COST MANAGEMENT

Unit-I
Introduction to Cost Management- Cost Accounting to Cost Management-Cost
Management Tools- A Strategic View to Cost Management.

Unit II
Overheads, Classification and Collection, Difference between Cost Allocation
and CostApportionment, ( Full fledged Problems on Primary and secondary
distribution,Simultaneous equations, Absorption of Overhead, Theory on
Under and Over absorption ofOverhead

Unit III
Marginal Costing – Nature and Scope- Applications-Break even charts and
Point, Decision Making (all types with full problems)Differential Cost
Analysis, Advantages and Disadvantages of Marginal Costing.

Module IV
Budgetary Control: - Objectives of Budgetary control, Functional Budgets,
Master Budgets, Key Factor Problems on Production Budgets and Flexible
Budgets.
Standard Costing :- Comparison with Budgetary control, analysis of Variances,
Simple Problems on Material and Labour variances only .

Unit V
Demerits of Traditional Costing, Activity Based Costing, Cost Drivers, Cost
Analysis UnderABC ( Unit level, Batch Level and Product Sustaining
Activities), Benefits and weaknesses of ABC, Simple Problems under ABC.
Unit VI
Cost Audit,-objectives,, Advantages, Areas and Scope of Cost Audit , Cost
Audit in India --Practical—Read the contents of the report of Cost Audit and
the annexure to the Cost Auditreport. Management Audit- Aims and the
objectives, Scope of Management Audit.Reporting to Management – Purpose
of reporting-Requisites of a good report,,Classifications of Report,Segment
reporting, Applicability of Accounting Standard 17, Objectives, Users of
Segment reporting.Cost Reduction, and Cost Control, Target Costing – its
Principles, Balanced Scorecard asa performance measure- Features- Purpose,
Reasons for use of balanced scorecard.

1
2
 MODULE 1

AN INTRODUCTION TO COST MANAGEMENT

LEARNING OBJECTIVES:-

After studying this module the students should get an insight into the world of Cost
Accounting, Cost Management, and have a clear idea of the new businessenvironment.
He would also understand as to how Cost Management can assist the business in the
application of the new Management techniques. It would also provide an insight into
the Cost Management tools.

Cost is defined as the amount of expenditure whether actual or notional incurred on or

attributable to a given thing or to ascertain the cost of a given thing. Then first part of the
sentence speaks of cost as the objective or the end product which finally results from a
process of costing and the second part as the process itself i.e the ascertainment of cost.

Costing refers to the techniques and processes of ascertaining cost, the methods used and
the actual process of cost finding. The technique of costing involves two fundamental steps
namely :-

a) Collection and Classification of expenditure according to the cost elements and,

b) Allocation and Apportionment of the expenditure to the cost centres or cost units.

Cost accounting is defined as the process of accounting for costs from the point at which
the expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centres and cost units.
Cost accountancy is defined as : the application of Costing and Cost Accounting
principles, methods and techniques to the science, art and practice of cost control and the
ascertainment of the purpose of managerial decision making.

Elements of Cost :-

Basically a manufacturing concern is concerned with the conversion of raw materials into
finished stock with the use of labour and other expenses for various services. To calculate
the cost we require to collect all the costs as per its elements and classify them so that the
final cost is arrived at. The break up of the cost is essential for the purpose of accounting
and control of the cost.

The elements of cost are composed of Material Cost ( commodities which make up
the product), Labour cost or wages for converting the materials including its remuneration
like salary commission, bonus etc and the Expenses i.e the cost of services provided to the
firm and the notional cost of the use of the owned assets. Each of these may be further
divided into Direct and Indirect for various purposes like allocation and apportionment of
cost on some basis. The Direct Material, Direct Labour and Direct expenses are costs

3
traceable to Cost centres whereas the indirect ones are not so easily traceable in a direct
manner.

Cost Centre is defined as a location , person or item of equipment ( or group of these) for
which cost may be ascertained and used for the purpose of cost control. Cost Centres may
be of two types:-

1. Personal cost centres

2. Impersonal cost centres.
A Personal cost centre consists of a person or a group of persons for which cost
may be ascertained. An Impersonal cost centre consists of a location or item of equipment
or group of these for which cost may be collected for the purpose for control.

In a manufacturing concern cost centres may follow a pattern or layout of departments

or sections of the factory and may thus be classified as :- Production Cost Centres and
Service Cost Centres.

A Production Cost centre consists of centres which are connected to Production

activities, where Raw materials are handled and converted to finished products for final
sale. These may be Welding shops, Machine shops etc.

Servive Cost Centres render ancillary function to production centres. Here only Indirect
costs are incurred. These include Power house, Internal transport, Canteen, Plant
Maintenance etc.

We may also have cost centres classified into Operation Cost Centre and Process
Cost Centre. Operations Cost Centre consist of those machines and persons who carry out
similar operations whereas Process Cost Centres consist of those engaged on a specific
process or a continuous sequence of Operations. In an operation cost centre all machines or
all operatives performing the same operation are brought together under one centre, the
purpose being to ascertain the cost of each operation irrespective of its location inside the
premisis.

Cost unit is a device for the purpose of breaking up or separating costs into smaller sub
divisions attributable to products or services. It is the uit quantity of product , service or
time or a combination of these in relation to which the costs may be ascertained or
expressed. The commonly used cost units are number of items, length by metre or
kilometers, tones, litres, cubic metre, Kilo watt hour, Tonne kilometer, passenger kilometer
etc.

CLASSIFICATION OF COSTS:-

Classification of Costs means the grouping of costs according to certain elements so that all
the items having similar features get similar treatment. It may be done under various basis.
The following are various classifications of costs.

1. Classification of Cost methods on the basis of nature of production.

4
 a) Job costing : This method is suitable when it is required to find out the cost of a
job or a specific order or a batch of finished products. Here the cost unit can be
taken as a unit of product or a batch of products or a specific order or contract.
The other variations of job costing are Batch costing, Terminal or Contract
costing and Multiple costing.
b) Process Costing :-This is employed in industries where a continuous process of
manufacturing is carried out. The ascertainment of cost is for a specific period
of time for each process. The undertakings which use this type of costing are
Chemical industries, refineries, Gas and Electricity Generation undertakings. The
other variations are Operation costing, Single or output costing, operating
costing etc.
2. Classification of costs on the basis of time:-
a) Historical Costs:- These are also called as Post mortem costs as the costs have
been incurred in the past and they represent the cost of actual operational
performance. Here it is used to compare the expected with the incurred costs.
b) Predetermined costs:- These costs are future costs which are computed in
advance
3. Classification of Costs based on Cost for Managerial Decision making: The
costs may be classified as follows:-
a) Marginal costing:- Marginal cost is the aggregate of variable costs i.e Prime
Costs Plus Variable Overhead. The system of Marginal costing is based on the
segregation of costs into Fixed and variable costs wherein fixed costs are
excluded from decision making and treated as period costs and only variable
costs are considered for decision making purposes, determination of cost of
products and the inventory of work in progress and the completed goods.
b) Out of Pocket Costs:- These include those costs which require the payment of
cash to other parties as against of those costs which do not require any cash
outlay like depreciation or allocation of other costs.
c) Differential Costs or Incremental costs:- These are the added costs which are
incurred when a particular project is taken on hand or additional products are
manufactured. Also if we have a change in the pattern of production the resulting
change in the total costs as a result of such a change in pattern is taken as
differential costs. If we have an increase in cost it is called as Incremental cost
and if there is a decrease in costs it is called as Decremental Costs.
d) Uniform Costing:- The term uniform costing is used for a common set of
principles and procedures which are used in common by most undertakings so
that the benefits of inter firm comparison is taken for better management.
e) Opportunity costs:- These refer to costs which result from the use or
application of money or facilities in a particular manner which has been left out
in favour of another facility or for an alternative use or the advantage or benefits
from a particular use are foregone for another use which has not been planned
earlier. It can also be spoken off as the cost of the next best alternative foregone.
If a particular input is used in an alternative usage which has not been planned
earlier involving additional costs then it is called as the opportunity costs.

5
 f) Replacement cost :- This is the current market cost/ prce of an item if it has to
be replaced.
g) Imputed cost :- These are hypothetical costs or notional cost of some items
which may not involve cash outlay used purely for decision making purposes.
Example may be the interest on funds provided by the director in an emergency
for use in an organization/ firm or use of facilities not owned by the firm
provided by somebody else.
h) Sunk costs:- These are historical costs of an item of an expenditure or asset
which is purchased in the past and is not relevant for a particular decision
making problem as of now. Example while replacing old plant and machinery
the amount of depreciation charged on such an asset is of no use or is irrelevant
as the amount is sunk cost.
i) Relevant costs:- These are costs which are relevant for a decision making
situation. This is because such costs which have no bearing on the decision
would be irrelevant.Example : Fixed costs become irrelevant in Marginal costing
and differential cost analysis. All this becomes important in certain times only
based on the situation.
4. Classification of cost according to functions:- A firm performs many types of
functions like Manufacturing, Administrative, Selling, Distribution, Preproduction
costs, and Research and Development etc as various activities. For each of these we
may have various types of expenses which can be grouped according to the
functions.
5. Classification of cost according to their variability in relation to output:-
a) Fixed costs :- These are costs which tend to be constant at all the levels of
production.. They do not increase or decrease with changes in output. The per
unit cost will change with output.
b) Variable costs :- These costs tend to vary with production, the more we produce
the more the cost and vice versa. However the per unit cost will remain same at
all levels of production.
c) Semi variable cost or semi fixed costs:- These are costs which are partly fixed
and partly variable in relation to output. In these cases the fixed element is fixed
for a particular level of output and then changes or increases. These also remain
fixed upto a level of output and further changes for a higher level of usage.
Example : Electricity bill.
6. Classification of cost according to controllability:-
a) Controllable Costs:- These are those costs which can be influenced by the
action of a specified person of an undertaking. Such a person may be a part of a
responsibility centre. Direct costs like Direct Material, Direct labour and Direct
expenses can be controlled at the shop floor level management.
b) Uncontrollable Costs are the costswhich cannot be influenced by the action of a
certain person at an organization level, that means these can be controlled only at
a very high level of the management hierarchy. That means to say that no cost is
uncontrollable, it is the level of the management hierarchy which determines
whether a certain cost at a certain level is controllable or not.
7. Other types of cost :-
6
 a) Conversion cost:- these are the costs which are incurred in converting the basic
material into finished product including all the cost of labour, expenses and other
material involved in it.
b) Common costs:- These are those costs which are incurred collectively for a
number of Cost Centres which will get suitably allocated and appropriated for
cost collection purposes.
c) Traceable costs:- These are those costs which can be identified to a particular
cost centre, or product or process.
d) Joint costs:- These are the common costs which exist when different goods are
produced out of a common material or process. The cost may be further divided
based on some basis to different products and the importance of the products.
e) Normal cost :- These are the costs which are normally incurred at a given level
of output under normal conditions of work.
f) Total cost :- This is the sum total of all the costs which may be attributed to a
cost centre, or product or a process or a batch of items..

Cost management:-
Cost management is a system that establishes linkages between costs and revenues and
relates them with the product to maximize the firm’s profits. It can also be defined as a set
of cost management techniques that function together to support the organization’s goals
and the objectives. Basically an effective cost management system must provide managers
the information to achieve short term profitability and also to look at the long term
objectives so that the competitive edge of the management is not lost.

The basic objective of the system of cost management is optimal utilization of

resources to enhance the operating income of the business firm. It does not focus on costs
independent of revenue not considers product attributes as is given. It is wholesome control
process.

Cost Management has come a long way from the times of basic accounting for
costs. Over the years with global competition, LPG, fully automated machine operations and
the system of outsourcing of functions to cheaper destinations it has become imperative that
the management focus has changed from just production or servicing to cost effective
production and servicing. The Focus has shifted now from just product costing to
OPERATIONAL AND STRATEGIC DECISIONS. To undertake this we will have to focus
on the best management and business practices. The coming in of systems of Enterprise
Resource Planning, Total Quality Management , Strategic Management etc have given way
to a new direction in which the management now plays its cards. The historical bias towards
product costs have given way to a new dimension in planning.

The goals of Cost Management can be summarized as follows:-

7
 1. Develop a system such that the product cost/service costs can be accurately
calculated.
2. Assess the overall performance of a product for its life cycle.
3. Find out the process of linking the various activities so that they can be improved
upon.
4. Control the costs at every stage as much as possible.
5. Performance evaluation and measurement have to be introduced to control the costs.
6. See these and other activities are linked to the basic management objectives.
7. Measure the variances from the actually planned goals.
8. Reset the activities towards the organizational goals.

The emphasis has shifted from cost accounting to cost management. It is not just the
preparation of cost statements, budgeting, standard costing, Inventory control measures and
financial reporting measures. The focus has shifted to Strategic and Operational decisions so
that the business success is focused upon. The emphasis has shifted from historical costs to
customer driven costs and that too at a very well controlled atmosphere. The final analysis is
to be on the customer value creation and what it has done to the business and at what costs.
The costs should not happen on its own but should be a function of management decisions.

Managers now a days have to operate in a very dynamic environment that requires
the modern day business to closely link technology available to the very cut throat
competitive environment and the expected behavioral changes of the customer. The clear
example of how Samsung Electronics edged out Nokia and I Phone from the market with
customer friendly and user driven products. Even the Blackberry was driven to wilderness.
These were considered as the best in the market. Samsung Galaxy drove the market crazy
but the strategy was not Price reduction but the supply of the product which the customer
wanted and did not know that he wanted and also showing this is the best that money could
buy.

Cost Management is broad in its focus. It includes reduction of cost continuously.

Continuous improvement in performance is considered as one of the key success factors in a
competitive environment. Cost Management is linked with Revenue and profit planning.
Sometimes additional costs are incurred toenhance revenue earning like additional
expenditure on advertisement, Sales Promotion, product diversification and modification
etc.

Cost Management cannot be undertaken in isolation. It has to be built in the system

and should be an integral part of the general management strategy and its implementation.
Under strategic cost Management we also use many tools like Activity based costing, value
analysis, target costing etc.

Contemporary business environment has focused on the:- 1. Technological changes. 2.

Globalisation. 3. Giving the highest importance to the service sector. 4. Customer focus.

8
 COST MANAGEMENT TOOLS ( Strategic view )

With the focus on cost reduction for various functions the management looks to various
tools for managing cost control in the new challenging business environment. The emphasis
is on serving the customer needs with different tools used to achieve the same goals. The
following are the various tools used :-

1. Activity based costing and Activity based management.

2. Benchmarking.
3. Just in time techniques used for costing.
4. Economic value addition.
5. Target Costing.
6. Balanced Score Card.
7. Strategic cost management
8. Value analysis and strategic positional analysis.
9. Managing the capacity costs using the flexible budget technique.
10. Using cost conformance techniques with the cost of quality ( when new products are
introduced we may have to take into account appraisal and prevention costs and in
case some failure happens conformance with standards will have to be maintained.
Ex : Toyota recalled many cars of its cars globally which had a problem to set it
right)

9
 Module 2
Overhead Accounting
Introduction
Expenses are classified as direct expenses and indirect expenses. Direct expenses include
material, labour and wages whereas indirect expenses or overhead expense refers to an
ongoing expense of running a business and it is also known as "Operating expense". For
example rent, gas, electricity, advertisement, warehouse expenses, stationery indirect wages
etc.

The term overhead is usually used when grouping expenses that are necessary to continue
functioning of the business but cannot be immediately related with the products or services
being offered. There are different types of overheads based on functions like Factory or
manufacturing Overheads, Office and Administration overheads, Selling and Distribution
overheads, Research and Development overheads. All indirect costs are called overheads.
These costs cannot be easily charged or identified with a particular cost centre or cost unit.
Thus, as overheads are not easily identifiable or chargeable with the end product they are
charged to the various production departments on some suitable basis to arrive at the total
cost incurred by each department.

Definition of Overheads

The Chartered Institute of Management Accountants (CIMA) defines overhead cost as “the
total cost of indirect materials, indirect labour and indirect expenses. In short, it is the cost
of materials, labour and expenses that cannot be economically identified with specific
saleable cost unit.

AccordingtoInstitute of Certified Management Accountants (I.C.M.A), indirect cost as

“expenditure on labour, material, services which cannot be economically identified with a
specific saleable cost per unit. Overhead costs are known as supplementary cost , Indirect
cost, on cost etc.

According to Wheldon “Overheads may be defined as the cost of indirect materials, indirect
labor and such other expenses, including services which cannot conveniently be charged
direct to specific cost units. Alternatively, overheads are all expenses other than direct
expenses.”

Blocker and Weltmer defined “Overhead costs as the operating costs of a business
enterprise which cannot be traced directly to a particular unit of output”.

Overhead Accounting
The important steps involved in accountingof overheads is as follows:-
1. Classification or Codification of Overheads
2. Collection of Overheads
10
 3. Allocation &Apportionment of Overheads
4. Re-Apportionment of Service Departments costs to Production
Departments
5. Absorption of Overheads.

Classification or Codification of Overheads

CIMA defines classification as “the arrangement of items in logical groups having regard to
their nature (subjective classification) or the purpose to be fulfilled (objective
classification)”.

Classification is the process of arranging the items into groups according to their degree of
similarity. Accurate classification of all items is a prerequisite to any form of cost analysis
and control system. The classification system must meet the objective of all the systems
which may use the classification. Overhead cost can be classified into three categories
namely Based on Functions, Based on Elements of cost, and On the basis of Behaviour

Under functional classification overheads can be grouped into Factory Overheads,

Administration Overheads, Selling Overheads and Distribution Overheads.

Element-wise classification overheads can be classified as indirect materials, indirect

labour and other indirect expenses.

On the basis of Behaviour expenses are grouped as Fixed expenses, Variable expenses and
Semi-Variable expenses.

Collection of Overheads
Overhead collection is the process of recording each item of costs in the records maintained
for the purpose of ascertainment of cost of each cost centre. For collection of overhead
expenses, the following are some of the documents maintained.

Stores requisition-
Different cost centres will procure their requirements of indirect materials from stores by
submitting the stores requisition notes which indicates the Standing instruction, Requisition
number, Quantity of materials and the departments to which indirect materials are issued
from the stores. A material issue analysis sheet is also prepared at the end of every month
and the total indirect materials issued from the stores are debited to Production Overhead
Control Account and credited to Stores Ledger Control Account .

Wages sheet

11
 The wages and incentives paid to indirect labour are recorded in the time cards and job card
along with the standing order number of each cost centres .Wage Analysis is prepared at the
end of every month from the entries recorded in the time cards and job cards and the total is
debited to Factory Overhead Account and credited to the Wages Control Account.

Cash book

The indirect expenses incurred will be entered in cash book and will be scrutinized on
monthly basis and collected according to month-wise standing order numbers, department
wise and debited to respective control accounts like Stores Ledger Control Account, Wages
Control Account, Cost Control Account and General Ledger Adjustment Account.

Invoice or purchase voucher

Payments to the outside parties for the stores or other services are made on the basis of
vouchers or invoice which are entered in the Purchase Journal maintained for the purpose of
cash payment. At the end of period the total of the Purchase Journal is debited to the
Production Overhead Account and corresponding credit is given to the General Ledger
Adjustment Account.

Subsidiary records
There are many items of overheads which do not result in immediate cash outflow and
requires some adjustment in relation to accrued expenses, for example, Depreciation,
Accrued Insurance, Outstanding Expenses, Notional rent, Interest on Capital etc. such items
are recorded periodically in Subsidiary Records like Plant register and all such records will
help in accumulating of production overheads which are reported information in various
reports of the organization. In other words, we can say that cost is ascertained from
materials requisition invoices, materials abstract, payroll, overtime vouchers, miscellaneous
vouchers of payment of wages, journal for depreciation and bad debts. Some of the
overheads expenses are collected from the Journal Book.

Meaning of Allocation of overheads

Allocation is defined as “assigning a whole item of cost directly to a cost centre” – CAS- 3
of the Institute of Cost Accountants of India (ICAI)previously known as the Institute of
Cost & Works Accountants of India (ICWAI). Cost allocation is a process of charging an
entire item of cost directly to a cost centre. An expense which can be identified with a
specific or particular cost centre is allocated to that centre. Allocation is possible only when
amount of overheads incurred in a cost centre is exactly known.

12
For example Power used by different department can exactly be allocated to a particular
department if sub-meters are installed in each department. Similarly, wages paid to
workers working in production department named refining department can be directly
charged or allocated to that department only. Thus, the term allocation means allotment of
entire cost without any division to a particular department or cost centre.In simple words, if
overhead cost is incurred by a particular cost centre and the exact amount is known then it
can be easily allocated to that department.

