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Managerial Accounting and Control Made Easy (MACME) – Prof. K.S.

Ranjani

[MACME]

Session Plan for MAC II

Module 1 COST ACCOUNTING BASICS Session 1 Introduction Reading(s) 1. Basics of Cost Accounting (MACME) 2. Breezy Boat Company(MAC) Session 2 Cost terms, purpose& approach Reading(s) Classification of Cost(MACME) Case Cost classification exercise (IIMA/F&A 377) Session 3 Break Even Analysis Reading(s) Break Even Analysis(MACME) ―Do you know where your "break even" point is?‖ By John H. Nardozzi, CPA ―Using Break-Even Analysis to Determine Your Company‘s Financial Health‖Arthur F. Rothberg, Managing Director, CFO Edge, LLC Case: The Craddock Cup(MAC) Module 2 COSTING SYSTEMS &METHODS Session 4 Absorption Costing Reading(s) Absorption Costing(MACME) Case Class Exercise(MACME) Session 5 Job Costing and Process Costing Reading(s) Job Costing and Process Costing(MACME) Wendy‘s Chili: A costing Conundrum(MAC) Session 6 Activity Based Costing Readings: Activity Based Costing(MACME) Case: Classic Pen Company: Developing an ABC Model (HBS/9-198-117) Session 7 Activity Based Management and use of ABC in service industries Reading(s) ABM (MACME) Activity Based Costing at UPS 2. Activity Based Costing & Capacity (HBS/9-105-059) Case Wilkerson Co (HBS/9-101-092) This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 2 -

[MACME]

Session 8 Cost allocation and Customer Profitability Reading(s) Activity Based Costing(MACME) Case Dakota Office Products(HBS/9-102-021) Module 3 COST ANALYSIS FOR DECISION MAKING Session9 In-sourcing and Outsourcing decision analysis Reading(s) Marginal Costing and Decision Analysis(MACME) Case Fine print Company(A),(B) and (C) Session 10 Product mix decisions with capacity constraints Readings(s) Marginal Costing and Decision Analysis(MACME) Case Moti Heera (P) Ltd (A) & (B) (IIMA/QM0003(A & B)) Session 11 Pricing and cost management Reading(s) Pricing and Cost Management(MACME) Case Mridula Ice Cream Parlour (A) (IIMA/F&A 0315(A)) Session 12 Target costing & life cycle cost management Reading(s) Target costing & life cycle cost management(MACME) 2. Achieving Full Cycle Cost management (SMR 153, Fall 2004) Case Toyota Motor Company: Target Costing (HBS/9-197-031) Module 4 BUDGETING & VARIANCE ANALYSIS Session 13 Standard Costs and Budgets Reading(s) Standard Costs and Budgets(MACME) Case Wilmont Chemical Corporation(MAC) Session 14 Variance Analysis Reading(s) Variance Analysis and Flexible Budget(MACME) 2. Variance Analysis and Flexible Budget (HBS/9-101-039) Case Entertainment now.com(MAC) Session 15 Wrap-up ***

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore

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an administrative office is a cost centre. A cost centre is a part of the company that does not generate any profit for the company. Therefore a cost unit is any unit with respect to which cost can be ascertained. The manager of a cost centre incurs costs and the centre is evaluated on how well they control their costs (Horngren. For example. but could be a combination of two or more functions. Cost Centre Cost centre refers to the point of accumulation of cost. For a tour operator. Definition of Cost CIMA (Chartered Institute of Management Accountants) defines cost as follows: ―the amount of expenditure(actual or notional) incurred on or attributable to a specified thing or activity‖. it can be incurred on an activity. An Engineering or product development function is a cost centre. Unlike what the term sounds like. It can be incurred on hourly basis.[MACME] 1. it could be ascertained per bottle. This material is prepared by Prof. Stratton. 2008).K. in an aircraft. Schatzberg.4 - . Cost Unit Costs need not always be incurred on output units. it has no reference to a physical place.S. BASICS OF COST ACCOUNTING Cost: ―A unit of product or service in relation to which costs are ascertained‖ Meaning of cost:  Cost is the resource foregone in order to receive anything of value. the cost could be calculated for a passenger mile. This is because. for a hotel it could be per guest per night. performing that activity results in costs being incurred. but they add cost to the company. a department etc. For example. it is an activity or set of activities that create costs. cost can be incurred per passenger and in a bottle manufacturing unit.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Composite cost units Sometimes costs need not be incurred on a single output function. and Burgstahler. Sundem.

. Therefore machine hours is a cost driver for equipment maintenance.[MACME] Other examples of cost centre are employees. For example.5 - . Cost Driver Any factor that has the effect of changing the level of total cost is called a cost driver.g.Ranjani for PGP/RAK MAC-II at IIM Indore Page .S. repairs and maintenance of equipment is a cost pool. number of machine hours worked will affect the equipment maintenance cost. Similar activities that can be grouped together usually makes a cost pool. For example. This material is prepared by Prof. Cost pool Costs are assembled into meaningful groups called cost pools (e. Quality control costs and inspection costs can be combined into a single cost pool. by type of cost or source). support functions in an organisation and any other activity where costs can be meaningfully accumulated.K.

 Indirect Material  Indirect Labour  Production overheads  Administration and selling overheads On the basis of behaviour of cost with respect to volume. Classification of Cost Cost can be classified on the basis of nature. Labour costs are those that are incurred in respect to salaries and wages together with related employment costs Overheads or indirect costs: Broadly classified into:  Factory or manufacturing overheads  Office or administrative overheads  Selling and distribution overheads Manufacturing overheads can be further sub divided into indirect material costs. we can classify cost as follows:  Fixed costs are those that remain constant within a level of activity  Variable costs are those that vary as a function of output This material is prepared by Prof. On the basis of nature of cost.6 - . traceability. inventoriability.K. behavior . controllability and marginality.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page . The cost of having them brought into the organization is called carriage inwards. we can classify cost as follows: Material Cost : Cost incurred to obtain material and receive them within the organization. indirect labour and indirect expenses.[MACME] 2.

but could vary due to other factors. cost can be classified as follows: Direct and indirect cost:  Direct costs are those costs that can be related to a unit of output or to a cost object (example.K. Rent could alter because of increase in floor space.Ranjani for PGP/RAK MAC-II at IIM Indore Page .product.. please note that fixed do not vary as a function of output. On the basis of traceability. division.eg rent is a fixed cost.[MACME]  Mixed costs are those costs which vary partly on account of output and partly remain constant  Step costs vary with the cost driver but do so in steps A word of caution : Fixed costs need not be FIXED. rising cost of real estate.S. department etc)  All costs that are not direct costs are called indirect costs On the basis of inventoriability cost can be classified as follows: Inventoriable and Period costs:  Costs that are assets when they are incurred and become expenses as they are consumed are called as inventoriable costs  Period costs are those that are incurred as a function of a period of time On the basis of Controllability cost can be classified as:  Controllable and Uncontrollable costs:  Controllable costs are those that can be controlled at a responsibility centre  Uncontrollable costs are those that are incurred at a responsibility centre. not because we produce more number of units. but cannot be controlled at the level of that responsibility centre This material is prepared by Prof. Hence.7 - .It does not vary as a function of output. but.

[MACME] Marginality  Marginal and Absorption cost:  The additional cost to produce an additional unit is called as marginal cost Marginal costing is formally defined as:  ‗the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution.K.S. whereas. under absorption costing.Ranjani for PGP/RAK MAC-II at IIM Indore Page . stock is valued at marginal cost and a proportion of manufacturing fixed overheads The following is an illustration of how entire costs of a product are factored into a cost sheet: Particulars Direct material Direct labour Direct expenses PRIME COST Production overhead Indirect material Indirect labour Indirect expenses FACTORY COST/PRODUCTION COST Selling Distribution and Administration overhead COST OF GOODS SOLD SELLING PRICE PROFIT Amount Amount 100 50 10 160 10 15 35 60 220 30 250 300 50 Case Cost classification exercise (IIMA/F&A 377) will be part of this session This material is prepared by Prof. Its special value is in decision making‘ Absorption Cost:  The cost that includes all direct costs as well as the absorbed overheads in the cost is called as absorption cost or full cost  The basic difference between the two costs is that under marginal costing the stock is valued at variable cost.8 - .

Definition According to Matz. rent. it is called as break even point-that is. It is expressed as Actual Sales-Break even sales. For example. Fixed costs do not change with the change in the quantity of output.S. the sales that generates just enough contribution to cover the fixed cost. Contribution Margin The revenue net of variable expenses is called as contribution margin. Margin of Safety The sales achieved over and above the Break even Sales is called Margin of Safety. the firm neither makes a profit nor loss.[MACME] 3. insurance. Variable cost: These expenses vary directly with the level of output. Break even Point When the contribution margin covers the fixed cost. total revenue is exactly equal to total cost. At this point. revenue and profit. It implies a no profit no loss zone.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Here.K. research and development etc. Break even Analysis Meaning Break even analysis occupies an important place in economic theory. Curry and Frank‖ A break even analysis indicates at what level of output cost and revenue are in equilibrium‖ Elements of Break even analysis Fixed costs: It is a cost incurred even at zero production. At this point the firm makes neither profit nor loss. Breakeven point is that point at a particular level of output at which total revenue is equal to total cost. labor cost. For example. The contribution margin is available to cover fixed expenses of a business. It analyses the relationship between cost of production. raw materials etc. This material is prepared by Prof.9 - .

