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Semester Two

Cost Amity
Accounting University
The principle concern of the book is to show how cost accounting
theory can be applied to solve the problems in practice. An attempt PAN African
has been made to relate theory to practice to make it eNetwork
understandable easily for all kind of students i.e. from accounts or
non-accounts background. Project
PREFACE

This Cost Accounting module seeks to discuss the concept of cost accounting & their
application in the organization. The principle concern of the book is to show how cost
accounting theory can be applied to solve the problems in practice. An attempt has been
made to relate theory to practice to make it understandable easily for all kind of students
i.e. from accounts or non-accounts background.
Each chapter is having various illustrations relating to each topic covered and followed
by multiple choice questions, which are designed to reinforce concepts & procedure
presented in the body of chapter.
I wish to express my sincere thanks to many of the authors who have received due
acknowledgements, without whom, this module would not have been completed.
I have taken every possible effort to remove the errors either of principle or of printing.
Even then, if the reader comes across any error, he/she is requested to point out the same
to me.
I hope that many students will find this module interesting & helpful. Further suggestion
for the improvement of the module is solicited.

Tanu Agrawal
2010

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INDEX

Chapter No. Chapter Name Page No.

Chapter 1 Introduction to Cost Accounting 2

Chapter 2 Material Costing 24

Chapter 3 Labor Costing 41

Chapter 4 Overheads Costing 59

Chapter 5 Marginal Costing and Cost Volume Profit 90


Analysis
Chapter 6 Standard Costing and variance analysis 121

Chapter 7 Budgets, cost reduction and control 151

Chapter 8 Introduction to Recent developments in 175


costing

Answer Key to end chapter questions Page no 193


Syllabus Page no 194
References Page no195

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CHAPTER-1 INTRODUCTION TO COST ACCOUNTING
At the end of the chapter you will be conversant with:

1.1 Introduction
1.2 Comparison Between Financial Accounting and Management Accounting
1.3 Difference Between Cost Accounting and Management Accounting
1.4 Difference Between Financial Accounting and Cost Accounting
1.5 Limitation of Financial Accounting
1.6 Advantages of Cost Accounting
1.7 Classification of Cost
1.8 Cost Centre
1.9 Cost Unit
1.10 Cost Sheet

1.1 Introduction:
Let us begin this subject by attempting to answer some questions such as: What is
Management Accounting? Is it the same as Cost Accounting? In what way it is different
from Financial Accounting?

Here is a list of questions, which can be answered with the help of Management
Accounting.

1. If Tata McGraw-Hill (TMH) Publishing Company, the publisher of books on


several topics, has an inventory of 8,000 copies of Management Accounting
textbook, at the end of the year, at what cost will it be reported in the Companys
Balance Sheet?

2. How many copies of this book must TMH sell before it makes any profit?

3. How much does it cost TMH if the demands of its striking employees have to be
met?

4. How much does it cost a fertilizer manufacturing company like FACT Ltd. to stop
polluting the environment?

5. How much does it cost Icfai to start a new program on capital markets?

6. What does the new economic policy cost India?

A keen observation of the above questions reveals that the word cost is common in all of
them except the second question. The second question has its focus on the word profit.
What is the meaning of the words: cost and profit?

Cost is defined as the resources consumed to accomplish a specified objective.

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TMH has to spend money to acquire the necessary resources; such as paper, ink,
machinery and the services of the people; to publish the textbook. Publication of the book
may consume some of these resources completely while it consumes others partly.

Profit is nothing but the difference between sales revenues and expired costs (called
expenses) of earning those revenues. Thus, even for the second question, costs must be
measured in order to ascertain the profit. This leads us to the conclusion that
measurement of cost is an integral part of Management Accounting. Then, how are costs
identified and measured? The answer to this question lies in Cost Accounting.

Cost Accounting is a system used to record, summarize and report cost information. Cost
information is presented in the form of special reports to the internal users, such as
managers in the company, which is used in deciding how to operate the organization.
These decisions are simply the choices managers make about how their organizations
should do things. Some cost information, is provided to external users, such as
shareholders and creditors as part of the financial statements).

Thus, cost accounting involves the accumulation, recording and reporting of costs and
other quantitative data. The information generated by the Cost Accounting system is used
by an organization for internal purposes and for external purposes. Providing cost
information to managers (internal purposes) to assist them in decision-making is called
Management Accounting.
Figure1.1

You would have noticed that the definition of cost given earlier referred to
accomplishing a specific objective. Each of the questions listed above also implies a
specific objective or purpose as indicated in Table 1.1 below.
Table 1.1
The Purpose of Cost Information
Question Number Implied Specific Objective
1&2. Will publishing the book be profitable to the company?
3. Should the company offer a higher compensation to its striking
employees to avoid the strike?
4. Should the company close its plant or install pollution control
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equipment?
5. Will the new program generate enough sales revenue to make it
feasible?
6. Are the benefits of liberalization worth its cost?
The table shows that most of the implied specific objectives are decisions or choices to be
made by managers or the management, whether it is a business concern, academic
institute or even a country.

1.2 COMPARISON BETWEEN FINANCIAL AND MANAGEMENT


ACCOUNTING
There are broadly three branches of accounting:- Financial Accounting, Cost Accounting
and Management Accounting .
Management accounting differs in several ways from financial accounting, they do have
certain similarities also, which have been enumerated as below:

Differences

1. Internal vs. External Uses

Management accounting focuses on providing information for internal users such as


supervisors, managers etc. Financial accounting concentrates on providing information to
the external users - stockholders, creditors, etc. A manager is required to direct day-to-
day operations, plan for the future, solve internal problems and make numerous
decisions, all of which require specialized information which is provided by Management
Accounting.. However, such specialized information may be useless and confusing to
others like common shareholders.

2. Emphasis on the Future

Since a large part of the overall responsibilities of a manager involves planning, a


managers information needs have a strong orientation towards the future. Summaries of
past costs and other past data are relevant only up to a point. Economic conditions,
customer demands and competitive conditions are so dynamic that the managers
planning framework, based on estimated figures, may or may not be reflective of past
experience.

On the other hand, Financial Accounting is concerned with the record of the financial
history of an organization. It has little to do with estimates and projections for the future.
Generally Accepted Accounting Principles (GAAP)

Financial Accounting statements are prepared in accordance with GAAP, as they


provide consistency and comparability and are relied on by outsiders for information
regarding the company. Management Accountants on the other hand, are not governed

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by GAAP. Managers set their own rules on the form and content of information. Whether
these rules conform to GAAP is immaterial.

3. Relevance and Flexibility of INFORMATION

Financial Accounting information is expected to be objectively determined, and to be


verifiable. For internal uses, the manager is often more concerned about receiving
information that is (a) relevant to a particular decision situation, and (b) flexible enough
to be used in a variety of decision-making situations. Objectivity and verifiability assume
secondary importance.

4. Emphasis on Precision

Audited financial statements have to be precise to the last paisa. As far as a manager is
concerned, when information is needed, timeliness is more important than its precision.
The more timely information comes to a manager, the more quickly problems are
attended to and solved. If a decision is to be made, waiting a week for slightly more
accurate information may turn out to be costlier to the company compared to acting on
the relevant information readily available. Thus, in managerial accounting, estimates and
approximations may be more useful than numbers that are accurate to the last paisa. For
this reason, managers are often willing to trade off some accuracy in information to
timeliness of information.

5. Organizational Focus

Financial accounting is primarily concerned with the reporting on business activities of


a company as a whole. Management accounting, by contrast, focuses less on the company
as a whole and more on the parts or segments of a company. These segments may be the
product lines, sales territories, divisions, departments, etc. While it is true that some
companies do report some breakup of revenues and costs in their financial statements,
such breakup tends to be of secondary importance. In management accounting,
segmented concentration is primarily emphasized.

6. Use of Other Disciplines

Management accounting extends beyond the boundaries of traditional accounting


practices and draws heavily from other disciplines such as economics, cost accounting,
finance, statistics, operations research and organizational behavior. Financial accounting
on the other hand is bound by conventional accounting systems and practices.

7. Freedom of Choice

Financial accounting is mandatory for business organizations. They should compulsorily


maintain financial records as per various legal statutes like Companies Act, Income Tax
Act, etc. By contrast, Management Accounting is not mandatory. There are no regulatory
bodies specifying what is to be done and how it is to be done and presented. Thus in
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Management Accounting, the question Is the information useful? Is more important
than the question Is the information required?

SIMILARITIES

1. Reliance on Common Accounting Information System


It would be a total waste of money to have two different data collection systems existing
side-by-side. For this reason, Management Accounting makes extensive use of routinely
generated financial accounting data, which will be improved upon as per the
requirements of the decision to be taken or the problem to be resolved.
2. Responsibility Accounting

Both Financial Accounting and Management Accounting rely heavily on the concept of
responsibility. Financial Accounting is concerned with the concept of responsibility or
stewardship over the company as a whole; while Management Accounting is concerned
with stewardship over its parts; and this concern extends to the last person in the
organization who has responsibility over cost.

1.3 COST ACCOUNTING AND MANAGEMENT ACCOUNTING


The terms cost accounting and management accounting have sometimes been used
synonymously by many accountants in recent years. But these two systems of accounting
are not the same. Despite the fact that the subject matter of cost accounting has broadened
over the years, it is, however, concerned mainly with the techniques of product costing
and deals with only cost and price information. It is limited to product costing procedures
and related information processing. It helps management in planning and controlling
costs relating to both production and distribution activities.

By nature, management accounting refers to reports prepared to fulfill the needs of


management. The accounting statements and reports in management accounting are
situation-specific. That is, management accounting reports attempt to fill the information
needs of managers with respect to a specific problem, situation, or decision.

Management accounting is not confined to the area of product costing, cost and price
information. In management accounting, the objective is to have a data pool which will
provide any and all information that management may need. For example, if management
decides to depend on long-term debt for expansion of business, it may be investigated as
to what effect this decision will have upon the earnings per share? Should debt in the
capital structure be too large or small? Similarly, management may be interested in
knowing the adequacy of cash inflows to pay current obligations or the effect of inflation
on business decisions and performance. Thus, management accounting helps
management deal with the total situation. In achieving this goal, management accounting
makes use of information drawn from financial accounting and other disciplines, such as
economics, cost accounting, finance, statistics, operational research and the like.

Now-a-days, the terms cost accounting and management accounting are used
interchangeably.
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1.4 Difference between Financial Accounting and Cost Accounting
The point of difference between cost accounting & financial accounting may be
summarized as follows:

1. Objective: Financial accounting aims at safeguarding the interest of the business & its
proprietors & others connected with it, by providing suitable information to various
parties- internal as well as external.
Cost accounting on the other hand, renders information for the guidance of the
management for proper planning organizational control & decision making.
2. Mode of presentation: Financial accounts are prepared according to some accepted
accounting concepts & conventions. They are kept in a manner so as to comply with the
requirements of the companies Act, Income Tax Laws & other statutes.
Whereas maintenance of cost records is purely voluntary & therefore there are no
statutory forms regarding their presentation.
3. Recording: In case of financial accounts stress is on the ascertainment & exhibition of
profits earned or losses incurred in the business. On account of this reason in financial
accounts the transactions are recorded, classified & analyzed in a subjective manner i.e.
according to the nature of expenditure.
In cost accounts the emphasis is more on aspects of planning & control, therefore
transactions are recorded in an objective manner i.e. according to the purpose for which
costs are incurred.
4. Analyzing Profit: Financial accounting reveals the profits of the business as a whole,
while cost accounting shows the profit made on each product, job or process.
5. Periodicity of reporting: Financial accounting is largely concerned with the
transitions between undertaking & the third parties and therefore it has to observe the
accounting period convention which is usually a year. Accounts are prepared & presented
at the end of the year only.
While cost accounting is mainly concerned with the people in the organization & cost
reports are frequently submitted to the management & concerned departments, whenever
it is required.

1.5 LIMITATION OF FINANCIAL ACCOUNTING:


Following are the limitations of financial accounting, which led to the development of
Cost Accounting:
1. It does not classify the accounts so as to give data regarding costs by departments,
processes, products, in the manufacturing division, by units or product-lines &
sales territories in the selling & distribution division.
2. it does not classify the expenses as direct & indirect items nor does it assign them
to the product at each stage of production. Thus, controllable and uncontrollable
items of overhead costs are not shown separately.
3. it does not provide day-to-day cost confirmation because the data are summarized
at the end of accounting period.
4. it does not provide analysis of losses due to idle plant & equipment, defective
material, inefficient labour or seasonal condition.

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5. it doesnt provide adequate information for reports to outside agencies such as
banks, government, insurance companies & trade associations.

1.6 ADVANTAGES OF COST ACCOUNTING

1. The cost accounting system provides data about profitable & unprofitable
products & activities.
2. All items of costs can be analyzed to minimize the losses & wastage emerging
from the manufacturing processes & reduce the costs associated with different
activities.
3. Production/manufacturing methods may be improved or changed so that costs can
be controlled & profit increased.
4. Cost data can be obtained & compared with standard cost within the form or
industry.
5. Cost accounting helps management in avoiding losses arising due to many factors,
such as low demand, competitive conditions, change in technology, seasonal
demand for the product.
6. Cost accounting also provides data cost data & information to determine the price
of the product.
7. Negotiation with government & labour unions can easily be made with the
information provided by the cost accounting system.
8. more accurate & reliable financial accounts can be prepared promptly for use of
management.
9. An adequate cost accounting system ensures maximum utilization of physical &
human resources, checks fraud & manipulations & helps employees as well as the
employers in their basic goals of getting higher earnings & maximizing the profits
of the concern.

1.7 CLSSIFICATION OF COST


Cost classification is the process of grouping costs according to their common
characteristics. A suitable classification of costs is very helpful in identifying a given
cost with cost centers or cost units. Costs may be classified according to their nature,
i.e., material, labor and expenses and a number of other characteristics. Depending upon
the purpose to be achieved and requirements of a particular concern the same cost
figures may be classified into different categories. The classification of costs can be
done in the following ways:
1. By Nature of Element
2. By Functions
3. By Traceability
4. By Variability
5. By Controllability
6. By Normality
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7. By Capital or Revenue
8. By Time
9. By Association with Product
10. According to Planning and Control
11. For Managerial Decisions
12. Others.
Each classification will be discussed in detail in the following paragraphs:
1. By Nature of Element
The costs are divided into three categories i.e. Materials, Labor and Overheads. Further
sub-classification of each element is possible; for example, material can be classified
into raw material components, spare parts, consumable stores, packing material, etc.
Materials: Materials are the principal substances that go into the production process
and are transformed into finished goods. Materials are further classified as direct
materials and indirect materials. Direct materials are that materials that can be directly
identified with and easily traced to finished goods. In manufacturing organizations, the
cost of direct materials constitutes a major proportion of the finished product cost. All
the other materials that go into the production of the finished goods are called indirect
material costs. Indirect materials generally form a part of the manufacturing overheads.
For example. a furniture manufacturer, teak wood is a direct material as it can be traced
easily to the furniture made, and the nails, adhesives and other sundry materials can be
treated as indirect materials.
Labor: Labor refers to the human effort to produce goods and services. It is a factor of
production; the talents, training, and skills of people which contribute to the production
of goods and services. It involves the physical and mental effort. It can be further
classified into direct and indirect labor. Direct labor is the effort of employees who
transforms direct materials into a finished product and it is physically traceable to the
finished good or service. In some industries labor cost forms a significant portion of
total costs. The labor which cannot be traced to a product is considered to be the
indirect labor. The indirect labor forms part of factory overhead. In the above example,
the cost of the workers who directly expend their energy on making the furniture with
the help of tools and machines is considered to be the direct labor. The salary paid to a
supervisor, who oversees the activities of a team of workers is considered as indirect
labor.

Overheads: Those elements of costs necessary in the production of an article or the


performance of a service which are of such a nature that the amount applicable to the
product or service cannot be determined accurately or readily. Usually they relate to those
objects of expenditures which do not become an integral part of the finished product or
service such as rent, heat, light, supplies, management, supervision, etc. In other words,
overheads consist of indirect materials, indirect labor and other indirect expenses. The
overheads can be classified into factory overheads, office and administration overheads
and selling and distribution overheads. Continuing with the above example, cost of
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factory lighting, rent of the factory, rent of administrative building, salary of
administrative staff and managers, depreciation of machinery etc. constitute overheads.

2. By Functions

It leads to grouping of costs according to the broad divisions of functions of a business


undertaking or basic managerial activities, i.e. production, administration, selling and
distribution. According to this classification costs are divided as follows:

Manufacturing and Production Costs

This category includes the total of costs incurred in manufacture, construction and
fabrication of units of production. The manufacturing and production costs comprise of
direct materials, direct labor and factory overheads.

Administrative Costs

This category includes costs incurred on account of planning, directing, controlling and
operating a company. For example, salaries paid to managers and other administrative
staff.

Selling and Distribution Costs

Selling costs and distribution costs are most often confused to be one and the same.
However, there is a distinction between the two. Selling costs are defined as the cost of
seeking to create and stimulate demand and of securing orders. Example of selling costs
are advertisement, salesman salaries, etc. Whereas, distribution costs are defined as the
cost of sequence of operations which begin with making the packed product available for
dispatch and ends with making the reconditioned, returned empty packages, if any
available for re-use. For example, insurance on goods in transit, warehousing etc. are
distribution costs.

3. By Traceability

According to this classification, total cost is divided into direct costs and indirect costs
Direct costs are those costs which are incurred for and may be conveniently
identified with or easily traced to a particular cost center or cost unit. The common
examples of direct costs are materials used and labor employed in manufacturing an
article or in a particular process of production.
Indirect costs are those costs which are incurred for the benefit of a number of
cost centers or cost units and cannot be conveniently identified with a particular cost
center or cost unit. Examples of indirect costs include rent of building, management
salaries, machinery depreciation, etc. The nature of the business and the cost unit chosen
will determine the costs as direct and indirect. For example, the hire charges of a mobile
crane used onsite by a contractor would be regarded as a direct cost since it is identifiable
with the project/site on which it is employed, but if the crane is used as a part of the
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services of a factory, the hire charges would be regarded as indirect cost because it will
probably benefit more than one cost center or department. The distinction between direct
and indirect cost is essential because the direct costs of a product or activity can be
accurately identified with the cost object while the indirect costs have to be apportioned
on the basis of certain assumptions about their incidence.

4. By Variability

The basis for this classification is the behavior of costs in relation to changes in the level
of activity or volume of production. On this basis, costs are classified into three groups
viz. fixed, variable and semi-variable.

Fixed Costs

Fixed costs are those which remain fixed in total with increase or decrease in the
volume of output or activity for a given period of time or for a given range of output.
Fixed costs per unit vary inversely with the volume of production, i.e. fixed cost per unit
decreases as production increases and increases as production decreases. Examples of
fixed costs are rent, insurance of factory building, factory managers salary, etc. These
costs are constant in total amount but fluctuate per unit as production level changes.
These costs are also termed as capacity costs.

Variable Costs

Variable costs are those which vary in total directly in proportion to the volume of
output. These costs per unit remain relatively constant with changes in volume of
production or activity. Thus, variable costs fluctuate in total amount but tend to remain
constant per unit as production level changes. Examples: direct material costs, direct
labor costs, power, repairs, etc.

Semi-variable Costs

Semi-variable costs are those which are partly fixed and partly variable. For example,
telephone expenses include a fixed portion of monthly charge plus variable charge
according to the number of calls made; thus total telephone expenses are semi-variable.
Other examples of such costs are depreciation, repairs and maintenance of building and
plant, etc. These are also called semi-fixed costs or mixed costs.

5. By Controllability

On this basis costs are classified into two categories:

Controllable Costs

If the costs are influenced by the action of a specified member of an undertaking, that is
to say, costs which are at least partly within the control of management they are called
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controllable costs. An organization is divided into a number of responsibility centers and
controllable costs incurred in a particular cost center can be influenced by the action of
the manager responsible for the center. Generally speaking, all direct costs including
direct material, direct labor and some of the overhead expenses are controllable by lower
level of management.

Uncontrollable Costs

If the costs cannot be influenced by the action of a specified member of an undertaking,


that is to say, which are not within the control of management they are called
uncontrollable costs. Most of the fixed costs are uncontrollable. For example, rent of the
building is not controllable and so is managerial salaries. Overhead cost, which is
incurred by one service section or department and is apportioned to another which
receives the service is also not controllable by the latter.

Controllability of costs depends on the level of management (top, middle or lower) and
the period of time (long-term or short-term).

6. By Normality

On this basis, is the costs are classified into two categories.

Normal Cost

It is the cost which is normally incurred at a given level of output in the conditions in
which that level of output is normally attained. It forms a part of production cost.

Abnormal Cost

It is the cost which is not normally incurred at a given level of output in the conditions
in which that level of output is normally attained. It is not considered as a part of
production cost, hence it is charged to Costing Profit and Loss Account.

7. By Capital and Revenue or Financial Accounting Classification

If the cost is incurred in purchasing assets either to earn income or increasing the
earning capacity of the business it is called capital cost, for example, the cost of a rolling
machine in case of steel plant. Though the cost is incurred at one point of time the
benefits accruing from it are spread over a number of accounting years. Revenue
expenditure is any expenditure done in order to maintain the earning capacity of the
concern such as cost of maintaining an asset or running a business. Example, cost of
materials used in production, labor charges paid to convert the material into production,
salaries, depreciation, repairs and maintenance charges, selling and distribution charges,
etc. While calculating cost, revenue items are considered whereas capital items are
completely ignored.

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8. By Time

Costs can be classified as (i) Historical costs and (ii) Predetermined costs.

Historical Costs

The costs which are ascertained after being incurred are called historical costs. Such
costs are available only when the production of a particular thing has already been done.
Such costs are only of historical value and not at all helpful for cost control purposes.

Predetermined Costs

Such costs are estimated costs, i.e. computed in advance of production taking into
consideration the previous periods costs and the factors affecting such costs. If they are
determined on scientific basis they become standard cost. Such costs when compared
with actual costs will give the variances and reasons of variance and will help the
management to fix the responsibility and to take remedial action to avoid its recurrence in
future.

Historical costs and predetermined costs are not mutually exclusive. Even in a system
when historical costs are used, predetermined costs have a very important role to play
because a figure of historical cost by itself has no meaning unless it is related to some
other standard figure to give meaningful information to the management.

9. By Association with Product

Costs on this basis are classified as Product Costs and Period Costs. This distinction is
required for the purpose of profit determination. This is because product costs are carried
forward to the next accounting period in the form of unsold finished stock. Whereas
period costs are written off in the accounting period in which it is incurred.

Product Cost

Product costs are associated with unit of output. Product costs are the costs absorbed
by or attached to the units produced. These costs go into the determination of inventory
valuation (finished goods and partly completed goods) hence are called Inventoriable
costs. This consists of direct materials, direct labor and factory overheads (partly or
fully). The extent of inclusion of factory costs depends on the type of costing system in
force absorption or direct costing. If absorption costing method is adopted, both the
fixed and variable factory overheads are included as part of product costs. If direct
costing method is adopted only variable factory overheads are included as part of
inventoriable cost.

Period Costs

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Period costs are costs associated with period for which they are incurred, rather than the
unit of output or manufacturing activity. These costs are not treated as part of inventory
and hence they are treated as expenses of the period for which they are incurred.
Administrative, Selling and Distribution costs are treated as period costs and are deducted
as an expense for the determination of income and are not regarded as a part of inventory.

10 According to Planning and Control

Cost accounting furnishes information to the management which is helpful in


discharging the two important functions of management i.e. planning and control. For the
purpose of planning and control, costs are classified as budgeted costs and standard costs.

Budgeted Costs

Budgeted costs represent an estimate of expenditure for different phases or segments of


business operations, such as manufacturing, administration, sales, research and
development, for a period of time in future which subsequently becomes the written
expression of managerial targets to be achieved. Various budgets are prepared for
different phases/segments of business, such as sales budget, raw material cost budget,
labor cost budget, cost of production budget, manufacturing overhead budget, office and
administration overhead budget. Continuous comparison of actual performance (i.e.,
actual cost) with that of the budgeted cost is made so as to report the variations from the
budgeted cost to the management for corrective action.

Standard Cost
The Institute of Cost and Management Accountants, London defines standard cost as
the predetermined cost based on a technical estimate for materials, labor and overhead
for a selected period of time and for a prescribed set of working conditions. Thus,
standard cost is a determination, in advance of production, of what should be its cost
under a set of conditions.
Budgeted costs and standard costs are similar to each other to the extent that both of
them represent estimates of cost for a period of time in future. In spite of this, they
differ in the following respects:
Standard costs are scientifically predetermined costs of every aspect of business
activity whereas budgeted costs are mere estimates made on the basis of past
actual financial accounting data adjusted to future trends. Thus, budgeted costs
are projection of financial accounts whereas standard costs are projection of cost
accounts.
The primary emphasis of budgeted costs is on the planning function of
management whereas the main thrust of standard costs is on control.
Budgeted costs are extensive whereas standard costs are intensive in their
application. Budgeted costs represent a macro approach of business operations
because they are estimated in respect of the operations of a department. Contrary
to this, standard costs are concerned with each and every aspect of business

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operation carried in a department, budgeted costs are calculated for different
functions of the business, i.e. production, sales, purchases, etc. whereas standard
costs are compiled for various elements of costs, i.e. materials, labor and
overhead.
11. For Managerial Decisions

On this basis, costs may be classified into the following categories:

Marginal Cost

Marginal cost is the additional cost to be incurred if an additional unit is produced. In


other words, marginal cost is the total of variable costs, i.e. prime cost plus variable
overheads. It is based on the distinction between fixed and variable costs.

Out of Pocket Costs

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

Differential Costs

If there is a change in costs due to change in the level of activity or pattern or method of
production they are known as differential costs. If the change increases the cost, it will be
called incremental cost and if the change results in the decrease in cost it is known as
decremental cost.

Sunk Costs

Sunk cost is another name for historical cost. It is a cost that has already been incurred
and is irrelevant to the decision making process. A good example is depreciation on a
fixed asset. Depreciation on a given asset is a sunk cost because the cost (of purchasing
the asset) has already been incurred (when it was purchased) and it cannot be affected by
any future action, though we allocate the depreciation cost to future periods the original
cost of the asset is unavoidable. What is relevant in this context is the salvage value of the
asset not the depreciation. Thus, sunk costs are not relevant for decision making and are
not affected by increase or decrease in volume.

Imputed (or notional) Costs

These costs appear in cost accounts only. For example notional rent charged on business
premises owned by the proprietor, interest on capital for which no interest has been paid.
When alternative capital investment projects are being evaluated it is necessary to
consider the imputed interest on capital before a decision is arrived as to which is the
most profitable project.
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Opportunity Cost

It is the maximum possible alternative earnings that will be foregone if the productive
capacity or services are put to some alternative use. For example, if an owned building is
proposed to be used for a project, the likely rent of the building is the opportunity cost
which should be taken into consideration while evaluating the profitability of the project.
Since opportunity costs are not actually costs incurred but only are benefits foregone,
they are not as a matter of fact recorded in the accounting books. However, they are
relevant costs for decision making purposes and are considered while evaluating different
alternatives.

Replacement Cost
It is the cost at which there could be purchase of an asset or material identical to that
which is being replaced or revalued. It is the cost of replacement at current market price.

Avoidable and unavoidable Cost

Avoidable costs are those which can be eliminated if a particular product or department
with which they are directly related to, is discontinued. For example, salary of the clerks
employed in a particular department can be eliminated, if the department is discontinued.
Unavoidable cost is that cost which will not be eliminated with the discontinuation of a
product or department. For example, salary of factory manager or factory rent cannot be
eliminated even if a product is eliminated.

12. Other Types of Costs

Future Costs

Are those costs that are expected to be incurred at a later date.

Programmed Cost

Certain decisions reflect the policies of the top management which results in periodic
appropriations and these costs are referred to as programmed cost. For example, the
expenditure incurred by the company under the Jawahar Rojgar Yojana program initiated
by the prime minister is a programmed cost which reflects the policy of the top
management.

Joint Cost

Joint cost is the cost of manufacturing joint products up to or prior to the split-off point.
Cost incurred after the split-off point is called separable cost. Joint cost is common to the
processing of joint products and by-products till the point of separation and cannot be
traced to a particular product before the point of split-off.

17
Conversion Cost

Conversion cost is the cost incurred in converting the raw material into finished product.
It can be calculated by deducting the cost of direct materials from the production cost.

Discretionary Costs

Discretionary costs are those costs which do not have obvious relationship to levels of
capacity or output activity and are determined as part of the periodic planning process. In
each planning period the management decides on how much to spend on certain
discretionary items such as advertising, research and development, employee

Committed Cost

Committed cost is a fixed cost which results from the decisions of the management in
the prior period and is not subject to the management control in the present on a short run
basis. They arise from the possession of production facilities, equipment, an organization
setup, etc.

Some examples of committed costs are: plant and equipment depreciation, taxes,
insurance premium and rent charges.

1.8 COST CENTRE


The smallest segment of activity or area of responsibility for which costs are
accumulated. In the manufacture and sale of a product or in the rendering of a service,
several activities may have to be performed. These activities are usually carried out by
different departments or sections of the company. For example, in a pharmaceutical
company, the raw materials may be purchased by a purchase department, stocked up in
a store, processed in one or more processing departments, packed in a packing
department and sold by a sales and distribution department. Hence cost statistics are
conveniently accumulated for each department. In Cost Accounting each department
would be called a Cost Center. Typically cost centers are departments, but in some
instances, a department may contain several cost centers. For example, a machining
department may be under one foreman but it may contain various groups of machines,
such as lathes, milling machines, etc.
As each department is managed by a departmental manager, the cost of a department
would be a measure of how the departments manager is performing. In fact, by
reporting departmental costs to the concerned managers, they will better understand the
cost consequences of their actions so that departmental performance becomes more cost
effective.

Box 1.1: Kyocera Cost Centers


Kyocera is a Japanese company that makes packages which hold the silicon chips in electronic
computers. The packages or containers are made from alumina powder.

18
The powder is first made into sheets and wiring patterns are then screen printed on the sheets.
The sheets are next converted into interconnected stacks and the stacks are baked in ovens.
The final step is quality control.

Based on the above description can you decide on the main cost centers of Kyoceras factory?

The following cost centers are clearly suggested by the above description.
Sheet Making Department
Screen Printing Department
Stack Making Department
Baking Department
Quality Control Department.

1.9 COST UNITS

Managers are often interested in knowing the cost of something. The something for
which the cost has to be ascertained is known as cost objective or cost object or cost unit.
Examples of cost units include products, activities, departments, number of patients
treated, sales regions, etc.

For example, if a factory produces motor cars then the cost unit would be a motor car
because the costs are all incurred in producing motor cars.

Let us take up a more complex situation. Consider a bus operator providing bus services
to the public between most of the major cities of the country. Suppose the bus operator
wants to fix a cost unit, what is it?

Note that here there is no production, what is provided is a service.

Each trip between two cities may be taken as a cost unit. Alternatively cost per kilometer
of travel may be taken as a cost unit. However, neither of the above cost units relates to
the passenger who buys the service.

If the operator wants to fix a price to be charged to each passenger, the above cost units
would have to be adjusted further.

Assume that a bus covers a distance of 700 km per day carrying 30 passengers on an
average, the output is 700 x 30 = 21,000 passenger kilometers per day. On an average the
passenger kilometers covered by each bus per week is 1,00,000. The total cost of
operation per bus per week is Rs.80,000, the cost per passenger kilometer is = Rs.0.80.

Cost per passenger kilometer


= (80,000/1,00,000)
= Re.0.80
19
The implication is that the bus operator must charge, on an average, over Rs.0.80 per
kilometer to each passenger in order to make a profit.

1.10 COST SHEET


Cost sheet is a statement which is prepared usually to present the detailed costs of total
production during the period in question. It provides information relating to cost per unit
at different stages of the total cost of production or at different stages of completion of
the product.

ADVANTAGES OF COST SHEET :


It discloses the total cost and the cost per unit
It enables a manufacturer to keep a close watch and control over the cost of
production
It provides a comparative study of various elements of current cost with past
results and std cost.
It acts as a guide to the manufacturer and helps him in formulating production
policies
It helps in fixing up the sales price more accurately
It helps in minimizing the cost of production
It helps in submission of accurate quotations of tenders for supply of goods.

Specimen of Cost Sheet

Cost Sheet for the Period__________________


Production _____________________Units

Total cost (Rs) Cost per unit (Rs)


Direct materials consumed:
Opening stock..
Add: Purchases..
Carriage inwards.
Less: Closing stock.
Less: Scrap.. xxxx
Direct wages xxxx
Direct expenses xxxx
I. Prime Cost xxxx
Add: Factory Overheads:
Indirect materials
Loose tools
Indirect wages
Rent & rates (Factory)
Lighting & Heating of factory
Power & fuel
20
Repairs & maintenance
Cleaning
Depreciation of P&M
Works stationery
Welfare service expenses
Insurance of fixed assets, stocks & finished
goods
Works managers salary
Add: Opening WIP xxxx
Less: Closing WIP xxxx
II. Factory or works cost xxxx
Add: Office & administrative overheads:
Rent & Rates of office
Office salaries
Lighting & Heating
Insurance of office building & equipments
Telephone & postage
Printing & stationery
Depreciation of office furniture
Legal expenses
Audit fees
Bank charges
III Cost of production xxxx
Add: Opening stock of finished goods
Less: Closing stock of finished goods
IV Cost of goods sold xxxx
Add: Selling & Distribution Overheads:
Showroom expenses
Lighting & heating
Salesmens salaries
Commissions
Traveling expenses of salesman
Sales printing & stationery
Advertising
Bad debts
Postage
Depreciation & expenses of delivery van
Debt collection expenses
Carriage freight outwards
Sample & other free gifts
V Cost of Sales xxxx
Net Profit (or loss) xxxx
Sales xxxx

Note: Items of expenses which are an appropriation of profit should not form a part of the
costs of a product. Example of such expenses are : (i) Income tax (ii) Dividends to
21
shareholders (iii) commission (out of profit) to managing directors or partners (iv) Capital
loss, that is loss arising out of sales of assets (v) interest on loan (vi) Donations (vii)
Capital expenditures (viii) Discount on shares & debentures (ix) underwriting
commission (x) writing off goodwill.

Illustration 1:
From the following particulars, prepare a cost sheet for the year ended 31.12.2007
Rs
Stock of finished good (1.1.2007) 6000
Stock of raw material (1.1.2007) 40000
WIP (1.1.2007) 15000

Purchase of raw material 4,75,000


Carriage inward 12,500
Factory rent, taxes 7250
Other production exp 43000
Stock of finished goods (31.12.2007) 15000

Wages 1,75,000
Work manager salary 30000
Factory employees salary 60000
Power expenses 9500
General expenses 32500

Sales for the year 8,60,000


Stock of raw materials (31.12.07) 50,000
WIP (31.12.2007) 10000

SOLUTION
Particulars Amount (Rs) Amount (Rs)
Raw Material consumed:
Opening stock of raw material 40,000
Add: Purchases 4,75,000
Carriage inward 12,500
Less: Closing stock of raw material 50,000 4,77,500
Wages 1,75,000
I Prime Cost 6,52,500
Add: Factory overheads:
Factory rent, taxes 7250
Other production exp 43000
Work manager salary 30,000
Factory employees salary 60,000
Power expenses 9,500
Add: Opening stock of WIP 15000
Less Closing stock of WIP 10,000

22
II Works or factory cost 8,07,250
Add: Office overheads
General Expenses 32500
III Cost of production 8,39,750
Add: Opening stock pf finished goods 6000
Less: Closing stock pf finished goods 15,000
IV Cost of goods sold 8,30,750
Profit 29,250
Sales 8,60,000

MULTIPLE CHOICE QUESTIONS


Q1 Which of the following statements is/are true?
Cost accounting is not a part of management accounting.
Cost accounting is a system to record, summarize and report cost information.
Cost accounting is a post mortem of past costs.
Cost accounting is not necessary if financial accounting provides necessary analysis.

