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 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.

Semester Two

PAN African eNetwork 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

INDEX

Chapter No. Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8

Chapter Name Introduction to Cost Accounting Material Costing Labor Costing Overheads Costing

Page No. 2 24 41 59

Marginal Costing and Cost Volume Profit 90 Analysis Standard Costing and variance analysis 121 Budgets, cost reduction and control 151

Introduction to Recent developments in 175 costing Page no 193 Page no 194 Page no195

Answer Key to end chapter questions Syllabus References

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. 3

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 1&2. 3. 4. Implied Specific Objective Will publishing the book be profitable to the company? Should the company offer a higher compensation to its striking employees to avoid the strike? Should the company close its plant or install pollution control 4

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-today 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 5

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 6

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. 7

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. 8

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 9

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 10

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 11

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 12

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. 13

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

14

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 15

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. 16

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) Direct materials consumed: Opening stock.. Add: Purchases.. Carriage inwards. Less: Closing stock. Less: Scrap.. Direct wages Direct expenses I. Prime Cost Add: Factory Overheads: Indirect materials Loose tools Indirect wages Rent & rates (Factory) Lighting & Heating of factory Power & fuel Cost per unit (Rs)

xxxx xxxx xxxx xxxx

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 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 Add: Opening stock of finished goods Less: Closing stock of finished goods IV Cost of goods sold 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 Net Profit (or loss) Sales

xxxx

xxxx

xxxx

xxxx xxxx 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 Stock of finished good (1.1.2007) Stock of raw material (1.1.2007) WIP (1.1.2007) Purchase of raw material Carriage inward Factory rent, taxes Other production exp Stock of finished goods (31.12.2007) Wages Work manager salary Factory employees salary Power expenses General expenses Sales for the year Stock of raw materials (31.12.07) WIP (31.12.2007) SOLUTION Particulars Raw Material consumed: Opening stock of raw material Add: Purchases Carriage inward Less: Closing stock of raw material Wages I Prime Cost Add: Factory overheads: Factory rent, taxes Other production exp Work manager salary Factory employees salary Power expenses Add: Opening stock of WIP Less Closing stock of WIP Rs 6000 40000 15000 4,75,000 12,500 7250 43000 15000 1,75,000 30000 60000 9500 32500 8,60,000 50,000 10000

Amount (Rs) 40,000 4,75,000 12,500 50,000

Amount (Rs)

4,77,500 1,75,000 6,52,500 7250 43000 30,000 60,000 9,500 15000 10,000

22

II Works or factory cost Add: Office overheads General Expenses 32500 III Cost of production Add: Opening stock pf finished goods 6000 Less: Closing stock pf finished goods 15,000 IV Cost of goods sold Profit Sales

8,07,250

8,39,750

8,30,750 29,250 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) (b) (c) (d)

Marginal costing Direct costing Standard costing 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 stockout, 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 July 12 175 units @ Re.1 per unit 175 units @ Re.2 per unit 36

Issues: July 21 July 30 i. ii. 105 units 70 units

Complete the receipts and issues valuation by adopting the FIFO, LIFO and Weighted Average Method. 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 Date 1-Jul Particulars Purchase Qty 175 units 175 units Rate Re 1 Re 2 Value 175 350 37 Qty Issues Rate Value Qty 175 350 Balance Value 175 525

12-Jul Purchase

21-Jul Issue 30-Jul issue

105 units 70 units

105 70

1 1

105 70

245 175

420 350

Value of Closing stock:- 175 Units of Rs 350

LIFO
Receipts Date 1-Jul Particulars Purchase Qty 175 units 175 units 105 units 70 units Rate Re 1 Re 2 Value 175 350 105 70 2 2 210 140 Qty Issues Rate Value Qty 175 350 245 175 Balance Value 175 525 315 175

12-Jul Purchase 21-Jul Issue 30-Jul issue

Value of Closing stock:- 175 Units of Rs 175

Weighted Average Method

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

* Wighted Average Rate:

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

38

Standard Price Method

Receipts Date Particulars Qty Rate 175 1-Jul Purchase units Re 1 12175 Jul Purchase units Re 2 21105 Jul Issue units 3070 Jul issue units Value 175 350 105 70 1.25 1.25 Issues Qty Rate Value Balance Qty Value 175 350 131.25 245 87.5 175 175 525 393.75 306.25

Value of Closing stock:- 175 Units of Rs 306.25

Current Price/Replacement Method

Receipts Date Particulars Qty Rate 175 1-Jul Purchase units Re 1 12175 Jul Purchase units Re 2 21105 Jul Issue units 3070 Jul issue units Value 175 350 105 70 1.25 1.75 Issues Qty Rate Value Balance Qty Value 175 350 131.25 245 122.5 175 175 525 393.75 271.25

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) (b) (c) (d) Up Down Steady 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 Average number of employees during a period x 100

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 Average number of workers during the period x 100

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 Number of workers at the end of the year 3,800 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 2 = 4,000

Labour Turnover Rate = 150 x100 4,000 Labour Flux Rate =

Number of workers replaced during the year x 100 Average number of workers during the year = 3.75%

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) 1. 2. 3. 4. 5. Replacement Costs. These costs are associated with replacement of workers and include: Cost of recruitment of new workers. Cost of training new workers. Loss of production due to (a) interruption in production, and (b) inefficiency of new workers. Loss of profit due to loss of production. 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 timekeeping 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. Abnormal Idle Time:- This is not caused by usual production routine. It may be:50

b.