S. Calculate breakeven point in sales.K. They incur a fixed cost of Rs. CM ratio = 1000000 – 500000/1000000 = 50% BEP in sales = 80000/ 50% = 160000 Margin of safety = Sales – BEP in sales = 1000000 – 160000 = 840000 Contribution = Sales – Variable cost This material is prepared by Prof.10 per unit. Solution: BEP in sales = FC/ CM ratio CM ratio or the Contribution Margin ratio is calculated as Contribution/Sales and is usually expressed as percentage. and margin of safety and profit. 20 per unit.80000 and variable cost Rs.[MACME] A Break Even Chart is shown below for better understanding: Illustration 1 A German Biscuit Company plans to sell 50000 units at Rs.10 - .Ranjani for PGP/RAK MAC-II at IIM Indore Page .

margin of safety and profit calculation depends upon the number of units.low enough to be competitive. You know how the numbers added up. Having an idea of when your costs will be covered and profits begin can help you make better purchasing decisions.11 - . Nardozzi. guesswork and gut reaction. CPA Nardozzi Consulting. this becomes an exercise in hand wringing.S. without regard to the differences in the two This material is prepared by Prof. oilheat dealers continually struggle with pricing. There is a way to determine your break even point without consulting a crystal ball or palm reader. yet as high as possible to make the maximum profit. you can come up with a total gallons figure.Through a simple analysis of three key factors. By determining how many customers you expect to have this year. Like all retailers. and the average use per customer. you can know what it will take this year for your company to make money. Your state oilheat dealers association can help you with degree day estimates and weather history. fixed cost and variable cost. many oilheat dealers simply copy the next guy up the Yellow Pages list. The breakeven point in sales. The object is to price your product .K. The first factor is the number of gallons you expect to sell this season. Readings DO YOU KNOW WHERE YOUR "BREAK EVEN" POINT IS? by John H. Worse. Too often. LLC Is your business profitable? Most oilheat dealers can answer that question with a fair degree of accuracy-for last year. and whether or not the ink on the books was black or red.[MACME] = 1000000 – 500000 = 500000 Profit = contribution – Fixed cost Profit = 500000 – 80000 = 420000 Explanation: The breakeven point in sales. and is a vital part of the price setting process. The next factor is your margin per gallon. margin of safety and profit will change if there is a change in any of these variables.in this case. But what about this year? Are you making money now? How many gallons will you have to sell this year before you turn a profit? At what price? Knowing your "break even" point is a relatively uncomplicated yet important business planning tool.Ranjani for PGP/RAK MAC-II at IIM Indore Page . a gallon of heating oil . Analyzing your company's past history and factoring in predicted weather patterns will provide a fairly accurate gauge of what you'll be delivering this year.

000 gallons ($1 million ÷ $0. BREAK EVEN MARGIN . Once this level is set. BREAK EVEN GALLONS . We do not include the cost of product (oil) or owner's salary in this analysis.20. At this point you have the information available to establish your break even point for two critical areas: gross margin and minimum gallons.333. etc. But even in its simplest form. USING BREAK-EVEN ANALYSIS TO DETERMINE YOUR COMPANY’S FINANCIAL HEALTH This material is prepared by Prof.Here we are trying to establish the smallest margin you can get away with for all five million gallons you expect to sell.12 - . You have the information on hand to make this analysis. In your analysis. and should take the time to sit down with your financial officer or accountant to locate your own "break even" point. a break even analysis can be a powerful tool to help you plan your season's buying. we factor in degree days and market trends. your overhead/administrative expenses run about $1 million. an examination of your overhead costs (including payroll.Ranjani for PGP/RAK MAC-II at IIM Indore Page . insurance. If you divide your overhead/administrative expenses ($1 million) by your total expected gallons (5 million) you show that your minimum margin per gallon is $0.S. This break even analysis is not complex. Again. you want to know how many gallons you need to sell at your expected margin in order to break even. Let's take a simple set of facts. interest payments. In our analysis we do not include the owner's salary in the overhead expenses.K. you want to determine the minimum margin you need to achieve when you sell the expected gallons so that you will cover costs. taxes. equipment. How would this work in practice? What are you trying to establish? First.) from previous years will provide an indication of what your expected overhead will be for the upcoming season. you establish the minimum number of gallons you need to sell before you show any profit. Your company expects to sell five million gallons. and your gross margin (sale price less the cost of product and delivery) is targeted at 30¢ per gallon. Finally. This tells you that the margin on every gallon after 3. It need not be that way.30). Your break even point comes when total overhead cost is met by total gross margin. In our example.If you divide your overhead expenses ($1 million) by your targeted margin ($0. as we consider company profit and any salary drawn by the owner to be part of the overall benefit of ownership. rent. and in determining a selling price for your product. Our break even analysis can help make this decision more clear cut. this would be 3. Second.333.000 goes directly to the bottom line of the company.[MACME] businesses. you'll know that every penny added to the margin goes directly to the bottom line.30). you might decide to include some part of your salary in the calculation. To be more accurate. The third factor in our break even equation is overhead (administration) costs.

As mentioned. it is necessary to have the capacity to accurately forecast your company‘s costs and sales.K. CFO Edge.13 - .Ranjani for PGP/RAK MAC-II at IIM Indore Page . These variations are all dependent on a number of cost factors. The result will then be dependent on fixed costs. Rothberg. This material is prepared by Prof. the margin of safety indicates specifically the amount of sales dollars above or below the break-even point. this number makes it possible for the company to determine the exact amount of money it may have gained or lost during the period in question.Variable Costs). labor should also be considered as a fixed cost. and per-unit revenue as allocated across the whole business. In-place labor will usually not vary with moderate changes in volume. which should be determined before attempting any kind of break-even analysis. no matter the amount of product sold. However. The Margin of Safety The margin of safety is a notable outcome of break-even analysis as it is indicative of the strength of the business. there are several types of costs that must be considered when conducting breakeven analysis. break-even analysis becomes a matter of simple math: Break-Even Point = Fixed Costs / (Unit Selling Price . In essence. Among these. For any level of sales. they will fluctuate depending on the volume of the business. Break-even analysis determines both the minimum amount of sales required to avoid a loss or to ―break-even‖ at the end of the fiscal year and permits you to adjust sales estimates accordingly. First and foremost. However. variable costs will also increase. The other main category of cost to be considered while conducting break-even analysis is variable costs. the most relevant are fixed costs. then the margin of safety is considered negative. which are those expenses that are the same regardless of the number of items sold. LLC Determining the break-even point is crucial to determining margins. The most common variable costs are those pertaining to raw materials necessary for manufacturing products. When sales are above the break-even point. The cost of maintaining corporate property would be the same. Fixed costs also generally would remain the same. As the business and sales grow. These are expenses that are based on the number of units processed. which. average per-unit variable costs. Cost Components of Break-Even Analysis Break-even analysis is primarily dependent on a few key factors. since replacing a skilled labor force is extremely difficult to do. While there are a number of different variations on break-even analysis. they are all useful in determining the lower limits of profits for calculating margins.[MACME] Arthur F. Managing Director. As such. in turn. typically indicating overall gains. aid in financial planning for the next year. even if the company discontinued all sales. when sales are below the break-even point. then the margin of safety is positive. which indicates an overall loss for the period.S. With these numbers. The most common fixed costs are rent and insurance.

which still covers all variable costs. Typically a company‘s optimal output lies where the contribution margin exceeds variable marginal cost.htm What is Process Analysis. However.ucf. Only when the contribution margin is positive will any losses imbued through the acceptance of a lower offer be compensated through increases in the volume of sales.Ranjani for PGP/RAK MAC-II at IIM Indore Page . _ Variable costs are also important to consider during break-even analysis. They must be factored in when determining overall gains or losses. Management Accounting: Concepts. meaning that the revenue from selling a product exceeds the variable cost of production. References and Further Reading Chapter 11: Conventional Linear Cost Volume Profit Analysis. The break-even process is invaluable in assessing the financial health of your company.info/Chapter11.[MACME] Contribution Margin Analysis When conducting a break-even analysis. whereas in gross profit analysis all costs of sales are considered. especially when volume considerations are taken into account.S. University of Central Florida http://oeas. as only variable costs are taken into account. Contribution margin differs from gross profit. Such a price. may yet be considered profitable since it will help to absorb any fixed costs. as it allows setting lower than normal price. Techniques. A professional services firm of this nature can lend their expertise to your financial analysis and provide an objective report for your use.14 - .K. & Controversial Issues http://maaw. Business Know-How.com/startup/break-even. _ The margin of safety is a useful tool in the analysis process as it supports assessment of longterm investments.edu/process_analysis/what_is_pa. 2003 http://www. which is defined as revenue less variable costs. such as primarily raw materials. In Summary Break-even analysis is an exceptionally useful tool for assessing the state of the company‘s finances. Martin. Los Angeles CEOs and CFOs who feel that they do not have the internal expertise or bandwidth to conduct a breakeven analysis can benefit significantly from consulting with an outsourced CFO services firm.htm Case: The Craddock Cup(MAC) This material is prepared by Prof. in order to successfully conduct break-even analysis. James R. it is helpful to keep in mind the concept of Contribution Margin.businessknowhow. if a lower price than normal is offered. However. that offer ought to be considered so long as the price still exceeds variable costs.htm#The%20Margin%20of%20Safety Break-Even Analysis. Tim Berry. These are expenses that will fluctuate in accordance with company sales figures. there are a few figures that must first be ascertained: _ Fixed costs are those expenses that remain the same regardless of company success. all other factors being equal. _ Contribution margin analysis is an indispensable part of price setting.

S. absorption costing is also referred to as full costing or the full absorption method. This includes fixed production overheads which have been absorbed into cost.[MACME] Section 2. Fixed costs are treated as period costs and are written off in full against the contribution earned in that period. Illustration .\ Difference between Absorption and Marginal Costing When absorption costing is used all stock items are valued at their full production cost. As a result. Absorption costing uses the total direct costs and overhead costs associated with manufacturing a product as the cost base. Absorption Cost Other information are as follows: Unit manufacturing cost Direct material Rs.Costing Systems and Methods 4. In other words. The current production level is 25000 unit.K. Calculate value of closing stock using a. Generally accepted accounting principles (GAAP) require absorption costing for external reporting. and both variable and fixed manufacturing overhead.ABC Company sells its products for Rs 66 each.12 Page .15 - This material is prepared by Prof. Marginal Cost b. ABSORPTION COSTING Meaning Absorption costing means that all of the manufacturing costs are absorbed by the units produced. although only 20000 units are sold. marginal cost values all stock items at their variable or marginal costs only. the cost of a finished unit in inventory will include direct materials. direct labor.Ranjani for PGP/RAK MAC-II at IIM Indore . Definition A managerial accounting cost method of expensing all costs associated with manufacturing a particular product. In contrast.