Q2 The relationship between cost and activity is called


(a) Cost analysis
(b) Cost behaviour
(c) Cost prediction
(d) Cost estimation

Q3 Which of the following is least likely to be an objective of cost accounting system?


(a) Product costing
(b) Optimum sales mix determination
(c) Maximization of profit
(d) Sales commission determination

Q4 Costing Technique in which all costs, variable as well as fixed, are charged to
product, operations or services is
(a) Historical costing
(b) Absorption costing
(c) Marginal costing
(d) Direct costing

Q5 Product costs in financial statements include


(a) Direct material, direct labor, overheads and interest
(b) Direct material, direct labor, overheads
(c) Selling & administrative cost
(d) Interest & selling cost

Q6 The costing approach wherein actual costs are ascertained after they have been
incurred is
23
(a) Marginal costing
(b) Direct costing
(c) Standard costing
(d) Historical costing

Q7 The cost which reflects the policies of the top management which result in periodic
appropriations are called as
(a) Future cost
(b) Discretionary cost
(c) Committed cost
(d) Programmed cost

Q8 In a given situation if a product is not produced the company can save on the salary of
workers to the tune of Rs.1,00,000. In this case the salary of the worker is
(a) Imputed cost
(b) Unavoidable cost
(c) Avoidable cost
(d) None of the above

Q9 Depreciation charged on Plant & Machinery is


(a) Future cost
(b) Discretionary cost
(c) Committed cost
(d) Programmed cost

Q10 Costs that are not relevant for decision-making and are not affected by increase or
decrease in volume are
(a) Out of pocket cost
(b) Sunk cost
(c) Differential cost
(d) Imputed cost

24
CHAPTER 2 MATERIAL CONTROL & COSTING
At the end of the chapter, you will be conversant with:
2.1 Classification Of Material
2.2 Concept & Objectives Of Materials Control
2.3 Purchase Of Material:
2.4 Material Control Techniques
2.4.1 Economic Order Quantity (Eoq)
2.4.2 Stock Levels:
2.4.3 Selective Inventory Control: Abc Analysis
2.4.4 Just-In-Time (Jit) System
2.5 Pricing Of Inventories

2.1 CLASSIFICATION OF MATERIAL


The term materials refers to all commodities consumed in the process of production.
The material is an important part of cost of a product. Without material no manufacturing
is possible. Material may be direct or indirect.
(i) Direct Material: All materials which can be conveniently identified or
attributed wholly to a particular cost unit are termed as direct
materials. It is an integral part of the finished product. For example,
timber used in manufacturing furniture, cotton in textile, sugarcane in
sugar etc.
(ii) Indirect Material: All materials which can not be conveniently
associated with a particular cost unit are called indirect materials.
Though such materials also become a part of finished product but they
are used in such small quantities that their allocation to a particular
cost centre is difficult & futile, for example, nails used in the
manufacture of furniture, thread in shoe, oil, grease etc.

2.2 CONCEPT & OBJECTIVES OF MATERIALS CONTROL


Materials cost constitutes a prime part of the total cost of production of manufacturing
firms. Proper accounting, therefore, for & control over materials purchase, consumptions,
& inventories are important for effective management of a business firm. Materials
control basically aims at efficient purchasing of materials, their efficient storing &
efficient use or consumption.
Material control consists of control at two levels: (i) Quantity controls, and (ii) finance
controls. For instance, the production department in a manufacturing company aims at
quantity controls, i.e. lesser and lesser units should be used in the production department.
Although lesser units would result in lower investments on purchase of materials, yet the
user (production) department normally does not think in terms of expenditure. In contrast,
the finance manager is interested in keeping the investments on materials at the lowest
point. In material control, balance has to be maintained between two opposing needs, that
is
(i) Maintenance of sufficient material for efficient production

25
(ii) Maintenance of investment in inventory at the lowest level. IN detail, the following
are the objectives in a good system of material control:
1. Material of the desired quality will be available when needed for efficient
& uninterrupted production.
2. Material will be purchased, only when it is required, and in economic
quantities.
3. The investment in material will be made at lowest level consistent with
operating requirement.
4. Purchase of material will be made at the most favorable prices under the
best possible terms.
5. Material will be protected against loss by fire, theft, spoilage etc.
6. Material should be stored in such a way that they can provide minimum of
handling time & cost.
7. Vouchers will be approved for payment only if the material has been
received & is available for issue.
8. Issues of material are properly authorized & properly accounted for.
9. Materials are, at all times, charged as the responsibility of some
individual.

2.3 PURCHASE OF MATERIAL:


The most important point of material control is purchasing of materials. Carelessness &
inefficiency in this respect may become the cause of heavy losses. To guard against this,
the following procedure for the purchase of materials should be adopted in a large
concern:
1. Purchase requisition: A form known as a purchase requisition serves three general
purposes:
(i) It automatically starts the purchasing process & informs the purchasing
department of the need for the purchase materials.
(ii) It fixes the responsibility of the department/personnel making the purchase
requisition.
(iii) it can be used for future reference.
Usually, purchase requisitions are prepared by the storekeepers for regular store items
which are below or approaching the minimum level of stock or to replace stock of
materials & parts in stores. The production control department can also given
requisitions for the purchase of specialized materials. A typical purchase requisition
contains details, such as number, date, department, quantity, description,
specification, signature of the person initiating the requisition, & signature of one or
more officers approving the purchase. Copies of purchase requisition are sent to the
purchase department & accounting department.
2. Purchase order After the requisition is received duly approved, the purchase
department places an order with a supplier, offering to buy certain materials at
stated prices & terms. The purchase order is a formal contract for the supply of
materials. The order should clearly state the materials required & the price, and
provide information, such as delivery period & the department for whom the
materials are purchased. Copies of purchase order are sent to the departments
concerned, the sender of the purchase requisition, and the store department
26
advising them to expect the materials as specified & where to send them upon
receipt. Copies of the purchase requisition & purchase order are sent to
accounting department, to be used in checking the suppliers invoice when a
voucher is being prepared for payment.
3. Receiving materials: The receiving department performs the function of
unloading & unpacking materials which are received by an organization. This will
need an inspection report which is sometimes incorporated in the receiving report,
indicating the items accepted & rejected, with reasons. Several copies of the
receiving report or goods received note are prepared, one going to each
department interested in the arrival of materials, including stores, buying &
accounts departments.
4. Approvals of invoices: Invoice approval indicates that goods according to the
purchase order have been received & payment can now be made. However, if the
goods or equipment received are not of type ordered, or are not in accordance
with specifications, or are damaged, the purchasing department issues a return
order indicating that the goods are to be returned to the supplier.
5. Making payment: After the purchase invoice total is approved, the process of
making payment begins. Payment depends on the terms agreed upon on any
particular order, & any terms which differ from normal practice should be
considered individually. When it is found that items written on the invoice
qualify for payment, a remittance advice is prepared after providing for deduction
on discounts, if any.

2.4 MATERIAL CONTROL TECHNIQUES


As we have already discussed that every management technique should be in consonance
with the shareholders, wealth maximization principle. To achieve this, the firm should
determine the optimum level of inventory.
Efficiently controlled inventories make the firm flexible. Inefficient inventory control
results in unbalanced inventory and inflexibility-the firm may sometimes run out of stock
and sometimes may pile up unnecessary stocks. This increases the level of investment
and makes the firm unprofitable.
To manage inventories efficiency, we should seek answers to the following two
questions:
How much should be ordered?
When should it be ordered?

The first question, how much to order, relates to the problem of determining economic
order quantity (EOQ), and is answered with an analysis of costs of maintaining certain
level of inventories.
The second question, when to order, arises because of uncertainty and is a problem of
determining the re-order point.

2.4.1 ECONOMIC ORDER QUANTITY (EOQ)


One of the major inventory management problems to be resolved is how much inventory
should be added when inventory is replenished.

27
1. If the firm is buying raw materials, it has to decide lots in which it has to be
purchased on replenishment.
2. If the firm is planning a production run, the issue is how much production to
schedule (or how much to make).

These problems are called order quantity problems, and the task of the firm is to
determine the optimum or economic order quantity (or economic lot size).
Assumptions of EOQ:
1. Constant or uniform demand: Although the EOQ model assumes constant
demand, demand may vary from day-to-day. If demand is stochastic that is, not
known in advance the model must be modified through the inclusion of a
safety stock.
2. Constant unit price: The EOQ formula derived is based on the assumption that
the purchase price Rs.P per unit of material will remain unaltered irrespective of
the order size. Quite often, bulk purchase discounts or quantity discounts are
offered by suppliers to induce customers for buying in larger quantities.
The inclusion of variable prices resulting from quantity discounts can be handled quite
easily through a modification of the original EOQ model, redefining total costs and
solving for the optimum order quantity.
3. Constant carrying costs: Unit carrying costs may vary substantially as the size
of the inventory rises, perhaps decreasing because of economies of scale or
storage efficiency or increasing as storage space runs out and new warehouses
have to be rented. This situation can be handled through a modification in the
original model similar to the one used for variable unit price.
4. Constant ordering costs: While this assumption is generally valid, its violation
can be accommodated by modifying the original EOQ model in a manner
similar to the one used for variable unit price.
5. Instantaneous delivery: If delivery is not instantaneous, which is generally the
case, the original EOQ model must be modified by including of a safety stock.
6. Independent orders: If multiple orders result in cost savings by reducing
paperwork and transportation cost, the original EOQ model must be further
modified. While this modification is somewhat complicated, special EOQ
models have been developed to deal with this.

Determining an optimum inventory level involves two types of costs:


(a) Ordering costs and
(b) Carrying costs.
The economic order quantity is that inventory level, which minimizes the total of
ordering and carrying costs.

Ordering Costs
Lets see if you remember what ordering costs are?
The term ordering costs is used in case of raw materials (or supplies) and includes the
entire costs of acquiring raw materials. They include costs incurred in the following
28
activities: requisitioning, purchase ordering, transporting, receiving, inspecting and
storing (store placement).
Ordering costs increase in proportion to the number of orders placed.
The clerical and staff costs, however, do not vary in proportion to the number of orders
placed, and one view is that so long as they are committed costs, they need not be
reckoned in computing ordering cost. Alternatively, it may be argued that as the number
of orders increases, the clerical and staff costs tend to increase. If the number of orders
are drastically reduced, the clerical and staff force released now can be used in other
departments. Thus, these costs may be included in the ordering costs. It is more
appropriate to include clerical and staff costs on a pro rata basis.
Ordering costs increase with the number of orders; thus the more frequently inventory is
acquired, the higher the firm's ordering costs. On the other hand, if the firm maintains
large inventory levels, there will be few orders placed and ordering costs will be
relatively small. Thus, ordering costs decrease with increasing size of inventory.

Carrying Costs
Do you have any idea what carrying costs are?
Costs incurred for maintaining a given level of inventory are called carrying costs. They
include storage, insurance, taxes, deterioration and obsolescence. The storage costs
comprise cost of storage space (warehousing cost), stores handling costs and clerical and
staff service costs (administrative costs) incurred in recording and providing special
facilities such as fencing, lines, racks etc.

EXAMPLES OF ORDERING AND CARRYING COSTS


Lets take a quick look at the various cost items that come under ordering and carrying
costs respectively.

Ordering Costs
Requisitioning
Order placing
Transportation
ving, inspecting and storing
Clerical and staff
Carrying Costs
Warehousing
Handling
Clerical and staff
Insurance
Deterioration and obsolescence

Carrying costs vary with inventory size. This behavior is contrary to that of ordering
costs, which decline with increase in inventory size. The economic size of inventory
would thus depend on trade-off between carrying costs and ordering costs.

29
Where,
A = annual demand
O = ordering cost per order
C = carrying cost per unit
Lets take an example so that you understand it better.
Example:
Your firm buys casting equipment from outside suppliers @Rs.30/unit. Total annual
needs are 800 units. You have with you following further data:
Annual return on investment: 10%
Rent, insurance, taxes per unit per year: Re.1
Cost of placing an order: Rs.100
How will you determine the economic order quantity?
Solution:

2.4.2 STOCK LEVELS:

Re-order Point/Level
We have now solved the problem of how much to order by determining the economic
order quantity, we have yet to seek the answer to the second problem, when to order.
This is a problem of determining the re-order point. Lets see what re-order point is?

30
The re-order point is that inventory level at which an order should be placed to replenish
the inventory.
To determine the re-order point under certainty, we should know:
(a) Lead time,
(b) Average usage, and
(c) Economic orders quantity.
Under such a situation, re-order point is simply that inventory level which will be
maintained for consumption during the lead-time. That is:
Reorder point = (lead time in days x daily usage ) + Safety Stock
Or
Maximum re-order period *Maximum Usage

Lead-time
It is the time normally taken in replenishing inventory after the order has been placed. By
certainty we mean that usage and lead-time do not fluctuate.
Safety stock
The demand for material may fluctuate from day to day or from week to week. Similarly,
the actual delivery time may be different from the normal lead-time. If the actual usage
increases or the delivery of inventory is delayed, the firm can face a problem of stock-
out, which can prove to be costly for the firm. Therefore, in order to guard against the
stock-out, the firm may maintain a safety-stock-some minimum or buffer inventory as
cushion against expected increased usage and/or delay in delivery time.

Maximum and minimum Level:

Maximum Level: It represents that level of stock above which the stock should not be
allowed to rise. It is to be foxed keeping in mind unnecessary blocking of capital in
stores.
Maximum Level= Re=order Level + Re-order quantity-(Minimum
consumption*Minimum re-order period)

Minimum Level:
It is that level which below which the inventory of any item should not be allowed to fall.
It is also known as safety or buffer stock. The main object of fixing this level is to avaoid
unnecessary delay or hampering of production due to shortage of materials.
Minimum Level= Re-order level- (Normal consumption*Normal re-order period)
Average Level:
This level of stock may be determined by using the following formula:
Average Level= (Maximum Level + Minimum Level) / 2
Or
= Minimum level+1/2(Re-order quantity)

Danger Level: This level is generally determined below the minimum level & represents
the level where immediate steps are taken for getting stock replenished. In some cases,
danger level of stock is fixed above the minimum level, but below the re-order level.
Danger Level= Average consumption * Lead time for emergency purchases
31
Figure2.1 : Inventory Level and Order Point for Replenishment

From the figure, it can be noticed that the level of inventory will be equal to the order
quantity (Q units) to start with. It progressively declines (though in a discrete manner)
to level O by the end of period 1. At that point an order for replenishment will be made
for Q units. In view of zero lead time, the inventory level jumps to Q and a similar
procedure occurs in the subsequent periods. As a result of this the average level of
inventory will remain at (Q/2) units, the simple average of the two end points Q and
Zero.
From the above discussion the average level of inventory is known to be (Q/2) units.
From the previous discussion, we know that as order quantity (Q) increases, the total
ordering costs will decrease while the total carrying costs will increase.
The economic order quantity, denoted by Q*, is that value at which the total cost of
both ordering and carrying will be minimized. It should be noted that total costs
associated with inventory
=

where the first expression of the equation represents the total ordering costs and the
second expression the total carrying costs. The behavior of ordering costs, carrying
costs and total costs for different levels of order Quantity (Q) is depicted in figure 2.2.
Figure 2.2: Behavior of costs associated with inventory for changes in order
quantity

32
From figure, it can be seen that the total cost curve reaches its minimum at the point of
intersection between the ordering costs curve and the carrying costs line. The value of Q
corresponding to it will be the economic order quantity Q*. We can calculate the EOQ
formula.
The order quantity Q becomes EOQ when the total ordering costs at Q is equal to the
total carrying costs. Using the notation, it amounts to stating:

(i.e.) 2UF = Q2 PC

or Q = units
To distinguish EOQ from other order quantities, we can say
EOQ = Q* =

In the above formula, when U is considered as the annual usage of material, the value
of Q* indicates the size of the order to be placed for the material which minimizes the
total inventory-related costs. When U is considered as the annual demand Q* denotes
the size of production run.
Suppose a firm expects a total demand for its product over the planning period to be
10,000 units, while the ordering cost per order is Rs.100 and the carrying cost per unit is
Rs.2. Substituting these values,
EOQ = = 1,000 units
Thus if the firm orders in 1,000 unit lot sizes, it will minimize its total inventory costs.
33
2.4.3 SELECTIVE INVENTORY CONTROL: ABC ANALYSIS
Usually a firm has to maintain several types of inventories. It is not desirable to keep the
same degree of control on all the items. The firm should pay maximum attention to those
items whose value is the highest. The firm should, therefore, classify inventories to
identify which items should receive the most effort in controlling. The firm should be
selective in its approach to control investment in various types of inventories. This
analytical approach is called the ABC analysis and tends to measure the significance of
each item of inventories in terms of its value.
The high-value items are classified as 'A items' and would be under the tightest control.
'C items' represent relatively least value and would be under simple control.
'B items' fall in between these two categories and require reasonable attention of
management.
The ABC analysis concentrates on important items and is also known as control by
importance and exception (CIE). As the items are classified in the importance of their
relative value, this approach is also known as proportional value analysis. (PVA). .
The following steps are involved in implementing the ABC analysis:
1. Classify the items of inventories, determining the expected use in units and the price
per unit for each item.
2. Determine the total value of each item by multiplying the expected units by its units
price
3. Rank the items in accordance with the total value, giving first rank to the item with
highest total value and so on.
4. Compute the ratios (percentage) of number of units of each item to total units of all
items and the ratio of total value of each item to total value of all items.
5. Combine items on the basis of their relative value to form three categories: -A, B and
C.
Let us understand this with the help of an example.
Example
A firm has 7 different items in its inventory. The average number of each of these
items held, along with their unit costs, is listed below. The firm wishes to
introduce an ABC inventory system. Suggest a breakdown of the items into A, B
& C classifications.

34
Solution.
ABC Analysis

Figures in column (5) are in lakhs. Here you will find of how the ABC system
works. Under this system all the items are classified into three groups. A category
inventory constitutes the first 70% of inventory. These inventories are required for
strict control. The next is B category where moderate control is imposed. The last
one is the C category. So as per this method which type of inventory requires the
special attention is identified.

2.4.4 JUST-IN-TIME (JIT) SYSTEM


As you must have guessed from the name, under this system materials arrive
exactly at the time they are needed for production.
The just-in-time (JIT) system is used to minimize inventory investment. The
philosophy is that materials should arrive at exactly the time they are needed for
production. Ideally, the firm would have only work-in-process inventory. Because
35
its objective is to minimize inventory investment, a JIT system uses no, or very
little, safety stocks. Extensive coordination must exist between the firm, its
suppliers, and shipping companies to ensure that material inputs arrive on time.
Failure of materials to arrive on time results in a shutdown of the production line
until the materials arrive. Likewise, a JIT system requires high-quality parts from
suppliers. When quality problems arise, production must be stopped until the
problems are resolved.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool
for attaining efficiency by emphasizing quality in terms of both the materials used
and their timely delivery. When JIT is working properly, it forces process
inefficiencies to surface and be resolved. A JIT system requires cooperation
among all parties involved in the process-suppliers, shipping companies, and the
firm's employees.

2.5 PRICING OF INVENTORIES

There are different ways of valuing the inventories and knowledge of these methods of
valuing stocks is essential for an efficient inventory management process. The
following methods can be adopted to value the raw material:
First-In-First-Out (FIFO): When a firm adopts the FIFO method to price its raw
material, the issue of material from the stores will be in the order which it was
received. Thus the pricing will be based on the cost of material that was
obtained first.
Last-In-First-Out (LIFO): In the LIFO method, the material issued will be priced
based on the material that has been purchased recently.
Weighted Average Cost Method: The pricing of materials will be done on
weighted average basis (weights will be given based on the quantity).
Standard Price Method: Material is priced based on a standard cost which is
predetermined. When the material is purchased the stock account will be debited
with the standard price. The difference between the purchase price and the
standard price will be carried into a variance account.
Replacement/Current Price Method: In this method, material is priced at the
value that is realizable at the time of the issue.

Illustration
The following information is extracted from the stores ledger of M/s Meena Ltd.
Material: X
Opening Stock: NIL
Purchases:
July 1 175 units @ Re.1 per unit
July 12 175 units @ Re.2 per unit

36
Issues:
July 21 105 units
July 30 70 units
i. Complete the receipts and issues valuation by adopting the FIFO, LIFO and
Weighted Average Method.
ii. If the standard price is Rs.1.25 per unit for the year and the replacement costs of
the material on July 21 and July 30 are Rs.1.25 and Rs.1.75 respectively, then
show the stock ledger account using the standard price method and the
replacement price method.
The illustration has been solved in the following tables.

Valuation of Work-in-process and Finished Stock


The valuation of work-in-process and finished goods inventory depends to a certain
extent on the method of pricing the raw material and to a large extent on the method of
costing used to apportion the fixed manufacturing overheads. Direct Costing and
Absorption Costing are the two techniques used for allocation of costs to the inventory.
Direct costing is based on the traceability of cost to the cost objective. All indirect costs
(which may include fixed manufacturing overheads) are charged to the income
statement and are known as period costs. If the fixed costs are directly identifiable, then
it is considered for inventory valuation.
Absorption costing is a technique which treats the fixed manufacturing overheads as
product costs. Thus, all costs i.e., both fixed and variable will be assigned to the
inventory value.
This difference in approach to costing will affect the inventory value and also the
profits. The direct costing method lowers the inventory value (by not considering the
indirect costs) and increases profits with a decrease in inventory level (when the
inventory level decreases the direct costs come down while the fixed costs remain the
same). Contrary to this the inventory valuation will be higher for stocks valued under
absorption costing method as it considers all the fixed manufacturing overheads.
Statement showing the valuation of raw material using FIFO, LIFO and Weighted
Average Methods, standard price & replacement price methods:

FIFO

Receipts Issues Balance


Date Particulars Qty Rate Value Qty Rate Value Qty Value
175
1-Jul Purchase units Re 1 175 175 175
175
12-Jul Purchase units Re 2 350 350 525

37
105
21-Jul Issue units 105 1 105 245 420
70
30-Jul issue units 70 1 70 175 350

Value of Closing stock:- 175 Units of Rs


350

LIFO

Receipts Issues Balance


Date Particulars Qty Rate Value Qty Rate Value Qty Value
175
1-Jul Purchase units Re 1 175 175 175
175
12-Jul Purchase units Re 2 350 350 525
105
21-Jul Issue units 105 2 210 245 315
70
30-Jul issue units 70 2 140 175 175

Value of Closing stock:- 175 Units of Rs


175

Weighted Average Method

Receipts Issues Balance


Date Particulars Qty Rate Value Qty Rate Value Qty Rate Value
175
1-Jul Purchase units Re 1 175 175 1 175
175
12-Jul Purchase units Re 2 350 350 1.5* 525
105
21-Jul Issue units 105 1.5 157.5 245 1.5 367.5
70
30-Jul issue units 70 1.5 157.5 175 1.5 262.5

* Wighted Average Rate: =


1.5
Value of Closing stock:- 175 Units of Rs
262.5

38
Standard Price Method

Receipts Issues Balance


Date Particulars Qty Rate Value Qty Rate Value Qty Value
175
1-Jul Purchase units Re 1 175 175 175
12- 175
Jul Purchase units Re 2 350 350 525
21- 105
Jul Issue units 105 1.25 131.25 245 393.75
30- 70
Jul issue units 70 1.25 87.5 175 306.25

Value of Closing stock:- 175 Units of Rs 306.25


Current Price/Replacement Method
Receipts Issues Balance
Date Particulars Qty Rate Value Qty Rate Value Qty Value
175
1-Jul Purchase units Re 1 175 175 175
12- 175
Jul Purchase units Re 2 350 350 525
21- 105
Jul Issue units 105 1.25 131.25 245 393.75
30- 70
Jul issue units 70 1.75 122.5 175 271.25

Value of Closing stock:- 175 Units of Rs


271.25

Now that you have understood the concepts, lets have a review to test your knowledge

Multiple Choice Questions:


Q1 Which of the following is not an advantage if a company that follows a policy of
centralized purchases and payments to suppliers?

39
Q2 Which of the following statements is not true of pricing of inventories?

Q3 Which of the following statements is false?

Q4 Mr Ram has annual sales of 209,000 units at an average selling price of Rs19.95. The
ordering costs are Rs80 per order and the carrying costs per year are Rs70.46 per unit.
What is the optimal order quantity?
(a) 78
(b) 209
(c) 487
(d) 689

Q5 Sakthi's Specialty Items maintains an average inventory of 129,000 items. Each item
is totally unique and hand-crafted. The ordering costs are Rs160 each due to the time
required to find such unusual items. The carrying costs are Rs254.00 a year per item.
Sakthi's sells about 49,000 items per year. What are the total ordering and carrying costs
per year for Sakthi's Specialty Items?
(a) Rs29,134,690
(b) Rs32,785,520
(c) Rs32,797,520
40
(d) Rs33,160,870

Q 6Which one of the following is a disadvantage of the just-in-time (JIT) inventory


system?
(a) lower inventory carrying costs
(b) less inventory storage space
(c) more efficient use of assets
(d) production shutdowns for lack of parts

Q7 Material control system would be most useful to a:


(a) Manufacturer
(b) Wholesaler
(c) Hospital
(d) Retailer
Q8 Economic order quantity (EOQ) model is used by a business to
(a) Minimize the cost of placing orders
(b) Minimize the unit purchase price of inventory
(c) minimize the number of orders placed during a year
(d) Minimize the combined costs of placing orders & carrying inventory.
Q9 A material pricing method in which the oldest cost incurred rarely have an effect on
the closing inventory valuation is:
(a) LIFO
(b) FIFO
(c) Weighted average
(d) Simple average

Q10 Alpha Company was using FIFO for material pricing & its value of closing
inventory was found lower. Assuming no opening inventory, what direction did the
purchase prices move during the period?

(a) Up
(b) Down
(c) Steady
(d) Can not be determined

41
CHAPTER 3 LABOUR COSTING

At the end of the chapter, you will be conversant with:


3.1 Types of Labour
3.2 Labour Costs
3.3 Control Over Labour Costs
3.3.1 Labour Turnover
3.4 Idle Time
3.5 Overtime
3.6 Methods Of Remuneration

INTRODUCTION

Labour cost is a second major element of cost. Under the present political conditions with
a restive labour in organized industry, it is very difficult to reduce labour cost. Therefore,
proper control and accounting for labour cost is one of the most important problems of
business enterprise. But control of labour cost presents certain practical difficulties unlike
the control of material cost. The human element in labour makes difficult the control of
labour cost whereas materials, being inanimate in nature, could be subjected to a rigid
control. Labour is the most perishable commodity and as such should be effectively
utilized immediately. Labour, once lost, cannot be recouped and is bound to increase the
cost of production. On the other hand, materials, being durable, can be used as and when
required and can be stored without having to incur immediate loss.

3.1 TYPES OF LABOUR

Just like materials, labour is also two types (a) direct labour, and (b) indirect labour.

(a) Direct Labour

Direct labour is that labour which is directly engaged in the production of goods or
services and which can be conveniently allocated to the job, process or commodity
unit. For example, labour engaged in making the bricks in a kiln is direct labour
because charges paid for making, 1,000 bricks can be conveniently allocated to the
cost of 1,000 bricks.

(b) Indirect Labour

Indirect labour is that labour which is not directly engaged in the production of goods
and services but which indirectly helps the direct labour engaged in production. The
examples of indirect labour are mechanics, supervisors, chowkidars, sweepers,
foremen, watchmen, timekeeper, cleaners, repairers etc. the cost of indirect labour
cannot be conveniently allocated to a particular job, order, process or article.

42
It may be mentioned that it may not always be possible to classify individual workers
as direct labour or indirect labour. For example, a worker who is engaged in actual
production may sometime required to do supervisory work. In such a case, the time
devoted to actual production should be treated as direct labour and that spent on
supervisory work taken as indirect labour.
The distinction between direct and indirect labour must be observed carefully because
payment of direct labour is a direct expenditure and is a part of prime cost whereas
payment of indirect labour is an item of indirect expenditure and is shown as works,
office, selling and distribution expenditure according to the nature of the time spent
by the indirect worker.

3.2 LABOUR COSTS

Labour costs represent the various items of expenditure incurred on workers by the
employer and would include the following:

(a) Monetary Benefits e.g. : (i) Basic Wages (ii) Dearness Allowance; (iii)
Employers Contribution to Provident Fund; (iv) Employers Contribution to
Employees State Insurance (ESI) Scheme; (v) Production Bonus; (vi) Profit
Bonus; (vii) Old Age Pension; (viii) Retirement Gratuity.
(b) Fringe Benefits or Labour Related Costs e.g.: (i) Subsidised Food; (ii) Subsidised
Housing; (iii) Subsidised Education to the children of workers; (iv) Medical
Facilities; (v) holidays pay; (vi) Recreational Facilities.

Fringe benefits are indirect forms of employee compensation. The total of these
benefits given to workers should be sufficient enough to attract and retain the labour
force. In other word, the will to work among workers should be created with the
consequent increase in efficiency.

3.3 CONTROL OVER LABOUR COSTS

Labour costs constitute a significant portion of the total cost of a product. Labour cost
may be excessive due to inefficiency of labour, high labour turnover, idle time and
unusual overtime work, inclusion of bogus workers in the wages sheet and many other
related factors. Inefficiency of labour is also a cause of excessive material and overhead
costs. Therefore, economic utilization of labour is a need of the present day industry to
reduce the cost of production of the products manufactured or services rendered.
Management is interested in labour costs on account of the following;
to use direct labour cost as a basis for increasing the efficiency of workers;
to identify direct labour cost with products, orders, jobs or processes for
ascertaining the cost of every product, order, job or process;
to use direct labour cost as a basis for absorption of overhead, if percentage of
direct labour cost to overhead is to be used as a method of absorption of overhead;
to determine indirect labour cost to be treated as overhead; and
to reduce the labour turnover.

43
Hence, control of labour costs is an important objective of management and the
realization of this objective depends upon the cooperation of every member of the
supervisory force from the top executive to the foreman. From functional point of view,
control of labour costs is effected in a large industrial concern by the coordinated efforts
of the following six departments:
1) Personnel Department,
2) Engineering Department,
3) Rate or Time and Motion Study Department,
4) Time-keeping Department,
5) Pay-roll Department, and
6) Cost Accounting Department.
The functioning of some of these departments in relation to control of labour cost is
given below:

1) PERSONNEL DEPARMENT

Personnel department with the help of various department supervisors and heads is
responsible for the execution of policies regarding the recruitment, discharge,
classification of employees and wages which have been laid down by the Board of
Directors or a committee of executives. The main functions of the personnel
department are to recruit workers, train them and place them to the jobs they are best
fitted.

3.3.1 LABOUR TURNOVER


Labour turnover denotes the percentage change in the labour force of an organization.
High percentage of labour turnover denotes that labour is not stable and there are frequent
changes in the labour force because of new workers engaged and workers who have left
the organization. A high labour turnover is not desirable. The definitions of labour
turnover are given below:
(1) Labour turnover according to separation method

= Number of employees left during a period x 100


Average number of employees during a period

This definition does not take into consideration the fact of surplus labour. This definition
will give incorrect result when the surplus workers are discharged because labour
turnover calculated in this way will be high.
(2) Labour turnover according to flux method

= Number of additions + separations during a period x 100


Average number of employees during a period

This definition will not be applicable when the organization is expanding. In such case,
many new workers are engaged and three may be no separation; even then labour
turnover calculated will be high.

44
Number of additions + separations during a period
(3) Labour Turnover = _______________2__________________________x100
Average number of employees during a period

This definition will misguide when an organization has reached its optimum size and
does not require expansion at all. In such case, labour turnover as per definition, will
show half the actual percentage of labour turnover.

(4) Labour turnover according to replacement method

= Number of workers replaced during a period x 100


Average number of workers during the period

This definition takes into account the surplus labour. This definition will also give correct
labour turnover when the factory is expanding because all additions are not to be taken,
only workers replaced due to leavers are to be taken. Therefore, this definition can be
taken to be the most reliable definition out of all the definitions given above.

ILLUSTRATION 1. From the following information, calculate the labour turnover rate
and labour flux rate:

Number of workers at the beginning of the year 3,800


Number of workers at the end of the year 4,200

During the year 40 workers leave while 160 workers are discharged. 600 workers are
required during the year, of these 150 workers are recruited because of leavers and the
rest are engaged in accordance with an expansion scheme.

SOLUTION

Average number of workers during the year = 3,800 + 4,200 = 4,000


2

Labour Turnover Rate = Number of workers replaced during the year x 100 =
Average number of workers during the year
150 x100 = 3.75%
4,000

Labour Flux Rate =


Number of additions + separations during the year x 100 =
Average number of employees during the year
600+200 x100 = 20%
4,000

Labour flux rate denotes total change in the composition of labour force due to additions
and separations of workers.
45
Causes of Labour Turnover
The various causes of labour turnover can be classified under the following three heads:

1. Personal causes;
2. Unavoidable causes ; and
3. Avoidable causes.

1. Personal Causes. Workers may leave the organization purely on personal


grounds, e.g.
(a) Domestic troubles and family responsibilities.
(b) Retirement due to old age.
(c) Accident making workers permanently incapable work.
(d) Women workers may leave after marriage in order to take up household
duties.
(e) Dislike for the job or place.
(f) Death.
(g) Workers finding better jobs at some other places.
(h) Workers may leave just because of their roving nature.
(i) Causes involving moral turpitude.

In all such cases, labour turnover is unavoidable and the employer can practically do
nothing to reduce the labour turnover.

2. Unavoidable Causes. In certain circumstances it becomes necessary for the


management to ask some of the workers to leave the organization. These
circumstances be as follows:
(a) Workers may be discharged due to insubordination or inefficiency.
(b) Workers may be discharged due to continued or ling absence.
(c) Workers may be retrenched due to shortage of work.

3. Avoidable Causes. (a) Low wages and allowances may induce workers to leave
the factory and join after factories where higher wages and allowances are paid.
(b) Unsatisfactory working conditions e.g., bad environment, inadequate
ventilation etc. leading to strained relations with the employer.
(c) Job dissatisfaction on account of wrong placement of workers may become a
cause of leaving the organization.
(d) Lack of accommodation, medical, transport and recreational facilities.
(e) Long hours of work.
(f) Lack of promotion opportunities.
(g) Unfair methods of promotion.
(h) Lack of security of employment.
(i) Lack of proper training facilities.
(j) Unsympathetic attitude of the management may force the workers to leave.

46
(b) Effects of Labour Turnover

There must be some labour turnover due to personal and unavoidable causes. It has
been observed by employers that a normal labour turnover, which is between 3% and
55, need not cause much anxiety. But a high labour turnover is always detrimental to
the organization. The effect of excessive labour turnover is low labour productivity
and increased cost of production. This is due to the following reasons:
Frequent changes in the labour force give rise to interruption in the continuous
flow of production with result that overall production is reduced.
New workers take time to become efficient. Hence lower efficiency of new
workers in increases the cost of production.
Selection and training costs of new workers recruited to replace the workers
who have left increase the cost production.
New workers being unfamiliar with the work give more scrap, rejects and
defective work which increase the cost of production.
New workers being inexperienced workers cause more depreciation of tools
and machinery. Due to faculty handling of new workers, breakdown of tools
and machinery may also occur very often hamper production.
New workers being inexperienced workers are more prone to accidents.
Consequently, all costs associated with accidents such as loss on account of
output lost, compensation for the injured workers, damage of materials and
equipment due to accidents etc. increase the cost of production.

(C) Reduction of Labour Turnover


As already pointed out, normal labour turnover is advantageous because it allows
injection of fresh blood into the firm. But excessive labour turnover is not
desirable because it shows that labour force is not contended. Therefore, every
effort should be made to remove the avoidable causes which given rise to
excessive labour turnover. The following steps may be taken to reduce the labour
turnover:

A suitable personnel policy should be framed for employing the right man
for the right job and giving a fair and equal treatment to all workers.
Good working conditions which may be conductive to health and
efficiency should be provided.
Fair rates of pay and allowances and other monetary benefits should be
introduced.
Maximum non-monetary benefits (i.e. fringe benefits) should be
introduced.
Distinction should be made between efficient and inefficient workers by
introducing incentive plans whereby efficient workers may be rewarded
more as compared to inefficient workers.
An employee suggestion box scheme should be introduced whereby
workers who suggest improvements in the method of production should be
suitably rewarded.