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) (b) (c) (d)

Group Bonus scheme Measured day work Premium bonus scheme 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. 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. 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.

ii.

iii.

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 64 Basis of Apportionment

Service Department Cost 1. 2. Maintenance Department Payroll or timekeeping

Basis of Apportionment Hours worked department for each

Total labor or machine hours or number of employees in each department Rate of labor turnover or number of employees in each department No. of requisitions or value of materials of each department No. of purchase orders or value of materials for each department No. of employees department in each

3.

Employment or personnel department

4. 5. 6. 7. 8.

Storekeeping department Purchase department Welfare, ambulance, canteen service, recreation room expenses Building service department Internal transport service or overhead crane service Transport department

Relative area in each department Weight, value graded product handled, weight and distance traveled Crane hours, truck hours, truck mileage, truck tonnage, truck tonne-hours, tonnage handled, number of packages Wattage, horse power, horse power machine hours, number of electric points, etc.

9.

10.

Power House (Electric power cost)

4.6 METHODS OF REAPPORTIONMENT OR REDISTRIBUTION The following are the methods of redistribution of service department costs to production departments: i. ii. iii. Direct Redistribution Step Method 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 P1 Rs. P2 Rs. P3 Rs. Service Departments S1 Rs. S2 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 P1 Rs. Total expenses as per summary Dept. S2 (4:4:2) Dept. S1 (3:3:4) Total 8,000 2,400 1,200 11,600 P2 Rs. 7,000 2,400 1,200 10,600 P3 Rs. 6,000 1,200 1,600 8,800 Service Departments S1 Rs. 4,000 (4,000) S2 Rs. 6,000 (6,000)

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

15,000

10,000

5,000

6,000

4,000 Production Departments

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

X (Timekeeping ) No. Employees of

Y (Stores)

Z (Maintenance)

10

5 6

20 24

15 20

No. of Stores Requisitions Machine Hours

1200

800

Apportion the expenses of service departments. Solution Department As per Secondary Distribution

67

Primary Distribution Summary Rs. X (Timekeeping) Y (Stores) Z (Maintenance) P Q 5,000 6,000 4,000 15,000 10,000 40,000 Note: Basis of apportionment:

From X to From Y to From Z to Y, Z, P & Z, P & Q P&Q Q Rs. ()5,000 1,000 500 2,000 1,500 ()7,000 840 3,360 2,800 ()5,340 3,204 2,136 23,564 16,436 40,000

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: P Rs.700; Q Rs.900 and R Rs.400 Service Departments: 68 Rs. 2,000

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 Service Rendered by Department X 20% Q 40% R 30% X Y 10%

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 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: (1)

P Rs.

Q Rs.

R Rs.

Total

69

Per Distribution Summary Service department X@ Service department Y

@@

700 120 264 1,084

900 240 132 1,272

400 180 132 712

468 (600) 132 0

600 60 (660) 0

3,068 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 Rs. As per Summary Service Department X
@

Q Rs. 900 187 129 52 4 1,272

R Rs. 400 140 129 39 4 712

X Rs. 468 (468) 130 (130)

Y Rs. 600 47 (647) 13 (13)

700 94 259

Service Department Y# Service X@@ Service Y##

Department 26 Department 5 1,084

@ 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 Rs. Original apportionment 468 (468) 129(20% of 647) (129) 3(20% of 13) 600 Y Rs. 600 47(10% of 468) (647) 13(10% of 129) (13) 660

Total of positive figures

(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 Department Labor Wages (1) A B C D (2) Rs. 8,000 12,000 4,000 12,000 36,000 Rate of Overhead Expenses Recovery (3 2)x 100 (3) Rs. 12,000 12,000 1,000 6,000 31,000 73 150% 100% 25% 50% 86% 86% 86% 86% 6,880 10,320 3,440 10,320 5,120 1,680 ()2,440 ()4,320 (4) Blanke Amount Amount of under t Recovered at or over absorption Rate* Blanket Rate of overhead (5) (6) [(3) (6)]

*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 1,800 C 4,000 D 9,40 0

Actual production during a month 600 (Nos.) 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: Product group A B C D Total Actual Production in Units 600 1,800 4,000 9,400 Conversion Factor 4 2 4/3 1 D Equivalent Units 2,400 3,600 5,333 9,400 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: Product group A B C D Equivalent Units 2,400 3,600 5,333 9,400 20,733 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 Overhead absorption Overhead rate per equivalent absorbed unit Rs. Rs. 3.65 3.65 3.65 3.65 8,760 13,140 19,467 34,310 75,677*

