even Chart is prepared as under :-
Advanced Cost Accounting - IV
105
Marginal Costing
(Important Concepts,
Advantages & Limitations)
Y
Sa
les
Re
ve
nu
eL
in
e
Actual Sales in rupees
Margin of Safety (in Sales rupees)
NOTES
Sales Revenue and costs (in ’000
)
. P. u
B. E Sales r
( in
s)
pee
gl
An
ce
en
id
c
n
fI
eo
o
Pr
a
re
A
t
fi
Co
tal
To
ine
st L
Break-even Point
Variable Costs
ss
Lo
a
Are
Fixed Cost Line
Fixed Costs
O
Units produced and sold
Margin of Safety Cost
Actual units sold
X
Break-even Chart
While preparing the Break-even Chart shown above, on OX axis the number
of units produced and sold are shown and on OY axis the costs amounts and sales
revenue at different levels of output are shown in thousand rupees. Fixed costs
amount remain constant for all levels of output and so the fixed costs line is drawn
parallel to the OX axis. Total costs line is plotted in the chart and this line begins on
OY axis at the point where fixed cost line begins and rises upward to the right as
the variable costs increase according to the increase in units produced and sold.
The Sales Revenue Line starts at O and it is a straight line rising to the right
because increase in units sold increase the sales revenue proportionately Total
Costs line and the sales revenue line intersect each other at a certain point and
this point is the break-even point because at this point the total costs incurred and
the sales revenue received become equal and so there is no profit or no loss at the
B. E. P. From this point the perpendicular drawn by a dotted line reaches the OX
axis at a point which shows the break-even position in number of units. From the
B.E.P. if perpendiculars drawn on OY axis shows the break-even position in terms
of the sales amount. The area covered by the sales revenue line and the total cost
line, shown as shaded area, is the profit area as the sales revenue line is above the
total costs line and the area covered by the total costs line and the sales revenue
line at the B.E.P. shows the loss area since the total costs line is above the sales
revenue line at the B.E.P. Angle formed by the sales revenue line and the total
costs line at B. E. P. is known as ‘angle of incidence’ and this angle determines
the area of profit. If angle of incidence is narrow, the profit area will be small and
if the angle of incidence is broad, the profit area will be large.
106
Advanced Cost Accounting - IV
On the OX axis, the distance from the B.E.P. units to the actual units sold
indicates the margin of safety in number of units. Similarly the distance between
Marginal Costing
(Important Concepts,
Advantages & Limitations)
B.E.P sales and the actual sales shown on OY axis shows the margin of safety in
terms of the sales value.
A break-even chart can be prepared in a different way. While preparing
this type of the break-even chart instead of plotting the fixed costs line first, the
variable costs line is first plotted. The variable costs line begins at O point and
rises to the right according to increase in the variable costs with increase in the
number of units produced and sold. The total costs line is plotted above the variable
costs line and it is a parallel line to the variable costs line. The sales revenue line
is plotted starting from O point and rising upwards to the right. The total costs line
and the sales revenue line intersect at a point and this point is the Break-even
Point. Other details like profit area, loss area, angle of incidence and margin of
safety are shown in the chart in the same way as explained in the simple breakeven chart. The Break-even Chart according to the second type appears as shown
below :-
NOTES
Check Your Progress
i)
Explain the following
concepts used in Marginal
Costing:
a) Contribution
b) P/V Ratio
c) Cost, Volume and Profit
d) Key Factor / Limiting
Factor
e) Break-even Point
Y
ii) What is meant by ‘Margin
of Safety’? How it is
calculated ? What is its
importance ?
Sa
les
Re
ve
nu
eL
in
e
Actual Sales in rupees
Sales revenue and costs in Thousand Rupees
Margin of Safety (in Sales rupees)
s)
. P. rupee
E
.
s
e
B Sal
( in
Total Costs Line
iii) What is Break-even Chart?
Mention the important
items which are shown in
the Break-even chart.
a
re
it A
f
o
Pr
Angle of Indence
Lo
ss
A
re
a
Break-even Point
sts
Co
d
e
Fix
Variable Costs
O
Fixed Cost Line
Fixed Costs
Units produced and sold
Margin of Safety Cost
Actual units sold
X
Units produced & sold
Break-even chart can also be prepared showing the details of variable costs,
fixed costs and the division of profit amount for various purposes for which the
profit is used. The total area of variable costs is shown distributed among direct
material costs, direst labour cost and direct expenses and variable manufacturing
and variable selling and distributions expenses as per the proportion of each item
of direct element cost in the total variable costs. The area of total fixed costs is
shown divided in fixed production expenses, fixed office and administration and
fixed selling and distribution expenses. This helps the management to know the
relative importance of each item. The profit area is also shown divided in amount
used for equity and preference shares dividend and amount to be transferred to
Advanced Cost Accounting - IV
107
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
various types of reserves created by the company management. The break-even
chart prepared in this way becomes more informative.
5.3
Uses of Marginal Costing
Marginal Costing is a technique of costing and it provides following uses or
advantages to the business enterprises which use it :-
108 Advanced Cost Accounting - IV
1)
It is simple to understand and follow the technique of marginal costing.
Grouping of all costs in the variable costs group and fixed costs group can
be done easily by considering the behaviour of the various items of costs.
The concept of contribution per unit and calculation of break-even point are
logical and easy to understand and follow.
2)
In marginal costing valuation of finished goods stock and stock of work-inprocess is done at the marginal cost. The valuation of stocks is, thus, made
at realistic values and over or under valuation of stocks does not take place
since the fixed costs are not considered in valuation of stocks. Recording
of assets in the form of stock of work-in-process and stock of finished
goods is done in the financial statements at proper values.
3)
In marginal costing all items of the fixed overheads are treated as ’period
costs’ and are entirely charged to the Profit and Loss Account prepared for
that period. Due to this appropriation and absorption of the fixed overheads
does not become necessary and there is no possibility of over or under
absorption of the fixed overheads.
4)
Marginal Costing is an important tool available to the management for cost
control. Marginal Costing provides information to the management as to
how the costs will behave with changes in the volume of output. Management
can find out how much should have been the costs at the level of output
achieved by it and how much are the actual costs incurred at that output
level. If actual costs are more than the expected amount of costs, the
management can calculate the variance and to find out the reasons for the
same and decide the action to be taken to avoid recurrence of similar situation
in future. Marginal costing enables preparation of flexible budgets and the
flexible budgets can help the management in controlling the costs.
5)
Marginal costing helps the management in taking proper decisions. Decisions
like how much quantity of a product should be produced and sold to breakeven, how much quantity should be produced to earn a certain amount of
profit, whether a product should be produced by the enterprise or it should
be purchased from outside (make or buy). which of the products produced
has a highest profitability, upto which output level production of a certain
product should be continued, should an export order at the offered price be
accepted or not, upto which level the selling price of its product could be
reduced by the management during depression period, if the enterprise is
producing and selling two or more than two types of products which sales-
Marginal Costing
(Important Concepts,
Advantages & Limitations)
mix will give maximum amount of profit when some key-factor is restricting
the production or sales are some of the questions in respect of which a
proper and correct decision can be taken by the management with the help
of marginal costing
6)
Marginal costing helps in fixation of selling price of a product. Marginal
Costing provides information about the marginal cost of a unit of the product.
Knowing the volume of sales and desired profit amount, how much
contribution per unit is required can be calculated and adding the contribution
per unit to the marginal cost per unit the total amount can be fixed as the
selling price per unit of the product. The price to be quoted for a contract
can also be decided by using the technique of the marginal costing.
NOTES
Check Your Progress
i)
Explain the uses
Marginal Costing.
of
ii) What are the limitations of
Marginal Costing ?
5.4
Limitations of Marginal Costing
Marginal Costing has the following limitations which should be kept in mind
while using marginal costing :1)
It is difficult to classify the costs in fixed costs and variable costs. Some
costs are of semi-fixed or semi-variable nature and they show the tendency
to remain constant upto a certain level of output but increase after that
level of output. A part of such semi-fixed cost moves with time and remaining
part moves with the units produced. It becomes difficult to treat them as
fixed costs or variable costs.
2)
In marginal costing valuation of stock of work-in-progress and of finished
goods is done at the marginal cost and the fixed costs are not included in
the stock valuation. The value of stock is, thus, not done properly and as
such they are shown at lower value in the financial statements than their
proper values. Profit calculated by using these values of stocks is reduced
due to this.
3)
In marginal costing product cost is calculated by considering the marginal /
variable cost but product cost is not dependent only on variable costs and
even some part of fixed costs should also be included along with the variable
costs to decide the product cost. Since this is not done in marginal costing
product cost calculated in marginal costing cannot be accepted as correct
especially in the long term pricing.
4)
Marginal costing is not very useful in job costing and long duration contract
costing.
5)
In marginal costing time factor is ignored. Two jobs may show the same
marginal costs but if one job takes considerable long time for completion as
compared to the other job it is obvious that the cost of the job taking more
time for completion should be more than the cost of the other job. Marginal
costing does not take into consideration this factor.
6)
Marginal costing is not acceptable to the income-tax authorities because
Advanced Cost Accounting - IV
109
Marginal Costing
(Important Concepts,
Advantages & Limitations)
profit calculated by using marginal costing varies from the profit calculated
by using traditional or absorption costing.
5.5
Key-Terms And Important Formulae
NOTES
1)
2)
3)
4)
5)
110 Advanced Cost Accounting - IV
Sales or Selling Price or Market Price or Value of Turn over or
Invoice Price or price Inflated Price or Volume of Sales :
=
Total Cost + Profit
or
=
Variable Cost + Fixed Cost + Profit
or
=
Contribution/ P/V Ratio
or
=
Contribution + Variable Cost
or
=
Marginal Cost/Marginal Cost Ratio
Profit or Net Margin :
=
Sales - Total Cost
or
=
Sales - (Variable Cost + Fixed Cost)
or
=
Margin of Safety x P/V Ratio
or
=
Contribution - Fixed Cost
Loss :
=
Total Cost - Sales
=
Fixed Cost - Contribution
or
Contribution or Contribution Margin or Marginal Contribution or
Marginal Income or Marginal Revenue or Marginal Balance or Profit
Pick-up or Gross Margin :
=
Sales - Variable Cost
or
=
Fixed Cost + Profit
or
=
Sales x P/V Ratio
or
=
Fixed Cost - Loss
or
=
Fixed Cost / Break Even Units
Fixed Cost or Constant Cost or Rigid Cost or Static Cost :
=
Total Cost - Variable Cost
or
=
Contribution - Profit
or
=
Contribution + Loss
or
=
Sales - ( Variable Cost + Profit)
6)
Variable Cost or Marginal Cost :
=
Total Cost - Fixed Cost
or
=
Sales - Contribution
or
=
Sales - (Fixed Cost + Profit)
or
=
Direct Material + Direct Labour + Direct Expenses +
Marginal Costing
(Important Concepts,
Advantages & Limitations)
NOTES
Variable Overheads
7)
Break-even Point (in Units) :
Fixed Cost
=
or
Contribution per unit
Break Even Sales In Rupees
=
Selling Price Per Unit
8)
Break Even Point (Sales Volume in Rupees) :
Fixed Cost
=
x Selling Price per unit
or
x Total Sales
or
Contribution per unit
Total Fixed Cost
=
Total Contribution
Fixed Cost
=
or
P/V Ratio
Fixed Cost
=
or
Variable Cost
1Sales
=
9)
Break Even Units x Selling Price Per unit
Profit / Volume Ratio or Contribution - Sales Ratio or Marginal
Income Ratio or Variable Profit Ratio :
Contribution
x 100
=
or
Sales
Change in Profits
x 100
=
or
Change in Sales
Change in Contribution
x 100
=
Change in Sales
Advanced Cost Accounting - IV
111
Marginal Costing
(Important Concepts,
Advantages & Limitations)
10)
Margin of Safety :
M/s in Rupees
= Actual Sales - Break Even Sales
M/s in units
= Actual Sales in units - Break Even Sales in Units
M/s in %
=
Margin of Safety
NOTES
x 100
or
Actual Sales
Profit
M/s in %
x 100
=
P/V Ratio
11)
Sales for desired Profits (in units) :
Fixed Cost + Desired Profit
=
Contribution per unit
12)
Sales for desired profits (in rupees) :
(Fixed Cost + Desired Profits) x Sales
=
or
Total Contribution
Fixed Cost + Desired Profit
=
P/V Ratio
5.6
Summary
Marginal Costing which is also known as ‘variable costing’ or ‘direct costing’
is a technique of costing which is useful for management of a manufacturing
concern in deciding the quantity to be produced and sold for earning maximum
profits. In order to use this technique certain important concepts used in Marginal
Costing should be properly understood by the management. Concept of contribution
is important. Contribution is the difference between sales value and variable costs
incurred for producing and selling the quantity required for obtaining that sales
value. Contribution is first used for meeting the fixed costs. When contribution
becomes equal to the fixed costs the concern reaches the Break-even Point
because at this point there is no profit or no loss and total cost becomes equal to
total sales revenue. When actual quantity produced and sold is less than the breakeven quantity there is loss and when actual quantity produced and sold is more
than the break-even quantity the concern earns profit. Break-even position can
be calculated by using the algebric equation and it can also be found out by preparing
the Break-even chart or Break-even graph. Management should understand the
relationship between cost, volume and profit and how a change in any one factor
affects the other factors and profit of the concern. Key-factor or limiting factor is
a factor which puts limit on the operations and production of the concern and
management should find out which is the key-factor for the concern. Proper
112 Advanced Cost Accounting - IV
attention should be given by the management to the uses of marginal costing and
also to the limitations of marginal costing.
5.7
Marginal Costing
(Important Concepts,
Advantages & Limitations)
Questions
1)
What is meant by ‘Contribution’ in Marginal Costing ? How it is calculated?
What is the importance of the concept of contribution ?
2)
What do you understand by ‘P/V Ratio’? How it is calculated? What is the
significance of P/v Ratio?
3)
Explain the concept of Cost, Volume and Profit Analysis.
4)
Explain the concept of ‘Break-even point’. Which methods can be used for
finding out the Break-even point of a business concern?
5)
What do you mean by ‘margin of safety’? Why the margin of safety is
regarded as important for a manufacturing concern?
6)
Prepare a Break-even Chart and indicate the various important items in it.
7)
What is Break-Even Analysis? State the important assumptions of Break
Even Analysis.
8)
Explain the uses and limitations of Marginal Costing.
9)
Write notes on :
NOTES
a) Break-even Point
b) Angle of Incidence
c) Margin of safety.
Multiple choice questions
1)
Under Marginal Costing product cost is calculated by considering only -------- of the product.
a) fixed costs
(b) semi fixed costs
(c) profit
(d) Variable Costs
2)
Contribution is difference between the Total Sales Value and Total -------Cost
(a) fixed
(b) variable
Advanced Cost Accounting - IV
113
Marginal Costing
(Important Concepts,
Advantages & Limitations)
(c) semi variable
(d) non-variable
3)
Sale = Variable Costs + Fixed Costs + ------------(a) Profit
NOTES
(b) purchases
(c) Contribution
(d) overheads
4)
Margin of Safety is the difference between the actual sales and the sale of
------------(a) break-even
(b) beginning
(c) closing date
(d) opening date
Ans. : (1 - d), (2 - b), (3 - a), (4 - a).
5.8
114 Advanced Cost Accounting - IV
Further Reading
i)
‘Advanced Cost Accounting’ - Nigam and Sharma.
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B. K. Bhar.
Unit 6
Marginal Costing (Illustrations)
Marginal Costing
(Illustrations)
Structure
6.0
Introduction
6.1
Unit Objectives
6.2
Illustration on Marginal Costing
6.3
Summary
6.4
Exercises
6.0
NOTES
Introduction
In units 4 and 5 we have considered theoretical information about the costing
technique Marginal Costing. In this Unit we will consider the practical part of
Marginal Costing by studying the illustrations provided on calculation of P/V Ratio,
calculation of Break-even Point, margin of safety, consideration of the key-factor
and its use in advising the management to take correct decision and how to find
out missing information by using the other data provided to us.
6.1
Unit Objectives
After studying the illustrations provided in this Unit, you should be able to :-
•
Understand how to use the formula by considering the data provided.
•
Solve practical problems by selecting the proper formula on the basis of
given information ; and
•
Advise the management in taking right decision by using formula used in
Marginal Costing.
Advanced Cost Accounting - IV
115
Marginal Costing
(Illustrations)
6.2
Illustrations
ILLUSTRATION 1
NOTES
From the following information find out : (a) P/V Ratio, (b) BEP (Sales), (c)
Profit when Sales are 1,20,000 and (d) Sales required to earn a profit of
60,000
Fixed Cost
40,000
Variable Cost per unit
2
Sales
2,00,000
Selling Price per unit
10
SOLUTION
(a) P/V Ratio :
Contribution per unit
=
Selling Price per unit
x 100
But Contribution per unit = Selling price per unit - Variable Cost
per unit

=
P/V Ratio
Selling Price per unit - Variable Cost per unit
Selling Price per unit
10 -
=
2
x 100
10
8
=
x 100
10
=
80%
(b) BEP Sales :
Fixed cost
=
P/V Ratio
40,000
=
80%
100
116 Advanced Cost Accounting - IV
=
40,000 ×
=
50,000
80
x 100
(c) Profit when sales are
Marginal Costing
(Illustrations)
1,20,000 :
Contribution
Where
But,
P/V Ratio
Contribution
=
Sales
= Fixed cost + Profit
Fixed cost + Profit

P/V Ratio

P/V ratio x Sales

Profit
=
NOTES
Sales
= Fixed cost + Profit
= (P/V Ratio x Sales) - Fixed cost
= (80% x
1,20,000) -
=
96,000 - 40,000
=
56,000
(d) Sales required to earn a profit of
40,000
60,000 :
Contribution
Where
But,
P/V Ratio
Contribution
=
Sales
= Fixed cost + Profit
Fixed cost + Profit

P/V Ratio
=
Sales
=
Sales
Fixed cost + Profit
=
P/V Ratio
40,000 + 60,000
80%
1,00,000
=
80%
100
=
1,00,000 x
=
1,25,000
80
Advanced Cost Accounting - IV
117
Marginal Costing
(Illustrations)
ILLUSTRATION 2
A Co. furnishes you with the following cost data for the year 2011-12
Process Material per unit
NOTES
3
Sales
Units 10,000
Operating labour per unit
3
Fixed cost
60,000
Chargeable Expenses per unit
1
Value of Sales per unit
25
Variable Overheads - 100% of Direct Labour
You are required to find out.
(a) P/V ratio
(b) BEP (Sales)
(c) Margin of Safety
SOLUTION
Calculation of Total Variable Cost per unit
Process Material
3.00
Add :
Operating Labour
3.00
Add :
Chargeable Expenses
1.00
Add :
Variable Overheads
3.00
(100% Direct Labour i.e.
3)
(+)
 Total
10.00
(a) P/V Ratio
=
Contribution per unit
x 100
Selling price per unit
But,
=
Contribution per unit = Selling Price per unit - Variable Cost per unit

P/V Ratio :
=
Selling Price per unit - Variable Cost per unit
Selling Price per unit
=
118 Advanced Cost Accounting - IV
20 25
10
x 100
x 100
15
=
Marginal Costing
(Illustrations)
x 100
25
=
60%
(b) BEP (Sales) :
=
NOTES
Fixed Cost
P/V Ratio
60,000
=
60%
60,000 x
=
100
60
=
1,00,000
(c) Margin of Safety :
=
Actual Sales - Break Even Sales
=
( 25 x 10,000 units) -
=
2,50,000 - 100,000
=
1,50,000
1,00,000
ILLUSTRATION 3
A Co. prepared the following budget estimates for the year 2011-2012
Sales
Units - 15,000
Fixed costs
34,000
Sales value
1,50,000
Marginal Cost per unit
6
You are required to calculate,
1)
P/V Ratio, BEP (Sales) and Margin of Safety.
2)
Also calculate the effect of the following :
a) decrease of 10% in Selling Price
b) increase of 10% in Variable Cost
Advanced Cost Accounting - IV
119
Marginal Costing
(Illustrations)
SOLUTION
• Calculation of Selling Price Per unit :
If 15,000 units
=
1 unit
=
NOTES
=
1,50,000
?
1 unit x
1,50,000
15,000 units
=
1)
10
i) P/V Ratio :
=
Contribution per unit
x 100
Selling price per unit
But, Contribution per unit = Selling Price per unit - Variable Cost per unit

=
P/V Ratio :
Selling Price per unit - Variable Cost per unit
Selling Price per unit
=
10 -
6
x 100
10
=
4
x 100
10
=
40%
ii) BEP (Sales) :
Fixed Cost
=
P/V Ratio
34,000
=
=
40%
34,000 x
100
40
=
85,000
iii) Margin of safety :
=
120 Advanced Cost Accounting - IV
Actual Sales - Break Even Sales
=
1,50,000 - 85,000
=
65,000
x 100
Marginal Costing
(Illustrations)
2) a) Decrease of 10% in Selling Price :
Original Selling Price
Decrease of
-
Per unit
10
10%
-
1
New Selling Price
=
Per unit
=
9
NOTES
i) P/V Ratio :
=
Contribution per unit
x 100
Selling Price per unit
But,
Contribution per unit = Selling Price per unit -Variable Cost per unit
P/V Ratio :
=
Selling Price per unit - Variable Cost per unit
x 100
Selling Price per unit
=
9-
6
x 100
9
=
=
3
x 100
9
1
33 / %
3
iii) BEP (Sales) :
=
Fixed Cost
P/V Ratio
=
=
=
34,000
1
33 / %
3
34,000
1
/
3
34,000 x 3
1
=
1,02,000
iii) Margin of Safety :
=
Actual Sales - Break Even Sales
=
(15000 units x
9) -
1,02,000
=
1,35,000 - 1,02,000
=
33,000
Advanced Cost Accounting - IV
121
Marginal Costing
(Illustrations)
2) b) Increase of 10% in Variable Cost :
Original Variable
Increase of
+
Cost per unit
6
10%
+
0.60
New Variable
=
=
Cost per unit
6.60
NOTES
i) P/V Ratio :
=
Contribution per unit
x 100
Selling Price per unit
But,
Contribution per unit = Selling Price per unit - Variable Cost per unit
 P/V Ratio :
=
Selling Price per unit - Variable Cost per unit
Selling Price per unit
=
10.00 -
6.60
x 100
10
=
3.40
x 100
10
=
34%
ii) BEP (Sales) :
=
Fixed Cost
P/V Ratio
=
34,000
34%
=
34,000 x
100
34
=
1,00,000
iii) Margin of Safety :
=
122 Advanced Cost Accounting - IV
Actual Sales - Break Even Sales
=
1,50,000 - 1,00,000
=
50,000
x 100
Marginal Costing
(Illustrations)
ILLUSTRATION 4
Atlas Co. has submitted the following cost data for the year 2011 - 2012
Invoice price per unit
40.00
Fixed - Production Overheads
1,50,000
Variable - Manufacturing Cost per unit
Selling on Cost - Constant
NOTES
5.00
20,000
Prime Cost Materials per unit
18.00
Rigid - Distribution Expenses
10,000
Marginal - Selling Overheads per unit
2.00
Calculate :
(i) BEP (Sales), (ii) Number of units to be sold to earn a profit of 1,20,000 and,
(iii) Number of units to be sold to earn an income of 25% of Sales.
SOLUTION
•
Calculation of Total Fixed Cost :
•
i) Fixed - Product Overheads
1,50,000
ii) Selling on Cost - Constant
20,000
iii) Rigid - Distribution Expenses
(+) 10,000
Total
1,80,000
Calculation of Total Variable Cost per unit :
i) Variable - Manufacturing Cost per unit
5.00
ii) Prime Cost Materials per unit
18.00
iii) Marginal - Selling Overheads per unit
Variable Cost per unit
•
2.00
25.00
Calculation of P/V Ratio :
P/V Ratio
=
Contribution per unit
x 100
Selling Price per unit
But,
Contribution per unit
=
Selling Price per unit - Variable Cost per unit
Advanced Cost Accounting - IV
123
Marginal Costing
(Illustrations)
P/V ratio
Selling Price per unit - Variable Cost per unit
=
x 100
Selling Price per unit
NOTES
40 -
=
25
x 100
40
15
=
x 100
40
=
37.50%
i) BEP (Sales) :
Fixed Cost
=
P/V Ratio
1,80,000
=
37.50%
1,80,000 x
=
100
37.50
=
4,80,000
ii) Number of units to be sold to earn a profit of
Where,
P/V Ratio
=
1,20,000 :
Contribution
Sales
But,
Contribution
=
Fixed Cost + Profit
P/V Ratio
Fixed Cost + Profit
=
Sales
Fixed Cost + Profit

Sales
=
=
P/V Ratio
1,80,000 + 1,20,000
37.50%
=
3,00,000 x
100
37.50
=
124 Advanced Cost Accounting - IV
8,00,000
Marginal Costing
(Illustrations)
But,
Total Sales
Number of units to be sold =
Selling Price per unit
8,00,000
=
40
NOTES
= 20,000 units.
iii) Number of units to be sold to earn an income of 25% of Sales :
Let x be the number of units to be sold
Fixed Cost + Desired Profit
X =
Contribution per unit
But,
Contribution per unit = Selling Price per unit - Variable Cost per unit
Fixed Cost + Desired Profit
X =
Selling Price per unit - Variable Cost per unit
1,80,000 + 25% (x x 40)
X =
40 -
25
1,80,00 + 10x
X =
15

15x =
1,80,000 + 10x

15x - 10x =
1,80,000

5x =
1,80,000

x =
1,80,000
5
x = 36,000 units
ILLUSTRATION 5
The total turnover and profit during the last two years of a company were as
follows :
Year
Total turnover
Profits
2011-12
15,00,000
2,00,000
2012-13
17,00,000
2,50,000
Actual Fixed Cost is 1,75,000.
You are required to calculate,
Advanced Cost Accounting - IV
125
Marginal Costing
(Illustrations)
(a) P/V Ratio, (b) BEP (Sales), (c) The profits made when Sales are
and (d) The Sales required to earn a profit of 4,00,000
25,00,000
SOLUTION
a) P/V Ratio
NOTES
Change in Profits
=
x 100
Change in Sales
2,50,000 -
=
2,00,000
x 100
17,00,000 - 15,00,000
50,000
=
x 100
2,00,000
=
25%
b) BEP (Sales) :
Fixed Cost
=
P/V Ratio
1,75,000
=
25%
1,75,000 x
=
100
25
=
7,00,000
c) The Profits made when Sales are
25,00,000
Where,
Contribution
P/V Ratio
=
Contribution
=

P/V Ratio
=

P/V Ratio x Sales =
Fixed Cost + Profit

Profit
=
(P/V Ratio x Sales) - Fixed Cost
=
(25% x 25,00,000) - 1,75,000
Sales
But
Fixed Cost + Profit
Fixed Cost + Profit
126 Advanced Cost Accounting - IV
Sales
=
6,25,000 - 1,75,000
=
4,50,000
d) The Sales required to earn a profit of
Marginal Costing
(Illustrations)
4,00,000
Where,
P/V Ratio
=
Contribution
Sales
NOTES
But,

Contribution
=
P/V Ratio
=
Fixed Cost + Profit
Fixed Cost + Profit
Sales

Sales
=
Fixed Cost + Profit
P/V Ratio
=
1,75,000 + 4,00,000
25%
=
5,75,000 x
100
25
=
23,00,000
ILLUSTRATION 6
From the following data which product would you recommend to be
manufactured in the factory where time being is the key factor.
Particulars
Product A
per unit
Direct Material
Basic Labour @
1 per hour
Variable Overheads @
2 per hour
Selling Price
24.00
13.00
2.00
3.00
4.00
6.00
100.00
Standard time to produce
Hrs.
Product B
per unit
2.00
110.00
3.00
SOLUTION
i) Calculation of P/V Ratio
Contribution per unit
P/V Ratio
=
Selling Price per unit
x 100
But,
Contribution per unit = Selling Price per unit - Variable Cost per unit
Advanced Cost Accounting - IV
127
Marginal Costing
(Illustrations)
P/V Ratio
=
Selling Price per unit - Variable Cost per unit
x 100
Selling Price per unit
Product A’
=
100 -
30
100
NOTES
Product B’
=
70
x 100 =
x 100 = 70%
100
110 - 22
x 100 =
110
88
x 100 = 80%
110
ii) Calculation of Profitability per hour :
Profitability
=
Contribution per unit
Standard Time per unit
Product A’
=
70
=
35 per hour
=
29.33 per hour
Hrs. 2
Product B’
=
88
Hrs. 3
Recommendations :
1)
Since product B has higher P/V Ratio than Product A, the production of
B should be increased in the factory.
2)
But as time is the key factor, contribution per hour should be the more
important factor to consider the profitability. Hence product A’ is more
profitable and should be produced more as it gives more profitability per
hour than Product B.
ILLUSTRATION 7
Two Companies P Ltd. and Q Ltd. produce and sell same type of product in
the same market. For the year ended 31st March, 2012 their forecasted Profit and
Loss A/c are as follows :
Particulars
P Ltd.
Sales
3,00,000
(-)
Less :
i) Variable Cost
ii) Fixed Cost
Q Ltd.
(+)
 Estimated Profit
2,00,000
50,000
3,00,000
2,50,000
(-)
(+)
2,25,000
25,000
50,000
You are required to calculate
i)
128 Advanced Cost Accounting - IV
P/V Ratio, BEP (Sales) and Margin of Safety of each business.
2,50,000
50,000
ii)
Explain giving reasons which business is likely to earn greater profits in the
conditions of-
Marginal Costing
(Illustrations)
a) heavy demand for the product.
b) low demand for the product.
SOLUTION
NOTES
i) P/V Ratio
Contribution
=
x 100
Sales
But,
Contribution

