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A REPORT ON

ANNUAL OPERATING PLAN


A Project on Financial Planning & Internal Control

By Deepesh Mittal 10BSPHH010219 IBS Hyderabad

A REPORT ON

ANNUAL OPERATING PLAN


A Project on Financial Planning & Internal Control
By Deepesh Mittal 10BSPHH010219

A report submitted in partial fulfillment of the requirements of MBA Program of IBS Hyderabad Distribution List: GlaxoSmithKline Consumer Healthcare Ltd. Dr. Rajnandan Patnaik (Professor, IBS Hyderabad)

May 13, 2011

Authorization
This is to certify that this project entitled Annual Operating Plan has been submitted by Deepesh Mittal while doing his Summer Internship at GlaxoSmithKline Consumer HealthCare Ltd, Gurgaon, as partial fulfillment of the requirement of MBA Program IBS Hyderabad 2010-2012.

______________________ Mr. Rakesh K. Bansal


(General Manager Finance Operations) (GlaxoSmithKline Consumer Healthcare Ltd.)

Date: May 13, 2011

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Acknowledgments
I would like to express my profound gratitude to all those who have been instrumental in the preparation of my project report. To start with, I would like to thank the organization GlaxoSmithKline Consumer Healthcare Ltd. (GSKCH) for providing me the chance to undertake this internship study and allowing me to explore the area of finance which was totally new to me and which would prove out to be very beneficial to me in my future assignments, my studies and my career ahead. I would like to thank Mr. Rakesh Bansal, Mr. Deepak Gupta and Mr. Arup Chakraborti for their continuous support, advice and encouragement, without which this report could not have been completed. I am deeply grateful to my faculty guide, Dr. Rajnandan Patnaik, for his invaluable suggestions, comments, feedback and support throughout the internship.

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Table of Contents
Content
Authorization Acknowledgment Executive Summary About GSK Introduction 1. Objectives 2. Scope of the Project 3. Methodology The Study 1. Strategic Planning 1.1 Introduction 1.2 Benefits of Strategic Planning 1.3 Limitations 2. Annual Operating Plan 2.1 Nature of Annual Operating Plan 2.2 Relation to Strategic Planning 2.3 Contrast with Forecasting 2.4 Use of an Annual Operating Plan 2.5 Content of an Annual Operating Plan 2.6 Annual Operating Plan Categories 2.6.1 Budgeted Production Cost 2.6.2 General & Administrative Expense 2.6.3 Research and Development Expense 2.6.4 Logistics Expense 2.6.5 Management by Objective 2.7 Annual Operating Plan Preparation Process 2.7.1 Issuance of Guidelines 2.7.2 Preparation of Formats and Templates 2.7.3 Initial Budget Proposal 22 23 25 19 20 21 21 21 11 11 12 13 17 6 6 9 Page No. i ii 1 2 4 4 5 5

2.7.4 Negotiation 2.7.5 Review and Approval 3. Internal Control & Variance Analysis 3.1 Need for comparison of actual & operating plan 3.2 Causes of Budget Variances 3.3 Variance Analysis 3.4 Calculating & Analysis variances 3.4.1 Variable Cost Variances 3.4.1.1 Direct Material Variance 3.4.1.2 Direct labor total variance 3.4.1.3 Variable production overhead total variances 3.4.2 Fixed Production Overhead Variances 3.4.2.1 Fixed Production overhead variance classification 3.4.3 Materials mix & yield variances 3.5 Reasons for variances 3.6 Interdependence between variances 4. Observations 5. Conclusion

26 26

28 29 31 34

36 39 42

44 47 50 51 53 54

Annexure I References

55 60

List of Illustrations
List of Exhibits
Page No. Exhibit 1.1 Exhibit 1.2 Exhibit 2.1 Exhibit 3.1 Exhibit 3.2 Exhibit 3.3 A company without a strategic planning process A company with a strategic planning process Types of plans and their contents Need of Internal Control Internal control process flow Variance analysis disaggregation 7 8 18 28 29 34

List of Tables
Table 1.1 Table 1.2 Table 1.3 Table 1.4 Table 1.5 Table 1.6 Table 1.7 Table 1.8 Table 1.9 Table 1.10 Table 1.11 Table 1.12 Table 1.13 Table 1.14 Table 1.15 Table 1.16 Table 1.17 Table 1.18 Table 1.19 Initial Financial Details Financial Details After Revised Budget Per unit profit Example to show Variance Calculations Direct Material Variance Direct Material Price Variance Direct Material Usage Variance Direct Labor Total Variance Direct Labor Rate Variance Direct Labor Efficiency Variance Variable Production Overhead Variable Production Overhead Expenditure Variance Variable Production Overhead Efficiency Variance Fixed Production Overhead Expenditure Variance Fixed Production Overhead Volume Variance Fixed Production Overhead Efficiency Variance Fixed Production Overhead Capacity Variance Material Mix for Product X Planned Standard Mix 31 32 32 35 36 37 38 39 40 41 42 43 44 45 45 46 47 48 48

List of Exhibits List of Tables (Continued)


Table 1.20 Table 1.21 Table 1.21 Table 1.22 Table 1.23 Calculating Mix Variance Calculating Mix Variance Calculating Yield Variance Solution-2 Mix Variance Solution-2 Yield Variance Page No. 48 48 49 49 50

Executive Summary
In order to identify, communicate and monitor progress on key priorities for the year that advances the strategic plan, organizations prepare an Annual Operating Plan. An Annual Operating Plan describes the significant key activities and associated monetary resources for the forthcoming fiscal year. This includes the recurring annual expenses as well. Annual Operating Plan of an organization is of great importance. This is because any organization will want to plan for priorities and manage its growth proactively. The growth of the business depends on lot of different factors including overall economic trends, location, specific market needs etc. Businesses that plan do so in order to guide and influence their growth, so that they can move more proactively towards their defined objectives rather than just reacting to business events. With the help of a plan business can track progress towards goals, measure results and hence can mange in a better way. Planning assigns priorities, specific responsibilities, activities, deadlines and budgets. These are the bricks and mortar of planning, critical to business success. Once the plan is prepared it needs to be checked thoroughly to ensure its accuracy and consistency. Then this plan needs to be approved by the management in order to be implemented. This project comprises of developing formats, graphs and key financial indicators to enable successful exercise of Annual Operating Planning process, validations, analysis and final approvals.

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About GSK
GlaxoSmithKline

GlaxoSmithKline plc (GSK) is a global pharmaceutical, vaccine, biologics and consumer healthcare company headquartered in London, United Kingdom. It is the worlds third largest pharmaceutical company measured by revenues. GSK was formed as a result of a merger of Glaxo Wellcome plc and SmithKline Beecham plc in the year 2000. GSK Consumer Healthcare Ltd and GSK Pharmaceuticals Ltd are the two businesses of GSK in India of which former is headquartered at DLF Gurgaon and the latter at Worli, Mumbai.1

GlaxoSmithKline Consumer Healthcare Ltd.

GSK has a large Consumer Healthcare Division which is responsible for producing and marketing various oral healthcare products, nutritional drinks and over-the-counter (OTC) medicines. In the Indian market, GSKs journey in the consumer healthcare segment began with Horlicks. In the early years, Horlicks, manufactured by Horlicks Limited, Slough, England was being imported, bottled and sold in India. The year 1955 saw a change in the import policy following which the import of Horlicks was stopped. In the year 1956-57, Horlicks Limited decided to set up a plant in India, at Nabha, Punjab. This led to the birth of Hindustan Milkfood Manufacturers Pvt. Ltd., which came to be known as HMM Ltd in 1991. In 1989, HMM Ltd became a part of SmithKline Beecham, which was formed as a result of a merger between SmithKline, USA and Beecham, UK.1 After the formation of GSK as a result of a merger in 2000, a need for a separate Consumer Healthcare Division was felt. This resulted in the formation of GlaxoSmithKline Consumer Healthcare Ltd. (GSKCH) in the year 2002.2

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GSKCH has various products under its umbrella which include3: Nutritional Products: Horlicks, Horlicks Biscuit, Boost, Maltova, Lucozade Sport and Viva

OTC Products:

Crocin, Eno, Sensodyne, Foodles and Iodex

The company recorded a 20% increase in sales and 28.8% increase in Profit After Tax in the year 2009 2010 over previous financial year.4

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Introduction
An annual operating plan is prepared to forecast sales revenue, production costs, overheads, cash flow etc of an organization. This plan is used to monitor the trading activities of an organization, usually for one year. Once the plan is prepared it needs to be checked thoroughly to ensure its accuracy and consistency. Then this plan needs to be approved by the management in order to be implemented. This project comprises of developing formats, graphs and key financial indicators to enable successful exercise of Annual Operating Planning process, validations and final approvals. There is a huge amount of data which is required to prepare an Annual Operating Plan. The format of an Annual Operating Plan should be such that it facilitates quick analysis by different departments of the organization. It should contain inbuilt cross checks to ensure validity of the exercise. The graphs and key financial indicators help in analyzing the progress of the business towards required objectives. They also help in deciding on priorities, activities, deadlines, budgets as well as in assigning specific responsibilities. Once the analysis is over the plan has to be submitted to the management for review and approval.