Solution Value of closing stock using absorption cost: Absorption cost uses all variable costs and the proportion of fixed expenses relating to production.9 Rs.9 Rs.000/Note: Marketing overheads are treated a speriod costs and are consequently written off in the same year under both the methods.6 Fixed manufacturing overheads are Rs.18 Rs.000/.12 Rs.Ranjani for PGP/RAK MAC-II at IIM Indore Page .175.[MACME] Direct labour Variable manufacturing overhead Variable marketing overhead Rs.for the period.000/Value of closing stock using marginal cost: Calculation of cost per unit Direct material Direct labour Variable manufacturing overhead Cost per unit Rs. So cost per unit will be calculated as follows: Direct material Direct labour Variable manufacturing overhead Proportion of fixed overhead absorbed will be =175.K.18 Rs.000/25000 Cost per unit Rs.230.S.7 Rs.46 Value of closing stock= 46*5000=Rs.60.16 - . Role of Absorption Costing in Pricing Decisions This material is prepared by Prof.39/- Value of closing stock=39*5000=195.and fixed marketing overheads are Rs.9 Rs.000/.18 Rs.12 Rs.

[MACME]

Absorption costing allows companies to clearly and completely show information about their financial condition. It also allows companies to price more accurately, ensuring that the final price of a product or service takes into account the actual costs that went into them. This is particularly useful for small businesses which need to give more consideration to overhead expenses. Absorption costing is taken in opposition to variable costing. Under variable costing, which may also be referred to as direct costing, only variable expenses are included in the computation. Therefore, fixed manufacturing costs are not included in the computation. Since variable costing focuses more on expenses which can be modified or adjusted, it helps management plan and make decisions on how expenses can be minimized. Data taken from absorption costing shows the entire picture, together with fixed costs, so does not conveniently provide this information. On the other hand, since variable costing only shows part of the picture, it may not be taken by investors as reliable information. Also, since fixed costs are included in the computation of absorption costing, it might be more beneficial to use this information when sales change, since the figures won‘t fluctuate too much. Due to the huge differences between the two costing methods, it is important to specify which method is being used. One way in which absorption costing can be helpful is when a company wants to make sure that a retail price accurately reflects the costs involved in the production of a good. This can be especially critical with small companies which lack financial reserves, and therefore cannot afford to take a loss or to sell products without accounting for overhead. For example, a garment manufacturer might think not just about the cost of wool and labor for making a sweater, but also the costs of knitting machines, the factory where the machines are installed, the cost of running the machines, insurance, and other types of overhead costs.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore

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[MACME]

5. JOB AND PROCESS COSTING

Specific order costing:  The choice of method of costing to be used by an organization depends upon the nature of activity undertaken by the organization  Specific order costing methods are appropriate for organizations which produce cost units which are separately identifiable from one another  Job costing , batch costing and contract costing are all types of specific order costing

We would, in the following section, cover job costing in detail.

Job Order Costing Job Costing is method of costing in which we calculate the cost of each job. Job here means a small work or group of small activities which we can identify in any product‘s production.

 A job order costing system is used when a job or batch is significantly different from other jobs or batches .Cost accounting is usually fairly simple in these systems. Labour and materials are entered on a job ticket  Overhead is usually added to the amount the customer will be charged for labour and materials  Job costing involves keeping an account of direct and indirect costs. Overhead is added to the price customers will be charged for labor and material. Such method is used in construction, motion picture, and shipping industries, in fabrication, repair, and maintenance works, and in services such as auditing etc.

If you go to an auto repair shop, they will start a job ticket just for the work to be done on your car Your job ticket will show charges for labour and materials, just for your job. Let's say they charge you Rs.350 per hour for labour. This charge includes the mechanic's payroll cost. This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 18 -

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But it also includes an overhead charge - which is generally not stated separately .The overhead charge covers the costs of operating the garage - tools and equipment, rent, insurance, maintenance, utilities, etc. It is a way to allocate overhead (discussed below), and build it in to the amount charged to customers The garage will also make a gross profit on the parts they use to repair your car. This gross profit covers the cost of buying and maintaining a parts inventory, including department employee wages, insurance and warehousing costs Allocating overheads

Let's look at a typical product -Before production starts, no costs have been incurred. Workers stand ready to make the product, inventory waits patiently in the warehouse and the manufacturing plant contains all the resources necessary to perform the manufacturing operation. We first add materials into production, from the inventory. At the same time the accounting department transfers the cost of inventory items to the ‗Work in Process‘ account, and the product or job now has a value. Next the workers start to convert the raw inventory into a product. As labour is added, the accounting department transfers payroll costs to the Work in Process account, increasing the value of the product or job. Overhead costs are allocated to the product or job, based on the costing method used. As work progresses on the product or job, it accumulates labour, materials and overhead costs. Finally, the total finished product or job cost is transferred to Finished Goods, and when it is sold the cost is transferred to Cost of Goods Sold

Accounting for Overhead Costs Overhead is allocated to products or jobs using a reasonable allocation method. We try to find some part of the manufacturing process that is regular and predictable, which is called as cost driver  Labour hours used is the most popular allocation method. The number of labour hours in a year is fairly predictable. Differences in employees pay rates are not relevant when using hours. The information is readily available from existing payroll records. There is usually a direct correlation between labour and the production process This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 19 -

with large work forces operating under labour contracts The labour costs are fairly predictable. product development cost for a new product can be allocated to that product. since the cost has been incurred for the joint benefit of several cost centres. It is used by very large companies.[MACME]  Labour cost is the second most popular allocation method. Simple Overhead Allocation The simplest form of overhead allocation is to treat all annual overhead as a single cost pool. Service departments are widely used in hospital accounting. These departments provide services to other departments.K.Ranjani for PGP/RAK MAC-II at IIM Indore . labour costs tends to be a very stable and predictable measure of the progress of production Other overhead (simpler) methods include:     number of units produced machine hours use (jet engines. trucking) Some companies use a sophisticated method involving service departments such as maintenance and computer processing. a reasonable estimation of the benefits received by each of the cost centre is made and cost is apportioned accordingly.S. cooling & janitorial costs) miles (taxis. Cost Apportionment: When it is not possible to allocate a cost to a particular cost centre. Because of the large number of employees. Cost Absorption: The last stage of distribution of costs where overheads are absorbed into the production units of a cost centre Page . and are closely linked to production.20 -   This material is prepared by Prof. and allocate it to one annual cost driver Some terminology that would be useful in the discussion of distribution of overheads are discussed as follows:  Cost allocation: Allocation is the process of identifying and attributing a cost to a specific cost centre-eg. diesel locomotives). square footage of floor space (heating.

K. Illustration 1 Assume Johnson's Bakery produces 2.000 -----------------------2.000 loaves = 30 paise per loaf In addition to direct costs (labour & materials). Johnson charges all lease costs to the Overhead account All other overhead costs will stay the same How will the new oven lease change Johnson's overhead costs? 60.000. to replace an old oven.Ranjani for PGP/RAK MAC-II at IIM Indore Page .S. Direct costs per loaf will not change.000 loaves of bread per year.000 in annual overhead cost.000 per year.[MACME] We determine the predetermined overhead absorption rate as the budgeted overheads divided by the budgeted cost driver.21 - . Johnson will allocate 30 paise per loaf to overhead costs Decision making using overhead costs Illustration 2 Assume Johnson's Bakery must lease a new oven for Rs20.000. and incurs Rs60. How much overhead cost must Johnson allocate to each loaf of bread? Total Annual Overhead -----------------------Units of Cost Driver = cost per unit of cost driver Rs60.000.000 -----------------------2.000 loaves = 40 paise per loaf This material is prepared by Prof.000 + 20.

based on the number of hours worked on each job How much will Sonia allocate per labour hour? 120. or why they are important for a business Overhead costs are generally "built in" to other costs.000 -----------------------12. but the company must charge the customer for these costs in some way Under/Over Absorption of overheads We discussed in the preceding sections that direct expenses are fairly easy to trace. However. 1. a lot of approximation is used in predicting and subsequently distributing over heads to a job.[MACME] Johnson's overhead cost per loaf will increase 10 paise. or similar types of businesses Overhead costs are generally "hidden" from customers in this way.000 hours = Rs10/. for a total of 12.22 - . The job takes 200 hours How much overhead cost will Sonia allocate to this job? Overhead per labour hour X labour hours on job = overhead allocated to job 10 x 200 = Rs. Sonia Auto parts will add the overhead cost to it's regular labour rate . this is an easy method for a garage.000 hours that will be billed to jobs They incur Rs120.K.S. from 30 to 40 paise Illustration 3 Sonia Auto parts has 8 mechanics working full time.500 hours per year each.per labour hour for overhead Illustration 4 Example of Overhead Allocation to a Job Sonia Auto parts works on the delivery truck belonging to Johnson's Bakery.2000 Sonia Auto parts will allocate Rs2000 in overhead costs to the repair job Why don't you see Overhead costs listed separately on repair tickets? Customers usually don't understand what overhead costs are. While overheads are predicted(this predicted overheads is called the budgeted overheads) and This material is prepared by Prof.Ranjani for PGP/RAK MAC-II at IIM Indore Page .Since overhead is allocated by labour hour.000 per year in overhead costs Sonia allocates overhead costs to car repair jobs.overhead per labour hour Sonia Auto parts will allocate Rs10/.