=
P/V Ratio =
Sales - Variable Cost
Sales - Variable Cost
x 100
Sales
P Ltd.
=
3,00,000 - 2,00,000
x 100
3,00,000
=
=
Q Ltd.
=
1,00,000
x 100
3,00,000
1
33 / %
3
3,00,000 - 2,25,000
x 100
3,00,000
=
75,000
x 100
3,00,000
=
25%
ii) BEP (Sales) :
=
Fixed Cost
P/V Ratio
P Ltd.
=
50,000
33 1/3 %
=
50,000
1/3
=
50,000 x
3
1
=
Q Ltd.
=
1,50,000
25,000
25%
Advanced Cost Accounting - IV
129
Marginal Costing
(Illustrations)
25,000 x
=
100
25
=
NOTES
1,00,000
iii) Margin of Safety :
=
P Ltd.
Q Ltd.
Actual Sales - Break Even Sales
=
3,00,000 - 1,50,000
=
1,50,000
=
3,00,000 -
=
2,00,000
1,00,000
Comments :
1)
In case of heavy demand the product of P Ltd. is more profitable as its P/
V Ratio (i.e. 33 1/3%) is higher than Q Ltd. (i.e. 25%)
2)
In case of low demand the product of Q Ltd. is more profitable as its Fixed
Cost (i.e. 25,000) and BEP (Sales) (i.e. 1,00,000) are very low than of
P Ltd. (i.e. Fixed Cost 50,000 and BEP (Sales) 1,50,000), and
consequently the Margin of Safety of Q Ltd. (i.e. 2,00,000) is much
higher as compared to P Ltd. (i.e. 1,50,000).
ILLUSTRATION 8
The following two suggestions are under considerations.
a)
10% reduction in price to yield an increase in Sales volume from 6,600 units
to 7,900 units.
b)
10% increase in price with decrease in volume of sales from 6,600 units to
5,700 units.
The following particulars are also given
Current Unit Price
1,000
Unit Variable Cost
500
Fixed Cost
30,00,000
Prepare a statement showing :
130 Advanced Cost Accounting - IV
i)
Gross Revenue,
ii)
Profit Contribution and
iii)
P/V Ratio of the two alternatives with present results.
Which suggestions you recommend ?
Marginal Costing
(Illustrations)
SOLUTION
In the Books of a company
Statement Showing Comparative Results for the Period ended.....
Particulars
Sales
Units
Unit Price per unit
Sales Volumn -Value
Present
Position
Proposal
A
Proposal
B
6,600
7,900
5,700
1,000
900
1,100
10%
10%
reduction
increase
(1)
66,00,000
71,10,000
62,70,000
(2)
33,00,000
39,50,000
28,50,000
Contribution (i.e. S - V)
(3)
33,00,000
31,60,000
34,20,000
Less : Fixed Cost
(4)
30,00,000
30,00,000
30,00,000
 Profit (i.e. C -P)
(5)
3,00,000
1,60,000
4,20,000
50%
44%
54%
NOTES
Less : Unit Variable Cost
@
500 per unit
P/V Ratio
C
3
x 100
i.e.
S
x 100
1
Recommendations :
From the two alternative proposals given, Proposal B should be
recommended which is more profitable as
i)
The profit expected is more and
ii)
The P/V Ratio is higher as compared to Proposal A.
Advanced Cost Accounting - IV
131
Marginal Costing
(Illustrations)
NOTES
6.3
Summary
This Unit has provided illustrations on Marginal Costing. These illustrations
show how, from the given data calculation of P/V Ratio, B. E. P. in units and in the
sales value, profitability of different products and on the basis of it how decision
about quantity of a particular product to be produced in case of application of a
key-factor can be done. These illustrations also point out how much quantity should
be produced and sold to reach the Break-even position and also to earn a desired
amount of profit by a business concern.
6.4
Exercises
I - Exercises
1)
Amol industries supply you with the following information
Sales
2,00,000
Fixed Cost
-
1,00,000
Variable cost
-
1,30,000
Find out the increase in the sales required to break-even.
2)
3)
132 Advanced Cost Accounting - IV
Chaby Ltd. furnishes you the following information. Calculate the breakeven point and show the same by drawing a graph.
Sales (value)
-
1,50,000
Sales (units)
-
15,000
Fixed cost
-
50,000
Variable cost
-
Direct Material
-
40,000
Direct Labour
-
45,000
Variable overheads
-
35,000
From the following particulars draw a break-even chart and find out the
break-even point.
Variable cost per unit -
15
Fixed Cost
-
54,000
Selling price per unit
-
20
4)
From the following particulars find out the (1) P/V Ratio, (2) BEP (Sales)
and (3) Margin of Safety.
Marginal Costing
(Illustrations)
% of Sales
5)
Variable Cost
-
10,000
80%
Fixed Cost
-
5,000
5%
Profit
-
15,000
15%
30,000
100%
NOTES
The sales and profit during two years are given below
Sales
Profit
2011
-
20 Lakhs
2 Lakhs
2012
-
30 Lakhs
4 Lakhs
Calculate (a) P/V Ratio, (b) Sales required to earn a profit of
6)
5 Lakhs
Ashim Ltd. gives you the following information :
Sales
-
50,000
Variable cost
-
25,000
Fixed cost
-
10,000
Calculate P/V Ratio, BEP and Margin of Safety. Also calculate the effect
of 20% increase in sales price and 20% decrease in sales price.
7)
The following are the figures obtained from the cost records of Neel Industries
Sales
-
5,000 units @
4 per unit
20,000
Direct material
-
4,000
Direct Labour
-
5,000
Variable Overheads
-
+ 3,000
12,000
Fixed Overheads
-
+ 4,000
+ 16,000
Net Profit
4,000
The company has decided to reduce the selling price by 10%. What extra
units should be sold to obtain the same amount of profit ?
8)
The P/V Ratio and Margin of Safety of Bardhan Industries are 50% and
40% respectively. The company has a sales volume of 8,00,000 Calculate
the net profit.
Advanced Cost Accounting - IV
133
Marginal Costing
(Illustrations)
9)
The following are the details of Manoj Ltd. for the two products A and B
A
B
Per unit
Per unit
NOTES
Sales Price
-
100
120
Material ( 10 per kg)
-
20
40
Wages
-
30
20
Variable Overheads
-
8
12
Total Fixed Costs
-
10,000
When material is the limiting factor, suggest which product should be
produced more.
II - Multiple Choice Questions
1)
The break-even means to have ............ amount which is exactly equal to
the amount of fixed costs.
a) contribution
(b) sales
(c) purchase
(d) revenue
2)
Complete the following
Change in profit
P/V Ratio
x 100
=
Change in .....
(a) Volume
(b) Quality
(c) Sales
(d) Buying
3)
Which is a correct equation
(a) Sales (-) Marginal cost = Contribution
(b) Sales (-) Fixed costs = Contribution
(c) Sales (-) Profit = Contribution
(d) Sales (-) Purchases = Contribution
134 Advanced Cost Accounting - IV
4)
If sales revenue is 1,50,000, Variable cost is 60,000 and Sales in terms
of units are 1000 then contribution per unit will be
(a)
80
(b)
60
(c)
90
Marginal Costing
(Illustrations)
NOTES
(d) 100
Ans. : (1 - a), (2 - c), (3 - a), (4 - c).
Advanced Cost Accounting - IV
135
Unit 7
Standard Costing (Introduction to
Standard Costing)
Standard Costing
(Introduction To
Standard Costing)
Structure
NOTES
7.0
Introduction
7.1
Unit Objectives
7.2
Historical Costing and its Limitations
7.3
Definition and meaning of various concepts
7.4
Features of Standard Costing
7.5
Objectives of Standard Costing
7.6
Standard Cost and Estimated Cost
7.7
Standard Costing and Budgetary Control
7.8
Advantages of Standard Costing
7.9
Limitations of Standard Costing
7.10 Summary
7.11 Key Terms
7.12 Questions
7.13 Further Reading
7.0
Introduction
Control of costs is one of the important objectives of cost accounting and it
cannot be achieved without some standard against which actual costs can be
compared. All managements are interested not only in knowing what costs are
but also how satisfactory they are. The use of standard costs increases cost
consciousness among management and employees and can improve business profits
by providing a base for performance evaluation. Standard Costing, therefore, helps
managerial planning and control in a significant manner. This system is now widely
used and serves as an effective tool for management control.
Advanced Cost Accounting - IV
137
Standard Costing
(Introduction To
Standard Costing)
7.1
Unit objectives
After studying the information given in this Unit you should be able to :-
NOTES
•
Understand the meaning and definition of Standard Costing;
•
Identify the Historical Cost and its limitations;
•
Distinguish between Standard Costing and Budgetary Control;
•
Understand features of Standard Costing; and
•
Understand advantages and limitations of Standard Costing.
7.2
Historical Costing and its Limitations
Historical Cost system is principally associated with recording of historical
or, as they are commonly called ‘actual costs’.
Basically, there are two types of costing, viz. Historical Costing and Standard
Costing. Historical costs are the actual costs incurred. The term, Historical Costing
may be defined as,
“The cost which is accumulated during the process of production by the usual
historical costing methods”. Historical costs are incurred during a specified period.
In Historical Costing system, the analysis of costs is done only after they are
incurred i.e. from the past records. Hence, corrective action to avoid inefficiency
and wastages cannot be taken. In order to know before hand, the estimated costs,
Standard Costing is used. Standard Costing system is based on the ascertainment
and use of pre-determined costs. This system is now widely used and serves as
an effective tool for management control.
The recording or historical costs is useful as it determines the cost of
resources used towards achieving organisational objectives. Historical Costs,
however, have the following limitations.
138 Advanced Cost Accounting - IV
i)
Historical costs are allocated after they have been incurred and therefore
are ineffective in cost control. The costs have been incurred, they cannot
be undone and no steps can be taken to correct inefficiencies and to promote
efficiencies.
ii)
Historical costs are not helpful in cost reduction since they contain no
standards or goals towards which employees can work.
iii)
Historical costs do not provide reliable guides to management in the tasks
of budgeting, planning, and decision making. Historical costs reflect a situation
in a previous period. But the company, in facts, may be working under the
conditions different from those prevailing during that previous period.
Therefore, historical costs are not useful in budget making, performance
evaluation, detecting above or below - standard performance.
7.3
Definition and Meaning of various concepts
The word ‘Standard’ means a criterion. Thus, a Standard Cost is one
which is pre-determined and used as a criterion for measuring the efficiency with
which actual cost has been incurred. Standard costs represent ‘planned’ cost of a
product. They are expected to be achieved in a particular production process
under normal conditions. Standard Cost is defined in the CIMA Official terminology
as, “a predetermined calculation of how much costs should be under specified
working conditions. It is built - up from an assessment of the value of cost elements
and correlates technical specifications and the qualification of materials, labour
and other costs to the prices and/or usage rates expected to apply during the
period in which the Standard Cost is intended to be used. Its main purpose is to
provide basis for control through variance accounting for the valuation of stock
and work-in-progress and in some cases for fixing selling prices”.
Standard Costing
(Introduction To
Standard Costing)
NOTES
A Standard Cost is a planned cost for a unit of product or service rendered.
Standard Costs are highly detailed scientifically pre-determined cost of material,
labour and overhead chargeable to product or service. Standard Costs represent
excellent target costs that should be obtained. The Institute of Cost and
Management Accountants (U.K.) defines Standard Costs 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 cost expresses what costs
should be under attainable good performance. They are projections of what actual
cost should be under an assumed set of conditions. The term ‘Standard’ has been
called by different names in accounting e.g. “a norm”, “ a model or example or
comparison”, “a measure of comparison”, “a criterion of excellence”, “a yardstick”,
“a benchmark”, “an Index of waste or potential savings, “a sea level from which
to measure cost altitudes, “a gauge”. A Standard may be a norm or a measure of
comparison in terms of specific items such as pounds or kilograms of materials,
labour hours required, hours of plant capacity used.
From the above definition, it is observed that Standard Cost is a target
cost which must be attained. It is based on technical and engineering studies,
production method, material specifications, material and labour price projections.
Standard Costing is a technique which uses standards for costs and
revenues for the purpose of control through variance analysis. According to CIMA,
London, Standard Costing is “the preparation and use of standard costs,
their comparison with actual cost and the analysis of variance to their causes
and points of incidence”.
Brown and Harward define Standard Costing as, “a technique of cost
accounting which compares the standard cost of each product or service
with the actual costs to determine the efficiency of the operation so that any
remedial action may be taken immediately”.
Thus, Standard Costing involves the setting of pre-determined cost
estimates in order to provide a basis for comparison with actual costs. A Standard
Advanced Cost Accounting - IV
139
Standard Costing
(Introduction To
Standard Costing)
Cost is a planned cost for a unit of product or service rendered. Standard Costing
is universally accepted as an effective instrument for cost control in industries. It
can be used in conjunction with any method of costing. However, it is specially
suitable where the manufacturing method involves production of standardised goods
of repetitive nature.
NOTES
7.4
Features of Standard Costing
Check Your Progress
i)
What is meant by
‘Historical Costing’ ? What
are the limitations of
historical costing?
With the help of above definitions the following Features of Standard
Costing can be pointed out :
i)
In Standard Costing all costs are pre-determined in advance. These predetermined costs are compared with the actual costs incurred. The difference
between the standard cost and the actual cost is known as the Variance.
These variances are then analysed and reasons found out for taking
corrective action.
ii)
The standards are set based on the past records and performances.
iii)
Comparison between actual performance and standard performance is
shown by way of reports which are presented to the top management.
iv)
Analysis of variances are made for taking appropriate action according to
the nature of expenses, i.e. controllable and uncontrollable.
v)
In case of controllable costs if there is adverse variance, efforts are taken
to prevent its recurrence. But in case of uncotrollable costs, the standards
are revised.
vi)
Standard Costing may be applied to any industry.
ii) Define ‘Standard Costing’.
What are the features of
standard costing ? State the
objectives of standard
costing.
7.5
Objectives of Standard Costing
The Objectives of Standard Costing technique are as follows :
140 Advanced Cost Accounting - IV
i)
To provide a formal basis for assessing performance and efficiency.
ii)
To control costs by establishing standards and analysis of variances.
iii)
To enable the principle of “Management by Exception” to be practiced at
the detailed operational level.
iv)
To assist in setting budgets.
v)
To assist in assigning responsibility for non-standard performance in order
to correct deficiencies or to capitalise on benefits.
vi)
To provide a basis for estimating.
vii)
To provide guidance on possible ways of improving performance.
7.6
Standard Cost and Estimated Cost
Standard Costing
(Introduction To
Standard Costing)
Both Standard Costs and Estimated Costs are predetermined costs,
determined in advance of production. However, these two types of costs differ in
respect of the following aspects :-
NOTES
Standard Cost
Estimated Cost
i) It is a specification of what the
cost “should be”.
i) It is an estimation of what the
cost “will be”
ii) It is ascertained and applied when
ii) It can be used in any business
Standard Costing system is in
situation for decision making where
operation.
accurate cost is not required.
iii) It is “planned” cost and established iii) It is “predetermined” cost based on
on a scientific basis.
iv) It is use for analysis of variances
and cost control purposes.
past performance.
iv) It is used in decision making and
selection of alternative with
maximum profitability.
v) It is determined for each element
of cost in the process of business
v) It is determined generally for the
period.
generally on unit basis i.e. standard
hours, standard unit etc.
vi) It is a part of accounting system
vi) It is used only as a statistical
and thus, finds a place in the
information and hence, are not
accounting records.
entered in the account books.
7.7
Standard Costing and Budgetary Control
Both techniques of Standard Costing and Budgetary Control are similar
in principle since both are concerned with setting performance and cost levels for
control purposes. But they differ in their scope. Standards are unit concept, i.e.
they apply to particular products to individual operations or processes. Budgets
are concerned with totals they laid down cost limits for function and departments
and for the firm as a whole. The important points of distinction between Standard
Costing and Budgetary Control are as follows :Advanced Cost Accounting - IV
141
Standard Costing
(Introduction To
Standard Costing)
NOTES
Standard Costing
i)
Standard Costs are determined
Budgetary Control
i)
Budgets are based on past
scientifically for each element
performance. It is written plan
of cost i.e. material, labour and
covering projected activities of a
overhead, Standard Costs are
firm for a definite time period. It is
fixed for each unit e.g. hour
a financial measure of target
standard, unit standard, labour mix,
and achievement.
material mix etc.
ii) It may be expressed both in
quantitative and monetary
ii) It is generally expressed in monetary
terms.
measure.
iii) It is concerned with
ascertainment and control of
costs.
iv) Its emphasis is on what should
be the cost.
v) It is determined for each element
of cost.
vi) Any variance adverse or
favourable is investigated.
vii) It is related with the control of
iii) It is concerned with the overall
profitabilityand financial position of
the concern.
iv) Its emphasis is on the level of costs
not to be exceeded.
v) It is determined for a specified
period.
vi) It puts emphasis more on excess
over the budget.
vii) It is concerned with the operation
costs and it is more intensive in
of business as a whole and it is more
scope.
extensive.
viii)It is introduced primarily to
viii) It is introduced to state in figures as
ascertain the efficiency and
approved plan of action relating to
effectiveness of cost
a particular period.
performance.
ix) It is limited to manufacturing
activities only.
x) It is projection of cost accounts.
142 Advanced Cost Accounting - IV
ix) It is used for all departments in an
organisation.
x) It is a projection of financial
accounts.
xi)
It is generally used in tactical
xi) It puts emphasis on policy
decisions like price fixation,
determination achievements of
computation of product cost,
goals, co-ordination of different
valuation of inventories etc.
departments and activities etc.
xii) It is less expensive.
xii) It is more expensive.
xiii) It cannot be applied in part
xiii) Budgeting may be either partial or
comprehensive.
7.8
Standard Costing
(Introduction To
Standard Costing)
NOTES
Advantages of Standard Costing
Following are some of the important advantages of standard costing :-
i)
Cost Control :
Standard Costing serves as a measuring rod of operating efficiency and
cost control. Under this system, costs are controlled by comparing actual
costs with standard costs, analysing the variance and taking corrective action.
ii)
Motivation :
The standard provide incentive and motivation to work with greater effort.
Plans may be formulated to reward those workers who achieve the
standards. This increases all round efficiency and productivity.
iii)
Formulation of price and production policies :
Standard Costing acts as a valuable guide to management in the formulation
of price and production policies. This enables management in the preparation
of price lists for prospective orders and planning production of new products.
iv)
Cost Reporting :
It provides for prompt reporting to cost for various purposes like fixation of
selling price, ascertaining the value of closing stocks and determining the
idle capacity. Prompt reporting enhances the value of reports.
v)
Reporting on the principle of exception :
Attention of management is drawn to adverse variances which are significant.
Analysis of investigating of significant deviations enable management to
take corrective action to prevent their recurrence.
vi)
Basis of Inventory Valuation :
It can be used to value stock and provide a basis for setting wage incentive
schemes.
Advanced Cost Accounting - IV
143
Standard Costing
(Introduction To
Standard Costing)
vii)
Measurement of efficiency :
It is a yardstick for evaluating efficiency at all levels. This also facilitates
cost control.
viii) Saving in clerical costs :
NOTES
Installation of Standard Costing saves clerical labour and expenses involved
in the work of cost accounting. Costing procedure is simplified and the
number of forms and records is reduced.
ix)
Budgetary Planning :
Being pre-determined costs, standard costs are very useful in planning.
budgeting and decision - making.
x)
Cost Consciousness :
Due to emphasis on cost variation, the entire organisation becomes cost
conscious. Employees in production and other departments realise the
importance of efficient operations which leads to cost reduction.
xi)
Effective delegation of authority:
As responsibility is defined clearly, delegation of authority is made more
effective.
xii)
All round efficiency :
Standard Costing facilitates the maximum use of working capital, plant and
equipments and other current asset. Wastages of materials is reduced to
the minimum and idle time is closely controlled. Consequently, the overall
efficiency of the concern is promoted to the maximum extent.
7.9
Limitations of Standard Costing
Following are some of the limitations of Standard Costing :-
i)
Difficulty in setting standards :
It is quite difficult to establish accurate standards. It requires technical skills.
Inaccurate and unreliable standards do more harm than good. Unless
standards are accurately set any performance evaluation will be meaningless.
ii)
More expensive :
A lot of input data is required which can be expensive. Again revision of
standards in the light of changed circumstances becomes expensive.
Therefore, it is not suitable for small firms.
iii)
144 Advanced Cost Accounting - IV
Adverse effect on morale of employees :
Fixation of inaccurate standards, especially those that are incapable of
achievement, adversely affects the morale of employees and acts as
hindrance to increased efficiency.
iv)
Unsuitable where technology changes frequently:
Standard Costing is not suitable in industries that are subject to frequent
technological changes. In case the technique is introduced inspite of such
changes, it beecomes necessary to constantly revise the standards.
v)
Standard Costing
(Introduction To
Standard Costing)
NOTES
Segregation of Variances :
For localising deviation and fixing responsibility, it becomes necessary to
distinguish between controllable and uncontrollable variances. Such a
distinction may not always be possible.
vi)
Price changes :
Operation of Standard Costing neccessitates the price estimation of the
prices of input factors. Such precise estimation may not be possible if prices
fluctuate too often.
vii)
Varying levels of output :
In case of some industries, the capacity utilisation cannot be precisely
estimated for absorption of overheads. Accordingly, if the standard level of
output set for pre-determining standard cost is not achieved, standard costs
do not serve the required purpose.
viii) Implementation of Standard Costing system :
Unless there is much interest on the part of management and complete
support and co-operation from employees implementation of Standard
Costing system is not possible.
ix)
Difficulty in understanding the technique :
The research evidence states that overly elaborate variances are imperfectly
understood by the line managers and thus, they are likely to be ineffective
for control purposes.
x)
Nature of Variance Analysis :
All forms of variance analysis are post morterm on past events. Obviously,
the past cannot be altered so the only value the variances can have is to
guide management if identical or similar circumstances occur in the future.
7.10 Summary
Basically there are two types of costing - Historical Costing and Standard
Costing. Historical Costing does the work of recording the actual costs which
have been incurred for manufacturing product or for rendering a service.
Knowledge of actual cost is necessary but not sufficient for the management
because the management’s objective is to control the costs and maximise the
Advanced Cost Accounting - IV
145
Standard Costing
(Introduction To
Standard Costing)
NOTES
profits of the business concern. Due to limitations of Historical Costing these
objectives cannot be achieved. So the need for Standard Costing arises.
In Standard Costing a pre-determined and planned cost is fixed for a product
or an activity and this cost is known as Standard Cost. Standard Cost is used as a
basis for comparing an actual cost so that the efficiency and effectiveness in
incurring the actual cost can be judged by the management. When the actual cost
exceeds the Standard Cost, the difference is calculated and the causes due to
which the excess cost has taken place are found out through analysis and corrective
action to minimise or eliminate the excess cost in the future is taken by the
management. Standard Costing thus helps the management in controlling the costs.
Standard Costing provides a number of advantages but it must be remembered
that Standard Costing also has some limitations.
7.11 Key Terms
i)
Historical Costing : A system of recording the costs after they have been
incurred. Actual costs are recorded in historical costing.
ii)
Standard Cost : Standard Cost is a pre-determined cost which is calculated
from management’s standards of efficient operation and the relevant necessary
expenditure. Standard cost is what the cost ‘should be’.
iii) Standard Costing : It is a technique of cost accounting which compares
the standard cost of each product or service with the actual costs to determine the
efficiency of the operation so that any remedial action may be taken immediately.
7.12 Questions
I - Theory Questions
146 Advanced Cost Accounting - IV
1)
What is ‘Standard Costing’ ? Explain in brief the significance of Standard
Costing as a technique of cost control.
2)
Define the terms ‘Standard Cost’ and ‘Standard Costing’. State the important
features of Standard Costing.
3)
“Standard Costing is a valuable aid to the management”. Discuss.
4)
What is ‘Standard Cost’? Differentiate clearly between ‘Standard Cost’
and ‘estimated cost’.
5)
What is Standard Costing? How it differs from Budgetary Control?
6)
What is meant by ‘Standard Costing’? Explain the objectives of Standard
Costing.
7)
Explain the advantages and limitations of Standard Costing.
II - Multiple Choice Questions.
1)
A Standard Cost is a --------------- cost for a unit of product or service
rendered.
Standard Costing
(Introduction To
Standard Costing)
(a) material
(b) labour
NOTES
(c) planned
(d) overhead
2)
The standards are set based on the -------------(a) past records and performances.
(b) present record and performances.
(c) future record and performances.
(d) upto date record.
3)
Standard Costing is a ------------------- of cost accounts.
(a) record
(b) performance
(c) projection
(d) target
4)
Budger is a ----------------- of cost accounts.
(a) financial
(b) cost
(c) management
(d) income.
Ans. (1 - c), (2 - a), (3 - c), (4 - a).
7.13 Further Reading
i)
‘Advanced Cost Accounting’ - Nigam and Sharma.
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
ii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B. K. Bhar.
Advanced Cost Accounting - IV
147
Unit 8
Standard Costing
(Types of Standard and Variance
Analysis)
Structure
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
8.0 Introduction
8.1 Unit Objectives
8.2 Pre-requisites to Standard Costing
8.3 Setting Standard
8.3.1 Types of Standards
8.3.2 Setting the Standards
8.4
Standard Material Cost
8.5
Standard Labour Cost
8.6
Standard Overheads
8.7
Problem in Setting Standard Costs
8.8
Variance Analysis
8.9
Different Types of Variances
8.9.1 Material Variances
8.9.2 Labour Variances
8.9.3 Overhead Variances
8.9.4 Sales Variances
8.10 Key Terms
8.11 Summary
8.12 Questions
8.13 Further Reading
8.0
Introduction
In this Unit, we will consider information about setting Standards, calculation
of variances related to material, labour and overheads and also sales variances.
Utility and success of Standard Costing depends upon setting of Standards correctly
and so this work of setting the Standard must be done in a very careful manner.
Advanced Cost Accounting - IV
149
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
The theoratical part of this work and formula used for calculation of various
variances are considered in this Unit and the practical problems of calculation of
variances will be provided in the next Unit.
8.1
Unit Objectives
After Studying the information given in this Unit, you should be able to :
•
Understand the preparation to be done before setting the Standards and
introduction of Standard Costing in any business concern.;
•
Know the various types of variances; and
•
Know how to calculate the variances by using the correct formula.
8.2
Pre-requisites to Standard Costing
While introducing the technique of Standard Costing consideration of the
following points is significant :-
150 Advanced Cost Accounting - IV
i)
Sound organisation structure with well-defined authority relationships.
ii)
Sound technical and engineering studies, known production methods, workstudy and work-measurement, material specifications and wage and material
price projections.
iii)
Classification of accounts and coding of incomes and expenses to facilitate
speedy collection and analysis
iv)
Determination of the type of Standard to be used.
v)
Fixation of Standard for each element of cost.
vi)
Determination of Standard Cost for each product.
vii)
Recording of actual costs incurred.
viii)
Comparison of actual costs with the pre-determined standards to ascertain
the deviations.
ix)
Investigation into the reasons and analysing variances.
x)
Reporting of significant adverse variances.
xi)
Action by management to ensure that adverse variances are not repeated.
xii)
Revision of Standards, if necessary.
8.3
Setting Standard
Standard Costing
(Types Of Standard &
Variance Analysis)
Before starting actual work of setting standards, it is necessary to know the
different types of standards.
8.3.1 Types of Standards
NOTES
Standards may be divided into two main classes viz. basic standard and
current standard.
(A)
Basic Standard :
Basic Standard is defined by the Terminology as “A standard established
for use over a long period from which a current standard be developed”. Thus this
type of standard is determined for an indefinite period. It remains unchanged for
a longer period. Its use is to show long-term trends and it operates in a similar way
to index numbers. Being a static standard, it is revised only when new products
are introduced or the existing ones are so modified as to be considered to be
practically new ones. The main advantage of this standard is in showing the changes
in trend of price and efficiency from year to year. The main disadvantage of this
type of Standard is that because it has remained unaltered over a long period of
time, it may be out of date. Hence, it is not useful for controlling cost.
B)
Current Standard :
The terminology defines Current Standard as “A standard established for
use over a short period of time, related to current conditions”. The period covered
by the standard is normally one year. Thus the Standard, which is related to current
conditions, reflects the performance that should be attained during the period for
which it is to be used. This type of standard is thus, realistic and capable of
attainment. But, however, its frequent revision increases clerical costs. It is also
not useful for studying the long-term trend of costs.
Current Standards may be either of the following :
i)
Ideal Standard :
This is defined by the Terminology as, “The standard which can be attained
under the most favourable conditions possible”. This standard is based upon
the performance level. But it does not make any provision for shrinkage,
spoilage or machine breakdowns. An ideal standard is only a theoretical
standard and thus, difficult to attain. Thus, it is not widely used in practice.
ii)
Expected Standard :
The Terminology defines expected standard as, “the standard which it is
anticipated can be attained during a further specified budget period.” It is a
target which is attainable and can be achieved if the expected conditions
operate during the period for which the standard is set. So it is also known
as “Attainable Standard”. While setting the standard due allowance would
be made for such - contingencies as wastage, spoilage, lost time etc.
Advanced Cost Accounting - IV
151
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
Check Your Progress
i)
Briefly mention the types
of standard.
ii) What you understand by
the terms ‘Ideal Standard’,
‘Expected Standard’ and
‘Normal Standard’ ?
As such, the standard is realistic, capable of achievements and provides an
incentive to the workers to improve performance. It can be used for product
costing, cost control, inventory valuation and as a basis for budgeting. But
frequent revision, as conditions change, is the only disadvantage of this type
of standard.
iii)
Normal Standard :
This is defined by the Terminology as, “The average standard which it is
anticipated can be attained over a future period of time, preferably long
enough to cover one trade cycle”. This type of standard is based upon
normal conditions i.e. condition which prevail over the entire life of a trade
cycle. The basic purpose of this standard is to eliminate the variations in
cost which arise due to trade cycle. It is used for planning and decisionmaking. But it is difficult to apply in practice.
8.3.2 Setting the Standards :
Establishing standard costs and keeping them up-to-date involves
considerable effort and co-operation of various members of the organisation. In a
small concern a single person sets the standard. But in a large concern a standard
committee is appointed to do this job. The Standard Committee consists of production
manager, personnel manager, production engineer, sales manager, cost accountant,
purchasing manager, marketing manager, finance manager etc. Of all these
functional heads, Cost Accountant will have to play a very important role. He has
to supply necessary cost data and ensure that the standards set are as accurate as
possible. Standards should be set for each demand of cost separately.
A Standard Cost is a measure in quantities, hours and value of the input
factors. It consists of three elements viz, direct material, direct labour and overhead.
The setting up of standards for direct material and direct labour involves the
establishment of physical standards and price standards. Physical Standards refer
to product specifications material specification, method of manufacture and
equipment to be used. As such, these should be in term of kg. of materials, unit of
time and hours of plant capacity. Price Standards are set on the basis of actual
average price expected to prevail during the next period or normal prices expected
to prevail during a cycle of reasons which may be of a number of years.
After the standards have been fixed, the management is interested in
calculation of variance from standards with the purpose of making the members
of various management levels to know what variances are and who is responsible
for it. Thus, the purpose of setting standards is to help in responsibility accounting.
152 Advanced Cost Accounting - IV
8.4
Standard Material Cost
Standard Costing
(Types Of Standard &
Variance Analysis)
The fixation of standard material cost necessitates determination of standard
material quantity and standard price per unit of materials.
(a)
Material Quantity Standard :
Before determining the standard quantity of materials it is necessary to fix
standard for quantity or grade and size in order to achieve maximum economy in
material usage. Material quantity (usage) standard is fixed by analysing each job
and determining the nature and quantity of materials required for each job or
process. The fixation of an effective material usage standard pre-supposes:
i)
An adequate purchasing systems.
ii)
A satisfactory inventory system.
iii)
Careful materials budgeting.
iv)
Control of materials issues and handling.
v)
Adequate control of materials receipts, storage, inspection and accounting.
vi)
A system of inspection, both inter-stage and after the product is completed.
NOTES
Each item of materials required should be according to established
specification. The chief designer, the chief inspector and the production manager
should combine to prepare a master list of specifications of materials for each
job or product. Substitute materials should also be specified. A system of codes
for identifying materials should be adopted. The materials usage standard should
adopt these specified materials and indicate the quantity required for each such
materials after adequate technical study.
(b)
Material Price Standard :
Material price standards are determined based on current and estimated
procurement prices. Three types of standards are used :
i)
Standards may be set based on current prices. These reflect the current
market prices and take into account the rates of contracts which are in
operation. This applies so short-term standards.
ii)
There may be normal or long-term price standards : These are
established after the study of long-term, secular market trends and forecasts.
Thus, the long - terms standards operate for 3 to 5 years. The trend of
prices is studied statistically and an average or norm is computed based on
the statistical trends. This price is adopted for long-term planning.
iii)
A fixed price or base price standard may be fixed. This is adopted in fixing
basic standard costs.
The fixation of material price standard is the most difficult task because
the prices of materials cannot be controlled by the management. The external
Advanced Cost Accounting - IV
153
Standard Costing
(Types Of Standard &
Variance Analysis)
factors decide the price of materials on which the management cannot
have any control. However, the standard price of each item is fixed by
careful examination of the prices of different materials and the market
conditions for the present as well as for the future. Allowances are made
for the following while setting the standard for the material price.
NOTES
i) Discount allowed.
ii) Terms of delivery i.e. whether free of cost or with cost.
iii) Whether ex-factory price or retail price.
iv) Price of similar substitutes.
v) Whether replacement of defective material will be free or with costs.
While fixing the standards, the Purchase department, the Stores department,
the Cost Accountant, the Finance Manager and the Production Department should
be consulted.
8.5
Standard Labour Cost
The standard time for each operation multiplied by the standard wage rate
gives the standard labour cost. It means for determining the standard labour
cost it is necessary to determine the following two standards:
a)
Standard Labour Time :
In this case, the usage of labour is measured in hours. The Cost Accountant
has to determine the hours required for each grade of labour for each process
or stage and each operation in each Cost centre to manufacture the units.
This is a major task which involves time and motion study, systematic time
setting estimates and past performance of labour. While fixing standard
time, normal idle time should also be considered which includes rest time
for fatigue, setting time of machines, unavoidable delays etc. The basis of
determining time standards should be fair to both the employees and the
employer. It should be reasonable and attainable and aiming at efficiency.
b)
Standard Labour Rate :
Labour rates depend upon the company’s method of payment of wages.
Generally, there are two systems of payment of wages i.e. piece-rate and
time-rate. In addition, to these two systems we also have the premium
plans of payment of wages. Hence, different methods of setting standards
are necessary for different wage systems. The past records of the wages
paid does not give a scientific base for the determination of standards. This
is because labour rates fluctuate according to the demand and supply of
labour and hence, past records cannot be considered. In case of big industries
where the Minimum Wages Act is applicable, fixing of labour rate standard
is easy. While fixing the standard rate the Personnel Department alongwith
154 Advanced Cost Accounting - IV
the cost and finance department are consulted.
In fixing labour cost standard the following points should be noted :
i)
The plant and machinery should be standard appropriate and well maintained.
The tools and equipment should be adequate and in good condition.
ii)
The layout in the production department and arrangement for feeding of
materials should be well-planned and well-established.
iii)
The routing and flow in issue of materials from stores to works and transfer
of finished products to the finished stores should be standardised and
regulated.
iv)
Avoidable lost times such a workers waiting for tools, waiting for materials,
waiting for instruction etc. should be eliminated or minimised as far as
possible.
v)
The grade of labour each job and the system of the wage payment of
labour should be properly established and the system accepted by all
concerned.
vi)
Adequate engineering and technical study to determine and standardise the
operation required for a job and the best way to carry out the operations.
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
The successful operation of the labour standard pre-purposes scientific
organisation and layout of the plant to ensure stable and uninterrupted working
conditions for labour. Standard labour time, determined by works and motion study
and time and motion study, together with the average part of actual and the results
of trial runs, constitute the criteria and basis for standard direct labour cost.
The Standard time applicable to each operation and the wage rate of the
relevant grade of worker determine the labour rate standard.
8.6
Standard Overheads
Setting Standards for overheads is difficult than setting standards for material
and labour because of the following two problems:
i)
Determination of the standard overhead cost.
ii)
Determination of the standard level of activity connected with number of
units, direct labour hours, machine hours, etc.
If Standard Costing is introduced alongwith budgetary control system, we
can ascertain the budgeted figures for number of units to be produced, direct
labour hours, machine hours etc. alongwith the other overhead costs which are
estimated in the budgets. The formula for finding out the standard overhead rate
is:
Advanced Cost Accounting - IV
155
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
Standard Overhead Costs for the Period
Standard Overhead Rate =
Standard Production for the period
The above formula is used when we want to find out per unit of costs of
overheads. Similarly, if we want to find out the overhead costs per direct labour
hours or machine hours we have to divide the standard cost for the period by
either direct labour hours or machine hours (which forms the base).
We cannot have a common overhead recovery rate for all the departments.
Each department will have a separate overhead rate because each department is
treated as a separate cost center.
Usually Overhead Standards are calculated separately for the fixed and
variable components Thus, this division of the overheads into fixed and variable
helps the management in controlling the costs.
Calculation and control of variable overheads is easier than the calculation
of fixed overheads because fixed overheads consists of mostly the uncontrollable
expenses.
From the above discussion we can summarise the steps in setting up standard
for overhead as follows:
i)
To determine the level of activity or load. If normal standard cost is to be
set up the normal level of activity should be adopted.
ii)
Analysis of overhead expenses by ‘fixed’, semi-variable and ‘variable’
items.
iii)
A careful budgeting of overheads and computing the size or expenses against
each item, for each department, corresponding to the projected volume of
activity. For this purpose, a flexible budget should be constructed
The overheads so computed will be collected by departments and a rate
per unit product worked out which should be taken as the standard manufacturing
overheads.
8.7
Problems in Setting Standard Costs
The problem involved in setting standard costs include the following :
156 Advanced Cost Accounting - IV
i)
Deciding how to incorporate inflation into planned unit costs.
ii)
Agreeing a labour efficiency standard (e.g. whether current times, expected
times or ideal times should be used in labour efficiency standard).
iii)
Deciding on the quality of materials to be used, because a better quality of
material will cost more, but perhaps reduce material wastage.
iv)
Deciding on the appropriate mix of component materials, where some
change in the mix is possible.
v)
Estimating materials prices where seasonal price variations or bulk purchase
discount may be significant.
vi)
Possible ‘behavioural’ problems.
vii)
The cost of setting up and maintaining a system for establishing standards
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
Revision of Standards : Accountants are not unanimous in their opinion regarding
revision of standards. One group contents that standards are the resultant effect
of a number or factors and these factors are bound to vary from time to time.
Hence. when change takes place, the standards should be revised in the light of
the changes. Without revision, the standards become outmoded affecting the
initiative and incentive of the operating personnel. Another group of accountants
feel that standards constitute a yardstick of actual performance. As such, too
frequent revisions destroy the means of measuring efficiency.
The above views reflect the extremes of the situation. It is true that update
standards provide a better target and are more meaningful to the employees.
However, the cumulative effect of change will certainly become significant although
minor changes may be ignored. It is therefore, necessary to revise the standards
wheni)
Prices of materials and labour change;
ii)
Manufacturing methods change;
iii)
Product designs of specification change;
iv)
There are errors in setting standards and
iv)
There are other relevant circumstances such as technological advancement.
Current Standard are reviewed every year in new budgets are prepared
and the entire standard cost structure is revised owing to any of the above changes.
Basic Standards are however, revised in the course of the year itself under the
following circumstances :
i)
When there are permanent changes in the methods of manufacture;
ii)
When the plant capacity changes; and
iii)
When disparity between the standards and expected performance becomes
so great that standards lose their significance.
Advanced Cost Accounting - IV
157
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
8.8
Variance Analysis
Variance Accounting is a technique whereby the planned activities of an
undertaking are expressed in budgets, standard costs, standard selling prices and
standard profit margins and the difference between these and the comparable
actual results are accounted for. The procedure is to collect, compare, comment
and correct.
‘Variance’ is the difference between planned, budgeted or standard cost
and actual costs and similarly in respect of revenues. In short, variance is the
difference between standard cost and actual cost.
Variance Analysis is defined by Terminology as, “that part of Variance
Accounting which relates to the analysis into constituent part of variance between
planned and actual performance”. Thus Variance Analysis is the analysis of
variance arising in standard cost system into their constituent parts. It is the analysis
and comparison of the factors which have caused the differences between
predetermined standards and actual results with a view to eliminating inefficiencies.
The purpose of variance analysis is to bring to the attention of management the
reason for the difference between budgeted operated profit and actual operating
profit. A break-up of the difference into the various constituent parts will enable
management to improve operations, increase efficiency, utilise resources more
effectively and reduce costs.
Favourable and Unfavorable Variances :Cost Variance may either be favourable or unfavourable or adverse. When
actual cost is less than standard cost, it has a ‘favourable’ effect on profit and
thus it is known as favourable variance. (positive/ Plus). On the other hand,
when actual cost is more than standard costs it has an ‘adverse’ and
‘unfavourable’ effect on profit and is known as adverse, unfavourable or negative
(minus) variance.
If only the variances are found it does not help the management in any
way. The analysis of variances and their causes are more important. Variances
can again be divided into two categories - (i) Controllable and (ii) Uncontrollable.
The controllable variances are those which can be controlled by the management
e.g. wastage of material, idle time of labour, machine break-down etc. This is
because all these costs can be controlled by the incharge of the department who
is responsible. On the other hand, some costs are uncontrollable in nature which
have to be incurred due to external factors e.g. if the minimum wages are increased
for the labourers by the Government the management cannot control this cost.
Thus, the management gives more stress on controlling the controllable costs by
analysis of the variances.
158 Advanced Cost Accounting - IV
8.9
Standard Costing
(Types Of Standard &
Variance Analysis)
Different Types of Variances
There are basically three main variances :
1) Direct Material Cost Variance
2) Direct Labour (Wages) Cost Variance
NOTES
3) Overhead Cost Variance
Thus, the addition of all the three factors gives us the “Total Cost Variance”.
This is illustrated as follows :
Total Cost Variance
(1) Material Cost Variance
(1) Material Price
Variance
(2) Labour Cost Variance
(2) Material Quality
(or usage) Variance
(1) Material Mix
Variance
(1) Ideal Time
Variance
(1) Labour Rate
Variance
(3) Overhead Cost Variance
(2) Labour Time
(or Efficiency) Variance
(2) Material Yield
Variance
(2) Labour Mix
Variance
(1) Overhead Expenditure
Variance
(3) Labour Yield
Variance
(4) Net Efficiency
Variance
(2) Overhead Efficiency
Variance
(3) Overhead Volume
Variance
8.9.1 Material Variances
Material Variances includes the following :
1)
Material Cost Variance:
The Material Cost Variance is also called Material Total Variance, is the
difference between standard direct material cost of actual production and the
actual cost of direct material. It’s formula is :
Material Cost variance = Standard Cost of Material - Actual Cost of Material
Thus, in symbol MCV = SC - AC
OR
Material Cost Variance = (Standard Quantity × Standard Price) - (Actual Quantity
× Actual Price)
Thus, in symbol MCV = (SQ × SP) - (AQ × AP)
Advanced Cost Accounting - IV
159
Standard Costing
(Types Of Standard &
Variance Analysis)
Material Cost Variance is analysed into two sub-variances - Material Price
Variance and Material Quantity (or usage) Variance.
2)
NOTES
Material Price Variance :
The Material Price Variance is the difference between the standard price
and the actual purchase price for each unit of material multiplied by the actual
quantity of material purchased. It is preferable to base the price variance on the
actual quantity of material purchased and not on the actual quantity used in order
that price variances can be reported for control purposes as soon as possible i.e.
when the materials are purchased. Its formula is :
Material Price Variance = (Standard Price - Actual Price) × Actual Quantity
Thus in symbol,
MPV = (SP - AP) × AQ
Material Price Variance occurs due to •
Change in the purchase price of materials.
•
Other materials purchased instead of the standard quality.
•
Inability to obtain cash discount.
•
Spending more on transportation.
•
Emergency purchases to meet urgent orders.
•
Hike in taxes and duties levied by the Government.
•
Failure to enter into forward contracts.
•
Purchases in uneconomical quantities.
Generally, the Purchase Manager is held responsible for the material price
variance. But he cannot be held responsible for the uncontrollable expenses e.g.
rise in price, Government taxes etc.
3)
Material Quantity (or usage) Variance :
Material Usage Variance is the difference between the standard usage
and the actual usage of materials for the output achieved. The Terminology defines
Material Usage Variance is, “that portion of the direct materials cost variance
which is the difference between the standard quantity specified for the production
achieved, whether completed or not, and the actual quantity used, both valued at
standard prices”. Its formula is :
Material Quantity Variance = (Standard Quantity - Actual Quantity) × Standard
Price
Thus, in symbol MQV (or MUV) = (SQ - AQ) × SP
This variance arises mainly due to the following reasons:
160 Advanced Cost Accounting - IV
•
Defective materials used in production which result into spoilage of articles.
•
Defective tools used, causing breakages, spoilage etc. for which more
material is required.
•
No proper handling of materials.
•
Untrained labourers or trainees spoil more materials.
•
Theft Pilferage of materials.
•
Change in the design or specification of the product due to Research and
Development or due to change in the customer’s choice.
•
Using other material mix than the standard mix.
•
Inefficient production methods.
•
Rigid inspection resulting in more rejections requiring additional materials
for rectification.
•
Accounting errors.
•
Inaccurate standards.
•
Increased rate of scrap than anticipated.
•
Failure to return excess materials to stores.
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
Thus, from the above, we derive the formula for Material Cost Variance as
Material Cost Variance = Material Price Variance + Material Usage
Variance
Thus, in symbol MCV = MPV + MUV
Again Material Usage Variance can be classified into1)
Material Mix Variance.
2)
Material Yield Variance.
The computation of these variances becomes useful when products involving
a mixture of ingredients are being manufactured.
1)
Material Mix Variance
Material Mix Variance is a part of the Material Usage Variance. Material Mix
Variance occurs due to the usage of other mixture of materials rather than the
standard mix specified. For example, this variance arises in chemical industries,
rubber industries etc. where the standard mixture of chemicals etc. is determined
in advance. Any deviation from this standard due to shortage of a particular
chemical or due to using substitutes which have different specifications, lead to
Material Mix Variance.
Advanced Cost Accounting - IV
161
Standard Costing
(Types Of Standard &
Variance Analysis)
Its formula is :
Material Mix Variance = Standard Price × (Standard Quantity Mix - Actual
Quantity Mix)
Thus, in symbol MMV = SP × (SQM - AQM)
NOTES
This formula is used when the actual weight of mix and standard weight of
mix do not differ.
Sometimes, there is a need to revise the standards e.g. in case of shortage
of materials. In this case the formula for the revised standard is MMV = SP × (RSQ - AQ)
where, RSQ = Revised Standard Quantity.
2)
Material Yield Variance :
Material Yield Variance is also a part of the Material Usage Variance.
Material Yield Variance arises when the actual yield differs from the standard
yield. It is defined as, “the difference between the standard yield specified and
the actual yield obtained”. This variance is worked out in processing industry e.g.
chemical industry, where the yield from a material is specified and is expected
from a given input of materials. Its formula is :
•
When Standard Mix and Actual Mix are the same :
Material Yield Variance
SC
= SC (AY - SY)
= Standard Cost per unit
where,
SC is calculated as under :
Standard Cost of Standard Mix
SC
=
Net Standard Output (Output - Loss)
where,
•
AY
= Actual Yield
SY
= Standard Yield
When Actual Mix differs from Standard Mix :
In such a case, the revised standard mix is calculated so that standard mix is
in proportion to actual mix.
Revised Standard Cost per unit is found out as Standard Cost of Revised Standard Mix
SC
=
Net Standard Output
162 Advanced Cost Accounting - IV
Formula :
MYV
where,
RSY
= SC (AY -RSY)
Standard Costing
(Types Of Standard &
Variance Analysis)
= Revised Standard Yield
Material Yield Variance is caused due to changes in waste, scrap etc.
NOTES
8.9.2 Labour Variances :
The Labour Variances are more or less the same as material variances.
Normally, labour is taken as a variable cost at times it becomes fixed cost as it is
not possible to remove or retrench in case of fall/stoppage in production.
Labour Rate Standard :
This is basically dependent on the agreement with the labour unions or rate
prevalent in the particular area or industry.
Labour Efficiency Standard :
The Labour (quantities) efficiency means the number of hours that the
appropriate grade of workers will take to perform the necessary work. It is based
on actual performance of worker or group of workers possessing average skill
and using average effort while performing manual operations or working of machine
under normal conditions. The standard time is fixed considering the past
performance or work study. This is on the basis that is acceptable to the workers
as well as the management.
1)
Labour Cost Variance (Direct Wages Variance) :
This is defined as, “the difference between the standard direct labour cost
and actual direct labour cost incurred for the production achieved”. Its formula is:
Labour Cost Variance
Thus, in symbol
LCV
= Standard Cost - Actual Cost
= SC - AC
OR
Labour Cost Variance
= (Standard Hours × Standard Rate) Actual Actual
Hours × Rate
Thus, in symbol
LCV
= (SH × SR) - (AH × AR)
When the actual hours for production differ from the standard hours, we
can use the formula as (Standard hours for actual production × SR) - (AH × AR)
The Labour Cost Variance is sub divided into, Labour Rate Variance and
Labour Efficiency Variance.
Advanced Cost Accounting - IV
163
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
(a) Labour Rate Variance :
According to the terminology, Labour Rate Variance is “the difference
between the standard and actual direct labour hour rate per hour for the total
hours worked”. Thus, this is “that part of the Labour Cost Variance which is due
to the difference between the standard rate specified and the actual rate paid. Its
Formula is :
Labour Rate Variance
Thus, in symbol
LRV
= (Standard Rate - Actual Rate) × Actual
Hours
= (SR - AR) × AH
Reasons : The following are the reasons for Labour Rate Variance.
•
Changes in basic wage rates.
•
Employment of different categories of workers which are different from
the standard categories (grades).
•
Using different methods for payment of wages.
•
Working more hours than specified.
•
Trainees are recruited who are not given full wages. This results into
favourable variance.
•
Payment of day rates although the standards specify piece rates.
•
Night Shift work.
•
Promotion of employees without proper authorisation by personal favoritism
of supervisors and paying them rates fixed for higher job classifications.
(b)
Labour Efficiency Variance:
This is also known as Labour Time Variance. Labour Efficiency Variance
is the difference between the standard hours allowed and the actual hours worked
for the volume of output achieved. The difference is valued at the standard rate.
The Terminology defines Labour Efficiency Variance as, “the difference between
the standard hours for the actual production achieved and the hours actually worked,
valued at standard labour rate”. Its formula is :
Labour Efficiency Variance = (Standard Hours - Actual Hours) × Standard
Rate
Thus, in symbol
LEV
= (SH - AH) × SR
Thus, Labour Cost Variance is the sum total of Labour Rate Variance and
Labour Efficiency Variance as shown below :
LCV
= LRV + LEV
Labour Efficiency Variance may arise because of the following reasons :
164 Advanced Cost Accounting - IV
•
Use of incorrect grade of labour.
Standard Costing
(Types Of Standard &
Variance Analysis)
•
Insufficient training.
•
Bad supervision.
•
Incorrect instructions .
•
Bad working conditions.
•
Worker’s dissatisfaction.
•
Inefficient organisation awaiting for materials, tools and instructions, delay
in routing etc.
•
Defective machinery and equipment.
•
High Labour Turnover.
•
Fixation of incorrect standards.
•
Wrong booking of Job time.
•
Power failure, machine breakdown etc.
NOTES
The labour Efficiency Variance can be segregated into the following :
(a) Idle Time Variance : It is that part of the Labour Efficiency Variance
which is due to the wastage of time over and above the normal idle time. Thus, the
idle time variance represents the difference between hours paid and hours worked
i.e. idle hours multiplied by the standard wage rate per hour. The causes for such
idle time are :
•
Breakdown of machines.
•
Strike by workers.
•
Power failure
•
Accident or fire in the factory etc.
•
Illness of workers.
Its formula is :
Idle Time Variance
(b)
=
Idle Hours × Standard Rate
Labour Mix Variance :
Labour Mix Variance arises when more than one grade of workers (i.e.
different mixture of workers) are engaged and the composition of actual grade of
workers differs from the standard grade. Its Formula is :
Labour Mix Variance = (Revised Standard Time - Actual Time) ×
Standard Rate
Advanced Cost Accounting - IV
165
Standard Costing
(Types Of Standard &
Variance Analysis)
Thus, in symbol
LMV
= (RST - AT) × SR
Where,
Total Actual Time
NOTES
RST means
=
× Standard Time
Total Standard Time
(c) Labour Yield Variance : The Labour Yield Variance arise due to the
difference in the standard output specified and the actual output obtained. Its
formula is :
Standard
Labour Yield Variance = Cost per unit
(d)
Standard output
Actual
for actual time
output
Net Efficiency Variance :
This variance is calculated after deducing idle hours from actual hours. The
Efficiency less Idle Time Variance is called Net Efficiency Variance. Its formula
is :
Net Efficiency Variance =
Standard Rate ×
Standard
Actual
Idle
Time - Hours Paid - Hours
8.9.3 Overhead Variances :
Overheads are classified into fixed and variable. Fixed overheads are those
which do not change with the level of operation and remain fixed for a given
period. Variable overheads are those which change directly with the level of
operation. But this should be noted that in most circumstances, the largest proportion
of overhead incurred will be fixed and only a small proportion variable. Because
of the difference in the nature of variability, overhead costs are analysed separately
for fixed and variable overheads, and so are the variance.
Overhead variences are classified as under :
Overhead Cost Variances
Total fixed overhead
variance
Expenditure/Budget
variance
Volume
variance
Efficiency
variance
166 Advanced Cost Accounting - IV
Total variable overhead
variance
Expenditure
variance
Capacity
variance
Efficiency
variance
Important terms used in Overhead Variances :
Budgeted Overheads
1)
Hourly Rate
Standard Costing
(Types Of Standard &
Variance Analysis)
=
Budgeted Hours
Budgeted Overheads
2) Unit Rate
=
Budgeted Output in units
3) Standard Hours
Budgeted Hours
=
for Actual Output
× Actual Output
Budgeted Output
4) Standard Output
Budgeted Output
=
for Actual Time
5) Recovered or
Absorbed
Overheads
× Actual Hours
Budgeted Hours
=
Actual Output × Standard Rate per hour
Standard Hours
Or
6) Budgeted
=
Overheads
7) Standard
Overheads
NOTES
Budgeted Output × Standard Rate per unit
Or
=
8) Actual Overheads =
× Standard Rate per hour
for actual output
Budgeted
Hours × Standard Rate per hour
Actual Hours × Standard Rate per hour
Standard Output
Or
× Standard Rate per unit
for actual time
Actual Hours × Actual Rate per hour
Or Actual Output × Actual Rate per unit
1)
Overhead Cost Variance
It is the difference between standard overhead cost specified for the actual
production and actual overhead cost incurred. It is the total of both variable and
fixed overhead variances. Its formula is :
Overhead Cost Variance =
Actual Output × Std. Overhead Rate Actual Output × Actual Overhead per unit
= Std. Hours for Actual output × Std. Overhead Rate - Actual Hours ×
Actual Overheads Rate per hour
= Recovered Overheads - Actual Overheads
2)
Variable Overhead Variance
The variable overheads may be manufacturing, administration, selling and
distribution. The total variable overhead variance is the difference between the
standard variable overhead variance charged to production (SC) and the actual
variable overheads incurred (AC).
=
SC - AC
Advanced Cost Accounting - IV
167
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
The actual cost per unit or output may vary from standard cost unit due to:
(i) Actual overhead incurred may be more or less than the standard overheads on
the basis of actual operation. (ii) Change in output per hour. Due to the two
situations, variable overhead variances are classified into.
(a) Variable Overhead Expenditure Variance : This variance occurs
due to actual expenditure being in excess or short of standard overhead. It is the
difference between the standard overhead allowed and actual overhead incurred
for the actual time taken Its formula is :
Recovered Variable Overheads - Actual Overheads
= Standard Variable Overheads on actual production - Actual Variable
Overheads
Standard variable overhead on actual production is the product of actual
production for the period multiplied by the stand rate per unit. If hourly rate is
used, then it as (Actual hours × Standard rate - Actual Overhead)
(b) Variable Overhead Efficiency Variance : The Variable overhead
efficiency variance is the difference between the standard hours of output (SH)
and the actual of input (AH) for the period multiplied by the standard variable
overhead rate (SR). Symbolically, it is :
(SH - AH) × SR
3)
Fixed Overhead Variance
The term “fixed overhead” relates to all items of expenditure which are
more or less constant, irrespective of fluctuations in the level of output. The
standard overhead rates are set according to rate per hour or rate per unit of
output. Total fixed overhead variances are classified as under.
(a) Total Fixed Overhead Cost Variance : It is the difference between
the standard overheads recovered or absorbed for actual output and the actual
fixed overheads incurred. In other words, it is the difference between the standard
overhead charged to production in a period and the overhead incurred. While
computing the standard cost, it is always necessary to take standard cost for the
production actually achieved, for this purpose, the standard hours for actual
production should be multiplied by the standard overhead rate per unit or per
hour. Its formula is :
Overhead Cost
Recovered or Absorbed - Actual Overhead
=
Variance
Overheads
Or
Standard hours for
× Std. Overheads Rate - Actual Overhead
actual output
(b) Fixed Overhead Expenditure : Also called fixed overhead spending
variance, it is the difference between the budgeted overhead and actual overhead.
In other words, it represents the difference between the budgeted fixed overhead
for the period and the actual overhead which was incurred. Its formula is :
168 Advanced Cost Accounting - IV
Fixed Overhead
=
Expenditure Variance
Total Budgeted
Total Actual
Fixed Overhead Fixed overhead
(c) Fixed Overheads Volume Variance : It is the difference between
budgeted and applied fixed overhead. It shows the difference in overhead recovery
due to the budgeted quantity of products being greater or less than the actual
production. The expenses being fixed for the period, hourly rate changes with the
change in the level of operation. The higher the actual level of operation the lower
will be cost per unit. In other words, fixed overhead volume variance is the
difference between the budgeted output and the actual output multiplied by the
standard fixed overhead rate. Symbolically, this variance is :
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
(BP - AP) × SR
The volume variance can be further subdivided into (i) Efficiency variance,
and (ii) Capacity variance.
i) Fixed Overhead Efficiency Variance : The actual output of quantity
produced may be different from the standard quantity of output fixed for the
period. This may be for a variety of reasons. This variance is the difference
between the standard hours allowed for the actual production and the actual hours
taken multiplied by speed with which the labour force has produced the output
compared with the budgeted time allowed. Symbolically it is :
(SH - AH) × SR
Its formula is :
Efficiency Variance =
Standard Overheads - Recovered Overheads
ii) Fixed Overhead Capacity Variance : This Variance relates to capacity
utilisation of the plant and machinery. The actual capacity utilised may be less or
more than the standard capacity. This variance is the difference between the
budgeted hours of input and the actual hours between the budgeted hours of input
and the actual hours of input multiplied by standard fixed overhead rate. Symbolically
It is :
(BH - AH) × SR
It would be seen that total of overhead efficiency and capacity variance
would be equal to overhead volume variance.
(d) Calender Varience : It is a part of the capacity variance, and is attributed
to the number of days in a period being less or more than those budgeted, it arises
due to the hours worked being more or less than the hours budgeted.
Calendar Variance
=
Possible Overheads =
Budgeted Overhead
=
Possible Overheads =
Possible hours × Std. Rate per hour
=
Possible Hours
Actual numbers of days × Std. Hours per
day
=
Advanced Cost Accounting - IV
169
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
Check Your Progress
i)
What do you meant by
‘Variance’ in Standard
Costing ? What is
‘favourable variance’ and
‘unfavourable or adverse
variance’?
8.9.4 Sales Variance :
Sales Variance may be computed in two difference ways. They may be
computed so as to show the effect apon the profit or they may be computed to
show the effect upon turnover. These variances, therefore, would show the effect
of a change in sales. Sales Variance which show the effect upon turnover are as
follows : Value Variance, Price Variance, Volume Variance, Mix Variance and
Quantity Variance.
Before calculating sales variances with reference to turnover, it is desirable
to understand the following terms very clearly :
ii) Explain the following:
a) Material Price Variance
b) Material Usage Variance
c) Labour Rate Variance
d) Labour Efficiency
Variance
(a)
iii) What
is
Overhead
Variance? Which variances
are included in Overhead
Variance ?
Budgeted sales
=
Budgeted quantity of sales × Standard selling
price
Standard sales
=
Actual quantity of sales × Standard selling price
Actual sales
=
Actual quantity of sales × Actual selling price
Total Value Variance :
It is the difference between the budgeted sales and actual sales. Its formula
is :
iv) What is the meaning of
‘variances analysis’ ? What
purpose is served by such
analysis ?
Value variance
=
(Budgeted sales - Actual sales)
If actual sales are more, a favourable variance would be shown and vice
versa.
(b)
Price Variance :
It is difference between the standard price of sales and actual price. Its
formula is :
(Standard sales - Actual sales)
Or
(Std. Price - Actual price) × Actual quantity sold.
(c)
Volume Variance :
This variance is the difference of the budgeted and actual quantities of
goods sold. It is calculated like material usage variance Its formula is :
Volume variance
=
(Budgeted sales - Standard sales).
Or
(Budgeted Quantity - Actual Quantity) × Standard Price
The volume variance can further be classified into Mix Variance; and
Quantity Variance.
170 Advanced Cost Accounting - IV
i) Mix Variance :
This variance arises due to the change in the proportion of articles actually
sold and the proportion in which various articles should have been sold. Its formula
is :
Mix Variance =
(Revised standard sales - Standard sales).
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
ii) Quantity Variance :
This is the difference between the budgeted sales and revised standard
sales :If the standard sales are more than the budgeted sales, it would cause a
favourable variance and vice versa. The total of price and volume variances
would be equal to value variance.
8.10 Key terms
(a) Standard Hour :
The standard hour is the quantity of output or amount which should be
performed in one hour.
(b) Cost Variance :
Cost Variance is the difference between standard cost and the comparable
actual cost incurred during a period.
(c) Variance Analysis :
Variance analysis is the process of computing the amount of variance and
isolating the cause of variance between actual and standard.
(d) Labour Cost Variance :
Labour Cost Variance (LCV) is the difference between the standard cost
of Direct Labour Hours specified for the output achieved and the Actual Cost of
Direct Labour Hours expended.
(e) Overhead Cost Variance :
It is the difference between overhead cost specified for the actual production
and the actual overhead cost incurred. It is the total of both variable variance and
fixed overhead variances.
8.11 Summary
Business units which wish to use the technique of Standard Costing have to
take into consideration the pre-requisites to Standard Costing and make sure that
Advanced Cost Accounting - IV
171
Standard Costing
(Types Of Standard &
Variance Analysis)
NOTES
they are properly fulfilled. There are two types of standards - basic standard and
current standard - out of which a standard is to be selected by the management. It
has to make arrangement for recording of actual costs and for comparison of
actual costs with the Standard Costs fixed for them. The deviation between
actual cost and standard cost is known as ‘variance’ and it may be ’unfavorable’
or ‘favourable’ variance. Variances are analysed and its causes are reported to
the top management which decides the corrective action to be taken for controlling
or eliminating the variances. Variances are calculated for material, labour and
overheads and also for sales. On the basis of price of material, quantity of material,
usage of material, yield obtained from the material, proportion of mixture of materials
different variances are calculated for the element of material. Similarly, on the
basis of labour time, labour rate, labour efficiency, labour mix, labour idle time,
labour yield different labour variances can be calculated. In case of overheads
fixed overheads, variable overheads, expenditure or budget variance, volume
variance, capacity variance, efficiency variance are some overhead variances
that can be calculated. In sales variances, value variance, price variance, volume
variance, mix variance and quantity variance are the variance which can be
calculated. Practical problems on calculation of these various variances will be
considered in the next Unit.
8.12 Questions
I - Theory Questions
172 Advanced Cost Accounting - IV
1)
What is meant by ‘variance’ in Standard Costing? How Variance analysis
is done?
2)
Define ‘Material Price Variance’. What are the causes of Material Price
Variance?
3)
What is ‘Material Usage Variance’? State the causes and responsibility for
Material Usage Variance.
4)
Explain Labour Rate Variance. Explain separately the controllable and
uncontrollable causes of Labour Rate Variance.
5)
What is ‘Labour Yield Variance’? State the formula for computation of
Labour Yield Variance. Giving example explain when Labour Yield Variance
is favourable and when it is unfavourable.
6)
What is Variable Overhead Efficiency Variance? State the formula for
computation of Variable Overhead Efficiency Variance.
7)
What is Selling Price Variance? State the causes of Sales Volume Variance.
8)
What is meant by Material Mix Variance ? Under which circumstances
Material Mix Variances arises? Give the formula for calculation of Material
Mix Variance.
9)
Write notes on :
Standard Costing
(Types Of Standard &
Variance Analysis)
i) Labour Rate Variance.
ii) Overhead Expenditure Variance.
iii) Sales Price Variance.
iv) Variance Analysis.
10)
Define the term ‘Standard Cost’. State the per-requisites to Standard
Costing.
NOTES
II - Multiple Choice Questions
1)
Match pairs
I Group
II Group
a) Expected Standard
(i) Price Standard
b) Material Quantity Standard
(ii) Based of on the performance level
c) Variance Accounting
(iii) Difference between planned
and actual cost.
d) Idle Standard
(iv) Material usage
(v) Attainable standard.
Ans: (a) = (v), (b) = (iv), (c) = (iii), (d) = (ii).
2)
Standard overheads cost for the period
Standard overhead rate =
........ For the period.
(a) Standard Production
(b) Standard Material
(c) Standard Labour
(d) Standard Time
3)
When actual cost is less than standard cost it has a ..... effect
(a) adverse
(b) unfavourable
(c) negative
(d) favourable.
4)
Idle time variance is a part of ....... which is due to the wastage of time
over and above normal idle time.
(a) High labour turnover
Advanced Cost Accounting - IV
173
Standard Costing
(Types Of Standard &
Variance Analysis)
(b) Job time
(c) Bad working conditions
(d) Labour Efficiency Variance
NOTES
Ans. : (2 - a ), (3 - d), (4 - d)
8.12 Further Reading
174 Advanced Cost Accounting - IV
i)
‘Advanced Cost Accounting’ -
Nigam and Sharma.
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B. K. Bhar.
Unit 9
Standard Costing
(Illustrations on Computation of
Variances)
Standard Costing (Illustrations
On Computation Of Variances)
NOTES
Structure
9.0 Introduction
9.1 Unit Objectives
9.2 Illustrations on Standard Costing
9.2.1 Material Variances
9.2.2 Labour Variances
9.2.3 Material and Labour Variances
9.2.4 Overhead Variances
9.2.5 Sales Variances
9.3
Summary
9.4
Exercises
9.5
Further Reading
9.0
Introduction
In the costing technique of Standard Costing calculation of variances is
very important as it helps the management of a business concern to know in
which areas there have been differences between the Standard
Costs and the Actual Costs incurred and what are the causes due to which the
variances have taken place. By analysing the various variances and by considering
the causes of the variances, the management can decide the action to be taken to
avoid occurrence of the variances in the future period. In Unit 8, we have considered
the different variances and formula used for calculation of the variances. In this
Unit, we shall consider some illustrations which are expected to explain how the
actual computation of the variances is done.
9.1
Unit Objectives
After studying the illustrations provided in this Unit you should be able to :
•
Decide the formula to be used for computation of the variances;
•
Understand when the variance is called ‘favourable’ and when it is regarded
Advanced Cost Accounting - IV
175
Standard Costing (Illustrations
On Computation Of Variances)
as ‘unfavourable’;
•
Know the causes of each variance; and
•
How the management decides action to be taken for minimising or eliminating
the variance.
NOTES
9.2
Illustrations on Standard Costing
Illustrations provided include illustrations on Material Variances, Labour
Variances, Overhead variances and Sales Variances. Some illustrations cover
computation of Material and Labour Variances together.
9.2.1 Illustrations on Material Variances :
ILLUSTRATION 1
In the manufacture of a Formica Table of four square feet, the standard
rate of formica is 40 per square feet. During December, 2006 Majestic Furnitures,
Malad made 1,000 Tables by using actually 4,200 square feet of formica @ 45
per square feet. You are required to calculate Material Variances and verify your
results.
SOLUTION
Working Notes :
1)
Calculation of Standard Quantity of Material required for Actual
Output :
If 1 Table