1. Objectives of the Project


To develop analytical tools to prepare and validate Annual Operating Plan. To understand how the organization works. To understand the concepts of forecasting, standard costing and purchase price variance. To analyze the factors that may affect the core operations of the organization. To propose the best possible options to counter the factors having adverse effect on the organization during the planning exercise.

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2. Scope of the Project


The scope of the project is limited to developing an annual operating plan for the production division of the GSKCH which comes under Global Manufacture and Supply division of GSKCH in India.

3. Methodology

1. Define the Objective:

The basic objective of this report is to develop analytical tools for preparing and validating the Annual Operating Plan of the organization. Reading and analyzing previous years Annual Operating Plans in order to have a better understanding of the project.

2. Background Study:

3. Preparation of Financial Preparing Financial models to enable proper and exhaustive Models: analysis of the Annual Operating Plan. These financial models include formats, graphs and key financial indicators. 4. Collection of Data: Collecting data required for the plan from different manufacturing and packaging sites of the organization located throughout the country.

5. Analysis and Reviews:

Analyzing the Plan using the prepared models followed by reviewing the output to ensure proper and exhaustive analysis. Understanding the factors which affect the organization favorably or adversely and provide recommendations to use the factors towards the growth of the organization.

6. Preparing the report:

The findings, analysis, conclusions and recommendations will be presented to the organization in the form a project report to enable proper reporting of the findings.

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The Study
1. Strategic Planning
1.1 Introduction
Most competent managers spend considerable time thinking about the future. The result may be an informal understanding of the future direction the entity is going to take, or it may be a formal statement of specific plans about how to get there. Such a formal statement of plans is known as a strategic plan and the process of preparing and revising this statement is called strategic planning. Strategic planning is the process of deciding on the programs that the organization will undertake and on the approximate amount of resources that will be allocated to each program over the next several years.5 In the strategy formulation process, management arrives at the goals of the organization and creates the main strategies for achieving those goals. The strategic planning process then takes the goals and strategies as given and develops programs that will carry out the strategies and achieve the goals efficiently and effectively. The decision by an industrial goods manufacturer to diversify into consumer goods is a strategy formulation, a strategic decision, after which a number of implementation issues have to be resolved: whether to diversify through acquisition or through organic growth, what product lines to emphasize, whether to make or to buy, which marketing channels to use.6 The document that describes how the strategic decision is to be implemented is the strategic plan.

1.2 Benefits of Strategic Planning


A formal strategic planning process can give to the organization: 1. A framework for developing the annual budget 2. A management development tool 3. A mechanism to force managers to think long term 4. A means of aligning managers with the long-term strategies of the company.

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1.2.1 Framework for Developing the Budget An operating budget calls for resource commitments over the coming year; it is essential that management make such resource commitments with a clear idea of where the organization is heading over the next several years. A broader framework is provided by the strategic plan. Thus a strategic plan facilitates in the formulation of an effective operating budget. As Exhibit 1.1 suggests, a company not having a strategic planning process considers too many strategic issues in the budgeting stage, which leads information overload, inadequate consideration of strategic alternatives, or neglecting some choices altogether. This is an indication of a dysfunctional environment that can seriously affect the quality of the decisions for resource allocation.

Strategic option A Strategic option B Budgeting Strategic option C Strategic option D

EXHIBIT 1.1 A company without a Strategic Planning Process6

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Exhibit 1.2 shows how the strategic planning process helps in narrowing the range of options so that the planners can make intelligent resource allocation decisions during the budgeting process. Thus the strategic plan helps the organization understand the implications of strategic decisions for action plans in short term.

Strategic option A Strategic option B Strategic option C Strategic option D


Strategic Option A Strategic Option C

Strategic Planning

Budgeting

EXHIBIT 1.2 A company with a Strategic Planning Process6

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1.2.2 Management Development Tool Formal strategic planning is considered to be an excellent management education and training tool. It provides the managers with a process for thinking about the strategies and their implementations. 1.2.3 Mechanism for Forcing Management to Think Long Term Managers tend to worry more about the tactical issues and managing the present, day-to-day affairs of the business than about creating the future. This process forces the managers to think through long-term issues. 1.2.4 Aligning Managers with Corporate Strategies

The discussions, negotiations and debates that take place during planning process help in clarifying the corporate strategies, unifying and aligning managers with such strategies and reveal the implications of different strategies for individual managers.

1.3 Limitations
There are several limitations or pitfalls to formal strategic planning. First, there is always a danger that planning can end up as just a form-filling exercise, devoid of strategic thinking. A second danger that looms this process is that an organization may create a separate department and assign the responsibility of preparing the strategic plan to that department. This results in forfeiting of input of line management as well as the educational benefits of the process.

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Strategic Planning is a time consuming and an expensive process. The most significant expense is the time devoted to it by the senior management and managers at different levels of the organization.

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2. Annual Operating Plan


2.1 Nature of Annual Operating Plan
Annual operating plans are important tools for effective short term planning and internal control in an organization. An annual operating plan is also known as an operating budget. An operating budget usually covers one year and states the revenues and expenses planned for that year. During the course of his study the researcher came across some of the characteristics of an annual operating plan. These characteristics are typical to an operating plan and are as follows: a) A budget estimates the profit potential of the business unit. b) It is stated in monetary terms, although the monetary amounts may be backed up by non monetary amounts (e.g., units sold or produced) c) It generally covers a period of one year. d) It is a management commitment; managers agree to accept responsibility for attaining the budgeted objectives. e) The budget proposal is reviewed and approved by an authority higher than the budgetee. f) Once approved, the budget can be changed only under specified conditions. g) Periodically, actual financial performance is compared to budget, and variances are analyzed and explained.6

2.2 Relation to Strategic Planning


Strategic planning, as we discussed earlier, is the process of deciding on the type and size of different programs that are to be undertaken in implementing as organizations strategies. Both strategic planning as well as the budget preparation involves planning, but the types of planning activities involved differ for the two processes. The budgeting process is concerned on focusing on a single year while the strategic planning focuses on activities that are distributed over a period of several years. Strategic planning precedes

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the budgeting process and provides the framework within which the annual operating plan is developed. Another important difference, as observed by the researcher, between the two processes is that the strategic plan is essentially structured by product lines or other programs, while the annual operating plan is structured by responsibility centersi. This rearrangement of the programs, so that it corresponds to the responsibility centers associated with its execution, is a necessity because the annual operating plan is used to influence a managers performance before the fact and later on to appraise the performance.

2.3 Contrast with Forecasting


While studying the previous years annual operating plan exercise the researcher found that an annual operating plan differs in several aspects from a forecast. An annual operating plan or a budget is a management plan with the implicit assumption that positive steps will be taken by the budgetee to make actual events correspond to the plan.6The budgetee is the manager who prepares the budget. A forecast is merely a prediction of what mostly like is going to happen. It does not carry any implications that the forecaster will attempt to shape events such that the forecast will actually be realized. The researcher observed that as compared to a budget, a forecast has the following characteristics: Forecast may or may not be in monetary terms. Forecast can be for any period of time. Forecaster is not responsible for meeting the forecasted results. Forecasts are not usually approved by senior management. Forecasts are updated as soon as new information indicates a change in conditions of the original forecast. Variances from the forecast are not analyzed periodically or formally.

Responsibility centers are those units in the organization that have control over costs, revenues, or investment funds. For accounting purposes responsibility centers are classified as Cost Centers, Profit Centers, Revenue Centers, and Investment Centers.

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An example of a forecast is one that is made by the treasurers office in order to help in cash planning. Such a forecast usually includes estimations of expenses, revenues, and other items that affect cash flows. However, the treasurer does not have any responsibility for making the actual expenses, sales or other items conform to the forecast. The top management does not clear the cash forecast; it may change daily or weekly without the approval of the higher authority; and the variances between the forecast and actual are usually not analyzed systematically. From the managements point of view, a financial forecast is exclusively a planning tool, whereas a budget is both a planning tool and a control tool. Every budget includes elements of forecasting; in which budgetees cannot be held responsible for certain events that affect their ability to meet the budgeted objectives.6

2.4 Use of an Annual Operating Plan


The annual operating plan exercise at GSK is carried out to meet the following four basic principles: 1. To fine-tune the strategic plan 2. To help in co-ordination of activities of different parts of organization 3. To assign various responsibilities to managers, to authorize the amount they are permitted to spend and to inform them of their expected performance 4. To obtain a commitment which forms a basis for evaluating a managers actual performance. 2.4.1 Fine-Tuning the Strategic Plan As discussed earlier, the strategic plan has the following characteristics: It is prepared early in the year. It is development is based on the best information available at that time. Relatively few managers are required to prepare it.