The following are the details of jobs during the period October 2010 to March 2011.Calculate under/over absorbed overheads.S. At the end of the accounting period.23 - .[MACME] allocated to jobs. the total overheads incurred by Sonia totals Rs.30. Illustration 5 In the example discussed above.K. there is an under absorption of overheads by Rs.2000/Illustration 6 X ltd follows job order costing.32. Solution Budgeted overheads= Budgeted labour hours*over head allocation rate =3000*10=Rs. This material is prepared by Prof.000/-(given) Since the budgeted overheads (this is also referred to as absorbed overheads in some texts) is less than the actual overheads.Ranjani for PGP/RAK MAC-II at IIM Indore Page . there is over absorption of overheads. the actual overheads incurred at the end of an accounting period may be more or less than the budgeted overheads. then there is an under absorption of overheads and when budgeted overheads is more than the actual overheads. When the budgeted overheads is less than the actual overheads. suppose Sonia Auto parts works a budgeted 3000 labour hours across several jobs including that of Johnson‘s Bakery.32. Particulars Job 101 Job 102 Job 103 Job 104 Job 105 Opening WIP 240000 90000 ------------------------------Material 400000 300000 500000 220000 240000 Labor 160000 400000 300000 240000 260000 Production Overheads charged to job is 50% of labor cost and administration overhead charged to jobs is 50% of material.000/Actual overheads=Rs.000/.

33% profit on Cost.500000/- This material is prepared by Prof. During March. Solution (1) Cost of completed jobs. Selling price is determined after marking up 33.S. Particulars Opening WIP Material Labor Production Overheads Closing WIP 103 0 500000 300000 150000 950000 104 0 220000 240000 120000 580000 (3) Under absorption/Over absorption of production overheads assuming that actual overheads incurred during the period is Rs.[MACME] Administration overheads are charged after completion of job.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Job no 103 and 104 were still in process. Job 101.24 - . (2) Value of closing work in process. 102 and 105 were complete.K. Calculate the following: (1) Cost of completed jobs.500000/(4) Selling price of Job 101.102 and 105. (3) Under absorption/Over absorption of production overheads assuming that actual overheads incurred during the period is Rs. Particulars Opening WIP Material Labor Production Overheads Works Cost Administration Overheads Total Cost 101 240000 400000 160000 80000 880000 102 90000 300000 400000 200000 990000 105 0 240000 260000 130000 630000 200000 150000 120000 1080000 1140000 750000 (2) Value of closing work in process.

[MACME] Budgeted Overhead:80000+200000+130000+150000+120000=680000 Actual Overhead:-500000. it is most efficient to accumulate costs at an aggregate level for a large batch of products.METHOD AND TECHNIQUES Process costing is a costing methodology that arrives at an individual product cost through the calculation of average costs for large quantities of identical products. if "Absorption Costing" is adopted as the technique  Only variable costs will be considered. Total Cost Profit SP 1080000 1140000 750000 359964 379962 249975 1439964 1519962 999975 PROCESS COSTING . For example. Over Absorption:680000-500000=180000.102 and 105. Process Costing may be adopted using any of the techniques of costing.K. for the purpose of valuation of stocks:  Fixed costs will be considered along with Variable costs.Ranjani for PGP/RAK MAC-II at IIM Indore Page . and then allocate them to the individual units produced. if "marginal costing" is adopted as the technique This material is prepared by Prof. The technique adopted would decide the procedure adopted in relation to various accounting aspects. A process costing system is used when a business is producing a large number of identical products. (4) Selling price of Job 101.25 - . In this situation.S.

K.Ranjani for PGP/RAK MAC-II at IIM Indore Page .S.26 - .[MACME] Example of an area where Process Costing is applied A common example of an industry where process costing may be applied is "Sugar Manufacturing Industry‖ The processes in this industry are: Cane Shredding The cane is broken/ cut into small pieces to enable easier movement through the milling machine Milling The shredded cane is passed through rollers which crush them to extract cane juice [Similar to the cane juice extracted by the vendors who sell you sugar cane juice] Heating and Adding lime The extracted juice is then heated to make it a concentrate and lime is added to the heated juice Clarification Muddy substance is removed from the concentrate through this process Evaporation Water is removed from the juice by evaporation This material is prepared by Prof.

K.Ranjani for PGP/RAK MAC-II at IIM Indore . The costs were as follows: Particulars Material Labor Process A 3000 1500 Process B 1500 3000 Process C 1500 5250 Page . C and the raw material were added in all the processes. Three processes.. B.[MACME] Crystallisation and Separation Sugar crystals are grown from the dry juice concentrate in this process Spinning Molasses are separated from sugar using Centrifugals in this process Drying Sugar is obtained by drying the wet raw sugar obtained in the spinning process The following features may be identified with process costing:    The output consists of products which are homogenous Production is carried on in different stages (each of which is called a process) having a continuous flow Production takes place continuously except in cases where the plant and machinery are shut down for maintenance etc Output is uniform and all units are identical during each process It would not be possible to trace the identity of any particular lot of output to any lot of input The input will pass through two or more processes before it takes the shape of the output The output of each process becomes the input for the next process until the final product is obtained.27 - This material is prepared by Prof. with the last process giving the final product The output of a process (except the last) may also be saleable in which case the process may generate some profit The input of a process (except the first) may be capable of being acquired from the outside sources The output of a process is transferred to the next process generally at cost to the process It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions Normal and abnormal losses may arise in the processes      Illustration 7 In a factory. A.S. viz. process cost accounts are in use for a certain period the production of the commodity was 1000 tones.

there is a good chance that you used Bounty paper towels to clean up the mess.28 - . wood pulp is converted into paper and then spooled into 2. Procter & Gamble (P&G) manufactures Bounty in two main processing departments—Paper making and Paper Converting. Show the process costs for each cost of the finished product.K. In the Paper Converting This material is prepared by Prof. The production is 1000 tones at the end of process.Ranjani for PGP/RAK MAC-II at IIM Indore Page .000 pound rolls. In the Paper Making Department.[MACME] Mfg Expenses 1500 4500 5250 Assume that there was no work in process either at the beginning or at the end.S. Process A A/c Particulars To material To Labor To Mfg Expenses Total Process B A/C Particulars To material To Labor To Mfg Expenses Total Process C A/C Particulars To material To Labor To Mfg Expenses Total Amt 3000 1500 1500 6000 Particulars By transferred out Amt 6000 Total 6000 Amt 1500 3000 4500 9000 Particulars By transferred out Amt 9000 Total 9000 Amt 1500 5250 5250 12000 Particulars By COGS Amt 12000 Total 12000 How Process Cost is Applied in Business If you have ever spilled milk.

Liquid Petroleum Gas. Bones. the output products are termed as joint products. P&G uses a similar costing approach for many of its products such as Tide. 3.000 pound rolls of paper.000 pound rolls of paper are simultaneously unwound into a machine that creates a two-ply paper towel that is decorated. Oil refining: Petrol. Paraffin. Hides. For example. Mining: Iron. In this type of manufacturing environment.000 pound rolls that are transferred in from the Paper Making Department) can be spread uniformly across the number of cases of Bounty produced. so it is termed as by-product.29 - . Those which have insignificant value are termed as by-product. Similarly. 4. CIMA(Chartered Institute of Management Accountants) defines joint product as ‗two or more product separated in processing each having a sufficiently high sale value to merit recognition as a main product‖ and by product as ―output of some value produce incidentally in manufacturing something else (main product)‖. Hides. the total costs incurred in the Paper Converting Department (including the cost of the 2. Wool.products are as follows: 1. The large sheets of paper towels that emerge from this process are wrapped around a cylindrical cardboard core measuring eight feet in length. we get petrol and diesel which has high significant value and therefore known as joint products. Crest toothpaste. and shipped.Ranjani for PGP/RAK MAC-II at IIM Indore Page . the total costs incurred in the Paper Making Department can be spread uniformly across its output of 2. Kerosene. the eight foot roll is cut into individual rolls of Bounty that are sent down a conveyor to be wrapped. two of the 2. and embossed to create texture. At the same time we also get some lubricant which is unwanted.S. given the homogeneous nature of the product. packed.K. Grease. 3. Once enough sheets wrap around the core. Some examples of By. copper. costs cannot be readily traced to individual rolls of Bounty. perforated. Sheep Rearing: Meat. Silver. however. 2. and Pringles Joint products and By-products When a production process yields two or more products simultaneously out of common raw material. Some examples of Joints products are as follows: 1. The joint products which arise out of common raw material may have wanted or unwanted value. Diesel. By. 4.[MACME] Department. from crude oil. 2. Grease Coke industry : Linoleum This material is prepared by Prof.products are secondary products. Lubricants Meat Processing: Meat. Sugar manufacture: Molasses used for industrial alcohol Iron and Steel manufacture: Furnace slag used in construction activities Meat trade: Bones.

Separable costs: These costs can be identified with a particular joint product. after the split-off point.Joint product is defined as a costing of a production process that yields multiple products simultaneously. Common costs: These costs cannot be identified with a particular joint product.S. For example some companies may classify kerosene obtained when refining crude oil as a byproduct because they believe kerosene has a low total sales value relative to the total sales values of gasoline and other products. the joint products acquire separate identities.Distinction among main products. By-products costing. At or beyond the split off point. This material is prepared by Prof.[MACME] Joint product costing. Costs incurred prior to this point are common costs.000. costing of products in the joint production process with low sales value.products Y & Z from the following data: Costs of manufacturer before separation: 25. By definition. The characteristic feature of joint products is that all costs incurred prior to the split-off point are common costs. decisions relating to the sale or further processing of each identifiable product can be made independently of decisions about the other products. 60. and cannot be identified with individual products that are derived at splitoff. Other companies may consider the vice versa. Main product is X. Illustration 8 Work out the estimated pre separation cost per ton of by . The costing is done at the time of production or at the time of sales.By product costing is defined as. There are two by-products Y & Z whose normal selling price is as follows: Sales price of Y: 500 per ton Sales price of Z: 800 per ton Selling and distribution expenses have been estimated to be 25% of SP and the net profit is expected to be 10% of SP. Split-off point: At this stage.Ranjani for PGP/RAK MAC-II at IIM Indore Page . joint products incur common costs until they reach the split-off point. joint products and byproducts are not so definite in practice.30 - . and any costs incurred after this point are separable costs.K. These costs are incurred for a specific product. Moreover the classification of products can change over time depending on the price of the product in that year.