1,000 Tables
= 4 sq. ft.
= ?
1,000 Tables × 4 sq. ft.
=
1 Table
=
4,000 sq. ft.
Calculation of Material Variances :
1.
176 Advanced Cost Accounting - IV
Material Cost Variance : (SQ × SP) - (AQ × AP)
=
(Standard Quantity × Standard Price) - (Actual Quantity × Actual
Price)
=
(4,000 sq. ft.×
40) - (4,200 sq. ft. × 45)
=
1,60,000 - 1,89,000
=
29,000 (Adverse)
2.
3.
Standard Costing (Illustrations
On Computation Of Variances)
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
=
( 40 -
45) × 4,200 sq. ft.
=
5 × 4,200 sq. ft.
=
21,000 (Adverse)
NOTES
Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
=
(4,000 sq. ft. - 4,200 sq. ft.) ×
= 200 sq. ft. ×
=
40
40
8,000 (Adverse)
Verification,
MCV
Material Cost Variance
29,000 (A)
 Total : 29,000 (A)
= MPV + MUV
= Material Price Variance + Material Usage Variance
=
21,000 (A) +
=
29,000 (A)
8,000 (A)
ILLUSTRATION 2
In Sudarshan Chemical Ltd. Someshwar nagar for producing 10 kgs.of a
product ‘SANNY’ the standard requirement is as follow :
Material
Quantity
Rate per kg.
kgs.
C2
8
6
D1
4
4
During January, 2007, 1,000 kgs. of product ‘SANNY’ were produced.
The actual consumption of material is as under :
Material
Quantity
Rate per kg.
C2
750
7
D1
500
5
You are required to calculate,
(1) Material Cost Variance, (2) Material Price Variance, and (3) Material
Usage Variance.
Also, verify the results.
Advanced Cost Accounting - IV
177
Standard Costing (Illustrations
On Computation Of Variances)
SOLUTION
Working Notes :
1.
Calculation of Standard Quantity of Material required for Actual
Output of 1,000 kgs :
NOTES
Material C2 :
If 10 kgs. output = 8 kgs. input
1,000 kgs. output = ?
1,000 kgs. × 8 kgs.
=
=
10 kgs.
800 kgs.
Material D1 :
If 10 kgs. output = 4 kgs. Input
1,000 kgs. output = ?
1,000 kgs. × 4 kgs.
=
=
10 kgs.
400 kgs.
Calculation of Material Variances :
1.
Material Cost Variance : (SQ × SP) - (AQ × AP)
=
(Standard Quantity × Standard Price) - (Actual Quantity × Actual
Price)
Material C2 :
=
(800 kgs.×
6) - (750 kgs. ×
=
4,800 -
=
450 (Adverse)
7)
5,250
Material D1 :
=
2.
(400 kgs. ×
4) - (500 kgs.×
=
1,600 - 2,500
=
900 (Adverse)
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
Material C2 :
178 Advanced Cost Accounting - IV
5)
=
( 6-
7) × 750 kgs.
=
1 × 750 kgs.
=
750 (Adverse)
Standard Costing (Illustrations
On Computation Of Variances)
Material D1 :
=
3.
( 4-
5) × 500 kgs.
=
1 × 500 kgs.
=
500 (Adverse)
NOTES
Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
Material C2 :
=
(800 kgs. - 750 kgs.) ×
=
50 kgs. ×
=
6
6
300 (Favourable)
Material D1 :
=
(400 kgs. - 500 kgs.) ×
=
100 kgs. ×
=
4
4
400 (Adverse)
Verification,
MCV
Material Cost Variance
= MPV + MUV
= Material Price Variance + Material Usage
Variance
C2 :
450 (A)
=
750 (A) +
300 (F)
D1 :
900 (A)
=
500 (A) +
400 (A)
1,350 (A)
=
1,250 (A) +
1,350 (A)
=
1,350 (A)

Total :
100 (A)
ILLUSTRATION 3
The following particulars derived from the cost records are made available
from which you are required to find out,
1) Material Cost Variance
2) Material Price Variance
3) Material Usage Variance
Opening Stock of Material
....
Nil
Advanced Cost Accounting - IV
179
Standard Costing (Illustrations
On Computation Of Variances)
Closing Stock of Material
....
1,000 units
required per tonne of output
.....
50 units
Standard price of material per unit
.....
1.50
Quantity of Material Purchased
.....
5,000 units
Cost of Materials purchased
.....
10,000
Quantity produced
.....
100 tones
Standard quantity of material
NOTES
Also verify your results.
SOLUTION
Working Notes :
1.
Calculation of Standard Quantity of materials required :
If 1 tonne

= 50 units
100 tonnes
= ?
=
100 tonnes × 50 units
1 tonne
= 5,000 units
2.
3.
Calculation of Actual Quantity of materials consumed in units :
=
Opening Stock + Purchases - Closing Stock
=
Nil + 5,000 units - 1,000 units
=
4,000 units.
Calculation of Actual Price of material per unit :
If 5,000 units

=
1 unit
10,000
= ?
=
1 unit × 10,000
=
5,000 units
2 per unit
Calculation of Material Variance :
1.
180 Advanced Cost Accounting - IV
Material Cost Variance : (SQ × SP) - (AQ × AP)
=
(Standard Quantity × Standard Price) - (Actual Quantity× Actual Price)
=
(5,000 units x
1.50) - (4,000 units ×
=
7,500 -
8,000
=
500 (Adverse)
2)
2.
3.
Standard Costing (Illustrations
On Computation Of Variances)
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
=
( 1.50 -
2) × 4,000 Units
=
0.50 × 4,000 units
=
2,000 (Adverse)
NOTES
Marginal Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
=
(5,000 units - 4,000 units) × 1.50
=
1,000 units × 1.50
=
1,500 (Favourable)
Verification,
MCV
= MPV + MUV
Material Cost Variance = Material Price Variance + Material Usage
Variance
500 (A)
Total :
500 (A)
=
2,000 (A) +
=
500 (A)
1,500 (F)
ILLUSTRATION 4
From the following information calculate,
(1)
Material Cost Variance
(2)
Material Price Variance
(3)
Material Usage Variance
(4)
Material Mix Variance
Material
Standard Mix
Actual Mix
X
70 kgs. @
2 per kg
60 kgs @
2 per kg
Y
30 kgs. @
4 per kg
50 kgs @
5 per kg
SOLUTION
Working Notes :
1.
Calculation of Standard Mixing Proportion between Material X and
Material Y in kgs.
Material X
:
Material Y
70 kgs
:
30 kgs
7
:
3
Advanced Cost Accounting - IV
181
Standard Costing (Illustrations
On Computation Of Variances)
2.
NOTES
3.
Calculation of Total quantity of Actual Material Consumed :
=
Material X + Material Y
=
60 kgs + 50 kgs
=
110 kgs
Calculation of Revised Standard Mix in Kgs :
=
Actual quantity of material consumed × Standard mixing proportion
Material X
=
110 kgs × 7/10 = 77 kgs
Material Y
=
110 kgs × 3/10 = 33 kgs
Calculation of Material Variances :
(1) Material Cost Variance : (SQ × SP) - (AP × AP)
= (Standard Quantity × Standard Price) - (Actual Quantity × Actual Price)
Material X
Material Y
= (70 kgs ×
2) - (60 kgs ×
=
140 -
=
20 (Favourable)
2)
120
= (30 kgs ×
4) - (50 kgs ×
=
120 -
=
130 (Adverse)
5)
250
(2) Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
Material X
Material Y
=
( 2-
2) × 60 kgs
=
NIL × 60 kgs
=
NIL
=
( 4-
5) × 50 kgs
=
1 × 50 kgs
=
50 (Adverse)
(3) Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
Material X
=
(70 kgs - 60 kgs) ×
=
10 kgs ×
=
182
Advanced Cost Accounting - IV
2
20 (Favourable)
2
Material Y
=
(30 kgs - 50 kgs) ×
=
20 kgs ×
=
Standard Costing (Illustrations
On Computation Of Variances)
4
4
80 (Adverse)
(4) Material Mix Variance : (RSM - AM) × SP
NOTES
=
(Revised Standard Mix - Actual Mix) × Standard Price
Material X
Material Y
=
(77 kgs - 60 kgs) ×
=
17 kgs ×
2
=
34 (Favourable)
=
(33 kgs - 50 kgs) ×
=
17 kgs ×
=
2
4
4
68 (Adverse)
Verification,
MCV
=
MPV + MUV
Material Cost Variance
=
Material Price Variance + Material
Usage Variance
Material X :
Material Y :


20 (F) =
130 (A)

Total :

NIL +
20 (F)
=
50 (A) + . 80 (A)
=
50 (A) +
=
110 (A)
60 (A)
ILLUSTRATION 5
On Toshniwal Chemicals, Tulapur for the output of “Tosha’ chemical of 10
kgs. the actual mix differs from the standard mix with a change in output. The
cost details for a period of March, 2007 are given below :
Standard Mix
Materials
Actual Mix
Quantity
kgs.
Price
Cost
Quantity
kgs.
Price
Cost
‘Bk’
60
20
1,200
75
22
1,650
‘Pk’
40
10
400
30
08
240
Total
100
1,600
105
1,890
Calculate the following material variances.
(1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance and (4) Material Mix Variance. Also verify your result.
Advanced Cost Accounting - IV
183
Standard Costing (Illustrations
On Computation Of Variances)
SOLUTION
Working Notes :
1.
Calculation of Standard Mixing Production between Material ‘Bk’
and Material ‘Pk’
NOTES
2.
Material ‘Bk’
:
Material ‘Pk’
60 kgs.
:
40 kgs.
3
:
2
Calculation of Total Quantity of actual material consumed :
= Material - ‘Bk’ + Material - ‘Pk’
= 75 kgs. + 30 kgs.
= 105 kgs.
3.
Calculation of Revised Standard Mix in kgs. :
3
Material - ‘Bk’
=
105 kgs. ×
5
=
63 kgs.
=
105 kgs. ×
2
Material - ‘Pk’
5
=
42 kgs.
Calculation of Material Variances :
1.
Material Cost Variance : (SQ × SP) - (AQ × AP)
= (Standard Quantity × Standard Price) - (Actual Quantity × Actual Price)
Material - ‘Bk’ :
=
(60 kgs. ×
20) - (75 kgs. ×
=
1,200 -
=
450 (Adverse)
22)
1,650
Material - ‘Pk’ :
2.
184 Advanced Cost Accounting - IV
=
(40 kgs. ×
10) - (30 kgs. ×
=
400 -
=
160 (Favourable)
8)
240
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
Standard Costing (Illustrations
On Computation Of Variances)
Material - ‘Bk’ :
=
( 20 -
22) × 75 kgs.
=
2 × 75 kgs.
=
150 (Adverse)
NOTES
Material - ‘Pk’ :
=
3.
( 10 -
8) × 30 kgs.
=
2 × 30 kgs.
=
60 (Favourable)
Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
Material ‘Bk’ :
= (60 kgs. - 75 kgs.) ×
= 15 kgs. ×
=
20
20
300 (Adverse)
Material ‘Pk’
= (40 kgs. - 30 kgs.) ×
= 10 kgs. ×
=
4.
10
10
100 (Favourable)
Material Mix Variance : (RSM - AM) × SP
= (Revised Standard Mix - Actual Mix) × Standard Price
Material - ‘Bk’ :
= (63 kgs. - 75 kgs.) × 20
= 12 kgs. ×
=
20
240 (Adverse)
Material - ‘Pk’ :
= (42 kgs. - 30 kgs.) ×
10
= 12 kgs.× 10
=
120 (Favourable)
Verification,
‘Bk’ :
MCV
=
MPV + MUV
450 (A)
=
150 (A) +
300 (A)
Advanced Cost Accounting - IV
185
Standard Costing (Illustrations
On Computation Of Variances)
‘Pk’ :

NOTES
160 (F)
=
60 (F) +
100 (F)
290 (A)
=
90 (A) +
200 (A)
Total : 
=
290 (A)
ILLUSTRATION 6
From the following cost data made available by Perfect Plastics Ltd., Pune,
compute the following material variances.
(1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance, (4) Material Mix Variance.
Material
Standard
Quantity
Actual
Price
Quantity
Units
Price
Units
A1
40
10
20
35
B2
20
20
10
20
C3
20
40
30
30
80
60
SOLUTION
Calculation of Material Variances :
1.
Material Cost Variance : (SQ × SP) - (AQ × AP)
A1
B2
C3
2.
186 Advanced Cost Accounting - IV
=
(Standard Quantity × Standard Price) - (Actual Quantity ×
Actual Price)
=
(40 units ×
=
400 -
=
300 (Adverse)
10) - (20 units × . 35)
700
=
(20 units ×
20) - (10 units ×
=
400 -
=
200 (Favourable)
20)
200
=
(20 units ×
40) - (30 units ×
=
800 -
=
100 (Adverse)
30)
900
Material Price Variance : (SP - AP) × AQ
A1
=
(Standard Price - Actual Price) × Actual Quantity
=
( 10 -
35) × 20 units
B2
C3
3.
=
25 × 20 units
=
500 (Adverse)
=
( 20 -
=
NIL × 10 units
=
NIL
=
(
Standard Costing (Illustrations
On Computation Of Variances)
20) × 10 units
NOTES
40 -
30) × 30 units
=
10 × 30 units
=
300 (Favourable)
Material Usage Variance : (SQ - AQ) × SP
A1
B2
C3
=
(Standard Quantity - Actual Quantity) × Standard Price
=
(40 units - 20 units) ×
=
(20 units ×
10
10)
=
200 (Favourable)
=
(20 units - 10 units) ×
=
10 units ×
20
20
=
200 (Favourable)
=
(20 units - 30 units) ×
=
10 units × Rs.40
=
400 (Adverse)
40
TAQ
4.
Material Mix Variance : SP ×
SQEM
×
TSQ
=
Total Actual
Standard Quantity
Standard
Quantity
of Each Material
Price × Total Standard ×
1
Quantity
60 units
A1 =
80 units
- 20 units
1
=
10 × (30 units - 20 units)
=
100 (Favourable)
=
20 ×
60 units
B2
=
Actual Quantity
of Each
Material
40 units
×
10 x
- AQEM
1
×
80 units
20 units
- 10 units
1
20 × (15 units - 10 units)
Advanced Cost Accounting - IV
187
Standard Costing (Illustrations
On Computation Of Variances)
=
100 (Favourable)
=
40 ×
60 units
C3
NOTES
20 units
×
- 30 units
80 units
1
=
40 × (15 units - 30 units)
=
600 (Adverse)
Verification
MCV
Material Cost Variance
=
MPV + MUV
=
Material Price Variance + Material Usage
Variance
A1 :
300 (A)
=
B2 :
200 (F)
=
C3 :
100 (A)

500 (A) +
Nil
200 (F)
+
200 (F)
=
300 (F) +
400 (A)
200 (A)
=
200 (A) + NIL
200 (A)
=
200 (A)
ILLUSTRATION 7
Godrej Co., Gurgao manufactures a product ‘Bosin’ by mixing three raw
materials viz. A1, B2, C3,. It is ascertained that 125 kgs. of raw materials input are
used for every 100 kgs. of output. In January, 2012, there was an output of 5,600
kgs. of product ‘Bosin’. The additional cost data relating to the period is as follows:
`
Standard
Raw Material
Mixing
Actual
Price per kg.
Mixing
Proportion
Proportion
%
%
Price per kg.
A1
50
40
60
45
B2
30
25
20
20
C3
20
10
20
15
During the period, the actual quantity of material consumed was 7,000 kgs.
You are required to compute the following material variances and verify the
results.
(1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance and (4) Material Mix Variance.
188 Advanced Cost Accounting - IV
Standard Costing (Illustrations
On Computation Of Variances)
SOLUTION
Working Notes :
1.
Calculation of Standard Quantity of Material required for Actual
Output :

If 100 kgs. output
=
125 kgs. input
kgs. output
=
?
NOTES
5,600 kgs.× 125 kgs
=
100 kgs.
= 7,000 kgs.
Apportionment of Total Standard Quantity (i.e. 7,000 kgs. among Raw
Materials A1, B2, and C3 in standard mixing proportion (i.e. 5 : 3 : 2).
5
A1
=
B2
=
C3
=
7,000 kgs. ×
=
3,500 kgs.
=
2,100 kgs.
=
1,400 kgs.
10
3
7,000 kgs.×
10
7,000 kgs.×
10
2
2.
Apportionment of Total Actual Quantity (i.e. 7,000 kgs.) among
Raw Materials A1, B2, and C3 in actual proportion (i.e. 6 : 2 : 2).
6
A1
=
B2
=
C3
=
7,000 kgs. ×
=
4,200 kgs.
=
1,400 kgs.
=
1,400 kgs
10
2
7,000 kgs.
×
10
2
3.
7,000 kgs. ×
.
10
Calculation of Revised Standard Mix in kgs.
= Actual Quantity of Material consumed x Standard Mixing Proportion
5
Material A1
= 7,000 kgs.×
Material B2
= 7,000 kgs. ×
=
3,500 kgs.
=
2,100 kgs.
10
3
10
Advanced Cost Accounting - IV
189
Standard Costing (Illustrations
On Computation Of Variances)
2
Material C3
=
7,000 kgs. ×
.
=
1,400 kgs
10
Calculation of Material Variances :
NOTES
1.
Material Cost Variances : (SQ × SP) - (AQ × AP)
=
(Standard Quantity × Standard Price) - (Actual Quantity × Actual Price)
Material A1 :
=
(3,500 kgs. ×
40) - ( 4,200 kgs.×
=
1,40,000 - 1,89,000
=
49,000 (Adverse)
45)
Material B2 :
=
(2,100 kgs.×
25) - (1,400 kgs ×
=
52,500 - 28,000
=
24,500 (Favourable)
20)
Material C3 :
=
2.
(1,400 kgs. × 10) - (1,400 kgs. ×
=
14,000 - 21,000
=
7,000 (Adverse)
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
Material A1 :
=
( 40 -
45) × 4,200 kgs.
=
5 × 4,200 kgs.
=
21,000 (Adverse)
Material B2 :
=
( 25 -
20) × 1,400 kgs.
=
5 × 1,400 kgs.
=
7,000 (Favourable)
Material C3 :
=
190 Advanced Cost Accounting - IV
15)
( 10 -
15) × 1,400 kgs.
=
5 × 1,400 kgs.
=
7,000 (Adverse)
3.
Material Usage Variance : (SQ - AQ) × SP
=
Standard Costing (Illustrations
On Computation Of Variances)
(Standard Quantity - Actual Quantity) × Standard Price
Material A1 :
=
(3,500 kgs. - 4,200 kgs.) ×
=
700 kgs. ×
=
40
NOTES
40
28,000 (Adverse)
Material B2 :
=
(2,100 kgs. - 1,400 kgs.) ×
=
700 kgs. ×
=
25
25
17,500 (Favourable)
Material C3 :
4.
=
(1,400 kgs. - 1,400 kgs.) ×
=
Nil ×
=
NIL
10
10
Material Mix Variance : (RSQ - AQ) × SP
=
(Revised Standard Quantity - Actual Quantity) × Standard Price
Material A1 :
=
(3,500 kgs. - 4,200 kgs.) ×
=
700 kgs. ×
=
40
40
28,000 (Adverse)
Material B2 :
=
(2,100 kgs. - 1,400 kgs.) ×
=
700 kgs. ×
=
25
25
17,500 (Favourable)
Material C3 :
=
(1,400 kgs. - 1,400 kgs.) × 10
=
NIL ×
=
NIL
10
Advanced Cost Accounting - IV
191
Standard Costing (Illustrations
On Computation Of Variances)
Verification,
MCV
=
MPV + MUV
Material Cost Variance
=
Material Price Variance + Material Usage
Variance
A1 :
49,000 (A)
=
21,000 (A) +
B2 :
24,500 (F)
=
7,000 (F) +
C3 :
7,000 (A)
=
7,000 (A) + NIL
31,500 (A)
=
21,000 (A) +
31,500 (A)
=
31,500 (A)
NOTES
 Total
28,000 (A)
17, 500 (F)
10,500 (A)
ILLUSTRATION 8
Sudarshan Ltd. Surat Manufactures a single product, the standard mix of
which is as follows :
Material Aey : 60% @
10 per kg.
Material Bee : 40% @
6 per kg.
Normal loss in production is 20 % of input. Due to acute shortage of Material
Aey, the standard mix was revised accordingly. The cost data relating to the
actual results for January, 2007 are as follows :
Units
kgs.
Material Aey @
10 per kg.
Material Bee @
5 per kg.
200
(+)
 Input
Less : Loss
 Output
100
300
(-)
60
240
You are required to calculate,
(1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance, (4) Material Mix Variance, and (5) Material Yield Variance.
Also verify your results.
SOLUTION
Working Notes :
1.
Calculation of Standard Quantity of material required for Actual
Output :
Normal loss in production is 20 % of input
192 Advanced Cost Accounting - IV
Input
Normal loss
-
100
Output
=
20
Standard Costing (Illustrations
On Computation Of Variances)
80
The standard mixing proportion of material Aey and Bee is 60% : 40% : i.e.
3 : 2.
Material Aey :
NOTES

If 80 kg. Output
=
60 kgs.
240 kgs. Output
=
?
If 80 kgs. Output
=
40 kgs.
240 kgs. Output
=
?
240 kgs. x 60 kgs.
=
=
80 kgs.
180 kgs.
Material Bee :

240 kgs. × 40 kgs.
=
=
80 kgs.
120 kgs.
2.
Calculation of Standard Mixing Proportion between Material Aey
and Material Bee :
3.
Aey
:
Bee
60%
:
40%
3/5
:
2/5
Calculation of Total Quantity of Actual Material Consumed in kgs. :
Material Aey
200 kgs.
Add : Material Bee

4.
(+)
Total
100 kgs
300 kgs.
Calculation of Revised Standard Mix in kgs. :
=
Actual Total Quantity of Materials Consumed × Standard Mixing
Proportion
Material Aey
=
300 kgs. ×
3
=
180 kgs.
=
120 kgs.
5
Material Bee
=
300 kgs. ×
2
5
Advanced Cost Accounting - IV
193
Standard Costing (Illustrations
On Computation Of Variances)
5.
Calculation of Standard Output :
Total Standard Output
300 kgs.
Less : Normal Loss i.e. 20%

NOTES
6.
(-)
Total
60 kgs
240 kgs.
Calculation of Standard Cost per unit of Output :
Material Aey : 60 kgs. ×
10
Material Bee : 40 kgs. ×
6

