Management Accounting Unit- 1 To 6.pdf

INDEX Units  UNIT 1  LESSON 1-NATURE AND SCOPE OF MANAGEMENT ACCOUNTING  UNIT 2  LESSON 1-INTRODUCTION- BUDGETING & BUDGETARY CONTROL  LESSON 2-FUNCTIONAL BUDGETS  LESSON 3- FIXED AND FLEXIBLE BUDGET  LESSON 4-RECENT DEVELOPMENTS IN BUDGET  UNIT 3  LESSON 1-STANDARD COSTING  LESSON 2- VARIANCE ANALYSIS – MATERIAL & LABOUR VARIANCE  LESSON 3-VARIANCE ANALYSIS - OVERHEAD & SALES VARIANCE  UNIT 4  LESSON 1-ABSORPTION COSTING VS. VARIABLE COSTING  LESSON 2-COST-VOLUME-PROFIT ANALYSIS  UNIT 5  LESSON 1-DECISION MAKING & VARIABLE COSTING  LESSON 2-DECISION MAKING & DIFFERENTIAL COST ANALYSIS  UNIT 6  LESSON 1-RESPONSIBILITY ACCOUNTING & DIVISIONAL PERFORMANCE MEASUREMENT  Previous Year Question Papers

Ms. Preeti Singh Assistant Professor Daulat Ram College

Page No. 1 to 17

18 to 32 33 to 46 47 to 60 61 to 71 72 to 83 84 to 107 108 to 131

132 to 149 150 to 170 171 to 194 195 to 206

207 to 220

LESSON-1

UNIT 1

NATURE AND SCOPE OF MANAGEMENT ACCOUNTING 1. STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Definitions 1.3 Nature of Management Accounting 1.4 Objectives of Management Accounting 1.5 Tools and Techniques of Management Accounting 1.6 Limitations of Management Accounting 1.7 Comparison between Financial Accounting, Cost Accounting and Management Accounting 1.7.1 Comparison between Financial Accounting and Management Accounting 1.7.2 Comparison between Cost Accounting and Management Accounting 1.8 Cost Control 1.9 Cost Reduction 1.9.1 Area and Scope of Cost Reduction 1.10 Comparison of Cost Control and Cost Reduction 1.11 Cost Management 1.12 Self-Test Questions

1.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn the meaning, nature and scope of management accounting (b) Learn to compare financial accounting, cost accounting and management accounting (c) Learn the various concept like cost control, cost reduction and cost management (d) Learn different tools and techniques of management accounting

1.1 INTRODUCTION Every organization requires accounting information for managing daily operations and to make variety of decisions in different situations. Management has to work for the success of the enterprise and it requires only that information which helps them in planning, organizing, commanding, coordinating and controlling. For these reasons, the 1

accounting information is to be analyzed, regrouped and looked into minutely. On the basis of information provided by accounting data, it is divided into three category financial accounting, cost accounting and management accounting. Management Accounting is a new approach to accounting. The term Management Accounting is composed of two words - Management and Accounting. It refers to Accounting for the Management. Management Accounting is a modern tool to management. It includes various methods, tools and techniques necessary for effective planning for choosing among alternative business actions, and for control through the evaluation and interpretation of performance and finally for decision making purpose. It is basically concerned with providing the information to the insiders for decision making and achieving the objectives of the organization effectively.

Management has to forecast, has to

Accounting information needed to be

plan, has to organise, has to command, has to co-ordinate and has to control various operations.

analysed for the management to contribute to the success of the enterprise.

1.2 DEFINITIONS CIMA, London

“Management accounting is an integral part of management concerned with identifying, presenting and interpreting information used for: (a) formulating strategy; (b) planning and controlling activities; (c) decision taking; (d) optimizing the use of resources; (e) disclosure to shareholders and others external to the entity; (f) disclosure to employees; (g) safeguarding assets”

American Accounting Association

“Management Accounting is the application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist management in establishing plans for reasonable economic objectives in the making of rational decisions with a view towards these objectives.” “The application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking.”

ICMA, London

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The management accounting team of AngloAmerican Council on Productivity Robert Anthony

Brown and Howard

J Batty

The Institute of Chartered Accountants of England and Wales

“The presentation of accounting information in such a way as to assist management in the creation of policy and in day to day operation of an understanding”. “Management accounting is concerned with accounting information which is useful to management” Management accounting may be defined broadly as that aspect of accounting, which is concerned with the efficient management of a business through the presentation to management of such information as, will facilitate efficient and opportune planning and control. “Management accounting is the term used to describe accounting methods, systems and techniques which coupled with special knowledge and ability, assists management in its task of maximizing profits or minimizing losses.” “Any form of Accounting which enables a business to be conducted more efficiently can be regarded as Management Accounting.”

From the above definitions, one can have clear view about the management accounting. It focuses on that accounting information, which is useful to the management for various reasons. The accounting information is rearranged in such a manner and provided to the top management for planning, controlling and decision making.

1.3 NATURE OF MANAGEMENT ACCOUNTING Decision Making System Selective Nature

Future Oriented

Nature of Management Accounting Not Rigid

Selective Nature

Optional

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Internal Use

(1) Decision Making System: Management accounting is useful in decision making. It uses various techniques and collects and analyzes the information/figure relating to cost, price, profit and savings for each of the available alternatives in order to make sound decisions. (2) Future Oriented: Management Accounting is an accounting system which is directly related to future course of events. As it is concerned with planning, decision making and controlling which relate to future period. Hence the primary nature of management accounting is that it is futuristic. (3) Internal Use: Financial accounting information is basically intended for outsiders or externals but management accounting is meant mainly for internal users. Because the information provided by the management accounting is use by the management for internal use. (4) Selective Nature: It is also a potent characteristic of this accounting system. Here selective means, in management accounting, a management accountant is only collect those data and information from a variety of alternatives or do comparison analysis which would be useful in decision making. Hence, it is selective in nature. (5) Optional: As there is no statutory obligation in management accounting. It is purely voluntary in nature. There is no obligation related to this accounting. It can be used according to its utility for the managements. (6) Not Rigid: In financial accounting, accountants need to follow different norms and rules for creating ledgers and other books of account. But there is no need to follow fixed norms in management accounting. Even there is flexibility for presenting the records and other information. Management accounting tool may be different from one organization to other organization. Usage of different tools is fully dependent on the persons who are using it.

1.4 OBJECTIVES OF MANAGEMENT ACCOUNTING

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(1) Planning: Management accounting assists management in planning the activities of the business. It involves forecasting on the basis of available information, setting goals, framing policies, determining the alternative courses of action and deciding on the program of activities. The techniques which are used in the management accounting are Budgeting, standard costing and variance analysis etc. (2) Controlling: Management accounting is a useful device of managerial control. It is an important function of management accounting. Control means measurement and evaluation of performance. Thus, management accounting helps management in discharging its control function successfully through budgetary control and standard costing. (3) Decision Making: The main objective of management accounting is to help in decision making. Modified data, analyzed data and interpreted information are highly useful to management for taking quality decision and policy formulation in a management accounting system. (4) Classifying, analyzing and interpretation of data: Under management accounting, the data is properly classified, analyzed and interpreted to make the accounting information more relevant for decision making purpose. By doing this exercise, the data become more understandable and explanatory for the management. (5) Increasing Efficiency: By setting norms or standards for the units or centers, the management accounting evaluates the performance and helps in improving the efficiency. For example - management accounting lays emphasis on management audit which means evaluating the efficiency of management policies to improve efficiency. (6) Coordinating: Budgeting is one of the techniques that create sink between the objectives of the organization as a whole with the objectives of all the departments. For instance - Preparing the functional budgets in the first instance and then co-coordinating the whole activities of the concern by integrating all functional budgets into one known as master budget involves coordination. (7) Increase Profitability: Management accounting can help companies lower their operational expenses. Business owners often use management accounting information to review the cost of economic resources and other business operations. This information allows owners to take better decision related to cost and ultimately helps in increasing the profitability of an organization. (8) Performance Evaluation: Setting goals, objectives and standards and planning the best and economical course of action and then measuring the performance on the basis of these, helps an organization to increase the effectiveness and thereby motivate the members of the organization. 5

1.5 TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING Management accounting deals with number of tools and techniques to help the managers in better planning, controlling and decision making. Some of the important tools and techniques are as follows: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)

Financial Planning Financial Statement Analysis Decision Making Standard costing and variance analysis Marginal costing and cost profit volume analysis Responsibility Accounting Discounted Cash flow Learning Curve Ratio analysis Statistical and Graphical Techniques Funds flow statement Cash flow statement Value analysis Risk analysis

1.6 LIMITATIONS OF MANAGEMENT ACCOUNTING Management accounting is a very useful tool of management but is subject to the following limitations: (1) Evolutionary stage: Management accounting is comparatively a new discipline. Its rules, principles and conventions are still in the developing stage. A lot of research needs to be done to increase its scope. This limits the usage of management accounting in making a perfect tool for planning and decision making. (2) Costly: The installation of this system of accounting involves huge cost. It involves huge investment (in terms of money and man power) and wide area of network of the management which is not specifically possible for the small organization. (3) Based on historical data: As management accounting requires lot information and data which is retrieve from the books of financial accounts and cost accounts which in turn based on historical data. The success of management accounting depends on the accuracy of the information. And the past data is inaccurate and not reliable for the decision making purpose.

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(4) Opposition to change: Management accounting demands a break away from traditional accounting practices. Installation of new techniques demands a change of attitude and acceptance and support from the employees. It calls for a rearrangement of the personnel and their activities, which is generally not like by the people involved. (5) Wide coverage: The application of management accounting requires wide knowledge of various disciplines like economics, taxation, statistics, and management and so on, not only of cost accounting and management accounting. This all brings inexactness and subjectivity in the conclusions obtained through it. (6) Not a substitute of management: Management accounting cannot replace the management. Management accountant is only an adviser to the management and provides necessary data for decision making. The decision regarding implementing his advice is to be taken by the management. There is always a temptation to take an easy course of arriving at decision by intuition rather than going by the advice of the management accountant. (7) Subjectivity: There is every possibility of personal bias and manipulation from the collection of data to the interpretation stage in management accounting. Thus, it losses objectivity and validity. The outcomes can be influenced and affected by the quality of the management team.

1.7 COMPARISON BETWEEN FINANCIAL ACCOUNTING, COST ACCOUNTING AND MANAGEMENT ACCOUNTING

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1.7.1 Comparison Accounting Basis Objective

External and internal users

Statutory Requirements

Compulsory and optional

Rigid and flexible

Historical and Futuristic

Periodicity

between

Financial

Financial Accounting The main objectives of financial accounting are to disclose the end results of the business, and the financial condition of the business on a particular date. The information provided by financial accounting is in the form of profit and loss account and balance sheet for external Users like shareholders, creditors, banks, investors and Government. Thus, financial accounting is primarily an external reporting process. Financial Accounting is to be done according to the provisions of Companies Act and Income Tax Act. It has obligations to satisfy various statutory provisions. Financial Accounting is compulsory and a necessity for joint stock companies, sole proprietorship and partnership firms and so on for various reasons. Financial Statement must be prepared in accordance for generally accepted accounting principles as they provide consistency and comparability. Financial Accounting data is historical in nature. It records and analyses business events long after they have taken place. Comparatively it is more precise

Accounting

and

Management

Management Accounting The main objective of managerial accounting is to help management by providing information that is used to plan, set goals and evaluate these goals. The information provided by management accounting is for internal use of the management. Thus, management accounting is primarily an internal reporting process.

Management Accounting is optional. Though it is meant for insiders, management can frame and adopt its own rules and principles.

Management accounting is entirely optional and its forms and contents depend upon the outlook of the management.

Management Accounting is not bounded by the accounting standards. It can be done in accordance with the need of management of a specific business. Management Accounting is futuristic in nature. It analyses the events as they take place and also anticipates such events for the future. The data reflects expected and estimated values which has relevance in future. The reports and accounts are In management accounting, weekly, reported on year to year basis. fortnightly and even monthly reporting is used.

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Basis Monetary and Non-Monetary

Financial Accounting Financial statements prepared under financial accounting provide monetary information only.

Types of Statement

The financial statement - profit and loss account, balance sheet and cash flow statements reveal the overall performance and position of the enterprise.

above mentioned Publication and These statements are required to be audit published for general use and need to be audited by statutory auditors.

Management Accounting Management accounting statements in addition to monetary information also provide non-monetary information, viz., quantities of materials consumed, labour hours, machines hour, quantities produced and sold and so on Management accounting reports emphasize on the details of operational costs, inventories, products, process and jobs. It traces the effect and impact of the business transactions and events on costs, inventories, processes, jobs and products. These reports are completely for internal use and are not required to be published as well as need not to be audited by statutory auditors.

1.7.2 Comparison between Cost Accounting and Management Accounting Basis Objective

Cost Accounting The objective of Cost accounting is cost ascertainment, allocation, distribution, analysis and cost control.

Scope

Cost accounting is concerned merely with assisting in management functions and does not provide for the evaluation of the performance of management Evolution of cost accounting is based on the limitation of financial accounting. The approach of the cost accountant is much narrower than that of a management accountant as they are more focused on cost ascertainment and cost control.

Evolution

Approaches

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Management Accounting The objective of Management accounting is to provide information related to decision making to management. It is concerned more with impact and effect aspect of costs. Management accounting is concerned, both, with assisting management in its functions, as well as evaluating the performance of the management as an institution. Evolution of Management accounting is based on the limitation of cost accounting. The approach of management accountant is much broader than that of a cost accountant as they have to use certain economic and statistical data along with the costing data to enable the management to be more accurate and precise in its functions of planning, control and decision-making.

Basis Source of Information

Cost Accounting Source of information for cost accounting is data provided by financial accounts. Installation Cost accounting system can be installed without management accounting. Hierarchical Cost accountant generally is placed at a lower level of Status hierarchy than the Management accountant. Techniques Techniques used in cost accounting are variable costing, break-even analysis, standard costing, marginal costing, uniform costing etc. Historical and Futuristic

Cost accounting is mostly historical in its approach and it projects the past records.

Planning

Cost accounting concerned with planning.

is more short-term

Management Accounting Source of information for management accounting data is derived cost accounts and financial accounts. Management accounting cannot be installed without a proper system cost accounting. Management accountant generally is placed at a higher level of hierarchy than the Cost accountant. Management accounting, in addition to the tools and techniques used in cost accounting also makes use of other techniques like cash flow, ratio analysis, etc., which are not within the scope of cost accounting. Management accounting is futuristic in nature. Management accounting is more predictive in nature than cost accounting. Management accounting is concerned equally with short-range and longrange planning and uses techniques like capital budgeting, ratio analysis, sensitivity analysis, funds flow statement statistical analysis etc., in the planning and forecasting.

1.8 COST CONTROL Meaning

CIMA, London has defined cost control as, “the guidance and regulation by executive action of the cost of operating an undertaking particularly where action is guided by cost accounting”. This definition reveals the following characteristics of cost control: (1) The word “guidance” reflects a goal or standard to be achieved which is required to be set for performance evaluation and controlling cost. (2) The word “regulation” means taking corrective measures to control deviations which can be found when actual cost is compared with standard cost. (3) The word “executive action” indicates that the action to regulate or control the deviation must be taken by executives. Hence cost control is an important component of cost accounting. It is exercised by making comparison between actual cost and pre-determined cost. 10

Aim Nature Process

Techniques

Advantages

Its aim is to achieve pre-determined cost targets and standards and keeping them within the budgeted limits. Cost Control is preventive in nature and is implemented for the total cost. The process of cost control includes the following steps: (1) Setting targets: Establishing the targets for different elements of the cost is the first step of cost controlling which may serve as a base for measuring the performance. Setting targets or establishing standards are not easy task. The past data is used and modified according to the future perspectives for making standards. (2) Comparison with actual performance: The next step is measuring the actual performance and compares it with established targets to know the deviations. (3) Taking corrective actions: After investigating the reasons for such deviation, next step will be to take corrective actions and prevent re-occurrence of deviations in future. Sometimes there is need to review standards and revising them according to the dynamic business conditions. There are various techniques used for cost controlling are as follows: (1) Budgetary control (2) Standard costing and variance analysis (3) Ratio analysis (4) Material control (5) Labour control (6) Overhead control (7) ABC analysis (8) Economic order quantity (9) Time and Motion Study The advantages of cost control are as follows: (1) It helps in utilizing the resources efficiently. (2) It helps in reduction of prices which are benefited by customers. (3) It helps in competing successfully in the market by keeping a close view on cost structure. (4) It increases the profit earning capacity of the business.

1.9 COST REDUCTION Meaning

CIMA, London defines cost reduction as “the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for use intended.” This definition reveals the following characteristics of cost reduction: (1) The reduction in cost should be real which can be achieved by increasing the productivity, elimination of wastes etc. (2) The cost reduction should be permanent. Its effectiveness should not be temporary or short lived like changes in cost due to change in tax structure, market prices of input etc. (3) The reduction in cost should be attained without impairing the 11

Aim

Nature Techniques

Advantages

suitability of product for the intended use i.e. the main utility of the product should not be sacrificed to have reduction in cost. The aim of cost reduction is to have real and permanent reduction in cost and to lower unit cost of production without negatively affecting the quality. Cost reduction is corrective measure in nature and is focused on unit cost. There are various techniques used for cost reduction are as follows: (1) Inventory Control (2) Production Planning and control (3) Value analysis (4) Improvement in Product Design (5) Standardization and Simplification (6) Market research (7) Minimization/ Elimination of wastes (8) Substitute material utilization (9) Labour control (10)Quality control techniques The following are the advantages of using cost reduction as technique in the organization: (1) It helps in increasing the profit of the organization. (2) It helps in increasing the capacity of the organization (3) It enhances the competitive edge of the organization (4) It also provides scope for more money for labour welfare schemes and thus improves men- management relationship. (5) As it results in reduction in cost due to which export price may be lowered which may increase total exports.

1.9.1 Area and Scope of Cost Reduction Area of Cost Application of Cost Reduction Reduction Product Design Product design constitutes the most important field where cost reduction may be attempted. It is the first step in the manufacture of a product and employing some changes at this stage can bring economies in cost. Cost reduction in product design has the greatest scope without impairing the quality of the product. Efficient designing for a new product and improving the design for an existing product reduce cost in the following way: (a) Material Cost: Changing design of the product, using economical substitutes,, economic quantity, variety of materials so that storage cost and investment in inventory are reduced. (b) Labour Cost: Improvement in product design can reduce time of operation etc. (c) Standardization and simplification of methods increases productivity and reduces cost. (d) Design of tools, equipments and machinery. 12

Organization

Production

Administration

Marketing

Finance

Cost reduction can be attained by bringing changes in the organizational structure. All efforts should be constantly made to reduce the costs by the adoption of new methods of organization and new production methods. By defining clear cut authority and responsibility, adopting proper channels of purchasing, receiving, inspection, storage of material etc., well defined channels of communication can bring permanent and real reduction in cost. The scope of cost reduction in this area is also very wide. As an efficient system of production control ensures proper production planning, initiates efficient production procedures and develops economical production programmes. It avoids wastage of time, money and non-monetary resources, brings about economy in various types of costs. Office should be re-organized if there is scope for improvement in the efficiency of persons engaged in the office which can lead to reduction in cost. The followings measures can be adopted: (1) Avoid the use of unnecessary forms. (2) Systematic supervision of the use of office machinery. (3) Possibility of reduction of files and filing space. (4) Expenditure on printing, postage and telephone. (5) Computerize the routine office jobs. In this area of cost reduction, improvement can be made by revising the methods of market research, advertising, packing, warehousing, distribution, after-sale services and so on. With the increasing difficulty in procuring funds, management should eliminate useless investment. Wasteful use of capital is as bad as inadequate capital. The following cost reduction programme can be used: (1) Better utilization of fixed assets (2) Better credit control (3) Capital budgeting (4) Avoid under/over capitalization (5) Procuring capital at minimum cost to get maximum return

1.10 COMPARISON OF COST CONTROL AND COST REDUCTION Cost control and cost reduction are two effective tools for management. Both concepts differ from each other in the following aspects: Basis Meaning

Cost Control Cost Control is defined as the “the guidance and regulation by executive action of the cost of operating an undertaking particularly where action is guided by cost accounting”. 13

Cost Reduction Cost Reduction is defined as “the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for use intended”.

Basis Objective

Cost Control Its main objective is to achieve pre-determined cost targets and standards and keeping them within the budgeted limits.

Nature Approach

It is temporary in nature. It has static approach as it limits its achievement to the targets established. It involves setting targets, comparison with actual cost and finally taking corrective actions.

Process

Dependence on It is a part of cost accounting function. cost accounting Function

Standards

Cost Control is a preventive function and is implemented for the total cost. It follows standards and always does comparison of actual performance with standard performance.

Cost Reduction Its main objective of is to have real and permanent reduction in cost and to lower unit cost of production without negatively affecting the quality. It is real and permanent in nature. It has dynamic approach as it is not one time activity and can be performed in different areas. It is not based on pre-determined targets. It concerned with finding out new product designs, methods etc. It can be achieved even when no cost accounting system is in operation. Cost reduction is a corrective function and is focused on unit cost. It does not follow standards. Even it assumes that there is room for changes in standards too.

1.11 COST MANAGEMENT The term „Cost Management‟ is a new terminology of management and has no uniform definition. But some authors tried to define it. According to Horngren, cost management is used “to describe the approaches and activities of mangers in the short term and long term planning and control decisions that increase value for customers and lower costs of products and services”. According to Hansen and Mowen, “Cost management identifies, collects, measures, classifies and reports information that is useful to managers in costing (determining what something costs), planning, controlling and decision making”. Cost management involves different cost accounting methods that have the goal of improving business cost efficiency by reducing costs or atleast having measures in place to restrict the growth of costs. Effective management of cost makes an organization more strong, more stable and helps in improving the potential of a business. The organization calls for a system that would help them in understanding the process and activities of the business. This provides supplying of information to the top management for improving the business performance and productivity. Cost management also helps in optimizing resources which will improve overall efficiency of the organization and help the firm to achieve its objectives. 14

1.12 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) The term management accounting was first coined in (a) 1960 (b) 1950 (c) 1945 (d) 1955 (2) The use of management accounting is (a) Optional (b) Compulsory (c) Legally obligatory (d) Compulsory to some and optional to others (3) Management accounting assists the management (a) Only in control (b) Only in direction (c) Only in planning (d) In planning, direction and control (4) Who coined the concept of management accounting? (a) R.N Anthony (b) James H. Bliss (c) J. Batty (d) American Accounting Association (5) The definition ‘Management Accounting is the presentation of accounting information in such a way as to assist management in the creation of policy and the day-to-day operation of an undertaking.’ (a) Ango-American Council on Productivity (b) AICPA (c) Robert N. Anthony (d) All of the above (6) Management accounting deals with (a) Quantitative information (b) Qualitative information (c) Both (a) and (b) (d) None of the above

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(7) Management accountancy is a structure for (a) Costing (b) Accounting (c) Decision making (d) Management Answers: (1) (b), (2) (a), (3) (d), (4) (b), (5) (a), (6) (c), (7) (c) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) Cost management is the process whereby companies use _____________ to report or control the various costs of doing business. (b) Management accounting is the application of ____________ techniques to the provision of information designed to assist all levels of management in planning and controlling the activities of the firm. (c) Management accounting is an integral part of ____________ concerned with identifying, presenting and interpreting information used for formulating strategy, planning and controlling and decision making. (d) Cost control is defined as regulation by executive action of the _________ of operating an undertaking particularly where action is guided by ___________. (e) Management accounting is primarily to assist _____________ in performing various functions. Answers: (a) cost accounting (b) accounting (c) management (d) cost, cost accounting (e) management Q2. True/False Statement: (a) Management accounting is also called controller. (b) Main emphasis of management accounting is on cost ascertainment and cost control for maximization of profit. (c) Management accounting system cannot be installed without a proper system of cost accounting. (d) Management accounting is a branch of financial accounting. (e) Management accounting is a substitute for management. (f) Management accounting is a branch of accounting that produces information for managers within an organization. Answers: (a) F (b) F (c) T (d) F (e) F (f) T

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EXERCISE 3: LONG ANSWER QUESTIONS Q1. What is cost reduction? Give examples. Q2. Distinguish between cost control and cost reduction? Q3. State objectives and limitations of management accounting? Q4. What is management accounting? How does management accounting differ from cost accounting and financial accounting? Q5. “Management accounting is the best tool for the management to achieve higher profits and efficient operations”. Elucidate the statement. Q6. Distinguish between cost accounting and management accounting?