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 Standing Charges 1. 2. Rent and rates Heating and Lighting 77

Basis Floor area occupied by each including the surrounding space. machine

The number of points used plus cost of special lighting or heating for any individual machine,

Expenses

Basis or according to floor area occupied by each machine. Estimated time devoted by the supervisory staff to each machine. On the basis of past experience. Insurance value of each machine Equitable basis depending upon facts. Cost of machine (including cost of any standby equipment such as spare motors, switchgears, etc.) less residual value spread over its working life. Actual consumption as shown by meter readings or estimated consumption ascertained from past experience. Cost of repairs spread over its working life. 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.

3. 4. 5. 6.

Supervision Lubricating Oil and Consumable Stores Insurance Miscellaneous expenses

Machine Expenses 1. Depreciation

2. Power

3. Repairs Advantages

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 Heat and Light Supervision 40,000 20,000 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. ii. When setting and adjusting, full time attention When machine can look after 3 machines. is producing, one man

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 Job No. 610 Job No. 580 100 100 Production time hours 70 80 Setting up time hours 30 20

Solution Computation of Comprehensive Machine Hour Rate Rs. Standing Charges: Rent, Heat and Light Supervision = = 2,500 5,200 Rs.

79

Depreciation 10% of Rs.2,00,000 Reserve Equipment Cost Labor Cost during adjustment 250 Hrs. @ Rs.6 setting and

= = =

20,000 60 1,500 29,260 16.72

Hourly Rate for Standing Charges Machine Charges: Power Labor (1/3 of Rs.6) Comprehensive Machine Hour Rate

0.50 2.00 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 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: x 70 = Rs.1,345.40

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

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 (1) Direct Material Cost: 240 % Working Department Finishing Department

100

x100 = 30%

x 100 =

(2)

Direct Labor Cost: 60 % 80 %

x 100

x 100 =

x 100 =

(3) Direct Rate:

Labor

Hour = 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 Percentage Rate (i) 82 Direct Labor Cost Rate (ii) Direct Labor Hour Rate (iii) Machi ne Hour Rate

Particulars

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

Comparative Statement of Job No. 20 for Finishing Department Materials Cost Percentage Rate (i) Rs. A. Material Used B. Direct Labor C. Prime Cost = (A+B) D. Overhead (i) @ 240% Material(20x2.4) of Direct 48 40 33.60 30 118 442 560 110 448 558 103.60 449.50 553.10 100 461.80 561.80 20 50 70 Direct Labor Cost Rate (ii) Rs. 20 50 70 Direct Labor Hour Rate (iii) Rs. 20 50 70 Machin e Hour Rate (iv) Rs. 20 50 70

Particulars

(ii) @ 80% of Direct Wages (50x0.8) (iii) 24 paise per hr. for 140 hrs. (iv) 60 paise per hr. for 50 hrs. E. Total Cost in the Dept. = (C+D) F. Cost b/f from Working Department G. Total cost

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 overabsorption 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) Less: Annual holiday hours 10 x 42 x 2 = 840 Other holiday hours 10 x 10 x 7 = 700 21,840 1,540

Available hours 85

20,300

Less: Hours lost in cleaning 10 x 2 x 48.4 (i.e. 52 3.6) Illness and absenteeism

968 1,100 2,068

Anticipated effective hours

18,232

Overhead absorption rate on direct labor =

= Rs.0.75 (approx.)

Actual Maximum hours Add: Overtime 21,840 800 22,640 Less: Holidays (840 + 420) Cleaning time Machine breakdown Illness and absenteeism 1,260 1,000 200 1,300 3,760 18,880

Overhead Absorption a/c Rs. To Overhead Control a/c 15,000 By Finished Goods Control (18,880 x 0.75) Ledger a/c Rs. 14,160

By Costing Profit and Loss a/c (Underabsorption of overheads) 15,000 86

840

15,000

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 Overhead absorption rate used (Rs.) Actual overhead incurred (Rs.) Overhead absorbed (Rs.) Direct labor hours recorded against: Work-in-progress Finished goods stock 2,800 5,400 4,930 3,700 820 1,210 4.00 81,900 72,800 Dept. II 3.00 1,20,960 1,00,800 Dept. III 7.00 79,360 86,800

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 a. (1) (2) (3) (4) (5) (6) b . Actual overhead incurred Overhead absorbed (Rs.) (Rs.) 81,900 72,800 +9,100 18,200 (Rs.) +0.50 4.50 +1,400 +2,700 Dept. II 1,20,960 1,00,800 +20,160 33,600 +0.60 3.60 +2,958 +2,220 Dept. III 79,360 86,800 7,440 12,400 0.60 6.40 492 726