600
(+)
Total Cost
Input
100
240
840
Normal Loss
-
20
Output
=
80
Total Standard Cost
=
Net Output
840
=
=
80 kgs.
10.50 per kg.
Calculation of Material Variances :
1.
Material Cost Variances : (SQ × SP) - (AQ × AP)
=
(Standard Quantity × Standard Price) - (Actual Quantity × Actual Price)
Material Aey :
=
(180 kgs. ×
10) - (200 kgs. ×
=
1,800 -
=
200 (Adverse)
10)
2,000
Material Bee :
=
2.
(120 kgs. ×
6) - (100 kgs. ×
=
720 -
=
220 (Favourable)
500
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
Material Aey :
194 Advanced Cost Accounting - IV
5)
=
( 10 -
10) × 200 kgs.
=
NIL × 200 kgs.
=
NIL
Standard Costing (Illustrations
On Computation Of Variances)
Material Bee :
=
( 6-
5) × 100 kgs.
=
1 × 100 kgs.
=
100 (Favourable)
NOTES
3.
Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
Material Aey :
=
(180 kgs. - 200 kgs.) ×
=
20 kgs. ×
=
10
10
200 (Adverse)
Material Bee :
=
(120 kgs. - 100 kgs.) ×
=
20 kgs. ×
=
4.
6
6
120 (Favourable)
Material Mix Variances : (RSQ - AQ) × SP
=
Revised Standard Quantity - Actual Quantity) × Standard Price
Material Aey :
=
(180 kgs. - 200 kgs.) ×
=
20 kgs. ×
=
10
10
200 (Adverse)
Material Bee :
=
(120 kgs. - 100 kgs.) ×
=
20 kgs. ×
=
5.
6
6
120 (Favourable)
Material Yield Variance : (SY - AY) × SC
=
(Standard Yield - Actual Yield) × Standard Cost per unit of output
=
(240 kgs. - 240 kgs.) ×
=
NIL ×
=
NIL
10.50
10.50
Advanced Cost Accounting - IV
195
Standard Costing (Illustrations
On Computation Of Variances )
Verification,
MCV
=
MPV + MUV
Material Cost Variance
=
Material Price Variance + Material Usage Variance
NIL +
NOTES
Aey :
200 (A)
=
Bee :
220 (F)
=
20 (F) =

Total
20 (F)
MUV
=
=
Material Usage Variance =
80 (A)
Total
=
80 (A) =
200 (A)
100 (F) +
120 (F)
100 (F) +
80 (A)
20 (F)
MMV + MYV
Material Mix Variance + Material Yield Variance
80 (A) + NIL
80 (A)
ILLUSTRATION 9
Zuari Co. Ltd., Nashik Road manufactures certain products. The cost data
relating to a standard product for November, 2012 are given below.
Raw
Standard Cost Data
Materials
Quantity
Kgs.
Price
Total
Aspi - 1
500
6.00
3,000
Bispi - 2
400
3.75
1,500
300
3.00
900
Cospi - 3
(+)
1,200
Less : 10% Normal Loss
(-)
120
1,080
Raw
5,400
Actual Cost Data
Materials
Quantity
Kgs.
Price
Total
Aspi - 1
400
6.00
2,400
Bispi - 2
500
3.60
1,800
400
2.80
1,120
Cospi - 3
(+)
1,300
Less : Actual Loss
(-)
220
1,080
196 Advanced Cost Accounting - IV
5,320
From the above mentioned cost data you are required to calculate,
Standard Costing (Illustrations
On Computation Of Variances)
(1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance, (4) Material Mix Variance and (5) Material Yield Variance.
Also verify your results.
NOTES
SOLUTION
Calculation of Material Variances :
1.
Material Cost Variance : (SQ × SP) - (AQ × AP)
=
(Standard Quantity ×Standard Price) - (Actual Quantity × Actual
Price)
=
Standard Material Cost for Actual Output - Actual Material Cost for
actual output
=
5,400 -
=
80 (Favourable)

2.
5,320
Total Material Cost Variance =
80 (F)
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
Material : Aspi - 1 :
=
( 6-
6) × 400 kgs.
=
NIL × 400 kgs.
=
NIL
Material : Bispi - 2 :
=
=
=
( 3.75 -
3.60) × 500 kgs.
0.15 × 500 kgs.
75 (Favourable)
Material : Cospi - 3 :
=
2.80) × 400 kgs.
=
0.20 × 400 kgs.
=
80 (Favourable)

=
3.
( 3-
Total Material Price Variance = NIL +
75 (F) +
80 (F)
155 (F)
Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
Advanced Cost Accounting - IV
197
Standard Costing (Illustrations
On Computation Of Variances)
Material : Aspi - 1 :
=
(500 kgs. - 400 Kgs.) ×
=
100 kgs. ×
=
NOTES
6
6
600 (Favourable)
Material : Bispi - 2 :
=
(400 kgs. - 500 kgs.) ×
=
100 kgs. ×
=
3.75
3.75
375 (Adverse)
Material Cospi - 3 :
=
(300 kgs. - 400 kgs.) ×
=
100 kgs. ×
=

4.
3
3
300 (Adverse)
Total Material Usage Variance =
(A) = 75 (A)
600 (F) +
375 (A) +
Material Mix Variance : (RSQ - ARQ) × SP
=
(Revised Standard Quantity - Actual Quantity) × Standard Price
Material : Aspi - 1 :
=
(541.67 kgs. - 400 kgs.) ×
=
141.67 kgs. ×
=
6
6
850 (Favourable)
Material : Bispi - 2 :
=
(433.33 kgs. - 500 kgs.) ×
=
66.67 kgs. ×
=
3.75
3.75
250 (Adverse)
Material : Cospi - 3 :
=
(325 kgs. - 400 kgs.) ×
=
75 kgs. ×
=

198 Advanced Cost Accounting - IV
3
3
225 (Adverse)
Total Material Mix Variance =
225 (A) = 375 (F)
850 (F) +
250 (A) +
300
5.
Standard Costing (Illustrations
On Computation Of Variances)
Material Yield Variance : (SY - AY) × SC
=
(Standard Yield - Actual Yield) × Standard Cost per unit of output
=
(1,170 kgs. - 1,080 kgs.) ×
=
90 kgs. ×
=
5
5
NOTES
450 (A)
Total Material Yield Variance =
450 (A)
Verification,
MCV
=
MPV + MUV
Material Cost Variance
=
Material Price Variance + Material Usage Variance
80 (F) =
Total
155 (F) +
80 (F) =
MUV
80 (F)
=
MMV + MYV
Material Usage Variance =
Material Mix Variance + Material Yield Variance
75 (A) =
Total
75 (A)
375 (F) +
75 (A) =
450 (A)
75 (A)
Working Notes :
1
2.
Calculation of Standard Mixing Proportion between Material Aspi 1, Bispi - 2 and Cospi - 3
Aspi - 1
:
Bispi - 2
:
Cospi - 3
500 kgs.
:
400 kgs.
:
300 kgs.
5/12
:
4/12
:
3/12
Calculation of Total Quantity of Actual Material Consumed in kgs.
Aspi - 1
400 kgs.
3.
Bispi -2
+
500 kgs.
Cospi -3
+
400 kgs.
Total
=
1,300 kgs.
Calculation of Revised Standard Mix in kgs.
=
Actual Total Quantity of Material consumed × Standard Mixing
Proportion
Aspi -1
=
1,300 kgs.
×
5
=
541.67 kgs.
=
433.33 kgs.
12
Bispi - 2
=
1,300 kgs.
×
4
12
Advanced Cost Accounting - IV
199
Standard Costing (Illustrations
On Computation Of Variances)
Cospi -3
=
1,300 kgs.
×
3
=
325 kgs.
12
4.
Calculation of Standard Output i.e. expected output from actual total
quantity of material
NOTES
Kgs.
Expected output from actual quantity
Less : Standard Normal Loss i.e. 10%
1,300
(-)
 Standard Output
5.
130
1,170
Calculation of Actual Output
Kgs.
Output from actual quantity
Less : Actual Loss
 Actual Output
6.
1,300
(-)
220
1,080
Calculation of Standard Cost per unit of output :
Total Standard Cost
=
Net Output
5,400
=
=
kgs. 1,080
5 per kg.
9.3.2 Labour Variances
ILLUSTRATION 1
In Mangalam Industries, Malad the budgeted labour force employed in a
welding process is as follows :
(1)
Un-skilled Labour Force :
200 workers @
(ii)
5 per hour for 40 hours.
Semi-skilled Labour Force :
300 workers @
6 per hour for 50 hours.
The actual labour force during a particular period was as follows :
(i)
Un-skilled Labour Force :
210 workers @
200
Advanced Cost Accounting - IV
4 per hour for 45 hours.
(ii)
Standard Costing (Illustrations
On Computation Of Variances)
Semi-skilled Labour Force :
290 workers @
7 per hour for 45 hours.
Compute the following labour variances.
(1) Labour Cost Variance, (2) Labour Rate Variance, and (3) Labour
Efficiency Variance.
NOTES
SOLUTION
Calculation of Labour Variances :
1.
Labour Cost Variance : (SH × SR) - (AH × AR)
=
(Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
Un-skilled Workers :
=
((200 workers × 40 Hours) ×
=
(8,000 Hrs.×
=
40,000 -
=
2,200 (Favourable)
5) - ((210 workers × 45 Hours) ×
5) - (9,450 Hours ×
4)
4)
37, 800
Semi-skilled Workers :
= ((300 workers × 50 Hours) ×
= (15,000 Hours ×
2.
6) - ((290 workers × 45 Hours) x
6) - (13,050 Hours ×
=
90,000 - 91,350
=
1,350 (Adverse)
7)
7)
Labour Rate Variances : (SR - AR) × AH
= (Standard Rate - Actual Rate) × Actual Hours
Un-skilled Workers :
= ( 5-
4) × 210 workers × 45 Hours
=
1 × 9,450 Hours.
=
9,450 (Favourable)
Semi-skilled Workers :
= ( 6-
3.
7) × 290 Workers × 45 Hours
=
1 × 13,050 Hours
=
13,050 (Adverse)
Labour Efficiency Variance : (SH - AH) × SR
= (Standard Hours - Actual Hours) × Standard Rate
Advanced Cost Accounting - IV
201
Standard Costing (Illustrations
On Computation Of Variances)
Un-skilled Workers :
= ((200 workers × 40 Hours) - (210 workers × 45 Hours) ×
= (8,000 Hours - 9,450 Hours) ×
= 1,450 Hours ×
NOTES
=
5
5
5
7,250 (Adverse)
Semi-skilled Workers :
= ((300 workers × 50 Hours) - (290 workers × 45 Hours) ×
= (15,000 Hours - 13,050 Hours) ×
= 1,950 Hours ×
=
6
6
6
11,700 (Favourable)
Verification,
LCV
=
LRV + LEV
Labour Cost Variance = Labour Rate Variance + Labour Efficiency Variance
USW :
2,200 (F)
=
9,450 (F) +
SSW :
1,350 (A)
=
13,050 (A) +
11,700 (F)
850 (F) =
3,600 (A) +
4,450 (F)

Total
850 (F) =
7,250 (A)
850 (F)
ILLUSTRATION 2
From the following information calculate for each of the department,
(1)
Labour Cost Variance
(2)
Labour Rate Variance
(3)
Labour Efficiency Variance
Gross Direct Wages
Standard Hours Produced
Hrs.
Standard Rate per hour
Actual Hours Worked
202 Advanced Cost Accounting - IV
Hrs.
Dept. X
Dept. Y
26,240
18,900
8,600
6,000
3.00
3.40
8,200
6,300
Standard Costing (Illustrations
On Computation Of Variances)
SOLUTION
Working Notes :
1.
Calculation of Actual Rate per hour
Dept X :
If 8,200 Hours
=
1 Hour
=

NOTES
26, 240
?
1 Hour ×
=
26,240
8,200 Hours
=
3.20
If 6,300 Hours
=
18,900
1 Hours
=
Dept Y :

?
1 Hour ×
=
=
(1)
18,900
6,300 Hours
3.00
Labour Cost Variance : (SH × SR) - (AH × AR)
= (Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
Dept. X
Dept. Y
(2)
=
(8,600 Hours ×
3.00) - (8,200 Hours ×
=
25,800 - 26,240
=
440 (Adverse)
=
(6,000 Hours ×
3.40) - (6,300 Hours ×
=
20,400 -
=
1,500 (Favourable)
3.20)
3.00)
18,900
Labour Rate Variance : (SR - AR) × AH
= (Standard Rate - Actual Rate) × Actual Hours
Dept. X
Dept. Y
=
( 3.00 -
3.20) × 6,300 Hours
=
0.20 × 8,200 Hours
=
1,640 (Adverse)
=
( 3.40 -
3.00) × 6,300 Hours
=
0.40 × 6,300 Hours
=
2,520 (Favourable)
Advanced Cost Accounting - IV
203
Standard Costing (Illustrations
On Computation Of Variances)
(3)
Labour Efficiency Variance : (SH - AH) × SR
= (Standard Hours - Actual Hours) × Standard Rate
Dept. X
NOTES
=
(8,600 Hours - 8,200 Hours) ×
=
400 Hours ×
=
Dept Y
3.00
3.00
1,200 (Favourable)
=
(6,000 Hours - 6,300 Hours) ×
=
300 Hours ×
=
3.40
3.40
1,020 (Adverse)
Verification,
LCV
=
LRV + LEV
Labour Cost Variance
=
Labour Rate Variance + Labour
Efficiency Variance
Dept X :
440 (A)
=
1,640 (A) +
1,200 (F)
Dept Y :
1,500 (F)
=
2,520 (F) +
1,020 (A)
1,060 (F)
=
880 (F) +
180 (F)
1,060 (F)
=
1060 (F)

Total
ILLUSTRATION 3
Using the following cost data, calculate,
(1)
Labour Cost Variance
(2)
Labour Rate Variance
(3)
Labour Efficiency Variance
(4)
Idle Time Variance
and verify your results.
Gross Direct Wages
3,000
Standard Hours produced
Hrs. 1,600
Standard Rate per hour
1.50
Actual Hours paid
Hrs. 1,500
(out of which hours not worked due to abnormality are 50 hours).
SOLUTION
Working Notes :
1.
204 Advanced Cost Accounting - IV
Calculation of Actual Rate per hour :
If 1,500 Hours
=
 1 Hour
=
3,000
?
1 Hour ×
=
1,500 Hours
=
(1)
Standard Costing (Illustrations
On Computation Of Variances)
3,000
2 per hour
Labour Cost Variance : (SH × SR) - (AH × AR)
= (Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
= (1,600 Hours ×
(2)
1,50) - (1,500 Hours ×
=
2,400 -
=
600 (Adverse)
NOTES
2.00)
3,000
Labour Rate Variance : (SR - AR) × AH
= (Standard Rate - Actual Rate) × Actual Hours
= ( 1,50 =
(3)
2.00 ) × 1,500 Hours
750 (Adverse)
Labour Efficiency Variance : (SH - AH) × SR
= (Standard Hours - Actual Hours) × Standard Rate
= (1,600 Hours - 1,450 Hours) ×
= 150 Hours ×
=
(4)
1.50
1.50
225 (Favourable)
Idle Time Variance : IT × SR
= Idle Time × Standard Rate
= 50 Hours ×
1.50
= 75 (Adverse)
Verification,
LCV
=
LRV + LEV + ITV
Labour Cost Variance
=
Labour Rate Variance + Labour
Efficiency Variance + Idle Time Variance
600 (A)
 Total
600 (A)
=
750 (A) +
=
600 (A)
225 (F) +
75 (A)
Advanced Cost Accounting - IV
205
Standard Costing (Illustrations
On Computation Of Variances)
ILLUSTRATION 4
Harison Electrical Ltd., Haridwar provides you the cost details regarding
manufacture of certain products for June, 2006.
Standard Time per unit of output
10 Hours
NOTES
Standard Rate per labour hour
8
Actual monthly production
1,100 units
Effective hours worked
11,500 Hours
Idle Time
500 hours
Actual Total Hours paid
12,000 Hours
Total Wage payment for the month
1,20,000
You are required to find out labour variances.
SOLUTION
Working Notes :
1.
Calculation of Standard Labour Hours for Actual Production :

If 1 unit
=
10 Hours
1,100 units
=
?
1,100 units × 10 Hours
=
=
2.
1 Unit
11,000 Hours
Calculation of Actual Rate per hour :
If 12,000 Hours =

1 Hour
1 Hour ×
=
=
1,20,000 Total Wages
= ?
1,20,000
12,000 Hours
10 per labour hour
Calculation of Labour Variances
1.
206
Advanced Cost Accounting - IV
Labour Cost Variance : (SH × SR) - (AH × AR)
=
(Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
=
(11,000 Hours ×
8) - (12,000 Hours ×
=
88,000 -
1,20,000
=
32,000 (Adverse)
10)
2.
Standard Costing (Illustrations
On Computation Of Variances)
Labour Rate Variance : (SR - AR) × AH
=
(Standard Rate - Actual Rate) × Actual Hours
=
( 8-
10) × 12,000 Hours
=
2 × 12,000 Hours
=
24,000 (Adverse)
NOTES
3.
Labour Efficiency Variance : (SH - AH) × SR
=
(Standard Hours - Actual Hours) × Standard Rate
=
(11,000 Hours - 11,500 Hours) ×
=
500 Hours ×
=
4.
8
8
4,000 (Adverse)
Idle Time Variance : IT × SR
=
Idle Time × Standard Rate
=
500 Hours ×
=
8
4,000 (Adverse)
Verification,
LCV
=
Labour Cost Variance =
32,000 (A)

Total :
LRV + LEV + ITV
Labour Rate Variance + Labour Efficiency
Variance + Idle Time Variance
=
32,000 (A) =
24,000 (A) +
4,000 (A) +
4,000 (A)
32,000 (A)
ILLUSTRATION 5
From the following details calculate,
(1)
Labour Cost Variance
(2)
Labour Rate Variance
(3)
Labour Efficiency Variance
(4)
Labour Mix Variance
Advanced Cost Accounting - IV
207
Standard Costing (Illustrations
On Computation Of Variances)
Standard
Worker
NOTES
Actual
Hours
Rate
Amount
Hours
Rate
Amount
Skilled
30
5.00
150
32
5.00
160
Un-skilled
40
4.00
160
32
4.25
136
Total
70
310
64
296
SOLUTION
Working Notes :
1.
2.
Calculation of Standard Mixing Proportion between Skilled and Unskilled workers in hours :
Skilled Workers
:
Un-skilled Workers
30 Hours
:
40 Hours
3
:
4
Calculation of total Actual Hours worked for :
= Skilled workers + Un-skilled workers
= 32 Hours + 32 Hours
3.
=
64 Hours.
Calculation of Revised Standard Mix in hours :
= Actual hours worked for x Standard mixing proportion
Skilled workers
=
64 Hours × 3/7 = 27.42 i.e. 27 Hours
Un-skilled workers
=
64 Hours × 4/7 = 36.57 i.e. 37 Hours
Calculation of Labour Variances :
(1)
Labour Cost Variance : (SH × SR) - (AH × AR)
= (Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
Skilled workers
Un-skilled workers
208 Advanced Cost Accounting - IV
=
(30 Hours x
5.00) - (32 Hours x
=
150 -
=
10 (Adverse)
=
5.00)
160
(40 Hours ×
4.00) - (32 Hours × 4.25)
=
160 -
136
=
24 (Favourable)
(2)
=
(Standard - Actual Rate) × Actual Hours
Skilled workers
Un-skilled workers
(3)
Standard Costing (Illustrations
On Computation Of Variances)
Labour Rate Variance : (SR - AR) × AH
=
( 5.00 -
5.00 ) × 32 Hours
=
NIL × 32 Hours
=
NIL
=
( 4.00 -
NOTES
4.25) × 32 Hours
=
00.25 × 32 Hours
=
8 (Adverse)
Labour Efficiency Variance : (SH - AH) × SR
= (Standard Hours - Actual Hours) × Standard Rate
Skilled workers
=
(30 Hours - 32 Hours) ×
=
2 Hours ×
=
Un-skilled workers
(4)
5
10 (Adverse)
=
(40 Hours - 32 Hours) ×
=
8 Hours ×
=
5
4
4
32 (Favourable)
Labour Mix Variance : (RSM - AM) × SR
= (Revised Standard Mix - Actual Mix) × Standard Rate
Skilled workers
=
(27 Hours - 32 Hours) ×
=
5 Hours ×
=
Un skilled workers
5.00
25 (Adverse)
=
(37 Hours - 32 Hours) ×
=
5 Hours ×
=
5.00
4.00
4.00
20 (Favourable)
Verification,
LCV
=
Labour Cost Variance =
LRV + LEV
Labour Rate Variance + Labour Efficiency
Variance
Skilled workers
=
10 (A) = NIL +
Un-skilled workers
=
24 (F) =
8 (A) +
14 (F)
=
8 (A) +
22 (F)
14 (F)
=
14 (F)
 Total
10 (A)
32 (F)
Advanced Cost Accounting - IV
209
Standard Costing (Illustrations
On Computation Of Variances)
ILLUSTRATION 6
Wacker Ltd., Wardha discloses the following cost details for a particular
job which is to be completed within a span of fifty weeks.
Standard Data
Actual Data
NOTES
Category
of workers
Total Number
Wage Rate
Total Number
Wage Rate
of Workers
(Per Worker
of Workers
(Per Worker
per week)
per week)
Skilled
80
75
70
80
Semi-skilled
40
50
40
60
Un-skilled
50
35
50
20
In actual practice, fifty-five weeks were taken up in total to complete the said job.
Calculate,
(1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, and (4) Labour Mix Variance.
Also verify your results.
SOLUTION
Working Notes :
1.
Calculation of Standard Labour Cost and Actual Labour Cost :
Standard
Category
of Workers
Actual
Weeks
(Number of
Rate
(Per
Workers ×
Number of
weeks)
Worker
per week)
Skilled
80 × 50 = 4,000
75
3,00,000
70 × 55 = 3,850
80
3,08,000
Semi-skilled
40 × 50 = 2,000
50
1,00,000
40 × 55 = 2,200
60
1,32,000
Un-skilled
50 × 50 = 2,500
35
87,500
50 × 55 = 2,750
20
55,000
 Total
8,500
4,87,500
8,800
210 Advanced Cost Accounting - IV
Amount
Weeks
(Number of
Rate
(Per
Workers ×
Number of
weeks)
Worker
per week)
Amount
4,95,000
2.
Calculation of Standard Mixing Proportion of number of skilled, semiskilled and un-skilled workers in weeks :
Skilled Workers
:
Semi-skilled Workers
:
Un-skilled Workers
4,000 weeks
:
2,000 weeks
:
2,500 weeks
8
4
:
17
3.
5
:
17
Standard Costing (Illustrations
On Computation Of Variances)
NOTES
17
Calculation of Total Actual Weeks worked :
Skilled Workers
=
Semi-skilled Workers
3,850 weeks
=
4.
+
+
Un-skilled Workers
2,200 weeks
2,750 weeks
8,800 weeks
Calculation of Standard Revised mix in weeks :
=
•
Actual weeks worked for × Standard mixing proportion
Skilled Workers :
8
=
8,800 weeks ×
17
=
•
4,141 weeks
Semi- skilled Workers :
4
=
8,800 weeks ×
17
=
•
2,071 weeks
Un-skilled Workers :
5
=
8,800 weeks ×
17
=
2,588 weeks
Calculation of Labour Variances :
1.
Labour Cost Variance : (SW × SR) - (AW × AR)
=
(Standard Weeks × Standard Rate) - (Actual Weeks × Actual Rate)
Skilled Workers :
= (4,000 weeks ×
75) - (3,850 weeks ×
=
3,00,000 -
=
8,000 (Adverse)
80)
3,08,000
Advanced Cost Accounting - IV
211
Standard Costing (Illustrations
On Computation Of Variances)
Semi-skilled Workers :
= (2,000 weeks ×
NOTES
50 ) - (2,200 weeks ×
=
1,00,000 - 1,32,000
=
32,000 (Adverse)
60)
Un-skilled Workers :
= (2,500 weeks ×
35) - ( 2,750 weeks ×
=
87,500 - 55,000
=
32,500 (Favourable)
20)
2. Labour Rate Variance : (SR - AR) × AW:
= (Standard Rate - Actual Rate) × Actual Weeks
Skilled Workers :
= ( 75 -
80 ) × 3,850 weeks
=
5 × 3,850 weeks
=
19,250 (Adverse)
Semi-skilled Workers ;
= ( 50 -
60 ) × 2,200 weeks
=
10 × 2,200 weeks
=
22,000 (Adverse)
Un-skilled Workers :
= ( 35 -
20) × 2,750 weeks
=
15 × 2,750 weeks
=
41,250 (Favourable)
3. Labour Efficiency Variance : (SW - AW) × SR
= (Standard Weeks - Actual Weeks) × Standard Rate
Skilled Workers :
= (4,000 weeks - 3,850 weeks) ×
= 150 weeks ×
=
75
75
11,250 (Favourable)
Semi-skilled Workers :
= (2,000 weeks - 2,200 weeks ) ×
212 Advanced Cost Accounting - IV
50
= 200 weeks ×
=
Standard Costing (Illustrations
On Computation Of Variances)
50
10,000 (Adverse)
Un-skilled Workers :
= (2,500 weeks - 2,750 weeks) ×
= 250 weeks ×
=
4.
35
NOTES
35
8,750 (Adverse)
Labour Mix Variance : (RSM - AM) × SR :
= (Revised Standard Mix - Actual Mix) × Standard Rate
Skilled Workers :
= (4,141 weeks - 3,850 weeks) ×
= 291 weeks ×
=
75
75
21,825 (Favourable)
Semi-skilled Workers :
= (2,071 weeks - 2,200 weeks) ×
= 129 weeks ×
=
50
50
6,450 (Adverse)
Un-skilled Workers :
= (2,588 weeks - 2,750 weeks) ×
= 162 weeks ×
=
35
35
5,670 (Adverse)
Verification,
LCV
=
LRV + LEV
Labour Cost Variance =Labour Rate Variance + Labour Efficiency Variance
Skilled Workers :
8,000 (A)
=
19,250 (A) +
11,250 (F)
=
22,000 (A) +
10,000 (A)
32,500 (F)
=
41,250 (F) +
8,750 (A)
7,500 (A)
=
7,500 (A)
=
Semi-skilled Workers :
32,000 (A)
Un-skilled Workers :
Total :
NIL +
7,500 (A)
7,500 (A)
Advanced Cost Accounting - IV
213
Standard Costing (Illustrations
On Computation Of Variances)
ILLUSTRATION 7
From the following cost data made available by Glostar Ltd. Gulbarga, calculate
(1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Labour Mix Variance.
NOTES
The Standard labour force for manufacture of a product ‘Marshall’ is as follows
:
•
20 un-trained workers @
•
10 trained workers @
0.75 per hour for 50 hours.
1.25 per hour for 50 hours.
Whereas the actual labour force employed for manufacture of a product
‘Marshall’ is as follows :
•
22 un-trained workers @
•
08 trained workers @
0.80 per hour for 50 hours.
1.20 per hour for 50 hours.
Also verify your results.
SOLUTION
Working Notes :
1. Calculation of Standard Labour Cost and Actual Labour Cost :
Standard
Category
Weeks
Actual
Rate
Amount
of Workers (Number of Workers (Per Worker
× Number of Hours)
Un-trained
Trained
 Total
Hours
Rate
Amount
(Number of Workers (Per Worker
per hour
× Number of Hours
per hour)
20 × 50 = 1,000
0.75
750
22 × 50 = 1,100
0.80
880
10 × 50 = 500
1.25
625
8 × 50 = 400
1.20
480
1,375
1,500
1,500
1,360
2.
Calculation of Standard Mixing Proportion of number of un-trained
and trained workers in hours :
Un-trained workers
:
Trained-workers
1,000 Hours
:
500 Hours
2
3
214 Advanced Cost Accounting - IV
1
:
3
3.
Un-trained workers
=
Trained workers
+
1,100 Hours
=
4.
400 Hours
1,500 Hours.
Calculation of Revised Standard Mix in hours :
=
•
Standard Costing (Illustrations
On Computation Of Variances)
Calculation of Total Actual Hours worked :
NOTES
Actual Hours worked × Standard Mixing Proportion
Untrained Workers :
2
=
1,500 Hours ×
3
=
•
1,000 Hours
Trained Workers :
1
=
1,500 Hours ×
3
=
500 Hours
Calculation of Labour Variances :
1.
Labour Cost Variance : (SH × SR) - (AH × AR)
=
(Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
Untrained Workers :
=
(1,000 Hours ×
0.75) - (1,100 Hours ×
=
750 -
=
130 (Adverse)
0.80)
880
Trained Workers :
=
2.
(500 Hours ×
1.25) - (400 Hours ×
=
625 -
=
145 (Favourable)
1.20)
480
Labour Rate Variance : (SR - AR) × AH
=
(Standard Rate - Actual Rate) × Actual Hours
Untrained Workers :
=
( 0.75 -
0.80) × 1,100 Hours
=
0.05 × 1,100 Hours
=
55 (Adverse)
Advanced Cost Accounting - IV
215
Standard Costing (Illustrations
On Computation Of Variances)
Trained Workers :
=
NOTES
3.
( 1.25 -
1.20) × 400 Hours
=
0.05 × 400 Hrs.
=
20 (Favourable)
Labour Efficiency Variance : (SH - AH) × SR
=
(Standard Hours - Actual Hours) × Standard Rate
Untrained Workers :
=
(1,000 Hours - 1,100 Hours) ×
=
100 Hours ×
=
0.75
0.75
75 (Adverse)
Trained Workers :
=
(500 Hours - 400 Hours) ×
=
100 Hours ×
=
4.
1.25
1.25
125 (Favourable)
Labour Mix Variance : (RSM - AM) × SR
=
(Revised Standard Mix - Actual Mix) × Standard Rate
Untrained Workers :
=
(1,000 Hours - 1,100 Hours) ×
=
100 Hours ×
=
0.75
0.75
75 (Adverse)
Trained Workers :
=
(500 Hours - 400 Hours) ×
=
100 Hours ×
=
1.25
1.25
125 (Favourable)
Verification,
LCV
=
Labour Cost Variance =
LRV + LEV
Labour Rate Variance + Labour Efficiency Variance
Un-trained Workers :
130 (A)
=
55 (A) +
75 (A)
145 (F)
=
20 (F) +
125 (F)
15 (F)
=
35 (A) +
=
15 (F)
Trained Workers :
216 Advanced Cost Accounting - IV

Total :
15 (F)
50 (F)
Standard Costing (Illustrations
On Computation Of Variances)
ILLUSTRATION 8
In Mafatlal Mills Ltd., Mumbai standard labour cost of producing
500 meter of cloth has been specified as follows :
•
Men Workers : 20 Hours @
•
Women Workers : 30 Hours @
15 per hour.
10 per hour.
NOTES
The actual cost data for producing 500 meter of cloth is as follows :
•
Men Workers : 30 Hours @
•
Women Workers : 30 Hours @
17 per hour
10 per hour
You are required to calculate,
(1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Labour Mix Variance, (5) Labour Yield Variance.
Also verify your results.
SOLUTION
Calculation of Labour Variances :
1
Labour Cost Variance : (SH × SR) - (AH × AR) :
=
•
Men Workers :
=
•
15) - (30 Hours ×
300 -
=
210 (Adverse)
17)
510
Women Workers :
=
=
(30 Hours ×
300 -
10) - (30 Hours ×
10)
300
NIL
Labour Rate Variance : (SR - AR) × AH :
=
•
(20 Hours ×
=
=
2.
(Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
(Standard Rate - Actual Rate) × Actual Hours
Men Workers :
=
( 15 - 17) × 30 Hours
=
2 × 30 Hours
=
60 (Adverse)
Advanced Cost Accounting - IV
217
Standard Costing (Illustrations
On Computation Of Variances)
•
NOTES
3.
Women Workers :
=
( 10 -
10) × 30 Hours
=
NIL × 30 Hours
=
NIL
Labour Efficiency Variance : (SH - AH) × SR :
= (Standard Hours - Actual Hours) × Standard Rate
•
Men Workers :
=
(20 Hours - 30 Hours) ×
=
10 Hours ×
=
•
4.
(30 Hours - 30 Hours) ×
=
NIL ×
=
NIL
10
(Revised Standard Mix - Actual Mix) × Standard Rate
Men Workers :
=
(24 Hours - 30 Hours) ×
=
6 Hours ×
15
15
90 (Adverse)
Women Workers :
=
(36 Hours - 30 Hours) ×
=
6 Hours ×
10
10
60 (Favourable)
Labour Yield Variance : (SO - AO) × SC
=
(Standard Output from actual hours worked - Actual Output) ×
Standard Cost per meter
=
(600 meter - 500 meter) ×
=
218 Advanced Cost Accounting - IV
10
Labour Mix Variance : (RSM - AM) × SR
=
5.
150 (Adverse)
=
=
•
15
Women Workers ;
=
•
15
120 (Adverse)
1.20
Standard Costing (Illustrations
On Computation Of Variances
)
Verification,
LCV
Labour Cost Variance
Men Workers :
=
LRV + LEV
=
Labour Rate Variance + Labour Efficiency
Variance
210 (A) =
60 (A) +
Women Workers : NIL
=
NIL + NIL
210 (A)
=
60 (A) +
210 (A)
=
210 (A)
=
LMV - LMV
 Total :
LEV
Labour Efficiency Variance=
150 (A)
 Total :
150 (A)
150 (A)
NOTES
150 (A)
Labour Mix Variance + Labour Yield Variance
=
30 (A) +
=
150 (A)
120 (A)
Working Notes :
1.
Calculation of Standard Mixing Proportion of men and women
workers in hours :
Men Workers
:
Women Workers
20 Hours
:
30 Hours
2
5
2.
3
:
Calculation of Total Actual Hours Worked :
Men Workers
=
Women Workers
+
30 Hours
=
3.
30 Hours
60 Hours.
Calculation of Revised Standard Mix in hours :
=
•
5
Actual Hours worked for × Standard Mixing Proportion
Men Workers :
2
=
60 Hours ×
=
24 Hours
5
Advanced Cost Accounting - IV
219
Standard Costing (Illustrations
On Computation Of Variances)
•
Women Workers :
3
NOTES
4.
=
60 Hours ×
=
36 Hours
5
Calculation of Standard Output i.e. expected output from Actual
Hours Worked :
If 50 Standard Hours =

60 Actual Hours
500 Meter Output
=
?
60 Hours × 500 Meter
=
=
50 Hours
600 Meter
5.
Calculation of Standard Labour Cost per meter :
•
Total Standard Labour Cost
Men Workers : (20 Hours ×
15)
Add : Women Workers : (30 Hours ×


=
10)
(+)
300
600
Total
If 500 Meter
=
1 Meter
=
1 Meter ×
=
300
600 Labour Cost
?
600
500 Meter
1.20 per meter
9.3.3 Material and Labour Variances
ILLUSTRATION 1
For a particular unit of product the standard data is given below :
•
Material : 5 kgs @
•
Labour : 40 Hours @
40 per kg
1 per hour
200
(+) 40
240
220 Advanced Cost Accounting - IV
For actual production of 100 units the actual data is as follows :
•
Material : 490 Kgs @
•
Labour : 3,960 Hours @
42 per kg
Standard Costing (Illustrations
On Computation Of Variances)
20,580
1.10 per hour
(+) 4,356
NOTES
24,936
Calculate the following and verify your results.
(1) Material Cost Variance
(2) Material Price Variance
(3) Material Usage Variance
(4) Labour Cost Variance
(5) Labour Rate Variance
(6) Labour Efficiency Variance
SOLUTION
Working Notes :
1.
Calculation of Standard Quantity of Material for Actual Production :

If 1 unit
=
5 kgs
100 units
=
?
100 units × 5 kgs
=
=
1 unit
500 kgs
Calculation of Material Variances :
(1)
(2)
(3)
Material Cost Variance : (SQ × SP) - (AQ × AP)
=
(Standard Quantity × Standard Price) - (Actual Quantity × Actual Price)
=
(500 kgs ×
40) - (490 kgs ×
=
20,000 - 20,580
=
580 (Adverse)
42)
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
=
( 40 -
42) × 490 kgs
=
2 × 490 kgs
=
980 (Adverse)
Material Usage Variance : (SQ - AQ) × SP
=
(Standard Quantity - Actual Quantity) × Standard Price
=
(500 kgs - 490 kgs) ×
40
Advanced Cost Accounting - IV
221
Standard Costing (Illustrations
On Computation Of Variances)
=
10 kgs ×
=
40
400 (Favourable)
Verification,
MCV
NOTES
Material Cost Variance

Total :
=
MPV + MUV
=
Material Price Variance + Material Usage
Variance
580 (A)
=
980 (A) + 400 (F)
580 (A)
=
580 (A)
Working Notes :
1.
Calculation of Standard Labour Hours for Actual Production :

If 1 Unit
=
40 Hours
100 units
=
?
100 units × 40 Hours
=
1 Unit
=
4,000 Hours
Calculation of Labour Variances :
(4)
(5)
(6)
Labour Cost Variance = (SH × SR) - (AH × AR)
=
(Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
=
(4,000 Hours ×
=
4,000 -
=
356 (Adverse)
1.10)
4,356
Labour Rate Variance : (SR - AR) × AH
=
(Standard Rate - Actual Rate) × Actual Hours
=
( 1.00 -
1.10) × 3,960 Hours
=
0.10 × 3,960 Hours
=
396 (Adverse)
Labour Efficiency Variance : (SH - AH) × SR
=
(Standard Hours - Actual Hours) × Standard Rate
=
(4,000 Hours - 3,960 Hours) ×
=
40 Hours ×
=
222 Advanced Cost Accounting - IV
1.00) - (3,960 Hours ×
Verification,
1.00
40 (Favourable)
1.00
LCV
Labour Cost Variance
356 (A)

otal :
Standard Costing (Illustrations
On Computation Of Variances)
=
LRV + LEV
=
Labour Rate Variance + Labour Efficiency
Variance
=
356 (A) =
396 (A) +
40 (F)
356 (A)
NOTES
ILLUSTRATION 2
Canon Co. Ltd., Chalisgaon has submitted the following cost data in relation
to a product manufactured in their workshop during October, 2006.
Particulars
Standard Cost
Raw Materials
Productive Labour
Actual Cost
1,000 Units
1,100 units
@
@
6 per unit
7 per unit
1,600 Hours
1,500 Hours
@
@
5 per hour
4 per hour
You are required to calculate
(1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance, (4) Labour Cost Variance, (5) Labour Rate Variance and (6) Labour
Efficiency Variance.
SOLUTION
Calculation of Material Variances :
1. Material Cost Variance : (SQ × SP) - (AQ × AP)
2.
3.
=
(Standard Quantity × Standard Price) - (Actual Quantity × Actual
Price)
=
(1,000 units ×
6) - (1,100 units ×
=
6,000 -
=
1,700 (Adverse)
7)
7,700
Material Price Variance : (SP - AP) × AQ
=
(Standard Price - Actual Price) × Actual Quantity
=
( 6-
7) × 1,100 units
=
1 × 1,100 units
=
1,100 (Adverse)
Material Usage Variance : (SQ - AQ) × SP
=
Standard Quantity - Actual Quantity) × Standard Price
=
(1,000 units - 1,100 units) × 6
Advanced Cost Accounting - IV
223
Standard Costing (Illustrations
On Computation Of Variances)
=
100 units ×
=
6
600 (Adverse)
Verification,
MCV
NOTES
Material Cost Variance
 Total :
=
MPV + MUV
=
Material Price Variance + Material Usages
Variance
1,700 (A)
=
1,100 (A) +
1,700 (A)
=
1,700 (A)
600 (A)
Calculation of Labour Variances :
4.
5.
Labour Cost Variance : (SH × SR) - (AH × AR)
=
(Standard Hours × Standard Rate) - (Actual Hours × Actual Rate)
=
(1,600 Hrs. ×
=
8,000 -
=
2,000 (Favourable)
4)
6,000
Labour Rate Variance : (SR - AR) × AH
=
6.
5) - (1,500 Hrs. ×
( 5-
4) × 1,500 Hrs.
=
1 × 1,500 Hrs.
=
1,500 (Favourable)
Labour Efficiency Variance : (SH - AH) × SR
=
(1,600 Hrs. - 1,500 Hrs.) ×
=
100 Hrs. ×
=
5
5
500 (Favourable)
Verification,
LCV
Labour Cost Variance
2,000 (F)
 Total :
224 Advanced Cost Accounting - IV
2,000 (F)
=
LRV + LEV
=
Labour Rate Variance + Labour Efficiency
Variance
=
1,500 (F) +
=
2,000 (F)
500 (F)
Standard Costing (Illustrations
On Computation Of Variances)
9.3.4 Overhead Variances
ILLUSTRATION 1
From the following cost records of a production unit for the month March, 2013
calculate
a)
Fixed Overhead Cost Variance
b)
Fixed Overhead Expenditure Variance and
c)
Fixed Overhead Volume Variance
Budgeted Hours
NOTES
Hours - 5,000
Actual Production
units - 950
Standard Fixed Overheads per hour
Actual Fixed Overheads
Standard Hours per unit of output
10
46,000
Hours - 5
SOLUTION
Working Notes :
i)
Calculation of Budgeted Fixed Overhead :
=
ii)
iii)
Standard Fixed Overheads per hour × Budgeted Hours
=
10 × 5,000 Hours.
=
50,000
Calculation of Actual Output in Standard Hours per unit of output :
=
Actual Output × Standard Hours per unit of output
=
950 Units × 5 Hours
=
4,750 Standard Hours
Calculation of Budgeted Output :
Budgeted Hours
=
Standard Hours per unit
5,000 Hours
=
=
iv)
5 Hours
1,000 units
Calculation of Budgeted fixed overhead Rate per unit of output :
Budgeted Fixed Overhead
=
Budgeted Output
Advanced Cost Accounting - IV
225
Standard Costing (Illustrations
On Computation Of Variances)
50,000
=
1,000 units
=
NOTES
50 per unit
Calculation of Fixed Overhead Variances
a)
(b)
Fixed Overhead Cost Variance :
=
Standard Fixed Overheads for Actual Output - Actual Fixed Overheads
for Actual output
=
(Budgeted Fixed Overhead Rate per unit × Actual output) - Actual
Fixed Overhead for Actual output
=
( 50 × 950 units) -
=
47,500 - 46,000
=
1,500 (F)
Fixed Overhead Expenditure Variance :
=
(c)
46,000
Budgeted Fixed Overheads - Actual Fixed Overheads
=
50,000 - 46,000
=
4,000 (F)
Fixed Overhead Volume Variance :
=
Budgeted Fixed Overhead Rate per unit × (Actual Output - Budgeted
output)
=
50 × (950 units - 1,000 units)
=
50 × 50 units
=
2,500 (A)
Verification,
Fixed Overhead Cost
Variance
Fixed Overhead
=
Expenditure Variance

