MODUEL-IV

Cost Management Tools :

Budgetary Control:
Functional budgets
Functional budgets are those which are prepared by heads of functional department s for their respective departments
and are subsidiary to the master budget. Functional budget may be
Operating budgets or financial budget. Operating budgets are those budgets which relate to the different activities
or operations of a firm. These are the primary budgets. Financial budgets are those which incorporate financial
decisions of an organization. They show in detail the inflow and outflow of cash and the overall financial position.
Master budget is the summary of all functional budgets. It summarizes sales, production, purchase, labour, finance
budgets etc. It is considered as the overall budget of the organization.
Different types of functional budgets:
1. Sales budget: It is forecast of total sales expressed in quantities and money. It is prepared by the sales manager.
While preparing sales budget we have to consider the past sales data , market conditions, general trade and business
conditions etc
2. Production budget: It is the forecast of the quantity of production for the budget period. It is usually expressed in
physical quantity.
3. Material budget: It shows the estimated quantities as well as cost of raw material required for the production of
different product during the budget period.
4. Purchase budget: It shows the quantity of different type of materials to be purchased during the budget period
taking into consideration the level of activity and the inventory levels.
5. Cash budget: It is prepared only after all the other functional budgets are prepared. It is also known as financial
budget. It is a statement showing estimated cash inflows and cash outflows over the budgeted period.

Cost budget
'
The direct materials budget has two components, (i) materials requirement, bud-get, and (ii) materials procurement or
purchase budget. The former deals with the total quantity of materials required during the budget period, while the
later deals with the materials to be acquired from the Market during the budget period. Materials to be acquired are
estimated after taking into account the losing rind the opening inventories and the materials for which orders have
already been placed.
Basically, there are three elements of cods, namely direct material direct labour and overheads. Separate budgets for
each of these elements have to be prepared.

Master Budget
When all the functional budgets i.e sales budget, production budget, cash budget etc. have been prepared, these are
summarized into what is known as a master budget. Thus a master budget is a consolidated summery of all the
functional budgets.

A master budget has two parts (1) operating budget, i.e budgeted profit and loss account, and (2) financial
budget, i.e budgeted balance sheet. Thus a projected profit and loss account and balance sheet together constitute a
master budget.

The master budget is prepared by the budget director and is presented to the budget committee for approval. If
approved it is submitted to the board of directors for final approval.

Performance budgeting
Performance oriented budgets are established in such a manner that each item of expenditure related to a specific
responsibility centre is closely linked with the performance of that centre. The following matters will be specified
very clearly in such budgeting
a. Objectives of the organization and for which funds are requested
b. Cost of activities proposed for the achievement of these objectives
c. Quantitative measures to measure the performance
d. Quantum of work to be performed under each activity.
Advantages of performance budgeting:
1. It improves budget formulation process
2. It enhances accountability of the executives
3. It facilitate more effective performance audit
4. It presents clearly the purpose and objectives for which funds are required

Zero based budgeting.

According to the official CIMA terminology, zero base budgeting is, “ a method of budgeting which requires each
cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for
the first time. Without approval, the budget allowance is zero” . Under ZBB the programmes and activities get
evaluated and ranked from zero base as if these were launched for first time. In this technique of budgeting the
unwanted projects and activities get dropped and wanted and desirable activities and projects get included in the
budget.
Features:
a. It starts from zero
b. All activities are identified in appropriate decision packages
c. All programmes are considered totally afresh
d. A detailed cost benefit analysis of each programme is undertaken
e. There is an officer responsible for each decision packages
f. Priorities are established and decision packages are ranked
Advantages of ZBB
1. It considers every time alternative ways of performing the same job. It helps the management to get a critical
appraisal of its activities.
2. It is helpful to the management in making optimum allocation of scarce resources
3. ZBB is particularly useful for service departments and Governments
4. It ensures active participation of managers in the budgeting process.
5. It promote high level of motivation at the level of unit managers
6. It focuses on output in relation to value for money.
7. It makes managers cost conscious and helps them in identifying priorities in the overall interest of the organization.