Under (+) or over () absorption (1 (Rs) 2) Direct (2 rate) labor hours

Supplementary overhead rate (3 4) Revised overhead application rate (rate + 5)

Adjustment work-in-progress Adjustment goods stock to

to (Rs.) finished

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

Q2 Showroom expenses is an example of (a) (b) (c) (d) Manufacturing overhead Administrative overhead Selling overhead Distribution overhead

Q3 Electricity expenses incurred for running electric motors can be apportioned on the basis of (a) (b) (c) (d) Kilowatt hours Capital value of the motors Physical size of the motors 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) (b) (c) (d) Errors in estimating overheads expenses Errors in estimating the levels of production Major unanticipated changes in method of production 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) (b) (c) (d) Units produced Prime cost Direct labour hours 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) (b) (c) (d) only i above only ii above only iii above both i & ii above

Q10 Allocation of service department costs to the production departments is necessary to (a) (b) (c) (d) Determine overheads rates Control costs Maximize organizational effectiveness 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 Fixed Cost Total Cost Total Cost for output of 40,000 units Variable costs of 40,001 units @ Rs.9/unit Fixed Cost Total Cost Total Cost for output of 40,001 units Less: Total Cost for output of 40,000 units Marginal cost 3,60,000 2,50,000 6,10,000 3,60,009 2,50,000 6,10,009 6,10,000 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 Where Q R(Q) V(Q) C P = = = = = The decision variable representing the production level The revenue resulting from production level Q The variable cost resulting from production level Q The fixed cost incurred The profit, which we are trying to maximize. = R(Q) V(Q) C

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 Sales revenue Less: cost: Marginal

Rs. X

Rs. Less: costs

Absorption Costing All manufacturing

Rs.

Rs. X

Sales revenue

Direct material cost Direct Labor cost Variable Overhead Contribution Margin Less: Overhead Fixed

X X X X X X X

Direct material cost Direct labor cost

X X

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

Operating Income

When product analysis is involved, the two forms of presentation are as follows: Absorption Cost Presentation Income Statement Period ended Product Alpha Rs. Sales 95 Product Beta Rs. Total Rs.

Less: Total Cost of Sales Operating Income

Marginal Cost Presentation Income Statement Period ended Product Alpha Product Beta Rs. Sales Less: Marginal cost of sales Contribution Less: Fixed Costs: Factory overhead Selling and distribution overhead Administration overhead Operating Income Rs. Tota l Rs.

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 Add/deduct under or overabsorbed factory overhead Actual factory cost of sales Illustration5.1 Comparative Income Statement under Marginal Costing and Absorption Costing. 96 (includes factory overhead absorbed) (example underabsorption means the product has not absorbed the full factory cost, therefore, this underabsorption is added)

DBF Ltd., furnishes the following details for the year ended 31st March, 2003 for preparing the Income Statement of the year: Sales Fixed manufacturing cost Variable manufacturing cost Inventory at the end Fixed selling and administrative expenses Variable selling and administrative expenses DBF Ltd. Income Statement (for the year ended 31st March, 2003) i. Under Absorption Costing Rs. Sales Less: 2500 units Rs.25 each Cost of Sales Variable manufacturing costs 2700 units Rs.14 each Fixed manufacturing costs Less: Inventory at close 200 units @ Rs.18 * each Gross Margin or Profit Total selling and administrative Less: expenses Operating Income 3,600 45,000 17,500 2,400 15,100 @ 37,800 10,800 48,600 @ 62,500 Rs. 2500 units Rs.10,800 2700 units 200 units Rs.1,500 Rs.900 @ Rs.14 per unit @ Rs.25 per unit

* Variable cost per unit = ii. Under Marginal Costing 97

= 18

Rs. Sales Less: 2500 units of Rs.25 each Variable Cost of Sales: Variable manufacturing costs Less: 2700 units @ Rs.14 each Inventory at the end 37,800 2,800

Rs. 62,500

200 units @ Rs.14 each Contribution Margin

35,000 27,500

Less:

Variable Selling and Administrative Expenses 900 Fixed Manufacturing costs 10,800 Fixed Selling expenses 1,500 13,200 14,300

Operating Income

Reconciliation of Difference between Absorption & Marginal Costing Income: Particulars Marginal Costing Income Absorption Costing Income Difference to explained 1. Difference in the value of closing Inventory (2800-3600) Amount (Rs.) 14,300 15,100 (800) (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 costvolume-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 200001, the Management Accountant has estimated the following profit levels depending upon the different quantities of the product manufactured and sold: Sales Quantity (000 units) 20 25 30 35 40 45 50 Sales Value Rs. Lakhs [Selling Price = Rs.10] 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Total Costs Rs.lakhs 3.6 3.7 3.8 3.9 4.0 4.1 4.2 Profit/(Loss) Rs.lakhs (1.6) (1.2) (0.8) (0.4) 0.4 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 Xaxis. 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 v Q F P Then we have Sales Revenue Total Cost = So, sQ [vQ + F] = So, (s v) Q F = Profit P P = = = = = Selling price per unit of the product. Variable cost per unit of the product manufactured and sold. Quantity (units) of the product manufactured and sold. Total fixed cost for the period under consideration. Profit for the period under consideration.