1,500 (F)
=
4,000 (F)

1,500 (F)
=
1,500
(F)
ILLUSTRATION 2
From the following cost date calculate,
226 Advanced Cost Accounting - IV
Fixed Overhead
+
a)
Fixed Overhead Cost Variance
b)
Fixed Overhead Expenditure Variance
Volume Variance
+
2,500 (A)
c)
Fixed Overhead Volume Variance
d)
Variable Overhead Cost Variance
e)
Variable Overhead Expenditure Variance
f)
Variable Overhead Efficiency Variance
Standard Costing (Illustrations
On Computation Of Variances)
Budgeted Output
Units - 1,000
Actual Output
units - 1,260
Budgeted Fixed Overheads
50,000
Actual Fixed Overheads
60,000
Budgeted Variable Overheads
30,000
Actual Variable Overheads
38,000
NOTES
SOLUTION
Working Notes :
1)
Calculation of Budgeted Fixed Overhead Rate per unit of output :
Budgeted Fixed Overheads
=
Budgeted Output
50,000
=
=
ii)
units 1,000
50 per unit
Calculation of Budgeted Variable Overhead Rate per unit of output
Budgeted Variable Overheads
=
=
Budgeted Output
30,000
Units 1,000
=
30 per unit
Calculation of Fixed Overhead Variances :
a)
Fixed Overhead Cost Variance :
=
Budgeted Fixed Overheads for actual output - Actual Fixed Overheads
for actual output
=
(Budgeted Fixed Overhead Rate per unit × Actual Output) - Actual
Fixed overhead for Actual output
=
( 50 × 1,260 units) - 60,000
Advanced Cost Accounting - IV
227
Standard Costing (Illustrations
On Computation Of Variances)
b)
=
63,000 - 60,000
=
3,000 (F)
Fixed overhead Expenditure Variance :
=
NOTES
c)
Budgeted Fixed Overheads - Actual Fixed Overheads
=
50,000 - 60,000
=
10,000 (A)
Fixed Overhead Volume Variance :
=
Budgeted Fixed Overhead Rate per unit × (Actual Output - Budgeted
Output)
=
50 × (1,260 units - 1,000 units)
=
50 × 260 units
=
13,000 (F)
Verification,
Fixed Overhead
Cost Variance
Fixed Overhead
=
Expenditure Variance

3,000 (F)
=
10,000 (A)

3,000 (F)
=
3,000 (F)
Fixed Overhead Volume
+
+
Variance
13,000 (F)
Calculation of Variable Overhead Variances :
d)
e)
Variable Overhead Cost Variance :
=
Budgeted Variable Overheads for actual output - Actual variable
overheads for actual output
=
(Budgeted Variable overhead Rate for unit × Actual output) - Actual
Variable overheads for Actual output
=
( 30 × 1,260 units) - 38,000
=
37,800 - 38,000
=
200 (A)
Variable Overhead Expenditure Variance :
=
228 Advanced Cost Accounting - IV
Budgeted Variable overheads - Actual Variable Overheads
=
30,000 -
=
8,000 (A)
38,000
f)
Standard Costing (Illustrations
On Computation Of Variances)
Variable overhead Efficiency Variance :
=
Budgeted Variable Overhead Rate per unit × (Actual output Budgeted Output)
=
30 × (1,260 units - 1,000 units)
=
30 × 260 units
=
7,800 (F)
NOTES
Verification,
Variable Overhead Cost
Variance
Variable Overhead
=
Expenditure Variance

200 (A)
=
8,000 (A)

200 (A)
=
200 (A)
Variable Overhead
+
+
Volume Variance
7,800 (F)
ILLUSTRATION 3
From the following cost details for the week ended 31st March, 2012 Calculate
a)
Fixed Overhead Cost Variance
b)
Fixed Overhead Expenditure Variance
c)
Fixed Overhead Volume Variance
d)
Fixed Overhead Efficiency Variance
e)
Fixed Overhead Capacity Variance
Standard Fixed Overheads
1,400
Actual Fixed Overheads
1,500
Standard Output for 40 hours per week
units 1,400
Actual Output
units 1,200
Actual Hours Worked
Hours 32
SOLUTION
Working Notes :
i)
Calculation of Standard Rate of fixed overhead per unit of output:
Budgeted Fixed Overheads
=
Budgeted Output
1,400
=
=
units 1,400
1 per unit
Advanced Cost Accounting - IV
229
Standard Costing (Illustrations
On Computation Of Variances)
ii)
Calculation of Standard Rate of fixed overhead per hour
Budgeted Fixed Overheads
=
Budgeted Hours
1,400
NOTES
=
=
40 Hours
35 per hour
Calculation of Fixed Overhead Variances :
a)
Fixed Overhead Cost Variance :
= Standard fixed overhead for Actual output - Actual fixed overheads
for Actual output
= (Budgeted Fixed Overhead Rate per unit × Actual output) - Actual
Fixed Overhead for Actual output
= ( 1 × 1,200 units) -
b)
=
1,200 -
=
300 (A)
1,500
1,500
Fixed Overhead Expenditure Variance :
= Budgeted Fixed Overhead - Actual Fixed Overhead
c)
=
1,400 -
=
100 (A)
1,500
Fixed Overhead Volume Variance :
= Budgeted Fixed Overheads Rate per unit × (Actual Output - Budgeted
Output)
d)
=
1 × (1,200 units - 1,400 units)
=
1 × 200 units
=
200 (A)
Fixed Overhead Efficiency Variance :
= Budgeted Fixed Overhead Rate per unit × (Standard Output in Actual
Hours - Actual Output)
230
Advanced Cost Accounting - IV
=
1 × (32 Hours × 35 units) - 1,200 units
=
1 × (1,120 Units - 1,200 units)
=
1 × 80 Units
=
80 (F)
e)
Standard Costing (Illustrations
On Computation Of Variances)
Fixed Overhead Capacity Variance :
= Budgeted Fixed Overhead Rate per hour × (Standard Hours - Actual
Hours)
=
35 × (40 Hrs. - 32 Hrs.)
=
35 × 8 Hrs.
=
280 (A)
NOTES
Verification,
Fixed Overhead
Cost Variance
Fixed Overhead
=
Fixed Overhead
+
Expenditure
Volume
Variance

300 (A)
=
100 (A)

300 (A)
=
300 (A)
Fixed Overhead
=
Volume Variance
Variance
+
Fixed Overhead
200 (A)
+
Fixed Overhead
Efficiency Variance

200 (A)
=
80 (F)

200 (A)
=
200 (A)
Capacity Variance
+
280 (A)
9.3.5 Sales Variances
ILLUSTRATION 1
Purvi Ltd., Patna provided the following cost information relating to their
budgeted sales and actual sales for March, 2012
Particulars
Product
Sales Quantity Selling Price
Units
Per Units
Budgeted Sales :
A
1,200
15
B
800
20
C
2,000
40
A
880
18
B
880
20
C
2,640
38
Actual Sales :
Advanced Cost Accounting - IV
231
Standard Costing (Illustrations
On Computation Of Variances)
NOTES
Calculate the following Sales Variances
1)
Total Sales Variance
2)
Sales Price Variance
3)
Sales Volume Variance
4)
Sales Mix Variance
5)
Sales Quantity Variance
SOLUTION
Working Notes :
1)
2)
Calculation of Standard Mixing Proportion :
A
:
B
:
C
=
1,200 units
:
800 Units
:
2,000 units
=
3
:
2
:
5
Calculation of Standard Mix :
Standard Mix = Total Actual Sales Quantity x Standard Mixing Proportion
A =
4,400 units × 3/10
=
1,320 units
B =
4,400 units × 2/10
=
880 units
C =
4,400 units × 5/10
=
2,200 units
Calculation of Sales Variances
1)
Total Sales Variances :
= Budgeted Sales - Actual Sales
= (Budgeted Quantity × Standard Selling Price) - (Actual Quantity × Actual
Selling Price)
A
B
C
232 Advanced Cost Accounting - IV
= (1,200 units ×
15) - (880 units ×
=
18,000 - 15,840
=
2,160 (A)
= (800 units ×
20) - (880 units ×
=
16,000 - 17,600
=
1,600 (F)
= (2,000 units ×
18)
20)
40) - (2,640 units ×
=
80,000 - 1,00,320
=
20,320 (F)
38)
A

Total
=
2)
Sales Price Variance :
B
2,160 (A) +
C
1,600 (F) +
Total
20,320 (F) =
Standard Costing (Illustrations
On Computation Of Variances)
19,760 (F)
= Actual Quantity × (Standard Selling Price - Actual Selling Price)
A
= 880 units × ( 15 = 880 units ×
=
B
NOTES
18)
3
2,640 (F)
= 880 units × ( 20 -
20)
= 880 units × NIL
= NIL
C
= 2,640 units × ( 40 = 2,640 units ×
=
38)
2
5,280 (A)
A
B

Total =
2,640 (F) + NIL +
3)
Sales Volume Variance :
C
5,280 (A) =
Total
2,640 (A)
= Standard Selling Price × (Budgeted Quantity - Actual Quantity)
A
B
C
=
15 × (1,200 units - 880 units)
=
15 × 320 units
=
4,800 (A)
=
20 × (800 units - 880 units)
=
20 × 80 units
=
1,600 (F)
= ( 40 × (2,000 units - 2,640 units,)
=
40 × 640 units
=
25,600 (F)
A

Total =
4,800 (A) +
B
1,600 (F) +
C
25,600 (F) =
Total
22,400 (F)
Advanced Cost Accounting - IV
233
Standard Costing (Illustrations
On Computation Of Variances)
4)
Sales Mix Variance :
= Standard Selling Price × (Standard Mix - Actual Mix)
A
NOTES
B
=
15 × (1,320 units - 880 units)
=
15 × 440 units
=
6,600 (A)
=
20 × (880 units - 880 units)
=
20 × NIL
= NIL
C
=
40 × (2,200 units - 2,640 units)
=
40 × 440 units
=
17,600 (F)
A
B

Total =
5)
Sales Quantity Variance :
C
6,600 (A) + NIL +
Total
17,600 (F) =
11,000 (F)
= Standard Selling Price × (Budgeted Quantity - Standard Mix)
A
B
C
=
15 × (1,200 units - 1,320 units)
=
15 × 120 units
=
1,800 (F)
=
20 × (800 units - 880 units)
=
20 × 80 units
=
1,600 (F)
=
40 × (2000 units - 2,200 units)
=
40 × 200 units
=
8,000 (F)
A
Total =
B
1,800 (F) +
C
1,600 (F) +
Total
8,000 (F) =
11,400 (F)
Verification,
Total Sales
Sales Price
=
Variance
234 Advanced Cost Accounting - IV
Sales Volume
+
Variance

19,760 (F)
=
2,640 (A)

19,760 (F)
=
19,760 (F)
Variance
+
22,400 (F)
Sales Volume
Sales Mix
=
Variance
Sales Quantity
+
Variance

22,400 (F)
=
11,000 (F)

22,400 (F)
=
22,400 (F)
Standard Costing (Illustrations
On Computation Of Variances)
Variance
+
11,400 (F)
NOTES
9.4
Summary
In this Unit we have studied illustrations related to computation of variances.
Computation of variances can be mainly grouped under four headings as under :
i)
Material Variances,
ii)
Labour Variances,
iii)
Overhead Variances, and
iv)
Sales Variances.
Material Cost Variance is the Total Material Variance, which can be divided
into Material Price Variance, Material Usage Variance, Material Mix Variance
and Material Yield Variance. Similarly Labour Cost Variance is the Total Labour
Variance and it can be divided into Labour Rate Variance, Labour Efficiency
Variance, Labour Mix Variance and Labour Yield Variance.
Overhead Variances include Fixed Overhead Cost Variance, Variable
Overhead Cost Variance, Fixed Overhead Expenditure Variance, Fixed Overhead
Volume Variance, Variable Overhead Expenditure Variance, Variable Overhead
Efficiency Variance and Variable Overhead Volume Variance.
Sales Variances include Total Sales Variance, Sales Price Variance, Sales
Volume Variance, Sales Mix Variance and Sales Quantity Variance.
For computation of these various variances there are specific formula and
depending upon the cost and other data available, proper formula should be used
for computation of a particular variance.
9.5
Exercises
1.
A company produces product “A”. The following are the details of standard
and actual production.
Standard quantity of material per unit
10 kgs.
Standard price
8 per kg.
Actual number of units produced
500 units
Actual quantity of material used
2,500 kg.
Price of material
5 per kg.
Advanced Cost Accounting - IV
235
Standard Costing (Illustrations
On Computation Of Variances)
You are required to calculate,
(a) Material Price Variance, (b) Material Usage Variance, (c) Material
Cost Variance.
NOTES
2.
Ankit Chemical Co. Ajmer produces certain chemical, the standard material
costs are :
30% Material A @
50 per kg.
70% Material B @
100 per kg.
Standard loss is expected 10% in production
During 2012 - 300 kgs of material A and B were mixed as below
185 kgs. of Material A @
40 per kg.
115 kgs. of Material B @
120 per kg.
The actual production was 200 kgs of chemical.
Calculate the following variances :
(a) Material Price, (b) Material Mix, (c) Material Yield
3.
Tip Top Industries, Tarapur furnishes the following information.
Material
Standard
Quantity
Rate
Actual
Amount
Units
Quantity
Rate Amount
Units
X
4
2.00
8.00
3
4.00
12.00
Y
3
3.00
9.00
2
3.00
6.00
Z
2
4.00
8.00
2
5.00
10.00
Total
9
25.00
7
28.00
Compute Material Price, Material Usage and Material Mix Variances.
4.
Calculate :
(a) Material Cost Variance (b) Material Price Variance (c) Material Usage
Variance from the following particulars
Material
Standard
Standard
Actual
Actual
Quantity
Price
Quantity
Price
kgs.
236 Advanced Cost Accounting - IV
kgs.
X
15
5
18
4
Y
20
4
24
3
5.
Standard Costing (Illustrations
On Computation Of Variances)
The standard mix of a product is as follows :
Material
Units
Price per Unit
ps.
A
30
20
B
20
15
C
50
30
NOTES
Standard loss in production is 10%
There is actual production of 8,000 units from 90 mixes during July 2006.
The actual purchases and consumption of materials during July 2006 were.
Material
Units
Price per unit
ps.
A
2,500
25
B
1,600
10
C
4,500
40
Compute the various material variances
6.
Compute :
(a) Labour Cost Variance (b) Labour Rate Variance
(c) Labour Efficiency Variance
Standard hours per unit
25 hours
Standard rate
5 per hour
Actual production
3,000 units
Actual hours
20,000 hours
Actual rate
7.
4 per hour
From the following particulars calculate the various labour variances :
Standard time per unit
10 hours per unit
Standard rate
5 per hour
Actual production
1,500 units
Actual time taken (hours) 18,000
Add : Idle time (hours)
Total
The actual wages paid were
1,000
19,000
1,14,000 @
hours
6 per hour.
Advanced Cost Accounting - IV
237
Standard Costing (Illustrations
On Computation Of Variances)
8.
A medium scale unit worked for 50 hours a week. It has 100 workers. The
following are the other details :
Standard rate per hour
2
Standard output per gang hour
NOTES
during a week
400 units
10 workers were paid
1.00 per hour
15 workers were paid
1.50 per hour
75 workers were paid
2.00 per hour
The actual production was
20,500 units
Calculate the labour variances
9.
From the data given below, calculate labour variances for the two
departments.
Particulars
Dept. A
Actual gross wages (direct)
2,000
Standard hours produced
Standard rate per hour
Actual hours worked
Dept. B
1,800
Hrs.
8,000
6,000
Ps.
30 ps.
35
Hrs.
8,200
5,800
10. In a factory, 100 workers are engaged and the average rate of wages is 50
ps. per hour. Standard working hours per week are 40 and the standard
performance is 10 units per gang hour.
During a week in March 2007, wages paid for 50 workers were @ 50 paise
per hour, 10 workers @ 70 paise per hour and 40 workers @ 40 paise per hour.
Actual output was 380 units.
The factory did not work for five hours due to break-down of machinery.
Calculate appropriate labour variances.
11. From the following cost data you are required to calculate : (1) Material
Cost Variance, (2) Material Price Variance, (3) Material Usage Variance and (4)
Material Mix Variance.
Raw Material
Standard
Quantity
Actual
Price
Units
238 Advanced Cost Accounting - IV
Quantity
Price
Units
A2
100
4.00
130
3.00
B1
150
5.00
130
6.00
Total
250
260
Standard Costing (Illustrations
On Computation Of Variances)
Also verify your results.
12. In Swojus Industries, Surat during Octomber, 2006 actual mix differs from
standard mix but there is a change in output. Output is chemical ‘Sopra’ : 10 kgs.
The cost details for the period are as follows :
Material
Standard
Amount
Actual Mix
Amount
NOTES
Mix
C
70 kgs. @
D
30 kgs. @
30
20 (+)
Total
2,100
600
75 kgs. @
25 kgs. @
32
2,400
18 (+)
450
2,700
2,850
Calculate the following variances :
(1) Material Cost Variance (2) Material Price Variance, (3) Material Usage
Variance, (4) Material Mix Variance and verify your results.
13.
From the following cost details of Ashoka Chemicals Ltd., Ahmedabad,
calculate (1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance, (4) Material Mix Variance.
Basic
Standard
Material
Quantity
Rate
Actual
Amount Quantity
kgs.
Rate
Amount
kgs.
AD
50
4.00
200
40
5.00
200
AC
30
3.00
90
40
2.00
80
AB
20
2.00
40
30
3.00
90
Total
100
330
110
370
Also verify your results.
14. Vishal Paints Co., Vikroli is engaged in the manufacture of ‘Distempers’ is
operating a technique of standard costing to control their costs. The cost details
are available regarding the product for November, 2006
Raw Material
Quantity
Standard Price per
Total
kg
kg
X1
40
70
2,800
Y2
10
50
500
Z3
50
20
1,000
Total
100
4,300
Advanced Cost Accounting - IV
239
Standard Costing (Illustrations
On Computation Of Variances)
The standard input mix is 100 kgs. and the standard output of the finished product
is 90 kgs. The actual results for the period are as follows :
Raw
Actual Material used
Rate per kg.
Material
kgs.
X1
2,40,000
75
Y2
40,000
45
Z3
2,20,000
15
NOTES
Actual output of the finished product is 4,20,000 kgs.
You are required to calculate (1) Material Cost Variance, (2) Material Price Variance, (3) Material Usage
Variance, (4) Material Mix Variance and (5) Material Yield Variance.
15. Bajaj Ltd., Baroda has established the following standard mix for producing
certain gallons of product ‘Silva’
Raw
Quantity
Rate per Gallon
Amount
Materials
Gallons
A3
5
7.00
35
B2
3
5.00
15
C1
2
2.00
04
Total
54
A standard loss of 10% of output is always expected in production processes. The
actual input was as under :
Raw
Quantity
Rate per Gallon
Material
Gallons
A3
53,000
6.00
B2
28,000
6.00
C1
19,000
3.00
Actual output for the period was 92,000 gallons of product ‘Silva’.
You are required to calculate (1) Material Cost Variance, (2) Material Rate Variance, (3) Material Usage
Variance, (4) Material Mix Variance and (5) Material Yield Variance.
Also Verify your results.
240 Advanced Cost Accounting - IV
16. In Cadburoy India Ltd., Chalisgaon a Works Department employed with
200 workers @ 5.50 per hour to manufacture a standard product. During
December, 2006 the factory is scheduled to run for 168 hours in a four weekly
period. The standard performance is fixed at 60 units per hour. During the month,
18 workers were paid @ 5 per hour. 12 workers @ 6 per hour and 8 workers
@ 4 per hour. The factory remain idle for two hours due to electricity failure.
The actual production for the month was 10,100 units.
Standard Costing (Illustrations
On Computation Of Variances)
NOTES
You are required to calculate,
(1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Labour Yield Variance and verify your results.
17. The following labour cost details are made available by Dabur India Ltd.,
Dombivali.
Gross Direct Wages
3,000
Standard Hours produced
Hrs. 1,600
Standard Rate per hour
1.50
Actual Hours paid for
Hrs. 1,500
(of which abnormal idle time is 200 Hours)
Calculate (1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Idle Time Variance.
18. It is estimated that a specific job can be completed by employing 10 trained
workers for 8 hours and 12 untrained workers for 10 hours each to be paid at a
standard rate of 20 per hour and 15 per hour respectively.
Actually, 8 trained workers for 12 hours each and 10 untrained workers 8
hours each worked to complete the job @ 18 and 20 per labour hour
respectively.
You are required to calculate (1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Labour Mix Variance and (5) Labour Yield Variance.
Also verify your results.
19. The following cost data has been obtained from the records of a production
company using standard costing technique for cost control.
Particulars
Standard
Actual
Production
Units
4,000
3,800
Working Days
Days
20
21
Fixed Overheads
40,000
39,000
Variable Overheads
12,000
12,000
Advanced Cost Accounting - IV
241
Standard Costing (Illustrations
On Computation Of Variances)
You are required to calculate different fixed overhead variances and variable
Overhead Variances.
20. The following cost information is made available from the records of a
manufacturing company for March, 2013
NOTES
Particulars
Budget
Actual
10,000
12,000
Units
2,000
2,100
Hours
10
-
-
22,000
Fixed overheads
Production
Standard Time per unit
Actual Hours worked
Compute Fixed Overhead
(a) Cost Variance, (b) Expenditure Variance, (c) Volume Variance, (d) Capacity
Variance, and (e) Efficiency Variance.
21.
From the following cost details calculate various fixed overhead variance.
Particulars
Output
Capacity hours per day
Number of working days
Hours required per unit
Budget
Actual
Units
12,000
13,000
Hours
8,000
8,800
Days
25
26
Hours
16
17
1,20,000
1,30,000
Fixed Overheads
22. In welding department at shop floor of Ronald Ltd., Raipur, the following
cost details are submitted for the week ended 21st March, 2013
Standard output for 40 hours per week
Standard overheads
Actual output
Actual Hours Worked
Actual overheads
units 1,500
1,420
units 1,300
Hours 35
1,500
Calculate overhead variances and verify your answer.
23. From the following cost data relating to standard sales and actual sales of
product A, B and C. Calculate -
242 Advanced Cost Accounting - IV
i) Sales Value Variance, (ii) Sales Price Variance, (iii) Sales Volume Variance, (iv)
Sales Mix Variance, and (v) Sales Quantity Variance.
Product
Standard Costing (Illustrations
On Computation Of Variances)
Standard
Actual
Quantity Sales Price Total
Quantity Sales Price Total
Units
Units
A
500
5.00
2,500
500
5.00
2,500
B
400
6.00
2,400
600
6.25
3,750
300
7.00 (+)
2,100
400
6.75
2,700
7,000
1,500
C
(+)
Total
1,200
NOTES
8,950
24. Swojas Ltd. Surat operates a Budgetary control and standard costing system.
From the following budgeted sales and actual sales data compute.
i)
Sales Value Variance,
ii)
Sales Volume Variance, and
iii)
Sales Price Variance.
Budget
Product
Unit to be
Actual
Sales Value
sold units
Unit Sold
Sales Value
units
A
100
1,200
100
1,100
B
50
600
50
600
C
100
900
200
1,700
D
75
450
50
300
Total
325
3,150
400
3,700
25.
Wifo Ltd., Walchand Nagar provides the following cost information relating
to budgeted sales and actual sales for March, 2013
Budget
Product
Actual
Sales
Selling Price
Sales
Selling Price
Quantity
Per unit
Quantity
Per unit
units
units
A
1,200
10
1,000
18
B
800
15
900
15
C
2,000
20
2,200
19
Total
4,000
Calculate the following variances
4,100
Advanced Cost Accounting - IV
243
Standard Costing (Illustrations
On Computation Of Variances)
NOTES
i)
Total Sales Variance
ii)
Sales Quantity Variance
iii)
Sales Mix Variance
iv)
Sales Price Variance and
v)
Sales Volume variance
Multiple Choice Questions
1)
Standard Cost of Revised Standard Mix
Standard Cost per Unit =
Net ...............
(a) Asset
(b) Actual Output
(c) Actual Yield
(d) Standard Output
2)
Material Yield Variance is a part of ........ variance
(a) Material usage
(b) Material mix
(c) Material price
(d) Material Waste
3)
Physical standards refer to product specifications, material specification,
.......... and equipment to be used.
(a) Method of manufacture
(b) Cost of manufacture
(c) Quantity of manufacture
(d) Variety of manufacture.
4)
Labour rates depend upon the company’s method of .......
(a) accounting
(b) costing
(c) payment of wages
(d) adopting labour in company.
Ans. : (1 - d), (2 - a), (3 - a), (4 - c)
244 Advanced Cost Accounting - IV
9.5
Further Reading
i)
‘Practical Costing (Self - Tator)’ - Gauri Shankar - Publisher : Himalaya
Publishing House
ii)
‘Question Bank in Cost Accounting’ - M. N. Arora.
iii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iv)
‘Advanced Cost Accounting’ - Nigam and Sharma
Standard Costing (Illustrations
On Computation Of Variances)
NOTES
Advanced Cost Accounting - IV
245
Unit 10 Uniform Costing and
Inter-firm Comparison
Uniform Costing &
Inter-firm Comparison
Structure
NOTES
10.0 Introduction
10.1 Unit Objectives
10.2 Meaning and definition of Uniform Costing
10.3 Organisation for Uniform Costing
10.4 Pre-requisites for introduction of Uniform Costing
10.5 Uniform Cost Manual
10.6 Advantages of Uniform Costing
10.7 Limitations of Uniform Costing
10.8 Inter-firm Comparison
10.8.1 Meaning
10.8.2 Pre-requisites for introduction
10.8.3 Advantages
10.8.4 Limitations
10.9 Summary
10.10 Key Terms
10.11 Questions
10.12 Further Reading
10.0 Introduction
Business enterprises engaged in performance of similar activities and
maintaining cost accounting books and records should be able to compare their
performance with other similar enterprises in order to know where they stand.
However, this is possible only if all enterprises use the same costing principles,
methods and procedures while recording the cost data. If one enterprise uses
FIFO for pricing issues and another follows LIFO method for pricing issues of
materials, the materials cost of the two enterprises does not remain comparable.
Therefore all enterprises belonging to a particular industry must agree to follow
uniform principles, methods and procedures of costing while collecting and
recording the cost data and when this happens uniform costing is adopted by the
enterprises.
Advanced Cost Accounting - IV
247
Uniform Costing &
Inter-firm Comparison
10.1 Unit Objectives
After studying the information given in this Unit you should be able to :
NOTES
•
Understand meaning of Uniform Costing;
•
Understand the pre-requisites for introducing Uniform Costing;
•
Know advantages and limitations of Uniform Costing; and
•
Understand meaning, advantages and limitations of inter-firm comparison.
10.2 Meaning and Definition
Like job costing, process costing and operating costing Uniform Costing is
not a method of costing. It is a system which is agreed to be accepted and followed
by enterprises belonging to the same industry. It is a system according to which
the enterprises which have agreed to follow it decide to use common or uniform
principles, methods and procedures of costing so that their cost records and
performances become comparable with each other. Comparision of cost data of
one enterprise becomes comparable with other member enterprises when the
data is compiled by all member enterprises by following the common cost principles
and the same method of costing and by following the same procedure of recording
of the cost data.
I.C.M.A. terminology defines uniform costing as “the use by several
undertakings of the same costing principles and/or practices”.
Uniform Costing can be adopted at three levels as mentioned below:
i)
A single enterprise having branches at different places and producing the
same product may adopt Uniform Costing at all branches. This enables the
management of the enterprise to compare cost data of one branch with other
branches to find out the efficiency of the branches. Since all branches come
under the same management, introduction and application of Uniform Costing at
this level becomes easy and effective.
ii)
All enterprises or majority of the enterprises belonging to the same industry
may decide to introduce and use uniform costing. As the management of each
enterprise is different, introduction and use of uniform costing is not as easy as at
the i) level mentioned above.
iii)
Enterprises belonging to different industries but which produce similar type
of products may agree to adopt uniform costing, e.g. cotton industry, silk industry,
woolen industry which produce cloth, enterprises engaged in mining of iron-ore,
silver, gold, manganese, etc. whose activity is mining and extraction of some
minerals. When uniform costing is used at this third level, it can be restricted to
only a few items as the nature of work as well as the value of the output differs to
a large extent in different mines.
248 Advanced Cost Accounting - IV
The uniform costing originated in the United States of America between
1902 and 1908 when The Steel Founders’ Society of America and the Tricity
System (Printers) made attempts to bring uniformity in some areas of their costing
records. Efforts were made in 1911 in Great Britain to introduce uniform costing
for the benefit of Printers and Federation of Master Printers was established as a
result of these efforts. First world war created a favourable environment for
creation of the uniform costing system in the industrially developed countries.
Rationalisation and scientific management, formation of syndicates and
combinations and establishment of industries under State ownership in various
countries including India are some other factors which contributed to the
establishment of the uniform costing system.
Uniform Costing &
Inter-firm Comparison
NOTES
Objects of Uniform Costing :
Uniform Costing is adopted to achieve the following objects :1)
To compare and bring uniformity in the procedure followed for calculation
of the cost of production of various enterprises of the same industry.
2)
To eliminate or minimize unhealthy competition among the different units of
the same industry.
3)
To improve production capacity level and efficiency of labour by comparing
the production costs of different units of the same industry and also by
comparing the costs of a unit with the average costs of the industry.
4)
To enable the member-units to know the best system of recording cost data
and help them in improving their current systems.
5)
To fix a common sale price for the product manufactured by the memberunits of the same industry.
6)
To encourage exchange of ideas among the member units and make
available the benefits of research and development activities of the large
size units to the small size units.
7)
To determine common policies to be followed by all the member units based
on the cost data provided by each member unit.
8)
To maintain and stabilise demand for the product in the market by exercising
proper control on production.
9)
To ensure resonable price to customers and profit to manufacturers.
10)
To control costs and set up standards common to different units.
Advanced Cost Accounting - IV
249
Uniform Costing &
Inter-firm Comparison
NOTES
10.3 Organisation for Uniform Costing
For introducing and applying the uniform costing and organisation is required
to be created. When a number of branches or units owned and managed by a
central management organisation decide to use uniform costing, it is easier to
establish an organisation for that purpose. In such organisation a few persons
responsible for top management of the enterprise and some representatives from
the costing departments of the branches are included. They discuss the areas in
which uniform principles, methods and producers can be adopted. They prepare
uniform cost manual for the guidance of cost accounting personnel working in
the branches and cost data recorded in uniform manner is provided to the members
of the organisation for analysis and comparison. As all branches belong to the
same enterprise there is no hesitation or suspision in providing the complete and
true data and the uniform costing becomes more effective in reducing and controlling
the various costs.
When different units belonging to the same industry decide to use uniform
costing they may create an organisation in which persons from the member-units
are included. The work of deciding the extent to which uniformity is to followed,
the manner in which cost data is to be provided by the member units periodically,
making comparisons of cost data and reporting of the conclusions drawn through
such comparison is performed by the central organisation. Sometimes the memberunits may decide to take help of the trade association existing in the industry. The
trade association decides the manner and extent to which uniform cost principles,
methods of costing and procedures to be followed by the members for recording
and reporting of the cost data. In such case the cost data may not be provided in
absolute figures but in the ratio form to maintain secrecy of the cost data.
10.4 Pre-requisites for introduction of Uniform
Costing
For installation of uniform costing and for the success of uniform costing
attention should be given to the following requisites :
1)
There should be mutual trust, confidence and co-operation among the
member units. The managements of the member units should have confidence
that the uniform system of costing is for their benefits and any information provided
by them to the organisation of the uniform costing will not be misused by it.
2)
The member units should have clear idea about the areas and the extent to
which uniformity is to be attained. The broad areas of uniformity should be
understood by them. Efforts should be made to avoid hundred percent rigidity in
the procedures to be followed for recording of costing data.
250 Advanced Cost Accounting - IV
3)
A healthy sense of competition should be created among the personnel of
the member units. They should understand that the competition among them is
with the objective of improving the efficiency of the weak member-units.
4)
All the member units must agree to bring commonness in the methods of
costing.
Uniform Costing &
Inter-firm Comparison
5)
A Uniform cost manual should be prepared by the organisation/trade
association for the guidance of the member-units.
6)
Uniformity should be achieved in respect of the following points :
i)
Method of Costing.
ii)
Technique of Costing.
iii)
Cost unit or cost centre.
iv)
Elements of cost.
v)
Items to be included in and excluded from the ascertainment of cost.
vi)
Treatment to be given to certain special items of cost such as notional
expenses, interest on capital, primary and secondary packing charges,
etc.
vii)
Method to be used for pricing of materials issued to production, jobs,
processes.
viii)
Method of remunerating labour.
ix)
Bases to be used for distribution of overheads.
x)
Methods to be used for apportionment of service department overheads
to other service and production departments.
xi)
Methods to be used for absorption of production overheads, office and
administration overheads and selling and distribution overheads.
xii)
Valuation of stock of work-in-progress and finished products.
xiii)
Method of depreciation for various assets.
xiv)
Method of accounting - integral cost accounts or non-integral cost
accounts.
xv)
Recording and presentation of cost data.
NOTES
10.5 Uniform Cost Manual
For introduction and use of uniform costing, one of the pre-requisites is
creation of uniform cost manual. It plays an important role in the designing and
application of uniform costing. Before agreeing to follow uniform costing, the
enterprises belonging to the same industry are independent enterprises run by
separate managements and so the method of costing, the technique of costing, the
procedures followed for compilation and recording of cost data and the cost
principles applied by them are likely to be different in these enterprises. Uniform
Advanced Cost Accounting - IV
251
Uniform Costing &
Inter-firm Comparison
NOTES
costing implies use of common cost principles, use of same method of costing and
recording of cost data and its presentation by using same system by all the
enterprises which agree to follow uniform costing. Thus the member-units have
to modify their existing cost systems to bring uniformity in their cost systems.
Preparation and circulation of uniform cost manual among the member units
guides them as to where and to what extent these modifications are expected to
be done by them.
A uniform cost manual is a written document containing instructions,
clarifications, rules and regulations and guidelines for the member units to enable
them to understand how costs are to be determined, analysed, controlled and
reported to the separate organisation established for introduction and application
of uniform costing. Copies of the uniform cost mannual are prepared and provided
to each member-unit. Depending upon the nature and complexity of the industry
in which uniform costing is to be used, the contents of the uniform cost manual
vary. However, a uniform cost manual is expected to include following information
in it :1)
Introduction :
Statement of objectives to be achieved by uniform costing
Scope of the uniform costing system
Advantages expected from use of uniform costing Co-operation expected
to be provided by management
Basic features of the uniform costing system
Organisation :
Organisation to be set-up for introduction and operation of the uniform costing
- Whether the cost accountants of member-units will be included in the
organisation or whether it will consist of experts and consultants from the
outside field.
Stages in which the uniform costing system is to be introduced.
3)
Accounting System :
General principles of accounting
Coding system to be used
Terminology to be used
Classification and description of accounts
4)
Cost accounting System :
Method of costing - job, process, etc.
Techniques of costing - standard costing, marginal costing, budgetory control
Relationship between financial and cost account.
252
Advanced Cost Accounting - IV
Items to be included and excluded in costs.
Uniform Costing &
Inter-firm Comparison
Classification of departments as production and service departments.
Treatment to be given to materials cost, material wastage, scrap and loss of material,
pricing of materials issued, direct material and indirect material.
Labour cost, method of remuneration, direct and indirect labour costs,
treatment to be given to idle time, overtime, holiday wages, welfare expenses, etc.
NOTES
Overheads - classification methods, bases to be used for distribution and
apportionment of overheads, methods of absorption of overheads.
5)
Presentation of information :
Forms and contents of statements to be prepared and presented to the
central organisation created for adoption of uniform costing system and the
periodicity of their submission.
Forms to be used for reporting to the management.
Operation and production cost.
Cost ratios and financial ratios.
Other supplementary information.
10.6 Advantages of Uniform Costing
When all or majority of the units of an industry decide to follow uniform
costing system there are some advantages which become available to the memberunits and also to the customers using products and services provided by the member
units. These advantages can be stated as under :1)
A standardised cost accounting system becomes available to each memberunit due to adoption of uniform costing by them. Developing a standard costing
system is an expensive work and many small size units cannot afford to incure
this expenditure and so they go without such standard costing system. When the
units - small size and large size - agree to adopt uniform costing, a central
organisation consisting of experts in costing field creates a standardised costing
system whose details are provided to each member-unit. Thus by incurring a
small amount of expenditure even the small size units can obtain the benefits of
using a standard costing system.
2)
Use of Uniform costing enables management of each member unit to
compare the costs of its own unit with the costs of the industry. Such comparison
enables it to know the areas in which its costs are more and where they are less
as compared to the industry’s costs. The managements come to know where
there is scope for them to reduce the costs and how such reduction in costs can
be achieved. The efficiency of all member units can, thus, be improved and they
can produce the products or provide the services at low costs.
Advanced Cost Accounting - IV
253
Uniform Costing &
Inter-firm Comparison
NOTES
3)
The member units know the procedure followed for calculation of costs
and they do not enter into unhealthy competition with the other units. Uniform
costing leads to competition among member units but such competition is a healthy
competition since the units are enlightened about the details which make up the
total cost.
4)
Information available due to uniform costing enables the central organisation
or the trade association to know the cost of production of each member unit.
Using this information it can fix a Standard Selling Price for the product or service
in such a way that the unit whose cost of production is more will be able to get a
certain minimum margin of profit.
5)
When a standardised price-list is published by the central organisation, it
creates confidence among the customers that they are purchasing the products /
services at reasonable prices. Creating this confidence, especially about the prices
charged by the public sector undertaking is very important and this becomes possible
only due to use of uniform costing system.
6)
The applications of uniform costing in an industry provides the means
whereby relevant information can be obtained to help in negotiations with the
government agencies in respect of demand for increase in price of the product or
concession in the form of subsidy or bargaining with labour union about increase
in wage rate or payment of bonus to labour. Information about costs collected
from the member units of the industry through uniform costing is very useful in
such matters.
7)
Uniform cost accounting facilitates the work of wage boards set up to fix
minimum wages and fair wages for the workers of an industry.
8)
Existence of uniform costing in an industry prepares the ground to make
inter-firm comparison. By making such comparison using standardised yard-sticks,
the management of a unit can find out which are its strength areas and in which
areas it is weak due to inefficiency, wastage and losses or use of improper and
ineffective control. By identifying the weak areas and reasons thereof it can pay
more attention to them and improve its working
9)
Due to use of uniform costing, benefits of research and development carried
on by large size units become available to the small size units of the industry. The
small size units may not be able to undertake research and development activities
on their own because of limited financial resources available to them.
10) Use of uniform costing proves beneficial in cost-plus contracts. When
government agencies or other parties want to give cost-plus contracts, they want
to make sure that the costs shown by the contractors are proper costs. When
uniform costing is followed in an industry, standardised methods are used for
collection and presentation of cost data. This creates confidence in the minds of
the contractees that the cost data for the contract work is properly collected and
presented to them and they can rely on it.
254 Advanced Cost Accounting - IV
10.7 Limitations of Uniform Costing
Uniform Costing &
Inter-firm Comparison
1)
Business units belonging to an industry differ from each other. They may
be of different sizes, using different methods of production, different costing
techniques and producing different volumes of output. In such situation deciding a
uniform costing system which will suit all member units is a very difficult matter.
NOTES
2)
Success of uniform costing depends on complete co-operation among the
member-units. As the units are under different managements creating and
maintaining such co-operation for a long period may not become possible.
3)
Uniform costing requires that each member unit should give true and
complete information about the various costs periodically in the agreed format.
For this full confidence on the part of member unit is required towards central
organisation and other member units. Lack of confidence will reduce the utility
and success of uniform costing.
4)
Use of uniform costing may lead to establishment of a single selling price
for the product of an industry. This may result in creation of monopoly in the
industry and exploitation of customers and workers. Such conditions are not in the
interest of the economy.
5)
In units belonging to the same industry there may be vast disparity. Some
units may use labour intensive methods while other units may be using mechanization
for production. Finding out and implementing the uniform costing principles, methods
and techniques in such situation may not become possible.
6)
Idealy it is expected that the large size units should share the information
which has become available to them through research and development activities
with the small size units. If, however, we consider the practical side, the
managements of the large size units may keep such information secret and are
not willing to share it with other units. If this happens, uniform costing will not
become successful.
Check Your Progress
i)
What is meaning of
‘Uniform Costing’ ? Give
definition of Uniform
costing.
ii) Who can adopt Uniform
Costing ? What are the
objects
of
Uniform
Costing?
iii) Which prerequisites are
required to be fulfilled
before
introducing
Uniform Costing ?
iv) Explain the organisation to
be created for introduction
and success of Uniform
Costing.
v ) What information is
included in Uniform Cost
Manual ?
vi) Explain in brief the
advantages and limitations
of Uniform Costing.
10.8 Inter-firm Comparison
10.8.1 Meaning :
Inter-firm comparison is the technique of evaluating the performance,
efficiency, costs and profits of firms in an industry. When uniform costing is
accepted and used by all or some firms belonging to the same industry, inter-firm
comparison is the next logical step to be taken by the member-units/firms. Interfirm comparison is made on the basis of ratios in codes and absolute information
is not provided of a firm to the other firm for making the comparison; e.g. gross
profit amount of A firm is not communicated to B firm for comparison of gross
performance but the ratio of gross profit to sales of A firm is calculated and it is
communicated to B firm and management of B firm can calculate the ratio of its
gross profit to sales and by comparing these ratios, find out whether its gross
Advanced Cost Accounting - IV
255
Uniform Costing &
Inter-firm Comparison
NOTES
performance is lower or higher in comparison to that of A firm. The firm whose
performance is not satisfactory can find out the causes due to which in a specific
area its efficiency is lower and by taking the appropriate action can control or
eliminate the causes and improve the efficiency.
10.8.2 Prerequisites for Introduction :
Just as there are certain pre requisites for introduction of uniform costing,
there are some prerequisites to be completed before introduction of inter-firm
comparison. They are as under :1)
The firms which agree to follow inter-firm comparison should create a
central organisation for collecting, comparing and providing information to the
member firms. In U.K. and other foreign countries there are professional
organisations independent of the member firms which act as the central
organisations. As they do not have any personal interest in the information collected
by them, they work in a completely impartail way and member-firms also provide
information to them without any hesitation. In India trade associations, Chambers
of Commerce, trade journals and periodicals and National Productivity Councils
act as the central organisations for collection, codification, calculation of ratios
and providing the ratios to firms for making inter-firm comparison. Without such
central organisation inter-firm comparison is not possible.
2)
The member-firms should have mutual trust in each other and they should
have confidence that the inter-firm comparison will be beneficial to all memberfirms.
3)
The member-firms should have clear idea about the areas in which the cost
data and other information is to be provided by them. They should know the
requirements of the management and the extent to which information should be
provided so that it will prove useful for member-firms to achieve improvement in
their working.
4)
Firms desirous to use inter-firm comparison must already be using uniform
costing system so that there is already uniformity about cost unit, costing method
and techniques, procedures followed for cost calculation, items to be included and
excluded from costs, etc. In other words, the base in the form of uniform costing
must already be in existence before introduction of the inter-firm comparison
among the member-firms.
5)
For collecting the information from member-firms the necessary forms should
be prepared and copies supplied to each member-firm. Information obtained is
analysed, studied and converted in the form of agreed ratios and by allotting codes
to each member-firm the information in ratios is provided to each member-firm.
Identity of the firms is not disclosed and each member-firm knows only its code.
By comparing its ratio with that of other member-firms and also with the average
ratios for the member-firms considered together, a member-firm can understand
where it stands and how much further progress in efficiency can still be made by
it.
256 Advanced Cost Accounting - IV
10.8.3 Advantages :
Uniform Costing &
Inter-firm Comparison
1)
By using the information provided by the central organisation, management
of a member-firm becomes aware of its points of strength and weakness and it
can take appropriate steps to reduce the weaknesses and to increase its strength.
Competitive capacity of each member-firm can thus be increased.
NOTES
2)
In inter-firm comparison as the information is provided in ratios and not in
absolute form the member-firms know that the information provided by them to
the central organisation will remain secret and confidential. The managements of
the member-firms, therefore, do not hesitate to provide the information to the
central organisation.
3)
The central organisation created for inter-firm comparison is a professional
body consisting of members who are experts in the various fields of the industry.
The benefit of the expert knowledge and experience of the central organisation
becomes available to each member-firm.
4) When all or majority of the firms of an industry become the members and
follow inter-firm comparison the situation existing in the industry and new
developments that are taking place in the industry become known to all firms
through the information provided by the central organisation. Using this information,
collective efforts can be made by the firms for improving the condition of the
industry. Spirit of co-operation among the managements of member-firms is thus
increased.
5)
Reliable information about costs, production capacity, existing demand, prices
charged by member-firms, margin of profit available, etc. becomes available due
to the inter-firm comparison and it can be used by the industry while negotiating
with the Government, trade unions about allotment of quotas to the firms, fixation
of price of the product or service provided by the industry, determenation of wage
rates of the workers of the industry, etc. Bargaining power of the representatives
of the industry is increased because of the reliable data available from the central
organisation.
6)
Through inter-firm comparison, managements of the member-firms get vital
information which helps them in making proper and timely changes in the policies
followed by them and for taking corrective action where their efficiency is less.
Proper use of resources, use of better methods of production and minimisation of
wastage enables them to increase their productivity and this helps in creating
stability in the industry in the long run.
10.8.4 Limitations :
Limitations of inter-firm comparison are similar to the limitations of the
uniform costing. Some of the limitations are mentioned below :1)
Inter-firm comparison becomes possible only when the prerequisites
necessary for introduction of inter-firm comparison are completed. It may be
Advanced Cost Accounting - IV
257
Uniform Costing &
Inter-firm Comparison
difficult for some firms to fulfill all these prerequisites.
2)
It may not be possible to create a professional and independent central
organisation to take responsibility of introducing and implementing the scheme of
inter-firm comparison in each industry. Absence of such central organisation may
hinder inter-firm comparison.
NOTES
Check Your Progress
i)
Define the term ‘Inter-firm
comparison’ and explain
the meaning of Inter-firm
comparison.
ii) State the prerequisites for
introduction of inter-firm
comparison.
iii) Mention the advantages
and limitations of interfirm comparison.
iv) Explain the scheme of
ratios used in inter-firm
comparison.
3)
Managements of the member-firms should be capable of interpreting and
using the data provided by the central organisation, otherwise their interest in the
use of inter-firm comparison will be lost.
4)
A spirit of co-operation and trust is very essential for implementation of
inter - firm comparison scheme. Managements of all member-firms may not have
this spirit and they may not provide full and correct data to the central organisation
which reduces the utility of the scheme of inter-firm comparison.
5)
Even though the member-firm belong to the some industry they may be
different in sizes, process of production, ownership and management, etc. and it
may be very difficult to bring them an common footing for the comparison of data
related to cost and efficiency.
Scheme of ratios for inter-firm comparison
As stated earlier, the inter-firm comparison is not done by using absolute
data about costs, sales and other information of the other-firms but by calculating
the ratios for the firms and by comparing ratios of one firm with the other firms.
Generally the following ratios are calculated for this purpose :Operating Profit
Assets Employed
Operating Profit
Sales
Factory Cost
Sales
S & D Cost
Sales
Direct Materials Cost
Sales
Sales
Assets Employed
2nd level
Adm. Cost
Sales
Direct Labour Cost
Sales
Cost of Sales
Materials
258 Advanced Cost Accounting - IV
1st level
3rd level
Sales
Fixed Assets
Factory Overheads
Sales
Cost of Sales
W.I.P.
Cost of Sales
Finished Stock
Sales
Current Assets
4th level
Sales
Debtors
10.9 Summary
Uniform Costing is not a method of costing. Uniform Costing is a system
decided to be adopted and used by all or majority of firms belonging to same
industry. The member-firms who have agreed to use uniform costing follow same
principles, methods, techniques, cost units, procedures of recording cost data so
that data of the member-firms becomes comparable with each other. Uniform
costing originated in U. S. A. between 1902 and 1908. In 1911 efforts were made
in Great Britain to introduce uniform costing in the printing industry. For adoption
and application of uniform costing a separate central organisation is required to be
created. This organisation may be an independent professional organisation
consisting experts from different fields or it may be an organisation cosisting of
representatives of the member-firms. It creates a foundation for introduction of
uniform costing by deciding the costing principles, cost units to be used, method
and technique of costing to be used by the member-firms, items of expense to be
included and excluded in calculation of cost, forms to be used for providing cost
data by the member-firms and periodicity of submission of the data and reports by
the member-firms to the central organisation, etc. Certain prerequisites should be
fulfilled before introducing uniform costing. They include creation of mutual
confidence and trust among member-firms, clear idea about objectives of uniform
costing, preparation of a uniform cost manual for guidance of member-firms,
creation of a healthy sense of competition among the member-firms and clear
idea about the extent to which uniformity is to be achieved. Uniform costing has
some advantages and it also has certain limitations. Availability of a standardised
cost accounting system to each member-unit at low cost, comparison of unit cost
by the management of a member-firm with other member-firms and the industry,
avoidance of unhealthy competition due to availability of proper information
regarding calculation of unit cost, small-size firms sharing the benefits of research
and development activity carried on by the large-size firms, avoidance of wastage
and losses by managements of member-firms by detecting the areas and causes
of inefficiency by comparing their cost data with cost data of other memberfirms, proper negotiations with Government agencies, trade unions, etc. about
subsidies, fixation of production quota and revision of wage-rates, bonus amount,
etc. by using the data provided by the central organisation are some of the important
advantages available from use of uniform costing.
Uniform Costing &
Inter-firm Comparison
NOTES
In the limitations of Uniform Costing mention can be made of variation of
size, production methods used by the member-firms which make it difficult to
adopt uniform costing, lack of confidence and co-operation among the managements
of member-firms, tendency to keep some information as secret and confidential
and so not providing complete and true data to the central organisation, unwillingness
on the part of large-size firms to share the benefits of their research with smallsize firms and practical difficulties involved in introduction and use of uniform
costing.
Inter-firm comparison is the technique of evaluating the performance,
efficiency, costs and profits of firms in an industry. Introduction and use of uniform
costing enables use of this technique. Firms belonging to the same industry and
Advanced Cost Accounting - IV
259
Uniform Costing &
Inter-firm Comparison
NOTES
who are already members following uniform costing can use the technique of
inter-firm comparison. A professional organisation or Trade Association, Chamber
of Commerce, trade journals and periodicals and National Productivity Councils
acts as a central organisation for inter-firm comparison. It collects the cost data
from the member-firms and converts it into ratios and by using codes for the
member-firms and provides it to the member-firms. Thus in inter-firm comparison
absolute data is not provided by the central organisation to the member-firms and
identity of a member-firm is not disclosed to other member-firms. Management
of a member-firms compares its own ratios with the ratios of other memberfirms to judge its performance, costs, productivity and efficiency. On the basis of
conclusions drawn, it locates the areas of its inefficiency and takes appropriate
steps to eliminate or reduce the causes responsible for such inefficiency.
10.11 Key Terms
i)
Uniform Cost Manual : It is a written document prepared to provide
instructions and guidance to the managements of member units about
determination of costs, their analysis and control and reporting to be done to
the Central Organisation created for introducing and applying Uniform
Costing. A copy of the Uniform Cost Manual is given to each member-unit.
ii)
Uniform Costing : Uniform Costing is the use by several undertakings of
the same costing principles and/or practices.
iii)
Inter-firm Comparison : It is a technique of evaluating the performance,
efficiency, costs and profits of firms in an industry.
10.12 Questions
260 Advanced Cost Accounting - IV
A]
Short answer questions :
1)
Define uniform costing.
2)
Mention the levels at which uniform costing can be adopted.
3)
Mention five objectives of uniform costing.
4)
Give three prerequisites for introduction of uniform costing.
5)
Mention four advantages of uniform costing.
6)
Mention four limitations of uniform costing.
7)
Give meaning of inter-firm comparison.
8)
State three advantages of inter-firm comparison.
9)
State three limitations of inter-firm comparison.
B]
Long answer questions
1)
Define uniform costing and explain objectives of uniform costing.
2)
Explain prerequisites to be fulfilled for introducing uniform costing.
3)
What are the advantages and limitation of uniform costing ?
4)
What is meant by ‘uniform cost manual’ ? What are its contents?
5)
‘Existence of uniform costing leads to introduction of inter-firm comparison.’
comment.
6)
What do you mean by ‘inter-firm comparison’ ? Which are the prerequisites
of inter-firm comparison ?
7)
Why is a central organisation required for inter-firm comparison ? What
work is performed by such central organisation ?
8)
Explain the advantages and limitations of inter-firm comparison.
9)
‘Use of codification and ratios is essential in inter-firm comparison’.
Comment and mention the important ratios used in inter-firm comparison.
C]
Multiple Choice Questions
1)
The Uniform Costing originated in ..... between 1902 & 1908.
Uniform Costing &
Inter-firm Comparison
NOTES
(a) U.K.
(b) U.S.
(c) Finland
(d) Poland
2)
A uniform cost manual is a .... containing instructions and guidelines for
member-units
(a) contract
(b) job
(c) process
(d) written document
3)
Use of uniform costing enable management of each member-unit to .... the
costs of its own units with the cost of the industry.
(a) examine
(b) inspect
(c) allocate
(d) compare
Advanced Cost Accounting - IV
261
Uniform Costing &
Inter-firm Comparison
4)
Uniform cost accounting facilitates the work of wage boards set up to fix
minimum wages and .... wages for the workers of an industry.
(a) maximum
(b) optimum
NOTES
(c) fair
(d) best
Ans. : (1 - b), (2 - d), (3 - d), (4 - c).
10.12 Further Reading
262 Advanced Cost Accounting - IV
i)
‘Advanced Cost Accounting’ - Nigam and Sharma.
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B. K. Bhar.
Unit 11 Activity Based Costing
Activity Based Costing
Structure
11.0 Introduction
NOTES
11.1 Unit Objectives
11.2 Activity Based Costing
11.2.1 Meaning and Definitions
11.2.2 Activity Based Costing Frame Work
11.3 Stages in Activity Based Costing
11.4 Purposes and Benefits
11.4.1 Purposes of Activity Based Costing
11.4.2 Benefits of Activity Based costing
11.5 Classification of Activities
11.6 Traditional Costing and Activity Based Costing System
11.7 Accounting treatment in Activity Based Costing
11.8 Cost Drivers
11.8.1 Types of Cost Drivers
11.8.2 Selection of a Suitable Cost Driver
11.9 Illustrations
11.10 Summary
11.11 Key Terms
11.12 Questions
11.13 Further Reading
11.0 Introduction
Activity Based Costing is a modern technique of accounting which is used
for charging of overheads to products. In traditional costing system overheads are
charged to production departments and service departments by completing primary
distribution of overheads, then service departments overheads are apportioned to
the production departments through secondary distribution of overheads and finally
the overheads of the production departments are absorbed by the products on
some basis selected for that purpose. To avoid such arbitrary charging of overheads
Advanced Cost Accounting - IV
263
Activity Based Costing
to the products manufactured, the Activity Based Costing system is used in the
modern times. Details of this new technique are provided in this Unit.
11.1 Unit Objectives
NOTES
After studying the information provided in this Unit you should be able to :-
•
Know the meaning and definition of Activity Based Costing;
•
Understand the stages involved in ABC system;
•
Understand how Activities are classified;
•
Know the ‘cost drivers’ which influence the activities;
•
Know the distinction between Traditional Costing approach and Activity
Based Costing approach; and
•
Understand the accounting treatment given in Activity Based Costing.
11.2 Activity Based Costing
11.2.1 Meaning and Definitions
Meaning
Check Your Progress
Define the term “Activity
Based Costing”.
Activity Based Costing (ABC) is a modern methodology of accounting,
in which costs are first traced to activities and then to products. It is an upcoming
and more polished approach for charging of overheads to products and ascertaining
the product costs more accurately and scientifically. Activity based costing is a
system which focuses on activities performed to produce products. Activities
become the focal points for cost accumulation. This costing system assumes that
activities are responsible for the incurrence of costs and products create the demand
for activities. Costs are charged to products based on individual product use of
each activity. In traditional product costing system, costs are first traced not to
activities but to an organiaational unit, such as department or plant and then to
products. It means under both activity based costing and traditional costing system,
the second and final stage consists of tracing costs to the product.
Definitions :
Activity Based Costing, is a technique of charging overheads to cost objects
i.e. products, services, jobs, customers etc. under which overheads are first
calculated separately for each activity and then are charged to various cost objects
on the basis of activities consumed by these cost objects. The term Activity Based
Costing has been defined by different experts and professional institutions in the
manner stated below :
264 Advanced Cost Accounting - IV
•
According to Cooper and Kalpan
Activity Based Costing
“Activity Based Costing systems calculate the costs of individual activities
and assign costs to cost objects such as products and services on the basis
of activities undertaken to produce each product or service”.
•
CIMA, London, defines Activity Based Costing as,
NOTES
“Cost attribution to cost units on the basis of benefits received from indirect
activities, i.e., ordering, setting up, assuring quality etc.”
•
CAM-1 defines Activity Based Costing as,
“the collection of financial and operation performance information tracing
the significant activities of the firm product costs”
11.2.2 The Activity Based Costing Frame Work
Activity Based Costing, as a useful technique was evolved between the
years 1960s and 1980s. It is now considered as a modern method of absorption
costing and has become a very popular technique used in most of the manufacturing
organisations for determinations of the product costs with reasonable accuracy. It
is modern and scientific approach developed by Cooper and Kalpan of Harvard
Business School in 1988, for assigning overhead costs to endproducts or services.
Thus, activity based costing is the accounting process of tracing costs from
resources to activities and then from activities to specific products ultimately.
It is an accounting system that tries to remove distortions from the distribution
of overhead costs between products. Activity Based Costing is designed to wipeoff the inadequacies in conventional cost accounting methods and furnishes more
accurate cost information for strategic and management decision-making. Activity
based costing promises not only to deliver a new costing model for you but also
provides greater impact on your management decisions with the finding of the
model. The Activity Based Costing Framework is shown below in Figure 11.1
Advanced Cost Accounting - IV
265
Activity Based Costing
ABC FRAMEWORK
General Ledger
Manufacturing Planning of Control
Activity Accounting
NOTES
External Reporting
Inventory Valuation
Strategic Activity
Check Your Progress
Improvement Opportunities
Explain the Activity Based
Costing Framework.
Decision Support
Activity - Based Budgeting
Fig. 11.1 : Activity Based Costing Framework
Activity Based Costing in Merchandising Areas
Activity Based Costing highlights improving on activities as the fundamental
cost objects. An activity is an event, task, or unit of work with a specified purpose.
Activity Based Costing uses the cost of these activities as the basis for assigning
costs to other cost objects such as products, services, or customers. Activity
Based Costing in Merchandising Areas are shown below in Figure 11.2.
Activities
Total Cost
of Activity
Cost Object as
• Products
• Service
• Customer
Fig. 11.2 : Activity Based Costing in Merchandising Areas
Activity Based Costing uses the cost driver notion while deciding how many
indirect cost pools to use and the preferred allocation base for each indirect cost
pool.
266 Advanced Cost Accounting - IV
11.3 Stages in Activity Based Costing
Activity Based Costing
There are two primary stages in Activity Based Costing, viz. (i) tracing
costs to activities, (ii) tracing activities to products.
The Different Stages involved in Activity Based Costing are shown below
in Figure 11.3.
NOTES
1
Identification of Major Activities
2
Creation of Cost Pool
Check Your Progress
Give the different stages of
Activity Based Costing.
3
Determination of Activity Cost Drivers
4
Ascertainment of Activity Cost Driver Rate
5
Charging of Activity Costs to Products
Fig. 11.3 : Stages involved in Activity Based Costing
1)
Identification of Major Activities :
Firstly, activities are identified and then classified into different categories
that have relationship with the different parts of the production process. For
example direct labour related activities, machine related activities (machine cost
centers) and various support activities, such as ordering, receiving materials, handling,
production scheduling, packing and dispatching etc.
2)
Creation of Cost-pool :
Secondly, factory overhead costs of the activities are determined and
classified into homogenous cost pools. A homogenous cost pool is a collection of
overhead costs that are logically related to the tasks being performed. A cost pool
should be created for each activity. Cost pool is like a cost center or activity
center around which costs are accumulated.
3)
Determination of Cost Drivers according to the Activity identified :
Thirdly, the factors that influence the cost of a particular activity should be
identified, which are known as Cost Drivers. Cost driver is an activity which
generates cost. It should be understood that direct costs do not need cost drivers
as they can be traced directly to a product. Direct costs are themselves cost
Advanced Cost Accounting - IV
267
Activity Based Costing
NOTES
drivers. However, all other factory or manufacturing costs need cost drivers.
Cost signify factors, forces or events that determine the costs of activities. Cost
drivers are the links and they can link a pool of costs in an activity centre to a
product. Activity Based Costing is based on the assumption that cost behaviour is
influenced by cost drivers. Therefore, in order to trace overhead costs to products,
appropriate cost drivers should be identified.
Certain Examples of Cost Drivers :
Check Your Progress
Give example of Cost
Drivers in Activity Based
Costing.
Examples of Cost Drivers in Activity Based Costing system are Number of
Units, number of set-ups, number of receiving orders for the receiving departments,
number of purchase orders for the cost of operating the purchase department,
number of dispatch orders for the dispatch department, number of set-up hours,
number of machine hours used on a product, number of parts received per month,
number of schedule changes, number of inspections, number of material handling
hours, value of materials in a product, amount of labour cost incurred, number of
vendors, number of direct labour hours, number of units scrapped, number of
labour transactions, number of sub-assemblies, number of purchasing and ordering
hours, number of customer orders processed, number of employees, number of
parts, number of orders on website of Internet.
4)
Ascertainment of Cost Driver Rate as per Activity identified :
Fourthly, cost driver rate as per the activity identified is ascertained by
using the following formula :
Activity Cost