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It is stated in fairly broad terms. The budget is completed just prior to the beginning of the budget year. It provides an opportunity to use the latest available information and is based on the judgment of the managers at all levels throughout the organization.7 The First Cut at the budget may reveal that the overall performance of the organization or of a particular business unit is not satisfactory. In such a case, the budgeting exercise provides the managers with an opportunity to make decisions that will help in improving the performance before a final commitment is made to a specific way of operating during that year. 2.4.2 Co-ordination It is the responsibility of every responsibility center manager in the organization to participate in the preparation of the budget.8 Thus, when the different parts of the budgets are assembled to form into an overall plan, inconsistencies may show up. During the course of his study the researcher found that the most common inconsistency that may arise is that the plans of the production organization are not consistent with the planned sales volume, in total or in certain product lines.

Even within the production organization, plans for shipments of finished products may be inconsistent with the plans of the departments or plants which are responsible of providing components for these products. Similarly, another observation of inconsistency that was observed was when line organizations assume a higher level of service from support organizations than those organizations intend to provide. During the budget preparation process such inconsistencies are identified and resolved.

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2.4.3 Assigning Responsibility

The approved budget should clarify the responsibility of each and every manager. The budget also allocates responsibility center managers with the specified amount of money they are allowed to spend for certain designated purposes without seeking the approval of the higher authorities. These responsibilities also include the various objectives as defined in the strategic plan. As the organization moves towards the successful achievement of its strategic objectives it has to divide these objectives over a period of years. Every year the managers are provided with the objectives they need to meet so that the organization can achieve its desired goal in the desired time period. The successful achievement of these objectives becomes the responsibility of the managers and is assigned to them in the operating plan. 2.4.4 Basis for Performance Evaluation

The annual operating plan or the budget is a benchmark against which actual performance can be measured. The budget assigns responsibility to each responsibility center in the organization. At the top level, the budget summary assigns responsibility to individual profit centers. Within profit centers, the budget assigns responsibility to functional areas. Within functional areas, the budget assigns responsibility to each individual responsibility centers.8This can be better understood with the help of an example. Nicolas G. Hayek, the chief executive officer of SMH (makers of Swatch and Omega watches), has been credited with both a dramatic turnaround of SMH as well as the revitalization of the Swiss watch industry itself. Nicolas Hayek uses the budgets as part of his broader set of tools in this revitalization process. Hayek has remarked: We are big believers in decentralization. This company has 211 profit centers. We set tough, demanding budgets for them. I personally participate in detailed budget reviews for our major profit centers. Then we

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track performance closely. We get monthly sales figures for all profit centers. Then we track performance closely. We get monthly sales figures for all profit centers on the sixth day of the following month. We get profit and loss statements about 10 or 15 days later. The moment anything looks strange, we react quickly, very decisively, very directly.9 In GSKCH, a monthly trade profit review exercise is carried out in which the top management compares the actual results with the expected results according to the operating plan for that particular year. In this review the top management is concerned if the desired objectives have been met or not and if the different business units are moving towards a successful achievement of their objectives for that year. These objectives are the ones which are assigned to different business unit managers in the operating plan. The researcher has been a part of three such Trade Profit Reviewii exercises in February, March and April respectively. During this exercise the researcher observed that the different business units of GSKCH send their financial performance reports for the previous month to the Finance department at the GSKCH headquarters. The finance department is then responsible for finding the variation between the actual performance of each business unit and the expected performance according to the annual operating plan 2010-2011. Then the reasons for these variations are studied. If these variations are having an adverse effect on the growth of the organization then recommendations are made so as to nullify the adverse impact. These details are then presented to the top management and required approvals for the recommendations are given by them which are then passed on to the specific business units. The finance department makes note of the conditions which caused such adverse impact so that they can consider

ii

Trade Profit Review or more commonly known as TPR is an internal review process at GSKCH in which the finance department of GSKCH presents the performance report of the organization for the previous month to the top management. It is usually carried out in the mid of every month. The top management, after their review, present new revised targets to different business units for the upcoming months. These targets are in line with the current economic conditions prevailing in the country as well as the international markets and with the operating plan for that year.

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recommendations, while preparing the annual operating plan for the upcoming budget year.

2.5 Content of an Annual Operating Plan


Exhibit 2.1 shows the content of a typical operating plan and contrasts the operating plan with other types of planning documents such as the strategic plan and the capital budget, the cash budget and the budgeted balance sheet. The amounts are the planned INR (Indian Rupee) or GBP (Great Britain Pound) amounts for the year, together with quantitative amounts such as head counts and production in units. Capital Budget Capital budget states the approved capital projects, plus a lump-sum amount for small projects that do not require high level approval. It is usually prepared separately from the operating budget and by different people. During the year, proposals for capital expenditure are considered at various levels of the organization and some are finally approved.6 Budgeted Balance Sheet The budgeted balance sheet shows the balance sheet implications of decisions included in the operating budget and the capital budget. Overall, it is not a compulsory control device, but some parts of it are useful for control.6 Budgeted Cash Flow Statement The budgeted cash flow statement shows how much of the cash needs during the year will be supplied by the retained earnings and how much, if any, must be obtained by borrowing or from other outside sources. It is, of course, important for financial planning. As its title indicates, the cash flow statement shows the inflows and outflows of cash during the year, usually by quarters.6

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Strategic Plan
1. Revenue and expense for each major program. 2. Not necessarily by responsibility centers. 3. Not as much details as operating budget.

Operating Plan
1. For organization as a whole and for each business unit. 2. Classified by responsibility centers. 3. Typically includes: Revenues Production cost and cost of sales General & administrative expense Research & development Logistics expense 4. Expenses may be flexible, discretionary or committed. 5. For one year, divided into months or quarters. 6. Total reconciles to strategic plan (unless revised).

Capital Budget
1. Each major capital project listed separately.

4. More expenses are variable. 5. For several years

6. Total reconciles to operating plan

2. Total project expenditures by quarters

Cash Forecast Budgeted Balance Sheet

Exhibit 2.1 Types of Plans & Their Contents

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2.6 Annual Operating Plan Categories


In relatively smaller organization, especially ones that have no business units, the whole budget may fit on a single page. But in larger organizations such as GSK, there is a summary page and other pages that contain the details of individual business units as well as the research and development, and general administrative expenses. 2.6.1 Budgeted Production Cost Typically it is considered that direct material cost and direct labour cost are developed from the product volumes contained in the sales budget10. But the researcher observed that this is not feasible in practice because these details depend on the actual mix of the products that are to be manufactured. Instead, the standard labor and material cost of the planned volume levels of a standard mix of products are shown in the operating budget. Production managers are responsible for planning to obtain the required quantities of material and labor, and they along with Finance managers prepare procurement budgets for items having long lead time. As per the observations of the researcher the budgeted cost developed by the managers may not be for the same quantity of products as shown in sales budget. This difference represents the additions or subtraction from the final inventory. But, the cost of sales which is reported in the summary budget is the standard costiii of the products budgeted to be sold. The researcher observed that in GSKCH control over the amounts that may be purchased is obtained by detailed open to buy authorizations which are made throughout the year and not by the amounts shown in the budget. The amounts shown in the budget act more as guidelines to ensure that the purchases are made more or less within the range of the budgeted quantity. The amounts mentioned in the budget are used by the finance department

iii

Standard cost is the amount the firm thinks a product or the operation of the process for a period of time 10 should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.

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to analyze the performance of the business unit. In every manufacturing organization the basic objective of the finance department is to ensure that the production cost is kept as economical as possible and GSKCH is no exception. The finance department, in its monthly review, ensures that the cost or raw material is as per the guidelines of the operations plan for that year. If it is not then the finance department has to analyze the reasons for that. Sometimes inflation is the cause of this variation. When an operating plan is made, the expected inflation rate is always taken into account. But since inflation depends on several economic factors, both domestic as well as international, it might happen that the inflation rate may change from as predicted by the finance managers in the previous year while preparing the operating plan. Several other factors also affect the production cost like changes in labor rates, changes in employee benefits schemes, changes in rent rates, depreciation, repairs & maintenance and so on. Thus finance managers have to be careful while preparing the production cost budget. 2.6.2 General and Administrative Expenses These are general and administrative expenses of staff units both at the business units as well as the headquarters. In general they are discretionary expensesiv. The researcher observed that the majority of these costs in GSKCH were due to insurance costs, travelling expense, canteen expenses, security costs, rewards and recognition costs and so on. During budget preparation much attention is given to such categories as they are discretionary and the appropriate amount to allocate is always a subject of much debate.

iv

A discretionary expense is a cost which is non-essential for the operation of a business. For example, a business may allow employees to charge certain meals and entertainment costs to the company in order to promote goodwill with the employees.