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LESSON-1

UNIT 2

INTRODUCTION-BUDGETING AND BUDGETARY CONTROL

1. STRUCTURE 1.0 Learning Objectives 1.1 Meaning of Budget 1.2 Meaning of Budgeting 1.3 Meaning of Budgetary Control 1.4 Objectives of Budgetary Control 1.5 Advantages of Budgetary Control 1.6 Limitation of Budgetary Control 1.7 Requisites for Effective Budgetary Control 1.8 Budget Administration 1.9 Types of Budgets 1.9.1 On the basis of Time 1.9.2 On the basis of Coverage 1.9.3 On the basis of Capacity 1.10 Self-Test Questions “Budgeting in a Company is like navigation in a ship. On the ship, the crew keeps a log of the happenings on and the position of the ship from hour to hour. The captain learns valuable lessons by studying the factors that caused misadventures in the past. But, to pilot his ship safely, he requires his navigation officer to plan the course ahead and to constantly check the position of the ship against the plan. If the ship is off-course, the navigation officer must report it immediately, so that the captain can take prompt corrective action. In addition, the navigation officer should be in a position to foresee possible obstacles and deviations and to minimize losses by taking early corrective action in case the ship is off-course.” Just as a ship that needs to be navigated properly to reach its destination safely, a Company needs a well-planned budget to help achieve its goals. The ship‟s log is like the previous budgets of the Company. Just as the Captain refers to the log to learn valuable lessons and avoid repeating mistakes, managers also use previous budgets to help set benchmark in light of current business conditions. Planning the ship‟s course in advance helps the Captain to expect and identify deviations from course and carry out salvage operations as early as possible. In the same way, preparing a budget helps the Company to meaningfully identify variances during the year. (Axzo Press on Budgeting)

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1.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn the meaning of budget and budgetary control (b) Understand the benefits of budget and budgetary control (c) Learn the advantages and limitations of budget and budgetary control (d) Learn the prerequisites for effective budgetary control (e) Learn the division of budget on different basis

1.1 MEANING OF BUDGET According to CIMA, London a budget is defined as “a financial and/or quantitative statement prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and the employment of capital”. According to Robert Anthony, “Budgeting also called profit planning involves a projection of the activity of the enterprise in terms of expenses, revenues, assets and equities over a specific period of time in future, usually one year”. According to Glenn A. Welsch, “a formal statement of management plans and policies for a given period to be used as a guide or blueprint in that period. The budget expresses revenue goals in the sales budget and expense limitations in the expense budget that must be attained in order to realize the net income objective. In addition, the budget expresses plans relating to such items as inventory levels, capital additions, cash requirements, financing, production plans, purchasing plans, labour requirements and so forth”. According to Brown and Howard, “a budget is a pre-determined statement of management policy during a given period which provides a standard for comparison with the results actually achieved”. According to Gorden Shillinglaw, a business budget is “a pre-determined detailed plan of action, developed and distributed as a guide to current operations and as a partial basis for subsequent evaluation of performance”. According to Kohler in „A Dictionary for Accountants‟ defines budget as “any financial plan serving as an estimate of and a control over future operations, any estimate of future costs and any systematic plan for utilization of manpower, material or other resources.”

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Distinctive features of a budget are:     

It is prepared in advance. It is based on future course of actions. It is a guide or blue print for future period. It is financial/Quantitative statement. It is goal oriented and prepared for attaining a given objective.

Budgeting is a process not an event

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2

3

1.2 MEANING OF BUDGETING Budgeting is an act of preparing budgets. According to Wildavsky budgeting is the process of “translating financial resources into human purposes”. In the words of J. Batty, “the entire process of preparing the budgets is known as budgeting”.

1.3 MEANING OF BUDGETARY CONTROL Budgetary control is a means to control all aspects of the business operations through budgeting. Budgetary control is defined by CIMA, London as “the establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision”. From this definition, the steps for Budgetary Control can be drawn as follows: (i) Establishment of Budgets: Budgetary control begins with the objective of preparation of various budgets such as sales Budget, production budget, overhead expenses budget, cash budget etc., (ii) Responsibilities of executives: The budgetary control system is designed to fix responsibilities for executives through setting targets in the form of budgets. (iii) Policy making: The established policies of the organization are designed as budgets so as to fix responsibility on executives. (iv) Continuous comparison of actuals with budgets: After establishing the budgets, the actuals performance is compared with them and deviations are calculated.

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(v) Achieving the standards: The desired result of the budgetary control system is comparison of actuals with the budgeted results and analyzing the causes of variances, if found any. (vi) Reporting to Executives: After the causes of Variances are analyzed, the variances and their causes are reported to top management so that they can take corrective action. Rowland and William in their book entitled Budgeting for Management Control has given the difference between budget, budgeting and budgetary control as follows: “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 this and in addition includes the science of planning the budgets themselves and the utilization of such budgets to affect an overall management tool for the business planning and control”.

DISTINGUISH BETWEEN FORECAST AND BUDGET Forecast (1) Forecast is a mere estimate of what is likely to happen. It is a statement of probable events which are likely to happen under anticipated conditions during a specified period of time. (2) Forecasts, being statements of future events, do not connote any sense of control.

(3) Forecasting is a preliminary step for budgeting. It ends with the forecast of likely events. (4) Forecasts have wider scope, since it can be made in those spheres also where budgets cannot interfere.

Budget (1) Budget shows that policy and programmes to be followed in a future period under planned conditions.

(2) A budget is a tool of control since it represents actions which can be shaped according to will so that it can be suited to the conditions which may or may not happen. (3) It begins when forecasting ends. Forecasts are converted into budgets. (4) Budgets have limited scope. It can be made of phenomenon non capable of being expressed quantitatively.

1.4 OBJECTIVES OF BUDGETARY CONTROL  PLANNING: Budgets are the plans to be pursued to attain objectives for each department and division in the organization during a specified period of time. These plans drawn up for material, labour, production, sales, purchase etc. Budgetary control will force the management at all levels to plan various activities well in advance in the organization. Planning helps in anticipating future requirements and expected performance. 21

 COORDINATING: Budget helps the management in creating sink between the objectives of the organization with the objectives of different departments. Budgeting also bring co-ordination in various activities of the business. For example, the budget of sales department should be in co-ordination with the budget of production department. Similarly, the budget of production department should be in co-ordination with the budget of purchase department.  COMMUNICATION: Budget is a communication device. Communication of ideas and plans to each department and division is effected by budgetary control. In order to make sure that each person is aware of what he is supposed to do, it is necessary that the approved budget copies need to be shared with all management personnel. Not only sharing will enhance the communication, but participating in the preparation of budgets will also contribute in communication of ideas and plan.  MOTIVATING: Budgetary control motivates the employees to improve their performance. Budget acts as a yardstick which will be followed by employees. When individuals participate in the preparation of budgets, it acts as a strong motivating force to achieve the targets.  CONTROLLING: A system of control can be established by preparing budgets against which comparison can be made with actual results. Budgetary control is an important instrument of managerial control in any organization. After comparison of budgeted performance with actual one, it reports the significant variations from the budgets to the top management in the organization. Since separate budgets are prepared for each department becomes easier to determine the weak points and areas of correction.  PERFORMANCE EVALUATION: Budgetary control helps the management in evaluating the performance of each department and division and even of individuals. It provides a useful means of informing managers how well they are performing in meeting targets they have previously helped to set. Even in some companies, on the basis of achieving the budget targets individuals are rewarded.

1.5 ADVANTAGES OF BUDGETARY CONTROL  Budgeting is an all-inclusive management tool. It harmonizes various organizational activities in the organization from planning to controlling. This results in smoother functioning of entire organization.  Budgets provide standards against which actual performance can be measured. This helps in taking corrective action, which is an important part of controlling.  Budgeting in the organization helps in reducing unproductive operations by minimizing waste of resources.  Budgeting motivates executives to attain the given goals.  Budgeting promotes coordination and communication. 22

 Budgeting acts as a safety signal for the management. It shows when to proceed cautiously and when manufacturing expansion can be safely undertaken.  Budgeting in the organization makes financial planning and control easy. The ultimate effect of budgeting is the thorough examination and scrutinizing the financial aspect of the business enterprise. This helps in optimum use of financial resources of the enterprise.  Budgeting helps in clearly defining responsibilities and authorities for the management. For which managers will be held responsible for achieving the budget targets.  Budgeting in the organization is an important device for fixing the responsibility of various positions. The persons occupying various positions can be made to understand their responsibilities with the help of budgets.  Budgeting ensures team work and thus encourages the spirit of support and mutual understanding among the staff.

1.6 LIMITATION OF BUDGETARY CONTROL  Benefits of the budget must exceed the cost: Budgeting is a fairly complex process and specifically for small businesses which may find that it is too much of a burden in terms of time and other resources, with only limited benefits. As a general rule, the benefit of producing the budget must exceed its cost which is difficult for these businesses.  Based on estimates: Budgetary control starts with the formulation of budgets which are mere estimates. Therefore, the adequacy of budgetary control system, to a very large extent, depends upon the accuracy of the data or basis with which estimates are formed.  Rigid: Budgets should be dynamic and can be adjusted according to the changes in business environment. It tends to bring about rigidity in operation, which is harmful. In this case, it will not be a correct tool of measuring performance. It is necessary that budgetary control system should be kept adequately flexible.  Only a tool of management: Budgetary control cannot replace management. It can be used as an instrument of management. „The budget should be considered not as a master, but as a servant.‟ Mostly, it is assumed that that the introduction of budgeting alone is enough to ensure success and security of future profits.  No automatic execution: Proper implementation of budget is cumbersome task. Preparation of budget will not ensure its proper implementation. It is necessary that the entire organization must participate in meeting the budgeted targets.  Resistance from staff: It is a part of human nature that all controls are resented to. Budgetary control which places restrictions on the authority of executive is also resented by the employees. They may not like to be evaluated on the basis of budgeted targets. 23

 Costly and time consuming: The mechanism of budgeting system is a detailed process involving too much time and costs. It requires employing the specialized staff and involves other expenditure which small companies may find difficult to incur.

1.7 REQUISITES FOR EFFECTIVE BUDGETARY CONTROL  Support of top management: If the budget system is to be made successful, it must be ensured that every member of the management is fully supported and also the impetus and direction should also come from the top management. No control system can be effective unless the organization is convinced that the management considers the system to be important.  Group efforts: This is an essential requirement. From top to bottom, everyone should be supportive and ready to attain the budgeted targets. The top management must understand and give enthusiastic support to the members so that there can be proper co-ordination in achievements of targets.  Budget Education: Continuous budget education is very much essential requisite for successful budgetary control system. The best way to ensure that is all those who are affected by the budgeted targets is provided continuous education about the objectives, techniques and targets to be achieved.  Achievable Goals: The budgeted values should be achievable, realistic and reasonable. Sometimes budgets are set at too high level, which will discourage the executives. Where the budget is too easy to achieve it will be of no benefit to the business and may, in fact, lead to lower levels of output and higher costs than before the budget was established.  Reporting System: Reports comparing budget and actual results should be prepared timely and then if any variance is there i.e. actual performance significantly different from expected one. An effective budgeting system also requires the presence of a proper feed‐back system. So timely and proper system of recording should be installed into the organization.  Cost-Benefit analysis: Cost for installing budgetary control system should not be more than the benefits. Because it will not be reasonable to have a system which doesn‟t add to your profitability.  Sound Organizational structure: For the success of a budgetary control system, it is essential that there should be a sound organization for budget preparation, budget maintenance, and budget administration. Responsibilities and authorities should be clearly specified to avoid any confusion.  Integration with Standard Costing System: Where standard costing system is also used, it should be completely integrated with the budget programme, in respect of both budget preparation and variance analysis.

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 Inspirational Approach: All the employees or staff other than executives should be strongly and properly inspired towards budgeting system. Human beings by nature do not like any pressure and they dislike or even rebel against anything forced upon them.

1.8 BUDGET ADMINISTRATION In organizing and administering a budgetary control system the following characteristics may apply: Budget Administration

Organization Chart

Budget Center

Budget Committee

Budget Officer

Budget Manual

Budget Period

Key Factor

(1) Organization Chart: For the purpose of effective budgetary control, it‟s important to have proper organization chart to clearly define the plan and structure of the organization. An organizational chart helps in explaining clearly the position of each executive's authority and responsibility and his relationship to other members. This chart shows functional responsibility of a particular executive, Delegation of authority to various levels and relative position of a functional head with heads of other functions. An organization chart for budgetary control may be as follows:

Organization Chart Chief Executive Budget Officer Budget Committee Sales Manager

Sales Budget, Selling Cost Budget, Advertising Budget and Distribution Budget

Purchase Manager

Purchase Budget, Material Budget

Production Manager

Personnel Manager

Production Budget, Plant Utilization Budget 25

Labour Cost Budget

Finance Manager

Cash Budget, Income and Expenditure Budget

Accounts Manager

Cost Budget, Capital Exp. Budget, Master Budget

(2) Budget Center: A Budget Center is defined by the terminology as "a section of the organization of an undertaking defined for the purpose of budgetary control." For cost control purpose, budget center need to be established and for each of which budget will be set with the help of the head of the department concerned. For example, for the preparation of purchase budget, the purchase manager will be consulted. (3) Budget Officer: The functional head of the budget committee is the budget officer. His main duty is assisting the various departmental heads in preparation of budgets. He is appointed to administer the budgeting programme. He Budget officer does not control; he is staff man; he advises but does not issue instructions. His duties will be to help in preparation of the various budgets and their coordination and compilation into the master budget; Compiling of information about actual performance on a continuous basis comparing it against the budget figures, ascertaining causes of deviation and preparing reports based thereon and sending them to the appropriate executive; Bringing to the notice of the management the need for revision of budgets and assisting them in the task; and Compiling information of all types for the purposes of efficient preparation of budgets and proper reporting. (4) Budget Committee: Budget Committee comprising of the Managing Director, the Production Manager, Sales Manager and Accountant as shown in the organizational chart. Each member has to prepare his own departmental budgets. In small concerns, the Budget Officer may co-ordinate the work for preparation and implementation of budgets. In large-scale concern a budget committee is setup for preparation of budgets and execution of budgetary control. The budget manual should specify the responsibilities and duties of the budget committee, which should include the following: (a) To provide historical data for preparing budgets to all the department heads. (b) To review budget estimates from the respective departments and suggest recommendations. (c) To recommend decisions on budget related matters where there may be conflicts between departments or divisions. (d) To inform departmental heads of any changes and approval of the revised budget. (e) To co-ordinate all budget related activities. (f) To analyze periodic reports by comparing the budgeted performance with actual one. Consider policies with respect to follow-up procedures. (g) To make recommendations for changes in budget policies and procedures. (h) To provide recommendations for the budget manual.

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(5) Budget Manual: A Budget Manual has been defined by CIMA, London as "a document which set out the responsibilities of persons engaged in the routine of and the forms and records required for budgetary control." It contains all details regarding the plan and procedures to be followed and the time schedules to be observed. The following are some important matters dealt with in the budget manual: (a) The dates by which preliminary forecasts and plans are to submitted; (b) The form in which these are to be submitted and the persons to whom these are to be forwarded; (c) The important factors that must be considered for each forecast or plan; (d) The categorization of expenses, e.g., variable and fixed, and the manner in which each category is to be estimated and dealt with; (e) The manner of scrutiny and the personnel to carry it out; (f) The matters which must be settled only with the consent of the managing director, departmental manager, etc.; (g) The finalization of the functional budgets and their compilation into the master budget; (h) The form in which the various reports are to be made out, their periodicity and dates, the persons to whom these and their copies are to be sent; (i) The reporting of the remedial action; (j) The manner in which budgets, after acceptance and issuance, are to be revised or amended; and (k) The matters, included in budgets, on which action may be taken only with the approval of top management. (6) Budget Period: CIMA defines budget period as “the period for which a budget is prepared and used, which may then be sub-divided into control periods”. It refers to the period of time covered by a budget. The broad classification in this regard has already been stated as “long-term budget” and “short-term budget”. For example, industries which are subject to fashion change use short-term budget whereas industries which involve long term expenditure with relatively little change in product design use long-term budget. Generally a budget is prepared for one year which corresponds to the accounting year. It is then sub-divided into quarters and in turn each quarter is broken down into three separate months. (7) Key Factor: A budget key factor or principal budget factor is described by the CIMA London as: “a factor which will limit the activities of an undertaking and which is taken into account in preparing budgets”. For example, if production cannot be increased inspite of heavy demand, due to non-availability of rawmaterial, then in this case raw-material is called here key factor/limiting factor. The Key Factors include: (1) Raw materials may be in short supply. (2) Non-availability of skilled labours. 27

(3) Government restrictions. (4) Limited sales due to insufficient sales promotion. (5) Shortage of power. (6) Underutilization of plant capacity. (7) Shortage of efficient executives. (8) Management policies regarding lack of capital. (9) Insufficient research into new product development. (10) Insufficiency due to shortage of space.

1.9 TYPES OF BUDGETS

Types of Budget

Long-Term Budget On the basis of Time

Short-Term Budget Current Budget Functional Budget

On the basis of Coverage Master Budget Fixed Budget On the Basis of Capacity Flexible Budget

1.9.1 On the Basis of Time (1) Long-term Budget: Long-term budgets are prepared for a longer period specifically for more than a year is called long-term budget. These budgets are prepared by top management team. These budgets are useful in business forecasting and planning. Capital expenditure budgets and research developments budgets are just examples of long-term budgets. (2) Short-term Budget: A budget which is prepared for period upto one year is called as short-term budget. Sometimes they may be prepared for shorter period as for quarterly or half yearly. The scope of budgeting activity may vary considerably among different organization. It is basically use by lower level of management. (3) Current Budget: A budget which is related to the current conditions and is prepared for use over a short period of time is called current budget.

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1.9.2 On the Basis of Coverage FUNCTIONAL BUDGETS: A functional budget is the one which is prepared for particular function of the business. For example, sales budget, production budget, purchase budget etc. These functional budgets are subsidiary to the master budget and they will vary according to the size and nature of the business. MASTER BUDGET: According to CIMA, London “master budget is a summary budget incorporating its component functional budgets and which is finally approved, adopted and employed.” A master budget is also known as comprehensive budget which incorporates all functional budgets in a capsule form. The Master Budget represents the activities of a business during a profit plan. This budget is also helpful in coordinating activities of various functional departments. A master budget has two components:  Operating Budget- Budgeted Profit and Loss Account  Financial Budget- Budgeted Balance Sheet This budget is prepared by Budget Director and presented to the Budget Committee for the approval. MERITS OF THE MASTER BUDGET:  A review of all the functional budgets in specific form is available in one re port.  It presents an overall profit position of the organization for the budget.  It also contains the information regarding the forecast balance sheet.  It examines the fitness of all the functional budgets

1.9.3 On the Basis of Capacity FIXED BUDGET A fixed budget is one which is prepared keeping in mind one level of output. According to ICMA London "Fixed budget is a budget which is designed to remain unchanged irrespective of the level of activity actually attained." This kind of budget is quite suitable for fixed expenses. Fixed budget is prepared before the beginning of the financial year. This type of budget is not going to highlight the cost variances due to the difference in the levels of activity. Fixed Budgets are suitable under static conditions.

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FLEXIBLE BUDGET In flexible budgeting, a series of budgets are prepared one for each of a number of alternative production levels or volumes. According to lCMA, London defined “Flexible Budget is a budget which, by recognizing the difference between fixed, semi-variable and variable costs is designed to change in relation to level of activity attained." A flexible budget shows the budgeted expenses against each item of cost at different levels of activity. This budget has come into use for solving the problems caused by the application of the fixed budget.

1.10 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) A budget is a plan of action expressed in… (a) Financial terms (b) Non‐financial terms (c) Both (d) Subjective matter (2) Budget is prepared for a… (a) Indefinite period (b) Definite period (c) Period of one year (d) Six months (3) A budget is tool which helps the management in planning and control of… (a) All business activities (b) Production activities (c) Purchase activities (d) Sales activities (4) Budgetary control helps the management in… (a) Obtaining bank credit (b) Issue of shares (c) Getting grants from government (d) All of these (5) Budgetary control helps to introduce a suitable incentive and remuneration based on… (a) Changes in government policies (b) Inflationary conditions (c) Both (d) None

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(6) Budgetary control __________ replace management in decision‐making. (a) Can (b) Cannot (c) Sometimes (d) Inadequate data (7) Revision of budgets is… (a) Unnecessary (b) Can‟t determine (c) Necessary (d) Inadequate data Answers: (1) (c), (2) (b), (3) (a), (4) (a), (5) (b), (6) (b), (7) (c) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) A system by which budgets are used as a means of planning and controlling all aspects of a business is called ______________. (b) A document which sets out the responsibilities of the persons engaged in the routine of and the forms and records required for budgetary control is called __________. (c) The entire process of preparing the budgets is known as ____________. (d) ____________ is defined as the factor the extent of whose influence must first be assessed in order to ensure that functional budgets are capable of fulfillments. Answers: (a) budgetary control (b) budget manual (c) budgeting (d) key factor Q2. True/False Statement: (a) A system of budgetary control can be used even when standard costing is in use in a concern. (b) A budget coordinates the activities of various departments. (c) A budget centre is a part of the organization for which a separate budget is prepared. (d) There is no difference between a forecast and a budget. (e) A budget manual contains a summary of all functional budgets. (f) Budgeting may be said to be an act of determining costing standard. (g) Strategic planning is the same thing as preparing annual budgets. Answers: (a) T (b) T (c) T (d) F (e) F (f) F (g) F

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Q3. Write short notes on: (a) Budget Period (b) Limitations of Budget (c) Master Budget (d) Budgeting (e) Distinguish between budget and forecast (f) Principal budget factor EXERCISE 3: LONG ANSWER QUESTIONS Q1. What are the main objectives of a system of budgetary control? Do you think budgetary control is subject to certain limitations? Q2. Briefly explain the essentials of an effective budgetary control system. Q3. State four limitations of budgetary control system. Q4. Briefly describe any five objectives of budgetary control. Q5. State Pre-requisites for Successful Budgeting control systems.

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LESSON 2 FUNCTIONAL BUDGETS 2. STRUCTURE 2.0 Learning Objectives 2.1 Functional Budgets 2.1.1 Sales Budget 2.1.2 Production Budget 2.1.3 Production Cost Budget 2.1.4 Direct Material Budget 2.1.5 Direct Labour Budget 2.1.6 Overheads Budget 2.1.7 Purchase Budget 2.1.8 Plant Utilization Budget 2.1.9 Capital Expenditure Budget 2.1.10 Research and Development Cost Budget 2.1.11 Cash Budget 2.2 Self-Test Questions

2.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Understand the concept of functional budgets (b) Learn more about different functional budgets (c) Learn pre-requisites for various important budgets

2.1 FUNCTIONAL BUDGETS A functional budget is the one which is prepared for particular function of the business. For example, sales budget, production budget, purchase budget etc. These functional budgets are subsidiary to the master budget and they will vary according to the size and nature of the business. The various commonly used functional budgets are discussed below: 2.1.1 Sales Budget The sales budget is a forecast of total sales, expressed in terms of money and quantity. The first step in the preparation of the sales budget is to forecast as accurately as possible 33

the sales anticipated during the budget period. The sales manager is directly responsible for the preparation and execution of sales budget. There is difference between sales forecast and sales budget. Sales forecast provides probable sales figure and relatively sales budget provides planned sales figure that is to be achieved during the period. While preparing sales budget the following factors need to be considered: (i) Market Conditions (ii) Production Capacity (iii) Key Factors (iv) Nature of Business (v) Order in hand (vi) Degree of competition (vii) Past sales (viii) Financial Aspects (ix) Government Restrictions (x) Advertisement, Publicity and Sales Promotion (xi) Pricing Policy (xii) Consumer Behaviour (xiii) Business Conditions (xiv) Types of Product 2.1.2 Production Budget The production budget is a forecast of the production for budget period. It is generally prepared on the basis of sales budget. It is prepared in two parts, firstly production units of each product to be manufactured and the cost of manufacturing budget detailing the budgeted costs. The production budget is prepared by the production manager and he/she will be responsible for the execution of the same. While preparing production budget the following factors need to be considered: (a) Sales requirement as per sales budget (b) Inventory Policy (storage facilities, length of the production period, and so on) (c) Production Policy (d) Production Capacity (introduction of additional plant, sub-contracting components‟ production and so on) (e) Make or Buy decision (f) Availability of inputs 2.1.3 Production Cost Budget This budget shows the cost of products to be manufactured. The quantities of production are now expressed in terms of cost in production. Cost of Production Budget is grouped in to Material Cost Budget, Labour Cost Budget and Overhead Cost Budget. Because it breaks up the cost of each product into three main elements material, labour and overheads. 34

Illustration 1: The following information has been available from the records of In charge Precision Tools Limited for the last six months of 2017 (and of only the sales of January, 2018) in respect of product „X‟: (i) The units to be sold in different months are: July 1,100 November 2,500 August 1,100 December, 2017 2,300 September 1,700 January, 2018 2,000 October 1,900 (ii) There will be no work in progress at the end of any month. (iii) Finished goods equal to half the sales for the next month will be in stock at the end of every month (including June, 2017). (iv) Budgeted production and production cost for the year ending 31st December, 2017 are as thus: Production (units) Direct materials per unit Direct wages per unit Total factory overheads apportioned to product It is required to prepare –

22,000 units Rs. 10.00 Rs. 4.00 Rs. 88,000

(a) A production budget for each of the last six months of 2017, and (b) A summarized production cost budget for the same period. Solution: Sales (in units) Add: Closing Stock Less: Opening Stock Production (in units)

Production budget July 1,100 550 1,650 550 1,100

Aug. 1,100 850 1,950 550 1,400

Sept. 1,700 950 2,650 850 1,800

Oct. 1,900 1,250 3,150 950 2,200

Nov. 2,500 1,150 3,650 1,250 2,400

Dec. 2,300 1,000 3,300 1,150 2,150

Production cost budget Production for six months (July to Dec) (in units) Direct material cost @ Rs. 10 per unit Direct wages @ Rs. 4 per unit Factory overheads @ Rs. 4 per unit Total production cost

11,050 units 1,10,500 44,200 44,200 1,98,900

2.1.4 Direct Material Budget This budget shows the estimated quantities of the all raw material requirements. That is why materials requirement budget, commonly known as materials budget. This budget