Meaning of Apportionment of Overheads

Apportionment of overheads means division or distribution of overheads to various
departments on some suitable basis. Thus, Apportionment may be defined as “the
distribution of overheads to more than one cost centre, on some equitable basis. When an
item of overhead cost is common to various cost centres, it is allotted to different cost
centres proportionately. For example, fire Insurance, employee welfare expenses, canteen
expenses, depreciation of machine which are common to different department are
apportioned on justifiable basis like floor area, number of employees and values of machine.
Under apportionment the cost Centre enjoys a proportion of the benefit of the whole
expenses.

Differences between Allocation & Apportionment of overheads:

1 Allocation means the allotment of whole items of cost to a cost centre whereas
apportionment means allotment of proportionate of item of cost to cost centre.

2. It deals with the entire cost incurred whereas apportionment deals only with proportionate
of cost incurred.

3. Cost is directly identified to cost centre while apportionment is indirect process of

division of cost to cost centres on some suitable basis.

4. In allocation entire benefit of cost is allocated to a cost centre whereas in apportionment

only a proportion of the benefits of whole expenses is charged to the cost centre.

Types of Departments

Production Department
Production Department is one that is engaged in the actual manufacture of product by
converting the raw materials or by assembling the parts into finished products. The
13
 number of production department depends upon the type of industry, size of the
enterprise, number of processes into converting raw materials to finished products.

For example: In a textile industry –weaving department, spinning department dyeing

department, finishing department are the producing department.

In a oil refinery company-crushing department, refining department and finishing

department are production departments.

In a Steel Industry -Steel Rolling Mill, Hot Mill, Cold Mill, Annealing shop Hardening
Polishing and Grinding are the producing departments.

Service Department
A service department, on the other hand, is one which is rendering service to production
departments. It contributes indirectly in converting the raw materials into finished
products. They are secondary to the main production process and enable smooth and
efficient running of the production department. Service departments are common to
most of the organizations like purchasing department, stores department, time keeping
department, personnel department, inspection department, canteen department, labor
welfare department, internal transport department, accounting department, Boiler House,
maintenance department etc.

Basis of Apportionment

The following table shows suitable bases of Apportionment

Name of the overhead cost Bases of apportionment
1. i) Building tax
ii) Lighting and heating Floor area
iii) Fire Insurance
iv) Air Conditioning
2. i) Fringe benefits
ii) Labor welfare expenses
iii) Time keeping Numbers of workers
iv) Personnel office
v) Supervision
3. i) Compensation to workers
ii) Holiday pay Direct wages
iii) ESI and PF contribution
4. General Overhead Direct labour hours, or direct wages, or
machine hours
5. i) Depreciation of plant and
machinery
ii) Repairs and maintenance of Capital values
plants and machinery
14
 iii) Insurance of stock
6. i) Power/steam consumption
ii) Internal transport
iii) Managerial salaries
7. Lighting expenses
8. Electric power
9. Material handling&
overhead
Technical estimates
No. of light points, or floor area
Horse power of machines, or number of
machine hours, or value of machines
stores Weight of materials, or Quantity of
materials, or value of materials.

Re-Apportionment of Service Departments Costs to Production

Departments
After the overheads have been allocated and apportioned to production and service
departments and added up to arrive at the total cost which is called total overheads as per
primary Distribution of overheads. The next step is tore-apportion the entire service
department’s costs to production departments. The costs of service department must be
transferred to productiondepartments so that becomes part of cost per unit of the product
manufactured. This process of re-apportionment of service department’sexpenses to
production department is known as Secondary Distribution.

The following table shows the bases of apportionment generally used for service
department.

Service department Bases of apportionment

Store-keeping departments Number of material requisition or value/
quantity of materials consumed in each
departments
Purchase departments Value of materials purchased for each
department, or number of purchase orders
placed.
Time keeping departments and payroll Number of employees, or total labour or
department machine hours
Personnel departments Rate of labour turnover, or total number of
employees in each department
Canteen, welfare and recreation departments Number of employees, or total wages.
Maintenance departments Number of hours worked in each department
Internal transport departments value or weigh of goods transported, or
distanced covered
Inspection departments Direct labour hours or machine operating
hours
Drawing office No. of drawings made or man hours worked

Methods of Re-apportionment or Re-Distribution

15
There two methods secondary distribution or Re-apportionment, they are

i) Repeated Distribution Method

ii) Simultaneous Equation Method

Repeated Distribution Method

This is one of the easiest methods of reapportioning service department expenses to
production expenses. Under this method the first service department cost as per the primary
distribution is apportioned according to the ratios or percentages given. Similarly, the
second service department cost plus proportionate sumreceived from first service
department is apportioned according to percentages given. After this, once again the first
service department cost is apportioned for the proportionate sum received from second
service department. This process is repeated till the total costs of service departments
become less and less with each phase of apportionment. The process comes to an end when
the service costs is exhausted or a small amount of the sum becomes negligible which can
be transferred to any of the production departments and rounded-off. The following
illustration No.4 explains its application as below.

Simultaneous Equation Method or Algebraic Method

This method is most widely used. Under this method the total cost of service department to
apportioned is calculated with the help of Simultaneous equations. Once the total cost to be
apportioned to production department is known it is apportioned based on the percentages
given. The following illustration No.5 explains its application as below
Absorption of Overheads
Meaning of Absorption
After accounting for overheads the next step is the recovery of cost from cost of production.
The allotment of overhead expenses to the cost centres or cost units is known as overhead
absorption or recovery of overheads.Absorption means the distribution of overhead
expenses allotted to a particular department over the units produced in the department.
Therefore, it is necessary to charge each unit of production with its share of overhead
expenses to determine the cost of per unit of product. Thus, the charge made to each job,
order, process, unit or product to recover indirect cost is known as absorption of overhead.
Absorption of overheads is possible with overhead rates Absorption of overheads is also
known as recovery, overhead costing, and levy and burden rate.

Definition
The Institute of cost and Management Accountant ( U.K) defines overhead absorption as
“the allotment of overhead to cost units”

16
Types of Overhead
Overhead absorption rates are generally calculated by dividing the total amount of overhead
expenses by the total output of products, or direct labor hours, or machine hours worked in
the plant. Thus, the overhead absorption rates to be absorbed to each unit of product, job, or
a particularproduction process can be calculated as below:

1 Actual overhead rate:

This rate is calculated by dividing the overhead expenses incurred during a particular period
quantity or value of the product.

Overhead rate = Total Overhead expenses

Output in units

2 Per Determined rate

This is determined in advance of the actual production and is computed by dividing the
budgeted overhead expenses for the accounting period by the budgeted base for the period
The formula is
Overhead rate = Budgeted overhead expenses for the period
Budgeted base of the period

3 Blanket or Single Overhead rate:

When a single overhead rate is computed for the factory as whole is known as single or
blanket or plant wide rate. It is calculated as under:

Blanket rate = Overhead cost for the entire factory

Total quantum of the base selected

Methods of Absorption of manufacturing Overhead

The following are the commonly used methods of Absorption

i) Direct Materials Cost Method OR Percentage on Direct Materials

Under this method percentage of factory expenses to cost of direct materials
consumed in production is calculated to absorb manufacturing overheads. The
formula to compute the rate is :-
Overhead Rate= Factory Overhead Expenses (estimate)
Anticipated Direct Material Cost X 100

For example in a factory the anticipated cost of direct material is 2, 00,000 and the
production overhead budgeted expenses are Rs. 40 000
Then, the overhead rate will be 20% i.e. 40,000/2, 00,000) x 100.

17
 ii) Direct labour or Wages Cost method OR Percentage on Direct Wages
The overhead rate is calculated as under

Overhead Rate= Factory Overhead Expenses

Direct Wages x 100
For example, if Factory Overhead Expensesis 1,50,000 and the Direct
Wages is Rs. 2,50,000
Then, the overhead rate will be 60% i.e. 1, 50,000/2, 50,000) x 100.

iii) Prime Cost Method OR Prime Cost Percentage

Under this method the recovery rate is calculated by dividing the budgeted Factory
overhead expenses by prime cost. (Prime cost is the sum of Direct materials +Direct
wages+ Direct expenses)
The formula is:
Overhead recovery rate =Factory Overhead Expenses
Prime Cost x 100

For example, if Factory overheads is 3,50,000 and Prime Cost is 7,00,000 then the
recovery rate is 50% i.e., 3,50,000/7,00,000x100

iv) Direct Labor Hour method OR Percentage of Direct Labor Hours

Here the rate is obtained by dividing the Factory overhead expenses by the total
Direct Labor Hours worked The formula is-

Overhead Rate = Factoryoverhead expenses

Direct Labor Hours X 100

For example, if Factory overheads is 3,50,000 and Direct Labor Hours is 800 then
the recovery rate is 437.5% i.e., 3,50,000/800x100

v) Machine Hour rate Method

By Machine Hour rate Method, manufacturing overhead expenses are charged to production
on the basis of number of hours machines are used on jobs or work orders.The Formula is-

Overhead Rate =Factory Overhead expenses

Machine Hours Worked X 100

Meaning of Under-absorption of overheads

Under-absorption of overheads means that the amount of overheads absorbed in the
production is less than the amount of actual overheads incurred.It represents under stating

18
the costs as the overheads incurred are not fully recovered in the cost of the product. Under-
absorption is also termed as 'Under- recovery',

For example, if the overheads absorbed on a predetermined basis are Rs: 80,000 and the
actual overheads incurred are 90,000, thenthere is under-absorption of Rs.10, 000.Itmeans
that the overheads amounting to Rs 10,000 is not reflected in the product.

Meaning of Over-absorption of Overheads

Over-absorption of overheads means the excess recovery compared to the actual overhead
incurred i.e., when the amount absorbed is more than the actual expenditure incurred it
would mean over-absorption of overheads. Over-absorption increases the cost of production
Over- absorption is also known as 'over recovery'.

For example, the overheads recovered are Rs.2, 00,000 and the actual production overheads
is only are Rs.1, 60,000, then there will be over-absorption of Rs.40, 000. ( Rs.2, 00,000 -
Rs.1, 60,000).

Reasons of Under / Over-absorption of overheads

The under or over-absorption of overheads may arise due the following reasons:

(i) Wrong estimation of overhead expenses: The actual overhead expenses may be
less or more than the budgeted amount.
i) The method of absorption may not be suitable or changes in the price of raw
materials , direct wages, excess machine hours worked due to seasonal
Fluctuations may lead to under or over-absorption of overheads.
ii) There may be under or over-absorption of overhead due to under or over
utilisation of plant capacity.
iii) Wrong estimation of output: When the actual output substantially differs from
the anticipated output, it leads to under or over-absorption of overheads.

19
 MODULE 3

MARGINAL COSTING.
MARGINAL COSTING AND DIFFERENTIAL COSTS

We very well know that Fixed Costs and Variable Costs behave differently with the changes in
the output. The more we produce the less is the effect of Fixed cost per unit and vice versa.
Similarly theper unit variable cost remains the same irrespective of the output but the total
changes with the output. Also the fixed cost tends to vary with time as against the variable costs
whichchanges with the output. Because of the inclusion of Fixed cost in determining the total
costs the cost per unit of a product or a process varies from period to period with the changes in
the output of products.

There is a school of thought which feels that why at all have fixed costs in the
product cost, because, it varies so much with time. Hence, considering of variable costs only for
decision making is ideal, as it tends to remain the same at all levels of output. This willhappen
on the assumptionthat the basic input cost of Direct Materials,Direct Wages and Direct
Expensesdo not change in the period. Such a school of thoughtopines that the Fixed cost needs
to be eliminated, as, by and large it is uncontrollable at a certain level of management. Marginal
Costing has developed, because of such a school of thought which wants to eliminate the fixed
costs from the decision making process, and retain only variable costs for decision making.

Marginal Cost is defined as 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. This
is subject to the condition that the fixed cost does not change with the increase or decrease in
volume.

Marginal cost is a constant ratio which may be expressed in terms of an amount per
unit of output, whereas Fixed Costs which is not normally traceable to particular units denotes
a fixed amount of expenditure incurred during an accounting period. There for fixed costs may
also be called as Period cost, Standby cost, Capacity cost, or constant cost. Variable cost may
also be called as Marginal cost, Direct cost , Activity cost or Out of Pocket Cost.

Marginal costing is the ascertainment of marginal cost and the effect on profit of
changes in the volume or type of output by differentiating between fixed cost and Variable
Costs. It is a technique applying the existing methods in a particular manner in order to bring
out the relationship between profit and volume of output. This may be used either in Process
costing, Job Costing, or Standard Costing. Sometimes Differential Costing may also be used
more or less synonymously with Marginal Costing.

20
 Sometimes the term Direct costing is used to mean Marginal costing. The other type of
costing which includes Fixed costs in the calculation of Product costs is known as Total costing,

FEATURES OF MARGINAL COSTING:-

1. Costs are to be segregated into Fixed and Variable cost and even semi variable costs should
be segregated.
2. In computing product costs only marginal costs are taken into account. The stock of
inventory/ both finished or otherwise called as work in progress are valued at variable costs
3. Fixed costs do not find any place in stock valuation as they are treated as period costs.
4. The system of pricing is based on marginal costing principles and with marginal
contribution.
5. The system is used for Cost Reporting to the management.
6. Profitability is based on marginal costing principles whether it is for a product or for a
department.

APPLICATIONS AND MERITS OF MARGINAL COSTING:-

1. Cost Control:- Marginal costing is basically a technique of Cost analysis and

Presentation. It is the same data available in the accounts which is presented in a
particular manner to suit the requirements of the presenter so that he can show how costs
can be controlled by eliminating Fixed costs. By this the concentration is purely on those
costs which if controlled can actually reduce costs. By Contribution analysis we come to
know as to how much is contributed by each product towards the profitability of the
products/ departments/ product line.
2. Profit Planning:- It is the planning of future operations to attain the maximum profits or
to maintain a certain level of profit or operations. The ratio of marginal contribution to
sales, shows us as to how relative profitability of different areas can actually change
owing to various circumstances like sales price, variable costs or product mix.
3. Evaluation of performance:- Every business has many segments to be looked into for
various purposes such as a department, Products, a product line,sales division, profit
centre’s etc. The performance of each of these can be individually studied by marginal
costing.
4. Decision making:- The best part of Marginal costing is its utility in decision making
which helps the management in taking the right type of decision depending upon the
circumstances of its use. It may involve:-
a) Pricing decision- times wherein the management may decide to fix the price
at a lower level may be below total costs for a short term to tide over a
difficult situation. This is because in times of recession it would be better to
recover the marginal costs and not worry about fixed costs than just wait for
the recession to get over and not have any business. This is because any

21
 contribution to fixed costs gets the business a positive inflow . Reduction of
price may become essential when there is a general fall in the market price,
to maintain a the market so that the competitors do not run away with the
market, to keep machines running in difficult times so that they do not break
down if kept unused for a long period of time, to retain the surplus staff
from being retrenched or that they do not get into the competitors hands etc
b) Make or buy decision :- Marginal costing becomes very useful to decide on
certain times when the management is confronted with a problem whether
they should make the product or buy it from outside and divert the resources
to produce any other profitable product.
c) Assessment of Capital Investment Plans :- The management may be in a
fix as to decide which of the Investment plans to undertake when they have
alternate plans. The technique of marginal costing helps is taking such a
decision.
d) Optimising the product mix
e)
f) :- When a company produces a different types of products it may face
problems as to which to produce in a higher quantity and how to price them
so that they do not compete with each other. Also to maximize profits which
one to produce in what quantity and what would be the best combination of
product mix.
g) Alternative use of production facilities:- Many a times the management of
a company may face a problem of plenty when they discontinue a product
lineand may haveachoice to use the facility to produce a different type of
product or give the facility to others for a rent and earn a return. These
choices may confuse the management in taking a decision. Marginal costing
offers a solution by using the techniques in providing a decision.

Problem of the Limiting Factor:- The concept of marginal costing can be used to maximize
the profit by deciding the best combination of products so that the contribution can be optimum.
This is best achieved when all the resources are at the best of usage and that the costs are
minimized. In achieving this we have to take into account all types of costs of all the types of
resources like material of all types, labour both direct and indirect, overhead of all kinds etc. But
in real life we find that an ideal situation is never available and we always have shortages of all
kinds which may affect the production and sale of items. Markets may be a key factor, fashions
may suddenly change, a new product may be offered by the competitors, government rules may
affect the business profitability, political compulsions may affect decision making etc. These
factors which have a say in the profitability of a product are called as a limited factor or key
factor. A limiting factor also called as key factor or scarce factor is defined as the factor in the
activities of an undertaking which at a particular point of time or over a period will limit the
volume of output. On such factors the management may have no control. Hence the firm by itself

22
may have no control or feel responsible for the lack of business or profit earning. When a
limiting factor is operating the contribution of each item of a product mix per unit of the limiting
factor should be taken into consideration for determining the highest contribution which may
possibly be obtained.

Limitations of Marginal Costing:-

The technique of marginal costing has certain limitations and has to be kept in view while being
used for decision making :-

1. The cost are segregated as fixed and variable under marginal costing. Which sometimes
presents a lot of technical difficulties as no costs are completely fixed or completely
variable. The variable shifts from its linear pattern to curvilinear fashion. Hence the
changes in the volume of activity may be accompanied with changes in the variable cost
per unit.
2. Value of cost of finished products and Work in Progress are always understated this is
because the fixed cost element is not included in the cost of finished products. This is not
a correct technique as all the units must bear its own share of fixed costs.
3. Even the Balance sheet and the Profit and loss statements show incorrect valuesas the
fixed overhead is excluded from the value of inventories until the adjustments are made
to the values of inventories.
4. Marginal Costing is best useful for a short term period in finding out profitability but in
the long run all costs must be covered.
5. With the increased use of computers and automated machines the elements of fixed cost
have become more relevant. Excluding them from costing is inappropriate in the long
run.
6. Pricing decisions of eliminating the fixed costs and recovering only the variable cost is
not good always as recovering all the cost is best in the long run.
7. Marginal Costing does not give full information. Increased production and sales may be
due to extensive use of machines in overtime conditions or by the expansion of resources
or replacing the human labour by automated machines. Marginal costing does not reveal
these.
8. It does not provide any standard for measurement of performance. Sometimes the use of
budgetary control and standard costing may provide a better measuring device for the
purpose of cost control

Differential Cost ( or incremental cost ) analysis:- Differential cost is the change in the costs
which result from the adoption of an alternative course of action. These alternative course may
be of the result of change in sales volume, price, Product mix ( by increasing or decreasing the
production of products), the various methods of productions , use of techniques like make or buy

23
decisions etc. When the change of cost occurs due to change in the activity from one level to
another differential cost is referred to as incremental cost (decremental cost if a decrease in
output is being considered) i.e. total increase in cost divided by the total increase in output.
However conventionally differential cost and incremental cost are used to convey the same
meaning.

Formulas used in Marginal Costing:-

1. Sales - variable cost = Fixed Cost + Profit S-V = F + P

2. Sales – variable cost = Contribution S–V=C
3. Contribution = Fixed Cost + Profit C=F+P
4. Contribution = Sales x P/V Ratio C = S x P/V ratio
5. P V Ratio = (Sales – Variable Cost) x 100 P V Ratio = S – V x 100
Sales 100
6. P V Ratio = Contribution P V Ratio = C x 100
Sales S

7. Sales = Contribution S =C
P V Ratio P V ratio
8. Contribution = Sales x P V Ratio C = S x P V Ratio
9. P V ratio = Change in Contribution
Change in Sales
10. P V Ratio = Change in profit
Change in Sales
11. P V ratio = Profit P V ratio = Profit
Margin of safety ratio M/S Ratio
12. Variable cost = Sales x Complement ratio
Sales X ( 100 % - P V ratio % )
13. Profitability = Contribution
Key factor
14. Profit = ( Sales x P V ratio ) – Fixed cost
15. Profit = P V ratio x Margin of Safety ratio P = P/v Ratio x M o S ratio
16. B E P Sales = Fixed Cost x Sales B E P Sales = F x S
Sales – Variable cost S–V
17. B E P Sales = Fixed Cost
P V Ratio

24
 18. B E P Sales (in units ) Fixed Cost BEP = F
Contribution per unit Cont per unit
19. BEP sales ( in units) = BEP Sales or Total Cost
Selling Price per unit Selling price per unit
20. Total Sales required to earn Profit:-
Sales = Fixed Cost + Profit S= F + P
P V Ratio P V Ratio
21. Sales = Contribution S = C
P V Ratio P V Ratio
22. Sales (in units) = Fixed Cost + Profit S = F + P
Contribution per unit C ( per unit)
23. Total Sales at a point of Loss:-
Sales = Fixed Cost - Loss S= F - P
P V Ratio P V Ratio
24. Margin of Safety :- Total Sales - BEP SalesMoS = S - BEP Sales
25. Margin of safety = ProfitMoS = P
P V Ratio P V ratio
26. Margin of safety ratio:- Total sales - BEP SalesMoS = S – BeP
Total sales S

COST VOLUME PROFIT RELATIONSHIP

This is perhaps the most important relationship we can study in the case of a production cycle.
Every business basically aims at earning high profits as it is its most important objective. But
profits themselves depends upon a number of factors like the Selling Price, Cost of Production,
volume of sales Market conditions, Pricing policy of the firm etc. Most of these factors are inter
dependent, i. e, selling price depends on the cost of production of the product for obtaining the
desired profit, Volume of sales depends on the volume of production which in turn depends on
the costs, also cost by itself is dependent on a number of factors like volume of production,
product mix, internal efficiency of production, changes in the methods of production, size of the
order or batch, size of the plant, its capacity, overhead cost and its influence on production etc.
Of all these Volume is the single largest factor which influences the cost. The management has
no control on the exterior forces which influences the volume of productionas the costs do not
always vary in proportion to changes in level of output.