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2.6.3 Research and Development Expenses In case of R&D budget, either of the two approaches are used or a combination of them. In the first approach, total amount is the key focus. This may be based on the current level of spending which has been adjusted for inflation or it might be a larger amount. This larger amount is usually in the belief of the company that more can be spent in good times, that is if the company is expecting an increase in sales revenue. The second approach is by aggregating the planned spending on each approved project with an allowance for work that is likely to be undertaken even though it has not been identified yet. GSK uses the second approach in order to calculate the R&D Budget. 2.6.4 Logistics Expenses Logistics expenses are usually reported separately from order getting expenses. These expenses comprise of order entry, order picking and warehousing, transportation between different business units for value addition,

transportation to the customer, and accounts receivable collection. Many companies include them in marketing budget. This is because logistics expenses tend to be the responsibility of the marketing department. In GSK as well the logistics expenses tend to be the responsibility of the value chain team known as commercialv. 2.6.5 Management by Objectives The managers are responsible to attain certain financial objectives during the budget year. These financial objectives are set forth in the operating plan. Other than this there are certain specific objectives which are implicitly mentioned in the operating plan such as opening a new packaging station, introducing a new product line, retain employees, install a new computer system and so on. In
v

In GSKCH the entire process from manufacturing to product distribution is distributed between two parts namely Manufacturing & Packaging and Value chain. The manufacturing & packaging is handled by a team known as Global Manufacturing and Supply (GMS) which is responsible for the manufacturing and packaging of the products. The Value chain team, known as commercial, is responsible for supply chain distribution and marketing of the product. The trainee is working under the GMS finance team.

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some companies these objectives are made explicit. This process is known as Management by Objective. The objectives of each responsibility center are set forth in quantitative terms wherever it is possible and are the responsibility of the responsibility center manager. These objectives are mentioned in the operating plan.

2.7 Annual Operating Plan Preparation Process

The finance department has the responsibility of administering the flow of information for the internal control system. The finance department at GSK performs the following functions with respect to internal control: Publishes forms and procedures for the preparation of annual operating plan Each year it co-ordinates and publishes the basic corporate wide assumptions which form the basis for the operating plan. Example: assumptions about the economy like change in inflation and so on. Make sure that the flow of information between different business units is coordinated properly. Preparation and analysis of operating plan Making recommendations to the senior management, related with the operating plan Co-ordinates the work of finance departments in different business units Analyzes reported performance against the operating plan, interprets the results and then prepare the summary reports for the top management. 2.7.1 Issuance of Guidelines The first step in preparing an operating plan is the development of the guidelines that form the basis for the preparation of the plan, or the budget. These guidelines are mentioned implicitly in the strategic plan of the organization. All responsibility centers have to follow these guidelines such as assumed inflation in general and in specific items like wages, organization policy on number of promotions, compensation at every wage and salary levels which should include employee benefits as well and so on.
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2.7.2 Preparation of Formats and Templates Once the guidelines have been released the next step is to prepare various formats according to specific business units. This is a very important step in the budgeting exercise. The data available at different business units is huge. The finance managers at these units need to know which data is required by the senior management. That is where these formatsvi come into picture. These formats ensure that the finance managers at each business units provide the required data in a common format. This helps the finance managers at the headquarters in analyzing the different proposed budgets without much difficulty. While preparation of these formats, it should be taken care that the format is prepared such that different guidelines for different business units are predefined in the format. The trainee was involved in the preparation of these formats. The formats were common for all the business units with special attention paid to the fact that each business unit had a different requirement and guidelines to follow. Thus formats had to be adjusted to the requirement of the particular business unit. The researcher had to study different cost drivers related to different business units and make sure that the cost drivers having a considerable impact on the production cost were dealt with in detail. This ensures that the finance department can analyze in depth the different costs which were incurred during production and can give recommendations which can help in reducing these costs. The formats also include various analytical tools such as graphs and comparative studies. The formats have already been populated with the standardsvii for different cost drivers and the 2011 plan figures. The finance departments at different sites only need to provide the actual figures for the current year and their proposed figures for the budget year. The formats have been so designed that as soon as the actual figures are populated the different comparative studies will automatically show the variations in the figures. The
vi

These formats are basically Excel worksheets which are designed for collection of data. There are separate workbooks for each site and each workbook contains several worksheets which document the data related with different cost drivers and the analysis of the collected data. vii Standards here refer to the standard costs allocated to different cost drivers. In GSKCH standards are set every three years. They were setup in 2008 and again in 2011.

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formats also provide for the changes in the different economic factors which may affect the performance of the business units. The formats have been designed in such a way that as soon as all the business unitsviii send in their completed format sheets a summarized budget sheet is prepared automatically for the headquarters to analyze. This helps the finance department at headquarter to analyze the all India budget at one glance. The different graphs present in both the business units formats as well as All India Summarized budget formats presents the data in a graphical format hence making the analysis much more comfortable. Some of these graphs also help in analyzing the current performance of the business units as compared to previous year performance and proposed performance for the budget year. The major problem faced during this exercise was the presence of huge amount of data which needs to be managed properly. Formats have been developed keeping the amount of data in mind. The basic aim of the formats has been a proper representation of the huge amount of the data with the most important data being provided the due importance. Also sufficient automated cross checks have been provided which check whether the guidelines have been met by the respective business units or not. One important change to the format that the trainee was able to make was the automation of the formats. The data in the formats, as provided by the business units, is in INR but it needs to be changed in GBP while presenting to the top management. Earlier this was done manually by preparing a separate sheet for each INR and GBP respectively. The trainee was able to prepare a programming code, using MACROSix in excel, which enabled the user to convert the data in the desired currency just by the click of a button thus saving considerable time and space.

viii

GSKCH has manufacturing plants at Nabha (Punjab), Rajamundry(Andhra Pradesh), Sonepat (Haryana) and Baddi (Haryana). They also have different packaging stations. These are located at Baddi (Haryana), Parsan (Punjab), Guwahati (Assam) and Hyderabad (Andhra Pradesh). These sites are the different business units of GSKCH. ix An Excel Macro is a set of instructions that can be triggered by a keyboard shortcut, toolbar button or an icon in a spreadsheet. Macros are used to eliminate the need to repeat the steps of common tasks over and over.

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The formats were submitted by the trainee to the senior management for review and recommendations. The formats were passed, after some minor changes, by the senior management. 2.7.3 Initial Budget Proposal By using the guidelines the different business unit finance managers develop a budget request. This budget is based on the existing levels of resources which are then modified to meet the guidelines. These changes from the current level of performance can be classified on the basis of a) Changes in External Forces The changes in the external forces include, but are not limited to the following: Changes in general level of economic activity which affects the volume of sales, e.g.: expected increase in demand for a particular product. Anticipated changes in price of purchased materials and services. Anticipated changes in labor rates. Anticipated changes in cost of discretionary activities e.g., R&D, administrative expenses etc.

b) Changes in Internal Policies and Practices The changes in the internal forces include the following: Changes in production cost due to new equipment and improved production methods. Changes in discretionary costs which are based on anticipated changes in workload. Changes in product mix and market share. It is essential that the specific changes from the current level of spending be classified by causes as mentioned above. This helps in analyzing the reasons for the required changes and deciding on the steps which need to be taken in order to counter the changes if they are having an adverse impact on the organization. The formats prepared in the second step are
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used here. In this step the business units receive the formats from the headquarters and they are supposed to fill in the details according to their budgets. Thus converting their budget formats into a common format as required by the senior management. The formats developed by the trainee will be sent to different business units once they confirm that they are ready with their proposed budgets. This is process is expected to start in second half of month of April. Once the business units send in their final budget proposal sheets the analysis of these sheets will take place. The trainee along with other members of the team will be responsible for the analysis of these sheets and ensure that the basic guidelines have been met or not. He will also analyze the performance of the company in the current year as compared to the operating plan for the current year, with the performance of the previous year and with the proposed plan. 2.7.4 Negotiation The planner has to discuss the proposed operating plan with the superiors. In this step the superior judges the validity of each and every adjustment. The basic consideration is that the performance in the budget year should be an improvement over the performance of the current financial year. Also the superior has to make sure that the proposed plan covers all the mandatory guidelines issued by the finance department and necessary adjustments have been made for the same. 2.7.5 Review and Approval The proposed plans go up through successive levels of the organization. When they reach the top of a business unit, the finance department puts together all the pieces and examines the plan as a whole. This analysis is basically required to check for consistencies, Example: is the production budget consistent with planned sales volume? Are support and services centers planning adequately for the services requested from them? The analysis, in
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part, checks if the budget will produce a desired profit. If not then it is sent back for reworking. Another important factor which is reviewed is if all the allocated tasks for the budget year have been properly incorporated in the plan or not. The finance department ensures that the allocation of the tasks is realistic so that no further revision of budget is required during the budget year.