Flexible budgets.
Flexible budget is designed to change in relation to the level of activity attained. The principle of flexible budget is
that a budget is of little use unless cost and revenue are related to the actual volume of production. It has been
developed with the objective of changing the budget figures to correspond with the actual output achieved. Thus a
budget might be prepared for various level of activity, say, 70%, 80%, 90%, and 100% capacity utilization. Then
whatever the level of output actually reached, it can be compared with an appropriate level.

Flexible budgets are prepared in those companies where it is extremely difficult to forecast output and sales
with accuracy. Such a situation may arise in the following cases,

1. Where nature of business is such that sales are difficult to predict, e.g demand for luxury goods is quite
unpredictable.
2. Where sales are affected by weather conditions, e.g, soft drink industry, woolen garments etc.
3. Where sales are affected by changes in fashion, e.g, readymade garments.
4. Where company frequently introduces new products.
5. Where large part of output is intended for export.

Preparation of flexible budgets

The preparation of flexible budgets necessitates the analysis of all costs into fixed and variable components. In
flexible budgeting varying levels of output are considered and each class of overhead will be different for each level.
In flexible budgeting a series of budgets are prepared for every major level of activity so that whatever that actual
level of output it can be compared with appropriate budget or can be interpolated between budgets of the activity
levels on either side. For example, budgets may be prepared for say, 60%, 70%, 80%, 90%, and 100% level of
activity. If the actual level of activity is 85%, than the budget allowance for 85% activity should be computed.

While computing fixed cost at various levels it is to be noted that fixed cost in total amount remains
unchanged at various levels of activity. However, fixed cost per unit decreases when level of output increases and
vice versa. Reading the behavior of variable costs, it is important to note that total variable cost increases in
proportion to increase in the level of activity and vice versa. However, variable cost per unit does not change with the
change in level of activity.

Standard Costing :
Standard cost and standard costing
Standard cost

Standard cost is a predetermined cost. It is a determination in advance of production, of what should be the cost.
When standard costs are used for the purpose of cost-control, the technique is known as the standard costing.

Standard cost is the pre-determined cost based on technical estimates for materials, labour and overhead for a
selected period of time for a prescribed set of working conditions.

Standard costing

Standard costing is simply the name given to a technique whereby standard costs are computed and subsequently
compared with the actual costs to find out the difference between the two.

Standard costing is the preparation of standard costs and applying them to measure the variations from actual
costs and analyzing the courses of variations with a view to maintain maximum efficiency in production.

BUDGETARY CONTROL
Budgetary control is the establishment of budgets relating to the responsibilities of executives of a policy and the
continuous comparison of the actual with the budgeted results, either to secure by individual action the objective of
the policy or to provide a basis for its revision.

Steps involved in Budgetary Control:

The following steps may be considered necessary for a comprehensive budgetary control programme:-
1. Laying down organizational goals or objectives
2. Formulating the necessary plans to ensure that the desired objectives are achieved.
3. Translating plans into budget
4. Relating the responsibilities of executives to the requirements of a policy.
5. Recording and reporting actual performance
6. Continuous comparison of actual with budgeted results
7. Ascertainment of deviations, if any
8. Focusing attention on significant deviations
9. Investigation into deviations to establish causes
10. Presentation of information to management, relating the variations to individual responsibility.
11. Taking corrective action to prevent recurrence of variations.
12. Provide a basis for revision of budgets.
Essentials of a Budgetary Control system: Successful implementation of a budgetary control system depends up on
the following essentials.
1. Support by top management: The wholehearted support of all managerial persons is very necessary for the
success of a budgetary control system.
2. Formal organization: The existence of a formal and sound organizational structure is of an absolute necessity for
an effective system of budgetary control.
3. Budget centers: For budgetary control purposes, the entire organization will be split into a number of departments,
area or functions, known as ‘centres’, and budgets will be prepared for each such centers
4. Clear cut objectives and reasonably attainable goals:- If goals are too high to be attained, the purpose of
budgeting is defeated. On the other hand, if the goals are so low that they can be attained very easily, there will be no
incentive to special effort.
5. Participative budgeting: Every executive responsible for the implementation of budgets should be given an
opportunity to take part in the preparation of budgets.
6. Budget committee: The work of preparing a budget manual should be entrusted to a Budget committee. The work
of scrutinizing the budgets as well as approving of the same should be the work of this committee.
7. Comprehensive budgeting: Budgeting should not be partial, it should cover all the functions .
8. Adequate accounting system: There should be an adequate accounting system for the successful budgetary
control system, because those who are involved in the preparation of estimates depend heavily on the accounting
department.
9. Periodic reporting: - There should be a prompt and timely communication and reporting system for the effective
implementation of a budgetary control system.