Activity Cost Driver Rate =
Cost Drivers
These rates can be used to measure activity performance and efficiency
and also provide a more suitable basis for budgeting.
5)
Charging of Overhead Costs of Activities to Products
Finally, the overhead costs of activities are charged to the products produced
and the product costs are ascertained more accurately.
Activity based costing ultimately helps in cost control as necessary
activities are simplified and unnecessary activities are eliminated.
11.4 Purposes And Benefits
11.4.1 Purposes of Activity Based Costing :
268 Advanced Cost Accounting - IV
Activity Based Costing aims at identifying as many costs as possible to be
subsequently accounted as direct costs of production. Any cost that is traced to a
particular product via its consumption of activity becomes direct cost of the product.
For instance, in conventional costing system, cost of set-up and adjustment time is
considered as factory overhead and subsequently assigned to different products
on the basis of direct labour hours. But, in Activity Based Costing, set-up and
adjustment time is determined for each product and its costs are directly charged
to each product. Thus, by emphasing on activities, it tries to ascertain the factores
that cause each major activity, its cost and the relationship between activities and
products. The relationship between activities and products has been shown in the
Figure 11.4.
Resources of Factors
Activities
Products
Activity Based Costing
NOTES
Fig. 11.4 : Activity Based Costing Process
Thus, the philosophy of Activity Based Costing, is, that costs can be controlled
more effectively and efficiently by focusing directly on managing the forces that
cause the activities rather than the cost.
Activity Based Costing system is used very well by the manufacturing
industries for product costing where,
i)
Production overheads are very high as compared to direct costs,
ii)
there is a tremendous diversity in the product range, and
iii)
consumption of overhead resources is not primarily driven by volume.
11.4.2 Benefits of Activity Based Costing
The following are certain important benefits of Activity Based Costing
system :i)
It brings accountability and reliability in products, determination of costs by
focussing on cause and effect relationship in the cost incurred.
ii)
It improves greatly the manager’s decision-making and enables managers
to control many fixed overhead costs.
iii)
It helps in fixing selling price of products.
iv)
It provides not only a base for calculating more accurate product costs, but
also a mechanism for managing costs. An Activity Based Costing system
focuses managements attention on the underlying causes of costs. It
assumes that resource-consuming activities cause costs and that products
incur costs through the activities they require for designing, engineering
manufacturing, marketing, delivery invoicing and servicing. By collecting
and reporting on the significant activities in which a business engages, it is
possible to understand and manage costs more effectively.
v)
With an effective activity based costing system, costs are managed in the
long run by controlling the activities that drive them. In other words, the aim
is to manage the activities rather than costs. By managing the forces that
cause the activities i.e. cost drivers, costs will be managed in the long term.
The application of activity-based systems may have the greatest potential
for contributing to cost management, budgeting, control and performance
evaluation.
Advanced Cost Accounting - IV
269
Activity Based Costing
NOTES
vi)
The availability of cost driver rates can also have significant impact on the
design of new products or can result in the design of existing products.
Designers are made aware of the product characteristic that cause overhead
costs through the cost driver rates that are applied in costing the product.
vii)
It helps in adjusting pricing policies according to changing circumstances
and to develop various product strategies for maximisation of profits.
viii)
It helps to identify unnecessary activities which may be eliminated in future
to achieve greater cost efficiency.
ix)
Thus, activity based costing system has developed very fast in the twentyfirst century because.
i)
Check Your Progress
How Activity Based
Costing is a management
decision making tool ?
majority of manufacturing industries are following mechanised production
technique which resulted in an increase in overhead costs sizably,
ii) introduction of LPC (Liberalisation, Privatisation and Globalisation) policy
by the Government has increased severe competition in the national as
well as international market which necessitated determination of product
costs with precise accuracy and
iii) basic requirement of analytical and classified overhead costs data for
long-run managerial decisions.
Activity Based Costing is a management decision-making tool.
11.5 Classification of Activities
Under activity based costing system, activities are identified and classified
into different categories or segments of the production process. The grouping of
activities is preferably done using the different levels at which activities are
performed. Broadly, activities are classified into one of the four activities categories,
viz., unit level activities, batch level activities, product level activities and facility
level activities. This Classification of Activities is shown below in Figure 11.5.
Unit Level
Activities
1
Batch Level
Activities
2
4
Facility Level
Activities
Classification
of
Activities
3
Product Level
Activities
270 Advanced Cost Accounting - IV
Fig. 11.5: Classification of Activities
1)
Unit Level Activities
Unit level activities are those activities which are performed each time a
unit is produced. They are repetitive activities. For example, direct labour hours,
machine hours, power, they are used each time a unit is produced. Direct materials
and direct labour activities are also unit level activities, although they are not
overhead costs of unit level activities, and vary with the number of units produced.
2)
Activity Based Costing
NOTES
Batch Level Activities :
Batch level activities are those activities which are performed each time
a batch of good or product is produced. The costs of batch level activities vary
with the number of batches, but are fixed with respect to the number of units in
each batch. Machine set-up inspections, production scheduling, materials handling
are examples of batch level activities which are related to batches, but not to
individual products.
3)
Product Level Activities :
Product level activities are those activities which are performed to support
the production of each different type of product. Maintenance of equipment,
engineering charges testing routines, maintaining bills of materials, handling materials
are some of the examples of batch level activities.
4)
Facility Level Activities :
Facility level activities are those which are needed to sustain a factory’s
general manufacturing process. These activities are common to a variety of
products and are most difficult to produce specific activities. Examples of facility
level activities are factory management, maintenance, security, plant depreciation.
Check Your Progress
How you classify activities ?
In Activity Based Costing system, facility level activities and costs are treated
as period costs as they are found difficult to assign to different products. The
costs associated with the first three categories, viz, unit level, batch level, product
level are assigned to products, using cost drivers that reflect the cause and effect
relationship between activity consumption and cost.
Activity Based Costing is a complement to Total Quality Management
11.6 Traditional Costing and Activity Based Costing
System
In traditional costing system, overhead costs are assumed to be influenced
only by units produced. It means, costs of batch level, product level and facility
level activities are fixed costs, i.e., costs of these do not vary as production volume
changes. Unit based cost systems apportion fixed overhead to individual products
and variable overhead are directly assigned to products using the base of number
of units produced.
Advanced Cost Accounting - IV
271
Activity Based Costing
NOTES
In Activity Based Costing, variable overhead is appropriately traced to
individual products. The costs incurred as the units are produced have been
traditionally treated as variable overhead. But when fixed overheads are apportioned
on the basis of units made, as in traditional costing, such apportionment is likely to
be arbitrary and also may not reflect activities and cost actually consumed by the
products. Activity Based Costing improves product costing procedure (as compared
to traditional costing) because it recognises that many so called fixed overhead
costs varying in proportion to changes other than production units. It means, under
Activity Based Costing the other two level activities-batch level and product level
are assumed to influence fixed overhead costs and batch level and product level,
thus are accepted as non unit-based cost drivers. By establishing the link between
these cost drivers and fixed overhead costs, they are finally traced to individual
products. Figure 11.6 presents an overview or product cost determination under
traditional costing and activity based system. It can be observed that both the
costing systems follow a two stage allocation procedure. In traditional costing, in
the first stage, overhead costs are allocated to production departments. But in
Activity Based Costing, in the first stage, overhead costs are assigned to each
major activity and not to departments. In traditional costing, overheads are pooled
or collected departmentwise. But, in Activity Based Costing, many activity- based
cost pools or cost centres are created. In traditional costing, overhead costs of
service departments are allocated/reapportioned to production departments and
therefore in this costing system finally only fewer cost pools exist. But Activity
Based Costing creates separate cost pools for service activities as well and
overhead costs of these service activities (service departments) assigned directly
to specific products through applying cost driver rates. Thus, in Activity Based
Costing there is no need to allocate or reapportion overheads of service
departments.
Traditional Product Costing System
Under Traditional approach, overheads are first allocated and apportioned
to various production departments and service departments, the overheads of
service departments are re-apportioned to production departments and then
overheads of production departments are charged to the end products on some
suitable basis, like machine hours, labour hours, direct wages etc. It is based on
that assumption that end products consume resources in proportion to the volume
of production.
272 Advanced Cost Accounting - IV
Comparison of Traditional Product Costing and Activity Based
Costing system is shown below in figure 11.6.
A)
Activity Based Costing
Traditional Product Costing System
Stage 1 : Overheads assigned
to Production Departments
Production
Departments
Stage 2 : Overheads Allocated to
Products
Departmental Overhead
Allocation Rate
Overhead
Cost
NOTES
Check Your Progress
What
is
Traditional
Product Costing System ?
B)
Activity-based Product Costing System :
Stage 1 : Overheads assigned to
Cost Centres or Cost
Pools.
Activity Cost
Pools
Stage 2 : Overheads assigned to
products using Cost
Driver Rates.
Activity Cost
Driver Rates
Products
Overhead
Cost
Fig. 11.6 : Comparison of Traditional Costing and Activity Based
Costing System
(Source : J. Innes & F. Mitchell, Activity Based Costing :
A Review with Case Studies, 1990, CIMA, U.K.)
Activity Based Costing brings accuracy and reliability in product cost
determination by focussing on cause-and-effect relationship in the cost incurrence.
Further, Activity Based Costing improves greatly the manager’s decision-making
as they can use more reliable product cost data. Activity Based Costing also
enables managers to control many fixed overhead costs by exercising more control
over the activities which have caused fixed overhead costs. This is possible since
behaviour of many fixed overhead costs in relation to activities now become more
Advanced Cost Accounting - IV
273
Activity Based Costing
NOTES
visible and clear. The traditional costing does not pay attention to the cause-andeffect relationships between resources used and production activities. Also, the
traditional costing uses more arbitrary bases for apportionment of overhead cost
than the Activity Based Costing system. The traditional costing pools many overhead
costs into the total overhead and does not trace them directly to specific products.
On the other hand, Activity Based Costing does allocate directly a large part of
such overhead costs to specific products. Activity Based Costing helps usefully in
fixing selling prices of products as more correct data of product cost is now readily
available.
Distinction between Traditional Product Costing Approach and
Activity Based Costing Approach : Traditional Product Costing Approach differs
from Activity Based Costing Approach in the following respects :
Points of
Distinction
i) Objective
Traditional Product
Costing Approach
Activity Based Costing
Approach
It is a subjective approach
It is an objective approach
because it uses arbitrary
because it uses activities as
bases for apportionment
bases for distribution of
of overheads.
overheads. It aims at identifying
as many costs as possible to
be subsequently accounted as
direct cost of production.
ii) Assumption It is based on the assumption It is based on the assumption that
Check Your Progress
How distinct is Traditional
Product Costing Approach
and Activity Based Costing
Approach ?
that end products consume
end products consume resources
resources in proportion to
in proportion to the volume of
the volume of production. activities.
iii) Procedure Overheads are first allocated Activity Based Costing is a
and apportioned to various
technique of charging overheads
production departments and
to cost objects i.e. products,
service departments, then
services, jobs, customers etc.,
overheads of service
under which overheads are first
departments are reapportioned calculated separately for each
274 Advanced Cost Accounting - IV
to production departments
activity and then are charged to
and then overheads of
various cost objects on the
production departments
basis of activities consumed by
are charged to the end
these cost objects.
Activity Based Costing
products on some suitable
basis like machine hours,
labour hours, direct wages
NOTES
etc.
iv) Accuracy
It is not so accurate, as
It is an accurate system of
Activity Based Costing, does costing because the distribution
not facilitate the
of overheads is based on the
identification of unnecessary cause-and-effect relationship in
activities.
the cost incurrence. However,
it facilitates the identification of
unnecessary activities.
v) Control
It does not facilitate the
It facilitates the control over
control over those activities
those activities which cause
which cause fixed overheads. fixed overheads. This is possible
because behaviour of fixed
overheads costs in relation
to activities become more visible
and clear.
Advanced Cost Accounting - IV
275
Activity Based Costing
NOTES
11.7 Accounting Treatment in Activity Based
Costing
Accounting of Overhead Costs in Activity Based Costing involves the
application of following steps :
Identify Significant Activities :
Step 1
An activity is considered to be significant when the total cost
involved in the activity is significant enough to justify to give an
activity a separate treatment.
Calculate the Total Cost of each Activity :
Step 2
For example, total cost of ordering, total cost of receiving
deliveries, total cost of production, set-up, total cost of shelfstocking etc. are to be calculated separately.
Find out the appropriate Activity Cost Drivers :
Step 3
For example, number of deliveries, number of production setups, number of orders, number of items sold, etc.
Calculate the Activity Cost Driver Rate :
Check Your Progress
Total Cost of an Activity
Step 4
Activity Cost Driver Rate =
Cost Driver
Give the accounting steps
involves in Activity Based
Costing.
e.g. if total cost of ordering is
80
8,000, Number of orders are
8,000
Cost per purchase order =
=
Orders 80
100 per purchase order
Charge Activity Cost to end products, jobs and processes:
Step 5
Activity cost charged to end products
= Activity Consumed × Activity cost driver rate.
e.g. number of purchase orders for product X and Product Y
are 10.
The implementation of activity based costing system has frequently shown
that the ‘maximum benefits resulted from its effective application are in cost
management rather than in providing product costs with precise accuracy. Hence,
appropriate use of activity based costing system to improve and develop a challenging
business, is a basic need of modern competitive era, can very well be termed as
Activity Based Cost Management.
276 Advanced Cost Accounting - IV
Activity Based Costing
11.8 Cost Drivers
Cost Drivers are forces that cause the activities. There are certain
important factors that influence the cost of a particular activity and certain
basis that drives the consumption of the activity. Following are the examples
of certain important activities and their cost drivers identified.
Important Activities
•
Material Planning
NOTES
Cost Drivers
• Volume of material receipts
• Number of material transactions.
•
Manufacturing
• Flow of product.
• Volume of service parts.
•
Financial Accounting
• Number of accounting
transactions.
• Volume of Activity.
•
Personnel
• Industrial Training requirements.
• Recruitment Activity.
•
Maintenance
• Number of Machine Breakdowns.
• Maintenance Schedule.
•
Management Accounting
• Requirements of Management.
• Corporate Requirements.
Thus, under activity based costing, overhead costs are grouped together
according to what causes them to be incurred and finally these cost drivers are
used as a suitable basis for absorption.
11.8.1 Types of Cost Drivers
Cost Driver is a factor that influences the cost of an activity. Cost drivers
are of two types :
i)
Resource Cost Driver :
Check Your Progress
It is a measure of the quantity of resource consumed by an activity, e.g.
number of purchase orders placed will influence the cost of purchasing the
materials, similarly, the number of times the machines are set-up will influence the
cost of setting-up of machines. Resource cost driver is used to assign the cost of
a resource to an activity or cost pool.
ii)
What is Resource Cost
Driver and Activity Cost
Driver ?
Activity Cost Driver :
It is a measure of the frequency and intensity of demand placed on the
activities by cost objects. It is used to assign activity costs to cost objects consuming
Advanced Cost Accounting - IV
277
Activity Based Costing
the activity.
2)
NOTES
Selection of a Suitable Cost Driver :
R. Hansen and Maryanne M. Mowen, pointed out, that atleast two major
factors should be considered in selecting cost drivers i.e., i) cost of measurement,
and ii) degree of correlation between the cost driver and the actual consumption
of overhead. The important factors that should be considered in selecting cost
drivers are as follows :
i)
Cost of Measurement :
In activity based costing, a large number of cost drivers can be selected
and used. Accordingly where possible, it is important to select cost drivers that
use information that is readily available. Information that is not available in the
existing system must be produced, and this production will increase the cost of the
firm’s information system. A homogenous cost pool could offer a number of possible
cost drivers. For this situation any cost driver that can be used with existing
information should be chosen. This choice minimises the costs of measurement.
ii)
Indirect Measures and the Degree of Correlation :
The existing information structure can be exploited in another way to minimise
the costs of obtaining cost driver quantities. It is sometimes possible to replace a
cost driver that directly measures the consumption of an activity with a cost driver
that indirectly measures that consumption. e.g., inspection hours could be replaced
by the actual number of inspections associated with each product; this number is
more likely to be known. This replacement works, of course, only if hours used
per inspection are approximately equal for each product.
iii)
Multitude of Cost Drivers :
In traditional product costing, the number of cost drivers used are few such
as direct labour hours, machine hours, direct labour cost, units produced. But
activity based costing may use a multitude of cost drivers that relate costs more
closely to the resources consumed and activities occurring.
iv)
Pool Rate :
After cost pool is defined and cost drivers are identified, the cost per unit of
the cost driver is computed for that pool which is called the pool rate. This pool
rate links costs drivers with the resource use. This pool rate can be based on
either planned or actual activity levels.
v)
Charging of Overheads :
The cost of each overhead pool are traced to products who are the users of
the resources. Thus at the final stage, the cost pool, cost driver and the pool rate
combine to determine how much cost should be assigned to each product. The
pool rate measure is simply the quantity of cost driver used by each product.
278 Advanced Cost Accounting - IV
Activity Based Costing
11.9 Illustrations
ILLUSTRATION 1
Amdos Ltd., Aurangabad has two production departments- A-1 and A-2,
two service departments - maintenance and factory office. Budgeted cost data
and the relevant cost drivers are as follows :
NOTES
Departmental Costs : ( )
• Dept A-1
6,00,000
• Dept A-2
17,00,000
• Factory Office Dept
• Maintenance Dept
3,00,000
(+)
 Total
2,40,000
28,40,000
Cost Drivers :
Factory Office Dept. (Number of Employees)
• Dept A-1
1,080
• Dept. A-2
270
• Maintenance Dept.
(+)
 Total
150
1,500
Maintenance Dept. (Number of Work Orders) :
• Dept A-1
570
• Dept A-2
190
• Factory Office Dept.
 Total
(+)
40
800
You are required to,
i)
Compute the cost driver allocation percentage and then use these
percentage to allocate the service department costs, using the direct method.
ii) Compute the cost driver allocation percentage and then use these
percentages to allocate the service department costs, using the step method.
Advanced Cost Accounting - IV
279
Activity Based Costing
SOLUTION
1) Direct Method :
Cost Driver Allocation Percentages :
NOTES
Particulars
Number of employees Percentage used
• Factory Office Dept.
• Dept A-1
• Dept A-2
(+)
 Total
Particulars
1,080
80%
270
20%
1,350
100%
Work Orders
Percentage used
Maintenance Dept. :
• Dept A-1
• Dept. A-2
(+)
 Total
570
75%
190
25%
760
100%
Service Dept. Allocation :Factory
Maintenance Dept. A-1 Dept. A-2
Particulars
Dept.
Dept.
Departmental Costs
3,00,000
2,40,000
6,00,000
17,00,000
• Factory Office Dept. (-) 3,00,000
---
2,40,000
60,000
1,80,000
60,000
Allocated Costs :
• Maintenance Dept.
---
(-) 2,40,000
 Total Costs
Nil
Nil
Factory Office Dept. Allocations :
3,00,000 × 80%
Dept. A-1 :
=
=
280 Advanced Cost Accounting - IV
Maintenance Dept. Allocations :
60,000
2,40,000 × 75%
Dept. A-1 :
2,40,000
3,00,000 × 20%
Dept. A-2 :
10,20,000 18,20,000
=
1,80,000
2,40,000 × 25%
Dept. A-2 :
=
60,000
Activity Based Costing
2) Sept Method :
Cost Driver Allocation Percentage
Particulars
Number of Employees Percentage Used
Factory Office :
NOTES
Dept. A-1
1,080
72%
Dept. A-2
270
18%
150
10%
Total
1,500
100%
Particulars
Work Orders
Percentage Used
570
75%
190
25%
760
100%
Maintenance Dept.