47
Men-management relationships should be improved by encouraging
labour participation in management.

In addition to the above steps, the personnel department should prepare


periodical reports on the labour turnover listing out the various reasons due to
which workers have left the organization. The report should be sent to the
management with the necessary recommendations so that corrective measures
may be taken to reduce labour turnover.

(d) Cost of Labour Turnover

The cost of labour turnover can be divided under two heads:


(i) Preventive Costs.
(ii) Replacement Costs.
(i) Preventive Costs. These are costs which are incurred to prevent
excessive labour turnover. The aim of these costs is to keep the
workers satisfied so that they may not leave the factory.
These costs may include:
1. Cost of providing good working conditions.
2. Cost of providing medical, housing and recreational facilities to workers.
3. Cost of providing educational facilities to the children of the workers.
4. Cost of providing Subsidised meals.
5. Cost of providing other welfare facilities.
6. Cost of providing safety measures against working conditions.
7. Measures of security and retirement benefits such as pension, gratuity,
employers contribution to prevent fund and other measures over and
above the compulsory legal provisions.

As prevention is better than cure, preventive cost should be incurred to prevent


excessive labour turnover. This cost of labour turnover should be apportioned among
different departments on the basis of average number of employees in each department
and justifiably treated as overhead. If preventive cost is incurred for reasons of image or
status of the employer or non-economical corporate goals, it may be debited to the
Costing Profit and Loss Account. If preventive cost is incurred for a particular
department, it may be taken as overhead of that department.

(ii) Replacement Costs. These costs are associated with replacement of


workers and include:
1. Cost of recruitment of new workers.
2. Cost of training new workers.
3. Loss of production due to (a) interruption in production, and (b)
inefficiency of new workers.
4. Loss of profit due to loss of production.
5. Loss in fixed overhead cost because of less production on account of new
inexperienced workers.

48
6. Wastage due to excessive spoilage on account of inept handling of
machines, tools and materials by new workers recruited as a result of
labour turnover.
7. Cost of accidents because of new workers having more proneness to
accidents.

These costs should be distributed among different departments on the basis of actual
number of workers replaced in each department and treated as overhead.

2. ENGINEERING DEPARTMENT
This department is required to maintain control over working conditions & production
methods for each job & department by performing the following functions:
1. Preparation of plans & specifications for each job scheduled for
production.
2. Inspection of jobs at successive stages of production to make sure
that jobs are being done according to the plans & specifications
laid down.
3. inspection of jobs after they are completed to ensure that they are
satisfactorily completed.
4. maintaining safety conditions.
5. maintaining good working conditions
6. Conducting research & experimental work before undertaking
new jobs.

3. TIME & MOTION STUDY DEPARTEMNT:

This department works in close harmony with the personnel, engineering & cost
departments. This department performs the following functions:
1. Making of time & motion study of labour & plant operations.
2. Making job analysis
3. Setting piece rates

4. TIME-KEEPING DEPARTEMNT:

This department is concerned with the recording of time of each worker engaged in the
factory. The recording of time is for two purposes, i.e. for time-keeping & time-booking.
Time keeping is concerned with the recording of time of workers for the purpose of
attendance & wage calculations whereas time booking is the reporting of each workers
time for each department, operation & job for the purpose of cost analysis &
apportionment of labour costs between various jobs & departments. These two recordings
should be regularly reconciled to establish the accuracy of recording of time because
wages calculated on the basis of time-keeping should agree with the wages charged to the
various jobs or production orders on the basis of time-booking.
(a) Time-Keeping:
Time-keeping will serve the following purposes:
1. Preparation of pay rolls in case of time-paid workers.
49
2. Meeting the statutory requirements.
3. Ensuring discipline in attendance.
4. Recording of each workers time in and ;out of the factory making distinction
between normal time, overtime, late attendance and early leaving.
5. For overhead distribution when overheads are absorbed on the basis of labour
hours.
If the size of factory and volume of work permits, there should be a separate time-
keeping office, near the factory gate for recording the time of workers. If the size of
the factory is small time-keeping office may form a part of personnel or gate office.
Payment of wages to workers on time basis is dependent upon time spent by them,
hence an accurate record of time should be maintained.

(b) Time-booking: As stated earlier, time booking is the recording of time spent by the
worker on different jobs or work orders carried out by him during his period of
attendance in the factory. The objects of time booking are:
1. To ensure that time paid for according to time-keeping is properly utilized on different
jobs or work orders.
2. To ascertain the labour cost of each individual job or work order.
3. To provide a basis for the apportionment of overhead expenses over various jobs or
work orders when the method for the allocation of overheads depends upon time spent on
different jobs.
4. To ascertain unproductive time or idle time.
5. Bonus payable under incentive schemes of wage payment is dependent upon the time
taken for completing a job; hence it is necessary to know about the time taken to
complete a particular job.

3.4 IDLE TIME:-


As we have already observed, there is bound to be some difference between the time
booked to different jobs or work orders & gate time. The difference of this time is known
as idle time. Idle time is that time for which the employer pays, but from which he
obtains no production. For example, if out of eight hours that a worker is supposed to put
in the factory, the workers job card shows only seven hours spent on jobs, one hour will
be idle time in such a case. Idle time is of two types:
(a) Normal Idle Time , and
(b) Abnormal Idle Time

a. Normal Idle time:- It is unavoidable, of normal nature and is inherent in


production environment. This may be due to:-
Time lost in moving from one job to another
Time lost in waiting for materials or instructions
Temporary absence from duty because of minor accidents, personal breaks
tea breaks etc.
Time taken in traveling form one dept to another dept.

b. Abnormal Idle Time:- This is not caused by usual production routine. It may be:-
50
Time lost through the break down of machinery
Time lost through lack of materials
Bottlenecks in production, resulting in a temporary absence of parts for
further processing.
Strikes, lockout, fire etc.
3.5 OVERTIME:- According to Factories Act, 1948, every worker is to be paid
overtime at a higher rate, generally at double the normal wage rate, if he is required to
work more than 8 hrs a day.

Accounting Treatment:-
1. Where the overtime work becomes necessary to complete a job within a specified
time limit, the overtime premium should be directly charges to the job concerned
by way of direct wages.
2. Where the overtime work becomes necessary to meet the increased seasonal
demand, then it is directly charged to the job.
3. Where overtime work becomes necessary on account of faulty planning in a dept,
the cost should be treated as an item of dept overheads.

3.6 Methods of Remuneration

Time Wage System Piece Wage System Incentive/Bonus


System
WAGE SYSTEMS
An important aspect of labour cost control is a wage system designed primarily for
exercising management control over labour. The following objectives should be
considered in the selection of a wage system:
1. Acceptance by employees to avert slowdowns and work stoppages.
2. Provision for flexibility.
3. Provision for economy in administration.
4. Supplying of labour statistics for use in industrial relations and for trade
associations, government agencies, and competitors.
5. Stabilisation of labour turnover.
6. Minimising of absenteeism.
7. Provision for incentive plans.

Basically there are two wage systems to pay for labour: (i) straight time which is by hour,
day, or week, and (ii) piece work, which is by the unit of product.

STRAIGHT TIME
Under the time basis, the worker is paid at an hourly, daily or weekly rate and his
remuneration depends upon the time for which he is employed and not upon his
production. If a worker works for an over time, the wage agreement usually provides that
51
all hours worked in excess of an agreed number are paid for at higher rate. The time basis
wage system for direct labour is found in those industries where:
1. The speed of production cannot be influenced by the energy or dexterity of the
worker.
2. The quality of work is of paramount importance.
3. It is difficult to measure the work done by the employees.

From the point of view of the worker, the straight time method has both advantages and
disadvantages. Workers have feelings of security and certainty which appeal to them.
They can depend upon a definite wage or salary regardless of the amount of work
completed or the efficiency of their work, provided it is above the minimum
requirements. However, this wage system does not give proper recognition or reward to
efficient workers whose productivity is above the average of the other workers. There is
little incentive to achieve better or superior performance.
From the employers point of view, time wage systems are easy to compute and
understand and provide economy in time-keeping and payroll recording. But on the other
hand, constant supervision is required; otherwise considerable wasted time may be paid
for. Among the workers, the inefficient workers receive the same wages as the efficient
workers, thus tending to cause dissatisfaction and frustration among the workers and
increasing the labour cost per unit produced.
The time basis is still the most popular wage system for workers, such as clerks,
accountants, stenographers, factory helpers, members of the supervisory staff and officers
whose work cannot be standardized and measured satisfactorily. This is preferred by
skilled and efficient workers with whom the quality of work is a more important factor
than volume of production.

PIECE WORK

Under this method, a fixed rate is paid for each unit produced, job performed or number
of operations completed, and the workers wages thus depend upon his output and not
upon time he spends in the factory.
Piece-rates are of advantage to management in the following respects:
1. Managerial supervision is not much needed for production, since each worker
assumes responsibility for his own time output.
2. Higher production reduces overhead costs per unit of output.
3. Labor costs can be computed in advance of production with the aid of fixed rate
unit or job.
4. Labor control becomes easier by isolating workers whose work is inefficient and
below the minimum standard requirements.

Piece work has some limitations too. It attaches more premiums to quantity than the
quality of work. It has the tendency of increasing imperfections, spoiled work, and
detectives and higher depreciation costs result because of considerable wear and tear of
plant and machinery. Also, this system does not maintain a regular wage for the
employee.
52
To avoid the limitations of straight or simply piece work system, a guarantee is normally
provided in the system that the employees wages shall not fall below a certain minimum
figure. This is known as Piece-rates with guaranteed day rate. Under this method the
worker receives a straight piece-rate for the number of pieces produced, provided that his
total wage is greater than his earnings on a time rate basis. When the piece-rate earnings
fall below this level, the time rate earnings are paid instead. An alternative form of the
methods is the guaranteed time rate (per hour, day or week), plus a piece-rate payment
for output above a stated minimum. Labour cost per piece decreases with increasing
production until piece-rate earnings exceed the guarantee, therefore, the labour cost per
piece remains constant.

INCENTIVE WAGE PLANS

The basic purpose of an incentive wage is to induce a worker to produce more so that he
can earn a higher wage and, at the same time, unit costs can be reduced. Incentive wage
plans aim to ensure greater output to help control over labour costs by minimization of
total coat for a given volume of production and to have a basis for reward from hours
served to work accomplished.
Incentive wage scheme has the following objectives:
1. Un-interrupted and higher production without any dispute between the labour and
management.
2. Stability in labour turnover.
3. Reducing labour absenteeism.
4. Developing cooperation, mutual trust, attitude of team work among workers and
between workers and supervisory staff.
5. Control of labour cost and reduction in labour cost unit of output.
6. Improving administrative efficiency.
7. Accurate budgeting through reliable labour cost information.
8. Generating workers satisfaction by avoiding work stoppages, slow down, and by
providing incentive schemes.

Incentive wage plans involve wage rates based upon various combinations of output and
time and are known as differential piece-rates and bonus-plans as well. Generally, the
following types of incentive plans are used:
1. Taylor Differential Piece-rate System
2. Merrick Differential Piece-rate System
3. Gantt Task Bonus Plan
4. Premium Bonus Plans ( Halsey, Halsey-Weir, Rowan, Bedaux, Emersion, etc )

TAYLOR DIFFERENTIAL PIECE-RATE SYSTEM

Under this system there are two wage rates, a low one for output below standard and a
higher one for above standard performance. The system aims to discourage below
average workers by providing no guaranteed hourly wage and by setting low piece-rates

53
for low level production, and a high rate resulting in high earnings if an efficient level of
production is attained. For example, in a factory, workers earn Rs.240 per eight hour day
and that production averages 12 units per hour per worker or Rs.2.50 per unit. The Taylor
system might suggest a pay of Rs.2 per unit if the worker averaged 14 units or less per
hour, but Rs.3 per unit to workers averaging 15 units or more per hour. The main
advantages of the Taylor system are that it provides a strong incentive to the efficient
worker, and is simple to understand and operate. But the incentive level may be set so
high that it cannot attract most workers.

MERRICK DIFFERENTIAL PIECE-RATE SYSTEM

This is an improvement over the Taylor system and depends on using three rates instead
of two as in the Taylor system. Normal piece-rates are paid on output, when it does not
exceed 83% of the standard output. 110% of normal piece-rate is paid when the output is
between 83% and 100%, and 120% of the normal piece rate is paid if the output is above
100%.
The Merrick system is useful to highly efficient workers as it provides incentives for
higher production. Similarly, it takes into account the less efficient worker who can at
least achieve 83% of the standard output. This minimum output is probably achievable by
all workers.

GRANTT TASK and BONUS PLAN

This system combines a guaranteed time rate with a bonus and piece rate plan using the
differential piece-rate system. Remuneration under the plan is computed as follows:
OUTPUT PAYMENT
Output below standard Time-rate (guaranteed)
Output at standard bonus@20% on the time-rate
Output above standard High piece-rate on worker

This plan provides incentives and opportunities to those who reach high level production.
At the same time it provides security and encouragement to less skilled workers. It is
simple to understand and workers are also satisfied in that they receive the total reward
for their efforts. A limitation of the plan is the tendency on the part of trade unions to
demand a high fixed guaranteed time-rate. But the incentive element of the plan would be
lost in case too high rate is fixed.

PREMIUM BONUS PLANS

Under the time-rates basis, any additional production above normal levels benefits the
employer, whereas with the piece-rates system the benefit goes to the employee (apart
from indirect benefits to the employer). Bonus plans have been developed to produce a
compromise, in that any savings are shared between employer and employee. The
following are the principal schemes under premium bonus plans.

1. Halsey Premium Plan


54
The principle of the Halsey scheme is that the worker receives a fixed proportion of any
time which he can save by completing the job in less than the allowed time. The most
common fixed proportion is 50% but this can be varied. This plan ensures that the
employee receives time wages until he produces in less than standard time. For above
standard production, savings are shared with the employer with the result that the rate of
increase happens to be lower for the employee. The cost per unit decreases when
production exceeds standard.
Total wages of a worker under this plan is calculated as follows:
Total wages = (Time Taken x Hourly rate) + (50% x (Time saved x Hourly rate)

2. Halsey-Weir Plan

This plan is also known as the Weir Premium Scheme and is based on a 33.33:66.67
sharing plan. Under this scheme the total emoluments of a worker are the aggregate of
guaranteed hourly wages for actual time worked, plus the amount of bonus at the rate of
33.33% of the time saved. Bonus is allowed at the same hourly rate at which he shall be
paid for actual time worked.
Total wages of a worker under this plan is calculated as follows:
Total wages = (Time Taken x Hourly rate) + (33.33% x (Time saved x Hourly rate)

3. Rowan Plan

This scheme is similar to Halsey plan in that standard time is fixed for the completion of
a job and the bonus is paid in respect of the time saved. But a ceiling is applied to the size
of the bonus. The bonus hours is calculated as a proportion of the time taken which the
time saved bears to the time allowed, and is paid for at time-work rates.
Total wages of a worker under this plan is calculated as follows:
Total wages = (Time Taken x Hourly rate) + (Time Saved x (Time taken x Hourly
Time Allowed rate)

GROUP BONUS SCHEMES

Where a group of workers is collectively responsible for manufacturing a product, it may


not be possible to adopt individual incentive schemes. The production of the workers as a
whole is measured, and the total bonus is determined by one of the individual incentive
schemes capable of group application. The computed bonus can then be shared equally,
or between workers of different skills in differing specified proportions. A group bonus
scheme has the following objective:
1. Developing collective interest and team spirit among all workers and employees.
2. Developing interest among foremen and supervisors to improve performance.
3. Reducing spoilage in materials consumption.
4. Reducing idle time.
5. Achieving maximum production at minimum cost.
6. Motivating workers to produce more to get bonus on the basis of team
performance.

55
Group bonus schemes may be employed:

1. Where individual output cannot be measured, but that of as group of worker can,
for example, on a production line.
2. Where output depends less upon the efforts of particular individuals, and more
upon the combined efforts of a group, department, or even of the whole
undertaking; or
3. Where the management wishes to encourage a team spirit.

ILLUSTRATIONS:

Illustration 1:
Q4 Find out wage per hour based on the following information:
Name Sohan
Annual Wages 2400
Annual Bonus @ 20% of A Wages
Employer contribution of P.F. @ 10% of A wages
Employer contribution of E.S.I.@ 5% of A wages
Total Leave permitted during the year 60 days
Cost of labour welfare activities including canteen subsidy 8000/-
Number of workers 200
Normal idle time 80 hrs
Working days per annum 320 days of 8 hrs
How will you treat, if Sohan had lost 60 hrs on some days on account of failure of power
supply?

Solution:
Calculation of total Labour Cost for the year
Rs
Wages 2,400
Bonus (20% of 2,400) 480
P.F. Contribution (10% of 2400) 240
ESI contribution (5% of 2400) 120
Gross wages (Total) 3240
Cost of Amenities per head (8000/200) 40
Total Labour cost 3280

Calculation of effective working hour per annum


Total Working days 320
Less Total leave days 60
Effective working days 260
Total Hors per day (260*8) 2,080
Less: Normal idle time (in hours) 80
effective hours per annum 2,000
labour cost per hour = Rs 3,280/2,000= Rs 1.64
56
Loss due to idle time = 60hours @ RS 1.64 p.h. = Rs 98.40
Loss of working hours due to failure of power supply in an abnormal loss & hence Rs
98.40 will be charged to costing Profit & Loss Account.

Illustration 2
For a certain work order, the standard time is 20 hours, wages RS 5 per hour, the actual
tiem taken is 13 hours & factory overhead charges are 80% of standard time.
Set out a comparative statement showing the effect of paying wages according to (i)
Halsey Bonus System, and (ii) The Rowan Incentive Bonus System.

SOLUTION
Normal wages for actual time taken 13 hours @ Rs 5 = Rs 65.00
Bonus under the Halsey Premium Scheme 50% (S-T)*R = 50% (20-13) * Rs5= Rs 17.50
Bonus under the Rowan Premium Scheme (S-T) *T *R = 20-13 *13 *Rs5 = Rs 22.75
S 20
Total wages including bonus payable under
Helsey Scheme = Rs 65 +Rs 17.50 = Rs 82.50
Total wages including bonus payable under
Rowan Premium Scheme = Rs 65 + Rs 22.75 = Rs 87.75
Employers saving under the Halsey Plan
Saving in labour cost: Rs
Stadard wages (20hors @ Rs5) 100
Less: Actual wages payable 82.50
17.50
Saving in overhead:
80% of wages for time saved = 80% (7Hrs @Rs 5) 28.00
Total Savings 45.50

Employers saving under the Rowan Plan


Saving in labour cost: Rs
Stadard wages (20hors @ Rs5) 100
Less: Actual wages payable 87.75
12.25
Saving in overhead:
80% of wages for time saved = 80% (7Hrs @Rs 5) 28.00
Total Savings 40.25

Comparative Statements showing the feects of paying wages under Halsey Plan & Rowan
Plan
Incentive Normal Bonus Total Employers Effective Rate of
Scheme wages Rs Rs Savings Earning per hour
Rs. Rs Rs.
Halsey 65 17.50 82.50 45.50 6.35(82.50/13)*
Rowan 65 22.75 87.75 40.25 6.75 (87.75/13)*
(Total Wages/Actual Time)
57
MULTIPLE CHOICE QUESTIONS:

Q1 Direct Labour means:


(a) Labour which can be conveniently associated with a particular cost unit
(b) labour which completes the work manually.
(c) Permanent labour of the production department
(d) none of the above

Q2 Labour turnover is measured by:


(a) No of workers joining/No of workers in the beginning of the period.
(b) No of workers left/No of works in the beginning plus at the end
(c) No of workers replaced/Average no of workers
(d) All of these

Q3 Labour productivity is measured by comparing:


(a) Total output with total man hours
(b) Actual time with standard time
(c) Added value for the product with total wage cost
(d) All of the above

Q4 Wage sheet is prepared by:


(a) Cost accounting department
(b) Payroll department
(c) Personnel department
(d) Time-keeping department

Q5 A satisfactory system of wage payment should


(a) Deprive the employer of a fair margin of profit
(b) Guarantee a minimum living wage
(c) Provide non-financial incentives
(d) none of the above

Q6 The time wage system


(a) Satisfies trade unions
(b) Increases cost of production
(c) Benefits the less efficient workers
(d) None of the above

Q7 The straight piece system


(a) Is opposed by trade union
(b) Recognizes individual efficiency
(c) Benefits the employer
(d) None of the above

Q8 Which of the following methods of remuneration is most likely to give stability of


labour cost to the employer?
58
(a) Group Bonus scheme
(b) Measured day work
(c) Premium bonus scheme
(d) Straight piece work

Q9 Differential piece rate system


(a) Are complicated
(b) Are discriminatory
(c) Pay workers in proportion to their efficiency
(d) none of the above

Q10 Under Gantt task & bonus plan, no bonus is available to a worker if his efficiency is
below:
(a) 100%
(b) 50%
(c) 75%
(d) 66 2/3 %

59
CHAPTER 4 OVERHEAD COSTING

At the end of the chapter, you will be conversant with:


4.1 Classification Of Overheads
4.2 Steps In Overhead Accounting
4.3 Types Of Departments
4.4 Distribution & Allocation Of Overhead
4.5 Principles Of Apportionment Of Overhead Cost
4.6 Methods Of Reapportionment Or Redistribution
4.7 Advantages Of Departmentalization Of Overhead
4.8 General Principles For Items Of Overhead Expenditure
4.9 Absorption Of Overhead
4.8 Methods Of Absorption Of Manufacturing Overhead
4.9 Choice Of An Overhead Rate
4.10 Under-Absorption/Over-Absorption Of Overhead

DEFINITION OF OVERHEAD

The costs attributable to a cost center or cost unit can be classified into two categories
direct and indirect. The costs which can be directly identified with a cost unit or cost
center is called as Direct/Prime Cost. The aggregate of indirect costs such as material
cost, indirect wages and indirect expenses is called overhead. In other words, any
expenditure over and above prime cost is known as overhead.

4.1 CLASSIFICATION OF OVERHEAD COSTS


cost classification. It involves two steps: (i) the determination of the class or groups into
which the overhead costs are subdivided; (ii) the actual process of classification of the
various expenses. The classification of overhead costs depends on the type and size of
business, nature of product or services rendered and the management policy. The various
types of classifications are:

Functional Classification,
Classification with regard to behavior of the expenditure, and
Element-wise classification.

FUNCTIONAL CLASSIFICATION OF OVERHEADS

Classification of overhead expenses with reference to major activity centers of a concern


is called functional classification. As per this classification the overhead expenses can be
classified as follows:.

1. Manufacturing or Production or Works Overhead

60
All the indirect expenses incurred by the operations of the manufacturing divisions of a
concern are classified as manufacturing overhead. Examples of such expenses are
depreciation, insurance charges on fixed assets like plant and machinery, stores, repairs
and maintenance of fixed assets, electricity charges, fuel charges, factory rent, etc.

2 Administration Overhead

All the expenses incurred towards the control and administration of an undertaking are
called Administration Overhead. Example: Office rent, salaries and wages of clerks,
secretaries and accountants, postage, telephone, general administration expenses,
depreciation and repairs of office building, etc.

3. Selling and Distribution Overhead

The cost incurred towards marketing, distribution and sales is called selling and
distribution overhead. It includes sales, office expenses, salesmens salaries and
commission, showroom expenses, advertisement charges, samples and free gifts,
warehouse rent, packaging expenses, transportation cost, etc.

4. Research and Development Expenses

The costs incurred for researching on new and improved products, new application of
materials or improved methods is called research costs. Development costs are incurred
towards commercial application of the discoveries made.

CLASSIFICATION WITH REGARD TO BEHAVIOR OF EXPENDITURE

Based on the behavior, the overheads can be classified into (a) Fixed overhead, (b)
Variable overhead, and (c) Semi-variable overhead.

1. Fixed overhead

Those costs remain constant regardless of the changes in the volume of activity.
Examples: rent, depreciation, etc.
Variable overhead

Variable overhead cost varies with changes in volume of activity. Example, material
cost, labor cost, etc.

2. Semi variable overhead

Semi variable overhead remains fixed up to a certain activity level, but once that level is
exceeded, they vary with the volume. Examples: salary of an employee (fixed amount
plus overtime depending on the overtime hours), telephone charges.

3. Element-wise Classification
61
Based on the elements, overheads can be classified as indirect material cost, indirect
labor cost, indirect expenses.

4.2 STEPS IN OVERHEAD ACCOUNTING


Unlike the direct costs which can be easily traceable and charged to the various cost
centers or units, the charge of the overheads presents a problem. Overheads cannot be
directly identifiable and easily traceable to cost units and cost centers. This necessitates
distribution of these costs to cost units on some arbitrary basis. The distribution of
overheads that cannot be specifically related to cost units, or cost centers is done by the
following procedure.
First the overhead is collected from different source documents, for different items of
overhead expenses. The documents which are used for the collection of overhead are
assigned a code number called standing order numbers. The various sources from which
overheads can be collected are departmental distribution summary, journal, invoice and
payroll.
A factory is administratively divided into various subdivisions known as departments
such as repairs department, power department, stores department etc. The following
factors must be considered while organizing a concern into a number of departments.
i. Every manufacturing process is to be divided into its natural divisions in order
to maintain natural flow of raw material from the time of its purchase till its
conversion into finished goods and sale.
ii. For ensuring smooth flow of production, the sequence of operations is taken into
consideration, while determining the location of the various departments and
layout of production facilities.
iii. For physical control on production and maintaining efficiency of the concern,
division of labor, authority and responsibility must be taken into consideration
while organizing department.

4.3 TYPES OF DEPARTMENTS

The main departments of a manufacturing concern are:

Production departments: The process of manufacturing is carried on in these department.

Service departments: Service departments render a particular type of service to the other
departments. For example, repairs and maintenance, electricity, etc.

Partly producing departments: A department may normally be service department, but


sometimes does some productive work, so it becomes partly producing department. For
example, a carpentry shop which is mainly responsible for the repairs and upkeep of
sundry fixtures and fittings may occasionally be required to manufacture packing boxes
for direct charges to out-turn, will be a partly producing department.
62
4.4 OVERHEAD ALLOCATION

The next step is primary distribution of overhead, that is the allocation and apportionment
of expenses to cost centers.
Tracing and assigning accumulated cost to one or more cost centers or cost units is
called cost allocation. For example, the cost of repairs and maintenance of a particular
machine is charged to that particular department wherein such machine is located.
Certain costs cannot be traced to a particular cost unit or cost center. The proportionate
allotment of costs (which cannot be identified wholly with a particular department) over
two or more cost centers or units is called cost apportionment.
The main difference between cost allocation and cost apportionment is that while the
allocation involves tracing of the whole of a cost to a cost unit or cost center, the
apportionment involves distribution of common costs over the cost units or cost
centers on some suitable basis.
Cost allocation is direct, but cost apportionment needs a suitable basis.

Bases of Apportionment

Apportionment of overhead costs to production and service departments and then


reapportionment of service departments costs to other service and production departments
should be done on some suitable equitable basis. There should be proper correlation
between the expenses and the basis of cost apportionment. The following are the main
bases of overhead apportionment used in manufacturing concerns.

Direct Allocation: Overheads are directly allocated to various departments on the basis
of expenses incurred for each department respectively. Examples are overtime premium
of workers engaged in a particular department, power when separate meters are available,
jobbing repairs, etc.

Direct Labor Hours: Under this basis, the overhead expenses are distributed to various
departments in the ratio of total number of labor hours worked in each department. For
example, administrative salaries and particularly salaries of the supervisors are
apportioned on the basis of labor hours worked. This is so because time is an element of
cost in these cases.

Direct Wages: According to this basis, expenses are distributed amongst the departments
in the ratio of direct wage bills of the various departments. Examples are holiday pay ,
Fringe benefits, ESI and PF contribution to workers etc.

Number of Workers: The total number of workers working in each department is taken
as a basis for apportioning overhead expenses amongst departments. Examples are
supervision costs, time keeping expenses etc.

63
Relative Areas of Departments: The area occupied by different departments
form the basis for the apportionment of certain expenses like lighting and
heating, rent, rates, taxes on building, air conditioning, etc.
Capital Values: In this method, the capital values of certain assets like
machinery and building are used as basis for the apportionment of certain
expenses. Examples are rates, taxes, depreciation, insurance charges of the
building, etc.
Light Points: This is used for apportioning lighting expenses.
Kilowatt Hours: This basis is used for the apportionment of power expenses.
Technical Estimates: This basis of apportionment is used for the apportionment
of those expenses for which it is difficult to find out any other basis of
apportionment. An assessment of the equitable proportion is carried out by
technical experts. This is used for distributing works managers salary, internal
transport, steam, water, etc. when these are used for processes.

Some overheads can be apportioned on one or more of the above basis. The underlying
fact is that there exists a correlation between the overhead cost and the basis for
apportionment. The choice of the most appropriate basis is thus matter of judgment.
Examples are fringe benefits, labor welfare expenses can be apportioned on the basis of
number of employees or on direct wages.

4.5 PRINCIPLES OF APPORTIONMENT OF OVERHEAD COST


The following are the principles for the determination of a suitable basis for cost
apportionment:
Service or Use or Benefit Derived: If the service rendered by a particular item
of expense to different departments can be measured, overhead can be
apportioned on that basis. For example, rent charges can be distributed
according to the floor space occupied by each department.
Ability to Pay Method: Under this method, overhead is distributed in proportion to
the sales, income or profitability of the departments, territories or products, etc.
Efficiency Method: Under this method, the apportionment of expenses is made
on the basis of production targets.
Survey Method: Under this method, a survey is made of the various factors involved
and the share of overhead costs to be borne by each cost center is determined.

Reapportionment of Service Department Costs to Production Departments.


The reapportionment of service department costs to the production departments or the
cost centers is known as Secondary Distribution.
Basis of apportionment of service cost can be tabulated as follows:

Service Department Cost Basis of Apportionment


64
Service Department Cost Basis of Apportionment

1. Maintenance Department Hours worked for each


department
2. Payroll or timekeeping Total labor or machine hours or
number of employees in each
department
3. Employment or personnel department Rate of labor turnover or
number of employees in each
department
4. Storekeeping department No. of requisitions or value of
materials of each department

5. Purchase department No. of purchase orders or value


of materials for each department

6. Welfare, ambulance, canteen service, No. of employees in each


recreation room expenses department
7. Building service department Relative area in each department

8. Internal transport service or overhead Weight, value graded product


crane service handled, weight and distance
traveled
9. Transport department Crane hours, truck hours, truck
mileage, truck tonnage, truck
tonne-hours, tonnage handled,
number of packages
10. Power House (Electric power cost) Wattage, horse power, horse
power machine hours, number
of electric points, etc.

4.6 METHODS OF REAPPORTIONMENT OR REDISTRIBUTION


The following are the methods of redistribution of service department costs to
production departments:
i. Direct Redistribution
ii. Step Method
iii. Reciprocal Service Method.

i. Direct Redistribution

65
Under this method, the costs of service departments are directly apportioned to
production departments without taking into account any service rendered by one service
department to another service department. Thus, proper apportionment cannot be made
and the production department may either be overcharged or undercharged. As budgeted
overhead for each department cannot be prepared thoroughly, the department overhead
rates cannot be ascertained correctly.

Illustration 4.1

In a light engineering factory, the following particulars have been collected for the
quarter ended 31st December, 2001. The department summary showed the following
expenses:
Production Departments Service Departments
P1 P2 P3 S1 S2
Rs. Rs. Rs. Rs. Rs.
8000 7000 6000 4000 6000
From the given data you are required to reapportion the service departments costs to
production departments using direct redistribution method. Apportion the expenses of
service department S2 in the ratio of 4:4:2 and those of service department S1 in the ratio
of 3:3:4 to the production departments P1, P2, and P3 respectively.

Solution

Production Overheads Distribution Summary for the quarter ending 31st December,
2001.

Production Departments Service


Departments
P1 P2 P3 S1 S2
Rs. Rs. Rs. Rs. Rs.
Total expenses as 8,000 7,000 6,000 4,000 6,000
per summary

Dept. S2 (4:4:2) 2,400 2,400 1,200 (6,000)

Dept. S1 (3:3:4) 1,200 1,200 1,600 (4,000)

Total 11,600 10,600 8,800

ii. Step Method


Under this method the sequence of distribution starts first with the service department
that provides greatest service, as measured by costs, to the greatest number of other

66
service departments and the last service department that distributes its cost will be the one
that provides least amount of services to the least number of other service departments.
Just like the direct method, under this method also if a service department costs are
distributed to other service departments, other service departments do not allocate their
costs back to it. Thus, the cost of last service department is apportioned only to the
production departments.

Illustration 4.2

A manufacturing company has two Production Departments P and Q and three Service
Departments Timekeeping, Stores and Maintenance. The departmental summary
showed the following expenses for July, 2001.

Production Departments Service Departments


(in order of their importance)
P Q X Y Z
(Timekeeping) (Stores) (Maintenance)

15,000 10,000 5,000 6,000 4,000


The other information relating to the above departments is as follows:
Service Departments Production
Departments

X Y Z P Q
(Stores)
(Timekeeping (Maintenance)
)
No. of 10 5 20 15
Employees
No. of Stores 6 24 20
Requisitions

Machine Hours 1200 800

Apportion the expenses of service departments.

Solution
Department As per Secondary Distribution

67
Primary From X to From Y to From Z to
Distribution Y, Z, P & Z, P & Q
Summary P&Q
Q
Rs. Rs.
X (Timekeeping) 5,000 ()5,000

Y (Stores) 6,000 1,000 ()7,000


Z (Maintenance) 4,000 500 840 ()5,340
P 15,000 2,000 3,360 3,204 23,564
Q 10,000 1,500 2,800 2,136 16,436
40,000 40,000

Note: Basis of apportionment:


a. Timekeeping: No. of employees (i.e. 2:1:4:3)
b. Stores: Number of stores requisition (i.e. 3:12:10)
c. Maintenance: Machine Hours (i.e. 3:2)

iii. Reciprocal Service Method

This method recognizes the fact that every department should be charged for the
services rendered to it. If two service departments provide service to each other, each
department should be charged for the cost of services rendered by the other.
Simultaneous Equation Method, Repeated Distribution Method, Trial and Error Method
are used to deal with inter-service department transfers.

Simultaneous Equation Method

The steps involve: (i) the ascertainment of the true cost of the service departments with
the help of simultaneous equation; (ii) the redistribution to production departments on the
basis of given percentage.

Illustration 4.3

A company has three production departments and two service departments. The
departmental distribution summary for a period has the following totals:

Production Departments: Rs.


P Rs.700; Q Rs.900 and R Rs.400 2,000
Service Departments:

68
X Rs.468 and Y Rs.600 1,068
3,068
The expenses of the service departments are charged out on a percentage basis as follows:
P Q R X Y
Service Rendered by 20% 40% 30% 10%
Department X
Service Rendered by 40% 20% 20% 20%
Department Y
Prepare a statement showing the apportionment of expenses of the two service
departments to Production Departments by Simultaneous Equation Method.

Solution

Let x = total overheads of department X

and y = total overheads of department Y

Then,

x = 468 + 0.2y
y = 600 + 0.1x

Re-arranging and multiplying to eliminate decimals:

10x 2y = 4680 ....... (1)


x + 10y = 6000 ....... (2)

Multiply equation (1) by 5, and add result to (2):

49x = 29,400
x = 600

Substituting this value in equation (1)

y = 660

All that now remains to be done is to take these values x = 600 and y = 660 and apportion
them on the basis of the agreed percentage to the three production departments; thus:

P Q R X Y Total
Rs. Rs. Rs.