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assist the purchase department in suitably planning the purchases, helps in preparation of purchase budget and provides data for raw material control. 2.1.5 Direct Labour Budget This budget shows the labour hours and cost of total labour force required during the budget period. This labour cost is classified into direct and indirect cost. Some organizations include only direct labour cost but some include both direct and indirect labour cost in this budget. The personnel manager is responsible for the preparation and execution of this budget. The rates of pay, allowances, bonus, etc., of each category are then considered and labour cost to be set for each budget centre is calculated by multiplying the wage rate with the labour hours for the number of units of products budgeted. 2.1.6 Overheads Budget Overhead means aggregate of all indirect cost which can be further classified as production overheads, office and administration overheads and selling and distribution overheads. That is why overhead budget is classified into three parts namely factory/production overhead budget, office and administration overhead budget and selling and distribution overhead budget. Factory Overhead Budget shows all indirect cost incurred in connection with the manufacture of a product during the budget period. It is useful for calculating the pre-determined overhead recovery rates. Office and Administration Overhead Budget shows all the cost related to formulation of policy, directing the organization and controlling the operations which are not related to production, selling and distribution, research or development activity or function to be incurred during the budget period. It is useful for calculating the pre-determined administrative overhead rates. Selling and Distribution Overhead budget shows the total cost of selling and Distribution that incurred to stimulate demand and securing orders during the budget period. It is useful for calculating the pre-determined selling and distribution overhead rates. Illustration 2: Prepare a Sales Overhead Budget for January, February and March from the estimates given below: Advertisement Salaries of the sales department Expenses of the sales department Counter salesmen‟s salaries and dearness allowance

Rs. 2,500 5,000 1,500 6,000

Commission to counter salesmen at 1% on their sales. Travelling salesmen‟s commission at 10% on their sales and expenses at 5% on their sales. The sales during the period were estimated as follows:

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Month January February March

Counter Sales Rs. 80,000 1,20,000 1,40,000

Travelling Salesmen’s Sales Rs. 10,000 15,000 20,000 [B.Com (Hons), Delhi]

Solution: Sales Overhead Budget (for the period ending January, February and March) ( in Rs.) Particulars Estimated Sales (Counter Sales + Travelling Salesmen‟s Sales) (1) Fixed Overheads: Advertisement Salaries of Sales department Expenses of Sales Department Counter Salesmen‟s Salaries and DA (2) Variable Overheads: Counter salesmen‟s commission @ 1% on sales Travelling salesmen‟s commission @ 10% Expenses 5% Total Sales Overheads (1) + (2)

January February 90,000 1,35,000

March 1,60,000

2,500 5,000 1,500 6,000 15,000

2,500 5,000 1,500 6,000 15,000

2,500 5,000 1,500 6,000 15,000

800 1,000 500 2,300 17,300

1,200 1,500 750 3,450 18,450

1,400 2,000 1,000 4,400 19,400

2.1.7 Purchase Budget This budget shows the physical quantities and cost of total materials to be purchased during the period. The purchase director or manager is responsible for the preparation and execution of the same. This budget includes the quantities of each type of raw material to be purchased, timing of purchases and estimated cost of material purchases. While preparing purchase budget the following factors need to be considered: (a) Estimated sales and production (b) Requirement of materials during budget period (c) Expected changes in the prices of raw materials (d) Quality standards for each item of material (e) Minimum and maximum stock level (f) Economic order quantity (g) Safety stocks (h) Availability of raw materials, i.e., seasonal or otherwise. (i) Availability of financial resources. Illustration 3: The sales director of a manufacturing company reports that next year he expected to sell 1,08,000 units of a certain product. The production manager consults the store keeper and costs his figures as follows: 37

The kinds of raw materials X and Y are required for manufacturing the product. Each unit of the product required 2 units of X and 3 units of Y. The estimated opening balances at the commencement of the next year are: Finished product: 20,000 units, X - 24,000 units, Y- 30,000 units. The desirable closing balances at the end of the next year are: Finished product: 28,000 units, X - 26,000 units, Y- 32,000 units. Draw up the material purchase budget for the next year. Solution:

Units to be produced Sales Add: desired closing stock

1,08,000 units 28,000 units 1,36,000 units 20,000 units 1,16,000 units

Less: opening stock Production

MATERIALS PURCHASE BUDGET Materials Finished Particulars Product A B (Units) (Units) (Units) Production budget 1,16,000 2,32,000 3,48,000 Estimated opening balance (+) 20,000 (-) 24,000 (-) 30,000 1,36,000 2,08,000 3,18,000 Estimated closing balance (-) 28,000 (+) 26,000 (+) 32,000 Estimated sale of product/ estimated 1,08,000 2,34,000 3,50,000 purchase of materials 2.1.8 Plant Utilization Budget Plant Utilization Budget is prepared for the estimation of plant capacity to meet the budgeted production during the budgeted period. This budget is expressed in working hours or other convenient units. Followings are the features of Plant Utilization Budget: (a) It will indicate the requirement of machine for sale and production department. (b) It will provide the base of reasonable depreciation so that machine can be replaced in future. (c) It may be base for the new inventions in the context of plant and machinery. (d) It will indicate the budgeted machine load on departments or machines. 2.1.9 Capital Expenditure Budget This budget represents the expenditure on all fixed assets to be incurred during the budget period. This budget is prepared after considering the factors such as capital development plans, expansion plans, renovation plans, replacement plans and expected future earnings.

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2.1.10 Research And Development Cost Budget This depends mostly on management decisions regarding the research and development. This budget shows the cost of researching for new or improved production, methods, processes, system or services to be incurred during the budget period. 2.1.11 Cash Budget This budget is one of the most important budgets and one of the last to be prepared. This budget represents the anticipated receipts and payment of cash during the budget period. It provides an estimate showing the amount of cash which would be available in a future period. This budget usually of two parts giving detailed estimates of (i) cash receipts and (ii) cash disbursements/payments. This budget enables the management to determine when there is likely to be surplus or shortage of cash. The estimates of cash-receipts are prepared on a monthly basis and depend upon estimated cash-sales, collections from debtors and anticipated receipts from other sources such as sale of assets, borrowings etc. Estimates of cash disbursements are based on estimated cash purchases, payment to creditors, employees‟ remuneration, bonus, advances to suppliers, budgeted capital expenditure for expansion etc. Thus this budget plays an important role in the financial management of a business undertaking. The main objectives of preparing cash budget are as follows: (a) To determine the probable cash position. This helps in arranging short term borrowings in advance to meet the situations of shortage of cash or making investments in times of cash in excess. (b) To enable the management to prepare the repayment schedule well in advance. (c) To establish a sound basis for control of cash position. (d) To determine the sudden and seasonal requirements, large stocks, delay in collection of receipts etc. on the cash position of the organization. A cash budget can be prepared by any of the following methods: (i) Receipts and payments method (ii) Adjusted profit and loss account method (iii) Balance sheet method. (i) Receipts and Payments Method: It is most popular and is universally used for preparing cash budget. In this method the cash receipts from various sources and cash payments to various agencies are estimated. Delay in cash receipts and lag in payments are taken into account for making estimates. The cash budget begins with the opening balance of cash of a period and the estimated cash receipts are added and from this, the total of estimated cash payments is deducted to find out the closing balance.

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(ii) Adjusted Profit and Loss Account Method: In this method the opening balance is adjusted with the anticipated increases or decreases in current assets and liabilities, provision for depreciation, special receipts and the net profit for the year before taxation and appropriations. From the aggregate amount of these, the estimated taxation and dividends payable, expenditure on fixed assets and special payments if any are deducted. The resulting balance is the estimated cash in hand at the end of the budget period. The vital point of difference between receipts and payments method and adjusted profit and loss method is that the former takes into account only cash transactions while the latter considers non-cash items as it reverses all accruals. (iii) Balance Sheet Method: Under this method of preparing cash budget a forecast balance sheet is prepared as at the end of the budget period with all items of assets and liabilities except cash balance which is arrived at as a balancing figure. The magnitude of the two sides of the balance sheet excluding cash balance would determine whether the bank account would show a debit or credit balance i.e. cash balance at bank or bank overdraft. Illustration 4: Prepare cash budget of a company for April, May and June 2017 in a columnar form using the following information: Months 2017 January (Actual) February (Actual) March (Actual) April (Budgeted) May (Budgeted) June (Budgeted)

Sales Rs. 80,000 80,000 75,000 90,000 85,000 80,000

Purchases Rs. 45,000 40,000 42,000 50,000 45,000 35,000

Wages Rs. 20,000 18,000 22,000 24,000 20,000 18,000

Expenses Rs. 5,000 6,000 6,000 7,000 6,000 5,000

You are further informed that: (a) 10% of the purchases and 20% of the sales are for cash. (b) The average collection period of the company is 0.5 month and the credit purchases are paid off regularly after one month. (c) Wages and expenses are paid half monthly and the rent of Rs. 500 included in expenses is paid monthly. (d) Cash and bank balance as on April 1, was Rs. 15,000 and the company wants to keep it on the end of every month below this figure, the excess cash being put in fixed deposits. (M.Com, Rajasthan) Solution: Particulars Cash balance b/d

Cash Budget for April to June 2017 April 15,000 40

May 11,700

( in Rs.) June 12,700

Particulars Add: cash inflows: Cash sales - 20% Cash collection from debtors

April

Less: cash out flows: Cash purchase 10% Payment to creditors Wages Rent Expenses Fixed deposits Balance c/d

May

June

18,000 66,000 99,000

17,000 70,000 98,700

16,000 66,000 94,700

5,000 37,800 23,000 500 6,000 15,000 11,700

4,500 45,000 22,000 500 6,000 8,000 12,700

3,500 40,500 19,000 500 5,000 13,000 13,200

Note: It is assumed that wages and expenses are paid on 16th and 1st of the following months i.e. fortnightly. Illustration 5: Lakshya Ltd. has seasonal sales; is sales it goods at Rs. 50 per unit sales are 25% cash and the reminder at 1.5 months‟ credit. The cost of the goods in terms of percentage the selling price is as follows: Materials Wages Factory expenses Depreciation Total

20% 25% 20% 10% 75%

In addition each month a sum of Rs. 1,00,000 has to be paid in respect of fixed factory and administrative expenses. Income tax Rs. 60,000 is payable in July, October and December. The company pays dividend on equity shares in August, amounting to Rs. 75,000. The company purchases material a month before the one in which it is required. Payment is made to suppliers after one month and in respect of expenses fortnightly, unless otherwise indicated. The sales in units for various months are as follows: April May June

3,000 5,000 6,000

July August September

8,000 8,000 10,000

Sales in each month are spread uniformly over the month. On 1st July, 2017, the company expected to have an overdraft of Rs. 54,000. Prepare the cash budget for the three months ending September 30, 2017.

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Solution:

CASH BUDGET for the quarter ending 30th September, 2017 July (Rs.)

Receipts: Cash sales Received from debtors Total receipts Payments: Fixed expenses Materials Wages Factory expenses Dividends/ income tax Total payments Add: Operating overdraft Less: Receipts Overdrafts at the end of the month Working notes: (i)

½ month‟s previous ½ month‟s current

September (Rs.)

1,00,000 2,06,250 3,06,250

1,00,000 2,62,500 3,62,500

1,25,000 3,00,000 4,25,000

1,00,000 80,000 87,500 70,000 60,000 3,97,500 54,000 4,51,000 3,06,250 1,45,250

1,00,000 80,000 1,00,000 80,000 75,000 4,35,000 1,45,250 5,80,250 3,62,500 2,17,750

1,00,000 1,00,000 1,12,500 90,000 4,02,500 2,17,750 6,20,250 4,25,000 1,95,250

Receipts from debtors (75% of total sales on credit)

½ of month preceding last month ½ of last month

(ii)

August (Rs.)

July (Rs.) 93,750 1,12,500 2,06,250

August (Rs.) September (Rs.) 1,12,500 1,50,000 1,50,000 1,50,000 2,62,500 3,00,000

Payments of wages and factory overheads July (Rs.) Wages FO 37,500 30,000

August (Rs.) Wages FO 50,000 40,000

September (Rs.) Wages FO 50,000 40,000

50,000

40,000

50,000

40,000

62,500

50,000

87,500

70,000

1,00,000

80,000

1,12,500

90,000

2.2 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) R&D budget and Capital expenditure budget are examples of (a) Short-term budget (b) Current budget

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(c) Long-term budget (d) None of the above (2) __________ contains the picture of total plans during the budget period and it comprises information relating to sales, profit, cost, production etc. (a) Master budget (b) Functional budget (c) Cost budget (d) None of the above (3) The budgets are classified on the basis of… (a) Time (b) Function (c) Flexibility (d) All (4) Sales budget shows the sales details as… (a) Month wise (b) Product wise (c) Area wise (d) All of the above (5) ________ is the first step of budgetary system and all other budgets depends on it. (a) Cost budget (b) Sales budget (c) Production budget (d) None of the above (6) _______also known as subsidiary budgets. (a) Master budget (b) Functional budget (c) Cost budget (d) None of the above (7) Production budget is… (a) Dependent on purchase budget (b) Dependent on sales budget (c) Dependent on cash budget (d) None Answers: (1) (c), (2) (a), (3) (d), (4) (d), (5) (b), (6) (b), (7) (b)

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EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) _______________ shows the anticipated sources and utilization of cash. (b) The ___________ budget represents the forecast of labour requirements to meet the demands of the company during the budget period. (c) The production budget shows the quantities of production. These quantities of production are expressed in terms of cost in ____________ budget. (d) ____________ budget is a summary budget incorporating its component functional budgets and which is finally approved, adopted and employed. (e) All other budgets are unreliable if ___________ budget is significantly off target. (f) ________ also called „Financial Budget‟ or „Ways and Means Budget‟ shows the estimates of cash receipts and outlays and cash balances by month throughout the budget period. Answers: (a) Cash budget (b) labour (c) production cost (d) master budget (e) Sales (f) Cash budget Q2. Write short notes on: (a) Principal Budget Factor (b) Functional Budget (c) Cash Budget (d) Production budget (e) Sales budget (f) Purchase budget (g) Master Budget EXERCISE 3: LONG ANSWER QUESTIONS Q1. List the important functional budgets prepared by a business. Q2. What is a cash budget? What are its uses? Q3. What is production budget? Q4. What are the steps involved in the preparation of a production budget? Q5. A company has to plan to prepare a production budget for the product P, Q and R. the sales forecasts for these product is 2,08,000 units, 1,82,000 units and 2,21,000 units respectively. The estimates requirements of inventory both at the beginning and at the end of the budget period are shown in the following table:

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Month April, 1st (units) March, 31st (units)

Inventory Table Product P Q 40,000 30,000 52,000 27,900

R 50,000 69,000

You are required to prepare the production budget for the company. Answers: Budgeted Production: P: 2,20,000 units; Q: 1,79,000 units; R: 2,40,000 units Q6. Chennai Engineering Co. Ltd. Manufactures two product X and Y. An estimate of number of units expected to be sold in the first seven months of 2015 is given below: Product X January February March April May June July

500 600 800 1,000 1,200 1,200 1,000

Product Y 1,400 1,400 1,200 1,000 800 800 900

It is anticipated that: (a) There will be no work-in progress at the end of any month (b) Finished units equal to half the anticipated sales for the next month will be in stock at the end of each month (including December 2014). The budgeted production and production costs for the year ending 31st December 2014 are as follows:

Production (units) Direct material per unit Direct wages per unit Other manufacturing charges apportionable to each type of product

Product X Rs. 11,000 12 5

Product Y Rs. 12,000 19 7

33,000

48,000

You are required to prepare: (a) A production budget showing the number of units to be manufactured each month. (b) A summarized production cost budget for the 6-month period- January to June 2015. (B.Com Adapted) Answers: Production for Six months: X - 5,550 units, Y - 6,350 units; Total Cost - X Rs. 1,10,000; Y Rs. 1,90,500

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Q7. A company produces two products M and N. A forecast of units to be sold in the first five months of the year is given below: Months January February March April May

Product M 1,000 units 1,200 units 1,600 units 2,000 units 2,400 units

Product N 2,800 units 2,800 units 2,400 units 2,000 units 1,600 units

Cost per unit is as follows: Product M Rs.

Product N Rs. 12.50 4.50 3.00

Direct Material Direct Labour Factory Overhead

19.00 7.00 4.00

There will be no opening and closing work-in-progress at the end of any month. Finished product (in units), equal to half of the budgeted sale of the next month, should be in stock at the end of each month (including previous year December). You are required to prepare: (a) Production Budget for January to April, and (b) Summarized Production Cost Budget. Answer: Jan. 1,100 2,800

Production Budget of Product M (units) Production Budget of Product M (units) Production Cost Budget of M is Rs. 1,30,000 Production Cost Budget of N is Rs. 2,82,000

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Feb. 1,400 2,600

Mar. 1,800 2,200

April 2,200 1,800

LESSON 3 FIXED AND FLEXIBLE BUDGET 3. STRUCTURE 3.0 Learning Objectives 3.1 Fixed Budget 3.1.1 Features 3.2 Flexible Budget 3.2.1 Features 3.2.2 Need of Flexible Budget 3.3 Distinction Between Fixed and Flexible Budget 3.4 Self-Test Questions

3.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Prepare different types of budget like flexible and fixed budget (b) Learn the difference between flexible and fixed budget (c) Understand the key features of fixed budget (d) Understand the key features of flexible budget

3.1 FIXED BUDGET A fixed budget is one which is prepared keeping in mind one level of output. According to ICMA London "Fixed budget is a budget which is designed to remain unchanged irrespective of the level of activity actually attained." This kind of budget is quite suitable for fixed expenses. Fixed budget is prepared before the beginning of the financial year. This type of budget is not going to highlight the cost variances due to the difference in the levels of activity. Fixed Budgets are suitable under static conditions. For preparation of this budget, sales forecast will have to be prepared along with the cost estimates. Cost estimates can be prepared by segregating the costs according to their behaviour i.e. fixed and variable. Cost predictions should be made element wise and the projected profit or loss can be worked out by deducting the costs from the sales revenue. Actually in practice, fixed budgets are prepared very rarely. The main reason is that the actual output differs from the budgeted output significantly. Thus if the budget is prepared on the assumption of producing 20,000 units and actually the number of units produced are 15,000, the comparison of actual results with the budgeted ones will be unfair and misleading. The budget may reveal the difference between the budgeted costs and actual 47

costs but the reasons for the deviations may not be pointed out. A fixed budget may be prepared when the budgeted output and actual output are quite close and not much deviation exists between the two. In such cases, maximum control can be exercised between the budgeted performance and actual performance.

3.1.1 Features  It is prepared for one fixed level of activity.  It does not change with the change in the level of activity.  Expenses are not classified into fixed, variable and semi-variable.

3.2 FLEXIBLE BUDGET In flexible budgeting, a series of budgets are prepared one for each of a number of alternative production levels or volumes. According to lCMA, London defined “Flexible Budget is a budget which, by recognizing the difference between fixed, semi-variable and variable costs is designed to change in relation to level of activity attained." A flexible budget shows the budgeted expenses against each item of cost at different levels of activity. This budget has come into use for solving the problems caused by the application of the fixed budget. For example, a budget can be prepared for capacity utilization levels of 50%, 60%, 70%, 80%, 90% and 100%. The basic principle of flexible budget is that if a budget is prepared for showing the results at, 20,000 units and the actual production is only 15,000 units, the comparison between the expenditures, budgeted and actual will not be fair as the budget was prepared for 20,000 units. Therefore a flexible budget is developed for a relevant range of production from 15,000 units to 20,000 units. Thus even if the actual production is 15,000 units, the results will be comparable with the budgeted performance of 20,000 units. Even if the production slips to 12,000 units, the manager has a tool that can be used to determine budgeted cost at 12,000 units of output. Thus It is more realistic and practicable because it gives due consideration to cost behavior at different levels of activity.

3.2.1 Features  It is prepared for different levels of activity.  It changes with the change in the level of activity.  Expenses are classified into fixed, variable and semi-variable. Semi-variable expenses are further segregated into fixed and variable expenses.

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3.2.2 Need of Flexible Budget  In case of industries where there are seasonal fluctuations in sales/production.  In case of a company which keeps on introducing new products or make changes in the design of its products frequently  In case of new business venture due to its typical nature it may be difficult to forecast the demand of a product accurately.  In case of labour intensive industry where the production of the concern is dependent upon the availability of labour.  Where the business is dependent upon the nature for example wool traders.

3.3 DISTINCTION BETWEEN FIXED AND FLEXIBLE BUDGET Basis Change with volume of activity

One or different level of activity

Variance Analysis

Helps in decision making

Basis of comparison

Fixed Budget It does not change with actual volume of activity achieved. Thus it is known as rigid or inflexible budget. It operates on one level of activity and under one set of conditions. It assumes that there will be no change in the prevailing conditions, which is unrealistic. Since all costs like – fixed, variable and semi-variable are related to only one level of activity so variance analysis does not give useful information. If the budgeted and actual activity levels differ significantly, then the aspects like cost ascertainment and price fixation do not give a correct picture. Comparison of actual performance with budgeted targets will be meaningless specially when there is a difference between the two activity levels.

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Flexible Budget It can be recreated on the basis of activity level to be achieved. Thus, it is not rigid. It consists of various budgets for different levels of activity.

Here analysis of variance provides useful information as each cost is analyzed according to its behaviour. Flexible budgeting at different levels of activity facilitates the ascertainment of cost, fixation of selling price and tendering of quotations. It provides a meaningful basis of comparison of the actual performance with the budgeted targets

Practical Questions: Illustration 1: Following information is recorded from WJK Ltd., these expenses budgeted for production of 10,000 units: Items Direct materials Direct labour Variable overheads Fixed overheads (Rs. 1,50,000) Variable expenses (direct) Selling expenses (10% fixed) Administrative expenses (Rs. 50,000 rigid for all levels of production) Distribution expenses (20% fixed) Total cost of sale per unit

Per Unit (Rs.) 120 30 50 15 10 15 5 5 250

Prepare a budget for production of 6,000 units, 7,000 units and 8,000 units showing distinctly Marginal cost and Total cost. Solution: Production Elements of cost Direct materials Direct labour Direct variable expenses Variable Overheads : Production Selling Distribution Marginal cost (A) Fixed Overheads : Fixed production overheads Administrative overheads Selling overheads Distribution overheads

Flexible Budget for WJK Ltd. 6,000 units Per Total unit (Rs.) (Rs.) 7,20,000 120.00 1,80,000 30.00

7,000 units Per Total unit (Rs.) (Rs.) 8,40,000 120.00 2,10,000 30.00

8,000 units Per Total units (Rs.) (Rs.) 9,60,000 120.00 2,40,000 30.00

60,000

10.00

70,000

10.00

80,000

10.00

3,00,000 81,000 24,000

50.00 13.50 4.00

3,50,000 94,500 28,000

50.00 13.50 4.00

4,00,000 1,08,000 32,000

50.00 13.00 4.00

13,65,000

227.50

15,92,500

227.50

18,20,000

227.50

1,50,000

25.00

1,50,000

21.43

1,50,000

18.75

50,000

8.33

50,000

7.14

50,000

6.25

15,000

2.50

15,000

2.14

15,000

1.88

10,000

1.67

10,000

1.43

10,000

1.25

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Fixed cost (B) Total cost (A+B) Marginal cost plus fixed cost

2,25,000

37.50

2,25,000

32.14

2,25,000

28.13

15,90,000

265.00

18,17,500

259.64

20,45,000

256.63

Working Notes: Total for 10,000 units (Rs.) Variable expenses per unit (Rs.) Fixed expenses 10% and 20% of total respectively (Rs.)

Selling Expenses 1,50,000 (15-1.5) = 13.50

Distribution Expenses 5,00,000 (5-1) = 4.00

15,000

10,000

Illustration 2: Shyam Manufacturers can produce 4,000 units of a certain product at 100% capacity. The following information is obtained from the books of account: Aug 2006 2,800 Rs. 500 1,800 700 1,400 1,000 200 1,400

Units produced Repairs and maintenance Power Shop labour Consumable stores Salaries Inspection Depreciation

Sept 2006 3,600 Rs. 560 2,000 900 1,800 1,000 240 1,400

Rate of production per hour is 10 units. Direct material cost per unit is Re. 1 and direct wages per hour is Rs. 4. You are required to: (1) Compute the cost of production at 100%, 80% and 60% capacity showing the variable, fixed and semi variable items under the flexible budget. (2) Find out the overhead absorption rate per unit at 80% capacity. (CS Inter) Solution: (i)

Flexible Budget for Shyam Manufacturers 100% 4,000 units Rs.

Variable costs: Direct materials(@ Re. 1 per unit) Direst wages (@ Rs. 4 per hour for 10 units) Shop labour

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80% 3,200 units Rs.

60% 2,400 units Rs.

4,000 1,600

3,200 1,280

2,400 960

1,000

800

600

Consumable stores Total „A‟ Semi variable costs: Power Inspection Repairs and maintenance Total „B‟ Fixed costs: Salaries Depreciation Total „C‟ Total cost (A + B + C) Cost per unit (total cost/units)

100% 4,000 units Rs. 2,000 8,600

80% 3,200 units Rs. 1,600 6,800

60% 2,400 units Rs. 1,200 5,160

2,100 260 590 2,950

1,900 220 530 2650

1,700 180 470 2,350

1,000 1,400 2,400 13,950 3.49

1,000 1,400 2,400 11,930 3.73

1,000 1,400 2,400 9,910 4.13

(ii) Calculation of overhead absorption rate per unit at 80% capacity Total cost at 80% Rs. 11,930 Less: Direct material and direct wages (i.e. Rs. 3,200 + 1,280) 4,480 Overhead cost 7,450 Overhead rate per unit = Rs. 7,450 /3,200 units = Rs. 2.33 Working notes: Calculation of semi variable costs Variable cost per unit = Difference in cost Difference in units Power = Rs. 2,000 - 1,800 = Rs. 200 3,600 - 2,800 units 800 units

= Re. 0.25

At 70%, fixed element in power cost = 1,800 - 700 (i.e. 2800 units @ 0.25 per unit) = Rs. 1,100 Semi variable power cost at 100% = 1,100 + 1,000 (i.e. 4,000 units @ 0.25) = Rs. 2,100 Semi variable power cost at 80% = 1,100 + 800 (i.e. 3,200 units @ 0.25) = Rs. 1,900 Semi variable power cost at 60% = 1,100 + 600 (i.e. 2,400 units @ 0.25) = Rs. 1,700 Similar calculations for inspection and repairs and maintenance.