4 for Q unit before sale. Assuming a net margin of 25% on cost.8.75 per unit respectively.000 units. Assume equal weight for Y and Z Solution: Particulars Selling Price Less: Selling and Distribution Exps (25% of SP) Product Y 500 125 375 Less: Net profit(10% of SP) 50 325 Less: Post separation cost Pre Separation Cost 95 230 800 200 600 80 520 145 375 Product Z Illustration 9 Two products P & Q are obtained in a crude form and require further processing at a cost of Rs.75 and Rs. During the process.5 for P and Rs. their sales are fixed @ Rs.K.000 and the outputs were: P.Ranjani for PGP/RAK MAC-II at IIM Indore Page .8. 88.000 units.[MACME] Costs to manufacture each ton after separation from the main product are : 95 (Y) and 145 (Z).13. joint cost incurred was Rs. Q-6. Ascertain the joint cost per unit Product Q Output(units) 6000 Product P 8000 This material is prepared by Prof.31 - .S.

00 64.75 7.Ranjani for PGP/RAK MAC-II at IIM Indore Page .000 units * 6 = 48.000 Q = 6.75 2. ie.[MACME] Selling Price Less: Profit(25% on cost.75 1.00 5.000 units * 3 = 18.00 6.75 11.000 = 8:3 Case: Wendy‘s Chili: A costing Conundrum(MAC) This material is prepared by Prof.00 3.K.32 - .S.000 4.000 8. 48.00 8.000 Therefore.00 4.00 *Ratio in Apportioning Joint Costs: P = 8.000:18.20% on SP) Cost of Sales Less:Further processing cost after separation Pre Separation Cost Share of Joint Cost(8:3)* Joint Cost per unit 13.00 84.

Activity Based Costing   Activity Based Costing (ABC) is a system that Assigns Overhead cost to the activities performed in a manufacturing or Services delivery process. – Ronald W. It also helps to identify non-value added activities and motivates cost reduction. there are six basic steps required to implement an ABC system:  Identify and define activities and activity pools  Directly trace costs to activities (to the extent feasible)  Assign costs to activity cost pools  Calculate activity rates  Assign costs to cost objects using the activity rates and activity measures previously determined  Prepare and distribute management reports This analysis of overhead costs into activities and their absorption using a variety of cost drivers is believed to produce more accurate results in allocating overheads to product cost.Hilton. An ABC approach attempts to ensure that overheads are traced to products in a way that more accurately reflects the overhead costs that have been incurred on their behalf. Michael W.Ranjani for PGP/RAK MAC-II at IIM Indore Page .33 - . In a modern manufacturing environment. a combination of two bases of cost.Eldenburg (2005) ABC is a costing that first assigns cost to activities and then to goods and services based on how much each goods and service uses the activity. According to Ray H Garrison and Eric W Noreen.K. Overhead costs are not always directly relatable to time or production volume. Activity based costing focuses on activities and costs are allocated to activities using resource drivers. Resource drivers show the cause of costs and are used to allocate costs to activities. –Leslie G. It increases awareness of cause and effect relationships and promotes performance improvement. This material is prepared by Prof. Cost is allocated depending on how much of the resource driver is used in the activity.S.[MACME] 6.Maher and Frank H Selto (2006) We have already seen in the foregoing discussions in Job and Process Costing that traditional costing methods use a single base(Labour hours that we had seen in the job costing example) or at most. However. Activity based Costing is based on the principle that a single absorption base cannot justifiably reflect the behaviour of overhead costs. overheads are more dependent on the complexity of the production.

we will identify the activities performed by the company and assigning cost to each activity then choosing the cost driver for calculating the allocation rate.Illustration 1 XYZ Company is considering Activity based costing to allocate Overheads. Now.Ranjani for PGP/RAK MAC-II at IIM Indore Page .e. Setup Cost: Total Cost /Total No. Compute the manufacturing cost for each product. Machine Maintenance: = Rs 2000 per setup Total Machine Maintenance cost/ Total Machine Hour = 90000 / 5000 hrs = Rs 18 per hour This material is prepared by Prof. In above case company performs two activities i. After calculating the allocation rate we can allocate the coat to product.[MACME] .S. we will calculate Allocation rate for each activity 1.of Setups = 2. Following information is given for the production of two products A and B.000 100 2.K. Setup and maintenance of machine. 00. Solution First.34 - . Activity Set-up Machine maintenance Total Manufacturing Cost Cost 200000 90000 290000 Product Number of setups Machine Hours A 40 1500 B 60 3500 Total 100 5000 XYZ Company plans to produce 350 units of product A and 250 units of product B.

000 Setup Product B 60*2000 = 1.35 - .732/- Case: Classic Pen Company: Developing an ABC Model (HBS/9-198-117) This material is prepared by Prof. next step is to allocation of cost to each product. Following table shows the allocation of cost.[MACME] Since.K. we have calculated the Allocation Rate.of Setup *cost per 40*2000 = 80.20.S. Activity Setup Product A No.000 Machine Maintenance Machine Hour*Cost per 1500*18 = 27000 Hour 3500*18 =63000 Total Cost Number of units Unit cost Rs 107000 300 Rs.306/- Rs 183000 250 Rs.Ranjani for PGP/RAK MAC-II at IIM Indore Page .

No longer is ABM‘s applicability limited to manufacturing organisations. and the application of ABC evolved from a manufacturing product costing orientation to a management philosophy of activity management applied in industries and organisations other than manufacturing. ABM draws on ABC to provide management reporting and decision making.[MACME] 7. and This material is prepared by Prof. The real value and power of ABM comes from the knowledge and information that leads to better decisions and the leverage it provides to measure improvement. Activity-based costing and activity-based management have been around for more than fifteen years.  product mix.Ranjani for PGP/RAK MAC-II at IIM Indore Page . The acronym itself has evolved from ABC to ABCM (activity-based cost management) to ABM. It allows product designers to understand the impact of different designs on cost and flexibility and then to modify their designs accordingly.mABM enables management to make informed decisions on the following:  Lines of business. ABM has grown largely out of the work of the Texasbased Consortium for Advanced Manufacturing-International (CAM-I). People undertake activities which consume resources – so controlling activities allows you to control costs at their source. Most forward-thinking companies have implemented them. Activity Based Management Activity-based management and activity-based costing (ABM/ABC) have brought about radical change in cost management systems. ABM is a fundamental shift in emphasis from traditional costing and performance measurement. government agencies and process industries.K.36 - . or are in the process of doing so. ABM also supports the quest for continuous improvement by allowing management to gain new insights into activity performance by focusing attention on the sources of demand for activities and by permitting management to create behavioural incentives to improve one or more aspects of the business.  what services should be offered.  process and product design.  capital investments. ABM supports business excellence by providing information to facilitate long-term strategic decisions about such things as product mix and sourcing. The principles and philosophies of activitybased thinking apply equally to service companies.S.

Ranjani for PGP/RAK MAC-II at IIM Indore Page .The process of ABM does consume resources. ABM gives us a much better chance of establishing a useful costing for outputs. And. Some areas of activity overlap and are difficult to separate. Companies considering or already implementing ABM should realise that although certain product or market factors might make it potentially beneficial. But there is a price to pay. — regulatory issues. IT capabilities. Reading: Activity Based Costing and Capacity By Robert. Among the most commonly cited are: — top-down pressure to reduce costs. It can be difficult to find out what costs apply in a particular activity. — competitive pressure/market conditions. It is not a single answer but merely one of the many tools that can be used to enhance organisational performance management.K. — the introduction of benchmarking. — seeking world-class status through process management. ABM is more than an accounting tool. and those involved may be suspicious of others charged with finding out.[MACME]  pricing. — organisation-wide programme. ABM is the application of ABC data to manage product portfolios and business processes better. it will only help you understand costs better to know what to correct. it's a system for continuous improvements. and the manpower costs can be significant.S. ABM is a costly exercise in its own right. of course. top management commitment.S.Kaplan Case Wilkerson Co (HBS/9-101-092) This material is prepared by Prof. and integration with financial and budgeting systems should be considered before implementation. Organisations have begun to look at ABM for a variety of reasons. those same factors might not lead to a successful implementation. ABC and ABM are a continuum of value.37 - . Other priorities. ABM will not reduce costs.

and a reasonable possibility of accessing it Contribution: Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted.K.pre existence of an opportunity. and profit it is a vital tool in many business decisions. Prices of products Volume or level of activity Per unit variable cost Total fixed cost Mix of product sold Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost. what marketing strategy to employ. what pricing policy to follow. This material is prepared by Prof. 2. Objectives of CVP Analysis: Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. These decisions include. what products to manufacture or sell. volume. 4.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Thus it is the amount available to cover fixed expenses and then to provide profits for the period. for example. and what type of productive facilities to acquire. 5. and profit in an organisation by focusing on interactions among the following five elements: 1. It helps them understand the interrelationship between cost. volume. Contribution margin ratio can be used in cost-volume profit calculations. 3. MARGINAL COSTING AND DECISION ANALYSIS Some important definitions: Relevant cost: Cost that can be avoided if a decision is not implemented is called relevant cost Sunk Cost: Costs that cannot be reversed or do not alter irrespective of any future decision Opportunity cost: Cost of the opportunity foregone in order to select a decision option This presupposes two important factors.38 - .[MACME] 8. Contribution Margin Ratio (CM Ratio): The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio).