This draws a close relationship between Costs Volume and Profit. Analysis of this
relationship opens up a pandoras box for the management to take up various decisions like
Profit Planning, Cost Control and Decision making. The main objectives of such an analysis is
as follows :-

25
1. To forecast profits accurately it is essential to know the relationship between the profit
and cost on the one hand and volume on the other hand.
2. We know that Sales and Costs other than fixed costs tend to vary with volume of output.
When we establish budgets we need to budget Volume first. CVP analysis is very useful
in setting up flexible budget which sets up the costs at various levels of output.
3. CVP analysis is of assistance in performance evaluation for the purpose of cost control.
For reviewing profits achieved and costs incurred, the effects on costs of changes in
volume are required to be evaluated.
4. When the business is slack Pricing plays an important role in fixing the volume . Analysis
of CVP helps in formulating proper pricing policies by projecting the effect which
different price structures have on costs and profits.
5. A proper study of CVP analysis is essential to know the amount of predetermined
overhead to be charged at various levels of production.

BREAK EVEN CHART:-

A Break even chart is a graphical representation of marginal costing or CVP analysis. It is an

aspect in profit planning. It shows profits at various levels of activities. And as a result
indicates the point at which a firm neither makes profits nor suffers losses. It shows the
following information at various levels of activity:-

1. Variable Cost, Fixed costs and Total costs

2. Sales value.
3. Profit or loss.
4. Break Even Point: the point at which the firm has no Profit or loss.
5. Margin of safety.

At different levels of activity we may have different profits and these are impacted by the
volume of production, Selling Price, Variable Costs, Fixed costs. In this context the Break
even graph may also be called as profit planning chart.

Break Even Point is determined by the following formulae:-

B E P Sales = Fixed Cost x Sales B E P Sales = F x S

Sales – Variable cost S–V

B E P Sales = Fixed Cost

P V Ratio

B E P Sales (in units ) Fixed Cost BEP = F

26
 Contribution per unit Cont per unit

BEP sales ( in units)= BEP Sales or Total Cost

Selling Price per unit Selling price per unit

A Break even chart is drawn on a graph paper. The Costs and Revenue are plotted on the Y
axis and the activity or Volume is plotted on the X axis. X axis may be expressed in a number of
ways like Volume in units, Standard hours, Sales value, Percentage level of activity.

The break even chart will give a clear picture of profit or loss at different level of activity. When
the sales line is above the total cost line we have profit and where it is below the total cost line
we have loss and where total cost line equals the total sales line we do not have profit or loss

Angle of Incidence :- The angle which the sales line makes with the total cost line is known as
the angle of incidence. It indicates the profit earning capacity over the break even point.. The
management of a firm will always try to have a large angle so that the profits may be enlarged.

Margin of safety :- This is represented by excess of sales over and above the break even point.
In a Break even chart it is the distance between the BEP and the present sales or production. The
soundness of a business may be gauged by the size of the margin of safety. A High margin of
safety shows that the BEP is much below the actual sales so that even if there is a fall in the sales
there will still be profit. A small margin indicates a difficult position.

Formula :- Margin of safety = Profit

P V ratio

Margin of safety ( %) = Actual sales - Sales at Break even x 100

Sales

Margin of safety can be improved by by taking the following steps :-

1. Lowering the fixed costs

2. Lowering the variable costs.

3. Increasing the volume of sales so as to improve marginal contribution.

4. Increasing the selling price if the market permits

5. Changing the product mix so as to improve contribution.

27
Profit Volume Ratio:-

This is the ratio of Contribution to Sales or Variable Profit Ratio and is always expressed as
as a percentage. P/V ratio is the rate at which contribution margin increases with the increase
in volume of production. It is very useful guide to the management of a firm for determining
the profit changes which result from the changes in volume. P/V ratio for individual firm is
one of the most important ratios selected for inter firm comparison. A high P/V ratio for a
business indicates that a slight increase in volume without any increase in fixed cost would
result in higher profits. This would be an indicator for increased sales promotion efforts for
increasing the volume. It may also be used for determining the desired volume of output for a
specified amount of profit. Profitability may increased by concentrating on the manufacture
of only those products which show a high P/V ratio. Also P/V ratio is not affected by the
decrease in fixed overhead.

Formula :- Profit volume ratio = Contribution x 100 or Sales – Variable Cost x 100

Sales Sales

28
 MODULE 4

Budgetary Control :- Objectives of Budgetary control, Functional Budgets, Master

Budgets,Key Factor Problems on Production Budgets and Flexible Budgets.
Standard Costing :- Comparison with Budgetary control, analysis of Variances,
SimpleProblems on Material and Labour variances only .

PART A - BUDGETARY CONTROL

Introduction

Budgetary control plays animportant role in the profitability of a business firm as it helps achieve
production and marketing goals at a minimum cost. Budgetary planning and control is an
effective management tool for planning, coordinating and controlling the various business
activities. As a planning device, it guides managers to anticipate the influence and impact of a
given set of events on the firm’s business and its resources; and at the same time, as a control
device, it provides a proper yardstick for evaluation of actual performance.

Concept of Budget

Budget is one of the control devices used by modern management. It is a statement of

anticipated results either in financial or in non-financial terms. According to the Institute of Cost
and Management Accountants (ICMA), England, a budget is “a financial and/or quantitative
statement prepared and approved prior to a definite period of time, of the policy to be pursued
during the period, for the purpose of attaining a given objective”. Thus, a budget is the
quantitative expression of plans- it expresses the plan in terms of physical units or monetary
units or both. It represents the individual and overall operating targets to be achieved. It is a
detailed plan of operations for a specific future period. Thus, the following are the essentials of a
budget:

 It is prepared prior to a given period and is based on a future plan of action;

 It relates to a future period and is based on objectives to be attained;

 It is a statement expressed in physical and/or monetary units prepared for the

implementation of a policy formulated by the management.

For example, a budget may provide for a sale of 10,000 units (i.e., physical units) or for a sale of
Rs. 1,00,000 (i.e., monetary units) or for sale of 10,000 units of Rs. 1,00,000 (i.e., both) by the
firm for a particular financial year.

29
Concept of Budgetary Control

The primary objective of any business enterprise is to attain the highest volume of sales at the
minimum cost, i.e., maximize its profits. Planning and control are absolutely essential in
achieving this goal and the system of budgetary control produces the framework, within which
the organization can reach this objective. Budgetary control is a systematic process of planning
the best use of resources to achieve a business objective. It contains two different processes: one
is the preparation of the budget and the other is the control of the prepared budget.

The ICMA, England defines budgetary control as, “the establishment of budgets relating to the
responsibilities of executives to the requirements of a policy, and the continuous comparison of
actual with budgeted results, either to secure by individual action the objective of that policy or
to provide a basis for its revision”.

According to Brown and Howard, “Budgetary control is a system of controlling costs which
includes the preparation of budgets, coordinating the departments and establishing
responsibilities, comparing actual performance with the budgeted, and acting upon results to
achieve maximum profitability”.

Thus, a budgetary control system consists of:

 Preparation of budgets for major activities of the business

 Measurement and recording of actual results

 Comparison of actual results with budgeted targets

 Computation of deviations, if any; and investigation and correction thereof

 Revision of budgets, in the light of changed circumstances

Budgetary control requires designing and drawing up of budgets, stating clearly the financial
responsibilities of managers in relation to the requirements of the overall policy of the company,
followed by a continuous comparison of actual business results with budgeted results, to realize
the objectives of the policy.

Rowland and William H Harr state the difference between budgets, budgeting, and budgetary
control thus: “Budgets are the individual objectives of a department, etc., whereas budgeting may
be said to be the act of building budgets. Budgetary control embraces all and in addition
includes the science of planning the budgets themselves and the utilization of such budgets to
effect an overall management tool for business planning and control.”

Objectives of Budgetary Control

The main objectives of budgetary control are:

30
  To locate the deficiencies in production system easily by providing for separate
production budget pared to ascertain the efficiency of production.

 To help economizing cost of operation, by exercising control over costs by preparing

separate budgets for each department, ascertaining causes of wastage and arranging for
their removal.

 To eliminate the danger of over capitalization and under capitalization by determining the
total capital requirements (fixed and working capital) of a business firm through
production and cash budgets.

 To provide useful information for formulating accurate and reliable business policies for
the success of a business firm.

 To facilitate evaluation of the results of various policies and supervision over the various
factors of production.

 To encourage research and development as budgetary control processis usually based on

past experience.

Functional Budgets

Different authorities have given different classifications of budgets. Some classify them on the
basis of functions involved, period covered, nature of transactions while others classify them
according to activity levels. Accordingly, the following classifications are generally followed:

A. On the basis of activity levels or flexibility of operations:

(a) Fixed budget (b) Flexible budget

B. On the basis of nature of purpose

(a) Operating budget (b) Financial budget

C. On the basis of time

(a) Long-term budget (b) Short-term budget (c) Current budget (d) Rolling budget
D. On the basis of function

(1) Subsidiary budgets:

(a)Sales budget (b) Production budget (c) Cost of Production budget (d) Purchase budget
(e)Manpower/Labour budget (f) Research & Development budget (g) Capital
Expenditure budget (h) Cash budget
(2) Master budget

31
Master Budgets

Immediately after the completion of different functional or departmental budgets, the major
responsibility of the budget officer is to consolidate the various budgets, in the form of a detailed
report of all operations of the firm for a definite period. The resultant statement is known as a
‘master budget’.

The master budget is expressed in financial terms and sets out management’s plan for the
resources and operations of the firm for a given period of time. It is a summary of the budget
schedules in capsule form made for the purpose of presenting the highlights of the budget period
in one report.

The ICMA, England defines master budget as, “the summary budget incorporating its component
functional budgets which is finally approved, adopted and employed”. Prof. Horngren explains
that a “master budget is a periodic business plan that includes a coordinated set of detailed
operating schedules and disbursements”. Davidson and others state, “the master budget,
sometimes called comprehensive budget, is a complete blueprint of the planned operations of the
firm for a period”. Rowland and William H Herr define the master budget as “a summary of the
budget schedules in capsule form made for the purpose of presenting, in one report, the
highlights of the budget forecast.”

Thus, the master budget is an overall budget of the firm which includes all other small
departmental budgets. It is a network consisting of many separate budgets that are
interdependent. It is also considered as an extensive analysis of the first year of a long range
plan. It coordinates various activities of the business firm and puts them on desired lines. In
fact, the master budget contains consolidated summary of all the budgets prepared by the
organization. It comprises of forecasts and estimates-for the sales and other incomes, for
manufacturing, marketing and other expenses, for working capital and investment requirements,
besides forecasting and projecting the figures of profit or loss. Generally only the few senior
executives of the firm are supplied with the copies of master budgets. Such a budget is of little
use to departmental managers. It draws the attention of the management to those issues which
must require immediate attention or which must be resolved or avoided without any delays in the
interest of the business.

Preparation of Master Budget

Preparation of master budget is a complex process that requires much time and effort by
management at all levels. It includes the preparation of a projected profit and loss account
(income statement) and projected balance sheet as at the end of the budget period. However,
preparation of master budget involves the following steps:

(i) Preparation of sales budget

32
 (ii) Preparation of production budget

(iii) Preparation of production cost t budget

(iv) Preparation of cash budget

(v) Preparation of projected profit and loss account on the basis of information collected
from above stated four steps; and

(vi) Preparation of projected balance sheet from the information available in last year’s
balance sheet and with the help of five steps stated above.

The format of the Master Budget is given in Tables 4.1 and 4.2

Table 4.1
ABC Co. Ltd.
Master Budget
(for the year ending …………)

Projected Profit and Loss Account for the year ending …………..
Particulars Previous Budgeted Particulars Previous Budgeted
Period Period Period Period
Amount Amount Amount Amount
(Rs.) (Rs.) (Rs.) (Rs.)
To cost of product (as By sales (as per Sales
per Production Cost Budget)
Budget) (a) x product
Direct material …units @ Rs…. xxx
(….Units @Rs…) xxx (b) x product
Direct wages xxx …units @ Rs…. xxx
----
- xxx
Prime cost
Factory overheads
(a) Variable xxx xxx
(b) Fixed xxx -----
---- xxx
Works cost
Administrative, selling
and distribution xxx
overheads xxx
To Net Profit
xxx xxx

Table 4.2
Budgeted Balance Sheet
Particulars Previous Budgeted Particulars Previous Budgeted

33
 Period Period Period Period
Amount Amount Amount Amount
(Rs.) (Rs.) (Rs.) (Rs.)
Shareholders’ Equity: Fixed Assets:
Pref. share capital Building
Equity share capital Plant & Machinery
Current Liabilities: Furniture
Bills payable Current Assets:
Sundry creditors Inventories
Bank loan Bills Receivable
------ ------ Sundry debtors ------ ------
------ ------ Cash in hand & at bank ------ ------

Subsidiary Budgets

Subsidiary Budgets are those budgets which show income or expenditure appropriate to or the
responsibility of a particular activity or function of the business. They are prepared on the basis
of the guidelines laid down under the master budget. There may be different types of subsidiary
budgets depending on nature and size of activity and policy of the management, but the
following are frequently prepared:

 Sales budget

 Production budget

 Production cost budget

 Materials budget

 Labour budget

 Manufacturing overhead budget

 Expenses budget

 Cash budget, etc

Key Factor

Key factor is defined as “the factor the extent of whose influence must first be assessed in order
to ensure that functional budgets (relating to different functions of a business, e.g., production,
purchases and cash) are reasonably capable of fulfillment.” A key factor is also known as
‘limiting factor’ or ‘governing factor’ or‘principal budget factor’. It is essential to consider this
factor in detail before preparing the budgets. In some businesses, the key factor might be sales;
while in others it might be production, materials, labour, machinery, power or capital. This most

34
important factor which governs the whole process of preparation of budgets should be pre-
determined. The budget relating to or dependent on that particular factor should be prepared first
and the other budgets should be based on it. A coordinated plan should then be finally approved.

The examples of key factors, which can be one or even more than one in a particular concern, are
as under:

First, sales may be the key factor and if it is so, it would be because of the restricted demand in
the market, severe competition or ineffective sales promotion. Secondly, management might be
another key factor because of absence of able managers or limited funds at their disposal.
Thirdly, materials may be the limiting factor on account of inadequate availability, fixed quotas,
licence restrictions, etc. Labour is yet another key factor because there might be shortage of
workers in general or in certain grades or skills. Lastly, plant capacity might be the governing
factor due to shortage of supply or lack of capital or space.

Thus, ordinarily, a commercial or industrial enterprise may have the following limiting factors:

(a) Limited Production capacity

(b) Non-availability of material

(c) Non-availability of key personnel

(d) Non-availability of finance

(e) Inadequate space

(f) Low market demand

(g) Poor management resources

Following is a indicative list of key factors in different industries:

Industry Key Factor

(i) Motor car Sales demand

(ii) Aluminum Power

(iii) Petroleum Refinery Supply of crude oil

(iv) Electro-optics Skilled technicians

(v) Hydel power generation Monsoon

35
The key factors should be correctly identified and diagnosed. Budgets will be meaningless,
unless the key factors are considered in depth. However, the key factors are not of a permanent
nature and they can be overcome by the management in the long run if an effort is made in this
direction by selecting optimum level of production, dealing in more profitable products,
introducing new technologies and methods, hiring new machinery, exploring substitute/
alternative raw materials or sources of supplies, changing material mix, working overtime or
additional shifts, providing incentives to workers, developing new markets, etc..

PRODUCTION BUDGET

Production Budget

The production budget of a business firm is mainly based on its sales budget. It forecasts
quantity of production in terms of items, period, areas, etc. The management usually takes up the
preparation of a production budget after the preparation of sales budget, as an estimate of future
sales, and consequently quantity of finished products to be made available by the production
department to realize the sales target – are indicated by the sales budget. Production budget is a
component of the master budget that establishes the level of production planned for budget
period. It fixes the target for the future output. It attempts to estimate the number of units of
each product that the company is planning to produce during the budget period. Sufficient
quantity of goods will have to be available to meet sales needs and the quantity of inventory
needed at the end of the period. A portion of these goods will already exist in the form of
beginning inventory. The reminder will have to be produced. The quantity to be produced is
decided after taking into consideration the following:

 Opening and closing levels of inventories; and

 Quantity required to meet projected sales.

Further, the budget executive has to analyze the following factors in the preparation of
production budget:

 Maximum production capacity of the business;

 Production planning of the concern;

 Management’s policy with respect to ‘produce or purchase’ of components;

 Availability of materials and labour;

 Availability of storage facility;

36
  Amount of investment required.

The production budget may be expressed in quantitative or financial units or both. The objective
of the production budget is to find out the volume of output to be achieved during a given period
based on projected sales volume. The production and sales volume should go hand in hand with
each other; otherwise the firm would have to face the problem of holding excessive stock leading
to blocked working capital or inadequate stock to meet the needs of the customers on time. The
production department must schedule its production in such a way as to ensure prompt deliveries
to the customers, without resulting in any stockpiling of inventories. To achieve this objective
sales department must be closely coordinated with the production department. Neither
department can plan and direct its activities in isolation. The sales department has to depend on
production from the plant and at the same time production department guides its production
levels on the basis of sales estimates as submitted by the sales department.

A format of production budget is given in Table 4.3.

Table 4.3
ABC Co. Ltd.
Production Budget
for the quarter ending 31st December 20xx

Particulars October November December

Sales in quantity xxx xxx xxx
(as per sales budget)
Add: Desired inventory at the end xxx xxx xxx
Total quantity required xxx xxx xxx
Less: Stock at the beginning xxx xxx xxx
Quantity to be produced xxx xxx xxx

Production Cost Budget

Production budget is followed by production cost budget that summarizes the direct material
budget, the direct labour budget and the manufacturing overhead budget. Each of these budgets
must consider the quantities to be produced as reflected in the production budget and the prices
of the factors which are expected to prevail during the budget period.

Materials Budget

Materials budget is prepared with a view to ensure regular supply of raw materials of the
required quantities according to the requirements of production schedules. A schedule of
materials requirement is prepared, indicating for each product the unit quantities of each material
required per unit of finished product. Multiplying these raw material requirements per unit of
product times the projected production of each product will give the total production

37
requirements, which then may be combined by type of raw material. The quantity of material so
calculated must be increased by some pre-determined percentage to allow for waste and spoilage.
The quantity of material required for production and the required inventory level will yield the
quantities of each material which will have to be available during the budget period. The
available quantity of material estimated should be deducted by the inventories of raw material at
the beginning of the budget period; the resultant material quantity is the quantity of material to
be purchased during the budget period, to support projected production.

The estimation of material requirements is the responsibility of the production engineering

department while the estimation of prices at which the raw materials could be procured from the
market is the responsibility of purchasing department. Materials budget checks wastage of raw
material and at the same time helps in the determination of economic order quantity.

The format of materials budget is given in Table 4.4.

Table 4.4
ABC Co. Ltd.
Production Budget
(for the year ending ……………..)
Particulars Units
A Quantity to be purchased xxx
Units to be consumed
(as per production budget)
Add: Minimum Closing Stock required xxx
Total raw material requirements xxx
Less: Stock at the beginning xx
Purchase requirements xxx

B Cost involvement (Rs.)

……….units @Rs…. xx
Carriage inwards xx
Cost of purchases xxx

Labour Budget

The labour budget is developed directly from the production budget. It indicates the quantity and
cost of direct labour required to meet production needs. Labour budget discloses the requirement
of skilled as well as unskilled workers for carrying out the budget output. It fixes up the number
and class of workers, their wages, training, leave and other conditions of workers. To be of
maximum value in planning, coordination and control, this budget will have to be in sufficient
detail to indicate the amount of each specific labour operation required to produce each product.
This budget helps Human Resources department in designing appropriate hiring and training of

38
qualified manpower. Thus, labour budget is essential for production planning and for planning
human resources for the enterprise.