Illustration 3: The budget manager of Pankaj Cosmetics Limited is preparing a budget for the accounting year starting from 1st July, 1984. As part of the budget operations, some items of factory overhead costs have been estimated by him under specified conditions of volume as follows: 52

Volume of production (in units) : Expenses: Indirect materials Indirect labour Maintenance Supervision Engineering services

1,20,000 Rs.

1,50,000 Rs.

2,64,000 1,50,000 84,000 1,98,000 94,000

3,30,000 1,87,500 1,02,000 2,34,000 94,000

Calculate the cost of factory overhead items given above at 1,40,000 units of production. [B.Com (Hons), Delhi] Solution: FACTORY OVERHEADS BUDGET (Production 1,40,000 units) Indirect material (variable @ Rs. 2.20 per unit) Indirect labour (variable @ Rs.1.25 per unit) Maintenance: Fixed variable @ Re. 0.60 per unit Supervision: Fixed variable @ Rs. 1.20 per unit Engineering services (fixed) Total factory overheads

Rs. 3,08,000 1,75,000 12,000 84,000 54,000 1,68,000 94,000 8,95,000

Working notes: (i) Indirect material Cost per unit Rs 2,64,000 1,20,000 = Rs. 2.20

Rs. 3,30,000 1,50,000 = Rs. 2.20

Therefore it is a variable expense. Similar calculations for Indirect Labour. (ii) Maintenance Cost per unit =

84,000 1,02,000 1,20,000 1,50,000 = Rs. 0.70 = Rs. 0.68 Therefore it is not a variable expense. It would be Semi-Variable Expense. Variable Cost per unit =

(1,02,000 - 84,000) (1,50,000 - 1,20,000)

= Rs. 0.60 per unit

Variable Cost (at 1,20,000 units) = 1,20,000 × 0.60 = Rs. 72,000 Fixed Cost = TC - VC = 84,000 - 72,000 = Rs. 12,000 53

Variable Cost (at 1,40,000 units) = 1,40,000 × 0.6 = Rs. 84,000 Illustration 4: The following data is available in a manufacturing company for a half yearly period. Rs. (Lakhs) Fixed Expenses: Wages and salaries Rent, rates and taxes Depreciation Sundry administration expenses

9.5 6.6 7.4 6.5

Semi-Variable Expenses: (at 50% of capacity) Maintenance and repairs Indirect labour Sales Department Salaries etc. Sundry administrative expenses

3.5 7.9 3.8 2.8

Variable expenses: (at 50% of capacity) Materials Labour Other expenses

21.7 20.4 7.9

Assume that the fixed expenses remain constant for all levels of production; semi variable expenses remain constant between 45% and 65% of capacity increasing by 10% between 65% and 80% capacity, and by 20% between 80% and 100% capacity. Sales at the various levels are: (Rs. Lakhs) 100.00 120.00 150.00 180.00 200.00

50% capacity 60% capacity 75% capacity 90% capacity 100% capacity

Prepare a flexible budget for the half year and forecast the profits at 60%, 75%, 90% and 100% of capacity. [B.Com (Hons), Delhi] Solution:

Sales Materials

Flexible Budget for the period

50% Rs. 100 21.7 54

(Figures in Rs. Lakh) CAPACITY LEVEL 60% 75% 90% 100% Rs. Rs. Rs. Rs. 120 150 180 200 26.0 32.5 39.0 43.4

Labour Other expenses Total variable expenses Semi-variable expenses: Maintenance and repairs Indirect labour Sales, deptt. Salaries etc. Sundry administration expenses Total semi variable expenses Fixed expenses: Wages and salaries Rent, rates and taxes Depreciation Sundry administration expenses Total fixed overheads Total cost Profit (Loss)

20.4 7.9 50.0

24.5 9.5 60.0

30.6 11.9 75.0

36.7 14.3 90.0

40.8 15.8 100.0

3.5 7.9 3.8 2.8 18.0

3.5 7.9 3.8 2.8 18.0

3.8 8.7 4.2 3.1 19.8

4.2 9.5 4.6 3.3 21.6

4.2 9.5 4.6 3.3 21.6

9.5 6.6 7.4 6.5 30.0 98.0 2.0

9.5 6.6 7.4 6.5 30.0 108.0 12.0

9.5 6.6 7.4 6.5 30.0 124.8 25.2

9.5 6.6 7.4 6.5 30.0 141.6 38.4

9.5 6.6 7.4 6.5 30.0 151.6 48.4

Illustration 5: A factory is currently working at 50% capacity and produces 10,000 units. Estimate the profits of the company when it works to 60 percent and 80 percent capacity and offer your critical comments. At 60% working, raw material cost increases by 2 percent and selling price falls by 2 percent. At 80%, raw material cost increases by 5 percent and selling price falls by 5 per cent. At 50% capacity working the product costs Rs. 180 per unit and is sold at Rs. 200 per unit. The unit cost of Rs. 180 is made up as follows: (in Rs.) Raw material 100 Labour 30 Factory overheads 30 (40% fixed) Administration overheads 20 (50% fixed) Solution:

Raw material Labour Factory OH: Fixed Variable Administration overheads

FLEXIBLE BUDGET 50% capacity Amount Per (10,000 unit units) Rs. Rs. 10,00,000 100.00 3,00,000 30.00 1,20,000 1,80,000

12.00 18.00

60% capacity Amount Per (12,000 unit units) Rs. Rs. 12,24,000 102.00 3,60,000 30.00 1,20,000 2,16,000

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10.00 18.00

80% capacity Amount Per (16,000 unit units) Rs. Rs. 16,80,000 105.00 4,80,000 30.00 1,20,000 2,88,000

7.50 18.00

Fixed Variable Total cost Profit Sales

1,00,000 1,00,000 18,00,000 2,00,000 20,00,000

10.00 10.00 180 20.00 200.00

1,00,000 1,20,000 21,40,000 2,12,000 23,52,000

8.33 10.00 178.33 17.67 196.00

1,00,000 1,60,000 28,28,000 2,12,000 30,40,000

6.25 10.00 176.75 13.25 190.00

3.4 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) _________ is stated as a budget which is made to change as per the levels of activity attained. (a) Fixed budget (b) Flexible budget (c) Both a and b (d) None of the above (2) _______ is prepared for single level of activity and single set of business conditions. (a) Fixed budget (b) Flexible budget (c) Both a and b (d) None of the above (3) Fixed budget is useless for comparison when the level of activity… (a) Increases (b) Fluctuates both ways (c) Decreases (d) Constant (4) In order to prepare a flexible budget, items of anticipated expenditures are classified into _______ classes. (a) Five (b) Three (c) Two (d) None of the above (5) Flexible budget is used when (a) Demand remains static even when there is change in taste and fashion of customers (b) When the business unit is new (c) Whenever there is change of activity due to change in government policies (d) All of the above

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(6) Flexible budgeting is used when the supply of material and labor required for production is _____. (a) Uncertain (b) Certain (c) Either a or b (d) None of the above (7) Which of the following statements are true flexible budget? (a) On the basis of fixed budget, marginal analysis can be obtained (b) Flexible budget is important for cost reduction and cost control (c) Fixed budgetary system is more flexible than flexible budgetary system (d) None of the above (8) In _________ actual performance can easily be compared due to availability of budgets at different levels of activity. (a) Fixed budget (b) Flexible budget (c) Both (a) and (b) (d) None of the above Answers: (1) (b), (2) (a), (3) (b), (4) (b), 5. (d), (6) (a), (7) (b), (8) (b) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) Flexible budget recognizes the difference between ____________ and ___________. (b) The method of budgeting whereby all the activities are re-valued each time a budget is formulated is regarded as ________________. (c) The difference between fixed and variable cost has a special significance in the preparation of _______________. (d) The primary difference between a fixed budget and a variable budget is that a _________ budget is a plan for a single level of sales while a ___________ budget consists of several plans, one of each of several levels of sales. Answers: (a) Variable and Fixed Costs (b) flexible budget (c) Flexible budget (d) Fixed and Variable budget Q2. True/False Statements: (i) (ii) (iii)

In a fixed budget, figures are adjusted according to actual level of activity. Fixed budgets are most suited for fixed expenses. A flexible budget is necessary for a business enterprise whose demand of goods is stable. 57

(iv) (v) (vi) (vii)

A fixed budget is concerned with budgeting of fixed assets. A flexible budget is preferable to fixed budget. A fixed budget is one which is designed to remain unchanged irrespective of level of activity actually attained. Flexible budgets change with the level of activity.

Answers: (a) F (b) T (c) F (d) F (e) T (f) T (g) T EXERCISE 3: LONG ANSWER QUESTIONS Q1. Distinguish between fixed budget and flexible budget. Briefly state the circumstances in which flexible budgets are used. Q2. State the uses of flexible budget. Q3. What are the key features of flexible budget? Q4. What are the key features of fixed budget? Q5. With the following data for a 60% activity level, prepare a budget at 80% and 100% activity. Production at 60% capacity - 600 units Materials Rs. 100 per unit Labour Rs. 40 per unit Expenses Rs. 10 per unit Factory Expenses Rs. 40,000 (40% fixed) Administration expenses Rs. 30,000 (60% fixed) Answers: At 60% Rs. 1,60,000; at 80% Rs. 2,02,000; and at 100% Rs. 2,44,000 Q6. The monthly budgets for factory overhead of were as follows: 60% Budgeted Production (units) Rs. Wages Consumable stores Maintenance Power and fuel Depreciation Insurance Total 58

a company for two levels of activity 100% 600

1,000 Rs.

1,200 900 1,100 1,600 4,000 1,000 9,800

2,000 1,500 1,500 2,000 4,000 1,000 12,000

You are required to: (a) Indicate which of the items are fixed, variable and semi-variable (b) Prepare a budget for 80% capacity (c) Find the total cost, both fixed and variable, per unit of output at 80% capacity. [B.Com (Hons), Delhi] Answer: Cost per unit at 80% Rs. 13.625 Q7. Gemini Steel Ltd. Manufactures a single product for which market demand exists for additional quantity. Present sales of Rs. 60,000 per month utilizes only 60% capacity of the plant. Marketing manager assures that with the reduction of 10% in the price, he would be in a position to increase the sale by about 25% to 30%. The following data are available: (a) Selling price is Rs. 10 per unit (b) Variable cost is Rs. 3 per unit (c) Semi-variable cost is Rs. 6,000 fixed + 50 paise per unit (d) Fixed cost Rs. 20,000 at present level estimated to be Rs. 24,000 at 80% output. You are required to prepare the following statements showing: (i) The operating profit at 60%, 70% and 80% levels at current selling price, and (ii) The operating profit at proposed selling price at the above levels. [B.Com (Hons), Delhi] Answers: Profit at current selling prices Rs. 13,000; 19,500 and 22,000; Profit at proposed selling price Rs. 7,000; Rs. 12,500 and Rs. 14,000 Q8. From the following data, prepare a flexible budget for production of 40,000 units, 60,000 units and 75,000 units of product X, distinctly showing variable and fixed cost as well as total cost. Also indicate element wise cost per unit. Budgeted output and costs per unit are: Budgeted output

1,00,000 units Per unit cost Rs.

Direct material Direct labour Direct variable expenses Manufacturing variable overhead Fixed production overhead Administration overhead (fixed) Selling overhead Distribution overhead

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90 45 10 40 5 5 10 (10% fixed) 15 (20% fixed) [B.com (Hons), Delhi]

Answer: Total Cost Rs. 96,40,000 at 40,000 units; Rs. 1,37,60,000 at 60,000 units; and Rs. 1,68,50,000 at 75,000 units Q9. A factory is currently running at 50% capacity and produces 5,000 units at a cost of Rs. 90 per units as per details given below: Material - Rs. 50 Labour - Rs. 15 Factory overheads - Rs. 15 (Rs. 6 fixed) Administration overheads - Rs. 10 (Rs. 5 fixed) The currently selling price is Rs. 100 per unit. At 60% working, material cost per unit increases by 2% and selling price per unit falls by 2%. At 80% working, material cost per unit increases by 5% and selling price per unit falls by 2.5%. Prepare a flexible budget showing profits of the factory at 60% and 80% working and offer your comments. [B.Com (Hons), Delhi] Answers: Profit at 60% Rs. 53,000; at 80% Rs. 73,000

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LESSON 4 RECENT DEVELOPMENTS IN BUDGET 4. STRUCTURE 4.0 Learning Objectives 4.1 Zero Base Budgeting (ZBB) 4.1.1 Meaning and Definition 4.1.2 Need for Zero-Based Budgeting 4.1.3 Features of Zero Base Budgeting 4.1.4 Four Steps involved in the process of Zero Base Budgeting 4.1.5 Advantages of Zero Base Budgeting 4.1.6 Disadvantages of Zero Base Budgeting 4.1.7 Distinction between Traditional Budgeting and Zero Base Budgeting 4.2 Programme Budgeting 4.2.1 Objectives 4.2.2 Limitations 4.3 Performance Budgeting 4.3.1 Meaning of Performance Budgeting 4.3.2 Purpose 4.3.3 Pre-Requisites of Performance Budgeting 4.3.4 Features Performance Budgeting 4.3.5 Steps Performance Budgeting 4.3.6 Advantages Performance Budgeting 4.3.7 Limitations Performance Budgeting 4.3.8 Traditional Budgeting and Performance Budgeting 4.4 Self-Test Questions

4.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Understand the meaning of zero base budgeting, its benefits and limitations (b) Understand the meaning of programme budgeting its objectives and limitations (c) Understand the meaning of performance budgeting, its purpose, pre-requisites, advantages and limitations. (d) Compare traditional budgeting with zero base budgeting, programme budgeting and performance budgeting. 61

4.1 ZERO BASE BUDGETING (ZBB) 4.1.1 Meaning and Definition Zero base budgeting is a revolutionary concept of planning the future activities and there is a sharp contradiction from conventional budgeting. Zero base budgeting, may be better termed budgeting from the beginning without any reference to any base-past budgets and actual happening. It is designed to meet the needs of the management in order to ensure the operational efficiency and effective utilization of the allocated resources of a concern. This technique was originally developed by Peter A. Phyhrr (who is known as the father of ZBB), Manager of Taxas Instrument during 1969. This concept is widely used in USA for controlling their state expenditure when Mr. Jimmy Carter was the president of the USA. Mr. Pyhrr was subsequently asked by Georgia governor Jimmy Carter to manage the Georgia budget process. Pyhrr authored "Zero Based Budgeting: A Practical Management Tool for Evaluating Expenses". At present this technique has for its global recognition for many countries have implemented in real terms. Zero Base Budgeting is so called because it requires each budget to be prepared and justified from zero, instead of simply using last year‟s budget as a base. Incremental level of expenditure on each activity is evaluated according to the resulting incremental benefits. Available resources are then allocated where they can be used most effectively. In real terms, the ZBB is simply an extension of the Cost Benefit Analysis Method to the area of corporate planning and budgeting. Peter Phyrr has defined Zero base budgeting as “a planning and budgeting process which requires each manager to justify his entire budget request in detail from scratch (hence zero base) and shifts the burden of proof to each manager to justify why he should spend any money at all. The approach requires that all activities be analyzed in decision packages which are evaluated by systematic analysis and ranked in order of importance”. CIMA defines Zero Base Budgeting as “a method of budgeting whereby all activities are re-evaluated each time a budget is set. Discrete levels of each activity are valued and a combination chosen to match funds available.” David Lieninger has defined ZBB as, “ZBB is a management tool, which provides a systematic method for evaluating all operations and programmes, current or new, allows for budget reductions and expansions in a rational manner and allows re‐ allocation of sources from low to high priority programmes."

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According to Peter Sarant, former director of management analysis training for the United States Civil Service Commission, defined as ZBB is "a technique which complements and links to existing planning, budgeting and review processes. It identifies alternative and efficient methods of utilizing limited resources. It is a flexible management approach which provides a credible rationale for reallocating resources by focusing on a systematic review and justification of the funding and performance levels of current programs."

4.1.2 Need for Zero-Based Budgeting  Low priority programs can be eliminated or reduced.  Effectiveness of programmes can be dramatically improved.  Programmes of high priority can obtain increased funding by shifting resources within an agency.  The government need not increase the tax revenue as ZBB can to do a more effective job with existing revenues.

4.1.3 Features of Zero Base Budgeting Zero-base budgeting is based on the premise that every rupee of expenditure requires justification. These are the following features which makes ZBB unique in comparison to traditional budgeting:  Each budget item whether old or new is to be identified and evaluated critically from the scratch each time a new budget is formulated.  It is holistic in nature as this technique deals practically with all the elements of budget proposals.  A detailed cost benefit analysis of each budget programme is undertaken and each programme has to compete for scarce resources.  Choices are made on the basis of what each unit can offer for a specific cost.  Individual unit‟s objects are linked to corporate targets.  It defines alternatives and efficient ways of utilizing limited resources.  Participation of all levels in decision-making.  Concentration of efforts is not simply on “how much” a unit will spend but “why” it needs to spend. Each manager has to justify why he should spend any money at all.

4.1.4 Four Steps Involved in the Process of Zero Base Budgeting  Developing ‘decision units’: Different departments/responsibility centers are considered as decision units. These decision units are for which cost-benefit analysis is proposed have to be developed so as to arrive at decision whether they should be allowed to continue or be dropped if the cost analysis proves to be unfavourable for it. 63

 Developing ‘decision package’: The content and format of the decision package must provide management with the information it needs to evaluate each decision unit. Describing and analyzing all current or proposed programmes usually called “decision packages”. This consists of identification, analysis and formulation assists an evaluation in terms of purposes, consequence, performance measures, alternatives and cause and benefits.  Ranking of Decision Packages: Evaluate and rank all decision packages to develop the appropriations request. The ranking process provides management to allocate its limited resources by making management concentrate on these questions. „How much should we spend‟ and „where should we spend it‟?  Funding: Prepare the detailed operating budgets and allocate the resources in accordance with the ranking.

4.1.5 Advantages of Zero Base Budgeting  It provides a systematic approach for the evaluation of different activities and rank them in order of preference for the allocation of scarce resources.  It provides an opportunity to the management to allocate resources for various activities only after having a thorough Cost-Benefit Analysis. The chance of arbitrary cuts and enhancement are thus avoided.  It will lead to goal congruence as departmental budgets are linked with overall corporate objectives  It helps in identifying and eliminating the areas of wasteful expenditure and if desired, it can also be used for suggesting alternate course of action.  This technique can be used for the implementation of the system of „Management by Objectives‟.  It promotes operational efficiency because it requires managers to review and justify their activities or the funds requested.  Cost behavior pattern are more closely examined.  This technique is relatively elastic because budgets are prepared every year on a zero base. This system makes it obligatory to develop financial planning and management information system  Since this system requires participation of all managers, preparation of budgets, responsibility of all levels at management in successful execution of budgetary system can be ensured.

4.1.6 Disadvantages of Zero Base Budgeting  It is an expensive method as ZBB incurs a huge cost every in its preparation.  It also requires high volume of paper work, hence sometimes it becomes a tedious job.

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 In ZBB there is a danger of emphasizing short term benefits at the expenses of long term ones.  Defining the decision units and decision packages is rather difficult.  Zero base budgeting requires a lot of training for managers.  Cost of preparing the various packages may be very high in large firms involving large number of decision packages.  It may lay more emphasis on short term benefits to the detriment of long-term objectives of the organization.  Where objectives are very difficult to quantify as in research and development, zero base budgeting does not offer any significant control advantage.

4.1.7 Distinction between Traditional Budgeting and Zero Base Budgeting Traditional Budgeting

Zero Base Budgeting

Traditional budgeting is accounting- Zero base budgeting is a decision-oriented oriented, with stressed laid on previous approach, in a rational manner, for level of expenditure. allocation of resources for both old and new programmes and activities. In traditional budgeting, first reference is In zero base budgeting a decision unit is made to past period levels of revenues and broken into understandable decision costs, and then adjustments are made for packages which are ranked according to inflation, market demand and new importance to enable top management to programmes. focus attention on top priority decision packages. In traditional budgeting, it is for top In zero base budgeting this responsibility is management to decide why a particular shifted from top management to the amount should be spent on a particular manager of decision unit. It is their decision unit. responsibility to justify why there should be a budget allocation for his division. Traditional budgeting is a routine and Zero base budgeting makes a very straight direct approach, treating each forward approach and immediately division/decision unit equally. spotlights the decisions packages enjoying priority over others. In traditional budgeting, managers In zero base budgeting, managers do not deliberately inflate their budget request, so have temporary approach for budgets. Top that after the cuts they may still get what management accords its approval only to a they require. carefully devised, result-oriented Decision Package. It is comparatively rigid, and not clearly This is very flexible and responsive to responsive to environmental changes. environmental changes.

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4.2 PROGRAMME BUDGETING Programme budgeting is a more transparent mechanism for monitoring budget expenditures and outlays of a specific programme. It allows for more efficient allocation of funds for the purpose of fulfilling concrete responsibilities, and enables decisionmakers to easily understand the connection between the required, that is approved funds and strategies, programs and outcomes. Programme budgeting, developed by U.S. president Lyndon Johnson, is the budgeting system that, contrary to conventional budgeting which is inherited with serious limitation that it ignores the benefits of an activity in its evaluation. As budget proposals are evaluated on the basis of costs. Consequently, conventional budgeting approach does not prove to be much effective. Hence, Program budgeting is an instrument of policy analysis, means of improving managerial performance, used for allocating and managing costs and a planning process.

4.2.1 Objectives    

Alternative means of achieving the goals shall be developed and analyzed. Long term costs are projected and compared with the benefits of each programme. Control over each and every programme. Improved analysis of each programme in relation to cost will be strengthened.

4.2.2 Limitations  It has no relevance in preparation of actual budget.  It does not serve as operating tool for the line executives who implement the policy and programme decisions.  The evaluation of on-going programme activities and operations are not focused but stresses only on new programme.

4.3 PERFORMANCE BUDGETING 4.3.1 Meaning of Performance Budgeting The concept of performance budgeting was first time used by the Hoover Commission in the US in the year 1949 and then it was applied in the defence budget of the said country in the 1960s. Performance budgeting involves evaluation of performance of every executive in an organization in the context of both specific as well as overall objectives of the organization. The concept of performance budgeting relates to greater management efficiency specially in government work. With a view to introducing a system‟s approach, the concept of performance budgeting was developed and as such there was a shift from financial classification to „cost‟ or „objective‟ classification. Performance budgeting, is therefore, looked upon as a budget based on functions, 66

activities and projects and is linked to the budgetary system based on objective classification of expenditure. According to National Institute of Bank Management, Bombay performance budgeting technique is “the process of analyzing identifying, simplifying and crystallizing specific performance objectives of a job to be achieved over a period in the frame work of the organizational objectives, the purpose and objectives of the job.” The technique is characterized by its specific direction towards the business objectives of the organization. Thus, performance budgeting lays immediate stress on the achievement of specific goals over a period of time. It requires preparation of periodic performance reports. Such reports compare budget and actual data and show any existing variances. Performance budgeting is a method of budgeting that provides the purpose and objectives for which funds are needed, costs of programs and related activities proposed to accomplish those objectives and outputs to be produced or services to be rendered under each program (Shah, 2007).

4.3.2 Purpose The main purposes of performance budgeting are:  To review at every stage, and at every level of the organization, so as to measure progress towards the short-term and long-term objectives.  To inter-relate physical and financial aspects of every programme, project or activity.  To facilitate more effective performance audit.  To assess the effects of the decision-making of supervisor to the middle and topmanagers.  To bring annual plans and budgets in line with the short and long-term plan objectives.  To present a comprehensive operational document showing the complete planning of the programmes and prospectus their objectives inter-woven with the financial and physical aspects.

4.3.3 Pre-Requisites of Performance Budgeting  Objectives of the firm should be defined clearly  Objectives should be divided into specific functions, programmes, activities and tasks, for different levels of management, within the realities of fiscal and physical constraints.  Realistic and acceptable norms, yardsticks, standards or performance indicators should be evolved, and expressed in quantifiable terms.

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 A decentralized responsibility structure and flexible management style should be adopted.  A suitable accounting and reporting system should be developed to facilitate monitoring, analysis and review of actual performance, by comparison with budgets.

4.3.4 Features of Performance Budgeting  The budget is prepared for each managerial level. The manager concerned is made responsible and held accountable for performance at his level over the specified period of time as given in the budget.  Performance budget implies that the budget must clearly indicate the actual output expected by spending a particular amount on a particular activity. Hence, it is an output oriented budget that focuses more on achievement rather than means of achievements.  Cost-Benefit analysis is done for making decisions regarding allocation of funds.  This system has been designed to plan for long term.  It tries to answer questions like- what is to be achieved? How is it to be achieved? When is it to be achieved? And so on.