Advantages and disadvantages

Advantages of standard costing system

1. Effective cost control

The most important advantage of standard costing system is that it facilitates the control of cost. Control is
exercised by comparing actual performance with standards and taking action on the basis of variances so
revealed.
2. Helps in planning
Establishing standards is a very useful exercise in the business planning which instills in management a habit
of thinking in advance.
3. Provides incentives
Standards provide incentives and motivation to work with greater effort. Schemes may be formulated to
reward those who achieve or surpass the standard. This increases efficiency and productivity.
4. Fixing prices and formulating polices
Standard costs are a valuable aid to management in determining prices and formulating production polices.
For example, prices may be fixed by adding a standard margin of profit to standard cost. Similarly, standard
costing furnishes cost estimates while planning production of new products.
5. Facilitates delegation of authority
In order that responsibility for off-standard performance may be identified directly with the persons
concerned, an organization chart is prepared which shows delegated authority and establishes responsibility of
each executive.

6. Facilitates co-ordination
While establishing standards, the performance of different departments such as production, sales, purchases
etc. is taken into account. Thus through the working of standard cost system, co-ordination of various
functions is achieved.
 7. Eliminates waste
By fixing standards, certain waste such as material wastage, idle time, lost machine hours, etc. are reduced.
8. Valuation of stock
Standard costing simplifies the valuation of stock because the stock is valued at standard cost. The difference
between standard and actual cost is transferred to a variance account. This ensures uniform pricing of stocks
in the form of raw materials, work-in-progress and finished goods.

Disadvantages of standard costing system

1. The system may not be appropriate to the business.

2. The staff may not be capable of operating the system.
3. A business may not be able to keep standards up-to-date. In other words, a business may not revise standards
to keep pace with the frequent changes in manufacturing conditions. Firms may avoid revising standards as it
is a costly affairs.
4. Inaccurate and unreliable standards cause misleading results and thus may not enjoy the confidence of the
users of the system.
5. Operation of the standard costing system is a costly affair and small firms cannot afford it.
6. Standard costing is expensive and unsuitable in job order industries which are manufacturing non-
standardised products.

Analysis of variances
Variance is the difference between standard cost (it is the predetermined cost of materials, labour and overhead) and
the actual cost.

If the standard cost > actual cost----- Favourable

If standard cost < actual cost----------Unfavourable

Material variance analysis

It is divided into 5 categories

(i) Material cost variance

(ii) Material price variance
(iii) Material usage variance
(iv) Material mix variance
(v) Material yield variance

Material cost variance (MCV)

It is the difference between the standard material cost for the actual production and the actual cost.

MCV = Standard cost of actual output – Actual cost

Standard cost of actual output = standard price × actual output

Actual cost = actual price × actual quantity

The material cost variance may arise either due to arise in quantity or price or both.
Material price variance (MPV)

It is that portion of MCV which due to the difference between the standard price specified and the actual price paid.

MPV = (standard price – actual price) × actual quantity

Material usage variance (MUV)

It is that portion of material cost variance which is due to the difference between standard quantity specified for the
actual output an actual quantity used of standard price.

MUV = (standard quantity – actual quantity) × standard price

[for verification, MCV = MPV + MUV]

Material mix variance (MMV)

The need to calculating material mix variance arises only when a product requires more than one type of material. If
there is a shortage on or more of the specified material it is possible that the proportion can be changed or different
material may be used. This may be cheaper or expensive and this will result in a mix variance.