The quantity of labour required to meet production needs can be estimated from standards or
from records of past performance. The simple way to compute the quantity of labour requirement
is to divide the required number of units of finished products by the number of direct labour
hours required to produce a single unit. For a labour mix, a separate calculation is to be made for
each type of labour. The resultant is multiplied by the labour cost per hour.

The format of labour budget is given in Table 4.5.

Table 4.5
ABC Co. Ltd.
Labour Budget
(for the year ending ……………..)
Products
A B C
1 Estimated production (units) xxx xxx xxx
(as per production budget)
2 Labour hour per unit x x x
3 Total labour hours required (1 X 2) xxxx xxxx xxxx
4 Labour cost per hour estimated x x x
5 Total labour cost ((3 X 4) xxxx xxxx xxxx

Manufacturing Overhead Budget

The manufacturing overhead budget is a schedule showing the expected amount of

manufacturing cost that will be incurred for the budgeted level of activity. Manufacturing
overheads consist of fixed, variable and semi-variable cost components. Of these, variable
overhead costs change proportionately with the volume of production, whereas fixed overhead
costs remain constant irrespective of output. The semi-variable overhead costs also change with
the output but not proportionately. Management has to use some equitable basis to apportion
the fixed overheads and the fixed elements of the semi-variable overheads to the various budget
centres. Therefore, the preparation of the Manufacturing Overhead Budget requires experience,
knowledge, expertise and intelligence on the part of budget officers.

Expenses Budget

Once the production plans have been established, it is time to determine the overhead required to
produce the products. Departmental managers ordinarily prepare their own budgets for indirect
labour and factory overheads.

39
Expenses budget consists of several sections, namely, factory overheads, administrative
expenses, and sales and distribution expenses. These budgets are prepared on the basis of figures
of income statements of the previous years. A proper distinction of recurring and non-recurring
expenses is made while preparing these budgets.

The format of expenses budget is given in Table 4.6.

Table 4.6
ABC Co. Ltd.
Expenses Budget
(for the year ending ……………..)
(Rs.) (Rs.)
Factory overheads:
Fuel & power xxx
Water xxx
Depreciation xxx
Supervisor’s salary xxx xxx

Administrative expenses:
Salaries xxx
Printing and stationery xxx
Rent and rates xxx
Lighting xxx
General expenses xxx xxx

Sales and distribution expenses:

Salesmen’s salaries xxx
Salesmen’s commission xxx
Advertising xxx
Entertainment and car expenses xxx
Shop display xxx
Display xxx xxx
Total expenses xxx

FLEXIBLE BUDGET

Flexible Budgeting

Some firms, recognizing the tendency of fixed overheads to vary with substantial changes in
production, use a flexible budget, in place of fixed budget (which is generally thought of as
predetermined costs projected at a particular capacity level. In effect, a flexible is simply a series
of fixed budgets that apply to varying levels of production. According to ICM, England, a

40
flexible budget is “a budget which, by recognizing the difference between fixed, semi-fixed and
variable costs, is designed to change in relation to the level of capacity attained”. Thus, a
flexible budget is a series of cost budgets, each prepared for a different level of capacity.
Capacity levels are set at percentages of total installed capacity or at the production of a specified
number of units at set levels of capacity. Under these various levels, costs – fixed, variable and
semi-variable – are broken down. It is a statement of how costs change with changes in the
activity level. Flexible budgets generally do not distinguish between variable and fixed
overhead, but provide a single rate for both types of overhead. This rate is established by
dividing estimated overhead at the normal production level by the normal volume of production.

Flexible budgeting is desirable in the following cases:

 Where, on account of typical nature of the business, the sales are unpredictable, e.g., in
luxury or semi-luxury trades;

 Where the business is newly set up and, therefore, it is almost impossible to forecast the
public demand, e.g., novelties in fashion trade;

 Where business is subject to the vagaries of nature such as soft drinks, etc;

 Where the performace depends on adequate supply of labour or raw materials or power
and the business is in an area which is already suffering from shortage of these essentials.

In all these situations there may be a significant difference between actual level of activity and
the planned level of activity. It will not be appropriate to use the budget based on the planned
level of activity for performance evaluation in such a situation. For example, if a business is
expected to produce 1,00,000 units during a given period while it could actually produce 90,000
units during that period, the budget or profit plan for 1,00,000 units would not be useful in such
an event. A performance budget showing the budget costs for 90,000 units should then be
prepared and compared with actual costs. This is possible only when budget is prepared in such
a way as to provide for adjustments in the event of the actual level of activity not being up to the
budgeted level of activity. A system of flexible budgeting provides for such adjustments. In
fact, a flexible budget is a series of fixed budgets providing for estimate of revenues and costs at
different levels of activity. A performance budget is prepared from the flexible budget after
actual performance to show the amount of revenues and costs that should have been there at the
actual level of activity.

A flexible budget can be constructed according to any one of the following methods:

 The Multi-activity or step method, wherein budgets are developed for different levels of
operation within a range;

 Formula method, also known as the budget cost allowance method where a budget is
prepared for the expected normal level of activity and then, ratios are worked out

41
 showing the relationship of each expense or group of expenses per unit level of activity
(on a variable cost basis providing progressively greater budget allowances as the volume
of activity increases).

 Graphic method, wherein, based on their variability the costs are classified as either
fixed, variable or semi-variable. Estimates are then made for different costs for different
levels of activity. The data are then plotted on a graph showing costs at different levels
of activity. The budgeted levels of activity are on the horizontal scale and the amounts of
budgeted costs are on the vertical scale. Budgeted costs can be shown in the graph
regarding each item of expenditure for each department or for the business as a whole.
The budgeted costs for any level of activity can be read from the graph plotted.

The major significance of flexible budgeting is that it provides completely realistic budget
estimates. There are very few chances for variances which too can be the result of inefficient
control or changes in operating conditions. Mangers prefer the technique of flexible budgeting as
it can be easily understood by the supervisors at all levels because of the realistic way in which
such budgets accommodate actual operating conditions in the plant.

Standard Costing

Standard costing is a tool which replaces the bottleneck of the historical costing. Historical
costing is one of the tools, which fulfills one of the objectives of costing, i.e., ascertainment of
costs. The actual cost of a product can be ascertained only after its production; this cost is
known as ‘historical cost.’

According to ICMA, England, standard costing is “the preparation and use of standard costs,
their comparison with the actual cost and the analysis of variances to their causes and points of
incidence.”

Standard costs are building blocks of any planning and control system. Standards are the
expected level of performance under normal conditions, which are established with reference to
given resources-both physical and human- and functional structure. Standards should be set not
at an ideal level but on the basis of existing resources and functional structure if they are to work
as targets which can be achieved. For example, the production cost standard should be set
considering the existing processes and product design and material specification. Labour and
overhead cost requirements should be standardized accordingly. Standards should be set with
reference to competitors’ production cost. Standard costs are always based on existing situation.
If the existing functional structure is further rationalized, then it is possible and/or necessary to
set new standards.

42
A typical standard costing system involves the following steps:

 Determination of standard cost for each element of cost-direct material, direct labour and
overhead.

 Recording of both standard and actual costs in appropriate books of accounts.

 Computation of variance between standard cost and actual cost.

 Analysis and investigation of the variances, and

 Feed correction and suggested modifications where required.

The standard costing technique, if properly implemented, would result in the following benefits:

 As standard costs for various inputs are readily available, prices can be determined in
anticipation of actual production.

 Determination and comparison of efficiency of different operations is made possible.

 By identifying variances and suggesting corrective measures for them, wastages are
eliminated.

 It ensures better control as performance standards and criteria are known to workers, they
take more interest in the work to achieve the standard.

 It brings about an improvement in production methods as it requires a continuous detailed

examination of all important functions of the concern.

 It provides continual incentives for management to keep costs and performance in tune
with predetermined objective.

However, the following limitations are attached to standard costing:

 Fixation of standard is not always possible for every type of work or operation.

 Fixation of standards is often quite time consuming; besides, they need to be revised
regularly; otherwise they loose their relevance and importance.

 Wrong standards may result in wastage of time, money and energy.

Comparison with Budgetary Control

43
Both standard costing and budgetary control are control techniques. Both the techniques are
used for cost control and cost effectiveness. Both the techniques attempt to fix up targets,
compare the target with actuals and analyze the variances. Further, budgets are used to express
the plan of actions and budgetary control is a mechanism of control instituted to achieve the
target plan. In this process, standards are fixed top achieve the target. Thus, standards are part
of budgetary control technique.

Despite of such common features, these techniques are different in the following ways:

Sl.No. Elements Standard costing Budgetary control

1 Scope Standard costs relate to various costs and
standards are extended to cover sales and
profits.
2 Focus Standard costing emphasizes attainment
of a particular level of efficiency.
3 Projection Standard costs are projection of Cost
Accounts, as they aim at efficiency at
every point.
4 Concern with operation This technique is specifically for
individual cost, viz., cost of materials,
cost of labour and so on.
5 Basis of preparation Standards are set systematically, based
on thorough technical information and
analysis.
6 Purpose of Preparation Prepared for achieving the standards.
7 Application It cannot be applied partially.
8 Standardization of products/processes It requires standardization by either
products or processes.
9 Periodical Revision Revision is not required unless the
circumstances change.
10 Expression of variances Variances are expressed through various
accounts in line with the objectives.
11 Terms of expression It is expressed in terms of ‘per unit.’
Budgets are set for all management
functions. Scope of budgetary control
is broader than standard costing
Budgetary control is exercised with
reference to a particular level of
activity and monetary level.
Budgets are a projection of Financial
Accounts as they aim at overall
efficiency.
This technique is concerned with the
entire business of the firm.
Budgets are based on past
performance and past records,
adjusted to future requirements.
Prepared for bringing down the costs
well within the budgets, i.e., actual
cost should not exceed budgeted cost.
It can be applied partially or wholly,
depending upon the purpose to serve.
It does not require any standardization
for application.
Periodical revision is required
immediately after the specific period
is over.
Variances are not revealed through the
accounts but are revealed in total.
It is expressed only in total volumes.
Final budgeted values for the entire
operation.

Analysis of Variances

A variance represents the difference between an actual cost and its corresponding standard. The
variance is the measure of efficiencies or inefficiencies. Variance analysis is a systematic
process which analyses and interprets the variance. It refers to the break-down of the total
variances into different components. Normally, variances can take two forms, namely:

44
  Favourable variances – where actual costs are less than the standard costs; and

 Unfavourable variances – where actual costs exceed the standard costs.

Sometimes, actual costs are just equal to standard costs set; the situation is then known as
Zero variance.

The objectives of variance analysis are to:

 Indicate whether costs are being kept under control.

 Locate any apparent deficiency in cost control efforts.

 Facilitate the identification of probable causes of deviation from standard.

 Assign responsibility for deviations that may have occurred.

A systematic analysis of variances helps managers improve performance by continuing activities

that result in favourable variances and modifying other activities to eliminate or reduce
unfavourable variances. Thus, it helps in monitoring and improving performance. By drawing
management’s attention to significant deviations that demand detailed investigation and
corrective action, variance analysis process facilitates management by exception.

Variances are computed for all the three basic cost elements of manufacturing – direct material,
direct labour and manufacturing overheads. Thus, there are three types of variances, namely:

 Direct material cost variance

 Direct labour cost variance; and

 Overhead variance

DIRECT MATERIAL COST VARIANCE

It is the difference between the standard cost of direct materials specified for the output achieved
and the actual cost of direct materials used. The standard cost of materials is computed by
multiplying the standard price with standard quantity for actual output and the actual cost is
computed by multiplying the actual price paid, with the actual quantity consumed. The formula
for its computation is as follows:

Direct Material CostVariance = Total Standard Cost for Actual Output – Total Actual Cost
= (Standard Price X Standard Quantity for Actual Output) –
(Actual Price X Actual Quantity)
If the actual cost is less than the standard cost, it would result in a favourble variance and vice
versa.

45
The material cost variance may arise either on account of change in price or change in quantity
or both. Thus, the direct material cost variance can be further divided into:
(i) Direct material price variance
(ii) Direct material quantity or usage variance

Direct material price variance is that portion of the direct material cost variance which is due
to the difference between the standard price specified and the actual price paid. The formula for
its computation is as follows:

Direct Material Price Variance = Actual Quantity used X (Standard Price-Actual Price)

Direct material quantity or usage variance is that portion of the direct material cost variance
which is due to the difference between the standard quantity specified (for the output achieved)
and the actual quantity used. The formula for its computation is as follows:

Direct Material Usage Variance =

Standard Rate X (Standard Quantity for Actual Output – Actual Quantity)

Direct Material Usage Variance may further be classified as:

(a) Material mix (or mixture) variance

(b) Material yield variance

(a) Material mix (or mixture) variance arises only when different raw materials are actually
mixed in order to obtain a product, as generally happens in process industries. It represents the
variations in cost arising as a result of change in the proportion in which different materials are
used, compared to the standard proportion fixed for the purpose, due to temporary shortages or
rising cost, etc., of a particular type of material. The formula for its computation is as follows:

Direct Material Mix Variance = Standard cost of standard mix – Standard cost of actual mix
In other words,
= Standard Price X (Revised Standard Quantity for Actual Output – Actual Quantity)
Where:

Total Weight of Actual Mix

Revised Standard Quantity = ------------------------------------- X Standard Quantity
Total Wight of Standard Mix

When the actual quantity is less than the revised one, there is a favourable variance and vice
versa.

46
The difference in the standard composition and the actual composition may be in any of the
following two ways:

(i) Total standard weight of mixture and the total actual weight of mixture may be the
same but the actual quantities of individual components of the mixture may differ.

In such a case, the material usage variance would be equal to material mix variance.

(ii) Standard weight of mix and the actual weight of mix may be different. In such a case,
the quantity variance shall be due to mix as well as due to reasons other than mix.

The formula for calculation of revised usage (or sub-usage) variance would, then be:

Revised Usage Variance =

Standard Price X (Standard Quantity for Actual Output – Revised Standard Quantity)

The total of mix variance and the revised usage variance would be equal to the total usage
variance calculated according to the formula given previously.

(b) Material yield variance is that portion of direct material usage variance which is due to the
difference between the standard yield specified and the actual yield obtained. This variance may
be due to abnormal contingencies, like spoilage and chemical reactions. The term ‘standard
yield’ here means the output which shall result in, by consuming the standard quantity of
materials. This variance is a measure of the loss or waste in production and hence it is often
referred to as ‘material loss or waste’ variance. The formula for calculating the variance can be
expressed as follows:

Direct Material Yield Variance =

Standard Cost per unit X (Standard Output or Yield for Actual Mix – Actual Output or Yield)

If the actual production is more than the standard production, the variance would be favourable
and vice versa. (It is to be noted here that the figures would be negative if actual production is
more, but the variance would be favourable; in case of other cost variances, a negative figure
denotes an unfavourable variance).

47
DIRECT LABOUR COST VARIANCE

The deviations in cost of direct labour may occur because of two main factors: (i) difference in
actual rates and standard rates of labour, and (ii) the variation in actual time taken by workers
and the standard time allotted to them for performing a job or an operation.

Labour variances are very much similar to material variances and they can be very easily
calculated by applying the same techniques as used in calculation of material variances. The
students can find out the various formulae for direct labour variances by simply putting the word
‘time’ in place of ‘quantity’ in the formulae meant for direct material variances.

Direct Labour Cost Variance is the difference between the standard direct wages specified for the
activity achieved and the direct wages paid. The formula for its computation is as follows:

Direct Labour CostVariance = Total Standard Cost for Actual Output – Total Actual Cost

= (Standard Rate X Standard Time for Actual Output) –

(Actual Rate X Actual Time)

The direct labour cost variance may arise on account of difference in either rates of wages or
time. Thus, it may be further analyzed as:

(i) Direct Labour Rate (Wages) Variance

(ii) Direct Labour Efficiency (Time) Variance

Direct Labour Rate (Wages) Variance is that portion of direct labour (wages) variance which
is due to the difference between the standard rate of pay specified and actual rate paid. The
formula for its computation is as follows:

Direct Labour Rate Variance = Actual Time X (Standard Rate – Actual Rate)

If the actual rate is lower than the standard rate, it shall result in a favourable variance and vice
versa.

Direct Labour Efficiency (Time)Variance is that portion of direct labour (wages) variance
which is due to the difference between the standard labour hours specified for the activity
achieved and the actual labour hours expended.

The formula for its computation is as follows:

Direct Labour Efficiency (Time) Variance =

48
Standard Rate X (Standard Time for Actual Output – Actual Time)

Direct Labour Efficiency (Time) Variance can be further segregated into:

(a) Direct Labour Mix (or gang composition) Variance

(b) Direct Labour Yield Variance

(a) Direct Labour Mix (or gang composition) Variance: This variance arises if during a
particular period, the grades of labour used in production are different from those envisaged. It is
computed to show to the management how much of the labour variance is due to the change in
the composition of labour force. The calculation is similar to material mix variance. The formula
for its computation is as follows:

Direct Labour Mix Variance = Standard Rate X (Revised Standard Time–Actual Time)

Where:

Total Actual Time

Revised Standard Time = ------------------------- X Standard Time
Total Standard Time

However, when standard hours and actual hours for the labour mix are same, then the formula
for calculating labour mix variance is as under:

Direct Labour Mix Variance

= Standard cost of standard labour mix – Standard cost of actual labour mix

(b) Direct Labour Yield Variance: Just as material yield variance is calculated, similarly labour
yield variance can also be calculated. It is the variance in labour cost on account of increase or
decrease in yield or output as compared to the corresponding standard. The formula for its
computation is as follows:

Direct Labour Yield Variance =

Standard Cost per unit X (Standard Output for Actual Mix – Actual Output)

If the actual production is more than the standard production, the variance would be favourable
and vice versa (though the figure would be negative in case of favourable variance).

49
Often, Idle Time Variance is computed, along with Direct Labour Efficiency Variance, to know
the ‘Total Direct Labour Efficiency Variance.’ Idle Time Varianceoccurs due to abnormal
wastage of time on account of strikes, lockouts, power failures, etc., when the actual hours
worked may be much less than the standard hours fixed. The variance on account of abnormal
circumstances is segregated from the time or efficiency variance. The formula for its
computation is as follows:

Idle Time Variance = Standard Hourly Rate X Idle Hours

OVERHEAD COST VARIANCE

The term ‘Overheads’ includes indirect material, indirect labour and indirect expense. Overhead
variance may relate to factory, office or selling and distribution overheads. It is the difference
between standard overheads for actual output, i.e., recovered overheads and actual overheads. It
is the total of both fixed and variable overhead variances.

Overhead Cost Variance = Recovered Overheads – Actual Overheads.

For the purposes of variance analysis, it is broadly divided into two categories, i.e., fixed and
variable.

(i) Variable Overhead Cost Variance: It is the difference between standard variable overheads
for actual output (or recovered variable overheads) and the actual variable overheads.

VOCV = Recovered Variable Overheads - Actual Variable Overheads

(ii) Fixed Overhead Cost Variance: It is the difference between standard fixed overheads for
actual output (or recovered fixed overheads) and the actual fixed overheads.

FOCV = Recovered Fixed Overheads - Actual Fixed Overheads

50
 Module 5
Activity Based Costing (ABC)
Introduction

In this modern era, for any organization the requirements of the customers have not only
increased in number but also became highly complex and complicated. In order to meet these
ever changing requirements of their customers and satisfy them, the organizations are producing
variety of products and are rendering various services. Products and services require resources in
different magnitudes. In a situation where selling prices are driven by the market and costs are
ever changing, i.e. increasing it becomes absolutely necessary for the organizations to measure
the quantum of resources used by their products and services more accurately to improve their
decisions in terms of pricing and product or service mix. This has led to the introduction of a
costing system called Activity Based Costing (ABC).

The limitations of traditional costing system has led to the evolution activity based costing.
Whether it is under traditional costing system or activity based costing the direct costs are easily
ascertained to the cost center. And hence there is no difference. But the differences, come into
existence when it is related to apportionment and appropriation of overheads. Some overheads
can be directly identified with cost centers through the process of cost allocation. In that case
also there will be a possibility very nominal difference which is negligible. Traditional costing
believes that the overheads should be identified with a cost center and accordingly the total
overheads are ascertained in the first step. After that an average rate is calculated for assigning
the overheads to products orservices on the basis of the quantum of production. Many
organizations use machine hour rate or labour hour rate as the base for assigning overheads. The
quantity produced or the associated parameters such as machine hours or labour hours are taken
as the only cost driver under the traditional costing system. Since the resources demanded by the
products and/or services are different and depends on the complexities involved, the cost(s)
ascertained in this traditional system may be distorted and may lead to either over absorption or
under absorptions of overheads, thus leads to improper pricing mechanism.