4.3.5 Steps for Performance Budgeting  Formulation of objectives  Establishing a meaningful functional programme and project which will accomplish these objectives  Evaluation and selection of programmes and projects on the basis of cost benefit analysis  Development of performance criteria for various programmes  Preparing financial plans for each program and the final annual budget  Assessing the performance of each programme an comparing the same with budgeted performance  Correcting deviation

4.3.6 Advantages of Performance Budgeting  It clearly indicate the actual output expected by spending a particular amount on a particular activity  It helps in improving performance of division/department in a continuous manner  It brings transparency and clarity in the budget formulation process  It helps in decision making at all levels of management in the organization.  It acts as a tool for reviewing efficiency of programs  It integrates the process of planning, programming and budgeting 68

4.3.7 Limitations of Performance Budgeting  Performance budgeting helps in evaluation of only quantitative and financial variables of the programme and therefore it lacks qualitative approach in the evaluation of programme which is very important for proper screening.  It has limited scope because it can be used for such programmes where evaluation can be done in a precise manner.  The application of performance budgeting requires that the departments of an organization are well organized and the programmes and activities properly defined which is practically unfeasible, therefore, only a limited number of organizations can be benefitted by this approach of budgeting.

4.3.8 Traditional Budgeting and Performance Budgeting Basis Emphasis

Preparation

Traditional Budgeting Performance Budgeting It gives more emphasis on It gives more emphasis on the physical financial aspect, than physical aspects or performance than the aspects or performance. financial aspects. It aims at establishing between inputs and outputs, with emphasis on performance. It is prepared with focus on It is prepared with focus on the expenditure control and function and not the cost of function as highlighting items of such. The functions, programmes, expenditure and variances activities and tasks, are reported, along between budgets and actual with costs thereof.

4.4 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) A budgeting process which demands each manager to justify his entire budget in detail from beginning is (a) Functional budget (b) Master budget (c) Zero base budgeting (d) None of the above (2) What does successful implementation of ZBB rely on? (a) Implementation of new technologies (b) Strong leadership (c) Reduction of silos (d) Robust management data

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(3) Who is championing zero based budgeting? (a) Government quangos (b) Public sector organisations (c) Small and medium sized companies (d) Large multinationals like Unilever and Diageo (4) Why is zero based budgeting making a comeback? (a) To improve efficiencies (b) To invest in new technologies (c) To help reduce costs (d) To cut costs and generate capital for investment in growth (5) Zero Based Budgeting (ZBB) lays emphasis on: 1. Unlimited deficit financing. 2. New budget right from the scratch. 3. The budget neglecting the expenditure. Choose the correct code: (a) 1, 2 and 3 (b) 2 and 3 (c) Only 2 (d) Only 3 Answers: (1) (c), (2) (d), (3) (d), (4) (d), (5) (c) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. True/False Statement: (a) Zero-based budgeting questions each activity in the current budget and determines whether an activity should be supported as is re-engineered of eliminated. (b) A potential problem with zero-based budgeting is a “spend it or lose it” attitude. (c) Programme budgeting is output oriented. (d) Zero base budgeting will be appropriate in areas where output is not related to production. (e) Zero base budgeting was first used by Jimmy Carter. (f) Zero base budgeting forces mangers to identify decision packages. Answers: (a) T (b) F (c) T (d) T (e) T (f) T Q2. Fill in the blanks: (a) _________________________ is a budget which specifies output or results to be achieved along with the inputs or expenditures to be incurred during the budget period. (b) ________________________ is a technique of preparing budget from scratch.

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Answers: (a) Performance Budget (b) Zero Base budgeting EXERCISE 3: LONG ANSWER QUESTIONS Q1. Write Short note: (1) Zero Base Budgeting (2) Performance Budgeting (3) Programme Budgeting Q2. State the important features of Zero Base Budgeting. Q3. Distinguish between zero-base budgeting and conventional budget. Q4. What is meant by Zero Base Budgeting? What are the essentials of introducing a system of Zero Base Budgeting? Explain in brief about the drawbacks of this system. Q5. What is the difference between Performance Budget and Programme Budget? What are the special areas of application of Programme Budgeting?

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LESSON 1

UNIT 3

STANDARD COSTING 1. STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Meaning and Definition of Standard Cost 1.3 Distinction between Standard Cost and Estimated Cost 1.4 Meaning of Standard Costing 1.5 Applicability of Standard Costing 1.6 Comparison between Standard Costing and Budgetary Control 1.7 Advantages of Standard Costing 1.8 Limitations of Standard Costing 1.9 Preliminaries in Establishing a System of Standard Costing 1.10 Setting Standard Cost 1.11 Standard Hour 1.12 Standard Cost Card (Cost Sheet) 1.13 Self-Test Questions

1.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn how the standard costs are set (b) Explain the concept of standard costing (c) Understand and describe the purpose of a standard costing system (d) Explain the applicability of standard costing (e) Learn the advantages and limitation of standard costing

1.1 INTRODUCTION Two vital functions of management of any organization are planning and controlling. While planning helps the management to make systematic efforts to achieve the well-defined objectives, control enables them to evaluate the actual performance and determine the difference between the planned performance and actual performance. Thus for evaluating performance, it is necessary to compare the actual performance with some pre-determined or pre planned targets. One of the important parameters of performance is the cost of production. According to M. Porter, for achieving sustainable competitive 72

advantage it is necessary to establish cost leadership. For achieving this, it is of paramount importance that the various costs are monitored closely and there is a constant comparison of the actual costs with some pre-determined targets. Standard Costing is an important tool in the hands of management for improving the management control by providing parameters for comparison of actual with these parameters. In this technique, all costs are pre-determined, i.e. cost is determined in advance of production. During the first stages of development of cost accounting, historical costing was the only method available for ascertaining and presenting costs. Historical costs have, however, the following limitations:  Historical cost is valid only for one accounting period, during which the particular manufacturing operation took place.  Data is obtained too late for price quotations and production planning.  Historical cost relating to one batch or lot of production is not a true guide for fixing price for other batch or lot of production.  Historical costing is comparatively expensive as it involves the maintenance of a large volume of records and forms. The limitations and disadvantages attached to historical costing system led to further thinking on the subject and resulted in the emergence of standard costing which makes use of scientifically predetermined standard costs under each element.

1.2 MEANING AND DEFINITION OF STANDARD COST Brown and Howard define Standard Cost as a Pre-determined Cost which determines what each product or service should cost under given circumstances. This definition states that standard costs represent planned cost of a product. Standard Cost as defined by the Institute of Cost and Management Accountant, London "is the Predetermined Cost based on technical estimate for materials, labour and overhead for a selected period of time and for a prescribed set of working conditions." The following are the features of standard cost can be drawn from the above definition:  Standard cost is a pre-determined cost. This means that the standard cost is determined even before the commencement of production.  Standard cost is not an estimated cost. There is a difference between saying what would be the cost and what should be the cost. Standard cost is a planned cost and it is a cost that should be the actual cost of production.  It is computed for a specific period of time.  It is calculated after taking into consideration the management‟s standard of efficient operation. 73

 Standard cost can be used as a basis for price fixation as well as for exercising control over the cost.  It is attained under a given set of efficient operating conditions.

1.3 DISTINCTION BETWEEN STANDARD COST AND ESTIMATED COST Basis Determination Emphasizes Usage

Which firm uses?

Recording

Standard Cost It is determined on a scientific basis. It emphasizes "what the cost should be." It is used to evaluate actual performance and it serves as an effective tool of cost. It is used by a firm having standard costing system in operation. It is a part of accounting system and standard costing variances are recorded in the books of accounts.

Estimated Cost It is determined on the basis of statistical facts and figures. It emphasizes "what the cost will be." It is used to cost ascertainment for fixing sales price. It is used by a firm having historical cost system It is not a part of accounting system because it is based on statistical facts and figures

1.4 MEANING OF STANDARD COSTING According to CIMA, London, “Standard Costing is defined as - the preparation and use of standard cost, their comparison with actual costs and the measurement and analysis of variances to their causes and points of incidence.” On the basis of above definition, the steps involved in the techniques of standard costing are as follows: (1) Pre-determination of technical data related to production. i.e., details of materials and labour operations required for each product, the quantum of inevitable losses, efficiencies expected, level of activity, etc. (2) Pre-determination of standard costs in full details under each element of cost, viz., labour, material and overhead. (3) Comparison of the actual performance and costs with the standards and working out the variances, i.e., the differences between the actuals and the standards. (4) Analysis of the variances in order to determine the reasons for deviations of actuals from the standards. (5) Presentation of information to the appropriate level of management to enable suitable action (remedial measures or revision of the standards) being taken.

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1.5 APPLICABILITY OF STANDARD COSTING The application of standard costing requires certain conditions to be fulfilled. These are:  A sufficient volume of standard products or components should be produced.  Methods, operations and processes should be capable of being standardized.  A sufficient number of costs should be capable of being controlled. Industries using process costing method like fertilizers, cement, steel, sugar etc. may use standard costing method because such industries are producing standardized products which are repetitive in nature. In job order industries, it is not useful to employ a full system of standard costing because in such industries each job undertaken may be different from another and setting standards for each job may prove difficult and expensive.

1.6 COMPARISON BETWEEN STANDARD COSTING AND BUDGETARY CONTROL Relationship: The following are certain basic principles common to both Standard Costing and Budgetary Control: (1) Determination of standards or pre-determined targets (2) For both of them measurement of actual performance is done (3) Comparison of actual costs with standard cost to find out deviations. (4) Analysis of variances to find out the causes of deviation between actual and standard performance. (5) To take corrective measures. Differences: Although basic principles of standard costing and budgetary control are same, but still they differ in the following respects: Basis Meaning

Scope

Aim

Projection

Standard Costing Budgetary Control Standard Cost are the "Norms" or Budgets are estimated costs. "what cost should be." They are "what the cost will be." The scope of standard costing is The scope of budgetary control relatively narrow as it covers mainly is wide as it relates to different production costs. functions of business such as sales, purchase, cash, capital expenditure etc. Standard costing aims at economy Budgeting is meant for and promptness in cost ascertainment determination of policy and and fixation of selling prices. delegation of responsibilities Standard Costing is a projection of Budgets are projections of cost accounts. financial accounts. 75

Basis Usefulness

Standard Costing Standard cost represents realistic yardsticks and are therefore more useful for controlling and reducing costs.

Intensity

It is intensive in application as it calls for detailed analysis of variance.

Dependence

Standard Costing cannot be used without budgets Under standard costing variances are revealed through different accounts.

Recording of Variance Preparation

Standard cost are planned and prepared on the basis of technical estimates

Budgetary Control Budgets represent an upper limit on spending without considering the effectiveness of the expenditure in terms of output. Budgetary control is extensive in nature and the intensity of analysis tends to be much less than in standard costing. Budget can be operated with standards. In budgetary control variances are not revealed through the accounts. Budgets are prepared on the basis of historical facts and figures.

1.7 ADVANTAGES OF STANDARD COSTING The advantages derived from a system of standard costing are tabulated below:  Effective cost control: the most important advantage of Standard Costing system is that it facilitates the control of cost. It establishes yard-sticks against which the efficiency of actual performances is measured.  Facilitates Motivation: The standards provide incentive and motivation to work with greater effort and vigilance for achieving the standard. This increase efficiency and productivity all round.  Operational Efficiency: At the very stage of setting the standards, simplification and standardization of products, methods, and operations are effected and waste of time and materials is eliminated. This assists in managerial planning for efficient operation and benefits all the divisions of the concern.  Less records: Costing procedure is simplified. There is a reduction in paper work in accounting and less number of forms and records are required.  Helps in fixing prices and valuation: Cost are available with promptitude for various purposes like fixation of selling prices, pricing of interdepartmental transfers, ascertaining the value of costing stocks of work-in-progress and finished stock and determining idle capacity.  Helps in planning: Standard Costing is an exercise in planning. It can be very easily fitted into and used for budgetary planning.

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 Facilitates delegation of authority: Standard Costing system facilities delegation of authority and fixation of responsibility for each department or individual. This also tones up the general organization of the concern.  Management by Exception: Variance analysis and reporting is based on the principles of management by exception. The top management may not be interested in details of actual performance but only in the variances form the standards, so that corrective measures may be taken in time.  Cost reduction: When constantly reviewed, the standards provide means for achieving cost reduction.  Regular Checks: The analysis of variances ensures that regular checks are made upon expenditure incurred. There is quick recognition of deviations from the predetermined standards.  Aids in policy making: Production and pricing policies may be formulated in advance before production starts. This helps in prompt decision-making.  Integration of accounts: Standard costing facilitates the integration of accounts so that reconciliation between cost accounts and financial accounts may be eliminated.  Optimal use of resources: Standard Costing optimizes the use of plant facilities, current assets and working capital.

1.8 LIMITATIONS OF STANDARD COSTING  Difficulty in setting standards: The process of setting up standards is a difficult task as it requires technical skill. Standards may be too strict or too liberal. If inaccurate standards are set, they can do more harm than good to the business.  Frequent Revision of Standard: In course of time, sometimes even in a short period the standards become rigid. They require revision because business conditions constantly keep on changing. Keeping them up to date can be a major problem. It may not always be possible to change standards to keep pace with the frequent changes in the manufacturing conditions.  Effect on Psychology of Employees: Sometimes, standards create adverse psychological effects on the morale and motivation of the employees. If the standard is set at high level, its non-achievement would result in frustration and build-up of resistance.  Explanation of variance difficult: Due to the play of random factors, variances cannot sometimes be properly explained, and it is difficult to distinguish between controllable and non-controllable expenses.  Not suitable for small concern: Standard costing may not sometimes be suitable for some small concerns. Where production cannot be carefully scheduled, frequent changes in production conditions result in variances. Detailed analysis of all of which would be meaningless, superfluous and costly. 77

 Expensive: Standard costing may not, sometimes, be suitable and costly in the case of industries dealing with non-standardized products and for repair jobs which keep on changing in accordance with customer„s specifications.  Lack of management’s enthusiasm: Lack of interest in standard costing on the part of the management makes the system practically ineffective. This limitation, of course, applies equally in the case of any other system which the management does not accept wholeheartedly.

1.9 PRELIMINARIES IN ESTABLISHING A SYSTEM OF STANDARD COSTING These preliminary steps must be taken before determination of standard cost: (1) Establishment of Cost Centres (2) Classification and Codification of Accounts. (3) Types of Standards to be applied. (a) Ideal Standard (b) Basic Standard (c) Current Standard (d) Expected Standard (e) Normal Standard (4) Organization for Standard Costing. (5) Setting of Standards. (1) Establishment of Cost Centres: It is the very first step required before setting of Standards. According to CIMA, London Cost Centre is "a location, person or item of equipment for which costs may be ascertained and used for the purpose of cost control." For the determination of standard costs, it is necessary to establish cost centres for each product and comparison of actual cost with the predetermined standards to ascertain the deviations to take corrective measures. (2) Classification and Codification of Accounts: Classification of Accounts and Codification of different items of expenses and incomes help quick ascertainment and analysis of cost information. (3) Types of Standards to be applied: Determination of the type of standard to be used is one of the important steps before setting up of standard cost. The different types of standards are given below: (a) Ideal Standard: The standard which basically develops under the most favorable/possible conditions. It is based on high degree of efficiency. No wastages/power failures/labor idle times and etc. it is merely a theoretical standard which is unrealistic and unattainable.

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(b) Basic Standard: The standard is fixed in relation to the base year and no adjustments made based on the changes taken place thereafter. It has no practical utility from the point of view of cost control. (c) Current Standard: The standard mainly develops for short period of time and depicts current situation at any given time. (d) Expected Standard: The standard which develops for future periods and depicts what need to be attained. Hence, it is more relevant for business purposes as the variances from the expected standard indicate real deviations from the attainable performance. (e) Normal Standard: It is a standard which is based on average performance in the past. It is attainable under normal conditions. The main purpose of normal standard is to eliminate variations in the cost arising out of trade cycles. (4) Organization for Standard Costing: The accurate standard costing system depends upon the reliable standards. Hence the organization structure should be like in which responsibility for setting standard is vested with the Standard Committee which consists of Purchase Manager, Production Manager, Personnel Manager, Time and Motion Study Engineers, Marketing Manager and Cost Accountant. (5) Setting of Standard: The Standard Committee is responsible for setting standards for each element of costs such as (a) Direct Material (1) Direct Material Price (2) Direct Material Quantity (b) Direct Labour (1) Labour Rate Standard (2) Labour Efficiency Standard (c) Overheads (Fixed Overheads and Variable Overheads).

1.10 SETTING STANDARD COST Standards for Material Two standards are developed for material costs:

Considerable Factors

Material Price Standard (1) Current market Price (2) Forecasts of Price Trends (3) Market Conditions (4) Discounts, packing and delivery charges etc.

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Material Quantity Standard (1) Quality of material (2) Quantity of material (3) Analysis of material requirements (4) Normal material losses

Standards for Labour Two standards are developed for labour costs:

Labour Rate Standard

Labour Efficiency Standard

(1) Current rates of Pay (1) Grade of labour (2) Method of wage payment (2) Time and motion study (3) Normal loss of labour time Considerable Factors (3) Forecast of wage trends (4) Guaranteed minimum (4) Most efficient method of wages and overtime wages working Standard for Direct Expenses Setting standards for direct expenses is quite simple as these may be based on past records adjusted according to anticipated changes therein. Standard for Overheads

Considerable Factors

(1) Standard Indirect Material Costs (2) Standard Indirect Labour Costs (3) Standard Indirect Expenses (4) Standard level of activity such as standard hours, standard production (in units)

1.11 STANDARD HOUR Usually production is expressed in terms of units, dozen. kgs, pound, liters etc. When productions are of different types, all products cannot be expressed in one unit. Under such circumstances, it is essential to have a common unit for all the products. Time factor is common to all the operation. ICMA, London, defines a Standard Time as a "hypothetical unit pre-established to represent the amount of work which should be performed in one hour at standard performance."

1.12 STANDARD COST CARD (COST SHEET) Standard Cost Card is a record of Standards for direct material, direct labour and overhead cost. This Standard cost is presented for each unit cost of a product. The total Standard Cost of manufacturing a product can be obtained by aggregating the different Standard Cost Cards of different processes. These Cost Cards are useful to the firm in production planning and pricing policies.

1.13 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) The process of standard costing (a) Can be incorporated in accounting routine (b) Helps in reaching variances from the accounting procedure 80

(c) Both (a) and (b) (d) None of the above (2) As per J. Batty, Standard Cost represents ______under given conditions. (a) Anticipated costs (b) Current costs (c) Historical costs (d) None of the above (3) When standard costs are used, the amount of detailed record keeping will normally (a) Reduce (b) Increase (c) Stay the same (d) None of the above (4) Standard costing committee is responsible for (a) Computation of variances (b) Linking the deviations with responsibilities (c) Setting all types of standards (d) All of the above (5) Which of the following statements are not true about normal standards? (a) Normal Standards are meant to smooth out fluctuations caused by cyclical and seasonal changes (b) Normal Standards can be applied for absorption of overheads for a long period of time (c) In establishing normal standards, allowance is given to normal fatigue and breaks, and normal waste and scrap (d) None of the above (6) Which of the following standards cannot be used for cost control? (a) Basic Standard (b) Normal Standard (c) Both (a) and (b) (d) None of the above (7) Basic standard is established for (a) Short period (b) Current period (c) Indefinite period (d) None of the above

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(8) __________ is based on past averages adjusted to anticipated future changes. (a) Ideal Standard (b) Normal Standard (c) Basic Standard (d) Perfection Standard (9) To establish an effective system of standard costing it is essential that (A) The technical process of operation should be prone to planning (B) The cost of the products should be given (C) The process or operating costs of products should be provided (D) The standard costing should be consistent with the technical procedure of the production of the specific entity (a) A, B and C (b) A, C and D (c) B, C and D (d) D, C and A Answers: (1) (c), (2) (a), (3) (a), (4) (d), (5) (d), (6) (c), (7) (c), (8) (b), (9) (b) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Differentiate: (a) Standard Costing and Budgetary Control (b) Actual Cost System and Standard Cost System (c) Standard Cost and Budgeted Cost Q2. Write short notes on: (a) Standard Cost (b) Standard Costing (c) Estimated Cost (d) Historical Costing (e) Ideal Standard (f) Current Standard Q3. Fill in the blanks: (a) The system of standard costing and budgetary control have the common objectives, both are ________________ (b) Standard costing works on the principle of _________________ Answers: (a) two different techniques (b) management by exception

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Q4. True/False Statements: (a) Standards are arrived at based on past performance. (b) Standard cost is also known as pre-determined cost of production. (c) Standard costing is a technique of cost control and not of cost reduction. (d) Standards which allow for normal down time and employees rest periods are called practical standards. (e) Standard should be set on a reasonable basis taking into consideration all known normal factors but without an abnormal loss provision. Answers: (a) F (b) T (c) F (d) T (e) T EXERCISE 3: LONG ANSWER QUESTIONS Q1. Discuss the advantages and limitations of standard costing. Q2. Distinguish between standard costing and budgetary control. Q3. What are the advantages of having a system of standard cost? Have they any significance in effective Budgetary Control? Q4. Standard Costing and Budgetary Control are the two important tools for controlling costs. Discuss. Q5. “Standard Costing and Budgetary Control are interrelated but not independent.” Comment.

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LESSON 2 VARIANCE ANALYSIS - MATERIAL AND LABOUR VARIANCE 2. STRUCTURE 2.0 Learning Objectives 2.1 Meaning of Variance 2.2 Variance Analysis 2.3 Favourable and Unfavourable Variance 2.4 Controllable and Uncontrollable Variance 2.5 Revision Variance 2.6 Method Variance 2.7 Material Variance 2.7.1 Material Cost Variance (MCV) 2.7.2 Material Price Variance (MPV) 2.7.3 Material Usage Variance (MUV) 2.7.4 Material Mix Variance (MMV) 2.7.5 Material Yield Variance (MYV) 2.8 Labour Variance 2.8.1 Labour Cost Variance (LCV) 2.8.2 Labour Rate Variance (LRV) 2.8.3 Labour Efficiency Variance (LEV) 2.8.4 Idle Time Variance (ITV) 2.8.5 Labour Mix Variance (Gang Composition Variance) 2.8.6 Labour Yield Variance (LYV) 2.8.7 Labour Revised Efficiency Variance (LREV) 2.9 Self-Test Questions

2.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn to compute direct material and direct labour variance (b) Learn to analyse direct material and direct labour variance (c) Explain how they are used for control (d) Calculate mix and yield variances for direct materials and direct labour.

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2.1 MEANING OF VARIANCE Standard Costing act as a measuring tool for the management for determination of "Variances" in order to evaluate the production performance. The primary object of standard costing is to reveal the difference between actual cost and standard cost. Variance is the difference between the standard cost and the actual cost. In other words it is the difference between what the cost should have been and what the actual cost is. Variances of different cost items provide the key to cost control. They indicate whether and to what extent standards set have been achieved. This enables management to correct adverse tendencies. After standard costs have been established, the next step is to ascertain the actual cost under each element and compare them with the standard cost. The difference between these two is termed as cost variance. According to the CIMA, London “Cost variance is the difference between a standard cost and the comparable actual cost incurred during a given period.” The Chartered Institute of Management Accountants, London, defines Variance as “the difference between planned, budgeted, or standard cost and actual cost; and similarly for revenue.”

2.2 VARIANCE ANALYSIS Variance analysis can be defined as “the analysis of performance by means of variances”. According to C.I.M.A., London “It is the process of computing the amount of and isolating the cause of variances between actual costs and standard costs.” According to CIMA Official Terminology, 2005 “the evaluation of performance by means of variances, whose timely reporting should maximize the opportunity for managerial action.” Variance analysis helps to fix the responsibility so that management can ascertain: (a) The amount of the variance (b) The reasons for the difference between the actual performance and budgeted performance (c) The person responsible for its occurrence and (d) Corrective actions to be taken

2.3 FAVOURABLE AND UNFAVOURABLE VARIANCE Variance analysis is a quantitative technique that involves identification and evaluation of causes behind differences between actual costs and standard costs. Variances are analyzed in terms of being favourable or unfavourable for business and are 85

monetized as a difference is a financial value which is easier for the relevant authorities to assess its financial impact on business. Where the actual cost is less than standard cost, the difference is known as Favourable or Credit or Positive Variance denoted by (F) or Cr. In other words, any variance which increases the actual profit is Favourable variance. Where the actual cost is more than standard cost, the difference is known as Unfavourable or Adverse or Debit Variance denoted by (A) or Dr. In other words, any variance which decreases the actual profit is Unfavourable variance.

2.4 CONTROLLABLE AND UNCONTROLLABLE VARIANCE Controllable Variance: A variance is said to be controllable if it can be identified as the primary responsibility of a specified person or a department. For example the workers may be held responsible for use of material in excess of standard quantity. The size of controllable variance reflects the degree of efficiency of person (or department) concerned. Actually it is the controllable variance with which the management is concerned because it is here where corrective action is required. Uncontrollable Variance: A Variance is said to be uncontrollable if variance is due to the factors beyond the control of the concerned person (or department). For example, change in market price of material or increase in material prices due to increase in import duty are the examples of adverse uncontrollable variance. No person or department can be held responsible for uncontrollable variances. Actually revision of standards is required to remove such variances in future. When variances are reported, attention of the management is particularly drawn towards controllable variances. If a variance has been caused by multiple factors, the part of cost variance relevant to each factor should be determined. There are certain variances which may arise under material, labour or overhead due to change in the basic condition on which the standards are established.

2.5 REVISION VARIANCE Sometimes the standard costs may be affected by changes in prices of various factors like wages, material, overhead rates and changes in methods. The standard costs are not disturbed to account for these uncontrollable factors and to avoid the amount of labour and cost involved in revision, the basic standard costs are allowed to stand. It is essential to isolate the variance arising out of non-revision in order to analyze the other

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variances correctly. Revision variance is the difference between the original standard cost and the revised standard costs. Revision variance = Original Standard Cost of Actual Output - Revised Standard Cost of Actual Output Creation of revision variance is only an interim adjustment which allows the standard costing system to operate even when there are changes in standard cost.