69
Per Distribution Summary 700 900 400 468 600 3,068
Service department X@ 120 240 180 (600) 60 0
@@
Service department Y 264 132 132 132 (660) 0
1,084 1,272 712 0 0 3,068
@ P = 0.20 x 600; Q = 0.40 x 600; R = 0.30 x 600; Y = 0.10 x 600
@@ P = 0.40 x 660; Q = 0.20 x 660; R = 0.20 x 660; X = 0.20 x 660
This method is not to be recommended where there are more than two service
departments as each creates an additional unknown.

Repeated Distribution (or continuous allotment) Method

Under this method, the service department totals are exhausted in turn repeatedly
according to the agreed percentages until the figures become too small to matter. By
solving illustration 4.3 by Repeated Distribution Method, we get the following
Secondary Distribution Summary.

P Q R X Y
Rs. Rs. Rs. Rs. Rs.
As per Summary 700 900 400 468 600
@
Service Department X 94 187 140 (468) 47

Service Department Y# 259 129 129 130 (647)

Service Department 26 52 39 (130) 13


X@@
Service Department 5 4 4 (13)
Y##
1,084 1,272 712
@ P = 0.20 x 468; Q = 0.40 x 468 R = 0.30 x 468; Y = 0.10 x 468
@@ P = 0.20 x 130; Q = 0.40 x 130 R = 0.30 x 130; Y = 0.10 x 130
# P = 0.40 x 130; Q = 0.20 x 130; R = 0.20 x 130; X = 0.20 x 130
## P = 0.40 x 13; Q = 0.20 x 13; R = 0.20 x 13;
(Note: Figures are adjusted to near values)

Trial and Error Method

Under this method, the cost of one service department is apportioned to another center.
The cost of another center plus the share received from the first center is again
70
apportioned to the first cost center and this process is repeated till the balancing figure
becomes negligible. By solving illustration 4.3 by Trial and Error Method, we get the
following:

Service Departments
X Y
Rs. Rs.
Original apportionment 468 600
(468) 47(10% of 468)
129(20% of 647) (647)
(129) 13(10% of 129)
3(20% of 13) (13)
Total of positive figures 600 660

(Note: Figures are adjusted to near values)

4.7 ADVANTAGES OF DEPARTMENTALIZATION OF OVERHEAD


It facilitates control of overhead expenses by means of predetermined budgets.
It helps in controlling the uses made of the services rendered to the respective
departments.
Correct costs can be determined as the actual overhead costs of the respective
departments are taken into consideration in determining the overhead rates.
The reasons for variance can be known by the analysis of under or
overabsorption of overhead. It helps in taking remedial measures.
It helps in arriving at the cost of work-in-progress correctly.

4.8 GENERAL PRINCIPLES FOR ITEMS OF OVERHEAD EXPENDITURE


The following general principles should be borne in mind while considering whether an
item of expenditure is to be treated as overhead:
The aggregate of indirect material costs, indirect wages and indirect expenses is
overhead. Thus, it comprises of all indirect costs. Therefore, the relationship of
the items of costs to products, jobs, etc. must be traced.
Direct costs are also treated as overhead in cases where efforts involved in
identifying and accounting are disproportionately large. For example, costs
incurred for items like nuts, bolts, etc. though incurred for a particular job or
product are so small that it is not convenient to charge them as direct costs.
Therefore, it is apportioned as overheads over the jobs or products.
The overheads can be apportioned to a cost center in accordance with the
principles of benefit and/or responsibilities. The benefit principle implies that if
cost center occupies a certain proportion of a large unit of space for which
71
standing charges such as rent and rates are accurately ascertained, it should be
charged with a corresponding proportion of such costs. The responsibility
principle implies that as the departmental head has no control over the amount
of rent and rates paid, his department should not bear any brunt of allocation of
such costs.
Capital expenditure should be excluded from costs and should not be treated as
overhead.
Expenditure which does not relate to production shall not be treated as overhead.
Example, donations, subscriptions, penal interests on loans, income tax, etc.
It is advisable to apportion the direct costs as overheads in certain
circumstances. For example, electricity bill can be apportioned over various
jobs, products or processes as overhead, in case separate electric consumption
meters are not installed at each user point.
All indirect expenses such as electricity charges for factory lighting,
depreciation of fixed assets should be treated as overheads.
The role of the item of expenditure should also be considered. For example,
in case of toothpaste, cost of the tube in which paste is packed is treated as
direct costs as without it the product is not saleable. But the secondary
packing to despatching the toothpastes to the depots is treated as overhead.

4.9 ABSORPTION OF OVERHEAD

The process of applying overhead to the cost units is known as overhead absorption. It
is also known as levy or recovery of overheads. Absorption involves the distribution of
overhead relating to a particular department among the units produced in that
department during the relevant time period.

Overhead Absorption Rates

The overhead rate and the overhead amount to be absorbed by a product can be
calculated as follows:

Overhead Rate = Overhead Expenses/Total quantum of basis (quantity or value)

Overhead absorbed in a product = Overhead rate x Units of base per product

(The units of base can be units of products, direct labor hours, machine hours, etc.)

ACTUAL RATE

This rate is computed by dividing the actual overhead expenses incurred during a period
of time by the actual quantum (quantity or value) of the base selected for that period.

Limitations of actual rate are as follows:

72
Actual rate cannot be determined unless the accounting period is over. This delays the
determination of the cost of products.

The actual rate is likely to witness wide seasonal and cyclical fluctuations. This makes
the cost comparison difficult.

Actual costs are useful only when compared with the established norms or standards.

PREDETERMINED RATE

Predetermined rate is computed by dividing the budgeted overhead expenses for the
period by the number of units of base for budget period. Predetermined rate helps in
cost control, quick preparation of cost estimates and fixing price in cost plus contracts.
The only limitation of this rate is that it may give rise to over and underabsorption of
expenses.

MOVING AVERAGE RATE

This rate is a compromise between the actual rate and predetermined rate. It is
computed by dividing the average of the past twelve months or six months actual
overhead cost by the estimated base for the months.

BLANKET AND MULTIPLE RATES

When a single overhead rate is computed for the factory as a whole it is known as single
or blanket rate. It is calculated as follows:

Blanket Rate = Overhead cost of entire factory


Total quantum of the base selected

The table 4.1 will make clear the calculation of blanket rate:

Direct Rate of Blanke Amount Amount of under


Overhead
Department Labor t Recovered at or over absorption
Expenses Recovery
Wages (3 2)x 100 Rate* Blanket Rate of overhead
(1) (2) (3) (4) (5) (6) [(3) (6)]
Rs. Rs.
A 8,000 12,000 150% 86% 6,880 5,120
B 12,000 12,000 100% 86% 10,320 1,680
C 4,000 1,000 25% 86% 3,440 ()2,440
D 12,000 6,000 50% 86% 10,320 ()4,320
36,000 31,000

73
*Blanket Rate = x 100 = 86.11% rounded off to 86%

When different rates are computed for each producing department, service department,
cost center, product or product line, each production factor, and for fixed overhead and
variable overhead, then they are known as multiple rates. It is calculated as follows:
Overhead Rate = Overhead apportioned to each cost center Corresponding Base
Costs and the degree of accuracy are the two main factors which determine the number
of rates to be calculated in a concern. Small concerns where only one product is
manufactured, may opt for blanket rate.

Frequency of Rate Revision

The frequency of revision of the overhead rates varies from concern to concern. In case
of seasonal factories annual rate normalizes the costs. In case of frequent changes in the
pattern of the overhead expenses and the base to which rate is related, the revision of
overhead rates at shorter intervals is favored.

4.8 METHODS OF ABSORPTION OF MANUFACTURING OVERHEAD

The main methods of absorption of overheads are as follows:

Rate per Unit of Production

Under this method, overhead rate is calculated by dividing the budgeted overhead
expenses by the budgeted production. This method is simple and suitable for extractive
industries.

Illustration 4.4

ABC Ltd. manufactures a number of sizes of product P. They have grouped various
sizes into four main groups called A, B, C and D groups. If the company manufactures
only one group in the factory, the monthly production can be one of the following:
Group A 5,000 Nos., Group B 10,000 Nos., Group C 15,000 Nos., Group D
20,000 Nos. From the following information you are required to apply the overhead
expenses to each product on the basis of number of units produced:

Product Group A B C D
Actual production during a month 600 1,800 4,000 9,40
(Nos.) 0
Overhead expense for the month is
Rs.75,600

74
Solution
The overhead cost is apportioned by assigning points to the product in each group as the
four groups are not uniform.
A = 5,000 units; B = 10,000 units; C = 15,000 units; D = 20,000 units
i.e., 1 unit A = 2 units B = 3 units C = 4 units D
or 4 units A = 3 units B = 2 units C = 1 unit D
With a given production capacity the factory produces either 1 unit of A or 4 units of D;
which means resources required to produce 1 unit of A is 4 times that of D. Hence, A
should absorb 4 times the overhead that D absorbs. Similarly, we can say that B should
absorb 2 times and C 4/3 times the overhead that the D absorbs.
On this basis, actual production of A, B and C may be converted into equivalent units of
D as follows:
Actual D
Product Conversion
Production Equivalent
group Factor
in Units Units
A 600 4 2,400
B 1,800 2 3,600
C 4,000 4/3 5,333
D 9,400 1 9,400
Total 20,733

Therefore, the overhead will be Rs. 3.65 per equivalent unit (i.e., 75,600/20,733) and
apportioned among the group products as under:
Overhead absorption Overhead
Product Equivalent
rate per equivalent absorbed
group Units
unit Rs. Rs.
A 2,400 3.65 8,760
B 3,600 3.65 13,140
C 5,333 3.65 19,467
D 9,400 3.65 34,310
20,733 75,677*

Direct Labor Cost Or Direct Wages Method

Under this method overhead rate for a particular job is determined as a percentage of
direct wages. This percentage is arrived at by dividing the overhead expenses by direct
wages and multiplying the result by hundred.
This method is suitable where labor cost constitutes a major proportion of the total cost
of production.
75
Advantages
Time factor is considered.
Labor rates are more stable when compared to the material prices.
Charge to production is proportional to the amount of wages paid.
Data for the calculation of this rate is available easily.
This method is useful particularly when (i) the ratio of skilled and unskilled
labor remains constant,and (ii) the production, labor employed and types of
work performed are uniform.
Disadvantages
This method is unjust as it is not related to efficiency of workers.
Time factor is completely ignored if workers are paid on piece rate basis.
It ignores contribution made by other factors of production like machinery.
No distinction is made between fixed and variable expenses.

Direct Labor Hour or Production Hour Method


Under this method Overhead Rate is calculated by dividing the Overhead Expenses by
the total productive hours of direct labor. For example, if in a particular period the
overhead expenses are Rs.1,00,000 and direct labor hours are 1,00,000 then overhead
rate per direct labor hour will be Rs.1.00.

This method is advantageous where:


The job is labor-oriented.
The time required for the execution of the various jobs in the factory are
uniform in nature.
The rate is not affected by the method of wage payment or the grade or the rate
of workers.
Disadvantages
This method leads to faulty distribution of overhead to product cost as the
method does not take into consideration other factors of production.
This method is not suitable where piece rate system is used, as data required for
calculation of this rate is not available.
Expenses like power, depreciation, insurance, etc. which are not related to labor
hours are ignored in this method.
No distinction is made between:
skilled and unskilled labor,
fixed and variable costs,
production of hand workers and that of machine workers.

76
Machine Hour Rate

Machine hour rate is the cost of running a machine per hour. This method is suitable
when the job is predominantly performed by machines.

Machine hour rate is calculated by dividing the total running expenses of a machine
during a particular period by the number of hours the machine is estimated to work
during the period. Machine hour rate should be calculated for a machine or group of
machines as a cost center.

Calculation of Machine Hour Rate


All the overheads relating to machine or machines, treated as a separate cost
center, are identified.
Overheads relating to a machine can be divided into two parts, fixed or standing
overhead and variable overheads. Standing charges are those expenses which
remain constant irrespective of the usage of the machine. For example, Rent
and Rates, Insurance, etc. Variable expenses such as power, fuel, repairs, etc.
vary with the use of the machine.
Fixed charges estimated for a period for a machine is divided by the total
number of normal working hours of that machine during the period in order to
arrive at the hourly rate for fixed charges. For variable expenses an hourly rate is
calculated for each item of expenses separately by dividing the expenses by the
normal working hours. The hours required for maintenance or for setting up or
setting off machine is not considered for arriving at the normal working hours.
The total of standing charged and the variable expenses will give the machine
hour rate. Comprehensive machine hour rate can be calculated by adding the
wages of the machine operators to the machine hour rate.
Sometimes, supplementary rate is used for the calculation of machine hour rate.
This method is used for correcting any error in the calculation of machine hour
rate.

Expenses Basis
Standing Charges
1. Rent and rates Floor area occupied by each machine
including the surrounding space.
2. Heating and Lighting The number of points used plus cost of special
lighting or heating for any individual machine,

77
Expenses Basis
or according to floor area occupied by each
machine.
3. Supervision Estimated time devoted by the supervisory
staff to each machine.
4. Lubricating Oil and On the basis of past experience.
Consumable Stores
5. Insurance Insurance value of each machine
6. Miscellaneous expenses Equitable basis depending upon facts.
Machine Expenses
1. Depreciation Cost of machine (including cost of any
standby equipment such as spare motors,
switchgears, etc.) less residual value spread
over its working life.
2. Power Actual consumption as shown by meter
readings or estimated consumption ascertained
from past experience.
3. Repairs Cost of repairs spread over its working life.
Advantages
It is more scientific, practical and accurate method of recovery of manufacturing
overheads.
Comparison of relative efficiencies and cost of operating different machines can
be made by this method.
It helps the management in decision-making. Idle time of machines, if any, can
be detected.
Disadvantages
The use of this method increases the cost of accounting procedure.
This method is not useful when blanket rate is used.
It gives inaccurate results if the use of labor is equally important.
It does not take into account expenses that are not proportionate to the working
hours of machine.

Illustration 4.5

A Compute comprehensive machine hour rate from the following data:

a. Cost of machine to be depreciated Rs.2,00,000; Life 10 years; Depreciation on


straight line.

b. Departmental overheads (annual):


78
Rs.
Rent 40,000
Heat and Light 20,000
Supervision 1,30,000

c. Departmental Area 60,000 square meters

Machine Area 2,500 square meters

d. 25 machines in the department


e. Annual cost of reserve equipment for the department = Rs.1,500
f. Hours run on production each machine (annual) = 1,750
g. Hours for setting and adjusting a machine (annual) = 250
h. Power cost Re.0.50 per hour of running time
i. Labor:
i. When setting and adjusting, full time attention
ii. When machine is producing, one man
can look after 3 machines.
j. Labor rate Rs.6 per hour.
B. Using the machine hour rate as calculated value work out the amount of factory
overhead to be absorbed on the following:
Total hours Production Setting up time
time hours hours
Job No. 610 100 70 30
Job No. 580 100 80 20

Solution

Computation of Comprehensive Machine Hour Rate

Rs. Rs.

Standing Charges:

Rent, Heat and Light =


2,500

Supervision =
5,200

79
Depreciation 10% of Rs.2,00,000 =
20,000

Reserve Equipment Cost =


60

Labor Cost during setting and =


adjustment 250 Hrs. @ Rs.6 1,500

29,260 16.72
Hourly Rate for Standing Charges
Machine Charges:

Power
0.50

Labor (1/3 of Rs.6)


2.00

Comprehensive Machine Hour Rate


19.22

Note: It is assumed that there is no power cost when the machine is


being set or adjusted.
B. If the machine hour rate as calculated in (A) adopted the overheads absorbed
over the various jobs will be
Job No. 610 = 19.22 x 70 = Rs.1,345.40
Job No. 580 = 19.22 x 80 = Rs.1,537.60

Direct Material Cost Method

Under this method percentage of factory expenses to the value of direct material
consumed in production is calculated to absorb the manufacturing overheads. The
overhead rate is arrived as follows:

This method is simple and can be used where output is uniform, where the prices of
materials are stable, where the proportion of overhead to the total cost is significant.

Disadvantages

This method is unstable and inaccurate as there exists no logical relationship


between items of manufacturing overhead and material cost.
Time factor is completely ignored in this method.
No distinction is made between fixed and variable expenses.

80
No distinction is made between the production of workers and that of achines.
This method is inequitable as the raw materials used in production may not pass
through all processes.

Prime Cost Method

The recovery rate under this method is calculated by dividing the budgeted overhead
expenses by the prime cost incurred by cost center.

Advantage

This method is simple and easy to use. It is useful in cases where there are no
wide fluctuations in processing.
Disadvantages
No adequate consideration is given to time factor.
No distinction is made between fixed and variable expenses.
It combines the shortcomings of both direct material and direct labor methods.

Illustration 4.6

The following figures have been extracted from the books of a manufacturing
company. All jobs pass through the companys two departments:

Production Finishing
Dept. Dept.
Rs. Rs.
Material used 12,000 1,000
Direct Labor 6,000 3,000
Factory Overheads 3,600 2,400
Direct Labor Hours 24,000 10,000
Machine Hours 20,000 4,000
The following information relates to
Job No. 20:
Working Dept. Finishing Dept.
Material used (Rs.) 240 20
Direct Labor (Rs.) 130 50
Direct Labor Hours 530 140
81
Machine Hours 510 50

You are required (a) to enumerate four methods of absorbing factory overhead by
jobs showing the rates for each department under the methods quoted; and (b) to
prepare a statement showing the different cost results for Job No.20 under each of
four methods referred to.

Solution

Method of Absorption Working Department Finishing Department


(1) Direct Material Cost:

240
x 100 x100 = 30% x 100 =
%

(2) Direct Labor Cost:

60 80
x 100 x 100 = x 100 =
% %

(3) Direct Labor Hour


Rate:

= 15 paise per hour


= 24 paise per hour

(4) Machine Hour Rate:

= 18 paise = 60 paise per hour

Comparative Statement of Job No. 20 for Working Department

Materials Cost Direct Direct Machi


Percentage Labor Labor ne
Particulars
Rate Cost Rate Hour Hour
(i) (ii) Rate (iii) Rate
82
(iv)
Rs. Rs. Rs. Rs.
A. Material used 240 240 240 240
B. Direct Labor 130 130 130 130
C. Prime Cost = (A+B) 370 370 370 370
D. Overhead
(i) @ 30% of Materials i.e. (240 x 0.3) 72
(ii) @ 60% of Direct Wages (130 x 0.6) 78
(iii) 15 paise per hr. for 530 hrs. 79.50
(iv) 18 paise per hr. for 510 hrs. 91.80
E. Total = (C+D) 442 448 449.50 461.8
0

Comparative Statement of Job No. 20 for Finishing Department

Materials Direct Direct


Machin
Cost Labor Labor
e Hour
Particulars Percentage Cost Hour
Rate
Rate Rate Rate
(iv)
(i) (ii) (iii)
Rs. Rs. Rs. Rs.
A. Material Used 20 20 20 20
B. Direct Labor 50 50 50 50
C. Prime Cost = (A+B) 70 70 70 70
D. Overhead
(i) @ 240% of Direct 48
Material(20x2.4)
(ii) @ 80% of Direct Wages 40
(50x0.8)
(iii) 24 paise per hr. for 140 hrs. 33.60
(iv) 60 paise per hr. for 50 hrs. 30
E. Total Cost in the Dept. = 118 110 103.60 100
(C+D)
F. Cost b/f from Working 442 448 449.50 461.80
Department
G. Total cost 560 558 553.10 561.80

83
SALE PRICE METHOD

Under this method, overhead recovery rate is calculated by dividing the budgeted
overhead expenses by the sale price of units of production.
This method is suitable for the absorption of administration, selling and distribution,
research, development and design costs.
4.9 CHOICE OF AN OVERHEAD RATE
The overhead absorption method varies from industry to industry. Type of industry,
nature of products and process of manufacture, organization set-up, individual
requirements, policy management and cost of operating are the factors which affect the
choice of an overhead rate. The overhead rate should be simple, easy, practical, accurate,
stable and related to time factor.
The following factors should be taken into consideration for determining the basis for
applying overheads to products.
Adequacy: The overhead rate should be such that equitable apportionment can
be made to the cost centers or cost units. The amount of overhead recovered
should be equivalent to the amount of overheads incurred.
Convenience: The overhead rate should be simple, easy to understand and
convenient in application.
Time Factor: Overhead rate should have some relation to the time taken by
various jobs for completion.
Manual or Machine Work: Different overhead rates should be applied for
manual and machine work.
Different Overhead Rates: When the nature of work done by various
departments is not the same, different overhead rates should be ascertained.
Information: The availability of information affects the selection of the
overhead rates. For example, labor hour rate can be applied where labor time
cards are maintained.

4.10 UNDERABSORPTION AND OVERABSORPTION OF OVERHEADS

Overhead costs are fully recovered from production, if actual rate method of absorption
is adopted. But if a predetermined rate is used, the actual expenses may be different
from the charged or budgeted overhead expenses. If the overheads absorbed are less
than the overheads incurred, it is underabsorption of overheads. On the other hand, if
the amount of overhead absorbed is more than the actual overheads incurred it is over-
absorption of overheads.

Causes of Under or Over-absorption of Overheads


The following are the causes of under or overabsorption of overheads:

84
Error in estimating the overheads may lead to over or underabsorption of
overheads.
The anticipated output may be different from the actual output.
The hours anticipated may be more or less than the actual hours worked.
Due to fluctuations in the prices of material or wage rates, the basis upon which
the factory overhead is recovered from production may not be correct.
If overheads are not charged to work-in-progress proportionately.
Non-recurring expenditure incurred due to unexpected changes in the methods
of production.
Seasonal fluctuations in the overhead expenses.

Illustration 4.7
A certain cost center consists of ten workers using similar machines. The normal week
consists of 6 days totaling 42 hours. Each worker has two weeks annual holiday,
together with other holidays of 10 days per annum. Each week two hours per operator
should be spent in cleaning, etc. and it is estimated that illness and absenteeism will
cause the loss of 1,100 hours per annum. It is not anticipated that any overtime will be
worked, or that other time than the stated will be lost.
Overheads allocated and apportioned to the cost center, which are to be absorbed at a
rate per direct labor hour, total Rs.13,560 and you are required to calculate the
absorption rate.
During the year, actual overheads amounted to Rs.15,000, time occupied in cleaning,
etc. totaled 1,000 hours, time lost by illness and absenteeism totaled 1,300 hours, time
lost by machine breakdown totaled 200 hours. Overtime worked on production during
the period amounted to 800 hours.
Present the overhead absorption account at the year-end assuming that standard costing
is not in operation.

Solution
Calculation of Overhead Absorption Rate

Hours
Maximum hours = (10 x 42 x 52) 21,840
Less: Annual holiday hours 10 x 42 x 2 = 840
Other holiday hours 10 x 10 x 7 = 700 1,540

Available hours 20,300

85
Less: Hours lost in cleaning 10 x 2 x 48.4 (i.e. 52 3.6) 968

Illness and absenteeism 1,100


2,068

Anticipated effective hours 18,232

Overhead absorption rate on direct labor = = Rs.0.75 (approx.)

Actual
Maximum hours 21,840
Add: Overtime 800

22,640
Less: Holidays (840 + 420) 1,260
Cleaning time 1,000
Machine breakdown 200
Illness and absenteeism 1,300
3,760

18,880

Overhead Absorption a/c

Rs. Rs.
To Overhead 15,000 By Finished Goods Ledger 14,160
Control a/c Control a/c
(18,880 x 0.75)
By Costing Profit and Loss a/c 840
(Underabsorption
of overheads)
15,000 15,000

86
Accounting for Under and Overabsorption of Overhead

The disposal of under/overabsorption of overheads depends on the extent of such


under/overabsorption and the circumstances under which it arises. The main methods of
disposal of under/overabsorption of overheads are as follows:

Use of Supplementary Rates

Supplementary rates are used to carry out adjustment for the difference between
overhead absorbed and overhead incurred. This rate can be calculated by dividing
under/overabsorbed overheads by the actual base.

Advantages

It facilitates the absorption of actual overhead incurred for production. Correction of


costs through supplementary rates is necessary for maintaining data for comparison.

Disadvantages

These rates can be determined only after the end of the accounting period. It requires a
lot of clerical work.

Illustration 4.8

Several departmental overhead application rates based on direct labor hours are being
used by a manufacturing company. At the end of the year, the following information
has been supplied to you:

Dept. I Dept. II Dept. III


Overhead absorption rate used (Rs.) 4.00 3.00 7.00
Actual overhead incurred (Rs.) 81,900 1,20,960 79,360
Overhead absorbed (Rs.) 72,800 1,00,800 86,800
Direct labor hours recorded against:
Work-in-progress 2,800 4,930 820
Finished goods stock 5,400 3,700 1,210
a. Calculate the revised overhead application rate per direct labor hour (to the
nearest paise), in the light of actual hours for the year supplied to you.

87
b. Calculate also the total amounts by which the work-in-progress and finished
goods stock in each department will have to be increased or decreased in the
light of the revision of the overhead application rate.
Solution:
Dept. I Dept. II Dept.
III
a. (1) Actual overhead incurred (Rs.) 81,900 1,20,960 79,360

(2) Overhead absorbed (Rs.) 72,800 1,00,800 86,800

(3) Under (+) or over () absorption (1 (Rs) +9,100 +20,160 7,440


2)
(4) Direct labor hours 18,200 33,600 12,400
(2 rate)
(5) Supplementary overhead rate (3 (Rs.) +0.50 +0.60 0.60
4)
(6) Revised overhead 4.50 3.60 6.40
application rate (rate + 5)
b Adjustment to (Rs.) +1,400 +2,958 492
. work-in-progress
Adjustment to finished +2,700 +2,220 726
goods stock

Writing off to costing profit and loss account

Insignificant amount of over-absorption and under-absorption may be written off to


costing profit and loss account. Under-absorption due to idle facilities should be written
off to costing profit and loss account. Under or over-absorption which arises due to
abnormal causes such as strikes, lockouts, breakdowns, etc. then such expenses should
be carried over to next year and is considered while fixing the rate for that period.

The value of stock is distorted under this method as the over or under-absorption of
overheads is not allocated to the stock of work-in-progress and finished goods.

Absorption in the accounts of subsequent years

The over or under-absorption of overheads can be carried over as deferred charge to the
next accounting period by transferring it to a suspense or overhead reserve account.
This method is suitable in case of new projects and when the normal business period is
more than one year. Criticism levied against this method is that it distorts the costs for
the purpose of comparison, as the over or under-absorbed costs are carried forward.

88
MULTIPLE CHOICE QUESTIONS

Q1 Costs are linked to cost objective in many ways and for many reasons. Which one of
the following is a purpose of cost allocation?

(a) Evaluating revenue centre performance


(b) Measuring income
(c) Budgeting cash & controlling expenditures
(d) Aiding in variable costing for internal reporting

Q2 Showroom expenses is an example of

(a) Manufacturing overhead


(b) Administrative overhead
(c) Selling overhead
(d) Distribution overhead

Q3 Electricity expenses incurred for running electric motors can be apportioned on the
basis of

(a) Kilowatt hours


(b) Capital value of the motors
(c) Physical size of the motors
(d) None of the above

Q4 Supplementary rates become useless when

(a) The prices are fixed on cost plus basis.


(b) The accounting period is fixed in order to avoid seasonal fluctuations in the
overhead cost or level of activity.
(c) The amount of under or overabsorption overheads are not significant enough to
justify the use of supplementary rates.
(d) Both (b) & (c)

Q5 Under or over-absorption occur due to

(a) Errors in estimating overheads expenses


(b) Errors in estimating the levels of production
(c) Major unanticipated changes in method of production
(d) All (a), (b) & (c)

Q6 Which of the following expenses is not related to manufacturing functions?

(a) Freight-in
(b) Freight-out
(c) Depreciation on plant
89
(d) Factory power

Q7 Which of the following can be taken as the basis of absorbing manufacturing


overhead costs?

(a) Units produced


(b) Prime cost
(c) Direct labour hours
(d) All of the above

Q8 Which of the following is true of manufacturing overhead?

(a) Consists of direct material & direct labour cost


(b) Is easily traced to cost
(c) Includes all selling cost
(d) Is a heterogeneous pool of indirect production costs that can include utility costs
and depreciation.

Q9 Which of the following is/are true of the difference between cost allocation and cost
apportionment?

i. Under cost allocation common costs are prorated and split among departments using
a specific basis and under cost apportionment costs are directly charged in whole to the
departments.

ii. Under cost apportionment common costs are prorated and split among departments
using a specific basis and under cost allocation costs are directly charged in whole to
the departments.

iii. Cost allocation requires a suitable basis for splitting joint costs while for cost
apportionment, there is no basis.

(a) only i above


(b) only ii above
(c) only iii above
(d) both i & ii above

Q10 Allocation of service department costs to the production departments is necessary


to

(a) Determine overheads rates


(b) Control costs
(c) Maximize organizational effectiveness
(d) Maximize efficiency

90
CHAPTER 5 MARGINAL COSTING AND COST
VOLUME PROFIT ANALYSIS
At the end of the chapter you will be conversant with:

5.1 Concept of Marginal Costing


5.2 Distinction between Marginal and Absorption Costing
5.3 Value of Marginal Costing to Management
5.4 The Break-even Point
5.5 Margin of safety
5.6 Contribution Margin Concept
5.7 Key Factor
5.8 Applying Cost-Volume-Profit Analysis
5.9 Alternative Choice Decision
5.9.1 Steps in Decision Making
5.9.2 Relevant costs for decision making
5.9.3 Application of Differential or Incremental Cost Analysis
5.9.4 Various Decisions

5.1 CONCEPT OF MARGINAL COSTING

Many factors cause changes in costs and hence in profits. Costs change because of
inflationary trends in the economy, changes in the labor market, technological advances,
or changes in size or quality of production facilities. Each of these represents a unique,
sporadic change. Regular, recurring events also cause costs to change. One of the most
significant causes of variations is a change in the volume of activity.

Marginal Cost Defined

The essence of Marginal Costing or Variable Costing technique lies in considering


fixed costs on the whole as separate, quite distinct from variable costs which only are
relevant to decision making. Variable costs only are matched with revenues under
different conditions of production and sales to compute what is known as contribution
towards recovery of fixed costs and yielding of profits.
Marginal Costing, according to the economic connotation of the term, is described in
simple words as the cost of producing an additional unit of output and it does not arise
if the additional unit is not produced. According to the Terminology of Cost
Accountancy of the Institute of Cost and Management Accountants, London, Marginal
Cost represents the amount at any given volume of output by which aggregate costs
are changed if the volume of output is increased or decreased by one unit. It relates to
the change in output in the particular circumstances under consideration. In the words of
Blocker and Weltmore, Marginal Cost is the increase or decrease in total cost which
results from producing or selling additional or fewer units of a product or from a change

91
in the method of production or distribution such as the use of improved machinery
addition or exclusion of a product or territory or selection of an additional sales channel.
Analyzing the definitions given above, we find that with the increase of one unit of
output the total cost is increased and this increase in total cost is known as Marginal
Cost.

Illustration 5.1

If variable costs per unit are Rs.9 and fixed costs are Rs.2,50,000 per annum, an output
of 40,000 units per annum results in the following expenditure:

(In Rupees)
Variable cost of 40,000 units @ Rs.9/unit 3,60,000
Fixed Cost 2,50,000
Total Cost Total Cost for output of 40,000 units 6,10,000
Variable costs of 40,001 units @ Rs.9/unit 3,60,009
Fixed Cost 2,50,000
Total Cost Total Cost for output of 40,001 units 6,10,009
Less: Total Cost for output of 40,000 units 6,10,000
Marginal cost 9

The Institute of Cost and Management Accountants, London, has defined Marginal
Costing as the ascertainment of marginal costs, by differentiating between fixed costs
and variable costs, and of the effect on profit of changes in volume or type of output.
In this technique of costing only variable costs are charged to operations, processes or
products, leaving all fixed costs to be written off against profits in the period in which
they arise.
Thus, in this context, marginal costing is not a system of costing in the sense in which
other systems of costing, like process or job costing are, but it has been designed simply
as an approach to the presentation of accounting information meaningful to
management from the viewpoint of adjudging the profitability of an enterprise by
carefully studying the impact of the entire range of costs according to their respective
nature.

Basic Characteristics of Marginal Costing


The concept of marginal costing is based on the important distinction between product
costs and period costs, the former being related to the volume of output and the latter to
the period of time rather than the volume of production.

92
Marginal Costing regards only variable (marginal) costs as the product costs.
Variability with volume is the criterion for the classification of costs into product and
period categories. Fixed costs are treated as period costs.
Prices are determined on the basis of marginal cost by adding contribution which is
the excess of sales or selling price over marginal cost of sales. It is a technique of
analysis and presentation of costs which help management in taking many managerial
decisions and is not an independent system of costing such as process costing or job
costing.
Mathematical Aids to Marginal Costing
Management accountants gather information to be used in the internal decision-making
situations of planning and control. A decision involves selecting one of several
alternatives. Decision-making involves three basic steps: problem definition,
alternative evaluation and alternative selection. Again, definition of problems involves
identifying the objective i.e., the goal that we are seeking to accomplish which is to earn
maximum profits in most business situations, the alternatives i.e., the various means by
which we can attempt to achieve the objective, the problem factors i.e., the Variable
conditions within and outside the firm that influence the outcome of a particular
alternative and the criterion i.e., the measure of the success to be obtained from an
alternative.
After defining these factors, and identifying the available alternatives, we begin to
narrow down the variety of possible actions by evaluating their effects on reaching our
objective. A well- constructed criterion allows us to select the alternative that will most
closely produce the desired result.
Let us examine a simple situation where our objective is to maximize profits from a
process to manufacture one product. Our alternatives are the various levels of
production at which we can operate. Our problem factors are the demand for our
product and the cost of running the factory. Our criterion, of course, is the difference
between revenues and expenses.
In the mathematical notation, our goal is to achieve,
Max P = R(Q) V(Q) C
Where
Q = The decision variable representing the production level
R(Q) = The revenue resulting from production level Q
V(Q) = The variable cost resulting from production level Q
C = The fixed cost incurred
P = The profit, which we are trying to maximize.
The equation is a model of the relationship, and we are seeking to achieve the greatest
benefit from it. We evaluate each possible production level (alternative) in terms of its
effect on profits (criterion). We will select the alternative that promises the greatest
profit (objective).
Another mathematical model that can be used is linear programming model. Like most
economic models, linear programming (LP) deals with the allocation of scarce

93
resources and the activities competing for them. The purpose of the model is to specify
the allocation scheme that contributes the most to the firms profits.

Working of Marginal Costing


According to traditional costing system, fixed costs of production are assigned to
products to be subsequently released by way of expenses as part of cost of goods sold or
are carried forward as part of the cost of inventory depending upon whether a periods
production was sold or not during the same period. Such an approach to the treatment of
fixed costs has brought into vogue various methods of allocation of overheads to
different departments on an equitable basis and their proper apportionments to units
produced.
Marginal costing removes all the difficulties involved in the allocation, apportionment
and recovery of fixed costs. It is able to accomplish this by excluding fixed costs from
product costs and by writing them off entirely against operations of the period.
Consequently, when the volume of output differs from the volume of sales, the net
income reported under marginal costing will differ from that reported under absorption
costing.

5.2 DISTINCTION BETWEEN MARGINAL COSTING AND ABSORPTION


COSTING
Under marginal costing, the distinction between direct/variable cost and period cost
determines when costs are matched with revenues. Direct or variable costs are assigned
to products and matched with revenues when revenues from the related products are
recognized while period costs are matched with revenues of the period in which the
costs were incurred.
But this is in contrast to what is known as absorption costing in which fixed
manufacturing costs are also treated as part of production cost and inventory values
arrived at accordingly. Adoption of this system not only influences inventory value, but
also reflects on the profit figure.
Also in absorption costing, arbitrary apportionment of fixed costs, over the products,
results in under or over absorption of such costs. Since marginal costing excludes fixed
costs the question of under or overabsorption of fixed costs does not arise.
Moreover, in absorption costing, managerial decision-making is based upon profit
which is the excess of sales value over total cost while in marginal costing, the
managerial decisions are guided by contribution which is the excess of sales value
over variable cost.