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3. Internal Control & Variance Analysis


3.1 Need for Comparison of Actual and Operating Plan
As discussed earlier the annual operating plan is also known as an operating budget. One of the objectives of budgeting is to provide the management with a base against which the actual performance can be compared and hence measured. This is advantageous if and only if the management is ready to take actions in order to ensure that the organization moves towards achieving the required performance.

Exhibit 3.1 Need of Internal Control6 In too many organizations the production of results as compared to the budget is considered to be the end of the process. If no action is taken on the management accounts then there is little point in producing them.1 Financial and management aspects of an organization have to be balanced delicately to ensure the continuous development of the organization. This is being depicted in Exhibit 3.1.

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PLAN

MONITOR

EVALUATE

FEEDBACK
Exhibit 3.2 Internal Control Process Flow If we identify the progress from a preceding position we are better informed regarding the effects of our actions and we have a clearer picture to understand the effect of the any future action that we plan to take. Having the knowledge of the amount of money being spent every month helps the manager in deciding on the course of action for the future. It helps the manager in deciding if the spending needs to be cut down or increased in order to meet the required objectives.

3.2 Causes of Budget Variances


There are two main reasons which cause the budget variances. It is very important for the managers to identify and understand these reasons as the action required may be completely different in both the cases. The two main reasons for budget variances are: 1. Reality is wrong 2. Differences between Budget Assumptions and Actual Outcome

3.2.1

Reality is wrong

It was observed by the researcher that sometimes the actual results are not of much help in analyzing the current performance of the organization. A strike or a natural disaster will have an impact on results. Labor strikes are a very common phenomenon in India and no organization remain unaffected by it. Organizations tend to allocate a certain amount during the budget planning process for this factor but it usually is not sufficient to counter the hit sustained by the

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organization due to such factors. Natural disasters sometimes cause damage in an unexpected sense. For example the Tsunami in Japan caused some of the manufacturing sites of GSKCH Asia to be shut down for some time and hence caused a reduction in the production volume which then had to be met from plants situated in other countries. Such kinds of factors are unpredictable and it is very difficult to provide a separate allocation for them. Even during the monthly or annual review of the progress of the company, the top management gives due importance to these factors while considering the progress of the company but the managers are supposed to find measures, during the working year, in order to offset the negative effect of these factors on the business. These measures include cost cutting in some alternative variable factor or if the production has been affected in some particular site then to try and cover the production gap from other manufacturing sites.

3.2.2

Difference between Budget Assumption and Actual Outcome

This is a key issue and the one which involves the use of variance analysis techniques.11 No one can predict the future outcome for certain. Due to certain factors which might be economic or non-economic, the prices of certain items change but not in accordance to the forecasted values. For example a war in an oil rich country will cause the prices of the oil to rise up unexpectedly. Similar thing is happening nowadays because of the internal turmoil going on in Libya. The prices of crude oil in the international market have gone up drastically and thus raising the prices of high speed diesel which is required by GSKCH plants in order to operate the machineries. Sometimes natural disasters also cause such changes. On several occasions it happens that a sudden change in the government policies has an adverse effect on the business of the organization. The best possible action for a manager in this scenario is to understand the reason why a particular factor is having an adverse effect on the organization, calculate the extent of the effect and to find a way in order to offset these negative impacts.

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Variance analysis techniques are used to understand the extent of effect a particular factor is having on the growth of the company.

3.3 Variance Analysis


A variance is the difference between an actual result and an expected result. The process by which the total difference between standard and actual results is analyzed is known as variance analysis.11When actual results are better than the expected results, we have a favorable variance else an adverse variance. In order to perform a proper variance analysis we need to follow the following 4 steps11: 1. Flexing the Budget 2. Analyzing the variances 3. Identifying the causes 4. Taking appropriate action We will discuss the steps with the help of an example for proper understanding of the procedure.
(In INR) Plan Actuals Production Volume 100 90 Sales Value 1000 990 Variable Expense 500 495 Fixed Expense 200 210 Operating Profit 300 285

Table 1.1 Initial Financial Details If we directly compare the actual with the plan then we can see that profit is down by Rs. 15. Flexing the Budget and Analyzing the Variances In the example we can see that it is futile to compare the actual variable costs with the plan. If we do so then the effect of the decrease in volumes will not be considered. Hence it is a necessity to prepare a revised budget. This does not imply that the original
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budget is of no use but it simply means that in order to analyze the financial performance of an organization more accurately we need to make certain amends.
Revised (in INR) Plan Plan Actuals Production Volume 100 90 90 Sales Value 1000 900 990 Variable Expense 500 450 495 Fixed Expense 200 200 210 Operating Profit 300 250 285

Table 1.2 Financial Details After Revised Budget Table 1.2 shows the Revised Plan which is calculated on the basis of the volume. The resultant plan shows that the expected profit for 90 units is Rs. 250 which gives us a profit of Rs. 15 instead of an adverse effect of Rs. 15 as seen earlier. Another way to include the effect of the volumes is by calculating the per unit expected and actual profit. This has been depicted in Table 1.3.
(in INR) Production Volume Sales Value Variable Expense Fixed Expense Operating Profit Profit Per Unit Plan Actuals 100 90 1000 990 500 495 200 210 300 285

3 3.166667

Table 1.3 Per Unit Profit As we can see from the data in Table 1.3 that even though the actual is showing an adverse effect of Rs.15 but after calculating the per unit profit we come to know that the product is still being sold at profit. Thus the manager can now concentrate his efforts in finding the reason for the decrease in volume produced.

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Identifying the Causes Once the manager knows the factor which is having an adverse impact on the performance of the organization, then he can work on to find the conditions for the same. For example, in the above example we can see that the decrease in volumes is having an adverse effect on the profits of the organization. Now the manager needs to see what conditions are causing the decrease in volumes. It is quite possible that the prices of the raw material went up and hence the manufacturing site bought and produced less. It is also possible that due to some strike or natural disaster the site could not function at full capacity and hence produced less. No accounting function is likely to know the cause of the variances. They will assume that the figures are right and the budget was realistic. The finance department has a role to quantify the impact, but its the operational managers who should know why and only they should provide input into the management report on the figures. Taking Appropriate Action A good reporting system should report on exceptions only. When the figures are in line or very close to the plan then there is no need to report an exception. In any other scenario the reviewer should know: 1. What is the financial impact? 2. What is the cause? Can it happen again? 3. Are there implications for other departments as well? 4. What is being done or needs to be done. Once the reviewer is clear about the issue then only he can take appropriate actions in order to take the challenge hands on.

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3.4 Calculating and Analyzing Variances


The focus of this section is on comparing the actual performance with the plan but the trainee observed that the competent managers never assume that optimal performance is being as per plan. Most organizations, just like GSKCH, make a monthly analysis of the differences between the plan and the actual revenues and expenses not only for the organization as a whole but for individual business units as well. A thorough analysis helps the manager in identifying the causes of variances and the business unit responsible for it. Variances are always hierarchical. As shown in Exhibit 3.3, variances begin with total business unit performance which is then divided into revenue and expense variances. In the case of the trainee, since he is a part of Global Manufacturing and Supply (GSM) division of GSKCH we will be concerned with only the expense variances. The general subdivision of variances is, none the less, being provided in Exhibit 3.3.
Total Variance

Nonmanufacturing Costs

Manufacturing Costs

Sales

Administration

Marketing

R&D

Variable Costs

Fixed Costs

Volume

Selling Price

Material

Direct Labor

Variable Overhead

Market Share

Industry Volume

Exhibit 3.3 Variance Analysis Disaggregation

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At GSKCH, the analytical framework which is followed in order to conduct variance analysis consists of the following ideas: Identify the key causal factors that affect profits or operating expenditure. Breakdown the overall operating expense variances by these causal factors. Try to calculate the specific, separable impact of each causal factor by varying only that factor which holds all other factors constant. Add complexity sequentially, one layer at a time, beginning at a very basic level. In order to understand the process of variances calculation we will take the help of an example. We will be using following example to calculate and understand the different variances.
Standard cost of Product A Materials(5Kgs X 10 per kg) Labour (4 hrs X 5 per hr) Variable overheads (4 hrs X 2 per hr) Fixed overheads 4 hrs X 6 per hr) Total
Budgeted Results Production (units) Sales (units) Selling Price per unit