Activity Based Costing is not only different but also refinement and improvement over the
traditional costing system for overheads. When we look at the methodology of traditional costing

51
system the costs more specifically overheads are first identified (allocated or apportioned) with
an organizational unit such as department or organizational unit or plant etc. and then they will
be traced (apportioned) to products and/or services. In Activity Based Costing system the costs
are first traced to activities and then to the products and/or services. The focal point of Activity
Based Costing is the activities that are included or involved in producing products and/or
rendering services. Therefore Activity Based Costing first ascertains the factors of the activities,
the relation between the activities and products and/or services and thus determines the cost
associated.

Fundamental Assignment to other

Cost Objects cost objects

Costs of Cos of
Activities
Activities  Product
 Service
 Customer

Fig. 5.1: Simple representation of Activity-Based Costing System

Terminology of Activity Based Costing

Cost Driver

A cost driver is a factor or variable which drives or generates cost i.e. it is a feature or
characteristics of an activity or event that would result in the occurrence of cost.For example, the
level of activity or the volume of an activity affects the cost(s) associated with the product and/or
service. Therefore the level or the volume are the cost drivers.
Cost drivers can be broadly divided into three types. They are:
1. Transaction Driver
The transaction drivers are the least expensive cost drivers. These drivers concentrate on the
number of times an activity is performed to produce products and/or rendering
services.Number of material receipts number of parts, number of setups etc. are the examples
of transaction drivers. When an organisation follows transaction drivers the results will be

52
 accurate only when the activities that are being performed use the resources in uniform
quantity.

2. Duration Driver
A duration driver considers the quantum of time involved in performing an activity. This
driver attempts to overcome on minimise the limitation that is associated with transaction
driver, when there is no gaurentee that all the transaction have utilised the same quantum of
resources. Let us take one of the transaction drivers, i.e. the number of set –ups. There is
every possibility that different set-ups would have consumed different quantum of time. In
such cases the duration driver provides comparatively better or improved allocation of costs.
Wherever the quantum of time is relevant the appropriate cost driver would be a duration
driver. The example of duration drivers are set-pus hours, inspection hours, labour hours,
machine hours etc.
One of the limitation of duration driver is that it is relatively complex to identify and
ascertain. In case of transaction drivers the relevant factor is the number which is easily
ascertainable. But in case of duration drivers the time consumed along with the number will
become relevant and thus puts burden on the organisation to collect additional information
and needless to say that it will be relatively costlier to ascertain the time and costs involved.

3. Intensity Driver
There are certain activities or events that demand resources which are either expensive and/or
variable, then transaction drivers and duration drivers fail to provide accurate results because
the intensity of resources is not taken into account. In such cases the intensity drivers will be
appropriate even though they are little expensive to determine accurately. For example in case
of repairs and maintenance not only the number of times and the number of hours, but also the
kind of maintenance material used, degree of complexity involved etc. will also be equally
important. Therefore these costs must be directly charged to the activity.

Activity

53
Classification of Activities
The activities required to be performed by an organisation in producing products may be
classified into:
a. Unit or Output level activities
These activities are performed in the process of producing each unit separately and
repeatedly and are directly proportionate to the number of units produced. The costs incurred
in such activates are called unit level costs. The cost drivers for these unit level activities
are machine hours, labour hours, inspection hours etc.
b. Batch level activities

These activities are performed in relation to a batch of products. Once the batch is set-up, the
number of units produced in the batch has no impact on the resources used. Examples of
batch level activities are number of shipping’s, number of material receipts etc.

c. Products level or product sustaining activities

These activities are not an integral part of the production. Theyfacilitateperformance of

activities and supports the process of production. Therefore cannot be directly identified in
terms of units. The example of these activities are R & D activities, technical support,
training and development of personnel etc. since there is no direct relationship between these
type of costs and number of units produced, they are apportioned on a logical base.

d. Organisation support or facility level activities

These activities facilitate the functioning of an organisation and therefore cannot be directly
traced to the products. The examples of these activities are general administration,
maintenance of building, air-conditioning etc. Some organisations apportion these costs to
the products on some logical base, such as machine hours or labour hours etc. which is
arbitrary in nature. Some other organisation deduct these expenses directly from their
operating profits.

Cost Pool

54
 Cost pool is a subset of the total cost that can be clearly identified as associated with a distinct
cost driver. An activity cost pool is a bucket in which costs are accumulated that relate to a
single activity measure in the activity based costing system.

For example when we take product design as the activity cost pool then all the costs that are
related to designing new product such as research expenditure, preparation of prototype,
testing for safety standards etc. will be accumulated to the cost pool of product design.

Cost Smoothing / Peanut Butter Costing

Many organisation assign the cost of resources uniformly to cost objects by using a broad
average on the basis of either machine hours or labour hours. This results in assigning the
resources to the products or services in a non-uniform way. This known as peanut butter
costing. Without a recognition of the product’s requirements in terms of quantity of resources
when this process of assigning happens it will lead to product cost cross subsidization which
means either over absorption or under absorption of overheads.

Under absorption of overhead

A product consumes a high level of resources but is reported to have a low cost per unit.

Over absorption of overhead

A products consumes a low level of recourse but is reported to have a high cost per unit.

Steps in Activity Based Costing

In simple Activity Based Costing traces costs to the activities and then activities to products
and/or services. To be very specific the following steps are identified in the process of Activity
Based Costing.

55
 Identification of Activities

Identification of Cost Drivers

Collection of the Costs (Cost Pools)

Charging Overheads

Step 1:Identification of all the activities carried on in an organisation such as handling of

materials, packaging, maintenance etc.

Step 2:Identification of cost drivers i.e. factors that affect the cost(s) of an activity. For example,
in case of handling of materials the cost driver may be the number of receipts or orders, for
packaging it may be the number of units and for maintenance it could be the number of hours
spent on the job.

Step 3:Collection of the costs relating to each activity known as cost pools.

Step 4:Charging of overheads to the products and/or services depending on the activity or
activities used or involved in terms of the cost drivers

For example: When there are 1000 orders in the materials handling department with a total cost
of Rs. 50,000, then the cost per order would amount to Rs.50. If a product involves 5 orders then
Rs. 250 would be charged as overheads towards materials handling.

56
 Stage 1: Overheads Stage 2: Overheads
assigned to cost assigned to products
centers /cost pools using cost driver rates

Activity cost pools Activity cost driver rates

Products

Overhead
cost

Fig. 5.2: Activity-Based Product Costing System

As Activity Based Costing system uses multiple cost drivers along with the quantity produced
which is the most popular measure for determining cost in traditional costing system. As the
Activity Based Costing system uses more number of cost drivers to ascertain the resources
required and consumed by the products and/or services, the accuracy of the cost of the product
and/or service determined increases manifold.

57
 An indicative list of activities and activity cost drivers:

Sl. No Business Activity Cost Driver

1. Procurement Number of purchase orders, supplies received.

2. Storage Number. of items, size of items.

3. Production No. of units, number of batches.

4. Inspection and Testing Number of components, number of hours.

5. Research and Development Number of research products, complexity of the projects, man
hours spent on the projects.

6. Customer service Number of orders, time spent on each customer, service calls.

Merits and demerits of Activity Based Costing System

Merits

1. It brings accuracy and reliability in determining the cost of the product.

2. Activity Based Costing provides more realistic product costs even in situations where
overheads constitutes a major portion of a total costs.
3. Activity Based Costing enables the management to control their overheads by exercising
a better control on the activities that drive the costs, more specifically the overheads.
4. Activity Based Costing minimises the occurrence of the product cost cross subsidization
to a large extent.
5. Activity Based Costing improves the accuracy of managerial decision making in
situations such as discontinuing a product, determination of product mix, accepting a
special order etc. by providing reliable product cost data.
6. Activity Based Costing determines the product cost accurately by using multiple cost
drivers depending upon the resources used.
7. Activity Based Costing provides correct product cost data even in situations where varied
products with different levels of volume or quantity are manufactured in an organisation.
8. Activity Based Costing helps the management in evaluating the performance of the
responsibility centers with the help of cost driver rate and provides for improved
performance of the responsibility center.
9. Activity Based Costing provides a mechanism for managing costs along with accurate
determination of product costs.
10. The application of Activity Based Costing contributes for a better system in budgetary
control also.

58
Demerits

1. Activity Based Costing system is relatively a complex system as it uses numerous cost
pool along with multiple cost drivers.
2. Selection of cost driver, apportionment of common costs etc. may pose difficulties in
effective implementation of the Activity Based Costing system an organisation.
3. Activity Based Costing system is not only costly but also highly time consuming
4. Activity Based Costing system may not be useful to the organisations, which produce the
products whose prices are driven by the market.
5. Activity Based Costing system will become highly complicated when an organisation
manufactures small number of a large verity of products. In that case the implementation
of Activity Based Costing may not yield any identifiable benefits to the organisation.

59
 Module 6
Cost Audit
Introduction
A cost audit is a mandatory fiscal examination of a company to confirm if the company is
running its processes efficiently or not. This kind of review can cover manufacturing, operations,
marketing and sales. For Indian companies, the review is performed internally by outside
auditors. Cost audits happen periodically, with the findings reported both internally and
externally. The reviewed company is then expected to act on the report and repair any
deficiencies found.

Meaning of Cost Audit

All manufacturing companies with a paid-up capital of Rs 50 crore (Rs 500 million) or more will be
required to conduct a statutory cost audit if the recommendations of an expert committee appointed by the
ministry of corporate affairs are accepted. Auditing is a systematic and independent examination of date,
statements, records operational activities and performance of the enterprise. While auditing the auditor
identifies and distinguishes the plan of action or schemes before him for examination, collects evidence,
evaluates the same and accordingly communicates his observations or opinion in the form of audit report.

The term cost audit means a systematic and accurate verification of the cost accounts and records
and checking of adherence to the objectives of the cost accounting.

60
Definition
The Definition for Audit and Assurance StandardAAS-1 by the Institute of Chartered
accountants of India(ICAI): "Auditing is the independent examination of financial information
of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such
an examination is conducted with a view to expressing an opinion thereon.

The Institute of Cost and Management Accountants of England defines Cost Audit as
follows - "the verification of cost records and accounts and a check on adherence to the cost
accounting procedures and their continuing relevance".

The Institute of Cost Accountants of India (ICAI) previously known as the Institute of Cost &
Works Accountants of India (ICWAI) defines cost audit as “audit of efficiency of minute
details of expenditure while the work is in-progress and not a post –mortem examination.

According to The Chartered Institute of Management Accountant, London (CIMA), “cost

audit is the verification of the correctness of cost accounts and of the adherence to the cost
accounting plan.”

According to the Institute of Cost and Management Accountants of Pakistan, a cost audit is
"an examination of cost accounting records and verification of facts to ascertain that the cost of
the product has been arrived at, in accordance with principles of cost accounting.

Objectives
1. To verifying the arithmetical accuracy of cost accounting entries in the books of
accounts.

2. To ensure that cost accounting principles are a strictly adhered in preparing cost accounts by
an enterprise.

3. To ensure that cost accounts are correctly maintained and also to detect errors, frauds and any
wrong practice in the existing system.

4. To check the day to day working of the costing department of the organization and to make
suggestions for improvement and also verify whether the records maintained as above give a
true and fair view of the cost of production.

61
5 To examine whether proper cost accounting records as per the provisions of the Companies
Act have been maintained.

6. To help the management in taking correct decisions on certain important matters ie., price
fixation, profit margin, actual cost of production etc.

7. To reduce the amount of detailed checking by the external auditor if effective internal cost
audit system is in operation.

Advantages of Cost Audit

The following are the advantages of cost audit to various stakeholders like the
Management, cost accountant, shareholders and government.

Management:

1. Cost audit provides the management with reliable information for decision making like,
pricing, cost reduction and cost control.

2. As a close checkis maintained withwastages relating to materials,labour and overheads and

thus corrective measures can be taken immediately if there are any deviations.

3. A reliable check on valuation of inventories and work-in-progress can be maintained.

4. Management by exception is possible because cost audit helps in detection of errors, frauds
and irregularities, hence the managers canfix individual responsibility for the inefficient
operations.

5. It helps in identifying mismanaged units or sick units.

6. Cost audit also helps the management in inter-unit comparison and this helps in improving the
performance of inefficient units.

Cost Accountant:

Cost audit assists the financialauditor because he can rely on important financial data such as
cost of closing stock of raw material, work in progress, and finished goods. In financial accounts
closing stock is valued at cost or market price whicheverisless. The actual cost of closing stock

62
 can be easily taken from costing books. The task of the financial auditor is greatly facilitated if
the cost account is audited.

Cost audit report enhances the status of cost accountant. It helps in improving costingmethods
used in costing departments and the existence of cost audit has a great moral influence on the
employees as a result of which the efficiency is increased.

Shareholders:

Cost audit increases the reliability of cost data which are used by shareholders to analyse the
financial position of the organization.

The shareholders are confident that the valuation of closing stock and work-in-progress are
computed on a fair basis.

Cost audit reveals whether the funds invested by the shareholders are being profitability used in
the business. Thus, shareholders are assured of a fair rate of return on their investments.

Government:

Costaudit is helpful in ascertaining the cost claims submitted to thegovernmentunder the cost –
plus-contract.Government departments like Defence Supplies, Railways, Electricity supply,
constructions projects are making use of cost audit reports for the determination of cost claims.
Cost audit creates confidence that the costs stated by the contactor are legitimate and correct.

Cost audit enables the government to decide whether protection should be given in favour of
certain industries or not.

e. The company should make available to the cost auditor, within 90 days from the end of the
financial year, all the cost accounting records as would be required for conducting the cost audit.
f. The cost auditor is required to submit his report in triplicate to the Central Government within
120 days from the end of the financial year of the company. A copy of the report should be sent
to the company also. The report should be in the form laid down in the Cost Audit (Report)
Rules, 1968 and the subsequent amendments to the same.
g. The company should furnish to the Central Government, within 30 days of the receipt of the cost
audit report, all information and explanations on every reservation and qualification contained in
the report. The Central Government is empowered to call for further information/explanations, if
required and may take the requisite action on the report.

63
Objectives of a Management Audit

1) To ascertain the current level of effectiveness in discharging the managerial duties.

2) To ensure that management objectives are met.

3) To suggest measures to for a better management

4) To help in improving the profit earning capacity of the organisation.

5) To lay down standards for future performance.

6) To ensure a proper control system.

Scope of Management Audit

The scope is broad and includes all functions of the organization, including objectives and
strategy, corporate structure, organizational planning, the budgetingprocess, human and financial
resources management, decision making, research and development, marketing, equipment and
operations, and management information systems. Management audit is of present and future
operations and covers external issues as well as internal concerns. Some of the important areas
which management auditor should probe to evaluate the performance efficiency and to make
suggestions to the management for remedial action and better control are production
management , sales performance management, improvement in sales turnover having high p/v
ratio, plant capacity utilisation, inventory management , liquidity status, preventive maintenance
measures, idle capacity , receivables management, overtime management, controllable expenses
and raw materials purchases procedure and storage,

The Management audit is identifies corporate strengths and weaknesses, sources of problems,
and potential problem areas. Recommendations for correction are presented to top management.
The final report comes in the form of an overall plan of action, the specific units and individuals
expected to carry out the recommendations, a schedule for action, and expected results.
Management audit becomes a powerful tool for corporate and organizational executives who
seek to improve effectiveness and achieve organisational goals.

Management audits are not limited to business corporations. Non-profit organizations—

including educational institutions, hospitals, charitable trusts, Sports Associations etc—often use
the management audit to attempt to improve operations. When conducted effectively, and when
recommendations are applied properly, management audit has proved its usefulness as an
effective managerial control technique.

64
REPORTING TO MANAGEMENT

7.1.1 Introduction

A report, in general, is a presentation and summation of facts and figures. It is a logical and
coherent structuring of information, ideas and concepts. It represents a formal communication
written for a specific purpose, conveying authentic information, to a well-defined audience in a
completely impartial and objective manner and containing recommendations, if required.

According to the British Association for Commercial and Industrial Education, “A report is a
document in which a given problem is examined for the purpose of conveying information and
findings, putting forward ideas first and sometimes making recommendations”. Continuing this
analogy, a business report may be considered as a statement related to planning and coordinating
managerial and employee performance or general state of affairs in a business organization that
serves business purposes of that organization”. According to Lisekar, “A business report is an
orderly and objective communication of factual information that serves a business purpose”.

Management reporting is that part of management control system which provides adequate
business information to various levels of management in the form of reports and statements at
regular intervals. Thus, the process of supplying adequate information to the management is
known as Management Reporting. Reporting is a communication process that facilitates
detection and correction of mistakes. The Cost/Management Accountant should evolve an
efficient and suitable system of reporting and presentation of cost and other financial information
to the management. The reporting system should be designed to meet the needs of individual
concerns and should be frequently reviewed and revised in accordance with the requirements.

7.1.2 Purpose of Reporting

In a small business, the management keeps in a close contact with the various activities of the
business and the need for presenting and reporting of information may not be keenly felt. But,
with the growth in the size of a business, the top management gets fewer opportunities to come
in contact with the activities of the business and its control becomes more and more remote.
Control in such a situation is achieved mainly through reports. In fact, no planning and control
procedure is complete without an effective system of reporting of operating results.

In large organizations, where diversified business activities are carried out, by different
departments, in different geographical locations, the top management cannot keep in a direct
watch over all the activities. So the managers have to base their decisions and actions on the
reports. Therefore, a suitable system of management reporting is an essential part of business
operation and administration. It provides management with data for policy and operating
decisions, and it alerts management to the need for changes or at least the desirability of
investigating such a need. A good reporting system not only signals the need for changes but

65
reflects the results of these changes once they are made, and indicates the desirability of further
action. In fact, management reporting is the instrument for making controls and decisions
effective. It provides a chance to evaluate performance and suggest remedial action if
performance is not in tune with expectations.

National Association of Accountants (NAA) brings out the significance of management reporting
to modern business thus:

“As an organization grows, management should rely to a greater extent upon

information compiled, summarized and interpreted by the accounting department
and other specialized functional groups in the company. Modern techniques for
collecting, focusing and transmitting information to management have had an
important place in making possible the efficient operation of large organizations
needed to utilize the advances in scientific and engineering knowledge for
producing better and less costly products. Even in small companies some
systematic plan for collecting and presenting financial information is essential
because management cannot personally observe and organize all the facts with
respect to sales, costs and other aspects of a company’s operations”.

A business report is basically a source of information to management or an individual to help

decision-making. It can be used in some cases for offering solution to a business problem. The
need for or purpose of a report is justified on the following basis:

1. Reports are required for various purposes related to planning and change in different areas of
business.

2. Report is a management tool for effective monitoring of business activities and taking
decisions, particularly where the business is large and diversified.

2. Reports contain the findings and recommendations that are expected to help in final decision-
making in the matter.

4. Reporting facilitates- communication of the degree to which activities have resulted in desired
results; comparison of what was wanted with what was achieved; analysis of reasons; suggesting
corrective action. Thus, a good reporting system can serve the objective of raising employee
morale and improving their performance.

5. A report can be explain and clarify a controversial situation and to justify and persuade
readers about the need for the action proposed.

6. A ‘problem-solving’ report provides management with background information such as origin

and cause of the problem. It also offers analysis of various options available to solve the
problem. Thus, reporting helps by investigating into certain basic research questions such as
how the problem arose, what was the extent of impact and what could be done about it.

66
7. Reporting helps in communicating with donors, public and community members about the
activities of the business.

8. Reports also act as a means of communicating with the Government, as to the compliance with
the latter’s rules and regulations.

9. Reports enable an organization to keep records for future reference; act as documentation of
firm’s progress, success, failures, etc.

Principles (Characteristics) of Good Report/Reporting System

A managerial report is a vehicle for carrying information to different levels of management in

the organization. It is the responsibility of the management accountant to prepare the reports
regularly and submit the same to the management, so that the business operations of the
enterprise are effectively and efficiently monitored and controlled. However, the task of
preparing a report is not so easy; the management accountant has to take adequate care in the
preparation of the report to make it effective and result-oriented. A number of basic rules have
been formulated to make the reporting system and the reports effective. The important among
them are listed below:

(i) Proper format and content: A report should be in a proper format, having a suggestive
title, sub-headings and paragraph division. It should be addressed to those for whom it has
been prepared, it should state by whom it is submitted, be dated and duly signed. The
language used in the report should be clear and unambiguous and vital information should
be in eye-catching position. The grammatical accuracy of language is of fundamental
importance. Contents of a report depend upon a very large number of factors and no
standards or rules can be prescribed in this regard. However, the contents should be in a
logical sequence like the following:

(a) Summary of the present position

(b) Courses of action, which might be taken, with the expected results
(c) Recommendations and the reasons for their submission

(ii) True and Fair Depiction: The report should present true and fair view of business affairs.
The position as depicted by the report must be based on facts and figures. Every effort
must be made to ensure that the whims and fancies of the management accountant do not
jeopardize the reported material. If recommendations are made at the end of a report, they
must be impartial and objective. They should come as logical conclusions to investigation
and analysis. They must not contain any self-interest on the part of the writer.