(A) When standard weights and actual weight are equal

MMV = standard cost of standard mix – standard cost of actual mix
Standard cost of standard mix = standard price × standard quantity
Standard cost of actual mix = standard price × actual quantity
(B) When actual weight and standard weight are different
MMV = [(total weight of actual mix / total weight of standard mix) × standard cost of standard mix] –
standard cost of actual mix

Material yield variance (MYV)

The difference between the standard output and the actual output is known as yield variance

MYV = (standard yield – actual yield) × standard price per unit of output

Standard price per unit of output = standard cost of standard mix / (gross output – standard loss)

Labour variance analysis

(1) Labour cost variance (LCV)

It is the difference between the standard labour cost for the actual production and the actual labour cost.
LCV = standard cost of labour – actual cost of labour
Standard cost of labour = standard rate × standard time
Actual cost of labour = actual rate × actual time
(2) Labour rate variance (LRV)
It is the proportion of labour cost variance which is due to the difference between standard wage rate per hour
and the actual wage rate per hour.
LRV = (standard time – actual time) × standard rate
(3) Labour efficiency variance (LEV)

It is that portion of labour cost variance which is due to the difference between standard hours of the actual
output specified and the actual hours worked.
 LEV = (standard time – actual time) × standard rate

(4) Labour mix variance (LMV)

It arises if during a period the grades of labour used in production are different from the budgeted ones.
LMV = (revised standard time – actual time) × standard time
Revised standard time = (total time of actual workers / total time of standard workers) × standard time
(5) Labour yield variance (LYV)
LYV = standard labour cost per unit [actual yield in unit – standard yield in units]

Overhead variance
Overhead variance is the difference between the standard cost of overhead absorbed in the actual output achieved and
the actual overhead cost. The term overhead includes indirect material, indirect labour and indirect expenses and the
variances relate of factory, office and selling and distribution overheads. Overhead variances are divided into two
broad categories i) Variable Overhead variances and ii) Fixed Overhead variances. Some overhead calculation is used
as below:
Standard Overhead Rate per Unit = Budgeted Overheads/ Budgeted Output
Standard Overhead Rate per Hour = Budgeted Overheads/ Budgeted Hours
Standard Hours for actual Output = (Budgeted hours/Budgeted output) X Actual Output
Standard Output for actual Time = (Budgeted Output/Budgeted Hours) X Actual Hours
Recovered or absorbed overhead = Standard Rate per Unit X Actual Output
Variable Overhead Variance: Variable cost varies in proportion to the level of output, where the cost is fixed per
unit. As such the standard cost per unit of these overheads remains the same irrespective of the level of output
attained. As the volume does not affect the variable cost per unit or per hour, the only factor leading to difference is
price.
Variable Overhead Cost Variance (VOCV): It is the difference between standard overheads for actual output i.e.
Recovered Overhead and actual variable overheads.
VOCV = Variable Recovered Overhead - Actual Variable Overhead
Variable Recovered Overhead = Variable Actual Output/Variable Standard Output X Standard
Variable Overhead
VOCV = (Variable Actual Output/Variable Standard Output X Standard Variable Overhead) - Actual Variable
Overhead.
It is divided into two namely Variable Overhead Expenditure Variance and Variable Overhead Efficiency Variance.
Variable Overhead Expenditure Variance (VOExp.V): It is the difference between actual variable overhead
expenditure incurred and the standard variable overheads set in for a particular period.
VOExp.V = Budgeted Variable Overhead - Actual Variable Overhead or BVO -AVO
Variable Overhead Efficiency Variance (VOEff.V): It shows the effect of change in labour efficiency on variable
overheads recovery.
VOEff.V = Standard Rate per hour (Standard hours for actual production - Actual Variable Hours)
Fixed Overhead Variance: Fixed overhead variance depends on a) fixed expenses incurred and
b) the volume of production obtained. The volume variance includes three variances namely i) Efficiency ii) Calendar
and iii) Capacity.
Fixed Overhead Cost Variance (FOCV): It is the difference between standard overheads for actual output i.e.
recovered overhead and actual fixed overheads.
FOCV = Fixed Recovered Overhead - Actual Fixed Overhead
Fixed Recovered Overhead = Fixed Actual Output/Fixed Standard Output X Standard Fixed
Overhead
FOCV = (Fixed Actual Output/Fixed Standard Output X Standard Fixed Overhead) – Actual Fixed Overhead.
Fixed Overhead Expenditure Variance (FOExp.V): It is that portion of the fixed overhead which is incurred
during a particular period due to the difference between the budgeted fixed overheads and the actual fixed overheads.
FOExp.V = Budgeted Fixed Overhead - Actual Fixed Overhead or BFO - AFO
Fixed Overhead Volume Variance (FOVV): This variance is the difference between the standard cost of overhead
absorbed in actual output and the standard allowance for that output.
This variance measures the over or under recovery of fixed overheads due to deviation of actual output from the
budgeted output level.
FOVV = (Fixed Actual Output/Fixed Standard Output X Standard Fixed Overhead) - Budgeted
Fixed Actual Overhead
Fixed Overhead Efficiency Variance (FOEff.V): The portion of the overhead variation which is due to the
differences between the budgeted efficiency of production and the actual efficiency attained, is the efficiency
variance.
FOEff.V = Standard Rate per hour (Standard hours for actual production - Actual Fixed Hours)