50 20 8 24 102

1200 1000 150

Actual Results Production (units) Sales (units) Materials - Volume (kg) Materials - Cost Labour - Hours (hours) Labour - Cost Variable Overheads Fixed Overheads Selling Price

1,000 900 4,850 46,075 3,800 26,600 9,450 25,000 140

Table 1.4 Example to show Variance Calculations

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3.4.1 Variable Cost Variances

3.4.1.1 Direct Material Variances The direct material total is defined as the difference between the standard price and the actual purchase price for the actual quantity of the material. This can be calculated at the time of delivery or at the time of usage.12
Plan Purchase Price Actual Purchase Price Direct Material Total Variance 50,000.00 46,075.00 3,925.00

Table 1.5 Direct Material Variance

The variance here is favorable since the actual purchase price is less than the planned purchase price or the standard purchase price which had been decided while preparing the plan. Direct Material variance can be further subdivided into sub variances: Direct Material Price Variance and Direct Material Usage Variance. Direct Material Price Variance Direct Material Price Variancex is the difference between what the actual quantities of material used for production did cost, and what it should have cost, that is the planned cost.

The direct material price variance is calculated on material purchases in the period if closing stocks of raw materials are valued at standard cost or material used if closing stocks of raw materials are valued at actual cost (FIFO).

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Material Used (kg) Standard Cost

4850 48,500

Actual Cost Direct Material Price Variance

46,075 2,425

Table 1.6 Direct Material Price Variance

The Table 1.6 depicts that the material used for production was 4850 Kg and the costs are adjusted to represent amount spend to purchase 4850 Kg of the material. The direct material price variance shows the amount of savings the organization has made for the amount of material used for production. In case of materials, an adverse price variance usually means that a supplier has increased the price of the goods after the standard has been set. If prices are rising due to increase in inflation there is little an organization can do. This is because the organization, while preparing the plan, takes into account the inflation factor and provides for it in the plan. But if the inflation increases more than the forecasted value than there is little left to be done by the organization. Whenever the purchasing department places a large order with a supplier, an attempt is made to fix the price of the ordered material for the life of the contract. But this is not always possible due to the inability to meet minimum order levels and hence the ordering organization does not become entitled to discounts.

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Direct Material Usage Variance

This is the difference between how much material should have been used for the number of units actually produced and how much material was actually used, valued at standard cost.

No. of units Weight per unit (Kg) Total Standard Weight (Kg) Actual weight (Kg) Variance (Kg) Standard Cost (per Kg) Direct Material Usage Variance

1000 5 5000 4850 150 10 1,500

Table 1.7 Direct Material Usage Variance

In Table 1.7 calculation for direct material usage variance has been shown. For a total of 1000 units total standard weight should have been 5000 Kg but the actual weight is 4850 Kg. Hence the company has saved the cost of 150 Kg that amounts to 1,500. Even though this is being shown as a saving, that is a favorable variance, but this can result in a lower quality product which can ultimately harm the image of the product in consumers mind and hence the image of the company. Management should be able to control the usage variance because the difference will have taken place within the manufacturing unit of the organization. Often the variance will have been caused due to carelessness, e.g. incorrect storage which could lead to spillage or deterioration of the material. It may also have been caused due to the careless usage or the workforce being unskilled or inexperienced in handling the material. Lastly the material used might have been of a poor quality. This often causes a high usage variance as many of the

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units produced will fail to meet the required quality levels and will therefore have to be scrapped.

3.4.1.2 Direct Labor total variance

Direct labor variance is the difference between the standard direct labor cost and the actual direct labor cost incurred for the production achieved. By doing this calculation, the hours worked or actually booked to the job can be compared with the actual standard hours produced at the end of the work.

Standard Labor rate per hour Standard Direct Labor hours produced Total Standard Direct Labor Cost Actual rate per hour Actual Labor hours produced Total Actual Direct Labor Cost Direct Labor total variance

5 4000 20,000 7 3800 26,600 -6,600

Table 1.8 Direct Labor Total Variance

As shown in Table 1.8 the standard labor rate and the actual labor rate vary. The actual labor rate is more than the standard labor rate by 2. Moreover the manufacturing unit was not able to meet the direct labor hours as specified by the standards. Thus the organization had to face an adverse labor rate variance of 6,600. This will also have an adverse impact on the other variance as the number of direct labor hours is less than the specified number. This will result in lower usage of the machinery and other equipment and might have caused a decrease in production volumes for the given time period. Direct labor total variance can be further subdivided into Direct Labor rate variance and direct labor efficiency variance.

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Direct Labor Rate Variance

Direct labor rate variance is defined as the difference between the standard and the actual direct labor rate per hour of the total hours worked or paid.12
Standard Labor rate per hour Actual Labor rate per hour Actual hours worked/paid Total Standard Labor Cost Total Actual Labor Cost Direct Labor rate variance 5 7 3800 19,000 26,600 -7,600

Table 1.9 Direct Labor Rate Variance

In Table 1.9 we can see that the standard labor rate and the actual labor rate differ by 2. Due to this difference in labor rates the cost to the company has increased by 7,600. Thus the increase in labor cost is causing an adverse impact on the expenses of the company. There are several reasons why the labor cost to the company may vary from the standard cost. Sometimes the standards are set before the pay rates have been negotiated. Other reason which is also possible is that usually the standards are set for duration of 2 or more years, 3 years in case of GSKCH. Hence the standards might not actually represent the true labor rate prevalent in that particular year. This is usually compensated in the plan for the year but sometimes due to unseen circumstances, like labor strike, the labor rates have to be renegotiated in the middle of the year. This also causes an adverse impact on the financials for that year and organization or the managers cannot do much about it. If this is not the case then other causes must be investigated. Temporary labor may been used and they might have been paid at a different rate. Lastly, special allowances may have been paid to the staff in the form of overtime, health benefits etc which will effectively increase the hourly rate.

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Direct Labor Efficiency Variance Direct labor efficiency variancexi is defined as the difference between the standard hours for the actual production achieved and the hours actually worked, valued at standard labor rate.12
Standard Labor rate per hour Standard hours produced Actual hours worked Direct Labor Efficiency Variance 5 4000 3800 1,000

Table 1.10 Direct Labor Efficiency Variance

In Table 1.10 we have shown the calculation for Direct Labor Efficiency Variance. We see that the actual hours worked was less than the standard hours by 200 hours. This might mean that the production time was reduced but it can also mean that due to certain circumstances the production could not take place for the planned duration. In either of the cases the direct labor efficiency variance will give us a favorable variance but in the second case this variance will have an adverse impact on the other variances e.g. production variance. There are several reasons for this variance. Inadequate training can be one of them. If the workers are inexperienced then they usually take longer to do the job or there might be several quality problems resulting in more rejects being produced. The cause can also be due to the poor quality material being purchased because the usual source is temporarily out of stock.

xi

When idle time occurs the efficiency variance is based on hours actually worked (not hours paid for) and an idle time variance is calculated.

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3.4.1.3 Variable Production Overhead total variances

Production/Manufacturing overhead costs refer to any costs within the manufacturing unit other than the direct material and direct labor. Manufacturing overheads include such things as indirect material (such as manufacturing supplies), indirect labor, utilities, quality control, material handling and depreciation on the manufacturing equipment and facilities. Variable manufacturing costs increase as the output increases. An example is the electricity needed to operate the machines. Another example is the manufacturing supplies (like nozzles, sprayers etc) that increase when the production increases. Sometimes the variable manufacturing cost increases while the output remains stable or even decreases. This may be caused due to the reason that the cost of overheads has increased due to some reason. An example can be that of electricity. It is possible that electricity rates may change due to several reasons, like shortage of electricity or other economic factors. This will cause an increase in the variable production overhead costs. Variable production overhead total variances can be defined as the difference between the standard cost of variable overheads and the actual cost of variable overheads.

Number of units produced Standard variable overhead Variable Overhead Cost Actual variable overhead Actual Variable overhead cost Variable Production Overhead

1000 8 8,000 9.45 9,450.00 -1,450.00

Table 1.11 Variable Production Overhead

In Table 1.11 we can see that the variable cost has increased by 1.45 even though the produced volumes are as per standard. This is possible if the cost of variable overheads, like electricity, manufacturing supplies, depreciation etc, has increased. Thus the company faces an adverse impact of 1,450 as compared to the plan.
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The Variable production overhead can be further divided into subcategories Variable production overhead expenditure variance and variable production overhead efficiency variance respectively. Variable Production Overhead Expenditure Variance

Variable production overhead expenditure variance can be defined as the difference between what the variable production did cost and what it should have cost.