INCOME DETERMINATION UNDER ABSORPTION AND MARGINAL


COSTING
Under absorption costing, both fixed manufacturing overheads, and variable
manufacturing overheads are treated as product costs while marginal costing excludes
fixed manufacturing overheads from product costs and includes only manufacturing

94
variable overheads. The figure given below shows the method of income determination
under absorption and marginal costing:
Figure 5.1

Marginal Costing Rs. Rs. Absorption Costing Rs. Rs.


Sales revenue X Sales revenue X
Less: Marginal Less: All manufacturing
cost: costs
X X
Direct material cost Direct material cost

X X
Direct Labor cost Direct labor cost

X Mfg. Overhead (Fixed & X


Variable Overhead X X
Variable)
Contribution
X Gross Margin X
Margin
Less: Non-manufacturing
Less: Fixed
X Overhead (Fixed & X
Overhead
Variable)
Operating Income X Operating Income X

When product analysis is involved, the two forms of presentation are as follows:

Absorption Cost Presentation


Income Statement
Period ended
Product
Product Beta Total
Alpha
Rs. Rs. Rs.
Sales
95
Less: Total Cost of

Sales
Operating Income

Marginal Cost Presentation

Income Statement
Period ended
Tota
Product Alpha Product Beta
l
Rs. Rs. Rs.
Sales
Less: Marginal cost of sales
Contribution
Less: Fixed Costs:
Factory overhead
Selling and distribution overhead
Administration overhead
Operating Income
In marginal costing presentation, product analysis normally ends at the contribution
figure.

In absorption costing, a predetermined rate is generally used for the absorption of


factory overhead to products and it is unlikely that the absorbed cost will equal the
actual cost in a period. The difference, known as under or overabsorbed cost is
incorporated in the profit statement presentation before final profit is calculated:

Rs
.
Factory Cost of Sales (includes factory overhead absorbed)
(example underabsorption means the
Add/deduct under or product has not absorbed the full factory

overabsorbed factory overhead cost, therefore, this underabsorption is
added)
Actual factory cost of sales

Illustration5.1

Comparative Income Statement under Marginal Costing and Absorption Costing.


96
DBF Ltd., furnishes the following details for the year ended 31st March, 2003 for
preparing the Income Statement of the year:
2500 @ Rs.25 per
Sales
units unit
Fixed manufacturing cost Rs.10,800
2700 @ Rs.14 per
Variable manufacturing cost
units unit
Inventory at the end 200 units
Fixed selling and administrative
Rs.1,500
expenses
Variable selling and administrative
Rs.900
expenses
DBF Ltd.
Income Statement
(for the year ended 31st March, 2003)
i. Under Absorption Costing
Rs. Rs.
2500 units @
Sales Rs.25 each 62,500

Less: Cost of Sales


Variable manufacturing costs

2700 units @
Rs.14 each 37,800

Fixed manufacturing costs 10,800


48,600
Less: Inventory at close

200 units @ Rs.18 * each 3,600 45,000

Gross Margin or Profit 17,500


Total selling and administrative
Less: expenses 2,400
Operating Income 15,100

* Variable cost per unit = = 18

ii. Under Marginal Costing


97
Rs. Rs.
Sales 2500 units of Rs.25 each 62,500
Less: Variable Cost of Sales:
Variable manufacturing costs
2700 units @ Rs.14 each 37,800
Less: Inventory at the end
200 units @ Rs.14 each 2,800 35,000
Contribution Margin 27,500

Variable Selling and


Less: Administrative Expenses 900
Fixed Manufacturing
costs 10,800
Fixed Selling expenses 1,500 13,200
Operating Income 14,300

Reconciliation of Difference between Absorption & Marginal Costing Income:

Particulars Amount (Rs.)


Marginal Costing Income 14,300
Absorption Costing Income 15,100
Difference to explained (800)

1. Difference in the value of closing Inventory (2800-3600) (800)

Note: The difference of Rs.800 in the net income calculated under the two methods is
due to the difference between the cost of closing inventory which, under absorption
costing, is Rs.3,600 and, under marginal costing, is Rs.2,800. This is the result of
holding back Rs.800 from out of total fixed manufacturing cost of Rs.10,800 as cost of
inventory under the method of absorption whereas Rs.800 is realized immediately as a
period cost under marginal costing.

By comparing the above statements, it can be found out that the information furnished
by the absorption costing statement cannot be as useful as the one given by marginal
costing because the conventional costing statement rarely classifies costs into fixed and
variable components. Thus, managers who are accustomed to look at operations from a
break-even analysis and flexible budget viewpoint, find that the conventional income
statement fails to dovetail with cost-volume-profit relationship. To illustrate, if
management wishes to consider the effects of increasing the volume of production, it
cannot calculate the effect on profit from absorption costing statement but it can do so
98
with marginal costing statement. Therefore, it is more efficient to present important
cost-volume-profit relationship as integral part of major financial and operating
statements.

5.3 VALUE OF MARGINAL COSTING TO MANAGEMENT

Marginal costing is a valuable technique to the management for the following reasons:

1. It integrates with other aspects of management accounting example cost-


volume-profit analysis, flexible budgeting and standard costing.
2. Period reports are more easily understood. Management can more readily
understand the assignment of costs to products if these are limited to marginal
cost because such costs are readily identifiable with the cost unit.
3. It emphasizes the significance of key factors affecting the performance of the
business in the profits-planning and decision-making areas. Contribution to
these factors is an important statistic for management.
4. The impact of fixed costs on profits is emphasized because the total amount of
such cost for the period appears in the income statement.
5. Marginal income figures facilitate relative appraisal of products, territories,
classes of customers and other segments of the business without having the
results obscured by allocation of joint fixed costs.
6. The profit for a period is not affected by changes in absorption of fixed expenses
resulting from building or reducing inventory. Other things remaining equal
(selling prices, costs, sales mix, etc.) profit moves in the same direction as sales
when marginal costing is in use.
7. There is a close relationship between variable costs and the controllable costs
classification. This relationship assists the control function.
8. It assists in the provision of relevant costs for decision-making. Without
marginal cost data, the information for management may be misleading. This is
the case, for example, in decision concerned with:
The acceptance of special orders.
The possible elimination of a product.
The possible outside purchase of components as compared with their internal
manufacture.
It assists short-term decision-making, particularly those decisions
concerned with product short-term pricing.
Thus, managers would recognize the value of marginal cost for profit-planning, control
and decision-making, but point to the fact that for decision-making purposes fixed costs
may be incremental relative to a decision situation as well as marginal cost.

5.3 THE BREAK-EVEN POINT

99
Monotonous Co., manufactures and sells a single variety of single product. For 2000-
01, the Management Accountant has estimated the following profit levels depending
upon the different quantities of the product manufactured and sold:

Sales Sales Value Rs.


Total Costs Profit/(Loss)
Quantity Lakhs [Selling
Rs.lakhs Rs.lakhs
(000 units) Price = Rs.10]
20 2.0 3.6 (1.6)
25 2.5 3.7 (1.2)
30 3.0 3.8 (0.8)
35 3.5 3.9 (0.4)
40 4.0 4.0
45 4.5 4.1 0.4
50 5.0 4.2 0.8
Rs.1.6 lakh. However, as more and more units are sold the loss goes on decreasing.
When sales are 40,000 units there is no loss. When sales increase beyond 40,000 units
the firm earns a profit.
The above situation can be represented on a graph as follows:
Figure 5.2

100
The graph shows that when sales quantity is 40,000 units the Sales Value Line and the
Total Cost Line intersect at the point BEP. This point is called the Break Even Point.
On the X-axis the BEP indicates that when sales quantity is 40,000 units, Total Cost
equals Sales Value. On the Y-axis BEP indicated that Total Cost equals Sales Value
when each of these amounts is Rs.4 lakhs.
The Break-Even Point is a kind of borderline. If sales are less than Break-even sales, the
company incurs a loss. If sales are more than Break-Even Sales the company earns a
profit.

Break-Even Point on P/V Graph

We can plot profit against sales quantity on a Profit-Volume Graph using the figures
given earlier. We get the following P/V graph.

Figure 5.3

101
Here the Break-Even Point BEP is the point at which the Profit Line intersects the X-
axis.
As seen earlier it is the point at which sales quantity is 40,000 units.

Break-Even Point Formula


We can arrive at the break even point using a mathematical model as shown below:
Let s = Selling price per unit of the product.
v = Variable cost per unit of the product manufactured and sold.
Q = Quantity (units) of the product manufactured and sold.
F = Total fixed cost for the period under consideration.
P = Profit for the period under consideration.
Then we have
Sales Revenue Total Cost = Profit
So, sQ [vQ + F] = P
So, (s v) Q F = P
We can use this equation to find the quantity QB of units to be manufactured and sold in
order to Break even.

Note that at the break even point P = 0


So the above equation becomes
(s v) QB F = 0

or QB = Since s v = Unit contribution

we have the formula

102
Break Even Quantity =

We may be interested in the Break Even Sales value instead of the Break Even Sales
quantity.
Break Break even Sales Quantity x Selling
Even Sales =
price per unit.
Value

The above can be written as:

Break-even Sales value =

is the C/S ratio

(also called the P/V ratio) or contribution margin


Break-
even Sales =
Value

Illustration 5.2

Sales Quantity
Sales Value Fixed Cost Variable Cost Profit
(in 000 units)

[Selling Price =Rs.10] [Rs.2/unit] Rs.


Rs. lakhs
Rs. lakhs Rs. lakhs lakhs
20 2.0 3.2 0.4 (1.60)
25 2.5 3.2 0.5 (1.20)
30 3.0 3.2 0.6 (0.80)
35 3.5 3.2 0.7 (0.40)
40 4.0 3.2 0.8
45 4.5 3.2 0.9 0.40
50 5.0 3.2 1.0 0.80

103
Break-even Quantity =

= 40,000 units
This can be verified by noting that the Profit is Zero for a sales quantity of 40,000
units in the table above.
Break-even Sales Value =

= =

Rs. 4,00,000

=
This can be verified by noting that when sales are Rs.4,00,000 in the above table, Profit
is zero.
Important Note

It may be noted that the C/S ratio =

In the above table we see that when profits increase from Rs.0.4 lakh to Rs.0.8 lakh,
corresponding sales increase from Rs.4.5 lakh to Rs.5 lakh.

So C/S Ratio = = = 0.8

Hence in using the formula for finding out Break Even Sales it is not necessary to know
either the unit contribution or the unit selling price. We can find the C/S ratio by the
formula
C/S Ratio =

5.5 MARGIN OF SAFETY

104
This is the difference between sales & the break-even point. If the distance is relatively
short, it indicates that a small drop in production or sales will reduce profits
considerable. if the distance is long, it means that the business can still make profits
even after a serious drop in production. It is important that there should be a reasonable
margin of safety, otherwise a reduced level of production may prove dangerous. the
margin of safety can be found by using the following formula:
Margin of safety = Profit/P/V ratio
or
Margin of safety = (Profit * Sales) / (Sales- Variable cost)

Contribution:
as stated earlier, the difference between selling price & variable cost(i.e. the marginal
cost) is known as contribution or gross margin or contribution margin. In other
words, fixed cost costs plus the amount of profit is equivalent to contribution. It can be
expressed by the following formula:
Contribution = Selling Price Variable Cost
= Fixed Cost + Profit
We can derive from it that profit can not result unless contribution exceeds fixed costs,
in other words, the point of no profit no loss shall be arrived at where contribution is
equal to fixed costs.

5.6 CONTRIBUTION MARGIN CONCEPT


Contribution margin is a concept that is developed for internal reporting to
management. The same basic cost and revenue data that are reported externally are used
in preparing contribution reports. Contribution margin is defined as revenue less
variable costs. Fixed costs are then subtracted from the contribution margin to equal the
net income. The amount by which the selling price per unit exceeds the variable cost
per unit is the contribution margin per unit.
Contribution margin ratio =

Profit/volume Ratio (P/V Ratio)


this term is important for studying the profitability of operations of a business. Profit
volume ratio establishes a relationship between the contribution & the sales value.
Tehratio can be shown in the form of percentage also. The formula can be expressed
thus:
P/V Ratio = Contribution/ Sales
= (Sales- Variable Cost)/Sales

5.7 KEY FACTOR


Key factor is that factor which is the most important one for taking decisions about
profitability of a product. The extent of its influence must be assessed first so as to
maximize the profits. Generally on the basis of contribution, the decision regarding
product mix is taken. It is not the maximization of total contribution that matters, but
105
the contribution in terms of key factor, that is to be compared for relative profitability.
Thus, it is the limiting factor or the governing factor or principle budget factor. If sales
cannot exceed a given quantity, sales is regarded as the key factor, if production
capacity is limited, contribution per unit i.e. in terms of output has to be compared.
This, profitability can be measured by:
Contribution/Key Factor
Illustration 5.3
Comment on the relative profitability of the following two products:
Production cost unit
Particulars
Product A (Rs) Product B (Rs)
Materials 200 150
Wages 100 200
Fixed Overheads 350 100
Variable Overheads 150 200
Profits 200 350
Sales price per unit 1000 1000
Out per week 200 Units 100 Units

Solution:
Particulars Product A (Rs) Product B (Rs)
Sales price per unit 1000 1000
Less: Variable Cost 450 550
Contribution per unit 550 450
Less: Fixed cost per unit 350 100
Profit per unit 200 350
Total Profit 40000 35000
P/V Ratio 55% 45%
Contribution per unit & total profit is higher in case of product A, though profit per unit
of product B is higher. If output in terms of units is the limiting factor, product A is
more profitable. In case there is no limit regarding units of output, product B would
prove to be more profitable. Similarly, in case there is any other key factor, contribution
has to be expressed in relation to that factor & decision has to be taken on that basis.

5.8 COST-VOLUME-PROFIT ANALYSIS

CVP analysis involves the analysis of how total costs, total revenues and total profits are
related to sales volume, and is therefore concerned with predicting the effects of changes
in costs and sales volume on profit. It is also known as 'breakeven analysis'.

Applying Cost Volume Profit Analysis


106
Cost Volume Profit CVP analysis is applied in the following situations:
Planning and forecasting of profit at various levels of activity.
Useful in developing flexible budgets for cost control purposes.
Helps the management in decision-making in the following typical areas:
Identification of the minimum volume of activity that the enterprise must
achieve to avoid incurring loss.
Identification of the minimum volume of activity that the enterprise must
achieve to attain its profit objective.
Provision of an estimate of the probable profit or loss at different
levels of activity within the range reasonably expected.
The provision of data on relevant costs for special decisions relating to
pricing, keeping or dropping product lines, accepting or rejecting particular
orders, make or buy decision, sales mix planning, altering plant layout, channels
of distribution specification, promotional activities, etc.
Guide in fixation of selling price where the volume has a close relationship with
the price level.
Evaluates the impact of cost factors on profit.

Assumptions of Cost-Volume-Profit Analysis

This analysis presumes that costs can be reliably divided into fixed and variable
category. This is very difficult in practice.
This analysis presumes an ability to predict cost at different activity volumes. In
practice, a lot of experience may be required to reliably develop this ability.
A series of break-even charts may be necessary where alternative pricing
policies are under consideration. Therefore, differential price policy makes
break-even analysis a difficult exercise.
It assumes that variable cost fluctuates with volume proportionally, while in
practical life the situation may be different.
This analysis presumes that efficiency and productivity remain unchanged. In
other words, this analysis presents a static picture of a dynamic situation.
The break-even analysis either covers a single product or presumes that product
mix will not change. A change in mix may significantly change the results.
This analysis disregards that selling prices are not constant at all levels of sales.
A high level of sales may only be obtained by offering substantial discounts,
depending on the competition in the market.
This analysis presumes that volume is the only relevant factor affecting cost. In
real life situations, other factors also affect cost and sales profoundly. Break-
even analysis becomes over-simplified presentation of facts, when other factors
are unjustifiably ignored. Technological methods, efficiency and cost control
continuously influence different variables and any analysis which completely
disregards these over changing factors will be only of limited practical value.

107
This analysis presumes that fixed cost remains constant over a given volume
range. It is true that fixed costs are fixed only in respect of a given capacity, but
each fixed cost has its own capacity. This factor is completely disregarded in the
break-even analysis. While factory rent may not increase, supervision may
increase with each additional shift.
This analysis presumes that influence of managerial policies, technological
methods and efficiency of men, material and machine will remain constant and
cost control will be neither strengthened nor weakened.
This analysis presumes that production and sales will be synchronized at all
points of time or, in other words, changes in beginning and ending inventory
levels will remain insignificant in amount.
The analysis also presumes that prices of input factors will remain constant.

Cost-volume-profit analysis is based on the above-mentioned limitations. Attempts to


draw inferences disregarding these limitations will lead to formation of wrong
conclusions. The application of cost-volume-profit relationship is restricted by the
assumptions on which it is based. Therefore, cost-volume-profit analysis cannot be used
indiscriminately.

Limitations of Cost-Volume-Profit Relationship


The cost-volume-profit relationship depends on the profit equation
P = (S V) Q F
where P = Profit
S = Unit Selling Price
V = Unit Variable Costs
F = Total Fixed Cost
Q = Sales Volume
This equation gives the basic Cost-Volume-Profit Model.
As long as S, V and F are constant the cost volume profit relationship will be linear.
In real life the following factors effect the linear Cost-Volume-Profit Relationship.
Variable cost per unit (V) may not be constant. For example, raw material cost
is variable. However, as volumes of production increase, raw material may be
purchased in bulk so that quantity discounts are available. Hence, raw material
cost may be say Rs.50 per unit of production up to say 20,000 units and Rs.40
per unit thereafter. So the linear relationship is affected at 20,000 units.
Fixed costs may stabilize at higher levels as volume increases. For example,
depreciation on plant is a fixed cost. But as production increases, the plant may
be operated for an extra shift so that it may be necessary to provide extra shift
allowance of depreciation.
Selling prices may be lower at high volumes because of sales discounts allowed.

108
Changes in efficiency will affect the cost-volume-profit relationship. An
increase in efficiency may increase volume with less than the expected increase
in cost.
More than one product may be produced. In this case volume may have to be
redefined in terms of rupees as each product may be measured in different units.

5.9 ALTERNATIVE CHOICE DECISIONS

Many of the decisions discussed in this chapter are frequently referred to as alternative
choice decisions. Alternative choice decisions involve situations with two or more
courses of action from which the decision maker must select the best alternative. A
decision involving more than two alternatives is called a multiple-alternative choice
decision.
Many factors enter into the selection of the best alternative. Some decisions are based
primarily on judgment, with little or no analytical data. Others involve systematic
decision models. In most business decisions, some accounting data are useful in
reaching a decision, and cost data are particularly useful in analyzing many alternative
choice decisions.

Managerial decision making is the process of choosing among alternative courses of


action. The manager chooses that course of action which he considers the most effective
means at his disposal for achieving goals and solving problems. Decision-making is an
integral part of all management functions planning, organization, co-ordination and
control. All decisions are futuristic in nature, involving a forecast of what management
thinks is likely to occur. But we must not forget that the future is highly uncertain. Thus
with uncertainty surrounding business decisions, decisions have to be made with the full
realization that there is some probability of the prediction which underlay the decision
taken, going wide off the mark. Some of the decisions which managers take are routine
in nature. These decisions take up very little of the managers time either because there
is very little uncertainty or because the cost is insignificant. On the other side of the
coin we have those nerve-racking decisions which managers have to take. The
manager has to spend a considerable amount of time and thought on these decisions
because they are crucial to the organization, totally surrounded by uncertainty and
involves large sums of money.
Let us now take a look at the process of decision-making.

5.9.1 Steps in Decision Making

Before discussing the use of accounting information useful for decision-making, it is


helpful to look at the process of decision-making itself. While this process is complex
and not amenable to standardization, the following steps seem useful for most of the
problems:

Defining the problem

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Developing alternative solutions
Evaluating the alternatives
Arrive at a decision.

Defining the Problem

Identifying a problem is the first and often a very critical step in the process of
decision making. While this may be fairly easy in some cases, it might be more
difficult in others. Perceptive analysis and insight may be required to articulate the
problem. The real problem may have to be distinguished from the apparent one.

Developing Alternative Solutions


Once the nature of a problem is understood, alternative courses of action to solve it
have to be developed. This requires a sound understanding of the factors causing the
problem and imaginative thinking about ways and means that can solve it. In the initial
stages of developing alternative solutions several possibilities may arise. The analyst
should eliminate those which are clearly unattractive and narrow his choice down to a few,
perhaps two or three. This will prevent the analysis from becoming complex and
unwieldy. Of course, there must be at least two alternatives. If only one course of action
is available, then there is no choice, hence no decision making problem. Often one of
the alternatives is to continue what is being currently done. Other alternatives may be
compared against this.
Evaluating the Alternatives
The alternative solutions developed in the preceding step have to be carefully evaluated.
Each solution may have several advantages and disadvantages. These have to be
weighed and balanced for judging its overall desirability.
If the advantages and disadvantages of an alternative are stated in qualitative terms
only, evaluation may be difficult. Consider, for example, the following statement: The
proposed change in the manufacturing method will reduce material costs but enhance
labor costs, maintenance charges, and electricity costs. Clearly, such a qualitative
expression of costs and benefits does not facilitate overall evaluation. On the other
hand, if it is stated that the material costs will be reduced by Rs.10,000, whereas labor
costs, maintenance charges, and electricity costs will increase by Rs.6,000, Rs.1,000,
and Rs.2,000, respectively, the net advantage of the proposed change in the
manufacturing method can be easily figured out.
While efforts should not be spared to quantify costs and benefits it may be difficult, or
even impossible, to measure certain consequences. How, for instance, can we measure
consequences such as improvement in morale, greater customer satisfaction, increased
vulnerability to competition, and higher threat of technological obsolescence. Such effects,
though difficult to measure, are important in overall evaluation and have to be duly
considered. Evaluation of non-measurable consequences is essentially a judgmental process.

Arrive At a Decision

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Once the alternative courses of action are evaluated in terms of their measurable and
non-measurable effects, the decision maker may be in a position to select one of the
alternatives finally. Of course, he may decide to gather further information in order to
sharpen his assessment before arriving at a decision. This, however, requires additional
effort, cost, and time. So the act of decision cannot be delayed beyond reason. At some
point, the decision maker would do well to reach a decision rather than defer it till more
information is gathered.

5.9.2 Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant
costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific
management decisions'.

We can demonstrate relevant costs with the following situation. A company is deciding
whether or not to eliminate a product line. The product line accounts for approximately
4% of the companys activities. If the product line is eliminated, the officers of the
corporation will continue to receive the same salaries and the central office expenses will
not change. The product line managers and other employees working directly on the
product line will be terminated. Hence, their salaries will be eliminated.
The salaries of the product line managers and other employees whose salaries will be
eliminated are relevant to the decision. If these salaries are $700,000 with the product line
and $0 without the product line, the $700,000 of savings is relevant. Those cost savings
and other possible cost savings will be considered along with the loss of sales revenues.
On the other hand, the officers salaries are not relevant in the decision. In other words, it
doesnt matter if the officers salaries are $500,000 or $5,000,000. The officers salaries
will be the same with or without the product line. Similarly, the decision maker does not
need to know the amount of its central office expenses, since they will be the same with
or without the product line. Expenses from previous years are also irrelevant.
To recap, relevant costs are the future costs that will differ among alternatives. You might
use the past costs to help you predict those future costs, but the past costs are otherwise
irrelevant to the decision. Accountants refer to the past costs as sunk costs.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and
they are common to all alternatives that we may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of


making a decision. Any costs which would be incurred whether or not the decision is
made are not said to be incremental to the decision.

c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not
relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal
value is relevant.

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Other terms:

d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g.
rent or rates on a factory would be incurred whatever products are produced.

e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated
fixed assets, development costs already incurred.

f) Committed costs: A future cash outflow that will be incurred anyway, whatever
decision is taken now, e.g. contracts already entered into which cannot be altered.

Opportunity cost

Relevant costs may also be expressed as opportunity costs. An opportunity cost is the
benefit foregone by choosing one opportunity instead of the next best alternative.

Example

A company is considering publishing a limited edition book bound in a special leather. It


has in stock the leather bought some years ago for $1,000. To buy an equivalent quantity
now would cost $2,000. The company has no plans to use the leather for other purposes,
although it has considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which could
cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).

In calculating the likely profit from the proposed book before deciding to go ahead with
the project, the leather would not be costed at $1,000. The cost was incurred in the past
for some reason which is no longer relevant. The leather exists and could be used on the
book without incurring any specific cost in doing so. In using the leather on the book,
however, the company will lose the opportunities of either disposing of it for $800 or of
using it to save an outlay of $900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting from the leather, is
the latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the
book for decision making purposes.

The relevant costs for decision purposes will be the sum of:

i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project
is approved, and will be avoided if it is not

ii) the opportunity cost of the leather (not represented by any outlay cost in connection to
the project).

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This total is a true representation of 'economic cost'

5.9.3 Application of Differential or Incremental Cost Analysis

The decisions involving alternative choices uses the technique of differential costing
which is an extension of marginal costing. This technique can be applied for decisions
involving alternative choices such as discontinuance of a product line, make or buy
decisions, own or lease, changes in sales mix etc. Let us consider important terms of
differential cost analysis before we proceed to applicability of differential cost analysis.

1. Incremental Profit

For complete analysis of a decision alternative, we have to consider both revenues and
costs and determine the profit associated with that decision. Referred to as the
incremental profit related to the decision, this represents the contribution to the total
profit of the firm which is specifically traceable to the alternative under analysis.
Difference between incremental revenues and incremental costs is explained in the
following paragraphs.

2. Incremental Revenues

These are measured as:

Revenues directly flowing from the decision + Increase in revenues from other activities
as a result of the decision Decrease in revenues from other activities as a result of the
decision.

3. Incremental Costs

These are measured as:

Costs directly related to the decision + Increase in costs of other activities as a result of
the decision Decrease in costs of other activities as a result of the decision.

5.9.4 VARIOUS DECISIONS:

1. MAKE OR BUY DECISIONS

A company is often faced with the decision as to whether it should manufacture a


component or buy it outside.

Suppose for example, that Masanzu Ltd. make four components, W, X, Y and Z, with
expected costs for the coming year as follows:

W X Y Z

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Production (units) 1,000 2,000 4,000 3,000
Unit marginal costs $ $ $ $
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12

Direct fixed costs/annum and committed fixed costs are as follows:

Incurred as a direct consequence of making W 1,000


Incurred as a direct consequence of making X 5,000
Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other committed fixed costs 30,000
50,000

A subcontractor has offered to supply units W, X, Y and Z for $12, $21, $10 and $14
respectively.

Decide whether Masanzu Ltd. should make or buy the components.

Solution and discussion

a) The relevant costs are the differential costs between making and buying.
They consist of differences in unit variable costs plus differences in
directly attributable fixed costs. Subcontracting will result in some
savings on fixed cost.

W X Y Z
$ $ $ $
Unit variable cost of making 14 17 7 12
Unit variable cost of buying 12 21 10 14
(2) -4 2 2
Annual requirements in units 1,000 2,000 4,000 3,000
Extra variable cost of buying per annum (2,000) 8,000 12,000 6,000
Fixed cost saved by buying 1,000 5,000 6,000 8,000
Extra total cost of buying (3,000) 3,000 6,000 (2,000)

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b) The company would save $3,000/annum by sub-contracting component W, and
$2,000/annum by sub-contracting component Z.

c) In this example, relevant costs are the variable costs of in-house manufacture, the
variable costs of sub-contracted units, and the saving in fixed costs.

d) Other important considerations are as follows:

i) If components W and Z are sub-contracted, the company will have spare capacity. How
should that spare capacity be profitably used? Are there hidden benefits to be obtained
from sub-contracting? Will there be resentment from the workforce?

ii) Would the sub-contractor be reliable with delivery times, and is the quality the same as
those manufactured internally?

iii) Does the company wish to be flexible and maintain better control over operations by
making everything itself?

iv) Are the estimates of fixed costs savings reliable? In the case of product W, buying is
clearly cheaper than making in-house. However, for product Z, the decision to buy rather
than make would only be financially attractive if the fixed cost savings of $8,000 could
be delivered by management. In practice, this may not materialise.

Now attempt the exercise given below:

Illustration 5.4 Make or buy

The Pip, a component used by Goya Manufacturing Ltd., is incorporated into a number of
its completed products. The Pip is purchased from a supplier at $2.50 per component and
some 20,000 are used annually in production.

The price of $2.50 is considered to be competitive, and the supplier has maintained good
quality service over the last five years. The production engineering department at Goya
Manufacturing Ltd. has submitted a proposal to manufacture the Pip in-house. The
variable cost per unit produced is estimated at $1.20 and additional annual fixed costs
that would be incurred if the Pip were manufactured are estimated at $20,800.

a) Determine whether Goya Manufacturing Ltd. should continue to purchase the Pip or
manufacture it in-house.

b) Indicate the level of production required that would make Goya Manufacturing Ltd.
decide in favour of manufacturing the Pip itself.

2. DECISION TO ACCEPT A SPECIAL ORDER


Special orders or one-time orders often have different characteristics than recurring
orders. As a result, each order should be evaluated based on costs relevant to the
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situation and the goals of the company. Let us take a look at how incremental or
differential cost analysis can be applied to a special order situation.
Crisp Chocolate Company is operating at only 60% of capacity due to slow holiday
season sales. A social service organization approaches the company with a proposal that
the company produce 10,00,000 chocolate bars of 25 gms to be sold for Re.1 by
members of the social service organization to raise money for poor students. The
proposal calls for a Rs.0.55 purchase price per bar for the social service concern. The
chocolate bars can be produced with the firms current excess capacity. The firms chief
accountant prepares the following cost estimates associated with the production and sale
of the chocolate bars.
Total Unit
Cost Cost
Rs. Rs.
Direct materials 2,50,000 0.25
Direct labor 1,00,000 0.10
Manufacturing overhead 2,50,000 0.25
(60% is allocated fixed overhead)
Variable selling and administrative cost 50,000 0.05
6,50,000 0.65

A glance at the unit cost data indicates that Crisp Chocolates would lose Rs.0.10 per bar, or
Rs.1,00,000 by accepting this special order. But when we apply incremental analysis,
we find that allocated fixed overhead costs are not relevant to this decision since fixed
overhead will exist whether the order is accepted or rejected.

Incremental Profit Analysis

Rs.
Direct Materials 0.25
Direct Labor 0.10
Variable Manufacturing Overhead (40%) 0.10
Variable Selling and Administration Cost 0.05
Incremental Cost 0.50
Sales Price 0.55
Incremental Profit 0.05
Here we see that accepting the order adds Rs.0.05 per bar or Rs.50,000 in total, to Crisp
Chocolates profit. If no other factors affect the decision, the order should be accepted.

OTHER ASPECTS
Other factors may influence special-order pricing decisions. These may be,
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Effect on regular customers: If regular customers are paying more, they may
demand price deductions or stop buying from the company.
Special order customers turning regular customers: Another problem is that
special order customers may decide to become regular customers, and changes
in the price may become necessary.

3. DECISION TO CONTINUE OR DROP A PRODUCT LINE


Sameeksha Limited produces and sells three products: Bips, Nips, and Dips. The income
statement of the company, prepared in the absorption costing format, is shown below.
The management of the company is considering dropping Dips since it shows a loss on
the income statement.
Income Statement of Sameeksha Limited
Bips Nips Dips Total
Rs. Rs. Rs. Rs.
Sales 30,00,000 15,00,000 9,00,000 54,00,000
Cost of goods sold
Variable 18,00,000 10,00,000 6,50,000 34,50,000
Fixed 5,00,000 2,50,000 1,50,000 9,00,000
23,00,000 12,50,000 8,00,000 43,50,000
Gross margin 7,00,000 2,50,000 1,00,000 10,50,000
Selling expenses
Variable 2,00,000 1,20,000 80,000 4,00,000
Fixed 1,50,000 75,000 45,000 2,70,000
3,50,000 1,95,000 1,25,000 6,70,000
Profit before tax 3,50,000 55,000 (25,000) 3,80,000

INCREMENTAL PROFIT ANALYSIS


In analyzing this decision, it is helpful to prepare the income statement in the variable
costing format and remove the fixed cost allocation to the products. This has been done
below where it becomes clear that Dips has a positive contribution margin. Hence it
should not be discontinued. The loss attributed to Dips in the conventional income
statement, shown as per absorption table, arises because of allocation of a portion of
common fixed costs which are irrelevant for decision making purposes.

Income Statement of Sameeksha Limited (Before Dropping Dips)

Bips Nips Dips Total


Rs. Rs. Rs. Rs.

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Bips Nips Dips Total
Rs. Rs. Rs. Rs.
Sales 30,00,000 15,00,000 9,00,000 54,00,000

Variable costs
Production 18,00,000 10,00,000 6,50,000 34,50,000

Selling 2,00,000 1,20,000 80,000 4,00,000

20,00,000 11,20,000 7,30,000 38,50,000

Contribution 10,00,000 3,80,000 1,70,000 15,50,000

Fixed costs
Production 9,00,000

Selling 2,70,000

11,70,000

Profit before tax 3,80,000

Income Statement of Sameeksha Limited (After Dropping Dips)

Bips Nips Total


Rs. Rs. Rs.
Sales 30,00,000 15,00,000 45,00,000

Variable costs

Production 18,00,000 10,00,000 28,00,000

Selling 2,00,000 1,20,000 3,20,000

20,00,000 11,20,000 31,20,000

Contribution 10,00,000 3,80,000 13,80,000

Fixed costs

Production 9,00,000

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Selling 2,70,000

11,70,000

Profit before tax 2,10,000

Hence it can be seen that if the product Dips is dropped, the profit before tax decreases
by Rs.1,70,000.

Other Aspects

A decision concerning the discontinuation of a product should also take into account
the following:

Complementary/competitive nature of the products of the company


Impact on the image of the company
Effect on the motivation of the employees
Value of resources released on discontinuation.

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MULTIPLE CHOICE QUESTIONS

Q1 Which of the following can improve the margin of safety?

a) Lowering the fixed cost


b) lowering the variable cost so as to improve marginal contribution.
c) increasing volume of sales, if there is available capacity.
d) All (a), (b) & (c) above

Q2 Break even sales is

a) The sales required to earn a particular amount of profit.


b) The sales at which there is neither profit nor loss.
c) The sales equal to amount of fixed expenses incurred by the company.
d) None of the above.

Q3 The contribution per unit does not depend upon

a) Selling price
b) direct material cost
c) fixed cost
d) direct labour

Q4 Margin of safety can be improved by

a) Increase of variable cost per unit


b) Decrease of sales price per unit
c) increase of fixed cost
d) decrease of variable cost per unit

Q5 Given the sales volume, which of the following would lead to an increase in
contribution margin?

a) Variable cost per unit remains same


b) variable cost per unit decreases
c) Fixed cost decreases
d) Variable cost per unit increases

Q6 The rupee amount of sales needed to attain a desired profit is calculated by dividing
_______ by the contribution margin ratio.

a) Fixed cost
b) Desired Profit
c) Desired profit plus fixed cost
d) Desired profit less fixed cost

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Q7 In CVP analysis, if quantity produced and sold is more than the break even quantity,
the operating income is increased by

a) Overhead cost per unit for each additional unit sold


b) Variable costs per unit for each additional unit sold
c) Fixed cost per unit for each additional unit sold
d) contribution margin per unit for each additional unit sold

Q8 Which of the following costs is not relevant to the decision- making program?

a) out of pocket cost


b) Differential cost
c) Avoidable cost
d) historical cost

Q9 In make or buy decision, the relevant costs include

a) Factory management costs plus variable manufacturing costs.


b) variable manufacturing costs plus depreciation costs
c) Avoidable fixed cost plus variable manufacturing costs
d) variable manufacturing costs plus unavoidable fixed costs.