Sales variance
Sales Value Variance
The difference between budgeted sales and actual sales results in Sales Value variance. The Formula is:
Sales Value Variance = Budgeted Sales - Actual Sales
If actual sales are more than the budgeted sales, a favourable variance would ' reported and vice versa.
The difference in value may be on account of difference in price or volume of ales which is therefore analysed
further.
Sales Price Variance
It can be calculated like material price variance. It is on account of the difference in actual selling price and the
standard selling price for actual quantity of sales. The formula is:
Actual quantity sold X (Standard Price - Actual Price) OR
Price Variance = Standard Sales - Actual Sales
Sales Volume Variance
It can be calculated like material usage variance. Budgeted sales may be different from the standard sales. In other
words, budgeted quantity of sales at standard price may vary from the actual quantity of sales at standard prices.
Thus, the variance is a result of difference in budgeted and actual quantities of goods sold. The formula is:
Standard Price X (Budgeted Quantity - Actual Quantity)
OR
Volume Variance = Budgeted Sales - Standard Sales
If the standard sales are more than the budgeted sales, it would cause a favourable variance and vice versa?
The total, of price and volume variances would be equal to sales value variance.

Disposal of variances
The disposal of variance can be explained as follows,

1) Transfer to profit and loss account

The standard cost variances are closed by transfer to P/L account. The advantages of this method are,
i. The stocks and work-in-progress can still be shown valued at the standard cost.
ii. Standard remain intact and they can be compared with each other during different periods, for the
purpose of cost control.
iii. Prompt inventory valuation is facilitated , and it can be done at any time as the valuation is done on
standard cost.
2) Allocation to finished stock, work-in-progress, and cost of sales
The variances are distributed to the finished stock, work-in-progress, and cost of sales in proportion to their
values of closing balances.
3) Transfer to reserve account
Under this method, the variances are carried forward to the next financial year to be set off in the subsequent
years. The adverse and favorable variances may cancel each other in the course of reasonable time and thus be
disposed-off. Therefore the variances are transferred to reserve accounts and the unwritten off accounts are
shown in the balance sheet of the year.

Cost Reduction and Productivity :

Cost reduction
Cost reduction is much wider in scope and consists of effecting savings in cost by continuous research for
improvement in products, methods, procedures, and organizational practices. In other words, cost reduction is the
achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without
impairing their suitability for use intended. This definition revels the following characteristics of cost reduction:
(i) Cost reduction must be real- say, through increase in productivity, change in product design, improvement
in technology, etc.
(ii) Cost reduction must be permanent- temporary reductions in cost due to windfalls, change in tax rates,
change in market prices, etc., do not come in the purview of cost reduction.
(iii) Cost reduction must not impair the suitability of products or services for the intended use. In other words,
cost reduction should not be at the cost of essential characteristics of the products or services.
The cost reduction is, therefore, the term used for planned and positive approach to the improvement of efficiency. It
can be viewed in many ways, such as increasing productivity, elimination of waste, improvement in product design,
better technology and techniques, incentive schemes, new layouts and better methods, etc. if the cost reductions are
not based on sound reasons, like improved methods, then very quickly the costs will grow back to their original size.
Difference between cost control and cost reduction

Cost control Cost reduction

1. Cost control is the achievement of predetermined targets Cost reduction is the achievement of the real and
of costs. permanent reduction in costs.

2. Costs control tends to assume a static state of affairs Cost reduction assumes the existence of concerned
and that standards once set are not challenged. potential savings in the standards or pre-determined
costs are set for cost control and that these standards
are always subject to challenge.