(iii) Promptness: The importance of promptness in reporting cannot be overemphasized. Time

is an important element in reporting, particularly in control reports. A report must be
prepared and presented before it becomes a matter of the past. In many cases, promptness

67
 in reporting is more important than any other of the general principles of reporting.
Information delayed is information denied. If, for example, reporting is delayed, an
opportunity for action may be lost or some wrong decision may be taken in the absence of
information. In order to achieve promptness in reporting, the method of collecting the data
should be improved, thereby increasing the speed with which the final information
becomes available. Use of mechanical devices in accounting not only helps in prompt
reporting but also avoids clerical errors. Besides, a partial solution to the problem of timely
reporting may be the use of ‘Flash’ reports.

(iv) Accuracy: Data presented in the reports should be accurate, but not extremely accurate at
the cost of promptness. It is better to have approximate but timely reports, than to have
very accurate but late reports. The margin of error allowed depends upon the purpose for
which the report is being prepared. Use of mechanical aids in accounting can prove
extremely useful for ensuring the accuracy of the reports.

(v) Simplicity: Reports should also possess the quality of simplicity. It should avoid scientific
and technical jargon or poetic embellishment to avoid confusion. The reports should not
attempt to portray very much. They should be simply written, in a direct style. A series of
simple statements is usually preferred to a single comprehensive one loaded with details
that little information can be gathered from it and that too with difficulty.

(vi) Consistency: The principleof consistency suggests that a good reporting system should
follow a uniform set of procedure over a period of time for the collection and analysis of
economic and accounting data. However, this does not mean that the reporting system
should not be improved over the period of time by incorporating necessary changes in it.
But the impact on the business affairs as a result of a change in the reporting system should
be disclosed in the report. Further, it is advisable to present information in a consistent
manner to different levels of the management.

(vii) Reader-orientation: A good report is always reader-oriented. While drafting a report, it is

necessary to keep in mind the person(s) who is (are) going to read it. A report meant for
the foremen will be different from another meant for technical experts or board of directors.

(viii) Comparative Figures: When presenting information, it is often useful if additional figures
are included to show a comparison either with past performance or with a predetermined
target. This facilitates a better assessment of the current performance. For instance, a
statement of monthly costs may have columns for “this month”, “last month”, “same month
last year” and average monthly costs for the year to date” with actual and budgeted figures.
As an alternative to absolute comparison, report may highlight the significant deviations
from standards or past performance. Such reports take the minimum time of the recipient
of the report and also enable their attention focused on significant exceptions and this is
called “reporting by exception”.

68
(ix) Supporting Material: To make a managerial report self-contained to the extent necessary
for decision-making, supporting materials/figures or other technical details must be
attached with the report in the form of appendix. This abbreviates and expedites the
presentation of main ideas and allows more emphasis to be placed on the data that belong
to the body of the report.

(x) Cost of Reporting: Reporting costs money and is an expensive activity where considerable
time is spent in analyzing data and preparing reports. The cost of reporting should be
compared with the value of advantage gained from the report or the loss sustained by not
reporting. In other words, a report must be produced at a cost which is reasonable having
regard to the likely benefits from the use of the report.

(xi) Needs of different levels of Management: Reports are prepared to meet the needs of the
different levels of management. The details to be shown in the report should be designed
to suit those levels, for example, while reporting to the top management, broad trends and
significant exceptions may be summarized on plant-wise basis. Reports to departmental
managers should be more detailed covering the department concerned, and reports to the
lower management level like section supervisors should be still more detailed.

(xii) Use of Visual Aids: Visual aids like Charts, Graphs and Diagrams should be used in the
reports, wherever possible. These facilitate quick grasp of the significant trends and leave
a lasting impression in the mind.

Summary of Reporting Practices observed in 30 leading companies and the trends as given
by NAA Research Series No. 28 (NAA Bulletin, Vol. 36)

1. To reduce the figures presented to the management (particularly top management) to a

minimum, consistent with the needs of the individual recipient. The principal techniques
to accomplish this are:

a. Begin each report with a summary

b. Concentrate attention on the items requiring action
c. Reduce the number of figures/digits to be remembered or compared
d. Use a variety of devices to emphasize significant points

2. To produce reports in a clear, attractive and easily readable form. A variety of techniques
are used to achieve this, including avoidance of closely packed masses of figures, use of
colour in the reports and standardizing terminology, arrangement of report content and
format.

69
 3. To stress timeliness of information, particularly where the figures measure current
performance or indicate a need for current action.

4. To utilize, as far as possible, terminology and language which is familiar to the recipients
of reports and to avoid technical accounting terms where non-technical terms can be used
to convey the same meaning.

5. To use a variety of communication media to the effectiveness of presentation and to

improve management’s overall understanding of the information presented.

6. To accept responsibility for the analysis and interpretation of accounting figures, by

including in accounting reports the comments designed to bring out significance of the
figures to the recipients of the reports. The analysis is frequently in the form of a letter or
written comments on or accompanying the report.

Reporting to Different Levels of Management

One of the general principles of reporting is that the system of reporting should be designed in
such a way so as to meet the informational needs of the different levels of management. In any
organization, there are three distinct levels of management – the Top Management, Middle
Management and Junior or Lower or Operational Management. The contents of the reports
depend upon the level to which reporting is done. For e.g., reports to top management have to be
comprehensive and concise and as we move to the lower levels of management, reports have to
be more detailed and specific.

The various levels of management and their reporting needs are discussed as follows:

Top Management Level: The top level management comprises of Board of Directors (B.O.D.),
Managing Director or General Manager, AssistantGeneral Manager or any other Chief Executive
by whatever name called. These managers at the top level are concerned more with the
formulation of business policies and working plans than in the day-to-day functioning of the
business. They are, therefore, interested in the overall efficiency or inefficiency of the business
as reflected in Profit and Loss Account and Balance Sheet so muchso that a monthly Profit and
Loss Account and Balance Sheet may be prepared and presented to them. Reports for top
management should be summarized by totals only and the areas of shortfall and variations should
be indicated to enable the top management to take action. Such reports should show the
efficiency of plans, soundness of organizations, etc.

Reports for the top management include the following:

(1) Periodical Profit and Loss Account and Balance Sheet

(2) Master Budget
(3) Capital Budget
(4) Reports on R & D Activities

70
 (5) Management Ratios-showing overall financial position
(6) Summaries of cost of production in various departments
(7) Plant Utilization Reports
(8) Variance Analysis Reports
(9) Report on Spoiled and Defective Work
(10) Overheads and Labour Efficiency Reports
(11) Inventory Position and Inventory Turnover
(12) Productivity Reports

Middle Management Level: This comprises of the heads of various departments Such as Sales
Manager, Production Manager, Purchase Manager, etc. The main difference between the Top
Management and Departmental Management is that the latter has to operate within the
framework of policy laid down by the former. Thus, the Departmental Managers are primarily
concerned with the execution of plans, administration of policies, directing operating supervisors
and appraising their performance. The reports for this level should show the efficiency and cost
data relating to their respective areas or departments.

Reports for Middle or Coordinating Level include the following:

(1) Department Efficiency Reports

(2) Idle Time Report
(3) Overheads Variance Reports
(4) Plant Utilization Reports
(5) Report on Production
(6) Report on Sales, etc
(7) Report on Wastage of Materials
(8) Reports on Costs (element-wise)
(9) Reports on Labour Rate and Efficiency Variances
(10) Reports on Material Price and Usage Variances

Junior or Operating or Lower Level Management

This level comprises Supervisors, Foreman, and Section Chiefs, etc. They are concerned with
the day-to-day operations of the various sections of the business and have no say in decision
making activities. The difference between the reports to this level and the reports to the top level
and middle level of management is that, in the case of the former, reports are likely to be in
physical units only (though these may also be both in physical and monetary terms) while reports
to the latter are in physical as well as monetary terms. Moreover, reports to the Junior Level are
prepared by the supervisors themselves without any expert advice and therefore these may not be
in a proper form.

71
Reports to Operating Management are detailed and specific, restricted only to the activity with
which they are concerned. Examples of such reports are:

(1) Analysis of Sales by the products, lines and regions

(2) Cost of Product Report
(3) Labour Utilization, Labour Turnover, Idle Time, Overtime, Absenteeism and Labour
Efficiency Reports
(4) Material Consumed and Material Variance Reports
(5) Report on Scrap, Shortage and Defective Output
(6) Sales Operating Statement, etc.

Forms of Reporting

Reports may be presented in the following forms:

Verbal (or Oral) – This type of reporting takes place in Group Meetings, Conferences,
Seminars, etc.

Written: This is the most common form of reporting to the management. There are various
types of written reports as discussed below:

7.1.6 Classification of Reports

Reports defy classification. The broad categorization generally accepted in business circles is -
by their Form, Content, Frequency and Users. This is shown below:

REPORTS

Form Content Frequency

Descriptive Production Routine

Tabular Sales Special

72
Graphical Material

Labour
The various types of reports shown in the above chart are described below:

According to Form

A report can be classified as Descriptive, Tabular and Graphical.

Descriptive Form: These are written in descriptive or narrative style. These should be in a
proper format with suitable headings, sub headings and paragraphs. The language used in the
report should be simple and clear. As these types of reports do not make use of tables and
diagrams, they are less effective as compared to the reports containing graphs, diagrams, etc.

Tabular Form: In this type of reports, data is presented in the form of tables. Such tables may
be designed to show comparison with actual/past performance or budgeted/future performance.
This form of reporting is usually employed in presenting cost data, profit or loss, comparative
profitability, etc. Such reports are definitely more effective than descriptive reports, because
important figures may be highlighted or underlined so as to draw recipient’s attention.

Graphical Form: Factual information is often clearer and easier to understand if presented in
graphical or pictorial form. This itself justifies the use of graphs in reports to the management.
Graphic presentation makes an otherwise dull and confusing data interesting and understandable
and is considered to be the most appealing form of reporting. However, graphical form suffers
from a limitation that graphs cannot be read to the degree of exactness to which they are drawn.
In brief, graphical form is extremely useful because of the following reasons:

(1) Graphs and diagrams are attractive to the eyes.

(2) They give a bird’s eye view of the entire data and are comparatively easily
understood.
(3) They have a greater memorizing effect.
(4) They facilitate comparison of data, e.g., actual with standard cost, etc.

There are several types of graphs and diagrams used in management reporting, as given below:

(i) Bar Chart: This is a very common type of chart, in which bars of thick lines (vertical or
horizontal) represent the magnitude of values. The longer the line, the higher is its
magnitude. Vertical bars are generally preferred because they give a better look. It should
be noted that it is the length of the bars that matters and not the width and therefore they
have a standard width. Bar charts may be of the following types:

(a) Simple Bar Chart: These charts are used to depict only one variable, e.g., comparative
figures of sales, production, etc., for various periods.

(b) Multiple Bar Chart: These charts represent two or more sets of connected data. These
are used whenever a comparison between two or more related variables is to be made

73
 over a period of time. Preferably each bar in a particular set should be represented by
different colours or designs for better visual effect.

(c) Sub-divided Bar Chart: These charts are used to present such data which are shown in
parts or which are the totals of various subdivisions. The bars are subdivided in the ratio
of components, the portion of each component being coloured or shaded differently for
the purpose of distinguishing between different components. Such charts may be used in
reports to show analysis of cost or sales by their constituent elements.

(d) Percentage Bar Chart: These are common size bars where length of the bar is kept
equal to 100% and segments are cut in these bars to represent the components (in
percentages) of an aggregate. Such bars have an added advantage of comparison on a
relative basis. (The length of the bar is always equal to 100% and it is subdivided.)

(ii) Pie (Circular) Chart: These are like percentage charts but these are presented as segments
of a circle instead of components of a bar. Such charts show the relationship of parts to the
whole. The angles at the centre of a circle equal 360o and various segments of the circle are
reduced in proportion to 360o. Then, these segments are measured on the circle with the
help of a protractor. For identification, different colours or shades may be used for
different components.

The limitation of a pie chart is that, it is less effective than the bar diagrams for accurate
reading and interpretation particularly, when the difference between the components is very
small.

(iii) Gnatt Chart (Progress Chart): This is a variant of the bar chart in which bars are drawn
horizontally. The Gnatt charts are widely used in the industry for facilitating a comparison
of the actual performance with that of the budgeted. This can be differentiated in the chart
through thick and thin lines or vice versa. It is used mostly for comparing the accomplished
targets as against the planned targets.

(iv) ‘Z’ Chart or Zee Chart:This chart depicts three curveson a single graph and on
completion, these three curves take the shape similar to that of the letter ‘Z’. This is the
reason why it is called a ‘Z’ chart. The three curves display:

a. The current figures for the period concerned

b. Cumulative amounts to the latest date
c. The moving annual total or ‘trends’

(v) Silhouette Charts: In this chart, a particular year or period is taken as the base period. The
value of the item concerning the base period is taken to be zero and through this a line
parallel to the ‘X’ axis is drawn. It is called the base line or reference line. Any value
more than the base value is plotted above the base line and any value less than this base

74
 value is plotted below the base line. Then, these plotted points are joined together. The
area between the base line and the joint line is shaded with dark colour. This makes the
presentation of information very attractive.

(vi) Control Chart: This chart was developed by Dr. W.A. Shewhart. It is a device used for
control of operational progress. It helps in revealing the variations from the established
standard. It consists of the following horizontal lines:

a. Reference Line (Central Line): It indicates the desired standard.

b. Upper Control Limit Line (UCL)
c. Lower Control Limit Line (LCL)

The control is done through two charts, viz., the mean chart and the range chart. As the
process proceeds, mean and a small range of sample data are plotted on the graph. If the
point plotted falls within the control limits, there is nothing to worry. If this point falls
outside the control limits, it is considered to be dangerous. In case the plotted points are
moving towards a particular limit, machine may be stopped and re-set to avoid the ‘out of
control’ situation.

(vii) Break Even Chart: This chart shows the cost-volume-profit relationship indicating BEP,
i.e., a point at which sales revenue is equal to the total cost, where there is no profit or loss.

According to Contents

According to the contents, Reports are divided as given below. (These are only indicative and
not exhaustive)

Reports on Materials

a. Inventory Position Report

b. Material Cost Variances, etc.
c. Material Price Trends
d. Material Productivity Report
e. Normal and abnormal Loss of Material
f. Purchase Department Costs
g. Ratio of Material Consumed to Cost of Product
h. Supply Position Report

Reports on Labour
a. Idle Time Report
b. Labour Absenteeism Report

75
 c. Labour Cost Variances
d. Labour Productivity Report
e. Labour Turnover Report
f. Overtime and Shift Working Reports
g. Ratio of Direct Wages to Cost of Production
h. Recruitment and Training Cost Reports, etc.
i. Report on Accidents

Reports on Overheads
a. Administrative Overheads Report
b. Fixed and Equitable Overhead Report
c. Overhead Variances Report
d. Power Cost Report
e. Ratio of Overheads to Cost of Production
f. Repairs and Maintenance Cost Report
g. Report on Overhead Absorption Ratio
h. Selling and Distribution Cost Reports

Reports to Production Department

a. Control Ratios – Ratios of Various Elements of Cost to Total Product Cost
b. Cost of Production
c. Cost Variances-Material, Labour and Overheads
d. Labour Time Utilization, Idle Time, Overtime with Causes
e. Machine Utilization and Idle Capacity
f. Material and Labour Cost /unit
g. Report on Labour Cost
h. Report on Material Consumption
i. Report on Overhead Absorption
j. Reports on Labour Turnover and Absenteeism
k. Spoilage, Defective Work, Scrap and Waste

Reports to Sales Department

a. Advertisement and Sales Promotion Expenditure
b. Analysis of Orders Received, Executed and on Hand
c. Cash Collection Reports
d. Market Research Activities
e. Ratios like Selling Overheads to Cost of Sales, etc.

76
 f. Reports on Bad Debts and Credit Control
g. Sales Analysis – Product-wise, Area-wise, Salesman-wise, etc.
h. Sales Variances
i. Selling and Distribution Costs
j. Warehousing and Showroom Expenditure Reports

According to Frequency of Reporting

Reports may be grouped into Routine Reports and Special Reports.

Routine Reports: Routine Reports are submitted to the management at predetermined time
schedules. It is a usual practice to keep a time schedule for release of such reports. In many
cases, routine reports are printed or cyclostyled, leaving blank columns or space to be filled in.
The executive in charge of reporting should keep a programme control chart and enter therein the
reports released from time to time. Examples of routine reports are variance reports, inventory
position reports, idle time and overtime reports, etc.

Special Reports: Quite often, certain problems may come up in businesses, requiring
investigation. Results of investigation into such cases and measures suggested to mitigate them
are presented by way of Special Reports. The form of these reports depends on the nature of the
problem in question. Unlike Routine reports where the interval at which they are submitted is
specifically laid down, Special Reports can be submitted only after proper investigation has been
made. No specific subject or schedule or frequency can be laid down for such investigation and
reporting thereon.

Special Reports mighty be required for the following issues:

1. Closing down a particular department
2. Cost of keeping excessive stocks of raw material, finished goods and losses due to
shortages
3. Cost of training
4. Delays in production and its effect on cost of product
5. Depreciation of assets
6. Effect of changes in production methods, systems and product designs
7. Effect of sales promotion schemes
8. Effect of surplus capacity on cost of product
9. Employee welfare schemes
10. Financial position of the organization
11. Improving the profitability of different products
12. Information about competitive products
13. Material price changes
14. Most suitable method of raising long-term capital

77
 15. Occurrence of accidents, losses and claims thereof, etc.
16. Problem of labour turnover and its effect
17. Problems of ‘make or buy’ decisions
18. Problems of capital investment
19. Problems of price fixation
20. Results of market studies and research
21. Schemes regarding cost reduction
22. Selling the product below the cost during temporary crisis
23. Starting new department or installing new plants
24. Stock turnover trends
25. Study of the change in Government policy and its impact on cost and profit
26. Study of the economic changes
27. Under and/or over absorption of overheads

According to Users

Another classification of Reports is according to the users, i.e., the person to whom reporting is
done. Accordingly Reports may be classified into External Reports and Internal Reports.
External Reports: External Reports are those which are prepared and submitted to external
parties or agencies periodically. These reports are:
a. Annual Accounts for shareholders – Income Statement, Balance Sheet and Directors’
Report
b. Report to Government Authorities – like tax returns, reports to Registrar of Companies,
other statutory reports, etc.
c. Report to Stock Exchange – if the shares of the company are listed on the stock exchange
d. Report to Banks/Financial Institutions –like stock statements, annual accounts, changes in
management, etc

Internal Reports: As opposed to External Reporting, Internal Reports refer to the reports to the
various levels of management; hence, often called ‘Management Reports’. These are not public
documents. They generally do not have to conform to any statutory standards. They are
basically vehicles for carrying information to the various levels of management. Such reports
are prepared keeping in view the recipient of the reports – his accomplishments, his time for
scanning the reports, the purpose to be served by the reports, etc.
Internal reports can be classified into:
a. Routine/periodic Reports
b. Special Reports
c. Operating Reports
d. Financial Reports
78
 CLASSIFICATION OF MANAGEMENT REPORTS: (Internal Reports)

Operating Reports Financial Reports

Static
Reports

Control Reports Information Reports Venture Measurement Dynamic

Reports Reports

Current Control Trend Reports Specific Venture

Reports Trend Reports

Summary Analytical Reports White Organization

Control Reports Reports

Of the above, (a) and (b) have already been discussed in the foregoing section; the remaining two
types of management reports are described below:

Operating Reports: These reports provide information about the operations of the company at
different functional levels. These reports are further classified as shown below:
 Control Reports: On the basis of Control, the reports can be classified into:
o Current Control Reports which are intended to spot deviation s from the budgeted
performance without loss of time, so that prompt control action can be taken at
the lower levels only. They relate to a small fragment of a whole period.
o Summary Control Reports which are intended to summarize the deviation from
objectives over a certain period so that control can be initiated at higher levels

79
  Information Reports: These reports provide useful information which will enable
programme and policy formulation for the future. These reports can be classified into:
o Trend Reports which provide information in a comparative mode over a period of
time. They clearly depict the direction of events over a period of time. Graphical
representation can be effectively used in trend reports.
o Analytical Reports which provide information in a classified manner about
composition of certain results so that one can identify specific factors in the
overall total. For example, the composition of various elements of cost in the
total cost of a product can be depicted. This can be done by a histogram with
markings for each element.
 Venture Measurement Reports: These reports are intended to communicate in a
summarized form the results of operations. These may be related to any specific venture
or activity or function, or to the organization as a whole. The reports in either case will
cover a specific period.
 Financial Reports: These reports provide information about the financial position of the
enterprise as on specific dates or the movement of finance during a specified period.
Balance sheet is a Static Report whereas funds flow statement is a Dynamic Report.
Cash flow statement and statement showing the financial position are examples of
dynamic reports as compared to the budget.