Q10 The term relevant cost applies to all the following decision situations except the

a) Acceptance of a special order


b) Manufacture or purchase of component parts
c) Determination of a product price
d) Replacement of equipment

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CHAPTER-6 STANDARD COSTING AND VARIANCE
ANALYSIS
At the end of the chapter you will be conversant with:
6.1 Historical Costing And Its Limitations
6.2 Need For Standards
6.3 Establishment Of Standard Cost
6.4 Revision Of Standards
6.5 Computation & Analysis Of Variances
6.5.1 Material Cost Variance
6.5.2 Labor Cost Variance
6.5.3 Overhead Variance

Introduction
One of the most important objectives of Cost accounting is to provide necessary
information to management for cost control. But, the control function of management
can be effective only if it is preceded by planning. The basic objective of any type of
control is to ensure that actual performance conforms to a predetermined plan. Hence,
for purposes of cost control it is necessary to have planned costs indicating what the
management wants to achieve. This is where standard costing comes in, as it is one of
the ways of planning costs.
Standard costing refers to the principles and procedure which involve the use of
predetermined standard costs relating to each element of cost, and for each line of
product manufactured or service rendered. A standard cost is an estimated cost which
suggests what the cost should be under given conditions. The significance of standard
costing can be understood better if it is viewed in contrast to actual historical costing.
The system of costing in which costs are recorded after they are incurred is known as
historical costing.

6.1 HISTORICAL COSTING AND ITS LIMITATIONS

Historical costing has its own usefulness. It provides management with a record of what
has happened. Information regarding actual costs classified by elements are known to
management accurately, at frequent intervals. The cost data can be verified with the
help of documents and evidence regarding various transactions. The result of activities
can also be known on the basis of actual performance. However, there are three serious
limitations of historical costing which are given below:

Actual records do not provide any basis for cost comparisons to evaluate the
efficiency of operations;

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Historical costs data are available only after a time-lag. Thus, corrective action
cannot be taken in time to prevent losses;
Historical costs fail to provide any guidance for future planning of operations,
because they arise out of the conditions peculiar to a particular period of time.

These limitations are sought to be overcome in the system of standard costing.

Definition

The Terminology of Cost Accountancy defines standard costing as the preparation


and use of standard costs, their comparison with actual costs, and analysis of variances
to their causes and points of incidence. The technique of standard costing thus
involves:

The ascertainment of standard costs


The use of standard costs
Their comparison with the actual costs and the measurement of variances
The analysis of variances for ascertaining the reasons for the same and
The location of responsibility for the variances and the corrective action to be
taken.

Since this technique is based wholly on the ascertainment of standard costs, it is


necessary to know what these standard costs are. Standard costs are pre-determined, or
forecast estimates of cost to manufacture a single unit, or a number of units of a
product, during a specific immediate future period. They are usually the planned costs of
the products under current and anticipated conditions, but sometimes they are the costs under
normal or ideal conditions of efficiency, based on an assumed given output, and having
regard to current conditions. They are revised to conform to super-normal or sub-normal
conditions, but more practically to allow for persisting alterations in the prices of material and
labor.
Therefore, a standard cost can be defined as A pre-determined cost calculated with respect
to a prescribed set of working conditions, correlating technical specifications and scientific
measurements of materials and labor to the price and wage rates expected to apply during the
period to which the standard cost is expected to relate, with an addition of an appropriate
share of budgeted overhead. Its main objective is to provide bases of control through variance
accounting for the valuation of stocks and work-in-progress and in exceptional cases for
fixing selling prices.

6.2 NEED FOR STANDARDS


The use of standards facilitate many business functions. Standards are very useful in the
monitoring and controlling of business activities in general. The need for standard costs
arises as a result of the benefits it provides for a business, such as
Cost control
Pricing decisions
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Performance appraisal
Cost awareness
Management by objective

Limitations of Standards
Despite the above needs, the technique has its own limitations also, which can be
summarized as shown hereunder:
Setting the standards is a difficult task as it involves technical skills.
Accountants are not unanimous regarding the circumstances to be taken as the basis
for setting standard costs. Even if the standard to be used is well defined, since
conditions do not remain static, the standards have to be revised in the light of the
changed circumstances. A revision of standards becomes expensive and if some
concerns do not revise the standards on this score, the same are likely to become rigid,
and as such, outmoded. Just as inaccurate standards are unreliable and harmful, so are
outmoded standards disadvantageous.
The fixation of inaccurate standards, specially those that are incapable of
achievement, adversely affect the morale of the employees, and act as hindrance
to increased efficiency.
For localizing deviations and fixing responsibilities, it becomes necessary to
distinguish between controllable and uncontrollable variances. Such a
distinction may not always be possible.
The system is unsuitable for the job type of industries producing articles
according to customers specifications. Even if the system is installed in the case
of such industries, the fixation of standards for each type of job becomes
difficult and expensive.
Even in the case of industries that are liable to frequent technological changes
affecting the conditions of production, standard costing may not be suitable. If
nevertheless it is installed, a constant revision of standards becomes necessary.
Although the benefits accruing from installing and operating a standard costing
system are far in excess of the cost associated with it, small concerns cannot
afford this technique.

6.3 ESTABLISHMENT OF STANDARD COSTS


Standard costs must be ascertained for each of the following elements of cost:
Direct material
Direct labor
Variable overhead
Fixed overhead.

Direct Material

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Standard quantities of material should be set for each product. It is thus
necessary to establish a standard drawing, formula or specification, which
should be adhered to except in special circumstances, when a revision may be
necessary.
If there is a normal loss in process, a standard loss should be set based on past
experience or by scientific analysis.
Standard prices of all materials consumed should be set for each product. Prices
should be fixed in co-operation with the buyer, and allowing for the following:

Stocks in hand

The possibility of price fluctuations

The extent of contracts already placed for materials

Direct Labor

The different grades of labor required in the production of various products


should be ascertained. It should be then possible to establish the labor cost by
evaluating the grades of labor at the standard rates per hour set by the personnel
department.

Standards of performance should be set in conjunction with the work-study


engineers. Thus the number of units produced per hour at the number of hours
required per unit can be established.

Variable Overhead

It is assumed that variable overheads move in consonance with production : therefore it


is necessary to consider only the cost per unit or cost per hour. Irrespective of
production, the variable overheads per unit or per hour will remain the same. Thus if
packing cost is one rupee per unit of production, then the variable overhead cost of
1,000 units will be Rs.1,000 and of 10,000 units, Rs.10,000. This is obviously only true
within limits.

Fixed Overhead

Fixed overhead relates to all items of expenditure which are more or less constant
irrespective of fluctuations in the level of output, within reasonable limits. The
following points must be considered:

The total cost of fixed overheads for the period

The budgeted production for the period; and

The number of hours expected to be worked during the period.


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It should now be possible to estimate the standard fixed overhead cost for each product
manufactured. A standard cost per unit can now be prepared, as shown in the
illustration

Illustration 6.1

Standard Cost of Product A


1 Unit Rs. Rs.
Direct materials : 60 units of X at Re.1 per unit 60
40 units of Y at Rs.1.5 per unit 60
100 120
10 Normal loss 10%
90 units
120
Scrap value at Re.1 per unit 10 110

Direct wages : Process 1 - 3 hours at Rs.10 per 30


hour
Process 2 - 1 hour at Rs.10 per 10
hour
Process 3 - 2 hours at Rs.5 per 10 50
hour
Variable Process 1 - Rs.3 per unit of A 3
overheads:
Process 2 - Rs.3 per unit of A 3

Process 3 - Rs.4 per unit of A 4 10

Fixed overheads: 20% of wages cost 10


Production Cost 180
Administration costs 10
190
Selling and distribution costs 10

Total Cost 200


Profit (25% on total cost) 50
Selling price 250
During a period 1000 units of product A are manufactured and sold, and the actual costs
are given as below, the standard costs and actual costs could be compared as follows:
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Total Variances

Product A 1,000 units


Variances
Element of cost Standard Actual (F) (A)
Rs. Rs. Rs. Rs.
Direct material 1,10,000 1,40,000 30,000
Direct wages 50,000 55,000 5,000
Prime Cost 1,60,000 1,95,000 35,000
Variable overhead:
Process cost 10,000 8,000 2,000
20% of wages cost 10,000 18,000 8,000
Fixed overhead:
Administration 10,000 12,000 2,000
Selling and distribution 10,000 15,000 5,000
Total Cost 2,00,000 2,48,000 2,000

Profit 50,000 52,000 (2,000)

Sales variance 48,000


Sales 2,50,000 3,00,000 50,000 50,000

(F) Favorable
(A) Adverse

6.4 REVISION OF STANDARDS


The question of whether standards should be revised is a difficult one. Some argue that
many revisions in standards only destroy the effectiveness and increase operational
details. In contrast, standards if not revised, destroy its utility as a means of inventory
valuation and cost control. Therefore, standard costs require continuous review and, at
times, frequent change. Changing prices, technological advances, changing quality of
materials, new labor negotiations etc., all influence standards and make them obsolete
resulting in unrealistic budgets, poor cost control and unreasonable unit cost for inventory
valuation and income determination.
A company should establish a program to revise standards wherever required so that
standards can be set at a currently attainable level. A periodic review of standards is
desirable to accomplish the objectives of standard costing. Standards through an annual

127
review program will become current attainable or expected standards or at least closer
to such standards.
As indicated by the definition of standard costing given earlier there is more to the
technique than simply setting standard costs. This is important but it is only a means to
an end control over costs and performances. The variances obtained are analyzed and
the reasons for their existence are determined. This allows management to take action to
prevent a recurrence of events that cause such variances.
All the time, therefore, there is a cycle of events. Actual and standard costs are
compared, variances are calculated, management is informed of what has gone wrong
and then action is taken to prevent the same thing happening in the future. There should,
therefore, be a positive improvement in efficiency.
MATERIAL AND LABOR
A variance occurs whenever actual costs differ from standard costs. The term variance
analysis refers to the systematic evaluation of variances in an attempt to provide
managers with useful information for measuring efficiency and improving performance.
Variance analysis refers to an examination of the conditions of operation which give rise
to any cost variance. It provides an explanation as to why and how variances have
arisen. Logically speaking, variance analysis involves not only the examination of
causes but also the determination of the contribution of each causal factor to the overall
variance. It also implies devising suitable steps for the control of costs wherever
necessary.
Variance analysis addresses two questions
What is the amount of difference between actual costs and standard costs?
Why did the difference occur?
The first question deals with the measurement of the variance, which is basically a
computation process. The second question deals with the cause of the variances.
Before proceeding further, it is better to be familiarized with some terms like favorable
and unfavorable variances, controllable and uncontrollable variances and revision
variances which occur frequently.

FAVORABLE AND UNFAVORABLE VARIANCES


If the actual cost is less than the standard cost, which is a reflection of efficiency, the
difference is known as a favorable variance. However, if actual costs exceed standard
costs, the difference is known as an unfavorable or adverse variance. An unfavorable or
adverse variance is a sign of inefficiency.
The difference between the total standard cost and total actual cost is known as the total
cost variance. It is a net variance, and may be said to reflect the aggregative effect of all
variances, both favorable and unfavorable.

CONTROLLABLE AND UNCONTROLLABLE VARIANCES

128
When the variance with respect to any cost item reflects the degree of efficiency of an
individual or department, that is, a particular individual or departmental head is
responsible for the variance it is known as a controllable variance. A controllable
variance is amenable to control. For example, if materials are used in excess of the
standard usage, the foreman concerned would be responsible for correcting it as soon as
possible. If the excessive usage is due to defective material supply, the purchasing
department would be responsible for correcting it.
An uncontrollable variance is one which is not amenable to control by individual or
departmental action. Such a variance is caused by external factors like change in market
conditions, fluctuations in demand and supply etc. No particular individual within the
organization can be held responsible for such variances.

REVISION VARIANCE

Due to unforeseen circumstances, it may be necessary to alter a standard during an


accounting period. Once a standard has been set for, say, a period of one year, it is
undesirable that it should be changed, because this will effect budgets, standard costs
etc. Therefore, it is often preferable to create a revision variance, which segregates the
difference due to this new factor, and thus it saves the work involved in revising the
standards.
Possible situations when a revision variance could be used are where there is a sudden,
steep rise in the price of a raw material due to an acute shortage of supply or a change in
mix of labor due to a shortage of a certain type of labor. However, revision variance can
be used only for a temporary period. Standards should be revised as soon as possible for
efficient operation of standard costing.

6.5 COMPUTATION AND ANALYSIS OF VARIANCES


Standards may be set and variances computed not only for each cost element but also
for each of the factors which determines the cost. The variances of particular elements
of cost and those relating to quantity and price are known as principal variances. When
variances are analyzed, a principal variance may be found to have a number of
constituent parts. A cost variance which is only a part of the principal variance is known
as a sub-variance. This concept will be made more clear further down.
Variances may be expressed either in amounts or in percentages. When it is expressed
in amount, the variance is calculated by subtracting actual cost from the standard cost.
To express variance as a percentage, the ratio of actual cost to the standard cost is
multiplied by 100. Thus, the actual cost is obtained as a percentage of the standard cost.
The base for comparison is the standard cost (100).
Hence, the actual cost percentage figure should be deducted from the standard cost
percentage (100) to derive the cost variance in percentage. For example, if the actual
cost is Rs.100 and the standard cost is Rs.125, the percentage variance will be computed
as follows :
Cost ratio = (100/125) x 100 = 80%
Cost variance = 100% 80% = 20% (favorable)
129
The variances for each element of cost, including the principal variances relating to
the price and quantity deviation from the standards, are explained below along with
the possible causes.
Chart 6.1 Variances on Material Cost
The following variances as illustrated in the chart constitute material cost variances:

6.5.1 MATERIAL COST VARIANCE


The difference between the standard cost of direct materials specified for the output
achieved and the actual cost of direct materials used is known as the materials cost
variance. This variance results from differences between quantities of materials allowed
for production and quantities consumed and from differences between prices paid and
prices determined. This can be calculated by using the following formula :

Material Cost Variance = (SQ x SP) (AQ x AP)

Where

SQ = Standard quantity for the actual output


SP = Standard Price
AQ = Actual Quantity
AP = Actual Price

A positive result on the application of the above formulae implies favorable variance
and a negative result implies favorable variance and a negative result implies
unfavorable variance (adverse variance).

MATERIAL USAGE VARIANCE


materials used in production and the standard quantities that should have been used to
produce the output achieved. As a formula this variance is shown as:
Material Usage Variance = (SQ AQ) x SP

130
A positive result on the application of the above formulae implies favorable usage
variance and a negative result implies unfavorable usage variance (adverse variance).

CAUSES
This type of variance is the result of using more or less than standard number of units of
a material in production. A materials usage variance is caused on account of one or
more of the following reasons :
Sub-standard or defective materials.
Carelessness in the use or handling of materials.
Failure to return excess materials to the stores.
Pilferage of materials.
Wastage due to inefficient production methods or unskilled employees.
Substitution of standard materials by non-standard materials.
Changes in the design of the product, machinery, tools, or methods of
processing not recognized in standards.
Non-standard material mixture.
Rigid inspection resulting in more rejections requiring additional materials for
rectification.
Failure to keep machines and tools in a good working condition.
Lack of proper tools and machines.
Accounting errors.
Inaccurate standards.
The adoption of a standard materials requisition will be of much use in analyzing the
causes of the materials usage variance. This document constitutes the authority for
standard quantities, and any extra materials to be drawn will have to be authorized on a
special form called the excess materials requisition of a different color. These forms
facilitate an analysis of the causes of variances. Although a materials usage variance is
of considerable importance, a favorable variance for a particular material need not mean
greater efficiency. Since it is quite likely that this favorable variance is offset by an
unfavorable variance in some other item of cost, it must be made sure that a favorable
usage variance is really advantageous to the concern.

MATERIAL PRICE VARIANCE


A material price variance occurs when raw materials are purchased at a price different
from standard price. It is that portion of the direct materials which is due to the
difference between actual price paid and standard price specified, multiplied by the
actual quantity. This is represented as
Material Price Variance = (SP AP) x AQ
A positive result on the application of the above formulae implies favorable price
variance and a negative result implies unfavorable price variance (adverse variance).
131
CAUSES
Depending upon the different kinds of direct materials used, there may be any number
of price variances. The variances arise because of the following reasons:
Fluctuations in market prices.
Purchasing non-standard lots and the consequent reduction in quantity discount.
Purchasing from suppliers other than those offering most favorable terms.
Increase in, or additional transport costs for a quick delivery.
Excessive shrinkage or loss in transit.
Failure to take advantage of cash discount.
Failure to purchase the standard quality of materials.
Error in buying due to wrong purchasing policy.
Failure to enter into forward contracts.
Buying substitute materials at different prices.
A materials price variance is normally the responsibility of the purchase manager.
However, in the case of some materials, the prices of which are liable to frequent
market fluctuations, forward contracts cannot be entered into. In such cases, the
purchase manager cannot be held responsible for the price variance which is mostly
uncontrollable. Similarly, when purchases are made in uneconomic lots due to lack of
working capital, the purchase department will not be responsible for the variance.
However, if the price of materials were to include transport and handling charges, the
excessive cost of transportation and handling resulting in a price variance, may be
controllable. Hence, it may sometimes become necessary even to analyze the
constituent elements of a material price variance. At any rate, it is only after the reasons
for the variance are known, a distinction could be drawn between controllable and
uncontrollable variances in reports to the management.

SUB-VARIANCES

The material usage variance is the principal variance which can be separated into sub-
variances the mix variance and the yield variance.

Material Mix Variance

A mix variance will result when materials are not actually placed into production in
the same ratio as the standard formula. Materials mix variance is that portion of the
materials quantity variance which is due to the difference between the standard and
actual composition of a mixture. It can be represented by the following formula :
Material mix variance = (Standard cost of actual quantity of the standard
mixture Standard
cost of actual quantity of the actual mixture).
or
132
Material mix variance = (Revised standard mix of actual input Actual mix) x
Standard price
A materials mixture variance thus considers a proportion of the direct materials for a
specified output. This type of variance occurs where materials are mixed in
accordance with a particular formula to manufacture a product. For instance, in the
manufacture of chemicals, paints, textiles, castings, sweets etc., a standard materials
mixture is of an absolute necessity. A product of good quality can be obtained only
when the relative strengths of the ingredients are in balance. If the standard mixture
is altered either because of the shortage of one of the materials and a substitute
being used, or inefficient storekeeping resulting in the issue of a substitute, the
actual composition of the mixture is bound to be different from the standard
composition.

MATERIAL YIELD VARIANCE

The portion of materials usage variance which is due to the difference between the
standard yield specified (in terms of actual inputs) and actual yield obtained is the
materials yield variance. When there is no materials mix variance, the materials yield
variance equals the total materials usage variance. The formula for calculating yield
variance is
Yield Variance = (Standard yield Actual yield) x Standard cost per unit of output
or
Yield Variance = (Standard loss on actual input Actual loss) x Standard cost per
unit

The above formula uses output or loss as the basis for computing the yield variance.
Yield variance can also be computed on the basis of input factors only. The fact is that
loss in inputs equals loss in output. A lower yield simply means that a higher quantity of
inputs have been used and the anticipated or standard output (based on actual inputs)
has not been achieved. Yield, in such a case, is known as sub-usage variance which can
be calculated by using the formula :

Sub-usage Variance = (Standard quantity Revised standard proportion of actual


input) x Standard cost per unit of input

The yield variance may either be independent of the mixture variance, or it may be due
to combinations of materials different from standard mixture. In the case of steel
industry, for instance, if the practice followed for pouring the molten metal is not in
accordance with what is laid down as the most efficient, yield variance occurs.
Similarly, in the case of biscuit manufacture, the yield of good biscuits will be affected
by if there is inefficiency in shaping and baking. However, there are instances in which
a change in the mixture of raw materials may affect the yield of the finished product. In
such cases, it is necessary to see that favorable mixture variances are not offset by
unfavorable yield variances.
133
Illustration 6.2

Quantity of materials purchased 6,000 units


Value of materials purchased Rs.18,000
Standard quantity of materials required per tonne of 60 units
output
Standard rate of material Rs.5.00 per unit

Opening stock of materials Nil


Closing stock of materials 1,000 units
Output during the period 160 tonnes

Solution
Materials consumed = 6,000 1,000 = 5,000 units
Actual rate of material
= = Rs.3 per unit
Standard quantity for
actual output = 60 x 160 = 9,600 units

Material cost variance = Standard cost -Actual cst


(Standard price x Standard quantity)
=
(Actual price x Actual quantity)
= Rs 5.00 x 9,600 Rs.3 x 5,000
= 48,000 15,000 = Rs.33,000 (Favorable)
Material price variance = Actual quantity (Standard price Actual price)
= 5,000 x (Rs.5.00 Rs.3.00)
= Rs.10,000 (Favorable)
Material usage variance = Standard Price x (Standard quantity Actual quantity)
= Rs.5.00 (9,600 5,000)
= Rs.23,000 (Favorable)

Verification:

Material cost variance = Material price variance + Material usage variance


Rs. 33,000 = Rs. 10,000+Rs. 23,000

Illustration 6.3

134
A manufacturing concern which has adopted standard costing furnished the following
information.

Standard:
Material for 70 kg finished product 100 kg
Price of materials Rs.2 per kg
Actual:

Output 2,10,000 kg
Material used 2,80,000 kg
Cost of materials Rs.5,04,000

Calculate

a) Material usage variance


b) Material price variance
c) Material cost variance

Solution
a. Material usage
= SP x (SQ AQ)

variance
= 2 x (3,00,000 2,80,000)

= Rs.40,000 (Favorable)
b. Material price
= AQ x (SP AP)

variance
= 2,80,000 x (2.0 1.8)

= 2,80,000 x 0.20
= Rs.56,000 (Favorable)
c.
Material cost = Standard Cost Actual Cost

variance
= (SQ x SP) (AQ x AP)

= (3,00,000 x 2) (2,80,000 x 1.8)


= 6,00,000 5,04,000
= Rs.96,000 (Favorable)
Verification:
Material cost variance = Material price variance + Material usage variance
Rs.96,000 = Rs.56,000 +Rs40,000.
Working Notes
135
1. Standard quantity: Material for 70 kg of finished products : 100 kg

2,10,000 kg of finished products = 3,00,000 kg

2. Actual price per kg = Rs. = Rs.1.80

Variances on Labor Cost


Direct labor variances arise when actual labor costs are different from standard labor
costs. In analyzing labor costs, the emphasis is on labor rates and labor hours. The
following variances as illustrated in Chart 6.2 constitute labor variances.

6.5.2 LABOR COST VARIANCE


The difference between the standard direct wages specified for the output achieved and
the actual direct wages paid is the labor cost variance. This is calculated by the formula:
Labor cost variance = (SH x SR) (AH x AR)
Where SH = Standard hours
SR = Standard rate
AH = Actual hours
AR = Actual rate

LABOR EFFICIENCY VARIANCE


This variance is calculated in the same way as the material usage variance. This
variance arises when labor operations are more efficient or less efficient than standard
performance. The difference between the actual hours expended and standard labor
hours specified multiplied by the standard labor rate per hour is the labor efficiency
variance. It is calculated using the following formula :

136
Labor efficiency variance = (Standard hours for the actual output Actual hours)
x Standard rate per hour
A positive result on the application of the above formulae implies favorable variance
and a negative result implies unfavorable variance (adverse variance).

CAUSES

The reasons for labor efficiency variance are:


Insufficient training;
Incompetent supervision;
Incorrect instructions;
Workers dissatisfaction;
Bad working conditions;
Inefficient organization waiting for materials, tools and instructions, delay in
routing, if these are not treated as idle time;
Use of defective machinery and equipment;
Wrong items of equipment for the type of work done;
High labor turnover; and
Fixation of incorrect standards.

LABOR RATE VARIANCE


When actual direct labor hour rates differ from standard rates, the result is a labor rate
variance. It is that portion of the direct wages variance which is due to the difference
between the standard rate of pay specified and the actual rate paid. The formula for its
calculation is:
Labor rate variance = (Standard rate Actual rate) x Actual hours
= (SR - AR) X AH
A positive result on the application of the above formulae implies favorable variance
and a negative result implies unfavorable variance (adverse variance).
Causes

The various causes of labor rate variance are:

1) Changes in basic wage rates.


2) Employment of workers of different grades and wage rates from those laid down
as the standards and paying them above or below the standard rates due to
shortage of labor or by mistake.
3) Paying guaranteed day rates to workers who are unable to earn their normal
wages.
4) Payment of day rates although the standards specify piece rates.
5) New workers being paid different rates from the standard rates.
137
6) Different rates being paid to workers employed to meet seasonal demands or to
do urgent work.
7) Promotion of employees without proper authorization by personal favoritism of
supervisors, and paying them rates fixed for higher job classifications.
8) of overtime wages in the standard rate but allowing an excessive amount of
overtime work.

A wage rate variance is mostly controllable, since rates of wages are determined by
conditions prevailing in the labor market, and indiscriminate awards by labor tribunals.
However, if the foreman of a cost center employs direct workers of wrong grades, he
would be responsible for the variance. In such a case, he should be informed of the
details with a view to taking a corrective action.

Sub-variance

LABOR MIX VARIANCE


This variance is calculated in the same way as materials mix variance. Standard labor
mix may not be adhered to under some circumstances and substitution will have to be
made. There may be changes in the wage rates of some workers; there may be a need to
use more skilled or expensive types of labor for example employment of men instead of
women; sometimes workers and operators may be absent. This led to the emergence of
a labor mix variance which is calculated by using the formula
Labor mix variance = (Revised standard labor mix in terms of actual total
hours Actual labor mix) x Standard rate per hour
A positive result on the application of the above formulae implies favorable variance
and a negative result implies unfavorable variance (adverse variance).

LABOR YIELD VARIANCE


The final product cost contains not only material cost but also labor cost. Therefore,
profit or loss (higher or lower output than the standard output) should take into account
labor yield variance also. A lower output simply means that final output does not
correspond with the production units that should have been produced from the hours
expended on the inputs. It can be calculated by the following formula:
Labor Yield Variance= (Standard output based on actual hours
Actual output) x Average Standard labor rate per unit of output
or
Labor Yield Variance= (Standard loss on actual hours Actual loss) x Average
standard labor rate per unit of output
Labor yield variance is also known as labor efficiency sub-variance which is calculated
in terms of inputs i.e., standard labor hours and revised labor hours mix
(in terms of actual hours). Labor efficiency sub-variance is calculated by using the
following formula :
138
Labor efficiency sub-variance = (Standard mix Revised Standard mix)
x Standard rate

IDLE TIME VARIANCE


This variance will arise when workers are not able to do the work due to some reason
during the hours for which they are paid. It could be due to breakdown, lack of
materials or power failures. Idle time variance will be equivalent to the standard labor
cost of the hours during which no work has been done but for which workers have been
paid for unproductive time. For example, in a factory, 2000 workers were idle due to a
power failure and as a result of which, a loss of production of 4,000 units of product X
and 8,000 units of product Y occurred. Each employee was paid his normal wage (a rate
of Rs.2 per hour). One standard hour is needed to manufacture four units of product X
and eight units of product Y. Idle time variance will be calculated as follows:
Standard hours lost

Product X =

Product Y =

Total hours lost = 2,000 hrs

Idle time variance (power failure)


2,000 hours @ Rs.2 per hour = Rs.4,000 (A)
Idle Time Variance = Actual Idle Time X Standard Rate

Illustration 6.4
Standard hours for manufacturing two products X and Y are 15 hours per unit and 20
hours per unit respectively. Both products require identical kind of labor and the standard
wage rate per hour is Rs.5. In the year 2001, 10,000 units of X and 15,000 units of Y
were manufactured. The total of labor hours actually worked were 4,50,500 and the
actual wage bill came to Rs.23,00,000. This includes 12,000 hours paid for @ Rs.7 per
hour and 9400 hours paid for @ Rs.7.50 per hour, the balance having been paid at Rs.5
per hour. Calculate the labor variances based on the above data.
Solution
Labor cost variance = (Standard labor cost for actual output
Actual labor cost)
Standard Cost
Product X 10,000 x 15 x 5 = 7,50,000
Product Y 15,000 x 20 x 5 = 15,00,000
22,50,000

139
Actual labor cost = Rs.23,00,000
Labor cost variance = Rs.22,50,000 Rs.23,00,000
= Rs.50,000 (Adverse)
Labor rate variance = Actual hours x (Standard rate Actual rate)
= 12,000 x (5 7) = Rs.24,000 (A)
= 9,400 x (5 7.5) =
Rs.23,500 (A)
= 4,29,100 x (5 5)= Rs.0
= Rs.47,500 (A)
Labor efficiency variance = Standard rate x (Standard time Actual time)
= 5 x (4,50,000 4,50,500)
= Rs.2,500 (Adverse)

Verification:
Labor cost variance = Labor rate variance + Labor efficiency variance
50,000(A) = 47,500(A) + 2,500(A).

Illustration 6.5

Standard labor hours and rate for production of one unit of Article X is given below:
Per unit (hr) Rate per hour Total
(Rs.) (Rs.)
Skilled worker 5 1.50 7.50
Unskilled worker 8 0.50 4.00
Semi-skilled worker 4 0.75 3.00
Rs.14.50

Actual Data Rate per hour (Rs.) Total


(Rs.)
Articles produced 1,000 units

Skilled worker 4,500 hr 2.00 9,000


Unskilled worker 10,000 hr 0.45 4,500

Semi-skilled workers 4,200 0.75 3,150


hr

140
Rs.16,650

Calculate
i. Labor cost variance
ii. Labor rate variance
iii. Labor efficiency variance
iv. Labor mix variance
v. Labor yield variance
vi. Labor efficiency sub-variance.
Solution
i. Labor cost variance
(SH for actual production x SR) (AH x AR)
Skilled (5,000 x 1.50) (4,500 x 2) = Rs.1,500 (A)
Unskilled (8,000 x 0.50) (10,000 x 0.45) = Rs. 500 (A)
Semi-skilled (4,000 x 0.75) (4,200 x 0.75) = Rs. 150 (A)

Total labor cost variance = Rs.2,150 (A)


ii. Labor rate variance
(SR AR) x AH
Skilled workers: (1.50 2.00) x 4,500 = Rs.2,250 (A)
Semi-skilled workers: (0.75 0.75) x 4,200 = Rs. 0
Unskilled workers: (0.50 0.45) x 10,000 = Rs. 500(F)
Total labor rate variance = Rs.1,750 (A)
iii. Labor efficiency variance

Skilled: (5,000 4,500) x 1.50 = Rs. 750 (F)

Unskilled (8,000 10,000) x 0.50 = Rs.1,000 (A)

Semi-skilled (4,000 4,200) x 0.75 = Rs. 150(A)

Total labor efficiency variance = Rs.400(A)


iv. Labor mix variance
First, revised standard hours should be calculated by using the following
formula:
x Total actual hours

Total standard hours = 17,000 = 5,000+8,000+4,000


141
Total actual hours = 18,000 = 4,500+ 10,000 + 4,200
Skilled =

Unskilled =

Semi-skilled =

Labor mix variance = (Revised standard mix of actual hours Actual labor mix) x
Standard rate
Skilled = (5,500 4,500) x 1.50 = Rs.1,500 (F)
Unskilled =(8,800 10,000) x 0.50 = Rs. 600 (A)
Semi-skilled (4,400 4,200)x0.75 = Rs. 150 (F)
Total labor mix variance = Rs.1,050 (F)
v. Labor yield variance
(Standard on actual hours Actual production) x Average standard labor rate per
unit
(1,100 1,000) x 14.50 = Rs.1,450 (Unfavorable)
vi. Labor efficiency sub-variance
(Standard hours for actual production Revised standard hours) x Standard rate
Skilled (5,000 5,500) x 1.50 = Rs.750 (A)
Unskilled (8,000 8,800) x 0.50 = Rs.400 (A)
Semi-skilled (4,000 4,400) x 0.75 = Rs.300 (A)
Total efficiency sub-variance = Rs.1,450(A)
Verification:
i. Labor cost variance = Labor rate variance + Labor efficiency variance
2,150(A) = 1,750(A) + 400(A)
ii. Labor efficiency variance = Labor mix variance + Labor yield variance
400(A) = 1,050(F) + 1,450(A)

6.5.3 OVERHEAD VARIANCE

Overhead cost variance can be defined as the difference between the standard cost
of overhead allowed for the actual output achieved & the actual overhead cost
incurred. In other words, overhead cost variance is under or over absorption of
overheads.

OVERHEAD COST VARIANCE

142
overhead cost variance results from the difference between the overheads recovered
or overheads applied and the actual overheads incurred. Overhead variance may be
calculated on the basis of number of units or on the number of Standards hours.

Overhead Cost Variance = Recovered Overheads - Actual Overheads

For understanding overheads recovered, it is important to have an understanding of


certain terms.
Standard Overhead Rate per unit =

Standard Overhead Rate per hour =

Standard Hours for actual output =

Therefore,
Overheads recovered = Standard OH Rate per unit x Actual output
or Overheads recovered = Standard OH Rate per hour x Standard Hours for Actual
output

Fixed Overhead Cost Variance


Fixed Overhead Cost Variance arises due to the difference between Fixed Overheads
(FOH) recovered and Actual FOH incurred.
FOH Cost Variance = Recovered FOH -Actual FOH
Standard FOH Rate per unit =

Standard FOH Rate per hour =

Standard Hours for actual output =

Therefore,
FOH recovered = Standard FOH Rate per unit x Actual output
or
FOH recovered = Standard FOH Rate per hour x Standard Hours for Actual output
Fixed Overheads Cost Variance can be further analyzed by dividing into FOH
Expenditure Variance and FOH Volume Variance. The following chart 6.3 depicts the
division of FOH Cost variance to FOH Expenditure variance and FOH Volume
Variance.
Chart 6.3

143
Fixed Overhead Expenditure Variance

FOH expenditure Variance arises due to the difference between the budgeted FOH
and the Actual FOH incurred. This is also called controllable variance.

FOH Expenditure Variance = Budgeted FOH - Actual FOH

Where, Budgeted FOH = Standard FOH Rate per unit Budgeted Output

Fixed Overhead Volume Variance

FOH Volume variance arises on account of difference in the actual output achieve
and the Budgeted level of output. This difference in the output causes over recovery
or under recovery of Fixed Overheads.

FOH Volume Variance = Recovered FOH - Budgeted FOH

or

FOH Volume Variance = Standard FOH Rate per unit (Actual output - Budgeted
output)

Variable Overhead Cost Variance


Variable Overhead Cost Variance arises due to difference between Variable Overheads
recovered and Variable overheads actually incurred.
VOH Cost Variance = Recovered VOH - Actual VOH

Standard VOH Rate per unit =

Standard VOH Rate per hour =

Standard hours for actual output =

Therefore,

144
VOH recovered = Standard VOH Rate per unit x Actual output
or
VOH recovered = Standard VOH Rate per hour x Standard Hours for Atcual output
Variable Overheads Cost Variance can be further analyzed by dividing into VOH
Expenditure Variance and VOH Efficiency Variance. The following chart 6.4 depicts
the division of VOH Cost variance to VOH Expenditure variance and VOH Efficiency
Variance.
Chart 6.4

Variable Overhead Expenditure Variance

VOH Expenditure variance is also known as Spending variance or Controllable


variance. This variance arises due to the difference between the Standard Variable
overheads and the Actual VOH incurred. This difference between the two arises due to
difference in Standard VOH rate and Actual VOH rate for actual time.
VOH Expenditure Variance = standard VOH - Actual VOH
or
VOH Expenditure Variance = Actual Time X (Standard VOH rate per hour - Actual
VOH rate per hour)
Since, generally variable overheads vary directly with output, a change in the level of
output does not affect the Standard variable OH per unit and hence no expenditure
variance arises. However, when actual VOH rate per unit is different from the standard
VOH rate per unit, then expenditure variance arises.