S. sales price and sales volume Change in variable cost. Break even analysis is designed to answer questions such as "How far sales could drop before the company begins to lose money. and sales volume effect contribution margin and profitability of companies in a variety of situations. selling price. fixed investment in automated equipment can reduce variable labor costs." Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure: Cost structure refers to the relative proportion of fixed and variable costs in an organization.[MACME] Applications of Cost Volume Profit (CVP) Concepts: Now we can explain how CVP concepts developed on above pages can be used in planning and decision making. We shall use these concepts to show how changes in variable costs. The purpose of management is to reduce the cost by choosing a blend of fixed and variable cost that maximizes the ultimate objective i.39 - . fixed costs. fixed cost. fixed costs.K.e.. Cost volume profit analysis is some time referred to simply as break even analysis. profit.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Break Even Analysis: Break even is the level of sales at which the profit is zero.      Change in fixed cost and sales volume Change in variable cost and sales volume Change in fixed cost. and sales volume. and sales volume Change in regular sales price Importance of Contribution Margin: CVP analysis can be used to help find the most profitable combination of variable costs. An organization often has some latitude in trading off between these two types of costs. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount. sales price. For example. Some illustrations on CVP analysis: Make or Buy: Illustration 1 Suppose Division A in Priyanka Products had a capacity to produce 1000 units a month and the break up of cost is as follows: This material is prepared by Prof. This is unfortunate because break even analysis is only one element of cost volume profit analysis.

250/.000/April 45.000/March 55. This material is prepared by Prof.[MACME] Particulars Material cost Labour Variable overheads Sales commission Fixed overhead Total Amount 100 75 25 5 20 225 Division B wanted 400 units from Division A.000/. Division A has the capability to produce these additional units without incurring additional fixed costs.000/Considering the volatile trend Rahul decides that it is better to suspend operations.Their contribution is showing the following trend: January 60. the contribution will not be earned if operations are suspended.240/It is advisable to continue producing the products in house Shut Down or Continue: Illustration 2 Rahul Enterprises is operating under difficult market conditions and are incurring monthly unavoidable costs of Rs. Solution The unavoidable cost will continue to be incurred even after suspending operations However. Hence operations should be continued till contribution becomes zero. Advise him.40. Should Priyanka decide to stop producing these products in house? Solution Cost of producing one unit(marginal cost)=100+75+25=200/Cost of purchasing one unit=Rs. Division A quotes Rs.per unit and Division B has an offer from the market to buy these units @ 240 per unit.40 - .S.000/February 50.Ranjani for PGP/RAK MAC-II at IIM Indore Page .K.

2. In producing parts.[MACME] Illustration 3 Product mix decisions with capacity constraints The following costs and other data apply to two component parts used by Bajaj Electricals limited. overheads are applied at Rs. Compute the number of units that Bajaj Electricals should produce if it allocates machine time on the basis of the potential cost savings per machine hour.40 4.Ranjani for PGP/RAK MAC-II at IIM Indore Page .000 1 30 The company hitherto has been manufacturing all required components.00 9. Solution Whenever there is a limiting factor or capacity constraint. Assuming that 14.000 hours of otherwise idle machine time can be devoted to the production of component.4 per machine hour. determine the relevant production costs that should be considered in the decision to schedule machine time.80 2.00 8. if purchased Part X 0.00 29.000 2 10 Part Y 16.41 - .40 8.K.80 6. This material is prepared by Prof.00 10. only 14. in the current year. Accordingly some of the parts must be purchased from outside suppliers.S. which will not be affected by any make or buy decision represent 70% of the applied overhead. However. product mix should be decided so as to maximise the profits.000 hours of available machine time is to be scheduled so that the company realizes maximum potential cost savings. Required: 1. Fixed capacity costs. Particulars Direct material Direct labour Overheads Unit cost Units needed per year Machine hours per unit Unit cost.

40 1 8000 ** After producing 8000 units of Y number of machine hours available is 3000. then contribution is calculated with respect to labour hour.00 2.40 2 3000** Part Y 16. For example. Case Moti Heera (P) Ltd (A) & (B) (IIMA/QM0003(A & B)) This material is prepared by Prof. In the above illustration. if labour hours are in short supply. The top ranked product is produced as per requirement and the least ranked product is produced to the extent that the constraining resource is available.20 10.00 4.80 2 2. The contribution per unit is arrived at.80 2.40 1.Ranjani for PGP/RAK MAC-II at IIM Indore Page .S. So we can only produce 3000 units of X.[MACME] Hence we use marginal costing to support this decision. Then the contribution is calculated with respect to the constraining factor.K. The product that yields maximum labour hour contribution is given priority in ranking.40 1 3.42 - .40 5.2 26.00 3.60 30. let us first calculate the contribution per unit: Particulars Direct material Direct labour Variable Overheads (30%) Unit variable cost Cost to purchase from outside Savings if produced in house Limiting factor-Machine hour/unit Savings/machine hour Rank Number of units Part X 0.00 9.

selling price based profit maximization or demand based profit maximization may be difficult to achieve for businesses. the cost of a product is calculated and a margin of profit is added on. many of the variables in this model are quite difficult to predict. Some public sector undertakings may have falling marginal costs. Fair profit is mostly a fixed percentage of profit . This is known as the mark up price or a margin price. differences in risks. Pricing and Cost Management Pricing a product is a veritable challenge for most organizations since markets are dynamic and several variables that influence prices are either too volatile or unpredictable. The variations occur due to factors like differences in turnover rate. In such a situation if the price is fixed by equating marginal cost and average revenue. intensity of competition etc.K.[MACME] 9. Marginal cost may be lower than average cost.S. basically the firm calculates the cost of a product and the markup % is added to arrive at the selling price. This is a traditional method of pricing popularly used by wholesalers. In this method. Marginal Cost plus pricing The marginal cost pricing method considers the allocation of resources as a base for pricing. which is arbitrarily determined. As a result. Pricing and cost are the prime factors that maximize profit.full cost pricing which takes into consideration both variable and fixed costs and adds a percentage as markup b. Full cost pricing is the simplest pricing method. retailers. in the case of public undertakings the returns may not even cover the costs and hence in many cases pricing on the basis of marginal cost may not be profitable to the investor. However. In this method.it will lead to This material is prepared by Prof. The pricing is done in such a way so as to allocate the resources efficiently. construction contractors In this method prices are set by adding a % of profit to the total cost of the output. Profit Optimization model Profit optimization model is based on the economic theory that profit is maximized at the output level where the marginal cost is equal to the marginal revenue. There is empirical evidence to show that the producers usually set their prices on the basis of a cost plus a fair margin of profits. Owing to the above.43 - . For instance.Ranjani for PGP/RAK MAC-II at IIM Indore Page . in the case of publtc undertakings. Fair profit may differ from industry to industry or among firms in the same line of production. Full Cost plus pricing This pricing method is used widely by producers. Some of the cost based pricing strategies are as follows: a. Full cost pricing can be done in two ways ie. Hence several of the pricing strategies are based on cost. the returns may not cover the costs. Demand function is very difficult to be predicted accurately.

This method can have some setbacks as it could leave the product at a high price against the competition. a seller must use other pricing tactics such as economy or penetration. but might still produce higher economic profits than would be earned under perfect competition. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist. the threat must in some way be made credible. Limit pricing A limit price is the price set by a monopolist to discourage economic entry into a market. The problem with limit pricing as a strategy is that once the entrant has entered the market. This would help the companies to expand its market share as a whole.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Skimming is usually employed to reimburse the cost of investment of the original research into the product: commonly used in electronic markets when a new range. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. such as DVD players. Selling a product at a high price. are firstly dispatched into the market at a high price. Other pricing strategies are broadly described as follows: Creaming or skimming In most skimming. This strategy is often used to target "early adopters" of a product or service. Early adopters generally have a relatively lower price-sensitivity . In this strategy price of the product becomes the limit according to budget.[MACME] losses.e.This type of pricing may be resorted to to enable the public to buy certain essential goods.S. and is illegal in many countries. This strategy is employed only for a limited duration to recover most of the investment made to build the product. This means that for limit pricing to be an effective deterrent to entry. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. Loss leader A loss leader or leader is a product sold at a low price (i. a greater understanding of the product's value. goods are sold at higher prices so that fewer sales are needed to break even. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time.this can be attributed to: their need for the product outweighing their need to economise. or simply having a higher disposable income.K. To gain further market share. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. the quantity used as a threat to deter entry is no longer the incumbent firm's best response.44 - . sacrificing high sales to gain a high profit is therefore "skimming" the market. at cost or below cost) to stimulate other profitable sales. This material is prepared by Prof.

this can be for different classes. or for different opening times. [3] Price discrimination Price discrimination is the practice of setting a different price for the same product in different segments to the market. also known as aggressive pricing (also known as "undercutting").K. such as ages. intended to drive out competitors from a market.Ranjani for PGP/RAK MAC-II at IIM Indore Page .45 - . Penetration pricing Penetration pricing includes setting the price low with the goals of attracting customers and gaining market share. then it's up to them to either price their goods at an above price or below. For example. or represent exceptional quality and distinction. based solely on the price. It is illegal in some countries. depending on what the company wants to achieve . This means that marketers will set prices depending on the results from the research.S. Premium pricing Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers. Case Mridula Ice Cream Parlour (A) (IIMA/F&A 0315(A)) This material is prepared by Prof. The price will be raised later once this market share is gained.[MACME] Market-oriented pricing Setting a price based upon analysis and research compiled from the target market. are more reliable or desirable. Predatory pricing Predatory pricing. For instance if the competitors are pricing their products at a lower price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation.

however. Here instead of calculating costs first and then setting the price based on these calculated costs. Target Costing and life cycle costing Target costing:    Target costing means a cost of product which can be incurred when we need to achieve the required profit. say for e.K. of course. Target costing helps to improve the process.S. which has all the best & the latest features in it.Ranjani for PGP/RAK MAC-II at IIM Indore Page . design and at the same time to reduce cost to offer a good competition to the other players in the market.1000/- This material is prepared by Prof. i.g. and can also extend to all upstream and dowi1stream support activities and their method of delivery. Without proper planning. product features. Rs.10000/(hypothetical figures) for high end mobile phones. target costing does it the other way around. Target costing can be related with the backward integration model.g. This authority includes.e. Target costing is an innovative technique that enables companies to deliver a customerdefined product at the lowest possible cost.  After that the company should decide the profit margin that it will accept. Target costing is convenient for firms operating in perfect competition. The steps in target costing are as follows:  Determine the price the consumer is willing to pay for the specific product. For e.46 - . well this can be done by conducting a market research. here company is planning to have a profit margin of 10 %( hypothetical figures). The estimated cost is also known as Target cost How Target Cost is Set: Target cost is set for a product based on the company‘s strategic policy. Design-to-cost responsibility is then assigned to cross-functional teams with extremely broad authority.[MACME] 10. target costing can be difficult to implement effectively. Cost-reduction activity continues until the target cost is achieved or all parties realize it is not possible. Target Costing presents a framework for managers to understand how target costing works and how to plan and implement an effective system. the consumers are ready to pay Rs.