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 Since s v

or QB =

= 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 Even Sales Value = Break even Sales Quantity x Selling price per unit.

= The above can be written as: Break-even Sales value =

is the C/S ratio (also called the P/V ratio) or contribution margin Breakeven Sales = Value Illustration 5.2

Sales Quantity Sales Value (in 000 units)

Fixed Cost

Variable Cost [Rs.2/unit] Rs. lakhs 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Profit Rs. lakhs (1.60) (1.20) (0.80) (0.40) 0.40 0.80

[Selling Price =Rs.10] Rs. lakhs Rs. lakhs 20 25 30 35 40 45 50 2.0 2.5 3.0 3.5 4.0 4.5 5.0 3.2 3.2 3.2 3.2 3.2 3.2 3.2

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: Particulars Materials Wages Fixed Overheads Variable Overheads Profits Sales price per unit Out per week Solution: Particulars Sales price per unit Less: Variable Cost Contribution per unit Less: Fixed cost per unit Profit per unit Total Profit P/V Ratio Product A (Rs) 1000 450 550 350 200 40000 55% Product B (Rs) 1000 550 450 100 350 35000 45% Production cost unit Product A (Rs) 200 100 350 150 200 1000 200 Units Product B (Rs) 150 200 100 200 350 1000 100 Units

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. Breakeven 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 where P = S V F Q = Profit = = = = Unit Selling Price Unit Variable Costs Total Fixed Cost Sales Volume (S V) Q F

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 109

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 110

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. 111

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). 112

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 113 Z

Production (units) Unit marginal costs Direct materials Direct labour

1,000 2,000 4,000 3,000 $ 4 8 14 $ 5 9 3 17 $ 2 4 1 7 $ 4 6 2 12

Variable production overheads 2

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

2,000 4,000 3,000 5,000 6,000 8,000

Extra variable cost of buying per annum (2,000) 8,000 12,000 6,000 (3,000) 3,000 6,000 (2,000)

114

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 115

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 Cost Rs. Direct materials Direct labor 2,50,000 1,00,000 Unit Cost Rs. 0.25 0.10 0.25 0.05 0.65

Manufacturing overhead 2,50,000 (60% is allocated fixed overhead) Variable selling and administrative cost 50,000 6,50,000

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 Direct Labor Variable Manufacturing Overhead (40%) Variable Selling and Administration Cost Incremental Cost Sales Price Incremental Profit 0.25 0.10 0.10 0.05 0.50 0.55 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, 116

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 Rs. Sales Cost of goods sold Variable Fixed Gross margin Selling expenses Variable Fixed Profit before tax 2,00,000 1,50,000 3,50,000 3,50,000 1,20,000 75,000 1,95,000 55,000 80,000 45,000 1,25,000 (25,000) 4,00,000 2,70,000 6,70,000 3,80,000 18,00,000 5,00,000 23,00,000 7,00,000 10,00,000 2,50,000 12,50,000 2,50,000 6,50,000 1,50,000 8,00,000 1,00,000 34,50,000 9,00,000 43,50,000 10,50,000 30,00,000 Nips Rs. 15,00,000 Dips Rs. 9,00,000 Total Rs. 54,00,000

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 Rs. Nips Rs. 117 Dips Rs. Total Rs.

Bips Rs. Sales Variable costs Production Selling 18,00,000 2,00,000 20,00,000 Contribution Fixed costs Production Selling 10,00,000 30,00,000

Nips Rs. 15,00,000

Dips Rs. 9,00,000

Total Rs. 54,00,000

10,00,000 1,20,000 11,20,000 3,80,000

6,50,000 80,000 7,30,000 1,70,000

34,50,000 4,00,000 38,50,000 15,50,000

9,00,000 2,70,000 11,70,000

Profit before tax Income Statement of Sameeksha Limited (After Dropping Dips) Bips Rs. 30,00,000 Nips Rs. 15,00,000 Total Rs. 45,00,000

3,80,000

Sales Variable costs Production Selling

18,00,000 2,00,000 20,00,000

10,00,000 1,20,000 11,20,000 3,80,000

28,00,000 3,20,000 31,20,000 13,80,000

Contribution Fixed costs Production

10,00,000

9,00,000

118

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.

119

MULTIPLE CHOICE QUESTIONS

Q1 Which of the following can improve the margin of safety? a) b) c) d) Lowering the fixed cost lowering the variable cost so as to improve marginal contribution. increasing volume of sales, if there is available capacity. All (a), (b) & (c) above

Q2 Break even sales is a) b) c) d) The sales required to earn a particular amount of profit. The sales at which there is neither profit nor loss. The sales equal to amount of fixed expenses incurred by the company. None of the above.