Number of hours worked Standard Variable spending per hour Standard Variable Cost Actual Variable spending per hour Actual Variable Cost Variable Production Overhead expenditure variance

3800 2 7,600 2.25 8,550 -950

Table 1.12 Variable Production Overhead Expenditure Variance

As we can see in Table 1.12 the variable spending increased while the number of hours worked remained constant. This caused an adverse impact on the organization in the form of an increased expenditure of 950. Variable Production Overhead Efficiency Variance

Production overhead efficiency variance can be defined as the direct labor efficiency variance in hours, valued at the variable production overhead rate per hour.

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Labor Efficiency Variance in hours Standard Overhead Rate per hour Variable production o/h efficiency variance

200 2 400

Table 1.13 Variable Production Overhead Efficiency Variance

We can see in Table 1.13 that the labor efficiency variance is 200 hours, as calculated earlier. Thus the production overhead efficiency will be favorable since less time is consumed in producing the required amount. Same thing can be seen from the resultant output of the calculation. This is because the variable overhead cost increases with the increase in the production time and volume. In this case the same volume is being produced but in less time. 3.4.2 Fixed Production Overhead variances classification

The total fixed production variance is an attempt to explain the under-or-ever absorbed fixed production overhead. There are different types of fixed production overhead variances.

3.4.2.1 Fixed Production overhead variance

Fixed production overhead variance is defined as the difference between the incurred costs of fixed production overhead and the amount of overhead actually absorbed. The amount of overhead absorbed is calculated by using the overhead rate, which is the total fixed production overhead divided by the budgeted labor hour of produced units. Particular attention is paid to whether the overhead is over-absorbed or under-absorbed, with the absorption being determined by how close the numerator and denominators are to the actual figure. There are several types of fixed production

overhead variances: fixed production overhead expenditure variance, fixed production overhead volume

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variance, fixed production overhead volume efficiency variance and fixed production overhead volume capacity variance. Fixed production overhead expenditure variance

This is the difference between the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure.

Fixed Overhead No. of units Produced Standard Overhead Cost Actual Overhead Cost Expenditure Variance

24 1200 28,800 25,000 3,800

Table 1.14 Fixed Production Overhead Expenditure Variance

As we can see in Table 1.14 that as per the company standard the overhead cost should have been 28,800 but the actual overhead cost was found to be 25,000 which is 3,800 favorable towards the company. Fixed Production overhead volume variance

It is the difference between the planned fixed production overhead volume and the actual amount. Both the budgeted and actual overhead are multiplied by the overhead rate.

Planned Production Volume Actual Production Volume Standard Overhead Rate per unit Planned Production Overhead Cost Actual Production Overhead Cost Production overhead volume variance

1000 1200 24 24,000 28,800 -4,800

Table 1.15 Fixed Production Overhead Volume Variance

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Table 1.15 shows the production overhead volume variance calculations. We can see that as the production volume increases the production overhead also increases thus causing an adverse effect on the company. But this variance also effects other variances like sales volume variance and sales revenue variance which increase as this variance increases. These variances have a positive impact on the company financials which are much more significant then the adverse impact caused due to this variance. Fixed Production overhead volume efficiency variance

This is the difference between the number of hours that actual production should have taken and the number of hours actually worked, usually the labor efficiency variance, multiplied by the standard absorption ratexii per hour.

Standard rate per hour Labor efficiency variance in hours Volume Efficiency variance

6 200 1,200

Table 1.16 Fixed Production overhead volume efficiency variance

Table 1.15 shows that the labor efficiency variance is 200 hours favorable. This means that it took less time to produce the planned number of units than as per plan. Hence the company will have considerable savings to show for this reduced production time. Since the production time was less it means that the machines and other such variables also had to function for a lesser time thus reducing the overhead cost and hence increasing the efficiency of the production system.

xii

In absorption costing, the rate determined in advance for all cost centers for allocating fixed or variable costs (together or separately) to the output , in an accounting period is known as the standard absorption rate. It is also called as recovery rate.

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Fixed Production overhead volume capacity variance

This is the difference between the planned hours of work and the actual hours worked, multiplied by the standard labor rate per hour.

Planned Hours Actual hours worked Variance in hours Standard Rate per hour Volume Capacity Variance

4800 4200 -600 6 -3,600

Table 1.17 Fixed Production overhead volume capacity variance

The fixed overhead volume capacity variance is unlike the other variances in that an excess of actual hours over planned hours results in a favorable variance and not an adverse variance as it does when considering labor efficiency, variable overhead efficiency and fixed overhead volume efficiency. Working more hours than planned produces an over absorption of fixed overheads, which is a favorable variance. 3.4.3 Materials mix and yield variances

The material usage variance can be subdivided into a materials mix variance and a materials yield variance if the proportion of materials in a mix is changeable and controllable. This is the case with most of the products manufactured by GSKCH hence the study of this variance becomes all the more important. The mix variance indicates the effect on costs of changing the mix of material inputs. The yield variance indicates the effect on costs of material inputs yielding more or less than expected. We will take a different example in order to understand these variances.

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Standard input to produce 1 unit of product X is given as :


Product X material mix Volume (in Kg) Cost per kg Total Cost

Material A 20 10 200

Material B 30 5 150

Table 1.18 Material Mix for Product X

In the month of March, 13 units of product X were produced from 250 Kg of material A and 350 Kg of material B. Solution 1 : Individual prices per kg as variance valuation cases Mix Variance Standard mix of actual use:
Total Proportion Quantity of Total in Product X Product X weight 0.4 600 240 0.6 600 360 600

Material A Material B Total weight

Table 1.19 Planned Standard Mix

Planned Mix Actual Mix Mix Variance (in Kg) Standard Cost (per Kg) Mix Variance Cost Total Mix Variance Cost

Material A Material B 240 360 250 350 -10 10 10 5 -100 50 -50

Table 1.20 Calculating Mix Variance

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The thing to note here is that the total mix variance in quantity is always zero. Here also we can see that the mix variance for material A is -10 kg while that of material B is 10 Kg. The total mix variance hence is zero. Yield Variance
Material A 13 units of Product X should have used Actual Input in standard mix was Yield variance in Kg Standard cost per kg Total yield variance 260 240 20 10 200 Material B 390 360 30 5 Net Yield Variance 150 350

Table 1.21 Calculating Yield Variance The yield variance as shown in Table 1.20 is favorable. This is because the mix of the material A and B which should have been used ideally was more than the actual standard mix used. Hence the savings are due to change in yield of the materials. Solution 2: Planned weighted average price per unit of input as variance valuation base

Therefore planned weighted average price = 350/50 - 7 per kg Mix Variance


Material A 13 units of Product X should have used Actual Input in standard mix was Usage variance in Kg Actual Price per kg Planned weighted price per Kg Difference in prices Mix Variance 260 250 10 10 7 3 30 Material B 390 350 40 5 7 Net Mix -2 Variance -80 -50

Table 1.22 Solution 2 Mix Variance

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Yield Variance
Material A Usage variance in Kg Planned weighted price per Kg Yield Variance 10 7 70 Material B 40 Net Yield 7 Variance 280 350

Table 1.23 Solution 2 Yield Variance

3.5

Reasons for Variances


The researcher observed that there were different reasons for the different variances. Some of the observed reasons are being mentioned below under specific variance heads. The reasons for favorable variances (F) and adverse variances (A) have been mentioned.

Material Price (F) unforeseen discounts received, greater care taken in purchasing, change in material standard (A) price increase, careless purchasing, change in material standard. Material Usage (F) material used of higher quality than standard, more effective use made of material (A) defective material, excessive waste, theft, stricter quality control Labor Rate (F) - use of workers at ray of pay lower than standard, decrease in pay due to large and easy availability of labor (A) wage rate increase, shortage of skilled labor

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Idle Time Machine breakdown, non-availability of material, illness Labor Efficiency (F) output produced more quickly than expected because of work motivation, better quality of equipment or materials (A) lost time in excess of standard allowed, output lower than standard set because of deliberate restriction, lack of training, sub-standard material used. Overhead Expenditure (F) savings in cost incurred, more economical use of services (A) increase in cost of services used, excessive use of services, change in type of services used Overhead Volume (F) production greater than planned (A) production less than planned

3.6

Interdependence between Variances


As discussed earlier, the cause of one adverse variance may be wholly or partly explained by the cause of another adverse/favorable variable. There are different variances which are interdependent and the change in one has a definite effect on the other. The trainee observed that the following variances were found to be interdependent during the course of his study: Material price or material usage and labor efficiency : As the price of the material increases the cost to the company increases and the production has to be in time in order to minimize that cost. Thus with the increase of material price the labor efficiency decreases as the company now

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tries to cut down on the production variables, like time required to produce the product, and hence the labor efficiency which is dependent on the production time suffers. In case of material usage, if there is no proper material usage, like spilling or detoriation is there then the labor efficiency decreases. Labor rate and material usage The increase in labor rate means that the workers are being payed more. The company assumes that the highly paid labor is the one which is more skilled and hence capable of handling the materials used for manufacturing in a better manner. There are some materials for which specific handling techniques need to be known and the highly paid labor is supposed to know them. Thus the increase in labor rate decreases the material usage. Sales price and Sales volume The increase in sales price will have an adverse effect on the sales volume. As the price of the product increases it may get out of reach of the previous set of customers or the customers might shift to an alternative product.