In conclusion.21 (b) The original life cycle cost per unit = (Rs.00/unit. The company seeks to make a mark-up of 40% product cost. 10000-1000=9000.50.K. There are powerful constraints on the product and its price and the company has to make the required product. Illustration 1 A company is planning a new product. Market research information suggests that the product should sell 10. 000 2 Manufacturing costs Rs. (c) Maximum total cost per unit = Rs.10/unit
3 End of life costs Rs.21. which has allowed companies to win considerable share of their respective markets. Hence Rs.000 = Rs. customers or competitors. the maximum manufacturing cost per unit would have to fall from Rs. It is estimated that the lifetime costs of the product will be as follows: 1 Design and development costs Rs.10) + Rs. Solution The target cost of the product can be calculated as follows: (a) Cost + Mark-up = Selling price 100% 40% 140% Rs.20. 000)/10.000 = Rs. 000 + (10.20.15.50.50. There will probably be a range of products and prices. target costing is based on the price-down.8.8. cost-down strategy.[MACME]  Subtract the price the consumer is willing to pay with the profit margin the company is willing to have i. it can be said that although target cost is used throughout the product life cycle. The marketdriven philosophy. 000 + Rs.15 Rs.17 This cost/unit is above the target cost per unit.it is primarily used and most effective in the product development and design stage. so the product is not worth making. manufacturing costs/ unit could be reduced.15. 000)/10. 000 + Rs.15. 000 on design.47 - .20.6. sell it at an acceptable and competitive This material is prepared by Prof.9000/.000 units at Rs. This is the target cost which is been determined.e.10 to (Rs. but the company cannot dictate to 
the market.15 – Rs.Ranjani for PGP/RAK MAC-II at IIM Indore Page .50 Therefore.is the target cost.S.50) = Rs. Some of this will be caused by the design and end of life costs: (Rs. 000 The company estimates that if it were to spend an additional Rs.6 Rs.50.000 x Rs.

S. Therefore. at the same time.[MACME] price and. This material is prepared by Prof.48 - . Life cycle cost management is a related approach that builds a conceptual framework that facilitates management‘s ability to exploit internal & external linkages.K. This means that the company has to find ways of not exceeding that cost. Life cycle cost management Life cycle costing also emphasizes on cost reduction and not cost control.Ranjani for PGP/RAK MAC-II at IIM Indore Page . If the profit is going to be adequate. instead of starting with the cost and working to the selling price by adding on the expected margin. make a profit. target costing will start with the selling price of a particular product and work back to the cost by removing the profit element. The following diagram represents the phases in the product life cycle: In life cycle management specific cost is associated with each stage of the product or services. the costs have to be sufficiently low.

K.  In this stage sales volume increases dramatically. and unit costs fall as fixed costs are recovered over greater volumes. Stage 4 Maturity stage  Initially profits will continue to increase. as initial setup and fixed costs are recovered.  Alternatively additional development costs may be incurred to refine the model to extend the life-cycle (this is typical with cars where 'product evolution' is the norm rather than 'product revolution'. Stage 2 Launch/Market development stage  Extensive marketing and promotion cost is incurred in this stage as this stage works on creating awareness about the existence of product/services Stage 3 Growth stage  Marketing and promotion will continue through this stage.  Marketing and distribution economies are achieved. a replacement product will need to have been developed.49 - .S.  However. incurring new levels of R&D and other product setup costs. including research and development (R&D). This material is prepared by Prof.[MACME] Stage 1 Pre-production/Product development stage  Since this is the launching stage a high level of cost is incurred (preproduction costs). price competition and product differentiation will start to erode profitability as firms compete for the limited new customers remaining Stage 5 Decline stage  Marketing costs are usually cut as the product is phased out  Production economies may be lost as volumes fall  Meanwhile. product design and building of production facilities.Ranjani for PGP/RAK MAC-II at IIM Indore Page .

50 - . 50 Rs.K. 2.000 + (Rs.[MACME] Illustration 2 Company X is considering whether to pursue Project A or Project B. 250 Rs.3.400 x 15 x 15 x 0.64 (Based on an interest rate of 3%) Calculations LIFE CYCLE COST Rs.2. 920 Rs. However.150 15 0.64) 0.200 x Rs. 840 The formula for calculating life cycle cost is: LIFE CYCLE COST = 
INITIAL COST + (ANNUAL COSTS x PROJECT LIFE x DISCOUNT FACTOR) This material is prepared by Prof. 000.3.5. 000 + (Rs. 150 Rs.4. Project B has an initial cost of Rs.64 Rs.64) Rs.Ranjani for PGP/RAK MAC-II at IIM Indore Page . 3.2. 000. Company X is more inclined to take on Project B because of the perceived lower cost.000 Rs. while Project A has an initial cost of Rs.S. Calculating life cycle cost PROJECT A Initial Cost Annual Costs Electricity Maintenance Project Life 15 (Years) Discount Factor 0. 000 PROJECT B Rs. applying the life cycle cost formula will help Company X determine if Project B is truly more cost-effective than Project A.

Marketing. team members focus on eliminating non-value-added costs of the process.S. Project A is the more cost effective option to pursue. the lowest initial cost does not lead to the lowest cost overall. Achieving Full Cycle Cost management (SMR 153.51 - . which is most cost effective.Ranjani for PGP/RAK MAC-II at IIM Indore Page . in which employees from various departments (Production. R&D. When is life cycle costing useful? When evaluating capital investment options. Engineering. improving product design and modifying process methods. the product life cycle is from 12 to 15 years. Life cycle costing calculates operating and maintenance costs incurred during the lifetime of the project plus the initial capital costs. after all costs incurred for producing the product. Nissan. as well as a feasible cost in which a given item may be produced.[MACME] As the above comparison demonstrates.K. In order to minimize costs. and Accounting) are given the responsibility of determining an acceptable market price and corresponding Return on Sales. LCC looks at the total cost of owning. Companies sometimes need to consider target prices and target costs for a product over a multi-year product life cycle. For Automobile companies suggest Ford. Rather than evaluating projects solely on the basis of initial costs. It is also being used for pricing the product. labor and replacement components). The decision making process involves a cross functional team. operating and maintaining a project over its useful life (including its fuel. Fall 2004) Case Toyota Motor Company: Target Costing (HBS/9-197-031) This material is prepared by Prof. energy. Product life cycle spans the time from initial R&D on a product to when customer service and support I s no longer offered for that product. In such high operations. using Life Cycle Costing (LCC) can help you determine the option. life cycle costing is used in development period for R&D and design is long and costly.

Once standards are established. The variances may be in quantity of materials or hours used to manufacture a product or in the cost of the materials or labor. direct labor. A variance can also be used to measure the difference between actual and expected sales. analysis of variances can be used to provide management with information about whether a variance is caused by quantity or price so that appropriate action can be taken. Standard Cost Variances A variance is the difference between the actual cost incurred and the standard cost against which it is measured. Standard Cost and Budgets When budgets are prepared. downtime from production due to maintenance or start up and break time must be included in the number of hours it takes to make a product. and cost per unit. Because overhead is normally applied on some basis. the expected number of hours and cost per hour for direct labor. The per unit costs can be further divided into the expected amount and cost of materials per unit. A standard cost can also be developed and used for pricing decisions and cost control even if a budget is not prepared. if a product. when considering labor hours. variance analysis can be used to review the performance of both revenue and expenses. Similarly.K. The scraps of material are called waste. There are two basic types of variances from a standard that can arise. Within the expected amount of materials. given that the chair is being produced with this specific fabric. direct labor dollars or hours) used to allocate the overhead is different from what was planned.[MACME] 11. and the expected total overhead costs and a method for assigning those costs to each unit. they are used to analyze and determine the reasons for actual cost variances from standards. more material than is actually needed for the chair must be ordered because the shape of the seat and the fabric are usually not exactly the same. the costs are usually computed at two levels. in total dollars so an income statement can be prepared. The cost of the full piece of material is used as the standard cost because the waste has no other use.Ranjani for PGP/RAK MAC-II at IIM Indore Page . For example. which are the rate variance and the volume variance. requires material. Here is more information about both types of variances: This material is prepared by Prof.52 - . waste or spoilage must be considered when determining the standard amount. the variances in overhead will occur because the total overhead pool of dollars or the activity level (for example. and overhead. which is not avoidable. Thus. Once standard costs are used in preparing budgets. such as a chair. The cost per unit is referred to as a standard cost. A standard cost in a manufacturing company consists of per unit costs for direct materials.S.