Variable Overhead Efficiency Variance


Variable OH Efficiency Variance arises due to the difference between Standard hours
for actual output and the actual hours expended to produce actual output. This overhead
calculation resembles the labor overhead efficiency variance, since overhead efficiency
variance arises due to efficiency/ inefficiency of labor hours expended to produce the
given output.

145
VOH Efficiency variance = standard VOH per hour x (Standard hours for actual output
- actual hours)
or
VOH Efficiency Variance = Recovered VOH - Standard VOH
Where, Standard VOH = Standard Rate per Unit x Standard output for actual time.

ILLUSTRATION 6.6 :

SOLUTION:

Variable Overhead Variance:

Actual variable overhead 14250

Standard Variance (8000*1.70) 13,600

Variable Overhead Variance = 13600-14250 = 650 (A)

146
ILLUSTRATION 6.7:

From the following data, calculate overhead variance:

Budgeted Actual

Output 15000 Units 16,000 units

Number of working Days 25 27

Fixed Overhead Rs 30,000 Rs 30,500

Variable Overheads Rs 45,000 Rs 47,000

There was an increase of 5% in capacity.

SOLUTION:

(1) Total overhead cost variance

Actual units * Standard Rate Actual Overhead Cost

16,000 units* (Rs2+Rs3) (Rs 30,500 + Rs 47,000)

= Rs 80,000 Rs 77,500 = Rs 2,500 (F)

Standard Rate = Standard Overheads/Standard Output

Standard Rate: Fixed : (Rs 30,000/ Rs 15,000) = Rs 2

Standard Rate: Variable: Rs 45,000/15,000 = Rs 3

Actual Overhead Cost= Fixed Overhead + Variable Overhead Cost

= Rs 30,500 + RS 47,000 = Rs 77,500

(2) Variable Overhead Expenditure Variance

Actual Units * Standard Rate Actual Variable Overhead Cost

16,000 * Rs 3 47,000 = Rs 1000 (F)

(3) Fixed Overhead Variance

Actual Units * Standard Rate (Fixed Overhead) Actual Fixed Overehad

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16,000 * Rs 2 Rs 30,500 = Rs 1,500 (F)

(4) Volume Variance

Actual Units * Standard rate Budgeted Fixed Overhead

16,000 * Rs 2 Rs 30,000 = Rs 2000 (F)

(5) Expenditure Variance

Budgeted Fixed Overhead Actual Fixed Overehad

= Rs 30,000 Rs 30,500= Rs 500 (U)

(6) Capacity Variance

Standard Rate (Revised Budgeted Units Budgeted Units)

Budgeted units for 25 days = 15,000 units

Budgeted units for 27 days = 15,000/25 * 27 = 16,200 units

Revised budgeted units after 5% increase in capacity

= 17,010 i.e. 16,200 + (5/100) * 16,200

Capacity Variance= Rs 2 (17,010-16,200) = Rs 1,620 (F)

(7) Efficiency Variance

Standard Rate (Actual Production Standard Production)

Standard Production

Budgeted production = 15,000 Units

Production increased due to increase in capacity = 810 units

Production increased due to 2 more working days = 1,200 units

17,010 units

Hence Efficiency Variance = Rs 2 (16,000 units 17,010 units) = Rs 2 (-


1,010 units) = Rs 2,020 Unfavourable

148
MULTIPLE CHOICE QUESTIONS:

Q1 Controllable variance arises due to the difference between

Q2 While computing variances from standard costs, the difference between the
actual and the standard prices multiplied by the actual quantity yields a

Q3 If the number of standard allowed hours equals the planned activity level of
hours, and then the fixed overhead volume variance is

Q4 The labor yield variance is

Q5 which department typically has the primary responsibility for an unfavorable


materials usage variance?

149
Q6 Idle time variance is the difference between

Q7 The material price variance arises because of

Q8 Which of the following is a purpose of standard costing?

Q9 The labor cost variance may be expressed as

150
Q10 Which of the following variances is most controllable by the Production
Control Supervisor?

151
CHAPTER 7 BUDGETS, COST REDUCTION AND
CONTROL
At the end of the chapter you will be conversant with:

7.1 Introduction To Budget & Budgetary Control


7.2 Budgeting As A Tool Of Management Planning And Control
7.3 Advantages Of Budgeting And Budgetary Control
7.4 Problems In Budgeting
7.5 Characteristics Of A Budget
7.6 Application Of The Budget
7.7 Organization Of The Budget
7.8 Concept Of Limiting Budget Factor
7.9 Budget Preparation : Sales Budget, Production Budget, Direct Material Budget,
Factory Overhead Budget, Closing Inventory Budget, Cash Budget
7.10 Fixed And Flexible Budgeting
7.11 Zero Base Budgeting (ZBB)

7.1 INTRODUCTION TO BUDGET & BUDGETARY CONTROL


Basically, management is the coordination of human effort, i.e., the accomplishment of
goals by utilizing the efforts of other people. Management is termed efficient if it
accomplishes the objectives with minimum effort and costs. Management planning and
control has been recognized as one of the most important approaches for facilitating
effective performance of the management process.
While all business endeavors have multiple objectives of profit and contribution to the
economic and social improvement, non-business endeavors have relatively precise
objectives generally to be accomplished within specified cost constraints. Whether it is
a business or non-business endeavor it is essential that the management and other
interested parties are very well acquainted with the objectives and goals so that proper
managerial guidance could be given and the effectiveness with which the desired
activities are performed could be measured.
So, whatever be the endeavor, the management process essentially conforms to the
general pattern planning, co-ordination and control. With the increasing competition
among profit-making enterprises, the concept of profit planning and control system has
gained wide acceptance which requires management to design its course in advance and
use appropriate techniques to assure co-ordination and control of operations.

Budgetary control is defined by the Institute of Cost and Management Accountants


(CIMA) as:

"The establishment of budgets relating the responsibilities of executives to the


requirements of a policy, and the continuous comparison of actual with budgeted results,

152
either to secure by individual action the objective of that policy, or to provide a basis for
its revision".

a) Budget:

resources set aside for carrying out specific


activities in a given period of time.

-ordinate the activities of the organisation.

An example would be an advertising budget or sales force budget.

b) Budgetary control:

ue whereby actual results are compared with budgets.

either exercise control action or revise the original budgets.

7.2 BUDGETING AS A TOOL OF MANAGEMENT PLANNING AND


CONTROL
Budget is a numeric representation of the managers plans for a specified period of
time. It is commonly used by business firms, governmental agencies, non-profit
organizations and even households. While there is considerable variation in the scope,
degree of formality and level of sophistication applied to budgeting, most of the well
managed business firms use budget which is a comprehensive and coordinated plan for
the operations and resources of the firm.
A Budget can serve as an extremely useful tool for all managers.
Communication: A budget can serve as a means of communicating information
within a firm. It is especially useful to lower level managers. For example, the
district sales managers can know from the budget the level of sales that are
expected of them or the production manager can know through the budget how
much he can spend towards labor expenses, etc.
The budget serves as a communicator over time. As everyone tend to forget what they
have planned without a written record, budget will remind them of their goals and
progress towards the goals.
Co-ordination: Whenever a manager is faced with managing two or more
interrelated processes, he encounters the need to co-ordinate operations to
maximize the utilization of the available resources and to minimize idleness. A
manager of a small manufacturing concern needs to coordinate such things as
raw material purchases, working capital matter, labor union negotiations, etc. As
the size of the operations increases, the number of factors to be co-ordinated
increase and the manager is likely to find himself in a precarious situation
153
without a concretely stated central plan. Co-ordination is essential when
responsibility for different segments is delegated to separate individuals. The
budget can serve for the above purpose of co-ordination.
Measurement of Success: Success is determined by comparing past
performance against a previous periods performance. However, this
comparison using historical records does not take into consideration the changes
that take place for example, the market for the product may have increased, etc.
Whereas budgets provides us to compare the actual performance with the
budgeted performance which is an estimate of what might have been taking all
the possible changes into account. Though budget is only a prior estimate of
future conditions and thus subject to manipulation, it can be used as a success
criterion, if done carefully and with additional data.
Motivation: Budgets prepared for the coming year motivates the managers to
do their best. And, if a reward system is attached to the budget it further
motivates the managers to achieve the levels of output.

7.3 ADVANTAGES OF BUDGETING AND BUDGETARY CONTROL

There are a number of advantages to budgeting and budgetary control:

Compels management to think about the future, which is probably the most
important feature of a budgetary planning and control system. Forces
management to look ahead, to set out detailed plans for achieving the targets for
each department, operation and (ideally) each manager, to anticipate and give the
organisation purpose and direction.
Promotes coordination and communication.
Clearly defines areas of responsibility. Requires managers of budget centres to be
made responsible for the achievement of budget targets for the operations under
their personal control.
Provides a basis for performance appraisal (variance analysis). A budget is
basically a yardstick against which actual performance is measured and assessed.
Control is provided by comparisons of actual results against budget plan.
Departures from budget can then be investigated and the reasons for the
differences can be divided into controllable and non-controllable factors.
Enables remedial action to be taken as variances emerge.
Motivates employees by participating in the setting of budgets.
Improves the allocation of scarce resources.
Economizes management time by using the management by exception principle.

7.4 PROBLEMS IN BUDGETING

Whilst budgets may be an essential part of any marketing activity they do have a number
of disadvantages, particularly in perception terms.

1. Budgets can be seen as pressure devices imposed by management, thus resulting in:

154
a) bad labour relations
b) inaccurate record-keeping.

2. Departmental conflict arises due to:

a) disputes over resource allocation


b) departments blaming each other if targets are not attained.

3. It is difficult to reconcile personal/individual and corporate goals.

4. Waste may arise as managers adopt the view, "we had better spend it or we will lose
it". This is often coupled with "empire building" in order to enhance the prestige of a
department.

Responsibility versus controlling, i.e. some costs are under the influence of more than
one person, e.g. power costs.

5. Managers may overestimate costs so that they will not be blamed in the future should
they overspend.

7.5 CHARACTERISTICS OF A BUDGET

A good budget is characterized by the following:

Participation: involve as many people as possible in drawing up a budget.


Comprehensiveness: embrace the whole organisation.
Standards: base it on established standards of performance.
Flexibility: allow for changing circumstances.
Feedback: constantly monitor performance.
Analysis of costs and revenues: this can be done on the basis of product lines,
departments or cost centres.

7.6 APPLICATION OF THE BUDGET

In the following areas, budgeting can be applied.

Outputs

Careful analysis of future sales will be made. Then the manager will begin to plan
production or purchase requirements to meet the expected sales figure. With the budgets
prepared he would be in a position to utilize the available resources efficiently to meet
the anticipated demand.

Inputs

155
Once the budget establishes a manufacturing firms output requirements, the manager
can go about planning for labor and materials acquisition to support the desired output
levels. Budgets help the managers to plan in advance for future and negotiate labor and
material contracts at favorable rates. Without budget he may be forced into emergency
purchases at higher costs, less skilled or over-time skill labor and sometimes he may
have to face with no production situation because of shortage of any input. Budget helps
managers to avoid off season lay offs and peak period bulges by spreading production
more evenly through the year.

Facilities

Good budgeting informs the manager about the adequacy of existing facilities for his
future needs. However, this requires additional storage of materials and finished
products and hence more space. Increased inventory costs leads to increased non-cash
working capital and hence cash may be borrowed until sales can be made. Thus,
budgeting facilitates the above anticipation and assists in establishing coordination.
Production of some materials need special equipment, the need of which can be
anticipated by budgeting and can be procured at favorable terms instead of a rush rental.

Administration

Budgeting applies equally well to administrative activities. Need for clerks, store-
keepers, book-keepers, secretaries, office supplies, etc., can be handled in the similar
fashion through foresight and planning. Anticipation can lead to efficiency and higher
profits in the office as well as in the production.

Cash needs

Budgeting provides estimation of future receipts and disbursements. Careful planning


facilitates the treasurer to minimize the chances of running out of cash and going
bankrupt and also avoids situations of excess cash which is not capable of earning
income.

Control

A well-structured budget can lead to efficient control of the firm as the manager has an
indication of what should be done and can more easily spot what is being ineffectively
done.

7.7 ORGANIZATION OF THE BUDGET

The following guidelines may be followed in preparing a budget.

Assigning personnel: The manager of an entity should assign his most qualified
personnel to the preparation of the budget. The organization chart that is generally found
in medium sized firms is shown in following Figure
156
Figure 7.1: Organization Chart

The four vice-presidents have responsibility for their respective functional areas. Each
will delegate authority to his subordinates in order to get work done. Though, the Vice-
President for finance provides information required by other departments, he makes
decisions concerning the operation of his own department only.
A better course of action is to establish a budget committee with representation from
each of the financial areas. A Budget Committee usually reports directly to top
management. In large companies the budget committee is composed of executives in-
charge of major functions of the business and includes the sales manager, personnel
manager, finance manager, the production manager, the chief engineer, the treasurer
and the chief accounts officer. One member of the budget committee is the budget
director who is in-charge of preparing a budget manual of instructions and
accumulating the proposed budget data. In large companies, the position may be full-
time job; in smaller companies, the post may be assigned to the finance manager or
chief accounts officer or some other officer who acts as budget director on a part-time
basis.
The principal functions of the budget committee are to:
Decide the companys general policies and objectives;
Receive and review individual budget estimates concerning different
departments/units/division;
Suggest changes, modifications in accordance with organizational objectives;
Approve budgets which act as an authority/target for departmental action;
Receive and analyze performance reports regarding the implementation of
budgets;
Suggest corrective action to improve efficiency and achieve budgetary goals.

Deriving Budget Figures


There are three ways that the budget committee can derive the estimates that appear in
the final budget.
In one approach, known as imposed budget or top-down approach, the budgeted figures
are obtained from the top level managers and then communicated downward to the
lower level managers. Low level managers do not participate in this type of budget i.e.,
they have nothing to say about what is expected of them.
One important advantage of this type of budgeting is that the top level managers are
involved in planning decisions and as such they have wider perspective of the firms
157
operation and would be in a position to allocate various resources among the various
areas of responsibility. They need to only implement as decided by top level mangers.
Additionally, this is very cheaper because of the relatively fewer persons involved.
However, this approach has two disadvantages. Firstly, top level managers, due to their
positions, are separated from actual production and marketing processes and their
allocation of resources to various areas would be without specific knowledge and as such
may not be proper. Secondly, as the lower level managers do not participate in preparing
the budget, they are not motivated to work as per the estimates.
Another approach, known as participative approach is designed to eliminate the above
disadvantages of imposed budgeting. In participating approach, estimations of lower
level managers are coordinated and communicated upward to the top level managers.
As lower level managers are given special importance in the preparation of budget
figures, they will make special efforts to meet those goals. Participating approach rests
on the belief that the low level managers who involve in day-to-day activities know
very well his requirements and abilities and as such can give proper budgeted figures.
However, this approach too has disadvantages. Firstly, the manager may inflate the
importance of his own area of responsibility and produce unrealistic demands.
Secondly, to be in a comfortable position, each manager may provide for more inputs
than required. And, from practical point of view, this approach is costlier to imposed
approach.
Keeping in view the disadvantages of both the approaches, very few firms follow either
a pure imposed or a pure participating approach. Thus, generally what is followed is the
mixed approach, known as negotiated approach in which the possible goals set by
higher level managers are communicated downward to lower level managers for their
acceptance. If the lower levels are not satisfied with the set goals they are allowed to
suggest alternatives, either in terms of expectations or resources. Then, the upper
management makes the necessary alterations. It is believed that this approach brings out
the advantage of the other two i.e., it combines a broad perspective of top management
with precise knowledge of line managers. It also achieves a personal commitment from
the lower levels to reasonable goals. Of course, all these advantages are obtained at a
cost of high managerial expenses.

Selecting the Time Frame


The time/budget period is an important factor in developing a comprehensive budgeting
program. This is the period for which forecasts can reasonably be made and budgets can
be formulated. A business enterprise generally prepares a Short range budget and a
Long range budget.

Short range budget

Short range budgets may cover periods of three, six or twelve months depending upon
the nature of the business. Most manufacturing firms use one year as the planning
period. Wholesale and retail firms usually employ a six-month budget which is related
to their selling seasons.
158
Long Range Budget

A Long range budget or planning is defined as a systematic and formalized process for
purposefully directing and controlling future operations towards a desired objective for
periods extending beyond one year. Long range budgets cover specific areas, such as
future sales, future production, long-term capital expenditures, extensive research and
development programs, financial requirements, profit/forecast. They evaluate the future
implications associated with present decisions and help management in making present
decisions and select the most profitable alternative. Long range budgeting does not
eliminate risk altogether, it only reduces the risk to a level which does not hamper the
production and achievement of company objectives.

7.8 CONCEPT OF LIMITING BUDGET FACTOR


When budgets are made, there is invariably some factor which governs or sets a limit to
the quantity which can be made or sold. This is known as the limiting or principal budget
factor. A principal budget factor is the factor the extent of whose influence must first be
assessed in order to ensure that the functional budgets are reasonably capable of fulfillment.
In the field of sales the limiting factor is customer demand which is influenced by many
factors, such as price and quality of the product, competition, the general purchasing
power of the public, advertising, etc. In the field of production, the principal budget
factor may be plant capacity, the supply of labor of the right quality or the availability
of scarce materials. Sometimes, management itself may impose limiting factors, for
example management may control production to maintain a definite price level or
management may not decide to purchase plant and machinery and thus to maintain the
same plant capacity.
The limiting or principal budget factors must be carefully considered while preparing
the budget. If not properly taken into account, budgets may not be realistic and become
difficult to achieve. Coordination among different departments will be lacking. The
principal budget factors can be eliminated by taking suitable measures, for example, the
plant capacity can be increased by purchase of additional plant.

7.9 BUDGET PREPARATION

After determining the principal budget factor, which is also known as the key budget
factor or limiting budget factor , different types of budgets are prepared. e.g. sales,
material or labour.

1) Sales Budget
After determining the price at which the product is to be sold, it should decide the
volume of units that it can sell. It cannot establish a high sales volume as the firm may
not be able to capture the market to sell that many units. Then, the sales budget is
prepared which is the numeric representation of the marketing department plans for the
coming year.
Following Table1 presents a specimen of a sales budget.

159
ABC Company Ltd.
Sales Budget for the year ending December 31, 20X3
Products Budgeted Budgeted Sales Total
Sales price
units
A 70,000 55 38,50,000

B 80,000 40 32,00,000

Total 1,50,000 70,50,000

2) Budgeting Production

Once the sales forecast is established, it is the task of the budget committee to prepare
plans for making the product available for sale. The requirements of the sales plan must
be translated into the supporting activities of the other major functions. In the case of a
service company, the sales plan must be converted to service capability requirements;
for a retail or wholesale enterprise, the sales plan must be translated into merchandise
purchases requirements; and in the case of a manufacturing enterprise, the sales plan
must be converted to production (manufacturing) requirements.

3) OUTPUTS

As the sales forecast deals with the number of units to be sold, production budget deals
with the products that are to be produced/manufactured. In rare cases production output
equals sales. It is highly possible that some of the items sold comes from the inventory
held or some of the units products add up to the inventory held. So, production
management should not only co-ordinate with sales management but also with
inventory management.
The general equation which deals with flow of goods is:
Beginning inventory + Production Sales = Ending inventory.
This can also be expressed as:
Production = Sales + Change in Inventory.
Where change in inventory is equal to
Ending Inventory Beginning Inventory.
Thus, if there is no change in inventory then cost of production will be equal to cost of
goods to be sold. But, if the management feels that the future sales will be growing it
will seek to utilize as much production capacity as possible in case of inflation in order
to produce at the lowest cost possible and to earn revenues later. In this case, as the
inventories have to be increased in anticipation of being sold at higher prices, production
must also be increased. On contrast, if a decline in future demand is expected, it is
160
appropriate to reduce the inventory in order to avoid holding losses from decline in prices
and thus production has to be below sales volume.

Table 2 exhibits a specimen of production budget.

Table 2
ABC Company Ltd.
Production Budget for the year ended December 31, 20X3
Product
A B
Budgeted sales (in units) 70,000 80,000

Add: Desired closing finished goods 20,000 30,000


inventory
90,000 1,10,000

Less: Beginning finished goods inventory 40,000 20,000

Budgeted Production requirement 50,000 90,000

The Schedule presented above is the overall production budget for ABC Company Ltd.
The publication of the production budget accomplishes the co-ordination of the efforts
of the production and sales divisions. The latter group knows what it has to sell and the
former knows what it has to produce.

4) INPUTS

The production budget forms the basis for direct labor budgets, material budgets and
manufacturing overhead budgets. Figure 7.2 presents graphically the flow of the
planning activity from sales through the manufacturing executives plan.
Figure 7.2: Sales Plan

161
Thus, after coordinating plans for output, the next step for the production manager is to
anticipate the acquisition of direct labor, direct material and manufacturing overhead
expenses.
Direct labor costs consists of wages paid to employees who are engaged directly in
specific productive output. Thus, direct labor budget represents the direct labor
requirements necessary to produce the types and quantities of outputs planned in the
production budget.
In planning for direct labor, the manager needs to examine such areas - manpower
needs, recruitment, training, job evaluation and specification, performance evaluation,
union negotiations and wage contracts.
The manager should identify his needs for skilled labor and see whether he can provide
for them for the existing pay roll or whether he can train some of his employees. He has

162
to determine the price per labor hour. He must also carefully consider the requirements
of union contracts before preparing a labor budget.
Table3 illustrates the preparation of a direct labor budget.
Table 3
ABC Company Ltd.
Direct Labor budget for the year ended December 31, 20X3
Products Total
A B
Budgeted production 50,000 90,000

Direct labor hours/unit 3 2


Total direct labor hrs. 1,50,000 1,80,000 3,30,000

Direct labor cost/hour Rs.5 Rs.5 Rs.5

Total direct labor cost 7,50,000 9,00,000 16,50,000

Laborers cannot produce a product unless they have materials and production planning
requires anticipating the need for materials.
A direct materials budget indicates the expected amount of direct materials required
to produce the budgeted units of finished good. This budget specifies the cost of direct
materials used and the cost of the direct materials purchased. Table 8.4 explains the
calculation of the direct materials budget. The usage part of the direct materials budget
determines the cost of purchases of direct materials.
Table 4
ABC Company Direct Materials Budget for the
Year Ending December 20X3
A. Usage Budget Product
A B Total
Budgeted production in 50,000 90,000
units
Direct materials
requirements
Product A: 5 kg per unit x 5
Product B: 8 kg per unit x8
Direct materials usage 2,50,000 7,20,000
(kg)
Cost per kg (Rs.) 1 1.5
Cost of direct materials Rs.2,50,000 Rs.10,80,000 Rs.13,30,000
B. Purchase Budget
Direct
Materials
(in kg)
163
Direct materials usage 2,50,000 7,20,000
Add: Budgeted closing 50,000 75,000
direct materials
inventory
Total requirements 3,00,000 7,95,000
Less: Beginning direct 70,000 1,00,000
materials inventory
Purchase of direct 2,30,000 6,95,000
materials
Cost per kg x Rs.1.00 x Rs.1.50
Cost of purchase Rs.2,30,000 Rs.10,42,500 Rs.12,72,500

The direct materials budget is useful in the following ways:


It helps the purchasing department to prepare a schedule to ensure delivery of
materials when needed.
It helps in fixing minimum and maximum levels of inventories in the stores
department.
It helps the finance manager to determine the financial requirements to meet
production targets.
The materials budget usually deals with direct materials only. Supplies and indirect
materials are generally included in the factory overhead budget.
In addition to direct labor and materials budget, the production manager may need to
plan for other manufacturing overhead items like indirect labor, supplies, repairs, power
and other factory overheads.

The factory overhead budget estimates the requirements and costs of the above
overheads for the production of the budgeted units. It requires that expenses should be
classified by departments since expenses are incurred by various departments. In this
way departmental heads should be held accountable for expenses incurred by their
departments. Generally, the department heads prepare budgets for their respective
departments for the budget period. However, they need considerable help and advice
from the budget director in order to achieve production budget.
Table 5 depicts the factory overhead budget wherein overhead costs have been
classified into fixed and variable components
Table 5
ABC Company
Factory Overhead Budget for the Year Ending December 20X3
(based on budgeted capacity of 3,30,000 direct labor hours)
Items Direct Rate Per Total Cost
Labor Direct
hours Labor hour
(Rs.)
164
A. Variable factory overhead:

Supplies 3,30,000 0.7 2,31,000


Repairs 3,30,000 0.3 99,000
Indirect labor 3,30,000 0.7 2,31,000
Others 3,30,000 0.25 82,500
Total variable factory overhead 6,43,500
cost
B. Fixed factory overhead cost:

Supervision 3,00,000
Depreciation 3,50,000
Property tax 1,50,000
Others 2,06,500
Total fixed factory overhead 10,06,500
cost
Total factory overhead cost 16,50,000

Predetermined overhead rate

= Rs.

Rs.5.00 per direct labor hour

BUDGETING CLOSING INVENTORIES


An inventory budget can be prepared to find out the values of direct materials and
finished goods inventory as shown in Table 6
Table 6: ABC Company
Ending Inventory Budget for the Year Ending December, 20X3
Direct materials inventory Rs.
Product A 50,000 kg x Rs.1.00 per 50,000
kg
Product B 75,000 kg x Rs.1.50 per 1,12,500
kg
1,62,500
Finished goods inventory
Product A 20,000 units x Rs.35.00* 7,00,000

Product B 30,000 units x Rs.32.00* 9,60,000

16,60,00
0

165
* Manufacturing cost per finished unit (calculated
in Table.7)
Table 7
Product A Product B
Quantity Unit Product Quantity Unit Product
required Cost Rs. unit required Cost unit
kgs/hrs cost Rs. kgs/hrs Rs. cost Rs.
Direct material 5 1 5 8 1.5 12
Direct labor 3 5 15 2 5 10
Factory overhead 3 5 15 2 5 10
Total manufacturing cost per 35 32
finished unit

5) Budgeting Cash
The next step in the budgeting process is to prepare cash budget. Managers must be
concerned with the amount of cash that flows in and out of the firm, as well as the
amount that happens to be on hand at any particular time. If the firm has less cash
than enough to keep the creditors satisfied it may have to face a suit filed by the
creditors. On the other hand, if the firm has excess cash on hand, the firm would
earn no income on it. So, the cash manager must have neither too little nor too
much.
The first step, then, in preparing cash budget is to establish the desired amount to have
on hand i.e., which will be enough to meet any emergencies. The second step requires
the manager to identify all the sources from which cash flows into the firm, like
revenues from sales, borrowing etc. He must also estimate the timing of the cash inflow.
The third step is to identify the applications or uses of cash, such as payment for
purchases, utility bills, salaries, etc. Even here he has to estimate the timing of the flow.
Finally, these predictions are brought together in the cash budget, and the results are
analyzed. If there will be excess funds on hand, then plans should be made to find
profitable temporary investments to occupy them and if shortages are predicted the
manager should plan for short-term loans.
Table 8 presents a typical cash budget
Table 8: ABC Company Cash Budget for the year ended 20X3
Amount Amount
(Rs.) (Rs.)
Beginning cash balance 2,00,000
Add: Receipts:
Cash Sales (50% of current years sales) 35,25,000

Receivables Collections (50% of 32,50,000


previous years sales)
Investment income 0 67,75,000
Total cash available for use 69,75,000
166
Less: Expenditures:
Cash Purchases 12,72,500
Labor and Factory Overheads 33,00,000
Administrative and Selling Expenses 14,00,000
Total cash to be used 59,72,500
Net cash available 10,02,500

Revision of Budgets
As stated earlier in the chapter, successful budgets should have adequate flexibility to
meet changing business conditions. Since budgets are used for planning, operation, co-
ordination and control, they should be revised if changes occur in the environment.
Revision of budgets may be necessary due to the following factors some of which might
have been considered earlier in the development of budgets:
Errors committed in preparing the budgets which may subsequently be known.
Emergence of unforeseen and unanticipated situations which may cause the
budget to be revised.
Changes in internal factors, example, production forecast, sales forecast,
capacity utilization, etc.
Changes in external factors, example, market trends, nature of the economy, prices of
inputs and resources, consumers tastes and fashions.

7.10 FIXED AND FLEXIBLE BUDGETING

FIXED BUDGETING
A fixed budget is the budget which is designed to remain unchanged irrespective of the
level of activity actually attained. It is based on a single level of activity. A fixed budget
performance report compares data from actual operations with the single level of
activity reflected in the budget. It is based on the assumption that the company will
work at some specified level of activity and that a stated production will be achieved.
Fixed budgets do not change when production level changes.
However, in practice, fixed budgeting is rarely used. The main reason is that actual
output is often significantly different from the budgeted control. The performance
report may be misleading and will not contain very useful information. For example, if
actual production is 12,000 units in place of the budgeted 10,000 units the cost incurred
cannot be compared with the budget which relates to different levels of activity. Since,
in fixed budgeting, units are overlooked, a cost-to-cost comparison without considering
the units may give misleading results.
FLEXIBLE BUDGETING
A flexible budget is defined as a budget which by recognizing the difference between
fixed, semi-fixed and variable costs, is designed to change in relation to the level of
activity attained.

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A flexible budget is defined as a budget which by recognizing the difference between
fixed, semi-fixed and variable costs, is designed to change in relation to the level of
activity attained.
A flexible budget is a budget that is prepared for a range, i.e., for more than one level of
activity. It is a set of alternative budgets to different expected levels of activity. Thus, a
flexible budget might be developed that would apply to a relevant range of
production, say 8,000 to 12,000 units. Under this approach, if actual production slips to
9,000 units from a projected 10,000 units, the manager has a specific tool (i.e., the
flexible budget) that can be used to determine budgeted cost at 9,000 units of output.
The flexible budget provides a reliable basis for comparisons because it is automatically
geared to changes in production activity.

Characteristics of Flexible Budgets

Flexible budgets have several desirable characteristics. They

Cover a range of activity


Are dynamic
Facilitate performance measurement.

Steps in Flexible Budgeting


The following steps (stages) are involved in developing a flexible budget:
Deciding the range of activity to which the budget is to be prepared.
Determining the cost behavior patterns (fixed, variable, semi-variable) for each
element of cost to be included in the budget.
Selecting the activity levels (generally in terms of production) to prepare
budgets at those levels.
Preparing the budget at each activity level selected by associating the activity
level with corresponding costs. The corresponding costs to be attached with
each activity level are determined in terms of their behavior, i.e., fixed, variable
and semi-variable.

FLEXIBLE BUDGETING AN ILLUSTRATION


A student health clinic of a college is used to illustrate the complete cycle in the
development of a flexible budget and the preparation of a flexible budget variance
analysis report. The health clinic serves students enrolled in the college. Most patients
require out patient services, but facilities are available for students requiring hospitalization.
The clinic has a small permanent professional staff that is supplemented by doctors and nurses
from the area who work part-time as needed. Consequently, a part of the salaries is fixed,
whereas a part of the medical salary cost varies with the number of students served.
The following steps are needed to develop a flexible budget.

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1. The first step in the budgeting process is to determine the range of activity the
budget will cover. The activity range is important because cost behavior patterns
may be different in different ranges of activity. For example, the building lease
cost may be fixed from 0 to 25,000 student visits a year, but beyond 25,000
visits additional space must be leased, causing a jump in the lease cost from
Rs.18,000 to Rs.30,000 annually.
2. Typically, firms analyze historical cost data using techniques such as scatter
diagram, linear regression, or other methods. Behavior patterns suggested by
historical cost data analysis are modified to reflect expected changes. Generally,
the behavior pattern for each cost is described in terms of fixed and variable
components.
Although, measures of activity like the number of medical staff hours, could have
been used, the number of student visits is the most appropriate in this illustration. The
health clinic manager selects an activity range of 12,000 to 20,000 student visits for the
budget year. This relatively wide activity range is selected because student enrollment
figures for the coming year are not yet available. Also, the national health service is
predicting a major epidemic during the year. If the epidemic strikes the campus, health
service visits will be noticeably higher than this years level of 15,000.
3. Budgets are prepared for three activity levels in this illustration viz. 12,000,
16,000 and 20,000 student visits. The number of budgets to be prepared for
different activity levels is at the discretion of the management, their decision
being influenced by the cost-benefit relationship of preparing more budgets. The
cost of preparing budgets, however, is not high once cost behavior data have
been developed.
Table 9
Student Health Clinic
Estimated Cost Behavior Patterns
For the Fiscal Year 2000 2001
Cost Fixed Cost (Rs.) Visit Variable
Cost per Student
Administrative salaries 35,000
Medical and nursing 80,000 8.00
salaries
Other Salaries 28,000 2.50
Medical supplies 6,000 5.00
External laboratory 1.00
fees and
other medical fees
Building lease 18,000
Utilities 6,500 .50
Maintenance 20,000 1.50

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Cost Fixed Cost (Rs.) Visit Variable
Cost per Student
Computer services 12,000 .75
Employee fringe 34,500 1.75
benefits
4. The data given in Table 8.1 is used to develop the flexible budget for each
selected activity level as shown in the table below. The fixed and variable
components for all costs are separated to highlight the composition of each cost
at each activity level.
Administrative salaries are entirely fixed and are therefore constant at Rs.35,000 for all
three activity levels. Medical and nursing salaries have a fixed component of Rs.80,000
and a variable component of Rs.8 per student visit. Hence, the variable part of this cost
is Rs.8 x 12,000 or Rs.96,000 at the activity level of 12,000 student visits. Likewise, it
is Rs.1,28,000 and Rs.1,60,000 respectively at the activity levels of 16,000 and 20,000
student visits. The total cost in case of other costs which also consists of a fixed and a
variable component is obtained by adding these two components.
Table 10
Student Health Clinic
Flexible Budget for the fiscal year 2000-01
Activity Level (Number of Student Visits)
12,000 16,000 20,000
Cost Fixed Variable Fixed Variable Fixed Variable
Rs. Rs. Rs. Rs. Rs. Rs.
Administrative salaries 35,000 35,000 35,000
Medical and nursing 80,000 96,000 80,000 128,000 80,000 160,000
salaries
Other salaries 28,000 30,000 28,000 40,000 28,000 50,000
Medical supplies 6,000 60,000 6,000 80,000 6,000 100,000
External laboratory fees 12,000 16,000 20,000
and other medical fees
Building lease 18,000 18,000 18,000
Utilities 6,500 6,000 6,500 8,000 6,500 10,000
Maintenance 20,000 18,000 20,000 24,000 20,000 30,000
Computer services 12,000 9,000 12,000 12,000 12,000 15,000
Employee fringe benefits 34,500 21,000 34,500 28,000 34,500 35,000
Total 2,40,000 2,52,000 2,40,000 3,36,000 2,40,000 4,20,000

Table 10 shows flexible budget for the health clinic identifying fixed and variable cost.
The fixed costs remain constant for all levels of activity, and the variable costs increase
with the level of activity. Usually fixed and variable costs are combined in the final
version of a flexible budget, as shown in Table 11, which combines the fixed and variable
cost data as shown in Table 10.