Some other classifications of management reports are:

1.On the basis of legal formalities to be complied with: as (a) Informal Reports and (b) Formal
Reports (which can be statutory non-statutory)
2. On the basis of functions: as (a) Informative Reports and (b) Interpretative Reports
3.On the basis of the nature of the subject dealt with: as (a) problem-determining reports, (b)
fact-finding reports, (c) performance reports, (d) technical reports, etc.
4. On the basis of persons submitting the reports: as (a) reports by individuals, and (b) reports
by committees or sub-committees.

-xxx-

80
SEGMENTAL REPORTING
Introduction
Many entities today carry on several classes of business or operate in several geographical areas
with different rates of profitability, different opportunities for growth and different degrees of
risk. It is not usually possible for the user of the financial statements of such an entity to make
judgments about either the nature of the entity's different activities or their contribution to the
entity's overall financial results unless the financial statements provide some segmental analysis
of the information they contain.
The business world today is bound by so many strategic decisions, that it has become a common
trend that, decisions are taken just for short-term benefits. The investors, as external users, rely
on the company’s annual reports to make decisions. These reports show a consolidated status of
the whole business and not division-wise. If the investor gets a hint about a non-performing
division, he may hesitate to invest in the company itself. But the companies till the introduction
of Accounting Standard 17 (AS-17), did not allow this hint in the investor’s mind by masking the
individual information through presentation of consolidated statements. The investors rarely get
to know about individual products/divisions and their performance. The shareholders need to
know whether the product lines into which the company is diversifying, contribute to the bottom
line of the company, enabling them to make an intelligent investment decision.
The segmental reporting information is the device which helps an investor find the performance
of the company’s individual divisions and judge the impact of management decisions. It is a
decisive information while evaluating and analyzing mergers and acquisitions.
According to AS-17, the objective of the segmental reporting is to understand the risks and
returns of a diversified enterprise or an enterprise whose operations are distributed globally, and
where the individual performance cannot be determined from a consolidated report.

Objectives
Segmental Reporting provides information about the different types of business activities in
which an enterprise engages (business segment) and the different economic environments in
which it operates (geographical segment).

This should help users of financial statements:

 Better understand the enterprise's performance.

 Better assess the risks and returns of the enterprise.
 Better assess its prospects for future net cash flows.
 Make more informed judgments about the enterprise as a whole

7.2.2 AS-17: Segment Reporting:

Applicability of Accounting Standard: Applicable to Level I Enterprises. Not applicable to Level

81
II and Level III enterprises in their entirely.

List of Level I Enterprises:

1. Enterprises whose equity or debt securities are listed whether in India or outside India.
2. Enterprises which are in the process of listing their equity or debt securities as evidenced
by the Board resolution in this regard.
3. Banks including co-operative banks.
4. Financial institutions
5. Enterprises carrying insurance business
6. Enterprises whose turnover exceeds Rs. 50 crores.
7. Enterprises having borrowings in excess of Rs. 10 crores at any time during the accounting
period.
8. Holding companies and subsidiaries of enterprises falling under any one of the categories
mentioned above.

List of Level II Enterprises:

1. Enterprises whose turnover exceeds Rs. 40 lakhs but does not exceed Rs. 50 crores.
2. Enterprises having borrowings in excess of Rs. 1 crore but not in excess of Rs. 10 crores at
any time during the accounting period.
3. Holding companies and subsidiaries of enterprises falling under any one of the categories
mentioned above.

List of Level III Enterprises:

Enterprises which are not covered under Level I, and Level II.

Main Gist of Accounting Standard:

In view of the complexities of types of businesses, the aggregated financial information is not
adequate to evaluate a company’s and management’s operating and financial strategies with
regard to specific or distinct line of activities i.e. segment. As an enterprise deals in multi-
product/multiple services and operates in different geographical areas, the degree of risk and
return also varies considerably. Segment information will enable the users to understand better
and also to assess the underlying risks and returns of an enterprise. Initially the segment needs to
be broadly classified into either ‘Business Segments’ or ‘Geographical Segments’ before being
slotted as ‘Primary’ or ‘Secondary’ for reporting in the financial statements as per AS-7.

82
1) Business Segment: A ‘Business Segment’ is a distinguishable component of an enterprise
that is engaged in providing an individual product or service or a group of products or services,
and that is subject to risk and return as distinctly different from those of other business segments.
The following factors are considered for grouping related products or services:
a) The nature of product / service.
b) The nature of production processes (e.g. labour intensive or capital intensive.)
c) The type or Class of customer (e.g. gender, income, etc.)
d) The method used to describe the products or provide services (e.g. wholesaler, franchisee,
dealer, etc.), similarity of economic and political condition relationship between operations in
different geographical areas, proximity of operation, special risks associated with operation in a
particular area, exchange control regulation, underlying currency risk, (geographical location
means the location of production facilities or service facilities and other assets of an enterprise
and the location of markets and customers.)
e) Nature of regulatory environment e.g. insurance, banking, public utilities, etc. the majority
of the factors will be considered to form a single segment even though, there may be
dissimilarities and a single business segment does not include products and services with
significant differing risks and returns (risk in investment and potential earnings as reward).

2) Geographical segment: A ‘Geographical segment’ is a distinguishable component of an

enterprise that is engaged in providing products or services within a particular economic
environment and that is subject to risk and returns that are different from those of components
operating in other economic environments. The following factors are considered for
identification of geographical segments.
a. Significant difference in risk and rewards.
b. Internal Management Information Systems (MIS) and organization structure.
c. Essential factors that defines a business segment.

Segment Accounting Policies: AS- 17 does not require that the enterprise apply accounting
policies to reportable segments on stand alone reporting entities, hence, additional segment
information may be disclosed that:
i. Information is reported internally to the Board or (CEO for the purpose of making
decisions about allocating resources to the segment and assessing its performance.
ii. The basis of measurement for additional information is closely described.

Segment Revenue: Segment Revenue is the aggregate of the portion of enterprise’s total
revenue that is attributable to a segment on a reasonable basis as distinct from other segments

83
including inter-segment transfer with the exception of:
a. Extra-ordinary item as AS-5.
b. Income by way of interest / dividend, etc. unless the operation of the segments are
primarily of a financial nature.
c. Gains or sale of investment or on extinguishments of debts unless the operation of the
segment, are primarily of a financial nature.

Inter-Segment Transfer: Inter-segment transfer should be made on the basis that is actually
used to price those transfers i.e. at cost, below cost or market price and the same should be
disclosed and followed consistently.

Segment Result: Segment result is segment revenue less segment expense.

Segment Assets: Segment Assets comprise of directly attributable or reasonably allocable
operating assets to the segment as reduced by related allowances or provisions, pertaining to
those assets including allocable common assets, however exclude:
a. Income tax asset.
b. General enterprise asset/Head Office (H.O.) asset.

Segment Liabilities: Segment liabilities are worked out on above basis but excluding:
a. Income tax liabilities
b. General enterprise liabilities/Head Office (H.O.) lease liabilities.

Disclosure required for primary segment:

a. Segment revenue with a break-up of sales to external customers and inter-segment result
deduction made to arrive at segment result in respect of total amount of non-cash expenses
(provisions, unrealized foreign exchange gain/loss as included in segment expenses).
b. Total amount of depreciation and amortization in respect of segment assets (not required if
cash flow of the enterprise reports operating, investing and financing activities).
c. Total carrying amount of segment assets.
d. Total amount of segment liabilities.
e. Total cost incurred during the period to acquire segment assets that are expected to be used
for more than one period (both fixed assets and intangible assets).

Disclosure required for secondary segment:

a. If primary format for reporting segment is business segment, it should also report:
1. Segment revenue from external customers by geographical location of customers for each
geographical segment consisting 10 percent or more of enterprise revenue.
84
2. Total carrying amount of segment assets, by geographical location of assets for each of
such geographical segment accounting for 10 percent or more of the total assets of all
geographical segments.
3. Total cost incurred during the accounting period to acquire segments assets, which are
expected to be used for more than one accounting period with 10 percent more criteria as in the
aforesaid line.

b. Where primary format is geographical, disclosure also required for each business segment
accounting for 10 percent or more of revenue form sales to external customers of enterprises,
total revenue or whose segment assets are 10 percent or more of the total assets of all business
segments.
1. Segment revenue from external customers.
2. Total carrying amount of segment assets.
3. Total cost incurred during the accounting period to acquire segment assets with expected
use extending beyond one accounting period (both tangible and intangible assets) of all
geographical location where geographical segment used for primary format is base on a location,
of assets which is different from location of customers.

Additional disclosure required for:

1. Revenue from sales to external customers for each customer based geographical segment
whose revenue from sales to external customers constitutes 10 percent or more of enterprise’s
revenue.
2. In a revenue situation, disclosure for:
i. Total carrying amount of segment assets by geographical location of assets.
ii. Total cost incurred during the accounting period to acquire segment assets expected to be
used for more than one accounting period both tangible and intangible by location of assets.

Interpretation of AS- 17:

1. Segment information will enable the users to understand better and also to assess the
underlying risks and returns of an enterprise.
2. Initially the segment needs to be broadly classified into either ‘Business Segments’ or
‘Geographical Segments’ before being slotted as ‘Primary’ or ‘Secondary’ for reporting in the
financial statement.
3. A ‘Business Segment’ is a distinguishable component of an enterprise that is engaged in
providing an individual product or service or a group of products or services, and that is subject

85
to risk and return as distinctly different from those of other business segments.
4. A ‘Geographical Segment’ is a distinguishable component of an enterprise that is engaged
in providing products or services within a particular economic environment and that is subject to
risk and returns that are different from those of companies operating in other economic
environments.
5. Segment revenue, costs, assets, etc. with a break-up consisting of 10 percent or more of
enterprise activity has to be disclosed in segment reporting.

7.2.3 ICAI’s Notification on Accounting Standard-17 (AS-17): Segment Reporting

(Adopted)

Issuing Authority: The Institute of Chartered Accountants of India.

Effective from: Accounting periods commencing on or after 1.4.2001
Applicable to:  Enterprises whose equity or debt securities are listed on a
recognized stock exchange in India
 Enterprises who are in the process of listing their securities
 Other enterprises whose turnover for the accounting period
exceeds Rs.50 crores.

Nature: Mandatory

Scope
To be applied in presenting general purpose financial statements. Also applicable in case of
consolidated financial statements.
Segment information should be prepared in conformity with the accounting policies adopted for
preparing and presenting the financial statements of the enterprises as a whole. To be complied
fully and not selectively.
Basis of Segment Reporting:
Enterprises must report information along: Product and services lines - Business Segment and
along the geographical lines - Geographical Segment One basis of segmentation should be
primary, the other being secondary.
Reportable Segment
Business segment or geographical segment identified for segment information disclosure.
Segments are organizational units for which information is reported to the board of directors and
CEO for evaluating the units performance and for allocation of resources.

86
Identify Reportable Segments (Primary and Secondary)
1. Identification to be governed by dominant source and nature of risks and returns
2. Internal Organization and Management Reporting may be referred to as the basis except
where
o Differences in products/services or difference in geographical areas affect risks
and returns equally, primary reporting by products/services and secondary
reporting by geographical areas is suggested.
o Neither products or services nor geographical areas form the basis of management
reporting. In such a case, management should determine whether risks & returns
are more related to products/services or geographical areas. Such identification
must be consistent with the following:
 If some of the internally reported segments meet the definitions as stated
below - no further segmentation is required.
 If some of the internally reported segments do not meet the definitions as
stated below - management should look to the next lower level of
segmentation to determine reportable segments which meet the requisite
definitions.
o If next lower level of segmentation meets the definition, following criteria may be
used for identify segments.
 Revenues from sale to external customers plus other segments is 10% or
more of total external and internal revenue of all segments.
 Segment result is 10% or more of :-
Combined result of all segments in profit or Combined result of all
segments in loss, whichever is more·
Segment assets are 10% or more of total assets of all segments
o a segment may be designated as a business or geographical segment at
management discretion, balance will be reconciling items
o the process should continue till external revenue attributable to reportable
segments is at least 75% of total enterprise revenue

Business Segment: Definition:

A business segment is a distinguishable component: That engages in providing product or

service and which is subject to risks and returns that differ.

87
Factors determining related product and services:
 Nature of product or services. Nature of production processes.
 Type or class of customers for the products or services.
 Methods used to distribute the products or provide the services.
 The nature of regulatory environment for example banking, insurance or public utilities,
if applicable.
Geographical Segment: Definition:
It is a distinguishable component of an enterprise that is engaged in providing products or
services within a particular economic environment which is subject to risks and returns that
differ.
Geographical segments may be identified by:
 Similarity of economic and political conditions.
 Relationships between operations in different geographical areas.
 Proximity of operations.
 Special risks associated with operations in a particular area.
 Exchange control regulations.
 Underlying currency risks.
Segment Disclosures: Primary Segment
Revenue (external and inter-segment shown separately).
 Segment results.
 Carrying amount of segment assets.
 Carrying amount of segment liabilities.
 Cost to acquire property, plant, equipment, and intangibles.
 Depreciation and amortization.
 Non-cash expenses other than depreciation.
Presentation of reconciliation between -
 Segment revenue to enterprise revenue.
 Segment results to enterprise results.
 Segment assets to enterprise assets.
 Segment liabilities to enterprise liabilities.

Segment Disclosures: Secondary Segment

In case of Geographical segment:

 Revenue from external customers by geographical area

 Carrying amount of segment assets by geographical location of assets.

88
  Cost of acquired property, plant, equipment, and intangibles
by geographical location of assets.

If location of customers is different from location of assets:

 Revenue from sales to external customers for each customer-based geographical segment.
 Total carrying cost of segment assets by geographical location of assets.
 Cost to acquire assets (both tangible and intangible) by location of assets.

Segment Disclosures: Secondary Segment

In case of Business Segment-

 Segment revenue from external customers.

 Total carrying amount of segment asset.
 Cost of acquiring segment assets (tangible and intangible).

Other Disclosures (for Primary as well as Secondary segments)

 When majority of enterprises' revenue is from inter segment sales.

 Basis for determining prices for inter-segment sales.
 When an enterprise operates in a single business or geographical
segment.
 Change in basis for determining prices for inter-segment sales.
 Change in accounting principles employed for segment disclosure.
 Revision in definitions of industry or geographic segment.
 Indicate type of products and services included in each reported segment.
 Indicate the composition of each reported geographical segment.

Differences between IAS, USGAAP & AS

IAS - 14 FAS - 131 AS - 17

Public entities. Report primary Public entities. Reports based Enterprises whose equity or
and secondary segment formats on internal operating structure. debt securities are listed on a
based on risks and returns and recognized stock exchange in
internal reporting structure. India, in the process of listing
& entities having turnover Rs.
50 Crores. Rest same as IAS -
14.
Use consolidated GAAP Use internal financial Use accounting policies
accounting policies. reporting policies even if adopted for the enterprise and

89

Disclosures for primary
segment format includes sales,
profits, capex, assets and
liabilities. For secondary
segment format, report sales,
assets and capex.
accounting policies may differ also specific policies related to
from consolidated GAAP. segment reporting.
Similar disclosures to IAS Similar disclosures to IAS
except liabilities and except capex in primary as
geographical capex not well as in secondary segment
required. Depreciation, formats.
amortization, tax, interest and
exceptional items required if
reported internally.

7.2.4 Segmental Reporting – Problems & Issues

The MNCs and the diversified companies are under pressure to disclose more segmental
information, but have been displaying their reluctance and resistance to disclose more. The
factors behind such resistance may be:

1. Fear of Competition: More disclosure means more transparency. The companies are afraid of
disclosing their business plans and strategies, activities and results very openly, as this is likely
to be taken advantage by their business rivals. However, financial experts argue that this
disclosure is more to help the investors in deciding the fate of the company, which misleads the
shareholders by window-dressing its financial statements.

2. Compiling Costs: Companies have to put special staff to compile the segmental information.
This involves more dexterity as the segmentation is the basis to reflect the positive result of
diversification, and hence justify the various management decisions. The information has to be
accurate and unambiguous, as to support the financial status of the company.

3. Fear of misinterpretation of information by investors: Investors always need more information

and simple information. The fallacy is that, if a financial statement is complex, the investor gets
suspicious. The investors are like a blinkered horse focused only on their returns, and are not
aware of the long-term vision of the company, and may take a decision based on the segmented
financials alone. However, studies have shown that there is more to business than numbers, and
investors, though basing their investment decision on pure numbers, can also sometimes be
vigilant enough to identify the mismatch between the strategy and numbers, and question the
management about it. This way there is a healthy balance between the management and the
investor, which is good for the long-term prospects of the company.

90
COST REDUCTION
In a situation where the selling prices are driven by the market, input costs are ever increasing &
there exists an intense competition in the market, the only way by which an organization can
retain or improve its profitability is by reducing the cost. Therefore, cost reduction has become
vital for many organizations not only for growth but also for their survival.

Cost reduction is a conscious attempt by an organization to bring the costs down. According to
CIMA " Cost reduction is to be understood as the achievement of real and permanent reduction
in the unit cost of goods manufactured or services rendered without impairing their sustainability
for the use intended or diminution in the quality of the product. Therefore, cost reduction implies
real and permanent reduction in cost of goods manufactured and/or services rendered. However,
this should not impair the product's suitability for the intended use.
The cost reduction can be achieved by
(1) Reducing the cost per unit, or
(2) Increasing Productivity.

Cost reduction should not be misinterpreted as cost control. In cost control, an effort is made by
the organization to keep the costs well within the established standards or targets, whereas cost
reduction focuses on the standards themselves and would attempt to bring them down. Cost
reduction is different from cost saving. Cost saving is essentially a short term phenomenon,
whereas cost reduction is always a permanent phenomenon.
Another important attribute of cost reduction is that it should be achieved by using internal or
controllable factors. Any reduction in costs by virtue of external or uncontrollable factors such
as, reduction in taxes, subsidies extended by government etc. does not come under the preview of
cost reduction. It is only cost saving.

Characteristics of Cost Reduction

1. It must be real Cost reduction must be real and measurable. It should not be assumed or
hypothetical. Any reduction that has come into existence by increasing the productivity or
changing the product design or using improved technology etc. are some of the real cost
reductions. Any reduction in costs by changing the method of accounting etc. is not real
reduction in cost.

2. It must be permanent Any temporary reduction in the costs due to cyclical changes, changes
in tax rates, changes in the price of raw materials etc. cannot be considered as cost reduction. The
cost reduction must be permanent. The costs reduced by changing the mechanism of placing the
orders, minimizing the occurrence of scrap by using an improved machinery etc. are permanent
reductions in cost.

3. It should not impair the intended useAnyalternation proposed should only bring the costs
down. It should not bring down the utility or quality of product or services rendered. If cost of a
product is reduced by using a lower quality input, then it does not amount to cost reduction. In
case of a computer, if the cost is reduced by using a lower capacity hard disk or RAM, then this
does not amount to cost reduction.

91
Scope or areas of Cost Reduction
Cost reduction in any organization is all pervasive, therefore it is impossible to enlist all the areas
in which cost reduction can take place. In simple, it is applicable to all the activities of the
business, wherever costs are being incurred. However, it may not be viable for any organization
to concentrate all the activities where costs can be reduced.

The important areas for Cost Reduction are:

1. Product Design Product designing is the first and the most important step in any
manufacturing process. It has a very high potential to contribute towards for cost reduction. The
possibility(s) for cost reduction must be explored both at introduction or initial stages and also at
the time of modifying the existing design. This will lead to reduction in material costs by
introducing economical substitutes. For example, in all most all cars, now the bumpers are made
of fiber only. Alternatively, it may bring down cost of labour by reducing the length of
manufacturing cycle by introducing automation.

2. Production Planning and Control The aim of production planning and control is to provide
better co-operation and co-ordination among all the resources utilized by an organization. If an
organization has an efficient production planning and control that will lead to lower investments
in material, improved productivity, reduced idle time, reduced overheads etc., which ultimately
result in cost reduction.

3. Plant Layout and Equipment

Plant layout, means physical arrangement of the equipment,work stations etc. Any improvement
or modification in the layout reduces the wasteful movements of the resources and thus reduces
the cost.