2.6 METHOD VARIANCE Method Variance is that part of Revision Variance which arises due to the use of methods other than those specified. According to CIMA, London, method variance is “the difference between the standard cost of a product or operation produced or performed by the normal method and the standard cost of a product or operation produced or performed by the alternative method actually employed.”

Variance

Sales Variance

Cost Variance

Direct Material Cost Variance

Material Price Variance

Overhead Cost Variance

Direct Labour Cost Variance

Variable Overhead Variance

Material Usage Variance

Labour Rate Variance

Sales Price Variance

Fixed Overhead Variance

Labour Efficiency Variance

Figure: Cost Variance Analysis

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Sales Volume Variance

Sales Mix Variance

Sales Quantity Variance

2.7 MATERIAL VARIANCE Material Cost Variance (MCV) Material Price Variance (MPV)

Material Usage Variance (MUV)

Material Mix Variance (MMV)

Material Yield Variance (MYV)

2.7.1 Material Cost Variance (MCV) It is the difference between the standard cost of material consumed for actual production and the actual cost of material consumed. It is calculated as: Material Cost Variance MCV

= =

Standard cost of standard quantity of material used for actual output

-

Actual cost of actual quantity of material used for actual output

[SQAO × SP]

-

[AQ × AP]

SQAO stands for Standard Quantity for Actual Output. It is calculated by the below given formula: SQAO = Standard Qty of Material × Actual Output Standard Output Interpretation of Variance:  If the standard cost is more than actual cost, it will be favourable variance. It represents positive (+) symbol.  If the standard cost is less than actual cost, it will be adverse variance. It represents negative (-) symbol. Reasons for Material Cost Variance:  Change in price of material or  Change in quantity of material or  Change in price and quantity of material Division of Material Cost Variance:  Material Price Variance (MPV), and  Material Usage Variance (MUV)

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2.7.2 Material Price Variance (MPV) It is that portion of Material Cost Variance which is due to the difference between the standard price specified and the actual price paid. It is calculated as: Material Price Variance

=

( Standard Price - Actual Price) × Actual Quantity

MPV

=

(SP - AP) × AQ

Interpretation of Variance:  If the standard price is more than actual price, it will be favourable variance. It represents positive (+) symbol.  If the standard price is less than actual price, it will be adverse variance. It represents negative (-) symbol. Reasons for Material Price Variance:  Change in the market price of material  Changes in the quantity of material purchased leading to lower/higher quantity discounts  Failure to take advantage of off-season price, or failure to purchase when price is cheaper  Failure to avail cash and/or trade discounts which were provided while setting standards  Incorrect setting of standards  Change in delivery costs  Emergency purchase on the request of production/sales manager  Changes in issue price due to differences in changes related to store-keeping, materials handling, carriage inward expenses etc.  Changes in the pattern or amount of taxes and duties

2.7.3 Material Usage Variance (MUV) It is that portion of Material Cost Variance which is due to the difference between the standard quantity specified and the actual quantity consumed both valued at standard prices. It is calculated as: Material Usage Variance

=

(Standard Quantity for Actual Output - Actual Quantity) × Standard Price

MUV

=

( SQAO - AQ ) × SP

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SQAO stands for Standard Quantity for Actual Output. It is calculated by the below given formula: SQAO = Standard Qty of Material × Actual Output Standard Output Interpretation of Variance:  If the standard quantity is more than actual quantity, it will be favourable variance. It represents positive (+) symbol.  If the standard quantity is less than actual quantity, it will be adverse variance. It represents negative (-) symbol. Reasons for Material Usage Variance:  Inefficiency in production resulting in wastages  Use of non-standard material  Use of non-standard material mixture  Change in specification or design of product  Pilferage  Defect in plant and machinery  Use of substitute materials  Poor inspection of raw materials  Change in the method of production  Yield from material in excess of or less than standard yield Division of Material Usage Variance:  Material Mix Variance (MMV), and  Material Yield Variance (MYV)

2.7.4 Material Mix Variance (MMV) It is that portion of Material Usage Variance which is due to the difference between the standard and the actual composition of materails. It arises only where more than one type of material is used for producing the finished product. It is calculated as: Material Mix Variance MMV

=

Standard Cost of Revised Standard Cost of Actual Quantity of Quantity of Actual Material Consumed Material Consumed (Revised Standard Quantity - Actual Quantity) × Standard Price

=

( RSQ - AQ ) × SP

=

RSQ is calculated by the below given formula: =

Standard Qty of one material Total Standard Quantities of all material

90

× Total Actual Quantities of all material

Interpretation of Variance:  If the revised quantity is more than actual quantity, it will be favourable variance. It represents positive (+) symbol.  If the revised quantity is less than actual quantity, it will be adverse variance. It represents negative (-) symbol. Reasons for Material Mix Variance:  Non-availability of one or more components of the mix  Non-purchase of materials at proper time  Larger proportion of the more expensive material is used than that the laid down in the standard mix, materials usage will reflect a higher cost than the standard  Contrarily, the use of cheaper materials in large proportions will indicate a lower cost of materials usage than the standard

2.7.5 Material Yield Variance (MYV) It is that portion of Material Usage Variance which is due to the difference between the actual yield obtained and standard yield specified for actual quantity used. While setting standards, the normal or standard loss is taken into account. But actual loss may differ from normal or standard loss. This results in actual yield different from standard yield. Material Yield Variance is calculated as: Material Yield Variance

=

MYV

=

(Actual Yield - Standard Yield for Actual Quantity) × Standard Output Price ( AY - SYAQ ) × SOP

1) Standard Yield for Actual Quantity (SYAQ) is calculated as below: SYAQ =

Standard Output × Total Actual Quantities of Total Standard Quantities all material of all material 2) Standard Output Price (SOP) is calculated as below: SOP =

SQ × SP Standard Output

Interpretation of Variance:  If the Actual Yield is more than Standard Yield, it will be favourable variance. It represents positive (+) symbol.  If the Actual Yield is more than Standard Yield, it will be adverse variance. It represents negative (-) symbol.

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Reasons for Material Yield Variance:  It arises only when the actual loss as % of total actual input differs from the standard loss as % of total standard input. Illustration 1: Mixers Ltd. is engaged in producing a „standard mix‟ using 60 kgs of chemical X and 40 kgs of chemical Y. The standard loss of production is 30%. The standard price of X is Rs. 5 per kg and of Y Rs. 10 per kg. The actual mix and yield were as follows: X: 80 kgs @ Rs. 4.50 per kg Y: 70 kgs @ Rs. 8.00 per kg Actual Yield: 115 kgs Calculate Direct Material Cost, Price, Usage, Mix and Yield Variances. [B.Com (Hons), Delhi] Solution: (1) Standard mix for actual input of 150 kgs Material X = 150 × 60% i.e. 90 kgs Material Y = 150 × 40% i.e. 60 kgs (2) Standard output for actual mix 150 × 70% = 105 kgs (3) Actual output = 115 kgs (4) Standard cost per unit of output Rs. (90 × 5 + 60 × 10) = Rs. 10 per kg. 105 kgs (5) Actual cost comes to Rs. 8 per kg (being Rs. 920/115) Material X Y

Standard Actual Qty (kg) Rate (Rs.) Amt (Rs.) Qty (kg) Rate (Rs.) Amt (Rs.) 90 5 450 80 4.50 360 60 10 600 70 8.00 560 150 1,050 150 920

Direct material cost variance = Standard Cost of actual output - Actual cost of actual output = Rs. (115× 10) - Rs. 920 = Rs. 230 (F) Direct material price variance = AQ (SR - AR) Material X = 80 × (5 - 4.50) = 40 (F) Materials Y = 70 × (10 - 8) = 140 (F) Rs. 180 (F)

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Direct material usage variance = SR (SQ - AQ) Material X = 5 × (98.57* - 80) = 92.85 (F) Material Y = 10 × (65.73* - 70) = 42.70 (A) Rs. 50.15 (F) Direct material mix variance = SR (SM-AM) Material X = 5 × (90 - 80) = 50 (F) Material Y = 10 × (60 - 70) = 100 (A) Rs. 50 (A) Direct material yield variance = Standard Cost per unit of output (Actual Output Standard output) = 10 × (115 - 105) = Rs. 100 (F) Verification DMCV= DMPV + DMUV = Rs. 180 (F) + Rs. 50 (F) = Rs. 230 (F) DMUV =DMMV + DMYV = Rs. 50 (A) + Rs. 100 (F) = Rs. 50 (F) * Standard Quantity for Actual Output 90 × (115/105) = 98.57 kg. 60 × (115/105) = 65.73 kg.

Illustration 2: The standard cost of a certain chemical mixture is: 35% Material A at Rs. 25 per kilogram 65% material B at Rs. 36 per kilogram A standard loss of 5% is expected in production. During a period there is used: 125 kilograms of Material A @ Rs. 27 per kg. 275 kilograms of Material B @ Rs. 34 per kg. The actual output was 365 kgs. [B.Com (Hons), Delhi] Calculate: (a) Material Cost Variance (b) Material Price Variance (c) Material Mix Variance (d) Material Yield Variance Solution: (i)

Standard Input for actual output 365 × 100/95 = 384.21 kg Material A: 35% = 134.47 kgs. 93

(ii)

(iii)

Material B: 65% = 249.74 kgs. Standard mix of actual input Material A 35% of 400 kgs = 140 kgs. Material B 65% of 400 kgs = 260 kgs. Cost per unit of output (standard) Rs. (35 × 25) + Rs. (65 × 36) = Rs. 3,215 95 95

= Rs. 33.84

(a) Material Cost Variance = (SP × SQ) - (AP × AQ) Material A: (25 × 134.47) - (27 × 125) = 13.25 (A) Material B: (36 × 249.74) - (34 × 275) = 359.35 (A) Rs. 372.60 (A) (b) Material Price Variance = AQ × (SP - AP) Material A: 125 × (25 - 27) = 250 (A) Material B: 275 × (36 - 34) = 550 (F) Rs. 300 (F) (c) Material Mix Variance = SP (SM - AM) Material A: 25 × (140 - 125) = 375 (F) Material B: 36 × (260 - 275) = 540 (A) Rs. 165 (A) (d) Material Yield Variance = Standard Output price per unit (SY - AY) = 33.84 × (380 - 365) = 33.84 × (15) = Rs. 507.60 (A) Verification MUV = MCV - MPV = 372.60 (A) - 300 (F) = 672.60 (A) This will be verified as underMUV = SP (SQ - AQ) Material A: 25 (134.47 - 125) = 236.75 (F) Material B: 36 (249.74 - 275) = 909.35 (A) 672.60 (A)

Illustration 3: The standard mix of product is given below: X: 60 units at 15 paise per unit Y: 80 units at 20 paise per unit Z: 100 units at 25 paise per unit

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Ten units of the finished products should be obtained from this mix. During the month of February, ten mixes were completed and the consumption was: X: 640 units at 20 P per unit Y: 960 units at 15 P per unit Z: 840 units at 30 P per unit Actual output was 90 units. Calculate the various Material Variances. Solution: (i) Calculation of revised quantity (RQ) X: 60/240 × 2,440 = 610 Y: 80/240 × 2,440 = 813 Z: 100/ 240 × 2,440 = 1,017 (ii) Standard cost of standard materials: X: 600 × 15 P. = Rs. 90 Y: 800 × 20 P. = Rs. 160 Z: 1,000 × 25 P. = Rs. 250 Rs. 500 (iii) Actual cost of actual material X: 640 × 20 P. = Rs. 128 Y: 960 × 15 P. = Rs. 144 Z: 840 × 30 P. = Rs. 252 2,440 Rs. 524

ANALYSIS OF MATERIAL VARIANCE Total Material Variance: (SC - AC) × AY (5 - 5.822) × 90 This is accounted for: (a) Material Price Variance: (SP - AP) × AQ X = (15 P. - 20 P.) × 640 Y = (20 P.- 15 P.) × 960 Z = (25 P.- 30 P.) × 840 (b) Material Usage Variance: (SQ - RQ) × SP X = (600 - 610) × 15 P. Y = (800 - 813) × 20 P. Z = (1,000 - 1,017) × 25 P. (c) Material Mix Variance: (RQ - AQ) × SP

Rs.

Rs. 74 (A)

95

32 (A) 48 (F) 42 (A)

26 (A)

1.50 (A) 2.60 (A) 4.25 (A)

8.35 (A)

X = (610 - 640) × 15 P. Y = (813 - 960) × 20 P. Z = (1,017 - 840) × 25 P. (d) Material Yield Variance: (AY - SY) × SC (90 - 100) × Rs. 5 Total Material Variances SC = 500/100 = Rs. 5 per unit

4.50 (A) 29.40 (A) 44.25 (F)

10.35 (F)

50.00 (A) 74. 00 (A)

2.8 LABOUR VARIANCE Labour Cost Variance (LCV) Labour Rate Variance (LRV)

Labour Efficiency Variance (LEV)

Idle Time Variance (ITV)

Labour Mix Variance (LMV)

Labour Yield Variance (LYV)

2.8.1 Labour Cost Variance (LCV) It is the difference between the Standard Cost of Labour Hours specified for the output achieved and the Actual Cost of Labour Hours expended. It is calculated as: Labour Cost Variance LCV

=

Standard Cost of Standard Labour Hours used for Actual Output

-

Actual Cost of Actual Labour Hours used for Actual Output

=

[SHAO × SR]

-

[AH × AR]

SHAO stands for Standard Labour Hours for Actual Output. It is calculated by the below given formula: SHAO = Standard Labour Hours × Actual Output Standard Output Interpretation of Variance:  If the standard cost is more than actual cost, it will be favourable variance. It represents positive (+) symbol.  If the standard cost is less than actual cost, it will be adverse variance. It represents negative (-) symbol.

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Reasons for Labour Cost Variance:  Change in Rate of Labour or  Change in Labour Hours or  Change in Rate and Labour Hours Division of Labour Cost Variance:  Labour Rate Variance (LRV), and  Labour Efficiency Variance (LEV)

2.8.2 Labour Rate Variance (LRV) It is that portion of Labour Cost Variance which is due to the difference between the standard rate specified and the actual rate paid. It is calculated as: Labour Rate Variance

=

(Standard Rate - Actual Rate) × Actual Hours

LRV

=

(SR - AR) × AH

Interpretation of Variance:  If the standard rate is more than actual rate, it will be favourable variance. It represents positive (+) symbol.  If the standard rate is less than actual rate, it will be adverse variance. It represents negative (-) symbol. Reasons for Labour Rate Variance:  Change in basic wage structure or change in piece-work rate  Use of a different method of payment, e.g. payment at day-rates while standards are based on piece-work method of remuneration  Higher or lower rates paid to casual and temporary workers  New workers not being allowed full normal wage rates  The composition of a gang as regards the skill and rate of wages being different from that laid down in the standard.  Overtime and night shift work in excess of or less than the standard.

2.8.3 Labour Efficiency Variance (LEV) It is that portion of Labour Cost Variance which is due to the difference between the standard hours specified for actual output and the actual hours expended both valued at standard rate. It is calculated as: Labour Efficiency Variance

=

(Standard Hours for Actual Output - Actual Hours) × Standard Rate

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LEV

=

( SHAO - AH ) × SR

SHAO stands for Standard Hours for Actual Output. It is calculated by the below given formula: SHAO = Standard Hours × Actual Output Standard Output Interpretation of Variance:  If the Standard Hours are more than Actual Hours, it will be favourable variance. It represents positive (+) symbol.  If the Standard Hours are less than Actual Hours, it will be adverse variance. It represents negative (-) symbol. Reasons for Labour Efficiency Variance:  Basic inefficiency of workers due to low morale, insufficient training, faulty instructions, incorrect scheduling of jobs, etc.  Use of non-standard material requiring more or less operation time.  Carrying out operations not provided for a booking them as direct wages.  Incorrect standard  Lack of proper supervision or strict supervision than specified  Poor working conditions  Use of defective machines, tools and other equipments.  Use of defective methods of operations Division of Labour Efficiency Variance:  Idle Time Variance (ILV)  Labour Mix Variance (LMV)  Labour Yield Variance (LYV)

2.8.4 Idle Time Variance (ITV) It is that portion of Labour Efficeincy Variance which is due to abnormal idle time such as time lost due to power failure, machinery break-down, strike etc. It arises due to the difference between Actual labour Hours worked and Actual Labour Hours paid. It is calculated as: Idle Time Variance

=

(Actual Hours worked - Actual Hours paid) × Standard Rate

ITV

=

Idle Hours × Standard rate [ IT × SR]

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Interpretation of Variance: As idle time represents a loss and is always an adverse or unfavourable variance. It represents negative (-) symbol.

2.8.5 Labour Mix Variance (Gang Composition Variance) It is that portion of Labour Efficiency Variance which is due to the difference between the standard and the actual composition of labour. It is calculated as: Labour Mix Variance

=

Standard Cost of Revised Standard Cost of Actual Labour Labour Hours Hours expended

=

(Revised Standard Hours - Actual Hours) × Standard Rate

LMV

=

( RSH - AH ) × SR

RSH is calculated as below: RSH =

Standard Hours of the grade Total Standard Hours of all grades

× Total Actual Hours of all grades

Interpretation of Variance:  If the revised hours are more than actual hours, it will be favourable variance. It represents positive (+) symbol.  If the revised hours are less than actual hours, it will be adverse variance. It represents negative (-) symbol. Reasons for Material Mix Variance: It arises only where more than one grade of labour is employed for producing the finished product. And when the actual two or more grades of labour are mixed in a ratio different from the standard labour mix ratio. One of the reason of this difference can be due to the non-avialability of one or more grades of labour mix.

2.8.6 Labour Yield Variance (LYV) It is that portion of Labour Efficiency Variance which is due to the difference between the actual yield obtained and standard yield specified for actual hours used. LYV is an output variance which represents a gain or loss on output in terms of finished production. Labour Yield Variance is calculated as: Labour Yield Variance LYV

=

(Actual Yield - Standard Yield for Actual Hours) × Standard Output Rate

= (AY - SYAH ) × SOR

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1) Standard Yield for Actual Hours (SYAH) is calculated as: SYAQ =

Standard Output × Total Actual Hours of all Total Standard Hours grades of all grades 2) Standard Output Price (SOP) is calculated as below: SOP =

SQ × SP Standard Output

Interpretation of Variance:  If the Actual Yield is more than Standard Yield, it will be favourable variance. It represents positive (+) symbol.  If the Actual Yield is more than Standard Yield, it will be adverse variance. It represents negative (-) symbol.

2.8.7 Labour Revised Efficiency Variance (LREV) It is that portion of Labour Efficiency Variance which arises due to the factors other than those which give rise to idle time variance and labour mix variance. Labour Revised Efficiency Variance

=

(Standard Hours for Actual Output - Actual Productive Hours) × Standard Rate

LREV

=

(SHAO - APH) × SR

Where, Actual Productive Hours= Actual Hours - Idle Hours Interpretation of the Variance:  If the Standard Hours are more than Actual Productive Hours, it will be favourable variance. It represents positive (+) symbol.  If the Standard Hours are less than Actual Productive Hours, it will be adverse variance. It represents negative (-) symbol. Illustration 4: The details regarding the composition and the weekly wage rates of labour force engaged on a job scheduled to be completed in 30 weeks are as follows: Category of workers Skilled Semi-skilled Unskilled

Standard No. of Weekly wage labourers rate (in Rs.) 75 60 45 40 60 30

Actual No. of Weekly wage labourers rate (in Rs.) 70 70 30 50 80 20

The work is actually completed in 32 weeks. Calculate the various labour variances. 100

Skilled Semi-skilled Unskilled

Weeks 2,250 1,350 1,800 5,400

Standard Rate Amount 60 1,35,000 40 54,000 30 54,000 2,43,000

Weeks 2,240 960 2,500 5,760

Actual Rate 70 50 20

Amount 1,56,800 48,000 51,200 2,56,000

Note: Number of weeks is calculated above by multiplying number of workers with number of weeks. Solution: Labour Cost Variance = (Standard Cost - Actual Cost) = 2,43,000 - 2,56,000 = Rs. 13,000 (A) Labour Rate Variance = (SR - AR) × AT Skilled (60 - 70) × 2,240 = Rs. 22,400 (A) Semi-skilled (40 - 50) × 960 = Rs. 9,600 (A) Unskilled (30 - 20) × 2560 = Rs. 25,600 (F) Total = Rs. 6,400 (A) Labour Time Variance = (ST - AT) × SR Skilled (2250 - 2240) × 60 = Rs. 600 (F) Semi-skilled (1350 - 960) × 40 = Rs. 15,600 (F) Unskilled (1800 - 2500) × 30 = Rs. 22,800 (A) Total Rs. 6,600 (A) Labour Mix Variance (Revised Standard time - AT ) × SR Skilled (2250/5400 × 5760 - 2240) × 60 = Rs. 9,600 (F) Semi-skilled (1350/5400 × 5760 - 960) × 40 = Rs. 19,200 (F) Unskilled (1800/5400 × 5760 - 2560) × 30 = Rs. 19,200 (A) Total Rs. 9,600 (F) Illustration 5: A gang of workers usually consists of 10 men, 5 women and 5 boys in a factory. They are paid at standard hourly rate of Rs. 1.25, Re. 0.80 and Re. 0.70 respectively. In a normal working week of 40 hours the gang is expected to produce 1,000 units of output. In a certain week, the gang consisted of 13 men, 4 women and 3 boys. Actual wages were paid at the rates of Rs. 1.20, Re. 0.85 and Re. 0.65 respectively. Two hours were lost due to abnormal idle to abnormal idle time and 960 units of output were produced. Calculate various labour variances. (ICWA Inter)

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Solution: Category of workers Men Women Boys

Hrs 400 200 200 800

Standard Rate Rs. 1.25 0.80 0.70

Amount 500 160 140 800

Hrs 520 160 120 800

Actual Rate Rs. 1.20 0.85 0.65

Amount 624 136 78 838

DLCV = Standard cost for actual output - Actual Cost = 960 × Re. 0.80 - Rs. 838 = Rs. 768 - Rs. 838 = Rs. 70 (Adverse) DLRV = Actual hrs. Paid for × (Standard Rate - Actual Rate) Men = 520 × (Rs. 1.25 - Rs. 1.20) = Rs. 26 (F) Women = 160 × (Re. 0.80 - Re. 0.85) = Rs. 8 (A) Boys = 120 × (Re. 0.70 - Re. 0.65) = Rs. 6 (F) Total Rs. 24 (Favourable) Total Direct labour efficiency variance (TDLEV) = Standard Rate × (Standard Time for actual output * - Actual Time paid for) Men = Rs. 1.25 × (384 - 520) = 170 (A) Women = Re. 0.80 × (192 - 160) = 25.60 (F) Boys = Re. 0.70 × (192 - 120) = 50.40 (F) Rs. 94 (Adverse) * (Standard hrs./Standard Output) × Actual Output Total Direct labour efficiency variance may be segregated into: Direct labour efficiency variance (DLEV) = Standard Rate × (Standard Time for actual output * - actual time worked) Men = Rs. 1.25 × (384 - 494) = 137.50 (A) Women = Re. 0.80 × (192 - 152) = 32.00 (F) Boys = Re. 0.70 × (192 - 114) = 50.40 (F) Rs. 50.90 (Adverse) Idle time variance (ITV) = Idle hrs. × Standard Rate Men = 26 × 1.25 = Rs. 32.50 (A) Women = 8 × 0.80 = Rs. 6.40 (A) Boys = 6 × 0.70 = Rs. 4.20 (A) Total 43.10 (Adverse)

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DLMV = Standard Rate × (Revised Standard Time - Actual Time Taken) Revised Standard Time = (Total Actual Time/ Total Standard Time) × Standard Time Men = (760/800) × 400 = 380 Women = (760 /800) × 200 = 190 Boys = (760/800) × 200 = 190 Men = Rs. 1.25 × (380 - 494) = 142.50 (A) Women = Re. 0.80 × (190 - 152) = 30.40 (F) Boys = Re. 0.70 × (190 - 114) = 53.20 (F) Total Rs. 58.90 (Adverse) Direct Labour Yield Variance (DLYV) = Standard Cost per unit× (Standard Output for actual time - actual output) = Re. 0.80 (950 - 960) = Rs. 8 (F) Verification DLCV = DLRV + DLEV = 24 (F) + 94 (A) = Rs. 70 (A) TDLEV = DLEV + ITV = 50.90 (A) + 43.10 (A) = Rs. 94 (A) Or = DLMV + ITV + DLYN = Rs. 58.90 (A) + 43.10 (A) + 8 (F) = Rs. 94 (A)

2.9 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) If labour time is based on the maximum efficiency, the unit cost will be (b) Higher (b) Lower (c) Equal (d) None of the above (2) Which of the following statements are true about standard labour time? (b) Standard labour time indicates the time in hours needed for a specified process (b) It is standardized on the basis of past experience with no adjustments made for time and motion study

103

(c) In fixing standard time due allowance should not be given to fatigue and tool setting (d) The Production manager does not provide any input in setting the labour time standard (3) The labour engaged in the making of a product is known as _______ (b) Direct labour (b) Indirect labour (c) Temporary labour (d) None of the above (4) ______ is responsible for setting up of materials price standard (a) Production department (b) Engineering department (c) Purchase department (d) None of the above (5) While determining material quantity standards, a proper consideration should be assigned to (a) Normal material wastage (b) Abnormal material wastage (c) Both (a) and (b) (d) None of the above (6) The sub-variance of material usage variance, known as Material mix variance is measured as (a) Total standard cost - Total actual cost (b) Standard cost of revised standard mix - Standard cost of actual mix (c) (Standard unit price - Actual unit price) * Actual quantity used (d) (Standard quantity - Actual quantity) * Unit standard price (7) Volume variance arises when (a) There is rise in overhead rate per hour (b) There is decline in overhead rate per hour (c) There is decrease or increase in actual output compared to the budgeted output (d) None of the above (8) Which variance is also known as Gang composition variance? (a) Labour mix variance (b) Labour cost variance (c) Labour efficiency variance (d) None of the above Answers: (1) (c), (2) (a), (3) (a), (4) (c), (5) (a), (6) (b), (7) (c), (8) (a)

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EXERCISE 2: SHORT ANSWER QUESTIONS Q1. State the meaning, method of computation and causes of: (a) Material Cost Variance (b) Material Price Variance (c) Material Usage Variance (d) Material Mix Variance (e) Material Yield Variance Q2. State the meaning, method of computation and causes of: (a) Labour Cost Variance (b) Labour Rate Variance (c) Labour Efficiency Variance (d) Labour Mix Variance (e) Labour Yield Variance EXERCISE 3: LONG ANSWER QUESTIONS Q1. Standard material cost for manufacturing 1000 units of output is 400 kg. of material at Rs. 2.50 per kg. When 2000 units are produced it is found that actual cost is 825 Kg of material at Rs. 2.70 per kg. Calculate material cost variance, material price variance and material usage variance. [B.Com (Hons), Delhi 2008] Answers: Material Cost Variance Rs. 227.50 (A), Material Price Variance Rs. 165 (A), Material Usage Variance Rs. 62.50 (A) Q2. From the following particulars find out the following variances: (a) Material Price Variance

(b) Material Usage Variance

Standard quantities of material per unit Standard price per kg. Actual number of units produced Actual quantity of material used Price of material

5 Kg Rs. 5 400 2,200 kg Rs. 4.80 per kg (B.Com, Madurai)

Answers: (a) Rs. 440 (F) (b) Rs. 1,000 (A) Q3. Philips Co. manufactures Product „P‟ by mixing three raw materials. For every 100 kg of P, 125 Kg of raw materials are used. In April there was an output of 5,600 Kg of P. the standard and actual particulars for April are as follows: 105

Raw Material

Standard Mix Rs.