Q3 The contribution per unit does not depend upon a) b) c) d) Selling price direct material cost fixed cost direct labour

Q4 Margin of safety can be improved by a) b) c) d) Increase of variable cost per unit Decrease of sales price per unit increase of fixed cost decrease of variable cost per unit

Q5 Given the sales volume, which of the following would lead to an increase in contribution margin? a) b) c) d) Variable cost per unit remains same variable cost per unit decreases Fixed cost decreases 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) b) c) d) Fixed cost Desired Profit Desired profit plus fixed cost Desired profit less fixed cost 120

Q7 In CVP analysis, if quantity produced and sold is more than the break even quantity, the operating income is increased by a) b) c) d) Overhead cost per unit for each additional unit sold Variable costs per unit for each additional unit sold Fixed cost per unit for each additional unit sold contribution margin per unit for each additional unit sold

Q8 Which of the following costs is not relevant to the decision- making program? a) b) c) d) out of pocket cost Differential cost Avoidable cost historical cost

Q9 In make or buy decision, the relevant costs include a) b) c) d) Factory management costs plus variable manufacturing costs. variable manufacturing costs plus depreciation costs Avoidable fixed cost plus variable manufacturing costs variable manufacturing costs plus unavoidable fixed costs.

Q10 The term relevant cost applies to all the following decision situations except the a) b) c) d) Acceptance of a special order Manufacture or purchase of component parts Determination of a product price Replacement of equipment

121

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; 122

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 123

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 124

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. 125

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

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 hour 50

Variable overheads:

Process 1 - Rs.3 per unit of A Process 2 - Rs.3 per unit of A Process 3 - Rs.4 per unit of A

3 3 4 10 10 180 10 190 10 200 50 Selling price 250

Fixed overheads:

20% of wages cost Production Cost Administration costs Selling and distribution costs Total Cost

Profit (25% on total cost)

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: 126

Total Variances Product A Element of cost Direct material Direct wages Prime Cost Variable overhead: Process cost 20% of wages cost Fixed overhead: Administration Selling and distribution Total Cost Profit Sales variance Sales (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 2,50,000 3,00,000 10,000 10,000 2,00,000 50,000 12,000 15,000 2,48,000 52,000 2,000 (2,000) 48,000 50,000 50,000 2,000 5,000 10,000 10,000 8,000 18,000 2,000 8,000 1,000 units Variances Standard Rs. 1,10,000 50,000 1,60,000 Actual Rs. 1,40,000 55,000 1,95,000 (F) Rs. (A) Rs. 30,000 5,000 35,000

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 Cost variance = 100% 80% = = 20% (favorable) 129 80%

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 SP = AQ = AP = Actual Price quantity for the Standard Actual actual output Price Quantity

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 subvariances 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 or Yield Variance unit = (Standard loss on actual input Actual loss) x Standard cost per = (Standard yield Actual yield) x Standard cost per unit of output

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 Value of materials purchased 6,000 units Rs.18,000

Standard quantity of materials required per tonne of 60 units output Standard rate of material Opening stock of materials Closing stock of materials Output during the period Solution Materials consumed = Actual rate of material = Standard quantity actual output Material cost variance for = = = = = Material price variance = = = Material usage variance = = = Verification: Material cost variance Rs. 33,000 Illustration 6.3 = = Material price variance + Material usage variance Rs. 10,000+Rs. 23,000 60 x 160 = 9,600 units Rs.5.00 per unit Nil 1,000 units 160 tonnes

6,000 1,000

= =

5,000 units Rs.3 per unit

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) Actual quantity (Standard price Actual price) 5,000 x (Rs.5.00 Rs.3.00) Rs.10,000 (Favorable) Standard Price x (Standard quantity Actual quantity) Rs.5.00 (9,600 5,000) Rs.23,000 (Favorable)

134

A manufacturing concern which has adopted standard costing furnished the following information. Standard: Material for 70 kg finished product 100 Price of materials Rs.2 per kg Actual: Output Material used Cost of materials Calculate a) Material usage variance b) Material price variance c) Material cost variance Solution a. Material variance usage = = = b. Material price variance = = = = c. Material cost variance = = = = = Verification: Material cost variance Rs.96,000 Working Notes = Material price variance + Material usage variance = Rs.56,000 +Rs40,000. 135 SP x (SQ AQ) 2 x (3,00,000 2,80,000) Rs.40,000 (Favorable) AQ x (SP AP) 2,80,000 x (2.0 1.8) 2,80,000 x 0.20 Rs.56,000 (Favorable) Standard Cost Actual Cost (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) 2,10,000 2,80,000 Rs.5,04,000

kg

kg kg

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 Where = SH (SH x SR) (AH x AR) = SR AH AR Standard = Standard = Actual = Actual rate hours rate hours

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: Changes in basic wage rates. 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
1) 2)