4. Factory Organization
Cost reduction can be achieved by improving the organization structure, to avoid overlapping of
responsibilities to improve communication for better co-ordination to delegation for better
supervision etc.

5. Purchasing & Material Control

Purchasing and material control provides for making purchases at the right prices, at the right
time which would reduce the investments and minimize the costs of funding them better control
of materials by proper inspection, storage, handling etc. minimizes the wastages and minimize.
This will enable the organization to reduce the material costs to some extent.

6. Direct labour
Better systems introduced in direct labour in terms of time keeping work study, incentive system
smoothing of labour force etc. will provide reduction of labour cost.

7. Marketing
Marketing department of an organization can contribute towards cost reduction by bringing more
orders which will be paving a way for utilizing the ideal capacity and reach higher productivity.

92
8. General administrationReducing the quantum of labour on staff or introducing the office
automation or improving the flow of work etc. are some of the examples of the areas in which
the general administration can bring in reduction in costs.

9. Financial Management
The financial management can reduce the costs of financing by following hedging policy to
finance its working capital requirements and provide for better Return on Investments. Above
this, the financial management enables investments in capital assets, that contribute to the wealth
of an organization.

Tools and techniques

There are innumerable tools and techniques that can be employed by an organization in cost
reduction. Here are some of the important tools followed by an organization.

Standard costing
Standard costing enables the organization to set its own budgets or standards and identify the
deviations and the reasons for the same. By plugging those deviations the organization can bring
in cost reduction.

Budgetary control
Budgetary control is used as a tool for planning and monitoring by many organizations. Through
budgetary control an organization can identify the cost that is incurred unnecessarily and by
monitoring them the reduction of cost can be achieved.

Inventory control
Inventory control aims to minimize the costs, that are associated with the inventory. Through
inventory control, the organization can strike a balance in respect of the cost of holding the cost
of storage and thus can reduce the cost.

Operation Research

Operation research is a quantitative and multi-disciplinary approach to problem solving

concerned with the efficient allocation and control of resources. The mathematical treatment
through which optimum solution is obtained for the OR models enables the organization to have
effective utilization of resources and reduce the costs.

Statistical quality control

This technique acts as a preventive step which inspects the individual components or products
and compares them with predetermined standards. The main aim of statistical control is to
lookout for the process which reduces the number of defectives and keep them within acceptable
limits and thus reduces costs.

93
An indicative list of other tools and techniques are;

a) Value analysis
b) Standardization
c) Simplification and variety reduction
d) Work study
e) Quality control
f) Design analysis
g) Low cost automation
h) Rationalization
i) Job evaluation and merit rating
j) Coding and classification
k) Production planning and control
l) Technological and business forecasting
m) Organization and method study
n) Market research

The advantages of cost reduction are;

1. It increases the profits and thus create more wealth to the shareholders and benefits to all
the stakeholders.
2. Increased profitability contributes to the management’s ability to spend money on labour
welfare schemes. This will improves the relationships between employees and employers.
3. Cost reduction ultimately lead to the reduction in the prices of goods and passion the
benefit to the consumers by providing goods at cheaper rates.
4. Cost reduction makes the organization competitive in the market as it can afford to
reduce their selling price of the products.
5. Cost reduction increases to profit and would lead to higher revenue to the government by
way of taxation.
6. Reduction in cost of the goods may make exports variable and thus contributes positively
to the balance of payments.
7. Cost reduction may be achieved by increasing the productivity and it will lead to the
effective utilization of the societal resources which are scares.
8. Cost reduction emphases the search for improvements in the products in many ways and
therefore provides better products for the use of consumers.

94
 The disadvantages of cost reduction are;

1. In the process of cost reduction the quality of product or service may be compromised by
the organizations.
2. Some of the reductions in costs may not be permanent and / or real.
3. The process of cost reduction may create a disharmony between and among the
objectives of various stakeholders.
4. The enthusiasm of top management to reduce the costs may put undue pressure on the
resources of management.
Cost

The CIMA, London defines cost as 'The regulation by executive action of the cost of operating
an understanding particularly, where such action is guided by cost accounting.

Control
Control in simple words means the determination and/or measurement of progress towards the
organizational objectives or goals in accordance with the sound principles.

"Control consists in verifying whether everything occurs in conformity with the plans adopted,
the instructions issued and principles established. It has an object to point out weaknesses and
errors in order to rectify them and prevent recurrence. It operates on everything(s), people and
their actions." – Henry Fayol, Father of Administrative Management.

COST CONTROL
By extending the logic of control to the costs incurred by an organization, cost control can be
defined as the comparative analysis of actual costs with appropriate standards or budgets to
provide for performance evaluation and formulation of corrective measures.The aim of cost
control is to achieve conformity between the actual performance and the standard or a budget.

Cost control aims to have the maximum utilization of cost incurred. The objective of cost control
is to perform the job at lower cost comparatively or extract better performance at the same cost.

Features
1. Cost control creates responsibility with defined authority.
2. Cost control fixes the responsibility of the cost incurred to the cost center or responsibility
center.
3. It provides for timely cost control reports to the organizations indicating the variances between
the actual performance and the standards or budgets.
4. It facilitates the formulation of the a corrective measures to reduce or eliminate the
unfavorable variance(s) if any.
5. It motivates employees positively and encourage them to accomplish the goals systematically.
6. It provides a mechanism for follow up and check whether the corrective measures under taken
are being applied effectively in an organization.

95
Steps in Cost Control
The steps in cost control are similar to that of a simple cost controlling mechanism with minute
changes.
Step1:Identify and fix a norm or a standard or target to be achieved.
Step2:Select a yardstick for measuring the standard or target.
Step3:Measure the actual performance in cost terms by applying the yardstick.
Step4:Compare the actual performance with the standard or target and identify the variances
both positive and negative if any.
Step5:Ascertain the reasons for the occurrence of variances and fix the responsibility to the
corresponding cost center or responsibility center.
Step6:Take corrective action to eliminate the causes of variances in order to achieve maximum
efficiency by bringing in the performance in conformity with standards or targets.
Step7:Review the standards or targets periodically and revise them if necessary.

Essentialsin Cost Control

The success of a cost control system depends on the following factors:
1. An organization should have a definite and well-defined standards or targets.
2. The authority and responsibility of the executives should have been clearly defined and known
to them.
3.The standards or targets should be preferably quantitative and measurable in terms of costs.
4. They should be clear fixation of responsibility to the centers.
5. Costs should be collected separately for each area of responsibility
6. The reporting system should enable the management to apply the principle of management by
exemption, by drawing their attention towards both good and bad performances.
7. There should be a proper rewarding system which motivates worker for better performance in
future and a mechanism that takes necessary steps to curb the bad performances.

Techniques of Cost Control

Cost control can be exercised by an organization primarily through budgeting and standard
costing.Budgeting is a process of preparing budgets. Budgetary control is a means of control in
which the actual performance is compared with budgeted performance, deviations are identified
and an appropriate action is taken. Welsh relates budgetary control with day-to-day control
process. According to him, 'Budgetary control involves the use of budget and budgetary reports
throughout the period to co-ordinate, evaluate and control day-to-day operations in accordance
with thegoals specified by budget.'

The objectives of the Budgetary Control are:

1. To provide a procedure for planning
2. To co-ordinate the activities of all departments in a business entity.
3. To facilitate the identification of responsibility for all the deviations and to provide
information on the basis of which a corrective action may be undertaken.

Standard Costing Standard cost is a pre-determined cost which is calculated form

managements' standard of efficient operations and the relevant necessary expenditure. The
technique of using standard cost for the purpose of cost control is called standard costing.

96
According to The Institute of Cost of Management Accounting, UK, Standard costing is 'the
preparation and using standard cost, their comparison with actual cost and the analysis of
variances to their causes and points of incidence’.
Standard costing as a system of cost accounting enables the organizations to find out as to how
much should be the cost of a product under the existing conditions. When actual cost is
compared with the standard cost and variances are identified the organizations can take
corrective measures.

Materials Control
Material means the raw material used for production including sub- assemblies, fabricated parts
etc. Material cost is a very important constituent of the manufacturing cost. Materials control
aims at creating an efficient system for purchasing, storing and consumption.This involves both
quantity controls and financial controls. In materials control a balance has to be strike between
the maintenance of sufficient inventory for uninterrupted production and keeping the investment
in inventory at the lowest possible levels.

Labour Control
Labour cost is the cost of human effort involved in producing or rendering a service. The control
process of labour cost also involves the comparison of actual labour cost with the standard or
budgeted labour cost.The labour cost controlling mechanism provides the optimum labour
facility with the optimum labour cost. In other words, it aims at bringing the efficiency of the
labour force with lowest possible labour cost. This may be done by minimizing ideal time, labour
turnover etc.

Overhead Controls
Overheads are those costs of a business entity that cannot be traced directly to a particular unit of
output.Overhead cost control would not only try to minimize the overhead costs incurred in
relation to production, administration and selling and distribution, but also makes an attempt to
avoid the possibility of over or under absorption of overheads and provides for a proper
estimation of the total cost.

Control on Capital Expenditure

Capital expenditure provides the long term benefits to the organization for the sacrifice of
monetary resources made today.Capital expenditure control provides for the mechanism as to
what will be the optimum expenditure to be measured by the organization in order to minimize
its cost of capital and maximize the return on investment.

Cost Reporting System

The reporting system developed by the organization must be efficient, in the sense that it should
report all the kinds of abnormalities be it favourable or unfavorable should be reported to the
management immediately in such a way that the top management can apply the principle of
management by exemption and take necessary action.

Differences between cost control and cost reduction

97
The scope of cost reduction is wider than that of cost control. Cost control aims at controlling the
cost within the standard set by the organization. Whereas cost reduction aims at reducing the
standards itself. The following are the difference between them.

Cost Control Cost Reduction

1. It aims at achieving the predetermined It aims at achieving real and permanent reduction of
costs or targets cost.

2. It is applicable to items for which the It is applicable to all the activities of business
standards have been identified. irrespective of whether they have standard or not.

3. It assumes that the standards are It assumes that there is a possibility of changing or
sacrosanct. resetting of standards.

4. In cost control, costs are optimized In cost reduction, it is assumed that there is always a
before their occurrence. possibility reducing costs.

5. It is a preventive activity. It is a correcting activity.

6. It follows a conservative procedure and It is a continuous, dynamic and innovative function

therefore lacks dynamism. always looking for ways to reduce costs.

7. It is concerned with setting up It is not concerned with maintenance of performance

performance standards, comparing as per pre-determined standards rather would always
actuals with it, analyzing the variance try to improve and change standards itself. It is the
and taking remedial measures to correct outcome or final result of cost control process.
them.

TARGET COSTING

There are many producers or sellers present in the market. The differentiation or uniqueness of
the products has faded away and the customer feels that there is no difference among the
products. Therefore substitution of the products has become rampant in all most all products and
therefore the traditional cost-plus profit pricing model will not be applicable. In this kind of
situation every organization must follow market based pricing strategy. The starting point of
market based pricing is the target price. Target price is estimated price of a product or service,
the potential customers willing to pay based on their perceived value for that product or service
and how the competitors will be pricing their product or service.

Target costing is a method of cost planning used during the planning cycle to reduce
manufacturing cost to target levels. The goal of target costing is to design costs of products at
research development and experimentation stage of the product life cycle rather than trying to
reduce costs during the manufacturing or modification stage.

98
The target cost is the difference between the target selling price and the target profit margin.
Once the target cost of the product or service has been set for the organization it will undertake
value engineering process to determine the target cost for each and every component.

Prerequisites for implementing target costing system

Any organization which is intending to implement a target costing must

1. Understand customers’ perceived value for a product or service An organization

cannot afford to manufacture a product or design a service, without understanding the
requirements of the customers and the price they are willing to pay for the product or
service. This can be done with the help of the sales and marketing department which will
be closely interacting with the customers. Alternatively can also take the help of market
research to identify the product features and the price which customers are willing to pay
for those features.
2. Analyze the competitors Any action initiated by a company will always be followed by
some kind of reaction by the competitors. To understand the reaction of the competitors,
a company needs to understand their technologies, cost of products or services and
financial conditions. This will help them to understand how distinctive their products or
services are and what price will they be able to charge.

99
 Devvelop a Product
or service that
satiesfies the need of
the customers

Ascertain the target

price

Drive a target cost

per unit

Detailed cost analysis

Perform value
engineering

Figure 8.1: Steps in implementing target costing:

100
There are five (5) steps in implementing target costing in a company. They are;

1. Develop a product or service that satisfies the needs of the customers

After understanding the needs of customers with the help of the marketing department or
market research the logical continuation is to develop a product or service or modify the
existing product or service as per the requirements of the customers.

2. Ascertain the target price

The determination of a target selling price at a target product volume depends on the
company’s perceived value of the product to the customer. The target price does not
depend on the costs that are associated with producing a product or rendering a service.
They are purely dependent on the customers, competitors and the market situation.

3. Derive a target cost per unit

Target cost per unit is nothing but the excess of the target price over its target operating
income per unit. The target operating income per unit is that income the company aims to
earn on a product or service. In simple words the target cost per unit is the estimated cost
per unit of a product or service which enables them to achieve a target income in the long
run by selling at the target price. Typically the target costs will be lower than the full cost
per unit of the product which is a target which a company commits to achieve.

Target cost = Target selling price – Target operating income

4. Undertake detailed cost analysis

At this stage a thorough analysis of the aspects of a product or service will be undertaken
to target for cost reduction. In case of a product the function(s) performed by different
components parts their costs, the importance of the components to the target customer
and their features will be studied in depth and unnecessary components will be removed
or necessary components will be added.

5. Perform value engineering

Value engineering is a systematic evaluation of all aspects of the value chain of the
business function with an objective of reducing the costs and achieving the target costs,
while satisfying the needs of the customers. In simple words value engineering is the
process of examining each component of a product to determine whether its costs can be
reduced while maintaining the functionality and performance. Value engineering results
in improvements in product design, changes in material specification or modifications in
the process.

101
Intricacies of Target costing

Target costing appears to be logical and rational. Undoubtedly it has some advantages also such
as provision of better products, meeting the customers’ demand, coordination among the
members of supply chain etc. However there are some problems in implementing the system
they are:

1. It focuses on achieving the target cost and in the process there is every possibility that it
may divert the attention away from the all other elements including the company goals.
2. The enthusiasm of the organization to achieve the target cost may create conflicts
between various parties involved in this process. For example, companies may put
excessive pressure on suppliers and sub-contractors to reduce the cost which may lead to
either strained relationship or alienation of relationships.
3. The employees of the organization who are working under continuous pressure to achieve
the target cost may feel or experience the burnout phenomena.
4. There might be a situation where the organization will be achieving the target cost after
repeated efforts of value engineering to reduce the cost but this may delay the launch of
the product, before which the competitors would have taken the early bird advantage.

BALANCED SCORECARD

The concept of Balanced Scorecard was developed by Robert S Kaplan and David R. Norton of
Harvard Business School during 1990’s. They felt that evaluation of performance of a business
entity solely on the basis of financial measures is inadequate and does not give a complete
picture of the real performance and hence developed the Balanced Scorecard which is not only a
system of measurement but also a management system. The Balanced Scorecard undoubtedly
measures the performance of a business entity along with helping the entity to set up and achieve
its strategic goals and objectives. In simple Balanced Scorecard is strategic management system
that translates an organization’s strategy into clear objectives, measures, targets and initiatives
organized by four perspectives namely:

 Financial
 Customer
 Internal
 Learning and growth
Purpose

102
 The Balanced Scorecard balances traditional financial measures of success such as profit
maximization and Return on Investment (ROI) with non- financial measures of the drivers of
future financial performance. The Balanced Scorecard enables companies to track financial
results while simultaneously monitoring how they are building their capabilities with
customers, with external processes and with their employees and systems for future growth
and profitability.

Strategy map

The organizations identify their strategic objectives and provide inter-linkage to them. A
strategy map is a comprehensive visual representation of the linkages among objectives and
measures the four perspectives of the Balanced Scorecard.

Features of Balanced Scorecard

Among the four perspectives of the Balanced Scorecard three of them are non-financial areas
in addition to the one looking at financial area.

FinancialPerspective

Goals Measures

Customer Perspective Internal Perspective

Goals Measures Goals Measures

Learning & Growth Perspective 103

Goals Measures
Fig. 8.2 Balanced Scorecard

1. Financial Perspective
The financial prospective has been treated as the ultimate objective for profit maximizing
companies even in Balanced Scorecard. The ultimate aim of financial performance
measures in Balanced Scorecard is to indicate whether company’s strategy,
implementation and execution are contributing to the improvement of the profits or not.
Balanced Scorecard measures objective of profitability in terms of operating income or
ROI.

To achieve higher degree of financial performance, the organization should concentrate

on both revenue growth and productivity. The revenue growth is typically achieved by
creating a deep relationship with the existing customers.Productivity improvements can
happen by reducing the costs and by utilizing their assets both financial and physical
more efficiently. The financial perspective of Balanced Scorecard attempts to integrate all
of them to create value to the shareholders.

2. Customers Perspective
Customer perspective of the Balanced Scorecard attempts to measure customer
satisfaction and the measures to be taken by the organization to provide that level of
satisfaction. According to Balanced Scorecard the management of an organization should
identify the targeted customer segments in which the entity competes and improve
customer satisfaction, retention, acquisition, profitability which will lead to market share
and account share of the entity.

The companies must also look into the objectives and measures for the value proportion it
offers, to build an attractive sustainable relationship with customers through product
innovation and leadership which would ultimately lead to complete customer satisfaction.
Balanced Scorecard defines how the company differentiates itself from competitors in
attracting, retaining and deepening the relationship with the target customers in its
customer perspective which would ultimately lead to improvement in financial
perspective.

3. Internal Perspective
When the company has clarity about its financial objectives and customer objectives, the
logical continuation is to search for the means, by which it can produce and deliver the

104
 value proportion for customers and achieve productivity improvements for the financial
objectives through its internal processes. The internal perspective of Balanced Scorecard
identifies the critical processes in which the organization must excel to achieve its
customers satisfaction, revenue growth and profitability objectives. The broad processes
existing an organization are:

i) Operating Processes
These are the most basic processes and are related to the day to day activities through
which the companies produce their products and services and deliver them to the
customers. Examples are: acquisition of raw materials, conversion raw material into
finished goods, distribution etc. of finished goods.

ii) Customer Management Processes

These processes are undertaken by an entity to expand and deepen relationships with the
target customers. The processes that are included in customer management are selection,
acquisition, retaining of customers and business growth.

iii) Innovation Processes

Innovation processes help or enable the development of new products and / or services
that enable a company to enter and penetrate new markets and new segments. Successful
innovations help the organization in acquiring the customers and thus lead to enhanced
operating profit.

iv) Regulatory and Social Processes

These processes promote meeting or exceeding the standards established by the
regulatory authorities and facilitate achievement of desired social objectives. If not
anything these processes will avoid shutdowns or litigations. The compliance to the
regulatory and social requirements enhances the reputation, improves employee safety
and health, which will lead to increased productivity and lower operating cost. With all
this, it creates a goodwill in the minds of shareholders and investors who are socially
conscious, and thus drive long term shareholder value creation.

4. Learning and Growth Perspective

This identifies the objectives for people, systems and organizational alignment that create
long term growth and improvement. The company must clearly identifies the employee
capabilities and skills, technology that will contribute to the improvements of
performance in the financial, customer and internal perspectives. In this process the
organization learns as to where they must invest in order to improve the skills of their
employees, enhance technology and systems and align people to the organizational
objectives. This perspective of Balanced Scorecard identifies how to mobilize the

105
 organizational intangible assets – human, informational and organizational assets to drive
the improvements in internal processes for implementing the strategy and achieve their
financial perspectives.

Reasons for the use of Balanced Scorecard:

The Balanced Scorecard was developed to improve the measurement of performance by

incorporating non-financial drivers. Its utility has increased over a period of time beyond
measurement. The uses of Balanced Scorecard are:

 It creates focus for the future

 The information flow between and among organizational units & employees will improve
drastically.
 It creates a system of management which is strategic in nature and focused on
implementation.
 It translates the strategy to operational terms and enables the clarity of thought.
 It creates the linkages to the numerous sectors of the business in such a way that they are
aligned to the organizational strategy.
 When the organization has a focused strategy it will reorient the employees to contribute
to the success by modifying their day-to-day tasks.
 The Balanced Scorecard can be used as a tool for communication &a tool for educating
the employees.
 The Balanced Scorecard can be used as a screen or a parameter to evaluate potential
investments & initiatives.
 It will create a sense of ownership & brings active involvement of the executive team to
bring success.
 It provides continual focus on the change initiatives & on the performance against
targeted outcomes.
 It mobilizes & motivates the organizational leadership for change.

106