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4. Observations
The trainee has tried to put in his observations at every point of time throughout the report. The following observations and recommendations cover a much broader scope as compared to previous observations which were very specific to the topic under discussion. GSKCH uses performance for the year to date as the basis for comparison, for the period ending on May 31, they would use planned and actual amounts for the 5 months ending on May 31. They also compare the monthly performance, say for May they will also compare the planned and the actual amounts for the month of May. They also compare the months performance with the previous year performance and come out with the latest estimates for the rest of the year. Then the latest estimates are compared with the annual plan and the variances are studied. Comparison between the previous year actuals and current year actual is also done so as to understand the direction of the business over a period of time and the factors which are effecting the organization in the long run. A comparison for the year to date is not as much influenced by the temporary aberrations that may be peculiar to the current month and, therefore, that needs not be of as much concern to the management. On the other hand, it may mask the emergence of an important factor that is not temporary. A comparison of the annual budget with the current expectation of actual performance for the whole year shows how clearly the business unit manager expects to meet the annual profit target. If performance for the year to date is worse than the budget for the year to date, it is possible that the deficit will be overcome in the remaining months. On the other hand, forces that caused actual performance to be below budget for the year to date may be expected to continue for the remainder of the year, which will make the final numbers significantly different from the budgeted amounts. Senior management needs a realistic estimate of the profit for the whole year, both because it my suggest the need to change the dividend policy, to obtain additional cash, or to change levels of discretionary spending, and also because a

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current estimate of the years performance is often provided to financial analysts and other outside parties. The comparison of the current year actual and the latest estimates is done with the standards as well. The standards can be either the predetermined standards or the historical standards. The predetermined standards are set for a period of 2 or more years, 3 years in case of GSKCH. These standards form the basis of the planning process. Historical standards are records of past actual performance. Results for the current month are compared with the results of the previous month. The problem with this comparison is that the conditions might have changed between the two periods in a way that invalidates the comparison. The other major problem is that the prior periods performance might not have been acceptable and hence it should not be treated as a basis for comparison.

5. Conclusion
GlaxoSmithKline Consumer Healthcare Ltd (GSK) produces consumer healthcare and OTC products. Operating Expenditure is a major part of the product costs. In line with Indias growth story, the organization has to be prepared with expected costs to be competitive in the market. Global Manufacturing and Supply (GMS) is dedicated to deal with this cost. Hence Annual Operating Plan is an important exercise to help the organization leverage its assets and capabilities to minimize cost and ensure continuity of supplies.

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Annexure I
1. Standard Costing
1.1 Introduction We know that management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs. Standard Costing is a technique which helps you to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.10 1.2 Meaning of Standard The word standard means a benchmark. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances. In the words of Backer and Jacobsen, Standard cost is the amount the firm thinks a product or an operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.10 The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. 10The predetermined cost is then compared to the actual cost and this gives us a variance which enables the management to take necessary measures.

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1.3 Setting Standards for Direct Materials If a material is purchased to be used for a product, it is known as a direct material. Although, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore, it involves two things: Quality of the material Price of the material When we want to purchase a material, the size and quality should be determined. The standard quality that needs to be maintained should be decided. The production department makes use of historical data and an allowance for changing conditions for setting up standards. The second step will be the determination of standard price. The cost of purchasing and store keeping of materials will be considered. This cost includes the following: Cost of material Ordering cost Carrying cost 1.4 Setting Direct Labor Cost The amount of money we pay in order to engage a labor force for manufacturing a product or for a service is known as wage. If the labor is engaged directly to produce the product, this is known as direct labor.10 Labor Cost is the second largest amount of cost. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages.10 Wages are different for different grades of workers. The time spent by different grades of workers is also considered while deciding the direct labor cost. The standard setting for direct labor cost is done on basis of the following: Standard Labor time for production Labor rate per hour

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For setting a standard labor time previous experience, past performance record, work-study, test run result etc are considered. The labor rate standard refers to the expected wage rates which are to be paid for different worker categories. 10 The anticipation of expected changes in labor rates is an essential factor. If there is an agreement with workers for payment of wages in the coming period, these rates should be used. Where a piece rate system is used, standard cost will be fixed per piece.10 1.5 Setting Standards of Overheads The purpose of setting standards for the overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced.10 Three things are considered while determining overhead rate. These are: Determination of overheads Determination of labor hours or units manufactured Calculating overheads rate by Diving A by B 1.6 Determination of Standard Costs 1.6.1 Determination of Cost Center Cost centersxiii are necessary for determining the costs. If the whole business unit is engaged in manufacturing a product then, then the entire business unit will be considered as a cost center. Cost centers help in determining the costs and fixation of responsibilities.

xiii

A cost center is a department or part of a department or an item of equipment or machinery or a person or a group of persons in respect of which costs are accumulated, and one where control can be exercised.

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1.6.2 Current Standards A current standard is a standard which is used for a short period of time and is related to current condition.10 It acts as a benchmark for the performance that is expected for the current period. Current standards are usually valid for a period of one year. 1.6.3 Ideal Standard Ideal standard represents a high level of efficiency. It is fixed on the basis of assumption that favorable conditions will prevail and management will be at its best. All the conditions, internal as well as external, need to be favorable and only then can ideal standards be achieved. This standard is not at all practicable and may never be achieved but still an effort is made. In practice, this standard has an adverse effect on the employees as they do not try to achieve the standards because they are not considered realistic. 1.6.4 Basic Standards Basic standardxiv is set for a long period of time and is not adjusted to accommodate present conditions. These standards are changes only on the changes in specification of material and technology productions.10 The changes in manufacturing cost can be measured with the help of this standard but it cannot serve as a cost control tool since it is not revised for a very long time.

xiv

A basic standard may be defined as a standard which is established for use for an indefinite period which 10 may be a long period.

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1.6.5 Normal Standards Normal standards xv are based on the conditions that may cover a period of five years. The standard attempts to cover variance in the production from one time to another time. An average is taken from the periods of recession and depression. The normal standard concept is theoretical and cannot be used for cost control purpose.10

xv

Normal Standard can be defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle.

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References
1. Available from: http://www.gsk-ch.in/History.aspx [Accessed 5 April 2011] 2. Available from: http://www.gsk-ch.in/Milestones.aspx [Accessed 5 April 2011] 3. Available from: http://www.gsk-ch.in/Products.aspx [Accessed 5 April 2011] 4. Available from: http://www.gsk-ch.in/downloads/GSK_Annual_Report_2010.pdf [Accesses 5 April 2011] 5. Available from: http://www.namac.org/strategic-planning-what [Accessed 6 April 2011] 6. ANTHONY R N., GOVINDARAJAN V., 2007. Management Control Systems. New Delhi: Tata McGraw Hill Education Private Ltd. 7. Available from :
http://www.352express.com/wpm/files/78/ANNUAL%20OPERATING%20PLAN.pdf

[Accessed 16 March 2011] 8. Berry, T., 2008. Annual Operations Plan for Managing Your Business. Available from: http://articles.bplans.com/growing-a-business/annual-operationsplan-for-managing-your-business/87 [Accessed 16 March 2011] 9. WILLIAM T., 1993. Message and Muscle: An interview with Swatch Titan Nicolas Hayek. Harvard Business Review. March-April. p. 110. 10. BROWN, Dr. G., 2003. INTRODUCTION TO COSTS ACCOUNTING: Methods and Techniques. [online] New York: Globusz Publishing. Available from: http://www.globusz.com/ebooks/Costing/index.htm [Accessed 17 February 2011] 11. Available from: http://www.accountingcoach.com/online-accountingcourse/30Xpg04.html#variable-manufacturing-overhead [Accessed 28 April 2011] 12. Available from: http://www.businessdictionary.com/definition/fixed-productionoverhead-variance.html [Accessed 1 May 2011]

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