(+)
Maintenance Dept. :
• Dept. A-1
• Dept. A-2

(+)
Total
Service Dept. Allocations :
Factory
Particulars
Maintenance Dept. A-1
Dept.
Departmental Costs
Dept. A-2
Dept.
3,00,000
2,40,000
6,00,000
17,00,000
(-) 3,00,000
30,000
2,16,000
54,000
---
(-) 2,70,000
2,02,500
67,500
Nil
Nil
Allocated Costs :
•
Factory Office Dept.
•
Maintenance Dept.
 Total Costs (
)
10,18,500 18,21,500
Factory Office Dept. Allocations :
Maintenance Dept. Allocations :
Maintenance Dept. : 3,00,000 × 10%
Dept. A-1 :
=
Dept. A-1 :
30,000
3,00,000 × 72%
=
Dept. A-2 :
2,16,000
2,70,000 × 75%
=
Dept. A-2 :
2,02,500
2,70,000 × 25%
=
67,500
3,00,000 × 18%
=
54,000
Advanced Cost Accounting - IV
281
Activity Based Costing
NOTES
ILLUSTRATION 2
Bitco Ltd., Badlapur, is noted for a full line of quality products. The
company operates one of its plants in Thane. That plant produces two types of
products, Indian Design A, and Contemporary B. The president of the company
recently decided to change from a volume based cost system to an activity based
cost system. Before making the change company wide, he wanted to assess the
effect on the product costs of the Thane plant. This plant was chosen because it
produces only two types of products, most other plants produce at least a dozen.
To assess the effect of the change, the following data have been gathered :
Quantity Prime Costs Machine Material Set-ups
Products
Units
Hours
Moves
Hrs.
Indian A
Contemporary B
2,00,000
7,00,000
50,000
7,00,000
100
50,000
1,50,000
12,500
1,00,000
50
-
8,50,000
62,500
8,00,000
150
Total Value
2,50,000 is the cost of maintenance of machines, material handling cost is
3,00,000 and and setup cost is 4,50,000. Under the current system, the costs
of maintenance, material handling, and set-ups are assigned to the products on the
basis of machine hours.
You are required to
A)
Compute the unit cost of each product using the current unit based
approach.
B)
Compute the unit cost of each product using as activity based approach.
SOLUTION
A)
Current Unit-based Approach :
Total overhead cost is 10,00,000 and the plant-wide rate is 16 per machine
hour. (i.e. 10,00,000/62,500 Hrs.)
Overhead cost of
10,00,000 is assigned as follows :
Indian A
:
16 × 50,000 Hrs.
=
8,00,000
Contemporary B
:
16 × 12,500 Hrs.
=
2,00,000
The unit costs for the two products are as follows :
Indian A
:
8,00,000 + 7,00,000 / 2,00,000 units
=
Contemporary B
282 Advanced Cost Accounting - IV
:
7.50 per unit
2,00,000 + 1,50,000 / 50,000 units
=
7.00 per unit
B)
Activity Based Costing
Activity-based Approach :
In the activity based approach, the consumption ratios are different for all
the three overhead activities so overhead pools are formed for each activity. The
overhead rates for each of these pools are calculated as follows :
Maintenance
:
2,50,000 / 62,500 Hrs
=
4 per hour
Material handling :
3,00,000 / 8,00,000
=
0.375 per move
Set-ups
:
4,50,000 / 150
=
3,000 per set-up
Overhead cost of
10,00,000 is assigned as follows :
Indian A
Contemporary B
• Maintenance :
( 4 × 50,000 Hrs.
• Maintenance :
2,00,000
• Material Handling :
( 0.375 × 7,00,000 mm)
 Total
( 4 × 12,500 Hrs.)
50,000
• Material Handling :
2,62,500
• Set-ups :
( 3,000 × 100 su) (+)
NOTES
( 0.375 × 1,00,000 mm)
37,500
• Set-ups :
3,00,000
7,62,500
( 3,000 × 50 su)
 Total
1,50,000
2,37,500
This produces the following unit costs :
Indian A
Prime Costs
Add : Overhead Costs (+)
 Total Costs
Units Produced
 Unit Cost
Contemporary B
7,00,000
Prime Costs
7,62,500 Add :Overhead Costs (+)
14,62,500
2,00,000
7.31
 Total Costs
Units Produced
 Unit Cost
1,50,000
2,37,500
3,87,500
50,000
7.75
Advanced Cost Accounting - IV
283
Activity Based Costing
ILLUSTRATION 3
Charminar Ltd. Chennai, produces three products X, Y and Z for which the
standard cost and quantities per unit are as follows :
Particulars
Products
NOTES
Output
Units
X
Y
Z
10,000
20,000
30,000
30
20
10
20
40
60
Direct material cost per unit
Direct labour wages per unit (@
20)
Machine hours per unit
Hrs.
3
2
1
Number of purchase requisitions
No.
1,000
200
300
Number of machine set-ups
No.
150
100
50
Production Overheads :
Dept. L -
7,00,000
Dept. M -
11,00,000
Dept. L is labour-intensive and Dept. M is machine-intensive. Total labour
hours in Dept. L are 1,40,000; Total machine hours in Dept. M are 1,00,000 Hrs.
Production Overheads by activity are as follows :
•
Receiving and Inspection
•
Production Scheduling/set-up
6,00,000
12,00,000
Prepare a Statement of Cost per unit under traditional absorption costing and
activity based costing approaches. Also compare the result of the two methods
and give your comments.
SOLUTION
Traditional Absorption Costing Method :
Step 1 :
Overhead Absorption Rate =
Overheads of the Depts.
Hours
Dept. L
=
7,00,000
1,40,000 labour hours
=
Dept. M
=
5 per labour hour
11,00,000
1,00,000 machine hours
=
284 Advanced Cost Accounting - IV
11 per machine hour
Activity Based Costing
Step 2 : Statement of Cost Under Traditional Method :
Particulars
Cost per unit
X
Y
Z
Direct Materials
30
20
10
Add :
Direct Wages
20
40
60
Add :
Overheads : Dept. L
5
-
-
• X - 1 hr. @
Add :
5
• Y - 2 hrs. @
5
-
10
-
• Z - 3 hrs. @
5
-
-
15
NOTES
Overheads Dept. M
• X - 3 hrs. @
11
33
-
-
• Y - 2 hrs. @
11
-
22
-
-
-
11
88
92
96
• Z - 1 hr. @
11
(+)
Total Cost
Activity Based Costing Method :
Step 1 :
•
Cost Driver Rates
=
Overhead Cost of the activity
Cost Drivers
Receiving and Inspection
=
6,00,000
1,500 Batches
=
•
Scheduling and Set-up
=
400 per batch
12,00,000
300 Batches
=
4,000 per set-up
Advanced Cost Accounting - IV
285
Activity Based Costing
Step 2 : Statement showing Activity Cost Chargeable to Products
Particulars
X
Y
Z
Receiving Set-up Receiving Set-up Receiving Set-up
NOTES
a) Activity Cost Driver
Rate
b) Activity consumed No.
400
4,000
400
4,000
400
4,000
1,000
150
200
100
300
50
c) Activity cost assinged
(a x b)
4,00,000 6,00,000 80,000 4,00,000 1,20,000 2,00,000
d) Number of units
No.
10,000 10,000 20,000
e) Rate per unit (c ÷ d)
40
60
20,000 30,000 30,000
4
20
4
6.67
Step 3 : Statement of Cost under Activity Based Costing :
Cost per unit
Particulars
X
Y
Z
Direct Materials cost per unit
30
20
10
Direct Wages per unit
20
40
60
40
4
4
60
20
6.67
150
84
80.67
Overhead per unit
• Receiving
• Set-up
Total Cost per unit
(+)
Comments :
As per traditional method, product Z appears quite costly as compared to
activity based costing, because product Z utilizes relatively more direct labour
hours. While, product X shows higher cost under activity based costing than
traditional method. Results shown by activity based costing are more accurate. If
selling prices are fixed on the basis of cost, product Z would be priced higher
under traditional approach and product X would be priced lower. Ultimately, this
will result in loss of sales of product Z and loss per unit on product X leading to a
loss to the company.
286 Advanced Cost Accounting - IV
11.10 Summary
•
Activity Based Costing is a modern technique of accounting which is used
for charging of overheats to products.
•
Following stages are involved in Activity Based Costing :
(i) Identification of major activities, (ii) Creation of cost pool,
(iii) Determination of Activity Cost Drivers, (iv) Ascertainment of
Activity cost Driver Rate & (v) Charging of Activity Cost to products.
•
Activities are classified : (i) Unit level activity, (ii) Batch level activity, (iii)
Product level activity & (iv) Facility level activity.
•
Cost Driver is a factor that influences the cost of an activity. Cost drivers
are of two types : (i) Resource Cost Driver & (ii) Activity Cost Driver.
Activity Based Costing
NOTES
11.11 Key Terms
1) Activity Based Costing :- Activity Based Costing highlights improving on
activities as the fundamental cost objects. An activity is an event, task, or unit of
work with a specified purpose.
2) Traditional Product Costing Approach :- It is a subjective approach because
it uses arbitary bases for apportionment of overheads.
3) Activity Based Costing Approach :- It is an objective approach because it
uses activity as bases for distribution of overheads.
4) ‘Cost Drivers’ are forces that causes the activities. These cost drivers are
used as a suitable basis for absorption.
11.12 Questions
1)
Theory Questions :
1.
What is ‘Activity Based Costing’ ? State the important stages in Activity
Based Costing.
2.
Define the concept ‘Activity Based Costing’. Briefly mention the basic
purposes of Activity Based Costing.
3.
Explain the basic purposes and important benefits of Activity Based Costing.
4.
Define the term “Activity Based Costing” ? How activities are classified
under Activity Based Costing System ?
5.
What is ‘Cost Driver’ ? State the important factors which should be
considered in selecting cost drivers.
Advanced Cost Accounting - IV
287
Activity Based Costing
NOTES
6.
How will the overhead costs allocated to products under activity based
costing system ?
7.
Define the term ‘Cost Driver’. Illustrate some of the main activities in a
manufacturing industry and its suitable cost drivers.
8.
Explain the following concepts in relation to Activity Based Costing System:
(i) Cost Driver., (ii) Cost Pool, (iii) Cost Object, (iv) Activity.
9.
“Activity Based Costing System is a more refined method of charging of
overhead to products than traditional method”. Discuss.
10.
“Activity based costing is the wave of the present and the future. All
companies should adopt it”. Explain.
11.
What is ‘Activity Based Coating’ ? Explain the role played by cost drivers
in tracing costs to products.
12.
Differentiate Between :
a) Traditional Product Costing Approach and Activity Based Costing
Approach,
b) Activity Based Costing System and Activity Based Cost Management,
c) Resource Cost Driver and Activity Cost Driver.
13.
Write short notes on :
a) Activity Based Costing, b) Stages in Activity Based Costing, c) Activity,
d) Cost Driver, e) Purposes of Activity Based Costing System, f)
Classification of Activities under Activity Based Costing System, g) Benefits
of Activity Based Costing System, h) Types of Cost Drivers, i) Cost Pools,
j) Activity Cost Driver Rate, k) Requirements for adopting activity based
costing system, l) Selection of a suitable Cost Driver.
2)
Objective Questions :
1.
288 Advanced Cost Accounting - IV
Match the following pairs :
Group A
Group B
Main Activities
Cost Drives
1) Production
a) Number of Accounting Transactions
2) Inspection
b) Engineering changes
3) Financial Accounting
c) Training Requirements
4) Maintenance
d) Shift Patterns
5) Personnel
e) Number of Machine Breakdowns
6) Production Control
f) Lack of Good Quality
Ans : 1) - d), 2) - f), 3) - a), 4) - e), 5) - c), 6) - b).
11.13 Further Reading
i)
‘Advanced Cost Accounting’ - Nigam and Sharma.
ii)
‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iii)
‘Cost Accounting’ - Jawahar Lal.
iv)
‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v)
‘Cost Accounting’ - B. K. Bhar.
Activity Based Costing
NOTES
Advanced Cost Accounting - IV
289
Unit 12 Cost Control and Cost Reduction
Cost Control &
Cost Reduction
Structure
12.0 Introduction
12.1 Unit objectives
12.2 Cost Control
NOTES
12.2.1 Steps involved in Cost Control
12.2.2 Control of Labour, Material and Overheads
12.2.3 Advantages of Cost Control
12.3 Cost Reduction
12.4 Distinction between Cost Control and Cost Reduction
12.5 Areas in which Cost Reduction Campaign or activity can be undertaken
12.5.1 Cost Reduction techniques
12.5.2 Major problems in Cost Reduction programme
12.6 Value Analysis
12.6.1 Procedure followed in Value Analysis
12.6.2 Benefits of Value Analysis
12.7 Productivity
12.7.1 Meaning and definition
12.7.2 Productivity Measurement
12.7.3 Efficiency measures to improve productivity
12.7.4 Measures to improve productivity
12.8 Illustrations
12.9 Key terms
12.10 Questions & Exercises.
12.11 Further Reading
12.0 Introduction
The functions of cost accounts consist not simply accumulation and
ascertainment, but equally important of cost control and reduction. The term Cost
Control refers to the process of preventing costs from varying from the
amount planned. The Chartered Institute of Management Accountants, London,
Advanced Cost Accounting - IV
291
Cost Control &
Cost Reduction
NOTES
defines it as, “the guidance and regulation by executive action of the costs of
operating and undertaking”. It is thus an attempt at keeping costs under a
specified ceiling, or at the lowest possible level consistent with the
performance of a specified task. It seeks to bring about conformance with
planned objectives.
Cost Reduction is a planned, positive approach to reducing
expenditure. Cost reduction exercises are planned campaigns to cut expenditure.
It is a continuous process with the object of getting a more or less permanent
benefit.
In short we can say that the essential features of Cost Accounting are,
determination of costs, planning and control of costs, cost analysis and furnishing
of information to management for decision making, and cost reduction. It would
be seen that the main objective is cost control and the determination of costs, and
cost reporting are just tools or means to achieve effective cost control. Cost Control
is exercised through numerous techniques some of which are Standard Costing,
Budgetary Control, Estimated Costing, Inventory Control, Quality Control and
Performance evaluation, analysis and reporting. Many management techniques
are in use to facilitate the work of cost control and cost reduction. Some of the
important techniques are value analysis, operations research, uniform costing and
inter-firm comparison, productivity etc. Therefore, cost reduction is an extention
of cost control. It aims at effecting economies in costs, it is an attempt to bring
costs down, generally, permanently.
12.1 Unit Objectives
After Studying this Unit you should be able to :
292 Advanced Cost Accounting - IV
•
Understand the meaning of Cost Control, Cost Reduction, Value analysis &
productivity.
•
Differentiate between Cost Control and Cost Reduction.
•
Identify the areas in which cost reduction activity can be undertaken.
•
Explain the procedure followed on value-analysis.
•
Measure material, labour, capital and management productivity.
•
Identify tools and techniques used in Cost Control-reduction.
12.2 Cost Control
Cost Control aims at achieving the pre-determined cost targets and ends
when the targets are achieved. It entails target setting, ascertaining the actual
performance and comparing it with the targets, investigating the variances and
taking preventive measures.
Cost Control &
Cost Reduction
NOTES
12.2.1 Steps involved in Cost Control
Cost Control involves the following steps :
i)
The first step is to establish the plan. The plans or targets may be in the
form of budgets, standards, estimates or even past actual and may be
expressed in physical as well as monetary terms. These serve as yardstick
by which the planned objective can be assessed quantitatively.
ii)
The plan and the policy laid down by the management are made known to
all those responsible for carrying them out. Communication is established
in two directions; directives are issued by higher level management to the
lower level for compliance and the lower level executives report
performances to the higher level.
iii)
The plan is given effect to and performance starts. The performance is
evaluated, costs are ascertained and information about results
achieved are collected and reported. The fact that cost are being
compiled for measuring performances acts as a motivating force and makes
individuals endeavour to better their performances.
iv)
The actual performance is compared with the pre-determined plan
and variances i.e. deviations form the plan are analysed as to their causes.
The variances are reported to the proper level of management.
v)
The variances are reviewed and decisions taken. Corrective action
and remedial measures, or revision of the target, as required, are taken.
Check Your Progress
Give the Steps involved
in Cost Control.
12.2.2 Control of Labour, Material and Overheads :
For the effective use of a cost control system it is essential that physical
control should be exercised on the shop-floor by those who are entrusted with the
actual incurring of expenditure either in the form of cash or in the utilisation of
labour, material and other resources. Control in terms of cost is remote and
historical because of the time-lag between the incidence and the compilation and
reporting of costs. On-the-spot control over consumption of materials and
utilization of labour and machine time is a direct form of control carried out at
the point where costs are incurred. The shop foreman keeps an eye on the target
set for his shop in physical terms, e.g. labour hours, machine hours, and quantities
of material, waste, and spoilage before he actually proceeds to incur expenditure.
1)
Control of labour cost is relatively simpler. The standard or estimated
Advanced Cost Accounting - IV
293
Cost Control &
Cost Reduction
NOTES
time required for an operation and the trade and grade of the worker who
would perform it are laid down after careful work study. The actual time
taken for the operation is recorded and variances from the standard time as
also any deviation in the actual employment of the specified trade and grade
of labour are highlighted.
2)
Material cost may be controlled in a similar manner. Standards or
estimates of direct material requirements of a job are established both in
quantity and price and the actual consumption is compared with the standard.
While quantity control may be exercised by the shop foreman who draws
the material for consumption in production, price is mainly controlled by the
purchase department at the stage when orders are placed on suppliers.
3)
Overhead may be controlled through budgets established in terms of
costs for each item and for each shop. Many of the items of overhead costs
like power, maintenance, overtime, shift work, and idle time may also be
budgeted in physical units to enable immediate control being exercised in
the shops’.
12.2.3 Advantages of Cost Control
Check Your Progress
The advantages of cost control are mainly as follows :
What are the advantages of
Cost Control ?
i)
Achieving the expected return on capital employed by maximising or
optimising profit.
ii)
Increase in productivity of the available resources.
iii)
Reasonable price for the customers.
iv)
Continued employment and job opportunity for the workers.
v)
Economic use of limited resources of production.
vi)
Increased credit-worthiness.
vii)
Prosperity and economic stability of the industry.
12.3 Cost Reduction
Cost reduction is an extension of cost control. Cost reduction is a much
wider concept than cost control. Cost control is essentially a short-term
programme in as much as it relates to objective and standards. But cost reduction
could have both short-term and long-term programmes.
(a) Meaning :
294 Advanced Cost Accounting - IV
Cost reduction should not be confused with cost control. Cost Control is
the regulation of the costs of operating a business and is concerned with the
keeping expenditure within acceptable limits. The major assumption in cost control
is that unless costs exceed budget or standard by an excessive amount, the control
of costs is satisfactory. Cost control is a very routine exercise which is almost
concurrently carried out for attainment of operational efficiency. On the other
hand, Cost Reduction brings about real and permanent savings by continuous
and planned research. A cost reduction programme does not stand of its own
volition. It is always planned and followed up.
(b)
Cost Reduction committee, Cost Reduction programme and its
necessity.
Cost Control is thus, a preventive function and acts within the
framework of some target or standard. Cost Reduction is a corrective function
by continuous process of analysis of costs, functions, etc. for further economy in
the application of the factors of production. In Cost Reduction the standards set
earlier are constantly challenged for further improvement. Products, processes,
procedures, organisation and methods and personnel are continually scrutinised in
order to improve efficiency and reduce costs. It is based on the philosophy that
every human action can be improved by continuous effort. It is thus a process of
continuous self-analysis and self-criticism. In practice, a Cost Reduction is real
and more or less permanent reduction in unit cost of goods or services without
impairing the suitability or goodwill of the concern. Cost Reduction may extend to
the design stage, factory organisation, methods or process and marketing and
finance. In order that cost reduction scheme works well, a Cost Reduction
Committee may be formed to formulate a detailed plan. It is essential to obtain cooperation from all levels, to determine the priority of actions, methods to be employed
in carrying out the investigation and finally to take steps for implementing the
recommendations. By continuous follow-up the cost reduction plan will be
successful.
Cost Control &
Cost Reduction
NOTES
Check Your Progress
How Cost Control is a
preventive function ?
12.4 Distinction between Cost Control and Cost
Reduction
The points of distinction between the Cost Control and Cost Reduction are as
follows Cost Control
Cost Reduction
i)
It is management by directive
dictating how to do a thing.
It adds thinking to doing at all levels
of management.
ii)
It represents efforts made towards
achieving a target/goal.
It represents achievement in
reduction of costs in all effort to reach
the goal.
iii) Cost control is a base of cost
reduction.
Cost reduction is an extension of cost
control.
iv) The process of cost control is to set It is not concerned with maintenance
target, ascertain actual performance, of performance according to
and compare it with target, investigate standards. It challenges standards.
the variances and correct them.
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Cost Control &
Cost Reduction
NOTES
v) Emphasis is on present and past.
Emphasis is on present and future.
vi) It tends to set up a conservative
procedure and lacks dynamic
approach.
It is a continuous process searching
for alternatives all the time & is
innovative in nature.
vii) Usually limited to items which have
standards.
Applicable to every section of the
business.
viii) It is preventive function; costs are
optimised before they are incurred.
It is corrective function and does
operate even when a cost control
system exists.
ix) It seeks to attain lowest cost possible Recognises no conditions as
under existing conditions.
permanent, since a change will result
in a lower cost.
12.5 Areas in which Cost Reduction Campaign or
activity can be undertaken
Cost Reduction may be implemented in the following areas :
a) Design :
Product design has the greatest scope for cost reduction, for a manufactured
article must be functionally useful and at the same time satisfy the customer.
While introducing a new design there must be a close co-operation between the
designers and cost estimators to consider the influence of design upon Check Your Progress
How product design has the
greater scope for cost
reduction ?
i)
material cost including material specification in relation to substitutes,
the yield factor, storage and purchasing problems;
ii) labour cost affected by manufacturing process, tolerances and
performance standards;
iii) direct expenses such as tools, jigs and fixtures;
iv) cost savings due to mechanisation, standardisation, and work
simplification; and
v) increase in use and esteem values and reduction in after-sales service
costs.
296 Advanced Cost Accounting - IV
Improvement of existing design must be a constant quest and the aim must
be to save material cost by establishing standards of materials, reducing labour
cost and overhead by reducing time taken for manufacture through improved
design and methods. Too much variety of the same product will probably add to
cost. A reduction in variety means longer production runs, more mechanisation,
higher productivity and lower cost per unit. There should be a proper value analysis,
budgetary control and standard costing to increase use value, esteem value, and
exchange value and finally to keep costs within reasonable limits.
b) Marketing :
Cost reduction in the field of marketing includes representation, advertising,
market research, sales office and administration, after sales service, packing,
transport and warehousing, Collection and suitable analysis of these services may
lead to the introduction of the most economic services in conformity with the
present activities of the business.
Cost Control &
Cost Reduction
NOTES
c) Finance :
Cost reduction in the field of finance is an important aspect because on
account of a slight negligence on the part of management, capital may be tied up
in fixed on current assets associated with risks of obsolescence, bad debts, bank
charges, loss of discount, etc. The return on capital employed must be continually
watched as a suitable cost reduction programme will ensure the maximum return
possible.
d) Factory organisation and production methods :
Cost reduction in this field includes correct assignment of authority and
responsibility, an exhaustive planning for production and production services such
as purchasing and material control, a balanced wage structure, institution of suitable
working conditions and suitable works services such as maintenance, inspection
and clerical services, adequate work measurement and system analysis, operation
research and linear programming applied in the field of the above production
services. In practice, the layout of factory, production scheduling, labour and
machine utilisation, service planning, maintenance, inspection and quality control
should be given due consideration before establishing a co-ordinated organisation
and production methods.
e) Factory labour and equipment :
The influence of factory layout and equipment on cost may be substantial.
The cost reduction programme may include replacement of obsolete, outmoded,
inefficient plant and equipment. A proper work study may enable labour efficiency
to be improved. A productivity deal with the employees may reduce unit labour
cost and consequently unit overhead cost. The substitution of labour by automatic
plant and machinery may substantially reduce total cost.
f) Utility services :
Utility services include labour, steam, air-conditioning, water and other
services. Due to under-utilisation of utility services costs may increase to a great
extent. So, utmost care is necessary to see that the utility services are efficiently
utilised.
Check Your Progress
12.5.1 Cost Reduction Techniques
Identify the cost reduction
techniques.
There are number of cost reduction techniques, such as
(i) Budgetary Control, (ii) Inventory Control, (iii) Standard Costing, (iv) Job
Evaluation and Marit Rating, (v) Job Study, Works Study & Motion Study,
Advanced Cost Accounting - IV
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Cost Control &
Cost Reduction
(vi) Reduction in variety of products, (vii) Value Analysis, (viii) Uniform Costing
and Intra-interfirm Comparison, (ix) Operational Research & (x) Productivity.
12.5.2 Major Problems in Cost Reduction Programme
NOTES
The major problems with cost reduction programme are i)
Resistance by employees to pressure to reduce costs, usually because, the
nature and purpose of the campaign has not been properly explained to
them, and they feel threatened by the change;
ii)
They may be confined to a small area of the business (e.g. to one department)
with the result that costs are reduced in the one cost centre only to reappear
as an extra cost in another cost centre.
iii)
Efforts to cut material and labour costs may erode confidence in established
systems for estimating material wage and labour productivity standards.
iv)
Cost reduction campaigns are often introduced as a rushed, desperate
measure instead of a well organised exercise.
v)
Cost reduction programme may demand the attention of a number of experts
from different fields. (It may be a difficult task)
Check Your Progress
Give two major problems
related to cost reduction
programme.
In nut shell we can say that,
Cost Reduction assumes that product or services will retain its essential
characteristics and quality. If reduction in cost results in deterioration of quality, it
will not be covered by the term “cost reduction”. Co-operation and team work are
essential features of any planned approach to cost reduction.
12.6 Value Analysis
In relation to the cost reduction, value analysis is one of the most important
tool used in modern management.
Check Your Progress
Define the term ‘Value’.
Value Analysis is also known by different names such as - “Value
Engineering” ‘Value Control’ and Product Research .
Meaning The meaning of the term “Value” may vary from person to person, time to
time and place to place. Value means an amount regarded as a suitable equivalent
for something else, a fair price or return for goods or services. It is worth in
usefulness or importance to the possessor. However, in the context of cost reduction
and control it refer to the “use value”.
298 Advanced Cost Accounting - IV
‘Value Analysis’ is the process of systematic analysis and evaluation of
various techniques and functions with a view to improve organisational
performance. It aims at reducing and controlling the cost of a product from the
point of view of its value by analysing the value currently received. Actually value
analysis investigates into the economic attributes of value analysis, believes in a
systematic action to improve performance and thereby creates higher value in a
product and ultimately controlling the cost and causes reduction in its cost.
Cost Control &
Cost Reduction
Basic Principles of Value Analysis Value analysis embodies in the main six basic principles viz.
NOTES
(i) Functional Analysis
(ii) Value thinking
(iii) Systematic method
(iv) Organised group work
(v) Integrated product planning &
(vi) Rationalisation and accelerated completion.
In functional analysis, the funtion of the product is detached from its existing
design and form. After this detachment, and with the help of functional thinking,
isolated from the product, many alternatives for solving the prescribed function
fulfillment may be devised and those which are the most valuable and which best
perform the funtion may be followed up.
12.6.1 Procedure followed in Value Analysis :
By analysing the value of goods and services purchased in relation to their
use, an attempt is made to substitute designs, components and materials of lower
cost, the basic idea is to examine the functions which are performed in the
manufacture of a product with a view to improving the value. This view is the
‘value in use’ and to some extent ‘esteem value’, but not cost or exchange value.
Closely related to value engineering, though by no means the same, the object of
value-related method is not the product, but one or more prescribed and defined
function and cost factors serves to control costs and wastes. The relationship
may be expressed as :
Value
=
Funtion
or
Cost
=
Worth
Price
Thus, value can be improved :
i) by improving function while cost remains the same, or
ii) by reducing cost while function remains the same, or
iii) by improving function and reducing cost simultaneously.
In Value Analysis, an assessment is made of the functions of products to
find ways and means of fulfilling them at lower cost. The products are assigned
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Cost Control &
Cost Reduction
NOTES
as value enabling different design solutions and possible improvements to be
compared with a view to finding the absolute optimum. If this cannot be calculated,
as many alternatives as possible must be devised to select the relative optimum.
Once the relative or absolute optimum solution has been established by systematic
examination, it can be put into effect through the known design media. Valuerelated design is, therefore, the optimum combination of high utility value and low
production value is high from the buyer’s point of view and its cost of production
is low, the difference between these two quantities is designated as its ‘value in
terms of value analysis’. The designer and the production expert must always be
mindful of utility value and cost of production.
The work of the value analyst centres round determining the essential
functions of the product that the customer requires and searching for the most
economic method of producing the product, having in mind the need to equate
with utility value.
In short following steps involved in ‘Value Analysis’ are shown in figure
below :-
Exploring and evaluating alternatives and developing
3 them. (taking efforts for improving the utility of the
product.)
Check Your Progress
Collecting information about the function, design, material,
2 labour, overhead costs, etc. of the product and finding out the
availability of the competative products in the market, and
Illustrate
the
Steps
involved in Value Analysis.
1
Identification of the problem; or Define the problem.
Fig. 12.1 : Steps involved in ‘Value Analysis’
12.6.2 Benefits of Value Analysis :
The benefits of Value Analysis can be stated as follows :
300 Advanced Cost Accounting - IV
i)
The reduction in the costs of a product and thus increasing the profitability
of a concern is the main advantage of value analysis.
ii)
Value analysis is help to improve organisational performance.
iii)
Value analysis is also helping to generate higher value of a product.
iv)
Value analysis is the process of matching the costs and benefits with the
unit (and manager) whose activities led to their achievement.
v)
Value analysis is being applied to components of a product, finished product
and also to methods of packing and ultimately benefits to many industries
e.g. oil industry, engineering, building construction and mine industry.
Cost Control &
Cost Reduction
12.7 Productivity
The organisational productivity is the measure of how well resources are
brought together in organisations and how these are utilised for accomplishing a
set of results. Productivity is reaching the optimum level of performance with the
minimum expenditure of resources.
NOTES
Productivity and cost control is an on going movement. Basically, productivity
is a physical concept. It could be defined as the relationship between output and
input resources. However, higher productivity need not be indicative of a greater
volume of production. It might mean that fewer resources have been used to
produce the same quantity of goods. In practical terms, it involves measuring
actual output obtained from labour and machines and comparing the result with
what could or should have been achieved. Where similar industries manufacture
a wide range of products, output may be measured as the ‘value-added’ concept
which may be used when comparing productivity.
12.7.1
Meaning and Definition :
‘Productivity may be defined as the ratio between the production of a given
commodity measured by volume and one and more of the corresponding input
factors also measured by volume’.
Productivity refers to measurable relationship between well defined output
and inputs. i.e. between the production results and the relative production agents
in both the financial and physical terms in relation to given time and condition. The
term productivity implies development of an a attitude of mind and constant urge
to find better, cheaper, quicker, easier and safe ways of doing a job, manufacturing
an article and providing a service.
In general terms, productivity aims at the maximization of the output by the
plant, most economic use of input and elimination or minimisation of wastage. The
operational and executive action of management has the effect of adding value to
the input and making it grow into the output. It is thus a measure of growth or
added value - a measure of effectiveness of the resources applied for production.
A high added value would indicate high productivity. The programme in fact is
“analysis for improved methods” (AIM), and in common parlance productivity
and efficiency would be taken to have similar meaning. Symbolically, efficiency
or efficiency ratio is :
E
=
Check Your Progress
Define
the
“Productivity”.
term
O
I
where,
E
=
Efficiency,
O
=
Output and
I
=
Inputs.
In simple words, productivity is a ratio between output of the wealth produced
and the input of resources used in the process of any economic activity. The
Advanced Cost Accounting - IV
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Cost Control &
Cost Reduction
NOTES
greater the amount of output produced from a fixed quantity of inputs, the higher
the productivity and vice-versa.
The aim of management is to increase the value of E by adjusting the
relative values of output over input. This requirement of theory and practice in
organising is applied to every management level in every function. Most productivity
comparisons between firms try to measure and explain the difference at two
levels. Firstly, it is the comparison of cost of a specified amount of materials,
labour, plant and machinery, repair and service facilities, etc. required for the
manufacture of goods. However, the fact remains that comparison of terms of
physical units is better than any cost data in as much as the former is more easily
understood by the staff.
12.7.2 Productivity Measurement :
There are different methods for measuring productivity which are shown
below in figure 12.2
Partial
Produtivity
Measure
1
Multi-factor
Productivity
Measure
2
Methods
for
Measuring
Productivity
3
Total
Productivity
Measure
Fig. 12.2 : Methods for Measuring Productivity
i) Partial Productivity Measure :
Partial Productivity Measure in a ratio form is given below.
Quantity of Output Produced
=
Quantity of Input Used
The higher the ratio the greater is the productivity.
Partial Productivity measure for different factors can be calculated as under :
Output
a) Labour Productivity
302 Advanced Cost Accounting - IV
=
Labour
Finished Output
=
Direct Labour Hours Input
b) Capital Productivity
Output
=
=
Capital
Fixed Capital
Output
c) Material Productivity =
=
Material
d) Energy Productivity
Finished Output in Units
Direct Material Inputs
Output
=
Cost Control &
Cost Reduction
Finished Output
=
Energy
Finished Output
NOTES
Power kwhs Used
ii) Multi factor Productivity Measure :
The Multi-factor Productivity can be computed as under :
a)
Output
=
Labour + Capital + Energy
b)
Finished Output
Value of Labour, Capital and Energy
Output
=
Labour + Capital + Materials
Finished Output
Value of Labour, Capital and Material
iii) The Total Productivity Measure can be computed as under :
a)
All Output
All Inputs
b)
All Gooods and services produced
All Resources used
c) As to total cost
Check Your Progress
Output
=
and
Value of Material, Labour and Power
d) As to Capital
Compute the Multi-factor
productivity.
Output Sales Value
=
Capital Employed
iv) Specific Productivity Performance Measures :
The following performance measures can be used to measure productivity
for different performing factors of production.
a) Direct Material Productivity or Direct Materials yield performance measure :
Direct Material Yield
=
Number of finished units produced during the period
Quantity of Direct Materials used in the period
b) Direct Labour Productivity Measure
Direct Labour Productivity =
Units Producted during the period
Direct Labour hours consumed during the period
c) Activity Productivity Measure :
Machinery Activity
=
Units Produced during the period
Machine Hours consumed during the period
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d) Management Productivity Measure : Material, Labour or machinery these
three measures are related to productivity of specific factors of production. All
these three productivity measures reflect their efficiency. In addition to these
three measures of productivity following measures will also help in calculation of
efficiency of the management.
NOTES
Total Productivity Measures :i) As to total cost
ii) As to Capital
- (a) with reference to Sales Value
(b) with reference to Profit Earned.
e) Capital Productivity Measure : It can be expressed as under.
Gross Value Added
Capital Productivity
=
Fixed Capital
12.7.3 Efficiency Measures to improve Productivity :
Following ratios are used to determine the production efficiency and the costs.
i) Activity Ratio
=
Standard Equivalent hours of actual output
x 100
Budgets Standard Hours
ii) Efficiency/Productivity Ratio :
Efficiency Ratio
=
x 100
Actual Hours taken
Check Your Progress
Which ratios are used to
determine the productivity
efficiency & the costs.
Standard Equivalent hours of Actual output
iii) Capacity Ratio :
Capacity Ratio
=
Actual Hours worked
x 100
Budgeted Hours
It should be noted that Activity Ratio = Efficiency Ratio x Capacity Ratio
iv) Calender Ratio =
Actual working days
Budgeted days in the period
304 Advanced Cost Accounting - IV
x 100
12.7.4 Measures to Improve Productivity :
Cost Control &
Cost Reduction
Productivity is a continuous process. It cannot take place in vacuum as it is
the follow up of different measures. The level of productivity can be increased
through the following measures.
i) Technological Measures :
NOTES
With the advance of technology, jobs tend to become more intellectual and
otherwise upgraded. The job that once required a day labourer now requires a
skilled crane operator, and the job that formerly required a clerk now requires a
computer expert. Technological advances bring both benefits and costs to society.
Thus, the adoptation of modern techniques is an important measure for improving
productivity. However, technology assessment is a useful technique that seeks to
provide feedback about technology’s effects and to try to anticipate the unintended,
indirect and possibly harmful effects of new technology.
ii) Managerial Measures :
If the manager is also a good leader, he can encourage and motivate his
subordinates in better manner. Manager can integrate the individual needs of
subordinates with the needs and goals of organisation. On the one hand, he ensures
that needs and wants of subordinates are satisfied and on the otherhand, he confirms
that objectives of organisation are duly accomplished. Ideal manager is able to
improve the productivity with the help of his subordinates. In short, proper planning,
organising, directings, co-ordinating and controlling results in increased productivity.
iii) Financial Measures :
Every business dreams of increasing productivity and today it has become
one of the important financial objective. In financial sense, increase in productivity
means various things like optimum output, less cost of production, less cost of
overheads, minimum efforts and labour and thereby a lower cost of production.
Thus, planning business finances and carrying out financial plans is a continuous
process all business organisations for improving productivity. In fact, the success
towards attaining firm’s goals heavily depends upon how good is financial plan.
Hence, adoptation of proper financial measures is, therefore, necessary for
increasing the productivity of an organisation.
iv) Operational Measures :
The level of productivity can be increased with the help of appropriate
operational measures. These measures include the following :
Check Your Progress
a)
Manage employees in creative and human ways, involving them in work
place decisions in order to increase their productivity.
b)
Work co-operatively with labour unions and government agencies to reduce
costs, develop flexible work rules, and reform public policies to encourage
technological innovations.
c)
Introduce new technology with due care for possible negative impacts on
How
the
level
of
productivity increases with
the help of operational
measures ?
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Cost Reduction
NOTES
people communities and valued tradition.
d)
Involve community leaders in discussions of options that could affect the
health and welfare of the communities where business is done.
e)
When threatening situation do arise, act quickly and openly to prevent or
alleviate human suffering and environment damage.
f)
Improve the quality of work life, reduce on the job hazards and encourage
equal employment opportunities for all groups.
g)
Encourage employee participation in job planning and job design, recognise
each employee’s individuality and worth as a person, and provide a
reasonable amount of job security and retirement security.
12.8 Illustrations
ILLUSTRATION 1
The actual output of Mahindra Ltd., Mumbai during March, 2012 was 8,000
units. The following cost details were made available for the same month.
A)
In all 20 workers were working in the factory workshop in 2 shifts of 8
hours each. There were 26 working days in the month. Each worker is
entitled to 12 days paid leave per annum.
B)
In all there were 12 machines working in the factory workshop, Every
machine remains off for one day, for maintenance, out of the working days
in a month. During march, 2012, 800 machine hours were lost due to minor
accidents.
C)
In all 10,000 units of materials were used as input, of which 15% is treated
as normal scrap. 500 units was the abnormal wastage due to wrong handling
in materials.
You are required to calculate,
A) Labour productivity per machine hour,
B) Machine productivity per machine hour, and
C) Materials productivity per unit of input.
SOLUTION
Working Notes :
1) Calculation of monthly effective working hours of the workers :
Number of
Number of
= Workers x
shifts
20
02
306 Advanced Cost Accounting - IV
=
8,000 Hours
x
Daily working
Actual working Days
x (26 days - 01 paid leave)
Hours
08
25
Cost Control &
Cost Reduction
2) Calculation of monthly effective machine hours :
Number
Number
of
of
=
x
Machines
Shifts
12
02
x
Daily
Actual Working
Machine
Working
days
Hours
x
Hours
(26 Days - 01 Day off) =4,800
08
25
Less : Machine Hours lost due to minor Accidents