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.
6)

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 Actual labor cost) Standard Cost Product X 10,000 x 15 x 5 = 7,50,000 Product Y 15,000 x 20 x 5 22,50,000 = 15,00,000 = (Standard labor cost for actual output

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) = = Rs.47,500 (A) 4,29,100 x (5 5)= Rs.0 =

Labor efficiency variance = Standard rate x (Standard time Actual time) = 5 x = Rs.2,500 (Adverse) Verification: Labor cost variance (4,50,000 4,50,500)

Labor

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

variance

Illustration 6.5 Standard labor hours and rate for production of one unit of Article X is given below: Per unit (hr) Skilled worker Unskilled worker Semi-skilled worker 5 8 4 Rate per hour (Rs.) 1.50 0.50 0.75 Total (Rs.) 7.50 4.00 3.00 Rs.14.50

Actual Data Articles produced 1,000 units Skilled worker 4,500 hr Unskilled worker 10,000 hr

Rate per hour (Rs.)

Total (Rs.)

2.00 0.45

9,000 4,500 3,150

Semi-skilled workers 4,200 0.75 hr 140

Rs.16,650 Calculate i. Labor cost variance ii. iii. iv. v. Labor rate variance Labor efficiency variance Labor mix variance Labor yield variance

vi. Labor efficiency sub-variance. Solution i. Skilled Unskilled Labor cost variance (SH for actual production x SR) (AH x AR) (5,000 x 1.50) (4,500 x 2) = Rs.1,500 (A) = Rs. 500 (A) = Rs. 150 (A) = Rs.2,150 (A) (8,000 x 0.50) (10,000 x 0.45)

Semi-skilled (4,000 x 0.75) (4,200 x 0.75) Total labor cost variance ii. Labor rate variance (SR AR) x AH Skilled workers:

(1.50 2.00) x 4,500 (0.50 0.45)

= Rs.2,250 (A) = Rs. 0 = Rs. 500(F) x 10,000 = Rs.1,750 (A)

Semi-skilled workers: (0.75 0.75) x 4,200 Unskilled workers: Total labor rate variance iii. Labor efficiency variance Skilled: (5,000 4,500) x 1.50 Unskilled Semi-skilled = Rs.

750 (F)

(8,000 10,000) x 0.50 = Rs.1,000 (A) (4,000 4,200) x 0.75 = Rs. 150(A) = Rs.400(A)

Total labor efficiency variance 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 = = = = (Revised standard mix of actual hours Actual labor mix) x = Rs.1,500 (F) Rs. 150 (F)

Labor mix variance Standard rate

Skilled = (5,500 4,500) x 1.50 Semi-skilled (4,400 Total labor mix variance v. Labor yield variance

Unskilled =(8,800 10,000) x 0.50 = Rs. 600 (A) 4,200)x0.75 = = Rs.1,050 (F)

(Standard on actual hours Actual production) x Average standard unit (1,100 1,000) x 14.50 = Rs.1,450 (Unfavorable)

labor rate per

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) = Rs.400 (A) = Rs.300 (A) Unskilled (8,000 8,800) x 0.50 Semi-skilled (4,000 4,400) x 0.75 Verification: i. ii. Labor cost variance = Labor rate variance + Labor efficiency variance Labor efficiency variance = Labor mix variance + Labor yield variance 2,150(A) = 1,750(A) + 400(A) 400(A) = 1,050(F) + 1,450(A)

Total efficiency sub-variance = Rs.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 Standard Variance (8000*1.70) Variable Overhead Variance = 14250 13,600 13600-14250 = 650 (A)

146

ILLUSTRATION 6.7: From the following data, calculate overhead variance: Budgeted Output Number of working Days Fixed Overhead Variable Overheads 15000 Units 25 Rs 30,000 Rs 45,000 27 Rs 30,500 Rs 47,000 Actual 16,000 units

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 147

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 Production increased due to increase in capacity Production increased due to 2 more working days = 15,000 Units = 810 units = 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, storekeepers, 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 VicePresident 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 incharge 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 fulltime 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 Sales units 70,000 80,000 1,50,000 Budgeted price 55 40 Sales Total

A B Total

38,50,000 32,00,000 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 Budgeted sales (in units) 70,000 B 80,000 30,000 1,10,000 20,000 90,000

Add: Desired closing finished goods 20,000 inventory 90,000 Less: Beginning finished goods inventory Budgeted Production requirement 40,000 50,000

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 A Budgeted production Direct labor hours/unit Total direct labor hrs. Direct labor cost/hour Total direct labor cost 50,000 3 1,50,000 Rs.5 7,50,000 B 90,000 2 1,80,000 Rs.5 9,00,000 3,30,000 Rs.5 16,50,000 Total

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 Add: Budgeted closing direct materials inventory Total requirements Less: Beginning direct materials inventory Purchase of direct materials Cost per kg Cost of purchase