I II III

Actual Price Per Kg.

50% 30% 20%

Mix Rs. 40 20 10

Price Per Kg. 60% 20% 20%

42 16 12

Calculate all material variances assuming actual quantity of material consumed was 7,000 Kg. [B.Com (Hons), Delhi] Answers: MCV Rs. 19,600 (A), MPV Rs. 5,600 (A), MUV Rs. 14,000 (A), MMV Rs. 14,000 (A), MYV Nil Q4. The standard cost of a product is: 10 hours per unit at Rs. 5 per hour The actual data is: Production 1,000 units Hours taken: Production Idle time Total time

10,400 hours 400 hours 10,800 hours

Payments made Rs. 56,160 at Rs. 5.20 per hour. Calculate: (a) Labour Cost Variance (b) Labour Efficiency Variance (c) Labour Rate Variance (d) Idle time Variance Answers: (a) Rs. 6,160 (A) (b) Rs. 4,000 (A) (c) Rs. 2,160 (A) (d) Rs. 2,000 (A) Q5. A job is schedule to be completed in 30 weeks with a labour employment of 100 skilled operatives, 40 semi-skilled operatives and 60 unskilled operatives. The standard weekly wages of each type of operatives are - skilled Rs. 60, Semi-skilled Rs. 36 and unskilled Rs. 24. The work is actually completed in 32 weeks with a labour force of 80 skilled, 50 semi-skilled and 70 unskilled operatives and the actual weekly wage rates average Rs. 65 for skilled, Rs. 40 for semi-skilled and Rs. 20 for unskilled labour. Analyse the variance in the labour cost due to various reasons. (ICWA) Answers: LCV Rs. 8,800 (A), LRV Rs. 10,240 (A), LEV Rs. 1,440 (F), LMV Rs. 19,200 (F), LREV Rs. 17,760 (A)

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Q6. The standard labour composition and the actual labour composition engaged during the month are given below: Standard number of workers in a group Standard wage rate (Rs. per hour) Actual number of workers employed during the month in the group Actual wage rate per hour (Rs.)

Skilled 30 5 24

Semi-Skilled 10 3 15

Unskilled 10 2 12

6

2.5

2

During the month of 200 working hours, the group produced 9,600 standard hours of work. Calculate wage rate variance, labour efficiency (revised) variance, labour mix variance, Total labour cost variance. (ICWA) Answers: Wage rate variance Rs. 3,300 (A), Labour efficiency (revised) variance Rs. 2,400 (A), Labour mix variance Rs. 3,000 (F), Total labour cost variance Rs. 2,700 (A)

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LESSON 3 VARIANCE ANALYSIS OVERHEAD AND SALES VARIANCE 3. STRUCTURE 3.0 Learning Objectives 3.1 Overhead Variance 3.2 Variable Overhead Cost Variance 3.2.1 Variable Overhead Expenditure Variance 3.2.2 Variable Overhead Efficiency Variance 3.3 Fixed Overhead Cost Variance 3.3.1 Fixed Overhead Expenditure Variance 3.3.2 Fixed Overhead Volume Variance 3.3.2.1 Fixed Overhead Efficiency Variance 3.3.2.2 Fixed Overhead Capacity Variance 3.3.2.3 Fixed Overhead Calender Variance 3.3.2.4 Revised Fixed Overhead Capacity Variance 3.4 Sales Variance 3.4.1 Turnover Method or Value Method 3.4.2 Margin Method Or Profit Method 3.5 Accounting Treatment of Variances 3.6 Control Ratios 3.7 Self-Test Question

3.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn to compute overhead and sales variance (b) Learn to analyse overhead and sales variance (c) Explain how they are used for control (d) Calculate control ratios and understand its use.

3.1 OVERHEAD VARIANCE Overhead is the aggregate of indirect material, indirect labour and indirect expenses. Variance analysis of overhead is different from that of direct material and direct labour variance. The overhead cost variance can be described as the difference between total standard Cost of overhead allowed for the actual output achieved and the actual 108

overhead cost incurred. In other words, overhead cost variance indicates under or over absorption of overheads. Favourable Overhead Variances indicate over absorption of overheads and Adverse Overhead Variances indicate under absorption of overheads. In case of direct material and direct labour variances, there is no question of dividing them into fixed and variable as the direct material and direct labour costs are variable. However, in case of overheads, it is necessary to divide them into fixed and variable for computation of variances. The absorbed overheads are the overheads which are charged to each unit of production on the basis of a pre-determined overhead rate. Since actual overheads can be known only at the time of finalization of expense accounts at the end of accounting period, the overheads are charged to each unit of production on the basis of Predetermined Overhead rates.

Overhead Cost Variance (OCV) Variable Overhead Variance (VOV)

Fixed Overhead Variance (FOV)

Basic Terms used in connection with overhead variance are explained below: When overhead rate per hour is used Standard Fixed = Budgeted Fixed Overhead Budgeted Hours Overhead Rate = Budgeted Variable Overhead Standard Budgeted Hours Variable Overhead Rate Absorbed (or = Standard Hours for Actual Output × Standard Overhead Rate Recovered Overhead) = Actual Hours × Standard Standard Overhead Rate Overhead = Budgeted Hours × Standard Budgeted Overhead Rate Overhead = Actual Hours × Actual Actual Overhead Rate Overhead SHAO= Budgeted Hours × AO SHAO/SOAH Budgeted Output Terms

109

When overhead rate per unit is used = Budgeted Fixed Overhead Budgeted Output = Budgeted Variable Overhead Budgeted Output = Actual Output × Standard Overhead Rate = Standard Output for Actual Hours × Standard Overhead Rate = Budgeted Output × Standard Overhead Rate = Actual Output × Actual Overhead Rate SOAH= Budgeted Output × AH Budgeted Hours

Overhead Cost Variance: It is the difference between total standard overhead cost absorbed in the output achieved and the actual overhead cost. It is calculated as: Overhead Cost Variance OCV

= Absorbed Overhead - Actual Overhead

=

Standard Hours for Actual Output

× Standard Overhead Absorption Rate

- Actual Overhead

Division of Overhead Cost Variance:  Variable Overhead Variance  Fixed Overhead Variance

Variable Overhead Cost Variance (VOCV)

Variable Overhead Expenditure Variance (VOEV)

Variable Overhead Efficiency Variance (VOEV)

3.2 VARIABLE OVERHEAD COST VARIANCE It is the difference between Absorbed Variable Overhead and Actual Variable Overhead. It is calculated as: Variable Overhead = Cost Variance

(Absorbed Variable Overhead - Actual Variable Overhead )

(Standard Hours for Actual Output × Standard Variable Overhead Rate) Actual Variable Overhead Or (SHAO × SVOR) - (AH × AVOR) =

Division of Overhead Cost Variance:  Variable Expenditure Overhead Variance  Variable Efficiency Overhead Variance

110

3.2.1 Variable Overhead Expenditure Variance It is that portion of Variable Overhead Cost Variance which arises due to the difference between Standard Variable Overhead allowed and Actual Variable Overhead incurred. It is calculated as: Variable Overhead = Expenditure Variance

(Standard Variable Overhead - Actual Variable Overhead )

(Actual Hours × Standard Variable Overhead Rate) - (Actual Hours × Actual Variable Overhead Rate) or (AH × SVOR) - (AH × AVOR) =

3.2.2 Variable Overhead Efficiency Variance It is that portion of Variable Overhead Cost Variance which arises due to the difference between Standard Hours for Actual Output and Actual Hours. It is calculated as: Variable Overhead = Efficiency Variance

(Absorbed Variable Overhead - Standard Variable Overhead)

(Standard Hours for Actual Output × Standard Variable Overhead Rate) (Actual Hours × Standard Variable Overhead Rate) or (SHAO × SVOR) - (AH × SVOR) =

Fixed Overhead Cost Variance (FOCV) Fixed Overhead Expenditure Variance (FOEV)

Fixed Overhead Volume Variance (FOVV)

Fixed Overhead Efficiency Variance (FOEV)

Fixed Overhead Capacity Variance (FOCV)

Fixed Overhead Calender Variance (FOCV)

3.3 FIXED OVERHEAD COST VARIANCE It is the difference between Total Standard Fixed Overhead Absorbed and Total Actual Fixed Overhead incurred. It is calculated as: 111

Fixed Overhead = Cost Variance

(Absorbed Fixed Overhead - Actual Fixed Overhead )

(Standard Hours for Actual Output × Standard Fixed Overhead Rate) (Actual Hours × Actual Fixed Overhead Rate) Or (SHAO × SFOR) - (AH × AFOR) =

Division of Fixed Overhead Cost Variance:  Fixed Overhead Expenditure Variance  Fixed Overhead Volume Variance

3.3.1 Fixed Overhead Expenditure Variance It is that portion of Fixed Overhead Cost Variance which arises due to the difference between Budgeted Fixed Overhead and Actual Fixed Overhead incurred. It is also known as Spending or Budget Variance. It is calculated as: Fixed Overhead = Expenditure Variance

(Budgeted Fixed Overhead - Actual Fixed Overhead )

(Budgeted Hours × Standard Fixed Overhead Rate) - (Actual Hours × Actual Fixed Overhead Rate) or (BH × SFOR) - (AH × AFOR) =

Reasons for Fixed Overhead Expenditure Variance:  Rise in general price level  Changes in production methods  Ineffective control

3.3.2 Fixed Overhead Volume Variance It is that portion of Fixed Overhead Cost Variance which arises due to the difference between Standard Hours for Actual Output and Budgeted Hours. It is calculated as: Fixed Overhead = Volume Variance

(Absorbed Fixed Overhead - Budgeted Fixed Overhead )

(Standard Hours for Actual Output × Standard Fixed Overhead Rate) (Budgeted Hours × Standard Fixed Overhead Rate) Or (SHAO - BH) × SFOR =

112

Reasons for Fixed Overhead Volume Variance:  Poor efficiency of workers  Poor efficiency of machinery  Lack of orders  Shortage of power  Ineffective supervision  More or less working days.

3.3.2.1 Fixed Overhead Efficiency Variance: It is that portion of Fixed Overhead Volume Variance which arises due to the difference between Standard Hours for Actual Output and Actual Hours. It is calculated as: Fixed Overhead = Efficiency Variance

(Absorbed Fixed Overhead - Standard Fixed Overhead )

(Standard Hours for Actual Output × Standard Fixed Overhead Rate) (Actual Hours × Standard Fixed Overhead Rate) or (SHAO - AH) × SFOR =

3.3.2.2 Fixed Overhead Capacity Variance: It is that portion of Fixed Overhead Volume Variance which arises due to the difference between Actual Hours and Budgeted Hours. This variance arises when plant capacity actually utilized is more or less than the capacity planned to be utilized due to factors like idle time, under or over customer demand, strikes, power failure etc. It is calculated as: Fixed Overhead = Capacity Variance

(Standard Fixed Overhead - Budgeted Fixed Overhead )

(Actual Hours × Standard Fixed Overhead Rate) - (Budgeted Hours × Standard Fixed Overhead Rate) Or (AH - BH) × SFOR =

Reasons for Fixed Overhead Expenditure Variance:  Shortage of Material  Shortage of Labour  Shortage of Power  Machine Break Down

113

3.3.2.3 Fixed Overhead Calender Variance: It is that portion of Fixed Overhead Volume Variance which arises due to the difference between Actual Number of Working Days and Budgeted Number of Working Days. It is calculated as: = (Revised Budgeted Fixed Overhead - Budgeted Fixed Overhead ) = (Revised Budgeted Hours - Budgeted Hours) × Standard Rate per hour

Fixed Overhead Calender Where Revised Budgeted Hours Budgeted Hours × Actual Number of Working Days Variance = Budgeted Number of Working Days OR

(Actual Number of Working Days - Standard Number of Working Days) × Standard Rate per day

3.3.2.4 Revised Fixed Overhead Capacity Variance: When Calender Variance is to be calculated, the method of calculating capacity variance has to be modified. It is calculated as follows: Revised = (Standard Fixed Overhead - Revised Budgeted Fixed Overhead ) Fixed Overhead Capacity = (Actual Hours - Revised Budgeted Hours) × Standard Fixed Overhead Rate Variance Or (AH - RBH) × SFOR Illustration 1: A factory supplies figures of production and overheads for a month: Budget Production (units) Variable overheads(Rs.) Fixed overheads (Rs.) Number of hours

Actual 50,000 4,00,000 6,00,000 2,00,000

Work out variances that are involved.

52,000 4,10,000 6,20,000 2,20,000 (CS Final)

Solution: VARIABLE OVERHEADS VARIANCE (i) Variable Overhead Expenditure Variance = Recovered Variable Overheads - Actual Variable Overheads Or (Standard Variable overheads on actual production - actual variable overheads) [(52,000 × 4,00,000) / 50,000 - 4,10,000] = Rs. 6,000 (F) (ii) Fixed Overhead Expenditure Variance (Budgeted Overheads - Actual Overheads) 114

= (Rs. 6,00,000 - 6,20,000) = Rs. 20,000 (A) (iii) Volume Variance = Recovered Overheads - Budgeted Overheads = Rs. (6,00,000/50,000) × 52,000 - Rs. 6,00,000 = Rs. 24,000 (F) (iv) Capacity Variance = Standard Overheads - Budgeted Overhead = [(Budgeted Output/Budgeted Hours) × Actual Hours - 6,00,000] = (12 × (50,000/2,00,000) × 2,20,000 - 6,00,000] = Rs. 60,000 (F) (v) Efficiency Variance = Recovered Overheads - Standard Overheads = Rs. 6,24,000 - 6,60,000* = Rs. 36,000 (F) *reverse signs are applied Illustration 2: Ridham Ltd. has furnished you the following data: Budget No. of working days Production in units Fixed overheads

25 20,000 Rs. 30,000

Actual (July, 1991) 27 22,000 Rs. 31,000

(i) Budgeted fixed overhead rate Re. 1 per hour. (ii) In July, 1991, actual hours worked 31,500. Calculate the following variances: (i) Efficiency variance (ii) Capacity variance (iii) Calendar variance (iv) Volume variance (v) Expenditure variance (vi) Total overhead variance Solution: BASIC CALCULATIONS (a) Budgeted hours = Rs. 30,000 / Re. 1 i.e. 30,000 hours (b) Actual hours = 31,500 hours (c) Standard hours = (30,000/20,000) × 22,000 = 33,000 hours (d) Possible hours = (27/25) × 30,000 = 32,400 hours (e) Budgeted fixed overheads = Rs. 30,000 (f) Actual fixed overheads = Rs. 31,000 (g) Standard fixed overhead = Rs. (30,000 × 22,000) / 20,000 = Rs. 33,000 (h) Standard rate per hour = Re. 1 115

[CA Inter]

(1) Efficiency Variance = SR × (SH - AH) = 1.00 × (33,000 - 31,500) = Rs. 1,500 (F) (2) Capacity Variance = SR × (BH - AH) = 1.00 (30,000 - 31,500) = Rs. 1,500 (F) (3) Revised Capacity Variance = SR × (PH - AH) = Re. 1 (32,400 - 31,500) = Rs. 900 (A) (4) Calendar Variance = SR × (BH - PH) = 1.00 × (30,000 - 32,400) = Rs. 2,400 (F) (5) Volume Variance = SR × (BH - SH) = 1.00 × (30,000 - 33,000) = Rs. 3,000 (F) (6) Expenditure Variance = BFO - AFO = Rs. 30,000 - 31,000 = Rs. 1,000 (A) (7) Total Overhead Variance = SFO - AFO = Rs. 33,000 - 31,000 = Rs. 2,000 (F) Reconciliation I Total overhead variance = Expenditure Variance + volume variance Rs. 2,000 (F) = Rs. 1,000 (A) + Rs. 3,000 (F) Reconciliation II Volume Variance = Efficiency Variance + Capacity Variance Rs. 3,000 (F) = Rs. 1,500 (F) + Rs. 1,500 (F) Reconciliation III Capacity Variance = Revised Capacity Variance + Calendar Variance Rs. 1,500 (F) = Rs. 900 (A) + Rs. 2,400 (F) Final reconciliation Total Overhead Variance = Expenditure Variance + Efficiency Variance + Revised Capacity Variance + Calendar Variance Rs. 2,000 (F) = Rs. 1,000(A) + 1,500 (F) + 900 (A) + 2,400 (F) Illustration 3: Find out variable overheads variances from the following: Budgeted variable overheads for January Rs. 8,000 Budgeted production for the month 500 units Standard time for one unit of production 10 hours Actual variable overheads Rs. 6,600 Actual production for the month 400 units 116

Actual hours worked

Rs. 3,800 hours

Solution: Standard variable overhead rate per unit = Rs. 16 Standard Variable overhead rate per hour = Rs. 8,000 = Rs. 1.60 500 × 10 Computation of variable overhead variances (a) Actual variable overheads during the period (b) Actual hours worked × Standard Variable overhead Rate per hour (3,800 hrs. × Rs. 1.60) (c) Actual production × Standard Variable overhead Rate per unit (400 units × Rs. 16) Variable overhead variances: (i) Expenditure Variances (a - b) (ii) Efficiency Variance (b - c) (iii) Total Variable Overheads Variance (a - c)

Rs. 6,600 6,080 6,400

Rs. 520 (A) Rs. 320 (F) Rs. 200 (A)

By application of formula: (i) Variable Overheads Variance = (SVO - AVO) = Rs. 6,400 - Rs. 6,600 = Rs. 200 (A) (ii) Expenditure Variance = (AT × SR ) - AVO = (3,800 Hrs. × Rs. 1.60) - Rs. 6,600 = Rs. 6,080 - Rs. 6,600 = Rs. 520 (A) (iii) Efficiency Variance = Standard Overhead Rate (Actual Hours - Standard Hours for Actual Production) = Rs. 1.60 (3,800 Hrs. - 4,000 Hrs.) = Rs. 320 (F)

3.4 SALES VARIANCE Sales Variances Turnover Method Price Variance Mix Variance

Margin Method

Volume Variance

Price Variance

Quantity Variance

Mix Variance

117

Volume Variance Quantity Variance

The analysis of variances will be complete only when the difference between the actual profit and standard profit is fully analyzed. As profit is difference between sales and cost. While cost variances are concerned with cost and their effect on budgeted profit due to favourable or adverse variances, the sales variances affect the budgeted profit due to changes in sales revenue i.e. changes caused by either a change in selling prices or sales quantities. Sales variance can be calculated by two methods: (1) Turnover (or Value) Method (2) Margin (or profit) Method

3.4.1 Turnover Method or Value Method The following variances are calculated under this method:

3.4.1.1 Sales Value Variance: This Variance refers to the difference between budgeted sales and actual sales. It may be calculated as follows: = Actual Value of Sales - Budgeted Value of Sales Sales Value Variance

= (Actual Sales Quantity × Actual Selling Price) - (Budgeted Sales Quantity × Budgeted Selling Price) = (AQ × AP) - (SQ × SP)

Interpretation of Sales Value Variance:  If the Actual Sales is more than Budgeted Sales, it will be favourable variance. It represents positive (+) symbol.  If the Actual Sales is more than Budgeted Sales, it will be adverse variance. It represents negative (-) symbol. Reason for Sales Value Variance:  Change in selling price of the product or  Change in quantity of the product or  Change in selling price and quantity of the product Division of Sales Value Variance:  Sales Price Variance  Sales Volume Variance

118

3.4.1.2 Sales Price Variance: This Variance is that portion of Sales Value Variance which occurs due to the difference between Actual selling Price and Budgeted Selling Price. It may be calculated as follows: = Actual Sales - Standard Sales Sales Price Variance

= (Actual Quantity × Actual Price) - (Actual Quantity × Standard Price) = (AQ × AP) - (AQ × SP) = (AP - SP) × AQ

Interpretation of Sales Price Variance:  If the Actual Price is more than Budgeted Price, it will be favourable variance. It represents positive (+) symbol.  If the Actual Price is more than Budgeted Price, it will be adverse variance. It represents negative (-) symbol. Reason for Sales Price Variance:  Change in the market price  Not giving cash discounts  Change in the delivery cost

3.4.1.3 Sales Volume Variance: This Variance is that portion of Sales Value Variance which occurs due to the difference between Actual Sales Quantity sold and Budgeted Sales Quantity specified. It may be calculated as follows: = Standard Sales - Budgeted Sales Sales Volume Variance

= (Actual Quantity × Standard Price) - (Standard Quantity × Standard Price) = (AQ × SP) - (SQ × SP) = (AQ - SQ) × SP

Interpretation of Sales Volume Variance:  If the Actual Quantity is more than Budgeted Quantity, it will be favourable variance. It represents positive (+) symbol.  If the Actual Quantity is more than Budgeted Quantity, it will be adverse variance. It represents negative (-) symbol. Reason for Sales Volume Variance:  Use of non-standard products  Use of non-standard sales mixture  Pilferage

119

 Change in the quality of the product  Use of substitute products Division of Sales Value Variance:  Sales Mix Variance  Sales Quantity Variance

3.4.1.4 Sales Mix Variance: This Variance is that portion of Sales Volume Variance which occurs due to the difference between standard value of revised mix and standard value of actual mix. It occurs due to changes in sales mix of different product. It may be calculated as follows: = Standard Sales - Revised Standard Sales Sales Mix Variance

= (Actual Quantity × Standard Price) - (Revised Standard Quantity × Standard Price) = (AQ × SP) - (RSQ × SP) = (AQ - RSQ) × SP Where, Revised Standard Quantity =

Standard Quantity of one product × Total of actual quantities of all product Total of Standard quantities of all product

Interpretation of Sales Mix Variance:  If the Actual Quantity is more than Revised Standard Quantity, it will be favourable variance. It represents positive (+) symbol.  If the Actual Quantity is more than Revised Standard Quantity, it will be adverse variance. It represents negative (-) symbol.