(-)
Effective Machine Hours
800
4,000
3) Calculation of effective input of materials :
Units
Material input i.e. materials used
10,000
Less : Normal Scrap i.e. 15 % of input 10,000 units
(-) 1,500
Less : Abnormal wastage of material due to wrong handling
(-) 500

NOTES
Effective input of materials
8,000
A) Calculation of Labour Productivity per labour hour :
Labour Productivity :
Output, (in number of units)
=
Input, (in effective working hours)
8,000 Units
=
8,000 Hours
= 1 unit per labour hour.
B) Calculation of Machine Productivity per machine hour :
Output, (in number of units)
=
Input, (in effective working hours)
8,000 units
=
4,000 Hours
= 2 units per Machine Hour
C) Calculation of Material Productivity per unit of input :
Output, (in number of units)
=
Input, (in effective units of materials)
8,000 units
=
8,000 units
= 1 unit per unit of input
ILLUSTRATION 2
The following is the performance data of Associated Cement Company. Achalapur
for the year 2012-13 :-
• Total Output - 56,00,000 Tons of Cement Valued at
• Raw Materials input - 42,00,000 Tons
5,600 per ton
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307
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Cost Reduction
• Average Employment - 28,000 Employees, each employee costs 5,600 per
month
• Energy Consumed - 28,00,000 MW Hours
• Average Capital Employed - 28,00,000
NOTES
Calculate
A)
Overall Productivity and
B)
Factor Productivities of
i) Manpower, ii) Material, iii) Energy and iv) Capital.
SOLUTION
A) Calculation of Overall Productivity :
=
Total Output x Cost of output
x 100
Total Input x Cost of output
=
56,00,000 Tons x
5,600
42,00,000 Tons x
5,600
x 100
= 133.33%
B) Calculation of Factor Productivity :
i) Manpower Productivity :
Output, (in number of units)
=
Input, (in number of employees)
56,00,000 Tons
=
28,000 Employees
= 200 tons per employee
ii) Material Productivity :
Output, (in number of units)
=
Input, (in tons of materials)
56,00,000 Tons
=
42,00,000 Tons
= 1.33 Tons per ton of material
iii) Energy Productivity :
Output, (in number of units)
=
Input, (in number of MW Hours)
56,00,000 Tons
=
308
Advanced Cost Accounting - IV
28,00,000 MW Hours
= 2 tons per MW Hour
iv) Capital Productivity :
=
Cost Control &
Cost Reduction
Output, (in number of units)
Input, (in amount of capital Employed)
=
56,00,000 Tons
28,00,000
NOTES
= 2 Tons Per Rupee
12.9 Key Terms
1)
Cost Control : The term cost control refers to the process of preventing
costs from varying from the amount planned.
2)
Cost Reduction : Cost Reduction is an extension of cost control. It aims
at effecting economies in costs or alternatively at cost savings. It is an
attempt to bring cost down, generally, permanently.
3)
Value Analysis : Value analysis is one of the important tools of modern
management in the area of cost reduction. Value analysis is the process of
systematic analysis and evaluation of various techniques and functions with
a view to improve organisational performance.
4)
Productivity : Productivity is a physical concept. It could be defined as
the relationship between output and input resources.
12.10 Questions and Exercises
I. Objective Questions
A) State with reasons whether the following statements are True or False:
1.
Cost control requires proper planning or budgetary system.
2.
Value of a product or service can be increased by reducing its costs.
3.
Value Analysis is applied to direct cost only.
4.
Executive action is a necessary pre-requisite for both cost control and cost
reduction.
5.
Cost reduction is temporary whereas cost control is permanent.
6.
Cost reduction is always real and permanent.
7.
Standard costing and budgetary control are essential ingredients for cost
control.
8.
Value Engineering is applied to indirect cost
9.
Productivity refers to the relationship between output and input resources.
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10.
Production planning should be based on realistic and detailed sales forecast.
ANSWER
True : 1,2,4,6,7,9,10.
NOTES
False : 3 - direct and indirect cost also.
5 - cost reduction is permanent whereas cost control is temporary.
8 - applied to direct cost.
B) Fill in the Blanks :
1.
Cost control is a ------ function.
2.
Cost reduction involved reduction in cost on ------ basis.
3.
Cost control requires an efficient ------ system.
4.
Cost reduction is ------ in character.
5.
Cost reduction is a ------ function.
6.
Value Analysis aims at providing maximum satisfaction to customers in
respect of ------ .
7.
Adoption of proper financial measures is absolutely necessary for increasing
the ------ of an organisation.
8.
Cost control does not necessarily aim at ------ in costs.
9.
Value Analysis applied to both ------ cost.
10.
Labour Productivity =
Output in number of units
Input in -------------------ANSWER
1. preventive, 2. permanent, 3. reporting, 4. futuristic, 5. corretive, 6. use value, 7.
productivity, 8. reduction, 9. direct and indirect, 10. working hours .
II. Theory Questions
310 Advanced Cost Accounting - IV
1.
What is Cost Control ? How it differs from Cost Reduction ?
2.
“No Cost is at such a satisfactory level that it can not be reduced” Comment.
3.
What is ‘Cost Reduction’ ? State the pre-requisites of a satisfactory Cost
Reduction Programme.
4.
“Cost control does not necessarily aim at reduction in costs. Its object is
more to ensure the maximum utility of the costs incurred”. Explain.
5.
Define ‘Cost Reduction’. State the critical areas covered in a Cost Reduction
Plan.
6.
“Cost ascertainment and cost control are the essential functions of Costing
Department”. Justify.
7.
What is ‘Cost Reduction Programme’ ? Explain the essential requisites and
the fields covered by Cost Reduction Programme.
8.
What is ‘Value Analysis’ ? State the importance of Value Analysis as a
technique of Cost Reduction.
9.
What is ‘Productivity’ ? State the various methods for measuring
productivity.
10.
Define ‘Productivity’. Explain in brief the operational measures to increase
the level of productivity.
11.
Explain the various methods used to improve productivity.
12.
What is ‘Productivity’ ? State the methods to enhance productivity.
Cost Control &
Cost Reduction
NOTES
III. Practical Problems
1.
The performance data of a Tata Steel plant indicate the following data for
the year ended 31st March, 2012.
a) Steel output 40,00,000 tons valued at
4,000 per ton
b) Raw materials consumption 60,00,000 tons
c) Average employment 20,000 employees, each employee costs
per month
4,500
d) Energy Consumption 20,00,000 MW Hours
e) Average Capital employed
20,000 millions.
Compute the factor productivity of manpower, material, energy and
capital employed.
IV.
Multiple Choice Questions
1.
Cost Reduction is planned ----------- approach to reducing expenditure.
(a) negative
(b) classical
(c) systematic
(d) positive
2.
Cost Control is a -------------- of Cost Control.
(a) base
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Cost Control &
Cost Reduction
(b) plan
(c) future
(d) setup
NOTES
3.
Cost reduction is an ------------ of Cost Control.
(a) example
(b) extention
(c) idea
(d) application
4.
Cost Reduction emphasis on ----------.
(a) present & future
(b) present & past
(c) past & future
(d) future & past
Ans. : (1 - d), (2 - a), (3 - b), (4 - a).
12.11 Further Reading
i) ‘Advanced Cost Accounting’ - Nigam and Sharma.
ii) ‘Cost Accounting - Principles and Practice’ - N. K. Prasad.
iii) ‘Cost Accounting’ - Jawahar Lal.
iv) ‘Theory and Practice of Cost Accounting’ - M. L. Agrawal.
v) ‘Cost Accounting’ - B. K. Bhar.
312 Advanced Cost Accounting - IV
Unit 13
Target Costing
Target Costing
Structure
13.0 Introduction
NOTES
13.1 Unit Objectives
13.2 Target Costing
13.2.1 Meaning and Concept
13.2.2 Definitions
13.2.3 Target Costing and Standard Costing
13.3 Origin of Target Costing
13.4 Features of Target Costing
13.5 Difference between Traditional Cost Management Approach and Target
Costing Approach
13.6 Advantages of Target Costing
13.7 Limitations of Target Costing
13.8 Specimen Illustrations
13.9 Summary
13.10 Key Terms
13.11 Questions
13.0 Introduction
Target Costing is a new concept of pricing introduced by the Japanese
companies in the recent times. In the traditional costing total cost for a product or
a service to be provided to customers is estimated first and by adding the desired
margin of profit to the total cost, the selling price for the product or service is
determined by a business enterprise. In target costing the price which customers
can afford or the market conditions will establish is decided first for the product or
the service and from it the desired margin of profit is deducted to decide the target
cost. By co-ordinating the efforts of production, engineering, research and designing
departments for cost reduction the objective of producing the product or providing
the service at the target cost is tried to be achieved. It is, thus, a reverse method
of pricing compared to the traditional cost-plus method of pricing.
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Target Costing
13.1 Unit Objectives
After studying the information given in this Unit you should be able to :
NOTES
•
Know meaning and definition of target costing;
•
Understand origin and need for target costing;
•
Know features of target costing;
•
Understand advantages and disadvantages of target costing, and
•
Understand the process of target costing.
13.2 Target Costing
13.2.1 Meaning and Concept :
Target costing is a pricing method used by business enterprises. It is a cost
management tool for reducing the overall cost of a product over its entire lifecycle with the help of production, engineering, research and design. A target cost
is the maximum amount of cost that can be incurred on a product and with it the
firm can still earn the required profit margin from that product at a particular
selling price. It is that cost of a product which enables a business enterprise to
remain and compete in the competitive market in the long run.
314 Advanced Cost Accounting - IV
The concept of target costing is a recent concept and it is based on the
competitive position existing in the market. In the past when there was no tough
competition in the market, the business enterprises used to find out the unsatisfied
requirement of customers in the society and use such information to plan production
of a product or service to satisfy that requirement. The materials to be used,
labour to be employed, method and process of production to be adopted were
decided and the costs to be incurred for creating the product was estimated and to
the total cost so estimated the expected margin of profit was added and thus the
selling price of the product or service used to be determined. This concept is used
even now by many undertakings. However, the conditions are changing in the
modern times and so because of competitive markets, instead of dictating its selling
price to the customers, it has become necessary for the undertaking to find out
what price the customers are ready to pay for the product or at what competitive
price the market is ready to accept the product in a certain quantity and fix that
price as the selling price of the product. To remain in the market for a long period
of time an undertaking must earn a certain margin of profit by selling the product
at the selling price already decided by it. By deducting the margin of profit expected
from the selling price of the product, the total cost of the product is decided and
this total cost is termed as the target cost of the product. It is regarded as the
maximum cost to be incurred for producing and supplying the product in the market.
The break-up of the target cost into material cost, labour cost and other expenses
and overheads is done and if the estimated cost is more than the target cost, cost
reduction measures are decided by changing materials, design of the product,
production methods and processes and by undertaking research and devlopment
activity in a combined efforts by the costing department and other departments
such as production, engineering, research and design.
Target costing is a strategic management tool that seeks to reduce a product’s
cost over its lifetime. Therefore, the target cost is not necessarily the cost to
currently build the product. Target costing presumes interaction between cost
accounting and the rest of the firm; well-executed long-range profit planning; and
a commitment to continuous cost reduction. Thus target costing is a device to
continuously control costs and manage profit over a product’s life cycle.
Target Costing
NOTES
13.2.2 Definitions :
The term Target Cost and Target Costing have been defined by different
experts and professional institutions as under :
Target Cost : CIMA defines Target Cost as “a product cost estimate derived
from a competitive market price”.
In the context of pricing in competitive environment, it is used to reduce
cost through continuous improvement and replacement of technology processes.
This is what, according to management, the cost should be, viewing the competitive
market prices. These costs are generated externally based on analysis of the
cost-structure of the leading competitors in the industry.
Target Costing : Target Costing is defined as “a cost management tool for
reducing the overall cost of a product over its entire life cycle with the help of the
production, engineering, R & D”.
ICMA defines Target Costing as,
“a disciplined process for determining and achieving a full-stream cost at
which a proposed product with specified functionality, performance and quality
must be produced in order to generate the desired profitability at the product’s
anticipated selling price over a specified period of time in the future”.
Target costing is the establishment of a maximum total cost for a product
by working backward from an estimated market price. Often it is the long-run
cost taking into account the requirements and expectations of the consumers about
the functionality of the product, its quality and the satisfaction it is expected to
provide to the consumers. How much price the consumers shall be ready to pay
for such a product or at what price the product will be able to obtain a certain
share in the competitive market is estimated in the beginning. This selling price is
expected to include a certain margin of profit during the life-cycle of the product.
After subtracting this margin of profit from the estimated selling price the remaining
amount is termed as the target cost. This is the maximum total cost at which the
product should be produced and it is found out whether the total cost estimed can
be kept below the target cost fixed. If the estimated total cost exceeds the target
cost, efforts are made to reduce the estimated cost by changing the type of
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Target Costing
NOTES
materials, reducing the quantity of materials used, increasing the productivity of
the labour, by using a new method of production, by changing the process, by
redesigning of the product or by introducing a new technology in production activity.
All this work is carried out during the research and development stage before the
costs have been actually incurred. Efforts for cost reduction are continued even
after the product has been produced so that the total cost can always be kept
below the target costs and profitality of the product is ensured over its entire lifecycle.
Target Costing is a result of team-work that provides a way to link profit
planning, market surveys, value analysis, budgetary control and effective financial
management.
13.2.3 Target Costing and Standard Costing :
Target Costing is a process in which a product cost estimate is derived by
subtracting a desired profit margin from the competitive market price. This may
be less than the planned initial product cost, but will be expected to be achieved by
the time the product reaches the mature production stage. Target costing thus
manages costs before they are even incurred. In target costing competitive market
price of the product is estimated first and then the target cost is worked out by
deducting the desired margin of profit from the estimated selling price of the
product. Efforts are made to reduce costs so that the total costs of the product
will remain below the target cost.
Standard costing is a technique of costing and in standard costing standard
costs for materials, labour and overheads are pre-determined for a product or a
service in a highly scientific way. When actual costs are incurred, they are recorded
and compared with the standard costs fixed in advance. The difference between
standard cost and actual cost is calculated as a favourable or unfavourable variance.
When standard cost is more than the actual cost, the difference is termed as a
favourable variance and when actual cost is more than the standard cost, the
difference is termed as unfavourable variance. The causes of favourable as well
as unfavourable variances are found out and efforts are made to increase the
favourable variance and eliminate or decrease the unfavourable variance. Thus,
in standard costing calculation of variances and steps to be taken for controlling
costs are taken after the production has been done whereas in target costing
whether the product can be produced at or below the target cost is determined at
the research and development stage itself and if estimated costs exceed the target
cost, action is taken for reducing the costs at that stage only by changing the
materials, changing methods and processes of production or by redesigning the
product.
Prof. Robin Cooper of Harward University says “We tend to build up a
model of the product, determine what it is going to cost and then ask whether we
can sell for that.” The Japanese turn around. They say, “It’s got to sell for x. Let
us work backwards to make sure we can achive it. I have never seen this done by
a U.S. Company with the same intensity”.
316 Advanced Cost Accounting - IV
Target Costing
13.3 Origin of Target costing
In today’s rapidly changing business environment, product innovation is one
of the keys to a company’s survival and competitiveness. Even when a business
enterprise invents a new product and introduces it in the market, it cannot enjoy
monopoly position in the market for a long period. Other business enterprises
come up with similar products and the pioneer enterprise loses its edge in the
market. The customers are becoming more informed and educated and they form
their own ideas about the type of the product, its quality and performance and the
price at which they are willing to purchase it from the market. It is , therefore, no
longer possible for the business enterprises to produce any product as per their
own wish on mass-scale, find out the total cost incurred per unit of the product,
add the desired amount of profit and sell the product in the market at the price so
calculated. The business enterprises are required to take into consideration the
markets are changing from stable markets to unstable markets in which the
customers expect to obtain a product which will be of a certain quality, possessing
a certain features to satisfy their requirements and at a certain price which they
are willing to pay. So it has become necessary for the enterprises to find out first
the price at which the customers are ready to purchase a certain quantity of the
product, subtract the desired amount of profit per unit and estimate the target cost
per unit and then find out whether they can produce the product at the target cost
or not. For keeping the total cost at or below the target cost where and how much
costs can be reduced is required to be found out by the managements of the
enterprises. If they become successful in doing this then they undertake the
production and can continue to sell the product at the price which customers are
willing to pay and can become successful in earning the desired profit over a long
term period. The enterprises are required to follow target costing not only in respect
of new products invented by them but also for the existing products because
product price is becoming the main factor of competition in the competitive markets.
NOTES
Check Your Progress
i)
Define ‘Target Costing’
Explain the meaning of
target costing and state the
origin of target costing.
ii) What is the difference
between ‘Target Costing’
and ‘Standard Costing’ ?
The origin of the target costing can be traced to Japan. One of the most
influential changes in the practice of management to emerge is ‘Kaizen’ - the
philosophy of continuous improvement. Originally a Japanese idea, it is being adopted
around the world as an integral part of management strategy. A variation of this
concept is that of ‘kaizen costing’, in which the emphasis is on gradual on going
cost reduction. Deriving from the thought of continuously improving costing,
Japanese organisation are moving to a more radical approach referred to as target
costing. In a move to maintain the competitive edge the Japanese believe that the
key to achieving a competitive edge is simplicity. They are beginning to realise
that there can be too much of a good thing - too much variety, too much flexibility
and even too much customer satisfaction. Organisations such as Nippondenso
were cited as using target costing principles to reduce its product range, increase
productivity and profitability. Additional Japanese companies utilising target costing
to seek a competitive edge include Isuzu Motors, Toyota Motor Corporation, NEC,
Sony, Sharp and Nissan.
Target costing, although its concept is used throughout the product life cycle,
is primarily used and most effective in the product devlopment and design stage.
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Target Costing
NOTES
Born out of the market driven philosophy, target costing is based on the pricedown, cost-down strategy, which has allowed companies to win considerable share
of their respective markets. In companies where target costing is used, there
seems to be a different culture and attitude. They place emphasis on their relative
position in the market and product leadership. Since more than 80% of product
cost is already determined by the time product design and processing is complete,
cost management must start (and done substantially) at the design stage. The
process of target costing is simple, logical and easy to implement. It describes a
process of first assessing a target price and then designing a product to meet this
price. Tata’s ‘NANO’ car is a very good example of target costing.
While a lot of the literature describes Japanese Companies using target
costing (e.g. Hiromoto 1991, Tanaka 1993, Cooper 1995, Gagne and Discenza,
1995) early uses of price-based costing can be seen in the philosophies of Ford
Motor Company during its early years (Shank and Fisher, 1999). The process of
target costing is usually described using examples from the assembly industry. For
assembled products it is easier to associate different product functions with specific
functional product components. Many researchers pointed out that target costing
is most beneficial to assembly-oriented industries (automotive manufactures,
electronic equipment companies,etc.) rather than process-oriented manufacturer
(e.g. Gagne and Discenza 1995, Morgan 1993). It is also pointed out that target
costing is more applicable for industries with frequent product changes and short
product life cycles. (e.g. Gagne and Discenza 1993 and 1995 Lee 1994). These
critiria fit many companies in the fashion driven apparel industry where products
have short seasons and change drives the industry more than anything else. The
processes in the apparel industry are largely assemble-oriented. Several
researchers have pointed out that target costing should also be used in processing
industries. Shank and Fisher (1999) point out that many product innovations in the
automotive or electronics industries are actually modifications of existing products
and they show the application of target costing in a paper mill with processes and
product variations that are very similar to textile processes and products. Cooper
and Chew (1996) are investigating the concept of target costing for process and
service industries, showing that key concept of target costing remains the same.
Target costing is an effective and efficient method for ensuring that a company
has profitable products that are well matched to its customers’ requirements.
13.4 Features of Target Costing
Important features of target costing can be mentioned as under :
318 Advanced Cost Accounting - IV
(1)
Target costing originated in Japan in the 1960s, where it is known as Genka
Kikaku. It is such a costing system where the management consider it as a
profit planning system.
(2)
Target costing is an activity which is aimed at reducing the life-cycle costs
of new products, while ensuring quality and customer requirements, by
examining all possible ideas for cost reduction at the product planning,
research and devlopment, and the prototyping phases of production.
(3)
Target costing is an important tool because it promotes cost consciousness
and focuses on profit margin, both of which strengthen an organisation’s
competitive position. It is not a technique that attempts to slash costs by
trimming functions or by closing departments; it is a steady and neverending process to make sure that costs are always kept to a minimum.
(4)
At a first glance, target costing is a set of management techniques and
calculation methods.
(5)
Target costing is built around the “Key formula” : improve product design
and planning till :
•
Estimated Cost = Target Cost
•
Estimated Cost = Target Selling Price - Target Profit
Target Costing
NOTES
Providing market based cost targets for future product and developing them
to functions, components and parts through analytical methods.
(6)
A target cost is a set of management tools and practices, bound to support
organisational learning about the economic performance of a future product.
Product economic performance is the ratio between cost and customer
value. Target costing suggested to optimize the economic performance of a
product, it is necessary to take into account the whole value chain which
will provide it.
(7)
Target costing integrates economic objectives and technological knowledge.
It requires an efficient learning process, effective feedback and
organisational memory. Target costing has a concrete and direct impact
upon behaviour of employees working in different departments as well as
on behaviour of the customers.
(8)
Target Costing provides a cross functional communication which also
provides a formal tool to support collective learning process and make the
knowledge-gap visible for all managerial personnel.
(9)
Target costing is particularly popular among Japanese firms such as Toyota,
Nissan, Toshiba and Daihatsu Motor in various industries such as automobile
manufacturing, electronics, machine tooling, and precision machine
manufacturing. As Japanese tastes became more diverse, assembly-oriented
production grew in popularity. This growing demand for a diverse range of
products shortened product life-cycles. With shorter product life cycles more
focus is placed on the costs occurring at each phase - devlopment, planning
and design.
(10) Compared to traditional standard costing approaches in which an estimate
of product, general administrative, marketing and distribution costs is taken
into consideration target costing takes on a more proactive approach to
pricing. Traditional costing determines cost based on the design of goods,
adds a markup and establishes a price. In comparison, the market place
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Target Costing
directs target costing by first setting a selling price, then subtracting target
income and finally reaching a cost.
(11)
NOTES
Traditionally, a product is designed, production is completed and then the
total cost is calculated and to it the expected profit margin is added and the
selling price of the product is fixed. When it is found that the response of
customers at the selling price fixed is very poor, the information is sent back
to production, development and design departments asking them to change
the design, change the process and method of production and thereby reduce
the cost so that the selling price can be reduced. As against this, in target
costing market based selling price of the product is first decided and after
deducting the expected profit margin from the selling price the target cost
of the product is decided. Product devlopment, design of the product and
method of production and process to be used is then decided keeping the
target cost of the product. Target costing thus eliminates the wastage of
time and resources which take place in traditional costing.
(12) The decision making process involves a cross functional team, in which
employees from various departments (Production, Engineering, R & D,
Marketing and Accounting) are given the responsibility of determining an
acceptable market price and corresponding Return on Sales, as well as a
feasible cost in which a given item may be produced. In order to minimize
costs, team members focus on eliminating non-value-added costs of the
process, improving product design and modifying process methods.
(13) Target costing, in particular, emphasizes the reduction of costs during the
planning and design stage of the product life cycle since the majority of
product cost is determined at this stage. In comparison to traditional product
costing methods, target costing allocates more of the total cost to the
development stage, simultaneously reducing costs during the production stage.
A number of cost-engineering techniques are used in the cost reduction
process. Just-In-Time, Total Quality Control, Materials Requirement Planning
and Value Engineering are among such methods promoted by target costing.
(14) Target costing is more useful in assembly-oriented industries because the
product life cycle in these industries is short and so instead of using the
traditional method of Economic Order Quantity they find it economical to
keep a very small quantity of materials and components by using Just-InTime method and Material Requirement Planning because they have to
produce a large variety and low volume products.
(15) Initially a project is accepted or rejected based on marketability and cost
and profit data. Once a project is accepted, the engineering department
constructs an engineering development plan. This plan considers all aspects
of product cost up-front. Target profit is then subtracted from expected
sales to reach an estimate of allowable cost. In order to reach successfully
this allowable cost, a great deal of effort is required from each department
to tighten overall cost. Individual processes are evaluated in order to direct
efforts towards the most valuable and feasible cost saving areas.
320 Advanced Cost Accounting - IV
(16) The prevalance of assembly-oriented products along with shortened product
life cycles has contributed to the success of target costing. Many firms
have turned to target costing as a way of reducing the price and improving
the quality of their products, creating a benefit in terms of a company’s
profits as well as increased customer satisfaction. Target costing adds value
to the production process by eliminating non-value added activities, thus
paving the way for decreased costs passed on to the customers. Target
costing enables companies to ascertain a more realistic price as well as
strengthen competition among firms to offer quality products at lower costs.
Target Costing
NOTES
13.5 Difference between Traditional Cost
Management Approach and Target Costing
Approach
Traditional product development typically starts with a basic product
developed in the Research and Development of a firm. This may be a design
group, a research lab and engineering team or any other group of people in the
company that is responsible for developing new products. The initial idea for the
product may have come from market or it may have originated in development
efforts inside the company. After the basic product design has been developed,
the price is typically found by adding all costs and a desired profit margin. Whether
this price is acceptable in the market or not is only known when the product is
actually introduced and offered to potential customers.
Japanies Companies have developed target costing as a response to the
problem of controlling and reducing costs over the product life cycle.
As a totally new product and its industry develops, it starts to compete
based on its new technology, concept and/or service. Competitors emerge and the
basis for competition evolves to other areas such as cycle time, quality or reliability.
As an industry becomes mature, the basis of competition typically moves to price.
Profit margins shrink. Companies begin focusing on cost reduction. However, the
cost structure for existing products is largely locked in and cost reduction activities
have limited impact. As companies begin to realize that the majority of a product’s
costs are committed based on decisions made during the development of a product,
the focus shifts to actions that can be taken during the product development phase.
Until recently, engineers have focused on satisfying a customer’s
requirements. Most development personnel have viewed a product’s cost as a
dependent variable, that is, the result of the decisions made about a product’s
functions, features and performance capabilities. Because a product’s costs are
often not assessed until later in the development cycle, it is common for product
costs to be higher than desired.
The traditional cost management approach is shown in the following figure:
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321
Target Costing
Product Requirements
Product Design
NOTES
Product Design & Cost Estimates
Make/Buy Analysis
Supplier Cost Estimates
Cost too
High ?
Production
Periodic Cost Reduction
Fig. 13.1 : Traditional Cost Management Approach
Target costing is fundamentally a different approach. It is based in three
premises :i)
orienting products to customer affordability or market- driven price.
ii) treating product cost as an independent variable during the definition of
a product’s requirements, and
iii) proactively working to achieve target cost during product and process
development.
Target costing builds upon a ‘design-to-cost’(DTC) approach with the focus
on market driven target prices as a basis for establishing target costs. The target
costing concept is similar to the cost as an independent variable (CAIV) approach
used by the US Department of Defense and to the price-to-win philosophy used
by a number of companies pursuing contracts involving development under contract.
Target costing is thus carrying out of continuous product development
activities to translate the cost challenge into reality.
The Target Costing Approach is shown in the following figure :
322 Advanced Cost Accounting - IV
Target Costing
Product Requirements & Market Analysis
Target Price less Profit
NOTES
Balance Target Cost & Requirements
Make/Buy
Analysis
Supplier Target
Costing
Cost Projections
Explore Product &
Process Design Alternatives
& Design Product & Process
DFMA &
Value Analysis
Production
Continuous Cost Reduction
Fig. 13.2 : Target Costing Approach
13.6 Advantages of Target Costing
i)
Target costing is a proactive approach to cost management. In the target
costing approach product cost is regarded as a dependent variable. Product
selling price/competitive market price is first estimated and after subtracting
the desired profit from it, the target cost at which the product should be
ready is worked out. This activity is carried out before the costs are incurred
and when the development and designing of the product is being planned.
This is different from the traditional cost management approach where
product costs are first incurred and then total product cost is found out and
by adding the profit margin the selling price of the product is determined.
ii)
Target costing orients organisations towards customers. By undertaking
the analysis of the markets information is obtained about the expectations
of the prospective customers and the price which they are ready to pay for
a product which will satisfy their requirements is found out and this becomes
the basis for calculating the target cost. Thus organisations are oriented to
the customers’ requirements.
iii)
Target costing helps in breaking down the barriers existing among various
departments of the organisation. The departments such as the development
department, production and engineering department, the research and
development department, the design department, the marketing department
have to work together to decide how cost reduction can be achieved and
the total product cost can be kept at or below the target cost.
iv)
In target costing suggestions are made by employees working in different
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323
Target Costing
NOTES
324 Advanced Cost Accounting - IV
departments for reducing the cost by using a new design, a new process or
method of production and after detailed discussions at various levels if the
suggestions are found useful, they are implemented. This increases
awareness among the employees and they feel empowered.
v)
In target costing the total cost of a product is to be kept at or below the
target cost determined for the product. For achieving this objective efforts
are made to minimize the inventory of materials required in the production
process. Techniques like Just-in-time and use of exact quality materials are
used for reducing the cost of materials. For this relations with the suppliers
are developed and they are given information about the exact requirements
of the firm. Thus target costing helps in developing better relations with
suppliers.
vi)
For reducing the cost of the product to its target cost, analysis of each stage
in the production process is undertaken and all such stages and steps which
do not add value to the product are located and eliminated. Target costing,
thus, minimizes non-value added activities.
vii)
Target costing ensures that the organisation will continue to earn the desired
margin of profit throughout the life-cycle of the product. Financial position
of the organisation becomes sound due to this and the management gets
funds for expansion as well as for undertaking development activities for
future products.
viii)
Target costing proves more beneficial in assembly oriented industries in
which the life-cycles of the products is short. Target costing provides marketbased cost targets for future products. This helps the organisation in being
ready with new products by the time the life cycle of the existing product
comes to an end. Surveys of competitive markets and analysis of the
information obtained from such surveys helps the organisation in anticipating
the changes expected by the customers, the new functions they expect
from the future products and the price at which they are ready to buy the
future product. The organisation can determine the customers/market
supported selling price for the future product and by subtracting the desired
profit margin from the selling price decide the target cost of the product and
start its efforts to produce the future product at or below the target cost so
decided.
ix)
In traditional cost management, use of cost reduction techniques and systems
is done only when the need for cost reduction is strongly felt. While in
target costing use of such techniques is done on continuous basis throughout
the life-cycle of the product.
Target Costing
13.7 Limitations of Target Costing
Though target costing provides the above mentioned advantages, it has
certain limitations also. The main limitations can be mentioned as under :i)
ii)
For effective implementation and use of target costing development of
detailed cost data and departmental information is required. Complete and
detailed cost data must be made available for using target costing approach.
For determining the competitive market price of the product to be created,
detailed study of the competitive market of the customers and also of the
possible cometetors is very essential. Proper market surveys must be carried
out and analysis of the information obtained through the surveys becomes
very important for taking correct decisions. Any lacuna in this will reduce
the utility of the target costing.
Target costing approach implementation requires willingness to co-operate.
Co-operation from employees working in development and research
department, design department, engineering and production department,
marketing department and accounting and costing department is required
to be obtained. Such co-operation may not be available due to personal ego
and departmental rivalry. Success of target costing thus depends upon the
extent to which the management can overcome these obstacles.
iii)
For implementation of the target costing approach, co-ordination in the
activities and efforts of various departments, sections, branches, etc. must
be achieved. Many meetings at various levels and of various employees
are required to be held for explanning and obtaining the co-ordination.
Keeping the interests and enthusiasm of all persons concerned is a difficult
thing to be achieved.
iv)
For reducing the product cost to or below the target cost of the product,
suggestions may be made to use substitute material and components having
lower price. Sometimes the substitute material and component may be of
low quality and if the suggestion is accepted and implemented, the quality
of the product and the function it is expected to perform may be adversely
affected. This will result in loss of confidence of the customers and decrease
in the market share of the organisation. To avoid this from happening the
management must take maximum care while considering the suggestions
made by the employees.
NOTES
Check Your Progress
i)
Briefly
mention
the
features of target costing.
ii) Point out difference
between ‘ traditional cost
management approach’ and
‘target costing approach’.
iii) Mention the advantages
and limitations of target
costing.
Advanced Cost Accounting - IV
325
Target Costing
13.8 Specimen Illustrations
(1)
NOTES
Super Electronics Ltd. has a capacity to produce 80,000 components of an
electronic product but it produces only 20,000 components and sells them at
a price of 120 per component. If selling price is reduced by 10 per
component, demand will increase by 100% for every reduction in price by
10. Find out the target cost for 80,000 components if the profit margin
desired by the company is 25% on the selling price.
SOLUTION
Selling price per component
Demand for component
120
20,000 units
110
40,000 units
100
80,000 units
Calculation of target cost of the component :-
(2)
Target Cost
=
Selling Price - Profit Margin desired
 Target Cost
=
100 - (25% of selling price)
=
100 - (25% of
=
100 -
=
75 per component.
100)
25
Following is the draft budget of Kalpana Enterprises prepared for the next
year :Units to be produced and sold
30,000 units
Sales price per unit
40
Variable cost per unit :Direct Materials
Direct labour (2 hrs x
10
4)
Variable Overheads
Contribution per unit ( 40 - 20)
326 Advanced Cost Accounting - IV
8
2
20
20
Total contribution on 30,000 units
6,00,000
Budgeted Fixed Costs for the year
4,80,000
Budgeted Profit for the year
1,20,000
The Board of Directors is not happy with the above draft budget and thinks
that the profit is not satisfactory. The Board has, therfore, appointed a committee
of experts to reconsider the draft budget and submit a new draft budget which will
Target Costing
show more profit amount.
The Committee after detail study and discussions has submitted a report which,
if implemented, will increase the profit from 1,20,000 to 2,80,000. The report
suggests that for creating additional demand for the product intensive advertising
should be undertaken by spending additional amount of 50,000 for the same. It
also states that the unit price of the product be increased to 45 and at this price
the demand for the product will increase to 36000 units.
NOTES
The report states that to satisfy the increased demand additional production is
possible with the present labour force if the workers increase their productivity
and should produce one unit of the product in reduced time than 2 hours time per
unit taken by them. This can be achieved if the workers are given wage rate of
6 per hour as an incentive for increasing their productivity.
Assuming that the Board accepts the suggestions in full, you are required to
find out the revised labour time for production of one unit of the product.
SOLUTION
Budgeted fixed costs as per the draft budget
4,80,000
Additional expenditure on advertising
50,000
Total fixed costs budgeted for next year
5,30,000
Desired Profit in the next year
2,80,000

8,10,000
Total contribution required in the next year
Expected sales in units in the next year
36,000 units
Required contribution per unit
22.50
( 8,10,000 ÷ 36,000 units)
Target Variable cost per unit
Target Labour Cost per unit
New wage Rate per hour is
= Target Price - Required Contribution per unit
=
45 -
=
22.50
22.50
= Target Variable Cost per unit - (Direct
Materials Cost + Variable Overheads)
=
22.50 - ( 10 +
=
22.50 -
=
10.50 per unit
2)
12
6
 Number of labour hours required to produce one unit of the product
Advanced Cost Accounting - IV
327
Target Costing
=
10.50 ÷
6
= 1.75 hours.
Therefore the workers should reduce time taken by them for producing one
unit of the product from present 2 hours to 1.75 hours, i.e. 1 hour 45 minutes.
NOTES
13.9 Summary
Target costing is a cost management tool for reducing the overall cost of a
product over its entire life-cycle. It originated in Japan and is then followed in
European countries and United States of America. Due to the competitive markets
and the awareness of the customers, the traditional method of determining the
selling price of a product (in which a new product is developed by an organisation,
cost incurred for creating the product is calculated and to it the desired profit
amount is added and thus the selling price of the product is decided) cannot be
followed by the business organisations. They have to make market survey and
find out what the prospective customers expect from the product and how much
price they are willing to pay for such a product, then subtract the expected profit
margin from the price and find out the cost at or below which they must be able to
produce and market the new product. This cost is termed as ‘target cost’. If the
estimated total cost of the product is more than the target cost, efforts are made
for cost reduction at various phases of production. For this persons working in
research and development department, production planning department, design
department, stores department, accounting and costing department co-operate
with each other and by suggesting change in the design of the product, use of
substitute materials and components, change in production processes and methods
and use of techniques like Just-In-Time and Total Quality Control try to reduce
the product cost over its entire life-cycle. Production activity is started only if the
estimated total cost is successfully brought down to the target cost of the product.
Thus cost reduction activity is undertaken during the development phase itself and
attention to cost reduction is given throughout the life-cycle of the product. The
process of target costing is simple, logical and easy to implement. It ensures that
the organisation will be earning the expected profit during the life-cycle of the
product. Before the life-cycle of the product comes to an end, the development
and research department is ready with a new product which is acceptable to the
customers and the market at a certain price. Target costing is beneficial to the
organisation in profit planning and strengthening the financial position of the
organisation.
Target costing is an activity which requires co-operation from employees
working in different departments and effective co-ordination in the implementation
of the target costing approach also is very essential. There are many advantages
available from using target costing but it must be remembered that there are some
limitations to use of target costing.
328 Advanced Cost Accounting - IV
13.10 Key Terms
Target Costing : It is a disciplined process for determining and achieving a full stream cost at which a proposed product with specified functionality, performance
and quality must be produced in order to generate the desired profitability at the
product’s anticipated selling price over a specified period of time in the future.
Target Costing
NOTES
13.11 Questions
A]
Short answer questions
1)
Briefly state the meaning of ‘target costing’.
2)
Define the terms ‘target cost’ and ‘target costing’
3)
How is target cost of a product calculated ?
4)
Briefly mention the origin of target costing.
5)
Give four features of target costing.
6)
Mention two advantages of target costing.
7)
State two main limitations of target costing.
B]
Long answer questions
1)
What is meant by target costing ? Why use of target costing has become
necessary ?
2)
Define ‘target costing’. Explain the concept of target costing.
3)
How does the target costing approach differs from the traditional cost
management approach ?
4)
Explain the features of target costing.
5)
Compare standard costing technique with target costing.
6)
Which advantages become available from target costing ?
7)
What is target costing ? Briefly trace the origin of target costing.
8)
Write short notes on :
a) Price determination in target costing.
b) Calculation of target cost.
c) Limitations of target costing
Advanced Cost Accounting - IV
329
Target Costing
C]
Multiple Choice Questions
1.
Target Costing integrate ----------- objectives and technological knowledge.
(a) economic
(b) social
NOTES
(c) management
(d) financial
2.
Target Costing builds up on a “------------------” approach.
(a) make-to-order
(b) cost-to-cost
(c) design-to-cost
(d) price-to-gain
3.
Targer Costing is a ----------------- approach to cost management.
(a) possitive
(b) negative
(c) proactive
(d) classical
4.
Target Costing is a set of -------------- techniques and calculation methods.
(a) accounting
(b) costing
(c) management
(d) computerised.
Ans. : (1 - a), (2 - c), (3 - c), (4 - c).
330 Advanced Cost Accounting - IV