2,50,000 50,000

7,20,000 75,000

3,00,000 70,000 2,30,000 x Rs.1.00 Rs.2,30,000

7,95,000 1,00,000 6,95,000 x Rs.1.50 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 Labor hour hours (Rs.) 164

A. Variable factory overhead: Supplies Repairs Indirect labor Others Total variable factory overhead cost B. Fixed factory overhead cost: Supervision Depreciation Property tax Others Total fixed factory overhead cost Total factory overhead cost 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 Product A 50,000 kg x Rs.1.00 per kg Product B 75,000 kg x Rs.1.50 per kg Finished goods inventory Product A 20,000 units x Rs.35.00* Product B 30,000 units x Rs.32.00* 7,00,000 9,60,000 16,60,00 0 165 Rs. 50,000 1,12,500 1,62,500 3,30,000 3,30,000 3,30,000 3,30,000 0.7 0.3 0.7 0.25 2,31,000 99,000 2,31,000 82,500 6,43,500

3,00,000 3,50,000 1,50,000 2,06,500 10,06,500 16,50,000

* Manufacturing in Table.7)

cost Table 7

per

finished

unit

(calculated

Direct material Direct labor Factory overhead Total manufacturing cost per finished unit 5) Budgeting Cash

Quantity required kgs/hrs 5 3 3

Product A Product B Unit Product Quantity Cost Rs. unit required cost Rs. kgs/hrs 1 5 8 5 15 2 5 15 2 35

Unit Cost Rs. 1.5 5 5

Product unit cost Rs. 12 10 10 32

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 previous years sales) Investment income Total cash available for use (50% of 32,50,000 0 166 67,75,000 69,75,000

Less: Expenditures: Cash Purchases Labor and Factory Overheads Administrative and Selling Expenses Total cash to be used Net cash available

12,72,500 33,00,000 14,00,000 59,72,500 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, coordination 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. 167

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.

168

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 Administrative salaries Fixed Cost (Rs.) 35,000 Visit Variable Cost per Student 8.00 2.50 5.00 1.00

Medical and nursing 80,000 salaries Other Salaries Medical supplies 28,000 6,000

External laboratory fees and other medical fees Building lease Utilities Maintenance 18,000 6,500 20,000 169

.50 1.50

Cost Computer services Employee benefits

Fixed Cost (Rs.) 12,000

Visit Variable Cost per Student .75 1.75

fringe 34,500

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 Cost Fixed Variable Fixed Variable Rs. Rs. Rs. Rs. Administrative salaries 35,000 35,000 Medical and nursing 80,000 96,000 80,000 128,000 salaries Other salaries 28,000 30,000 28,000 40,000 Medical supplies 6,000 60,000 6,000 80,000 External laboratory fees 12,000 16,000 and other medical fees Building lease 18,000 18,000 Utilities 6,500 6,000 6,500 8,000 Maintenance 20,000 18,000 20,000 24,000 Computer services 12,000 9,000 12,000 12,000 Employee fringe benefits 34,500 21,000 34,500 28,000 Total 2,40,000 2,52,000 2,40,000 3,36,000

20,000 Fixed Rs. 35,000 80,000 28,000 6,000 18,000 6,500 20,000 12,000 34,500 2,40,000

Variable Rs. 160,000 50,000 100,000 20,000 10,000 30,000 15,000 35,000 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. 170

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 1,76,000 Therefore, fixed cost = = = Fixed Cost + Variable Cost Fixed Cost + (12,000 x 8) 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 Cost For the Fiscal Year 2000-01 Budget for Actual 18,500 Cost Students* 171 Variance (Favorable) Unfavorable

Administrative salaries 35,000 Medical and nursing salaries 228,000 Other salaries 74,250 Medical supplies 98,500 External laboratory fees and 18,500 other medical fees Building lease 18,000 Utilities 15,750 Maintenance 47,750 Computer services 25,875 Employee fringe benefits 66,875 Total 6,28,500 *Actual activity level = 18,500 student visits.

37,000 236,900 67,000 96,000 21,250 18,000 19,250 39,250 21,375 69,975 6,26,000

2,000 8,900 -7,250 -2,500 2,750 3,500 -8,500 -4,500 3,100 -2,500

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. 172

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

173

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?

175

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 176

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

177

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: 178

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 toand 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 179

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

181

Target costing builds upon a design-to-cost (DTC) approach with the focus on marketdriven 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 welldefined 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 183

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: 184

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. Costbased 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 valueadded 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 186

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 : 187

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 : 188

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 189

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 190

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) (b) (c) (d) (e) (f) Exact function of the item must be identified & its significance evaluated. Cost-benefit analysis of the item must be carried out. The aspect of standardization should be seriously looked into. Economics of labour etc. should also be measured. Redesigning may be adopted if it results in lower costs. Combination of activities, items or segregation should also be considered to reduce costs of incentives etc.

191

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. 192

(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

193

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)

194

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,

195

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

196