or expenses.[MACME]   Rate variance. of the Policy to be pursued during that period for the purpose of attaining a given objective. It is also possible to report these variances for revenue. If the variance relates to the sale of goods.Ranjani for PGP/RAK MAC-II at IIM Indore Page . budgets are prepared on the basis of future estimated production and sales in order to find out the profit in a specified period. or changes in the quantity from the expected amount. A standard usually refers to a projected amount per unit of product. if the variance relates to the application of overhead. Case. According to Institute of Cost and Works Accountants.‖ Budgeting is a process which includes both the functions of budget and budgetory control.S.K. it is called the labor efficiency variance. Wilmont Chemical Corporation This material is prepared by Prof. or per unit of output. multiplied by the actual quantity purchased. A volume variance is the difference between the actual quantity sold or consumed and the budgeted amount. ―A budget is a financial and / or quantitative statement prepared prior to a defined period of time. Thus. Budgeting may be defined as the process of preparing plans for future activities of the business enterprise after considering and involving the objectives of the said organisation. factory overhead). A budget usually refers to a department‗s or a company’s projected revenues. If it relates to the use of direct materials. The ―rate‖ variance designation is most commonly applied to the labor rate variance. costs. The rate variance uses a different designation when applied to the purchase of materials. This analysis helps to measure performance. If the variance relates to the use of direct labor. The most common variances that a cost accountant elects to report on are subdivided within the rate and volume variance categories for direct materials. it is called the material yield variance. multiplied by the standard price or cost per unit. Volume variance. Finally.53 - . and overhead. This also provides process/steps of collection and preparation of data. direct labor. it is called the sales volume variance. A rate variance (which is also known as a price variance) is the difference between the actual price paid for something and the expected price. variances are based on either changes in cost from the expected amount. it is called the overhead efficiency variance. cost estimation. which involves the actual cost of direct labor in comparison to the standard cost of direct labor. minimizing wastage and better utilisation of resources of the organisation. per unit of input (such as direct materials. Thus. and may be called the purchase price variance or the material price variance. by which deviations from the plan can be measured. In other words Budget is an estimate and a quantified plan for future activities to coordinate and control the uses of resources for a specified period. Budget is a planning function and budgetory control is a controlling system or a technique.

This material is prepared by Prof. Favourable Variance A variance can be put into the favorable category when the results are better than expected. a favorable variance is shown by noting a letter F in parenthesis on the reports. In accounting practice. this difference is known as variance. Variance Analysis and Flexible Budgets Meaning of Variance Analysis Variance is the difference in the actual result and the standard result. the analysis is typically used to help mangers prevent a negative situation from recurring by providing information about what went wrong. if actual more than expected than unfavourable and standard more than actual than favourable result. This difference is studied by the cost accountant to understand why this gap was formed and the reasons for it. When there is a difference in the result. This would be denoted on the reports with the letter A or U. This study or the reasons found out by the accountants on the basis of variance is known as variance analysis. the variance can be judged as unfavorable if the results are worse than expected. This means that revenues were more than the expected amount or costs were below the budgeted amount. the variance would be termed unfavorable or adverse. a variance is defined as the difference between the expected amount and the actual amount of costs or revenues. Definition In accounting. The analysis includes an explanation of the difference between actual and expected figures as well as an evaluation as to why the variance may have occurred. or perhaps a move up the corporate ladder. However. A favorable variance might earn a bonus for a manger. Taking cost into consideration. Then the actual results are processed after the period. Consistently creating an unfavourable variance might result in a manger being reprimanded or losing their job. If the actual result is better than the set result then it is known as a favourable result and if the actual result is worst then the standard result then it is unfavourable or adverse result. If the revenues were below expectations or the costs were higher than standard. if actual is more than expected than favourable and standard more than actual than unfavourable result.[MACME] 12. Then the actual results are compared with the expected or set standard results.Ranjani for PGP/RAK MAC-II at IIM Indore Page .K. Unfavourable Variance In contrast.54 - . Variance analysis uses this standard or expected amount versus the actual amount to judge performance. It is a controlling technique in which the standard result is first set in the beginning of the month or year according to the accounting rules or company standards.S. Taking revenue into consideration. The purpose of this detailed information is to assist managers in determining what may have gone right or wrong and to help in future decision-making.

There are several reasons for this. The analysis is also used with overhead and labor spending and efficiency.S. So at this time you cannot say that the results were bad.e. The variance is the price paid for the materials less the expected cost and then multiplied by the actual number of units used in the process. Problems Not all companies use variance analysis in their managerial process. one of which is that it can be quite complex for the accountants to process all of the information necessary to discover why there may have been a problem or benefit that caused the variance. adverse.55 - .Ranjani for PGP/RAK MAC-II at IIM Indore Page .K. Many a time what happens that the sales crosses the expected so in case of revenue there is a favourable result. Another commonly seen usage is the selling price variance or the actual sales price minus expected. times the number of units. Many people think that adverse result is not good for the company but it is not true.[MACME] Common Uses Variance analysis is commonly used in several aspects of business accounting. Finally. and that time obviously the costs will be incurred more than expected i. thus the analysis may have little usefulness. the results eventually were better than expected. Therefore adverse effects are not always bad. Item Budget £'000 SALES REVENUE Standard product Premium product Total sales revenue COSTS Wages Rent Marketing 35 15 20 38 17 14 3 2 -6 A A F 75 30 105 90 25 115 15 -5 10 F A F Actual £'000 Variance £'000 Favourable or Adverse This material is prepared by Prof. One of the most common is in the purchase of manufacturing materials. the standard figures used to calculate the variance may not be as accurate as the actual figures.

The first keyword is "expected.K. the result is adverse. They can see where the costs have increased and thus they can either increase the sales value or reduce other costs to keep the profit per unit of the product same. There are two keywords in that statement.[MACME] Other overheads Total costs 27 97 35 104 8 7 A A Profit 8 11 3 F In the given illustration 1) 2) 3) 4) Standard product actual is better than the expected thus the result is favourable Premium products actual sales are less than expected therefore unfavourable result.Ranjani for PGP/RAK MAC-II at IIM Indore Page . Therefore overall sales are better than expected. The second keyword is "future" which is a period in the time to come. Variance analysis helps in finding out where the actual results have been increased or decreased and thus corrective action can be taken by the managers to improve the profitability of the company by doing variance analysis." Expected means something that is likely to happen.S. Wages. budgeting is the process of preparing a detailed statement of financial results that are likely to happen in a period in a time to come. This material is prepared by Prof. Reconciliation of Actual and Budgeted profits Budgeted Profit is the profit which financial analysts of a company expect to have in a specific period of time (which normally is one year) in the future and Actual Profit is the profit which is actually earned by the company Budgeting for a business is a process of preparing a detailed statement of financial results that are expected for a given time period in the future. 6) Thus overall cost has its actual more than the expected.56 - . thus the total variance has a positive effect on the cost account. 7) The overall revenue is better than the overall cost structure in actual condition thus the total profit is favourable. So. 5) Marketing cost has its actual less than the expected thus its result is favourable. rent and other overheads has its actual cost more than the expected thus adverse result. In the given illustration though the cost is adverse the total profit is more than expected.

not to what the factory should have spent to make 9. Relationship between the budgeted and actual profit Budgeted profit plus All favourable variances minus All adverse (unfavourable) variances equals Actual profit This material is prepared by Prof.000 units or any other production level. if differences exist between them.000 units or 11. The flexible budget is a tool for performance evaluation. A variance is the difference between an actual result and a budgeted amount.K. A favourable (F) variance means that performance exceeded expectations—actual revenue exceeded budgeted revenue or actual cost was less than budgeted cost. the better the accuracy of estimated utilisation of resources. then management should compare actual factory costs for 10. An unfavourable (A) variance or adverse variance means that performance fell short of expectations—actual revenue was less than budgeted revenue or actual cost exceeded budgeted cost.57 - .[MACME] Reconciliation is the process of analyzing two related records and. The more closer the Budgeted profits are to the actual profits . finding the cause and bringing the two records into agreement.000 units to what the factory should have spent to make 10. It is prepared at the end of the period. The motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10.000 units. We classify a variance as favourable or unfavourable based on their effect on current profit.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page .000 units. A flexible budget adjusts the fixed budget as per the actual level of output.

000 80.00.00.02.00 9.80.000 97.76.000 5.000 5.000 3.60.000 1.000 Flexible Budget 1.00.57.79.000 1.000 6.20.200 9.200 9.000 Actual Result 1.000 1.S.00.58 - This material is prepared by Prof.21.00 5.60.00 5.000 6.000 1.000 6.15.20.000 1.23.00.000 A 500 80 5 5.000 Solution: Per unit Sales volume Sales Less variable costs Purchases Installation costs Delivery Contribution Less fixed costs Delivery Overheads Net profit 900 Fixed Budget 1.000 1.00.000 1.000 1.000 1.000 2.000 1.000 6.[MACME] Illustration 1 Amt in Rs Per Fixed unit Budget Sales volume Sales Purchases Installation costs Delivery fixed costs Delivery Overheads 1.000 900.000 80.000 96.000 97.20.23.000 0 3000 A 37000 A Page .200 10.000 Variance 120.000 500.000 2.000 24.000 Flexible Budget 1.000 1.000 1.200 10.000 5.000 9.K.000 96.000 5.21.000 5.20.000 6.78.85.000 7.000 3.000 F 1000 A 0 63000 F 1.000 Actual Result 1.00 80.000 6.80.94.000 1.000 1.000 1.76.Ranjani for PGP/RAK MAC-II at IIM Indore .000 6.000 1.81.24.57.

and unfavourable variances are usually negative amounts This material is prepared by Prof.S. Favourable variances are usually positive amounts.[MACME] Reconciliation between Actual and Budgeted Profit Budgeted Profit Add Favourable variances 24000 63000 Less adverse variances 120000 1000 3000 Actual profit 87000 194000 -124000 157000 Although the budget report shows variances.K.Ranjani for PGP/RAK MAC-II at IIM Indore Page . it does not explain the reasons for the variance.59 - . The budget report is used by management to identify the sales or expenses whose amounts are not what were expected so management can find out why the variances occurred. By understanding the variances. management can decide whether any action is needed.

K.Ranjani for PGP/RAK MAC-II at IIM Indore Page .60 - .[MACME] This material is prepared by Prof.S.