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Table11
Student Health Clinic Flexible Budget For the Fiscal Year 2000-01
Activity Level
(Number of Student Visits)
Cost 12,000 16,000 20,000
(Rs) (Rs) (Rs)
Administrative salaries 35,000 35,000 35,000
Medical and nursing salaries 1,76,000 2,08,000 2,40,000
Other salaries 58,000 68,000 78,000
Medical supplies 66,000 86,000 1,06,000
External laboratory fees and other 12,000 16,000 20,000
medical fees
Building lease 18,000 18,000 18,000
Utilities 12,500 14,500 16,500
Maintenance 38,000 44,000 50,000
Computer services 21,000 24,000 27,000
Employee fringe benefits 55,500 62,500 69,500
Total 4,92,000 5,76,000 6,60,000

It is simple to calculate the cost behavior data from the flexible budget. For example,
consider the medical and nursing salaries.
Variable Cost =

= Rs.8 per student visit


Using the total cost formula for 12,000 student visits and substituting the variable cost
figure, the fixed cost component can be identified.
Total Cost = Fixed Cost + Variable Cost
1,76,000 = Fixed Cost + (12,000 x 8)
Therefore, fixed cost = Rs.80,000
The variable cost per student could be substituted into the total cost formula for medical
and nursing salaries at the activity levels of 16,000 or 20,000 student visits, but the
fixed component would be the same i.e., Rs.80,000. The fixed and variable cost
components for other costs can be calculated in the same manner.
Table 12
Student Health Clinic Flexible Budget Performance Report
For the Fiscal Year 2000-01
Cost Budget for Actual Variance
18,500 Cost (Favorable)
Students* Unfavorable

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Administrative salaries 35,000 37,000 2,000
Medical and nursing salaries 228,000 236,900 8,900
Other salaries 74,250 67,000 -7,250
Medical supplies 98,500 96,000 -2,500
External laboratory fees and 18,500 21,250 2,750
other medical fees
Building lease 18,000 18,000 -
Utilities 15,750 19,250 3,500
Maintenance 47,750 39,250 -8,500
Computer services 25,875 21,375 -4,500
Employee fringe benefits 66,875 69,975 3,100
Total 6,28,500 6,26,000 -2,500
*Actual activity level = 18,500 student visits.
The health clinic had 18,500 student visits during the year. Since a budget for this
activity level was not prepared, a new budget is prepared. Although it may appear
strange that a budget is prepared after the completion of an activity, one has to consider
that this type of budget is not a plan for future operations. It is a budget for analysis and
reporting of performance. The budget at the activity level of 18,500 student visits is
shown above, based on which the performance report is prepared.

7.11 ZERO BASE BUDGETING (ZBB)

After a budgeting system has been in operation for some time, there is a tendency for
next year's budget to be justified by reference to the actual levels being achieved at
present. In fact this is part of the financial analysis discussed so far, but the proper
analysis process takes into account all the changes which should affect the future
activities of the company. Even using such an analytical base, some businesses find that
historical comparisons, and particularly the current level of constraints on resources, can
inhibit really innovative changes in budgets. This can cause a severe handicap for the
business because the budget should be the first year of the long range plan. Thus, if
changes are not started in the budget period, it will be difficult for the business to make
the progress necessary to achieve longer term objectives.

One way of breaking out of this cyclical budgeting problem is to go back to basics and
develop the budget from an assumption of no existing resources (that is, a zero base).
This means all resources will have to be justified and the chosen way of achieving any
specified objectives will have to be compared with the alternatives. For example, in the
sales area, the current existing field sales force will be ignored, and the optimum way of
achieving the sales objectives in that particular market for the particular goods or services
should be developed. This might not include any field sales force, or a different-sized
team, and the company then has to plan how to implement this new strategy.

The obvious problem of this zero-base budgeting process is the massive amount of
managerial time needed to carry out the exercise. Hence, some companies carry out the
full process every five years, but in that year the business can almost grind to a halt.
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Thus, an alternative way is to look in depth at one area of the business each year on a
rolling basis, so that each sector does a zero base budget every five years or so.

MULTIPLE CHOICE QUESTIONS


Q1 The budget wherein it is reviewed and updated at regular intervals is called

Q2 Which is not true of the Zero-Based Budgeting?

Q3 Which of the following is not a part of operating budget?

Q4 The classification of fixed and variable cost has a special significance in the
preparation of

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Q5 A budget of indirect materials, indirect labor and other indirect manufacturing costs
is a(n)

Q6 Which of the following statements is false?

Q7 When a flexible budget is used, then increase in the actual production level within a
relevant range would increase

Q8 Which of the following statements is/are true?

174
Q9 A budget that gives a summary of all the functional budgets and projected profit
and loss account is known as

Q10 Which of the following statements is not true with regard to budgets?

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CHAPTER-8 INTRODUCTION TO RECENT
DEVELOPMENT IN COSTING

At the end of the chapter you will be conversant with:

8.1 Activity Based Costing


8.2. Target Costing
8.3. Transfer Pricing
8.4 Responsibility Accounting
8.5. Value Analysis

8.1 ACTIVITY BASED COSTING

Before discussing Activity based costing, lets first discuss the traditional method of
accounting:

What is the traditional method used in cost accounting?

The traditional method of cost accounting refers to the allocation of manufacturing


overhead costs to the products manufactured. The traditional method (also known as the
conventional method) assigns or allocates the factorys indirect costs to the items
manufactured on the basis of volume such as the number of units produced, the direct
labor hours, or the production machine hours. We will use machine hours in our
discussion.
By using only machine hours to allocate the manufacturing overhead to products, it is
implying that the machine hours are the underlying cause of the factory overhead.
Traditionally, that may have been reasonable or at least sufficient for the companys
external financial statements. However, in recent decades the manufacturing overhead
has been driven or caused by many other factors. For example, some customers are likely
to demand additional manufacturing operations for their diverse products. Other
customers simply want great quantities of uniform products.
If a manufacturer wants to know the true cost to produce specific products for specific
customers, the traditional method of cost accounting is inadequate. Activity based costing
(ABC) was developed to overcome the shortcomings of the traditional method. Instead of
just one cost driver such as machine hours, ABC will use many cost drivers to allocate a
manufacturers indirect costs. A few of the cost drivers that would be used under ABC
include the number of machine setups, the pounds of material purchased or used, the
number of engineering change orders, the number of machine hours, and so on.

What is the major weakness of the traditional method of allocating factory


overhead?

Under the traditional method of allocating factory overhead (manufacturing overhead,


burden), most of the factory overhead costs are allocated on the basis of just one factor
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such as machine hours or direct labor hours. In other words, the traditional method
implies there is only one driver of the factory overhead and the driver is machine hours
(or direct labor hours, or some other indicator of volume produced).
In reality there are many drivers of the factory overhead: machine setups, unique
inspections, special handling, special storage, and so on. The more diversity in products
and/or in customer demands, the bigger the problem of allocating all the costs of these
various activities via only one activity such as the production machines hours.
Under the traditional method, the costs of performing all of the diverse activities will be
contained in one cost pool and will be divided by the number of production machine
hours. This results is one average rate that is applied to all products regardless of the
number of activities and the complexity of those activities. Since the cost of many of the
diverse activities do not correlate at all with the number of production machine hours, the
resulting allocations are misleading.
Activity-based costing is intended to overcome the weakness of the traditional method by
having various pools of costs and then allocating each pools costs on the basis of its root
cause.

Under ABC a manufacturer will use many cost drivers to assign overhead costs to
products. The objective of Activity Based Costing is to assign the overhead costs based
on their root causes rather than merely spreading the costs on the basis of direct labor
hours or production machine hours.

In the 1930s, the Comptroller of the Tennessee Valley Authority, Eric Kohler developped
the concept of Activity Accounting. The Tennessee Valley Authority was engaged in
flood control, navigation, hydro-electric power generation, etc. Kohler could not use a
traditional managerial accounting system for these kind of operations. Instead Kohler
defined activities and introduced activity accountants. An activity is (a portion of) a work
carried out by a (part of) a company. For each activity Kohler created an activity account
(Aiyathurai, Cooper and Sinha, 1991, PP 61-64). An activity account is an income or
expense account containing transactions over which an activity supervisor exercises
responsibility and control (Kohler, 1952, pp, 18-19). Thus instead of determining the
costs of a product, Kohler determined the costs of an activity.
In 1971 Staubus described another activity accounting system. Staubus also created an
account for every activity. On the left side of this account Staubus recorded the costs of
the inputs of the activity. These inputs are the outputs from previous activities within the
company and / or outputs from another entity (for instance an outside supplier). On the
right hand side of the account Staubus recorded the value of the output of the activity.
The outputs to another activity are measured at standard costs. If however the output is
sold to a customer, the output is measured at the net realizable value (selling price minus
selling costs). Staubus activity accounting culminates in a comparison of outputs, at
standard cost or net realizable value, and inputs (Staubus, 1971).

Activity Cost Analysis at General Electric

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In 1963 General Electric formed a team which had to study indirect costs. This team
focused mainly on indirect activities in GE such as data processing, inspection, quality
control etc. and determined the costs of these activities. Then they identified the causes of
these activities ("key controlling parameters"). For instance a new drawing, made by the
engineering department is a key controlling parameter and triggers activities such as data
processing, inspection, quality control, etc. The team also collected information about the
quantity or count of each key controlling parameter, such as the number of new drawings
per period. Then the team estimated the total costs per unit key performance parameter,
for instance the costs per 1 new drawing made by the engineering department:

Figure 8.1

With this technique GE wanted to get better control of indirect costs by controlling the
activities that cause the indirect costs.

Like traditional cost accounting, activity based cost management is a cost allocation
methodology. But there is a significant difference - unlike traditional cost accounting,
activity based costing works on following principle:

Activities incur costs through the consumption of resources, while customer demand for
products and services causes activities to be performed.

Basic flow of activity based cost management is as follows:

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Figure 8.2

ACTIVITY BASED COSTING BENEFITS


Activity based cost management has several benefits. As a business process improvement
(BPI) tool activity based costing links elements such as process flow analysis, and
performance management. This supports ongoing evaluation of effectiveness of
improvement initiatives, including the activity based costing management endeavors.

By identifying cost pools, or activity centers, activity based accounting assigns costs to
products and services based on the number of transactions involved in the process of
providing a product or service. This supports managers to work out how to maximize
shareholder value and improve performance.

Activity based cost management also helps in identifying the most and least profitable
customers, products and channels. It also assists in determining the true contributors to-
and detractors from- financial performance. Moreover, activity based cost management
equips managers with cost intelligence to drive improvements.

Other benefits of activity based costing include accurately predicting costs, profits and
resource requirements associated with changes in the organization. These changes might
include changes in production volumes, resource costs and organizational structure.

DRAWBACKS

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Activity Based Costing is a very helpful tool if your organization has clarity of
methodology and the process under observation.

One major limitation of the method comes up when looking at using it for estimation of
plans/budgets. It is next to impossible to have a proper estimation of the costs for some
critical activities such as R&D. When proper estimation of the costs for one activity is
missed out it results in breakdown in the whole chain of activities.

Another glaring drawback is that the potential for improved accuracy in product costs
may be limited if the organization is already using multiple absorption rates in each
production centre.

Conclusion
Activity based cost management has more advantages than limitations. When
implemented properly, activity based cost management can bring about constructive
changes in financial control systems.

For instance, when you carry out planning / budgeting with activity based costing you
can always have more accurate estimations done. You can always work-out where your
estimations went wrong, since you know what each activity contributed in your planning
/ budgeting.

However, the true benefit of activity based cost management is not that it is an
improvement upon the existing accounting system. Activity based accounting provides
the structure for the establishment of a true management-oriented system and therein lies
its true benefit.

8.2. TARGET COSTING

As companies begin to realize that the majority of a product's costs are committed based
on decisions made during the development of a product, the focus shifts to actions that
can be taken during the product development phase.

Until recently, engineers have focused on satisfying a customer's requirements. Most


development personnel have viewed a product's cost as a dependent variable that is the

180
result of the decisions made about a products functions, features and performance
capabilities. Because a product's costs are often not assessed until later in the
development cycle, it is common for product costs to be higher than desired. This process
is represented in Figure 8.3.

Figure 8.3

Target costing represents a fundamentally different approach. It is based on three


premises: 1.) orienting products to customer affordability or market-driven pricing, 2.)
treating product cost as an independent variable during the definition of a product's
requirements, and 3.) proactively working to achieve target cost during product and
process development. This target costing approach is represented in Figure 8.4.

Figure 8.4

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Target costing builds upon a design-to-cost (DTC) approach with the focus on market-
driven target prices as a basis for establishing target costs. The target costing concept is
similar to the cost as an independent variable (CAIV) approach used by the U.S.
Department of Defense and to the price-to-win philosophy used by a number of
companies pursuing contracts involving development under contract.

The following ten steps are required to install a comprehensive target costing approach
within an organization.

1. Re-orient culture and attitudes. The first and most challenging step is re-orient
thinking toward market-driven pricing and prioritized customer needs rather than
just technical requirements as a basis for product development. This is a
fundamental change from the attitude in most organizations where cost is the
result of the design rather than the influencer of the design and that pricing is
derived from building up a estimate of the cost of manufacturing a product.
2. Establish a market-driven target price. A target price needs to be established
based upon market factors such as the company position in the market place
(market share), business and market penetration strategy, competition and
competitive price response, targeted market niche or price point, and elasticity of
demand. If the company is responding to a request for proposal/quotation, the
target price is based on analysis of the price to win considering customer
affordability and competitive analysis.
3. Determine the target cost. Once the target price is established, a worksheet (see
example below) is used to calculate the target cost by subtracting the standard
profit margin, warranty reserves, and any uncontrollable corporate allocations. If
a bid includes non-recurring development costs, these are also subtracted. The
target cost is allocated down to lower level assemblies of subsystems in a manner
consistent with the structure of teams or individual designer responsibilities.

182
4. Balance target cost with requirements. Before the target cost is finalized, it
must be considered in conjunction with product requirements. The greatest
opportunity to control a product's costs is through proper setting of requirements
or specifications. This requires a careful understanding of the voice of the
customer, use of conjoint analysis to understand the value that customers place on
particular product capabilities, and use of techniques such as quality function
deployment to help make these tradeoff's among various product requirements
including target cost.
5. Establish a target costing process and a team-based organization. A well-
defined process is required that integrates activities and tasks to support to support
target costing. This process needs to be based on early and proactive
consideration of target costs and incorporate tools and methodologies described
subsequently. Further, a team-based organization is required that integrates
essential disciplines such as marketing, engineering, manufacturing, purchasing,
and finance. Responsibilities to support target costing need to be clearly defined.
6. Brainstorm and analyze alternatives. The second most significant opportunity
to achieve cost reduction is through consideration of multiple concept and design
alternatives for both the product and its manufacturing and support processes at
each stage of the development cycle. These opportunities can be achieved when
there is out-of-the-box or creative consideration of alternatives coupled with
structured analysis and decision-making methods.
7. Establish product cost models to support decision-making. Product cost
models and cost tables provide the tools to evaluate the implications of concept
and design alternatives. In the early stages of development, these models are
based on parametric estimating or analogy techniques. Further on in the
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development cycle as the product and process become more defined, these models
are based on industrial engineering or bottom-up estimating techniques. The
models need to be comprehensive to address all of the proposed materials,
fabrication processes, and assembly process and need to be validated to insure
reasonable accuracy. A target cost worksheet can be used to capture the various
elements of product cost, compare alternatives, as well as track changing
estimates against target cost over the development cycle.
8. Use tools to reduce costs. Use of tools and methodologies related to design for
manufacturability and assembly, design for inspection and test, modularity and
part standardization, and value analysis or function analysis. These methodologies
will consist of guidelines, databases, training, procedures, and supporting analytic
tools.
9. Reduce indirect cost application. Since a significant portion of a product's costs
(typically 30-50%) are indirect, these costs must also be addressed. The enterprise
must examine these costs, re-engineer indirect business processes, and minimize
non-value-added costs. But in addition to these steps, development personnel
generally lack an understanding of the relationship of these costs to the product
and process design decisions that they make. Use of activity-based costing and an
understanding of the organization's cost drivers can provide a basis for
understanding how design decisions impact indirect costs and, as a result, allow
their avoidance.
10. Measure results and maintain management focus. Current estimated costs need
to be tracked against target cost throughout development and the rate of closure
monitored. Management needs to focus attention of target cost achievement
during design reviews and phase-gate reviews to communicate the importance of
target costing to the organization

8.3. TRANSFER PRICING

TRANSFER PRICING
Transfer pricing is simply the act of pricing of goods and services or intangibles when the
same is transferred for use or consumption to other departments in the same company or
to a related party (e.g. Subsidiary). For example, goods from the production division may
be sold to the marketing division, or goods from a parent company may be sold to a
foreign subsidiary.
There can be either Market-based, i.e. equivalent to what is being charged in the outside
market for similar goods, or it can be non-market based. Importantly, two-thirds of the
managers say their transfer pricing is non-market based.
There can be internal and external reasons for transfer pricing. Internal include
motivating managers and monitoring performance, e.g. by putting a cost to imported
inputs. External would be taxes and tariffs.

Transfer pricing methods:

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Cost Plus method

The Cost Plus (CP) method, generally used for the trade of finished goods, is determined
by adding an appropriate markup to the costs incurred by the selling party in
manufacturing/purchasing the goods or services provided, with the appropriate markup
being based on the profits of other companies comparable to the tested party. For
example, the arm's length price for a transaction involving the sale of finished clothing to
a related distributor would be determined by adding an appropriate markup to the cost of
materials, labour, manufacturing, and so on. Cost-based method calculates transfer price
on the cost of the goods or services available as per the cost accounting records of the
company. The method is generally accepted by the tax customs authorities, since it
provides some indication that the transfer price approximates the real cost of item. Cost-
based approaches are, however, not as transparent as they appear. A company can easily
manipulate its cost accounts to alter the magnitude of the transfer price. Companies that
adopt the cost-based transfer pricing method have to choose between alternative
approaches which are listed below:

Actual cost approach


Standard cost approach
Variable cost approach
Marginal cost approach

Apart from this, companies also have to decide on the treatment of fixed cost and
research and development cost. These issues can prove problematic for the company that
adopts a cost-based transfer pricing method. Cost-based method usually creates
difficulties for the selling profit center. As their incentives to be cost effective may fall, if
they know that they can recover increased cost simply by raising the transfer price
without an incentive. To produce efficiently, the transfer price may erode the
competitiveness of the final product in the market place.

Resale Price method

The Resale Price (RP), while similar to the CP method, is found by working backwards
from transactions taking place at the next stage in the supply chain, and is determined by
subtracting an appropriate gross markup from the sale price to an unrelated third party,
with the appropriate gross margin being determined by examining the conditions under
which the goods or services are sold and comparing said transaction to other, third-party
transactions. In our clothing example, then, the arm's length price would be determined
by subtracting an appropriate gross margin from the price at which the distributor sold the
products received from the manufacturer to third-party retailers--department stores,
boutiques, etc.

In this example, both the CP and RP methods are being used to examine the same
transaction--the one between the manufacturer and the distributor--meaning that the
selection of one for use is ultimately dependent on the availability of data and comparable
transactions. This flexibility is not available in other transactions, particularly those
185
involving intangible goods (i.e. it is exceedingly difficult to determine the costs involved
in developing technological know-how, and so the arm's length price for the payment of
royalties from one company to another is best determined by working backwards from
the profits gained based on the usage of the know-how--in other words, the RP method).

Profit Split Method

The PS method (and its derivatives, including the Comparative and Residual Profit Split
methods) is applied when the businesses involved in the examined transaction are too
integrated to allow for separate evaluation, and so the ultimate profit derived from the
endeavor is split-based on the level of contribution--itself often determined by some
measurable factor such as employee compensation, payment of administration expenses,
etc.--of each of the participants in the project.

To present a highly simplified example, if Company A above sent three researchers to


Company A(sub) to aid in the development of widgets tailored for the Turkish market
while Company A(sub) allocated seven identically-compensated researchers to aid in the
development, we would expect that Company A(sub) would pay Company A 30% of the
royalty fee portion of the ultimate profits for the technical knowledge provided by
Company A's researchers.

The residual profit split method initially focuses on the company in a controlled
transaction which performs the most routine functions, for example toll-manufacturing or
(limited risk) distributing services. Routine functions are functions which are low value-
added compared to the overall profitability. Such company is generally referred to as
'least-complex entity'. The residual profit split method seeks to set the appropriate arm's
length remuneration for such least-complex entity, whereby the remaining profit is
allocated to the other company of the controlled transaction.

An example: Company A sells widgets through its subsidiary, a limited-risk distributor,


in the Turkish market. Assume that an overall profit of 100 is made on the sale. The
limited-risk distributor should receive an at arm's length return of 5. Then, the residual
profit of 95 would be allocated to Company A, being the complex entity or entrepreneur.
In case of an overall loss, the Turkish subsidiary should, in principle, continue to receive
the arm's length return of 5.

Transactional Net Margin Method (TNMM)

TNMM, meanwhile, is a method that focuses on the arm's length operating profit
(earnings after all operating expenses, including overhead, but before interest and taxes)
earned by one of the entities (the tested party) in the transaction. It stipulates that
relative operating profit (relative to sales, costs, or assets to allow comparisons between
different companies or transactions) may be a more robust measure of an arm's length
result when close comparables, as required for the traditional methods, are not available.
For example, two distributors may sell different products that require different sales
efforts per unit sold. This may lead to very different gross margins (and hence the resale
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price method may not be easily applicable). However, the operating margins would not
be expected to be materially different since the margins reflects a competitive return only.
The margin is measured pre-interest since the level of interest expense is a function of
how a company decides to finance its operations and unrelated to the transfer pricing.

Although not one of the traditional three methods, the TNMM and its counterpart under
the U.S. transfer pricing regulations, the Comparable Profits Method or CPM is one of
the most-widely used transfer pricing methods. See for example, the IRS' annual APA
report which publishes details on the transfer pricing methods used in APAs.

8.4 RESPONSIBILITY ACCOUNTING:

Responsibility accounting is a management control system based on the principles of


delegating and locating responsibility. The authority is delegated on responsibility centre
and accounting for the responsibility centre. Responsibility accounting is a system under
which managers are given decisions making authority and responsibility for each activity
occurring within a specific area of the company. Under this system, managers are made
responsible for the activities of segments. These segments may be called departments,
branches or divisions etc., one of the uses of management accounting is managerial
control. Among the control techniques responsibility accounting has assumed
considerable significance. While the other control devices are applicable to the
organization as a whole, responsibility accounting represents a method of measuring the
performance of various divisions of an organization. The term division with reference
to responsibility accounting is used in general sense to include any logical segment,
component, sub-component of an organization. Defined in this way, it includes a
decision, a department, a branch office, a service centre, a product line, a channel of
distribution, for the operating performance it is separately identifiable and measurable is
some what of practical significance to management.

Concept of Responsibility accounting:


According to the Institute of Cost and Works Accountants of India (ICWAI)
Responsibility Accounting is a system of management accounting under which
accountability is established according to the responsibility delegated to various levels of
management and management information and reporting system instituted to give
adequate feed back in terms of the delegated responsibility. Under this system divisions
or units of an organization under a specified authority in person are developed as
responsibility centers are evaluated individually for their performance.

Significance of Responsibility Accounting


The significance of responsibility accounting for management can be explained in the
following way:
Easy Identification:
It enables the identification of individual managers responsible for satisfactory or
unsatisfactory performance.
Motivational Benefits :

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If a system of responsibility accounting is implemented, consider- able motivational
benefits are assured.
Data Availability :
A mechanism for presenting performance data is provided. A framework of
managerial performance appraisal system can be established on that basis, besides
motivating managers to act in the best interests of the enterprise.
Ready-hand Information:
Relevant and up to the minutes information is made available which can be used to
estimate future costs and or revenues and to fix up standards for departmental
budgets.
Planning and Decision Making:
Responsibility accounting helps not only in control but in planning and decision
making too.
Delegation and Control:
The twin objectives of management are delegating responsibility while retaining
control are achieved by adoption of responsibility accounting system.

Principles of responsibility Accounting


The main features of responsibility accounting are that it collects and reports planned and
actual accounting
information about the inputs and outputs of responsibility accounting.

Inputs and outputs :

Responsibility accounting is based on information relating to inputs and outputs. The


resources used are called inputs. The resources used by an organization are essentially
physical in nature such as quantity of materials consumed, hours of labour, and so on. For
managerial control, these heterogeneous physical resources are expressed in monetary
terms they are called cost. Thus, inputs are expressed as cost. Similarly, outputs are
measured in monetary terms as revenues. In other words, responsibility accounting is
based on cost and revenue data or financial information.

Objectives of Responsibility Accounting::


Responsibility accounting is a method of dividing the organizational structure into
various responsibility centers to measure their performance. In other words responsibility
accounting is a device to measure divisional performance measurement may be stated as
under:
1. To determine the contribution that a division as a sub-unit makes to the total
organization.
2. To provide a basis for evaluating the quality of the divisional managers performance.
Responsibility accounting is used to measure the performance of managers and it
therefore, influence the way the managers behave.
3. To motivate the divisional manager to operate his division in a manner consistent with
the basic goals of the organization as a whole.

Responsibility Centre :
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For control purposes, responsibility centers are generally categorized into:
1. Cost centres
2. Profit centers
3. Investment centers.

1. Cost Centre or Expense Centre:


An expense centre is a responsibility centre in which inputs, but not outputs, are
measured in monetary terms. Responsibility accounting is based on financial information
relating to inputs (costs) and outputs (revenues). In an expense centre of responsibility,
the accounting system records only the cost incurred by the centre but the revenues
earned (outputs) are excluded. An expense centre measures financial performance in
terms of cost incurred by it. In other words, the performance measured in an expense
centre is efficiency of operation in that centre in terms of the quantity of inputs used in
producing some given output. The modus operandi is to compare actual inputs to some
predetermined level that represents efficient utilization. The variance between the actual
and budget standard would be indicative of the efficiency of the division.

2. Profit Centre:
A centre in which both the inputs and outputs are measured in monetary terms is called a
profit centre. In other words both costs and revenues of the centre are accounted for.
Since the difference of revenues and costs is termed as profit, this centre is called profit
centre. In a centre, there are financial measures of the outputs as well as of the input, it is
possible to measure the effectiveness and efficiency of performance in financial terms.
Profit analysis can be used as a basis for evaluating the performance of divisional
manager. A profit centre as well as additional data regarding revenues. Therefore,
management can determine hether the division was effective in attaining its objectives.
This objective is presumably to earn a satisfactory profit. Profit directly traceable to the
division and voidable if the division were closed down. The concept of divisional profit is
referred to as profit contribution as it is amount of profit contribution directly by the
division.
The performance of the managers is measured by profit. In other words managers can be
expected to behave as if they were running their own business. For this reason, the profit
centre is good training for general management responsibility .

Measurement of Expenses :
Another problem with profit centers may relate to the measure of certain type of
expenses which have to be involved in the computation of profit centres. There is a scope
for difference of opinion relating to the treatment of those type of expenses which are not
traceable or attributable should be ignored in working out the profit of the division as a
profit centre.

3. Investment Centres
A centre in which assets employed are also measured besides the measurement of inputs
and outputs is called an investment centre. Inputs are accounted for in terms of costs,
outputs are calculated on investment centre. Inputs are accounted for in terms of costs,
outputs are accounted for in terms of revenues and assets employed in terms of values. It
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is the broadest measurement, in the sense that the performance is measured not only in
terms of profits but also in terms of assets employed to generate profits.
An investment centre differs from a profit centre in that as investment centre is evaluated
on the basis of the rate of return earned on the assets invested in the segment while a
profit centre is evaluated on the basis of excess revenue over expenses for the period.

Problems in Responsibility Accounting

While implementing the system of responsibility accounting, the following difficulties


are likely to be faced by the management:
1. Classification of costs: For responsibility accounting system to be effective a proper
classification between controllable and non controllable costs is a prime requisite. But
practical difficulties arise while doing so on account of the complex nature and variety of
costs.
2. Inter-departmental Conflicts:
Separate departmental persuits may lead to inter-departmental rivalry and it may be
prejudicial to the interest of the enterprise as a whole. Managers may act in the best
interests of their own, but not in the best interests of the enterprise
3. Delay in Reporting: Responsibility reports may be delayed. Each responsibility centre
can take its own time in preparing reports.
4. Overloading of Information: Responsibility accounting reports may be overloading
with all available information. This danger is inherent in the system but with clear
instructions by management as to the functioning of the system and preparation of
reports, etc., only relevant information flow in.
5. Complete Reliance will be deceptive:
Responsibility accounting cant be relied upon completely as a tool of management
control. It is a system just to direct the attention of management to those areas of
performance which required further investigation.

Conclusion :
Responsibility accounting is a management control system fro measurement of division
performance of an organization. Responsibility accounting focuses on responsibility
centers such as cost centre, profit centre and investment centre. For effective
implementation of responsible accounting certain principles must be followed.
Responsibility accounting helps not only in control but in planning and decision making
too.

8.5. VALUE ANALYSIS

Concept of value:

IT may not be out of place here to understand the meaning of the term value. As a
matter of fact, the term value has different meanings for different persons. For example,
for a designer the value means the quality of the product, for a salesman the term
value means the price which can fetch for the product in te market, and for the top
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management the term value means return on capital employed. However, an industrial
product may have the following concepts of value:

(1) Use Value: This refers to the characteristics which the product should
possess to provide a useful service for which it is intended. For instance, a
watch is meant for indicating time, in case it gives fairly correct time, it is
giving its full use value. The use value is measured in terms of quality of
performance.
(2) Cost Value: The value is measured in terms of cost in case of product is
manufactured in the organization. It refers to the cost of production. In
case a product is procured from outside, it refers to cost of its purchase.
(3) Exchange Value: It refers to sales value which a product would fetch. It is
important for the sales department since the profit is excess of the selling
price (i.e. exchange value) over the cost of product. Hence, the sales
department must ascertain what value the product has for the customers as
compared to competitive products available in the market. It will help in
advising the m management in fixing the selling price of the product.
(4) Esteem Value: This may also be referred to as the prestige value. Certain
products or articles have value simply because of their attractiveness or
esteemed features. A watch made of gold, has an esteem value for its
owner.

Importance of value analysis in cost reduction:

Also termed as value engineering, the approach focuses upon improvement


in value by resulting to a careful & in depth study of products at the stage of
their designing. The different components can be redesigned or standardized.
Less costly manufacturing processes can be used. Such a study reveals the
fields which involve avoidable costs & after locating these areas, steps can be
taken to eliminate or if not possible reduce such unwanted costs, of course,
without in any way compromising on quality.

Following points deserve consideration before embarking upon value analysis


in order to critically examine each & every product and its part:

(a) Exact function of the item must be identified & its significance evaluated.
(b) Cost-benefit analysis of the item must be carried out.
(c) The aspect of standardization should be seriously looked into.
(d) Economics of labour etc. should also be measured.
(e) Redesigning may be adopted if it results in lower costs.
(f) Combination of activities, items or segregation should also be considered
to reduce costs of incentives etc.

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MULTIPLE CHOICE QUESTIONS:

Q1 Which one of the following, is/are the weakness of traditional costing method?
(a) It takes in to consideration many drivers of the factory overhead
(b) traditional method implies there is only one driver of the factory overhead
(c) one average rate is applied to all products regardless of the number of activities
and the complexity of those activities.
(d) Both (a) &(c)
Q2 benefits of activity based costing include
a) Accurately predicting costs, profits and resource requirements
b) Results in increasing activities of the operations
c) Results in increasing the costs of the operations
d) None of the above
Q3 Target costing is based on which of the following premises?
a) Treating product cost as an independent variable during the definition of a
product's requirements
b) Proactively working to achieve target cost during product and process
development.
c) does not concentrate eon market driven pricing
d) both (a) &(b)
Q4 Which one of the following is true:
i. A well-defined process is required that integrates activities and tasks to support to
support target costing.
ii. Current estimated costs need to be tracked against target cost throughout
development and the rate of closure monitored
(a) Only i
(b) Only ii
(c) Both i & ii
(d) None of the above

Q5 Under Cost plus method price of the product is determined by:


(a) Adding profit margin to selling price for the product.
(b) adding an appropriate markup to the cost of the product
(c) by subtracting an appropriate gross markup from the sale price to an unrelated
third party
(d) none of the above

Q6 Under Resale Price Method price of the product is determined by:


(a) Adding profit margin to selling price for the product.
(b) adding an appropriate markup to the cost of the product
(c) by subtracting an appropriate gross markup from the sale price to an unrelated
third party
(d) none of the above
Q7 Cost Centre is:
(a) A responsibility centre in which inputs, are measured in monetary terms.
(b) A responsibility centre in which outputs are measured in monetary terms.
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(c) A responsibility centre in which assets employed, are measured in monetary
terms.
(d) All of the above

Q8 Value for a product can be determined by:


(a) Quality of the product
(b) price of the product
(c) usage of the product
(d) All of the above

Q9 In activity based costing system, the primary criteria for making cost allocation
decision is:
(a) Cause & effect
(b) Benefits received
(c) fairness
(d) Total Costs before taking into overhead costs

Q10 In an investment centre, the manager is accountable for:


a) Costs only
b) Cash Flows only
c) Investments only
d) Investment, revenue & costs

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CHAPTER ANSWER KEY
CHAPTER1
Q1 (b), Q2 (b), Q3 (d), Q4 (b), Q5 (b), Q6 (d), Q7 (d), Q8 (c) , Q9 (c), Q10 (b)

CHAPTER2
Q1 (d),Q2 (d), Q3(d), Q4 d, Q5 c, 6 d, Q7 (a), Q8 (d), Q9 (b), Q10 (b)

CHAPTER3
Q1 (a), Q2 (c), Q3 (d), Q4 (b), Q5 (b), Q6 (c), Q7 (b), Q8 (b), Q9 (c), Q10 (a)

CHAPTER4
Q1 (b), Q2 (c), Q3 (a), Q4 (d), Q5 (d), Q6 (b), Q7 (d), Q8 (d), Q9 (b), Q10 (a)

CHAPTER5
Q1 (d), Q2 (b), Q3 (c), Q4 (d), Q5 (b), Q6 (c), Q7 (d), Q8 (d), Q9 (c), Q10 (c)
CHAPTER6
Q1 (c), Q2 (d), Q3 (a), Q4 (b), Q5 (c), Q6 (a), Q7 (c), Q8 (c), Q9 (b), Q10 (b)

CHAPTER7
Q1 (c), Q2 (a), Q3 (d), Q4 (a), Q5 (b), Q6 (c), Q7 (d), Q8 (a), Q9 (c), Q10 (c)

CHAPTER8
Q1 (d), Q2 (a), Q3 (d), Q4 , Q5 (b), Q6 (c), Q7 (a), Q8 (d), Q9 (d), Q10 (d)

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SYLLABUS: COST ACCOUNTING
Course Objective:
To develop an understanding of basic elements of cost and its classification, allocation
and how the costing techniques are useful in the process of managerial decision-making.
To expose the students to the latest techniques to facilitate the process of decision making
in todays dynamic business world.

Course Contents:

Module I: Introduction to Cost Accounting


Relevance of Financial Accounting; Cost Accounting and Management Accounting;
Elements of cost; Cost Classification; Cost centre; Cost unit; Cost Sheet;

Module II: Material Control &Costing


Classification; Purchase Procedure; Material Control-: EOQ, Stock levels, JIT; ABC
Analysis. Pricing of Material:- LIFO,FIFO, weighted average method, standard cost
method, Current price method.

Module III: Labor Costing & Overheads Costing


Classification; Labor turnover, Labor Cost Control:- Time keeping and Time booking;;
Idle time; Overtime;, Methods of remuneration
Classification of overheads - fixed, variable, semi-variable; Collection of overheads;
Distribution; allocation and absorption; under/over absorption.

Module IV: Marginal Costing and Cost Volume Profit Analysis


Meaning, marginal cost; Absorption costing vs. Marginal Costing and its reconciliation;
B.E.P; Contribution; Key factor; P/V ratio; margin of safety; Applications of marginal
costing techniques; CVP analysis, alternative choices decisions.

Module V: Standard Costing and variance analysis


Standard cost, standard hour, standard cost sheet, cost variances-material, labour and
overhead

Module VI: Budgets, cost reduction and control


Budgetary control and budgeting-Objectives, advantages and limitations; Fixed and
Flexible budgets, types of budgets; Cost Reduction and control-techniques of cost
reduction.

Module VII: Introduction to Recent developments in costing


Activity Based Costing, Target Costing, transfer pricing, Responsibility accounting, and
Value analysis,

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REFERENCES:
1. Williamson, D. Cost and Management Accounting, Prentice Hall of India
2. Jain, S.P. & Narang, K.L., Cost Accounting- principles and practice, Kalyani
Publishers
3. Horngren, Foster, Datar, Cost Accounting, Prentice Hall of India
4. Jawharlal, Seema Srivastave, Cost Accounting, TMH Publication
5. A Murtly & S Gurusamy, Essentials of cost accounting , TMH Publication

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