3. Cost control is concerned with predetermining costs, Cost reduction is not concerned with maintenance of
comparing it with actual costs, analyzing the variances performance according to predetermined targets.
and taking corrective action. It is rather concerned with finding out new product
designs, methods, etc.

4. Cost control is a prevent the costs from exceeding the Cost reduction is a corrective function because it
predetermined targets. challenge the predetermined targets and seeks to
improve performance by correcting the targets.

5. Cost control is a part of cost accounting function. Cost reduction may be achieved even when no cost
accounting system is in operation.

6. Cost control lacks dynamic approach to cost improvement. Cost reduction is a more dynamic approach to cost
Improvement and elimination of waste.

Values Analysis
Values analysis is defined as A systematic interdisciplinary examination of factors affecting the cost of a product or
service in order to devise means of achieving the specified purpose most economically at the required standard of
quality and reliability. Value analysis aims at identifying and removing unnecessary costs that do not add value to the
product in order to offer better value to the customers. It is an innovative and systematic multi-disciplinary approach
of probing into the economic attributes of value.
Concept
1. Use value:- This refers to the utility of the product to the user of the same. In other words, use value refers to
the measure of quality of performance of the product.
2. Esteem value:- It measures the properties and features which make the product attractive. These qualities
usually do not add to the utility of the product but make its ownership desirable. A buyer may be ready to pay
a higher price for a watch made of gold because of its esteem value, although its utility value may be the same
as that of a steel watch.
3. Cost value:- If the product is manufactured by the seller it refers to the cost of production and if the seller has
obtained the product from outside, it refers to the cost of purchase.
4. Exchange value:- It measures those properties of the product which facilitates its exchange of something else
that the buyer may want.
Productivity
In a business organization various inputs(raw material, labor, capital utilities) are used to produce the output.
Productivity refers to the efficiency and effectiveness with which these inputs are used in producing the output.
Efficiency and effectiveness can be improved only by eliminating wastes in all forms. Higher productivity can be
achieved either by producing the same output with lower input or by producing higher output with the same input or
by producing higher output with lower input. Any of these would result in higher output per unit of input.
Improvement in productivity
1. Standardization and simplification of production lines.
2. Elimination of non-productive work.
3. Correct designing of the product.
 4. Use of machineries, which are the most suitable for the operations involved.
5. Introduction of method improvement including the introduction of low-cost automation.
6. Efficient production planning, scheduling and work-loading.
7. Use of the right worker for each operation.
8. Optimum utilization of space and machine time.
Advantages of productivity
1. Optimum utilization of resources resulting in a reduction in cost and improvement in profit.
2. Full value, better quality and a reasonable price for the customers.
3. Better working conditions and proper reward for workers.
4. Expansion and growth of industry.
Value added
An organization in the process of manufacturing adds utility or value to raw materials by converting them into a
finished product. Therefore the finished product fetches a market value, which is higher, as compared to the cost of
raw materials.
The excess of the market value over the cost of materials is defined as value added, thus value added by a firm during
a specified period can be stated as,
Value added = sales – cost of throughput(cost of items bought from outside and processed)
Learning Curve
When a specific task is performed repeatedly, efficiency gradually improves in non-leaner pattern and consequently
labor hour per unit declines. A learning curve depicts how labor hour unit declines with increase in output.
The following two models based on two different assumptions are in common use,
Model 1:- The cumulative average time per unit declines by a constant percentage each time the cumulative quantity
is doubled. This model is known as cumulative average-time learning model.
Model 2:- The incremental unit time (time required to produce the last unit) declines by a constant percentage each
time the cumulative quantity is doubled. This model is known as incremental unit time learning model.
Application of Learning Curve
The prediction of cost must take into consideration the effects of learning. The concept of learning curve helps
managers to incorporate learning effects in predicting cost. Usually direct labor cost and variable overheads per unit
of output vary in direct proportion to the time taken to complete the unit. Therefore as efficiency increases, variable
costs per units declines. Moreover, with an increase in efficiency, the volume of production increases and as a result,
average fixed overhead per unit of output declines. Therefore, the learning curve concept has many applications in
business decisions. For example, in preparing the quotation for competitive bidding, learning rate is applied to
determine the cumulative average unit cost for the quantity to be supplied.