3.4.1.5 Sales Quantity Variance: This Variance is that portion of Sales Volume Variance which occurs due to the difference between Budgeted Sales and Revised Standard Sales. It may be calculated as follows: = Revised Standard Sales - Budgeted Sales Sales Mix Variance

= (Revised Standard Quantity × Standard Price) - (Standard Quantity × Standard Price) = (RSQ × SP) - (SQ × SP) = (RSQ - SQ) × SP Where, Revised Standard Quantity =

Standard Quantity of one product × Total of actual quantities of all product Total of Standard quantities of all product

120

3.4.2 Margin Method or Profit Method This method studies the effect of changes in sale quantities and selling prices on the profits of the company. The sales management is interested in knowing sales margin variance. Under this method, the following variances are calculated:

3.4.2.1 Total Sales Margin Variance: This is the difference between the actual value of sales margin and budgeted value of sales margin. It is calculated as follows: Total Sales Margin Variance

= Actual Profit - Budgeted Profit = (Actual Quantity × Actual Profit per unit) - (Standard Quantity × Standard Profit per unit)

Division of Sales Margin Variance:  Sales Margin Price Variance  Sales Margin Volume Variance

3.4.2.2 Sales Margin Price Variance: This is that portion of the total Sales Margin Variance that arises due to the difference between the actual profit and standard profit. It is calculated as follows: Sales = Actual Profit - Standard Profit Margin Price = (Actual Profit per unit - Standard Profit per unit) × Actual Quantity Sold Variance

3.4.2.3 Sales Margin Volume Variance: This is that portion of the total Sales Margin Variance that arises due to the difference between standard profit and Budgeted profit. It is calculated as follows: Sales Margin Volume Variance

= Standard Profit - Budgeted Profit = (Actual Quantity - Standard Quantity) × Standard Profit per unit

Division of Sales Margin Volume Variance:  Sales Margin Mix Variance  Sales Margin Quantity Variance

121

3.4.2.4 Sales Margin Mix Variance: This is that portion of the Sales Margin Volume Variance that arises due to the difference between Standard Profit and Revised Standard profit. It is calculated as follows: = Standard Profit - Revised Standard Profit Sales = (Actual Quantity × Standard Profit Per Unit) - (Revised Standard Quantity × Margin Standard Profit Per Unit) Mix Variance = (AQ × SP) - (RSQ × SP) = (AQ - RSQ) × SP Where, Revised Standard Quantity =

Standard Quantity of one product × Total of actual quantities of all product Total of Standard quantities of all product

3.4.2.5 Sales Margin Quantity Variance: This Variance is that portion of Sales Margin Volume Variance which occurs due to the difference between Budgeted Profit and Revised Standard Profit. It may be calculated as follows: = Revised Standard Profit - Budgeted Profit Sales = (Revised Standard Quantity × Standard Profit per unit) - (Standard Quantity × Margin Quantity Standard Profit per unit) Variance = (RSQ × SP) - (SQ × SP) = (RSQ - SQ) × SP Where, Revised Standard Quantity =

Standard Quantity of one product × Total of actual quantities of all product Total of Standard quantities of all product

Illustration 4: From the following figures calculate different sales variances: Product X Y Total

Quantity 360 320

Budget Price Rs. 60 40

Value Rs. 21,600 12,800 34,400

122

Quantity 364 316

Actual Price Rs. 59 41

Value Rs. 21,476 12,956 34,432

Solution: The standard value of the actual mix of sales and the standard value of the standard mix of sales must be calculated. Product X Y Total

Standard sales Quantity Price Rs. 364 60 316 40

Value Rs. 21,840 12,640 34,480

Product X (a) Sales Volume Variance: (SS - BS) Rs. = Rs. 21,840 - 21,600 = 240 (F) (b) Sales Price Variance: (AS - SS) = Rs. 21,476 - 21,840 = 364 (A) (c) Sales Volume Variance: (AS - BS) = Rs. 21,476 - 21,600 = 124 (A) (d) Sales Quantity Variance: (RSS - BS) = Rs. 21,650 - 21,600 = 50 (F) (e) Sales Mix Variance: (SS - RSS) = Rs. 21,840 - 21,650 = 190 (F) Check: (i) Value Variance = Price Variance + Volume Variance Rs. 124 (A) = Rs. 364 (A) + Rs. 240 (F) (ii) Volume Variance = Quantity Variance + Mix Variance Rs. 240 (F) = Rs. 50 (F) + Rs. 190 (F) Product Y (a) Sales Volume Variance = (SS - BS) Rs. = Rs. 12,640 - 12,800 =160 (A) (b) Sales Price Variance = (BS - AS) = Rs. 12,956 - 12,640 = 316 (F) (c) Sales value variance = (AS - BS) = Rs. 12,956 - 12,800 = 156 (F) (d) Sales Quantity Variance = (RSS - BS) = Rs. 12,830 - 12,800 = 30 (F) (e) Sales Mix Variance = (SS - RSS) = Rs. 12,640 - 12,830 = 190 (A)

Check: (i) Value Variance = Price Variance + Volume Variance Rs. 156 (F) = Rs. 316 (F) + Rs. 160 (A) 123

Revised Standard Sales Ratio Value Rs. 216.128 21,650 128.216 12,830 34,480

(ii) Value Variance = Quantity Variance + Mix Variance Rs. 160 (A) = Rs. 30 (F) + Rs. 190 (A)

3.5 ACCOUNTING TREATMENT OF VARIANCES The cost records maintained and entries made under a system of standard costing vary from company to company depending upon the information that is desired from cost records, and the intended use of standard cost and variance analysis. Variances which emerge in standard costing and recorded in the cost books may be disposed of in any of the following ways: (i) Transfer to costing profit and loss account: In this method, the stock of work-inprogress, finished goods and cost of sales are maintained at standard cost and all variances are charged to costing profit and loss account at the end of the accounting period. This method is favoured because standard costs facilities prompt inventory valuation and also variances are separated out so as to attract the attention of the management. (ii) Allocation of variances to finished stock, work-in-progress and cost of sales account: Under this method the variances are distributed over stocks of finished goods, work-in-progress and to cost of sales account in proportion to the closing balances (value) of each account depending upon the type of variance. (iii) Transfer to reserve account: In this method favourable variances are carried forward as deferred credits until they are set-off by adverse variances. It is considered that controllable variances according to method (ii).

3.6 CONTROL RATIOS In addition to variances, Control Ratios are also used by management for the purpose of controlling. It is expressed in %. If the ratio is 100% or more, it indicates a favourable position and versa, if the ratio is less than 100%. It indicates unfavorable position. Three important control ratios are as follows: (1) Efficiency Ratio: It is defined as “the standard hours equivalent to the work produced expressed as a percentage of actual hours spent in production”. It is calculated as: Efficiency Ratio = Standard hours for actual output × 100 Actual Hours worked

124

(2) Activity Ratio: It is defined as “the standard hours equivalent to the work produced, expressed as percentage of budgeted standard hours”. It is calculated as: Activity Ratio = Standard hours for actual output × 100 Budgetary Hours (3) Capacity Ratio: It shows the relationship between actual hours worked and the budgeted hours. It is calculated as: Capacity Ratio = Actual hours worked × 100 Budgetary Hours (4) Calender Ratio: Calender Ratio indicates the extent of actual working days availed during the budget period. It is calculated as: Calender Ratio = Actual number of working days in the budget period × 100 Budgeted number of working days in the budget period Illustration 5: (A) Calculate (a) Efficiency ratio (b) Activity ratio (c) Capacity ratio From the following figures: Budgeted production Standard hours per unit Actual production Actual working hours

88 units 10 75 units 600 [B.Com (Hons), Delhi]

Solution: (a) Efficiency ratio =

Standard Hours for Actual Production × 10 Actual Hours Worked

=

(75 units @ 10 hours) × 100 600 = 125%

= 750 ×100 600

(b) Activity Ratio =

Standard Hours for Actual Production ×100 Budgeted hours = 750 ×100 880 = 85.23%

(c) Capacity Ratio =

Actual Hours Worked ×100 Budgeted hours

125

= 600 × 100 880 = 68.18% Illustration 5: (B) In M/s Pandavs, 3,000 jars of mixed pickles can be filled in one hour, 5,000 jars, of pickled onion can be filled in one hour and 10,000 bottles of sauce can be filled in one hour. The budgeted and actual production for December, 1989 was as follows: Budget Actual Mixed pickles 1,92,000 jars 2,02,500 jars Pickled onions 3,00,000 jars 3,20,000 jars Sauce 3,60,000 bottles 4,00,000 bottles The clock hours for the month were 160. Express the budgeted and actual production in standard hours and calculate the efficiency. Answers:

STATEMENT OF STANDARD HOURS AND EFFICIENCY

Particulars Mixed pickles Pickled onions Sauce Total

Budgeted standard hours 1,92,000/3,000 = 64 hr 3,00,000/5,000 = 60 hr 3,60,000/10,000 = 36 hr 160 hours

Efficiency ratio =

=

Actual standard hours 2,02,500/3,000 = 67.5 hr 3,20,000/5,000 = 64 hr 4,00,000/10,000 = 40 hr 171.5 hours

Actual Production in Terms of Standard Hours × 100 Actual hours worked 171.5 × 100 = 107.1875% 160

Illustration 6: Nagaro Ltd. produces two commodities. Good and Better, in one of its departments. Each unit takes 5 hours and 10 hours as production time, respectively. 1,000 units of Good and 600 units of Better were produced during March 1991. Actual man hours spent in this production were 10,000. Yearly budgeted hours are 96,000. Compute the various control ratios. Solution: BASIC CALCULATION (i) Budgeted hours = 96,000/ 12 hours i.e. 8,000 hours (ii) Actual hours worked: 10,000 hours (iii) Standard hours: (a) Good 1,000 × 5 = 5,000 (b) Better 600 ×10 = 6,000 11,000 hours CONTROL RATIOS (a) Activity Ratio = Standard Hours For Actual Production × 100 Budgeted Hours 126

= (11,000/ 8,000) × 100 i.e. 137.5% (b) Capacity Ratio =

Actual Hours Worked × 100 Budgeted Hours

= (10,000/ 8,000) × 100 = 125% (c) Efficiency Ratio =

Standard Hours For Actual Production × 100 Actual Hours Worked

= (11,000/ 10,000) × 100 = 110%

3.8 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) Sales margin variance due to sales quantities is measured as (a) Standard profit - Revised standard profit (b) Revised standard profit - Budgeted profit (c) Standard profit + Revised standard profit (d) Revised standard profit + Budgeted profit (2) The formula to estimate the sales margin variance due to sales mixture is (a) Standard profit - Revised standard profit (b) Revised standard profit - Budgeted profit (c) Standard profit + Revised standard profit (d) Revised standard profit + Budgeted profit (3) Sales margin variance due to volume can be classified into ___ parts. (a) 3 (b) 2 (c) 4 (d) 5 (4) Analysis of overhead variances can be done by (a) Two variance method (b) Three variance method (c) Four variance method (d) All of the above Answers: (1) (b), (2) (a), (3) (b), (4) (d)

127

EXERCISE 2: SHORT ANSWER QUESTIONS Q1. State the meaning, method of computation and causes of: (a) Variable Overhead Cost Variance (b) Variable Overhead Efficiency Variance (c) Variable Overhead Expenditure Variance (d) Fixed Overhead Cost Variance (e) Fixed Overhead Expenditure Variance (f) Fixed Overhead Volume Variance (g) Fixed Overhead Efficiency Variance (h) Fixed Overhead Capacity Variance (i) Fixed Overhead Calender Variance (j) Overhead Cost Variance Q2. State the meaning, method of computation and causes of: (a) Sales Value Variance (b) Sales Price Variance (c) Sales Volume Variance (d) Sales Mix Variance (e) Sales Quantity Variance Q3. What do you understand by the following: (a) Efficiency Ratio (b) Activity Ratio (c) Capacity Ratio EXERCISE 3: LONG ANSWER QUESTIONS Q1. From the following calculate fixed overhead expenditure and volume variances: Budgeted fixed overhead for the month of November

Rs. 1,00,000

Budgeted production for the month:

50,000 units

Actual production for the month:

54,000 units

Actual fixed overhead for the month:

Rs. 1,20,000 (M.Com, Madras)

Answers: Expenditure variance Rs. 20,000 (A), Volume Variance Rs. 8,000 (F) Q2. The following information is available from the records of a company: Budgeted Rs. 10,000 2,000

Fixed overhead for January Production in January 128

Actual 12,000 2,100

Standard time per unit (hrs.) Actual hours worked in January (hrs.)

10 -

22,000

Compute: (1) Fixed overhead cost variance (2) Expenditure variance (3) Volume variance (4) Capacity Variance (5) Efficiency variance Answers: (1) Rs. 1500 (A), (2) Rs. 2,000 (A), (3) Rs. 500 (F) (4) Rs. 1,000 (F), (5) Rs. 500 (A) Q3. Budgeted and actual sales for the month of March, 2016 of two products X and Y of ABC Ltd. were as follows: Product

Budgeted Units

Sales Price p.u. (in Rs.)

X

6,000

5

Y

10,000

2

Actual Units 5,000 1,500 7,500 1,750

Actual Price p.u. (in Rs.) 5 4.75 2 1.9

Budgeted Costs for the product X and Y were Rs. 4 and Rs. 1.50 per unit respectively. Work out from the above data the following variances: (1) Sales value variance (2) Sales volume variance (3) Sales price variance (4) Sales mixture variance (5) Sales quantity variance Answers: (1) Rs. 450 (F) (2) Rs. 550 (A) (3) Rs. 1,000 (F) (4) 1,782 (F), (5) Rs. 782 (A) Q4. ABC Ltd. Manufactures two products A and B. Product A takes 6 hours to make while Product B takes 12 hours. In a month of 25 days of 8 hours each, 1200 units of A and 750 units of B were produced. The firm employs 75 men in the department responsible for producing these two products. The budgeted hours are 1,86,000 per annum. You are required to calculate activity ratio, capacity ration and efficiency ratio. (ICWA, Inter June, 1990) Answers: Activity ratio 104.5%, Capacity ratio 96.8%, Efficiency ratio 108%

129

Q5. Calculate: (1) Efficiency ratio (2) Capacity ratio from the following figures: Budgeted production 80 units Actual production 60 units Standard time per unit 8 hours Actual hours worked 500 Answers: (1) Efficiency ratio 96%; (2) Capacity ratio 78.12%

[B.Com (Hons), Delhi]

Q6. Argon Ltd. furnishes the following information relating to budgeted sales and actual sales for the month of March, 2017: Budgeted Sales:

Actual Sales:

Product A B C A B C

Sales Quantity units Sales Price Per unit 1,200 15 800 20 2,000 40 880 18 880 20 2,640 38

You are required to calculate: (1) Sales price variance (2) Sales volume variance (3) Sales mix variance (4) Total sales value variance (5) Assume products to be homogeneous

[B.Com (Hons), Delhi]

Answers: (1) Sales price variance Rs. 2,640 (A), (2) Sales volume variance Rs. 22,400 (F), (3) Sales mix variance Rs. 11,000 (F), (4) Total sales value variance Rs. 19,760 (F) Q7. A factory supplies figures of production and overheads for a month: Budgeted Production (Units) Variable Overheads (Rs.) Fixed Overhead (Rs.) Number of hours

Actual 50,000 4,00,000 6,00,000 2,00,000

Work out all variance that are involved.

52,000 4,10,000 6,20,000 2,20,000 (CS Final)

Answers: (1) Variable Overhead expenditure variance Rs. 6,000 (F) (2) Fixed Overhead expenditure Rs. 20,000 (F) (3) Volume Variance Rs. 24,000 (F) (4) Capacity Variance Rs. 60,000 (F) (5) Efficiency Variance Rs. 36,000 (F) 130

Q8. Calculate the following: (i) Efficiency Ratio (ii) Activity Ratio (iii) Capacity Ratio Details Budget production (units) Standard hours per unit Actual production Actual working hours

Units per hour 880 10 750 6,000 [B.com (Hons), Delhi]

Ans: (i) ER = 125%, (ii) AR = 85.23%, (iii) CR = 68.18%

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LESSON 1

UNIT 4

ABSORPTION COSTING VERSUS VARIABLE COSTING 1. STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Prior Knowledge Required 1.2.1 Variable Costs Vs Fixed Costs 1.2.2 Product Costs and Period Costs 1.2.3 Manufacturing Costs and Non-Manufacturing Costs 1.3 Absorption Costing 1.3.1 Characteristics of Absorption Costing 1.3.2 Income Determination under Absorption Costing 1.4 Marginal Costing 1.4.1 Characteristics of Variable/Marginal Costing 1.4.2 Advantages of Marginal Costing 1.4.3 Disadvantages of Marginal Costing 1.4.4 Income Determination under Marginal Costing 1.5 Statement of Reconciliation 1.6 Difference between Absorption Costing and Marginal Costing 1.7 Difference in Profit under Absorption Costing and Marginal Costing 1.8 Self-Test Questions

1.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn the Concepts of marginal costing and absorption costing (b) Differentiate between absorption and marginal costing (c) Explain advantages and limitations of marginal costing (d) Explain the difference in profit under marginal costing and absorption costing

1.1 INTRODUCTION Marginal Costing and Absorption Costing are not a method of costing like job, batch or contract costing but are the two main techniques of Management Accounting for ascertaining cost and determining income of an organization. These two techniques are often used in management accounting, for different purposes: 132

(1) Marginal Costing helps with short-term decision-making (2) Absorption Costing is used to calculate inventory valuations and profit calculations in financial statements The use of each system is dependent on the information needs of the business or organization:  Can we afford to sell 2,000 units of our product each month to ABC Limited at a discount of 5 per cent? (use marginal costing for decision making)  „What profit have we made this year?‟ (use absorption costing for calculating profit) These costing systems use the same costs, but they are treated differently according to their behaviour.

1.2 PRIOR KNOWLEDGE REQUIRED

Product Costs vs Period Costs

Manufacturing Costs vs NonManufacturing Costs

Variable Costs vs Fixed Costs

1.2.1 Variable Costs Vs Fixed Costs Variable Cost is that portion of cost which tends to vary in direct proportion to the volume of output. When volume of output increases, total variable cost also increases, and vice versa but the variable cost per unit remains fixed. Fixed Cost is that portion of cost which tends to remain constant in total amount over a specific range of activity for a specified period of time, but it does not increase or decrease with the change in the volume of production. 133

Variable Costs

Fixed Costs

Variable Cost= Direct Material+ Direct Labour+ Direct Expenses+ Variable Production OH+ Variable S & D OH

Fixed Cost= Fixed Production OH+ Fixed Administration OH+ Fixed S & D OH

Variable Cost per unit is assumed to remain constant at all levels of output.

Fixed Cost per unit of output will vary inversely with changes in the level of output. As output increases, Fixed Cost per unit decreases and vice versa

Variable costs are incurred only when production takes place. Hence, no production means no variable costs.

Fixed Costs are incurred even at zero level of output.

Variable Costs are considered as productrelated costs.

Fixed Costs are treated as period-related costs.

1.2.2 Product Costs and Period Costs Product Costs are those costs which are necessary for production and which will not be incurred if there is no production. These costs are assigned to the product and are included in inventory valuation. These are also called as Inventoriable Costs. These are included in inventory valuation. They are treated as assets till the goods to which they are assigned are actually sold. Examples: Direct Material, Direct Wages, Production OH, etc. Period Costs are those costs which are not necessary for production and incurred even if there is no production. These costs are not assigned to the products but are charged as expenses against the revenue of the period in which they are incurred. As these are not included in the value of inventory, it is also called as Non-Inventoriable Costs. They are written off as expense in the period in which they are incurred. Examples: General Administration Costs, Salesmen Salary, Selling Expenses, etc.

134

Product Cost

Recorded as an asset in the form of inventory in the Balance Sheet

Period Cost

Recorded as an expenses in the Profit and Loss Account of the current period

Figure: Product and Period Cost In the above figure, it is showing accounting treatment of product and period costs. Classification into product and period cost is important from the point of view of profit determination. This is so because product cost is carried forward to the next accounting period as part of the unsold finished stock whereas period cost is written off in the accounting period in which it is incurred.

1.2.3 Manufacturing Costs and Non-Manufacturing Costs These costs are apportioned on the basis of traceability of cost into direct versus indirect costs associated with producing a product. There are three major categories of manufacturing costs consisting of direct labor, direct material, and manufacturing overhead. There can be Variable Manufacturing Costs and Fixed Manufacturing Costs. Non-manufacturing Costs are fixed costs which are not associated with production. It is also known as "period" costs, consists of selling and administrative expenses.

1.3 ABSORPTION COSTING Absorption Costing is a conventional technique of cost ascertainment. CIMA, London, defines the Absorption Costing as “the practice of charging all costs, both variable and fixed to operations, processes or products”. It is also known as 'Full Costing Technique'. It is a procedure of cost recognition wherein costs are classified on the basis of functions as Production Costs, Administration Costs, Selling Costs and Distribution Costs. In this type of costing system, fixed factory overheads are absorbed on actual cost basis or on the basis of a pre-determined overhead rate based on normal capacity. Under/Over absorbed overhead are adjusted before computing profit for a particular period. Closing stock is valued at total cost which includes fixed factory overhead. The figure below explains absorption costing system:

135

Direct Materials Direct Labour Variable Factory OH Fixed Factory OH

Charged as expenses when goods are sold

Charged to cost of goods produced

All Selling and Administration Overhead

Charged as expenses when incurred

Figure: Absorption Costing Approach

1.3.1 Characteristics of Absorption Costing  All costs are classified on functional basis as Production Costs, Administration Costs, Selling Costs, and Distribution Costs.  All variable manufacturing costs and fixed production overheads are treated as product costs and hence are charged to operations or product.  All Administration Costs, Selling Costs, and Distribution Costs are treated as period costs and hence are not charged to operations or product but written off against the profits in the period in which they arise. These are Non-Inventoriable Costs.  All cost of production, both Fixed and Variable, are included in inventory valuation.  There may be under or over absorption of factory overhead.  Fixed cost can be charged on actual basis or at pre-determined overhead rates based on normal capacity.

1.3.2 Income Determination under Absorption Costing The income statement is prepared as shown below: Income Statement under Absorption Costing Particulars Sales Less: Variable Manufacturing Costs Direct Material Consumed Direct Labour Variable Manufacturing Overhead Fixed Manufacturing Overhead Cost of goods produced Add: Opening stock of finished goods (valued at 136

Rs.

XXXX XXXX XXXX XXXX XXXX XXXX

Rs. XXXX

Less:

Add: Less: Add:

Less:

cost of previous period) Closing stock of finished goods (valued at production cost of Current period) Cost of goods sold Under absorption of Fixed Manufacturing Overhead Over absorption of Fixed Manufacturing Overhead Variable Office and Administration Overhead Variable Selling and Distribution Overhead Total Variable Cost Contribution (Sales-Total Variable Cost) Fixed Production Overhead Fixed Administration Overhead Fixed Selling and Distribution Overhead Net Profit

(XXXX) XXXX XXXX

XXXX XXXX XXXX XXXX XXXX XXXX XXXX

XXXX XXXX

1.4 MARGINAL COSTING Marginal Cost: The CIMA London has defined the term Marginal Cost “as the amount at any given volume of output by which the aggregate costs are charged if the volume of output is changed by one unit.” Accordingly, it means that the added or additional cost of an extra unit of output. For example, if the total number of units produced are 1,800 and the total cost of production is Rs. 1,12,000, if one unit is additionally produced the total cost of production may become Rs. 1,12,010 and if the production quantity is decreased by one unit, the total cost may come down to Rs. 1,11,990. Thus the change in the total cost is by Rs. 10 and hence the marginal cost is Rs. 10. The increase or decrease in the total cost is by the same amount because the variable cost always remains constant on per unit basis. Marginal Costing: This technique of costing is also known as “Variable Costing”, “Differential Costing” or “Out-of-pocket” costing. According to CIMA Terminology Marginal Costing is the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs in this technique of costing only variable costs are charged to operations, processes or products leaving all indirect costs to be written off against profits in the period in which they arise. According to J. Batty, Marginal costing is "a technique of cost accounting pays special attention to the behaviour of costs with changes in the volume of output." This

137

definition lays emphasis on the ascertainment of marginal costs and also the effect of changes in volume or type of output on the company's profit. To clarify the point, let us take a simple example, suppose company X is manufacturing three products A, B and C at present and the number of units produced are 45,000, 50,000 and 30,000 respectively p.a. If it decides to change the product mix and decides that the production of B is to be reduced by 5,000 units and that of A should be increased by 5,000 units, there will be impact on profits and it will be essential to measure the same before the final decision is taken. This decision is regarding the change in the volume of output. Now suppose if the company has to take a decision that product B should not be produced at all and the capacity, which will be available, should be utilized for A and B this will be change in the type of output and again the impact on profit will have to be measured. This can be done with the help of marginal costing by preparing comparative statement showing profits before the decision and after the decision. This is subject to one assumption and that is the fixed cost remains constant irrespective of the changes in the production. Thus marginal costing is a useful technique for decisionmaking. Under this technique, only variable costs are charged as product costs and included in inventory valuation. Fixed manufacturing costs are not allotted to products but are considered as period costs and thus charged directly to Profit and Loss Account of that year. Fixed costs also do not enter in stock valuation. Direct Materials Direct Labour Variable Factory Overhead

Charged to cost of goods produced

Fixed Factory OH and all Selling and Administration Overhead

Charged as expenses when goods are sold

Charged as expenses when incurred

Figure: Variable Costing Approach

1.4.1 Characteristics of Variable/Marginal Costing  Division of Cost into Fixed and Variable Cost: In marginal costing, costs are segregated into fixed and variable. Only variable costs are charged to the production, i.e. included in the cost of production. Fixed costs are not included in the cost of production, which means that they are not absorbed in the production. 138

 Valuation of Inventory: Another important feature of marginal costing is the valuation of inventory is done at variable cost only. This means, that variable costs only are taken into consideration while valuing the inventory. Fixed costs are eliminated from the inventory valuation because they are largely period costs and relate to a particular period or year.  Fixed costs as period costs: The fixed costs are written off soon after they are incurred and do not find place in product cost or inventories.  Variable costs as product costs: Only marginal or variable costs are charged to products produced during the period.  Contribution: Contribution is the difference between sales value and variable cost of sales. Profitability of each department or product is determined with reference to their contribution margin.

1.4.2 Advantages of Marginal Costing  Simple Technique: Marginal costing system is comparatively simple to operate because it avoids the complications involved in apportionment and recovery of fixed overheads which is arbitrary division of indivisible fixed costs.  Useful technique for cost control: Marginal costing is essentially useful to management as a technique in cost analysis and cost presentation. It enables the presentation of data in a useful manner to different levels of management for the purpose of controlling costs. Therefore, it is an important technique in cost control.  Profit Planning: Future profit planning of the business enterprises can well be carried out by marginal costing. The contribution ratio and marginal cost ratios are very useful to ascertain the changes in selling price, variable cost etc. Thus, marginal costing is greatly helpful in profit planning.  No over or under absorption of overheads: It avoids the complications of over or under absorption of fixed cost by excluding it from cost of production.  Clear Relationships: It establishes a clear relationship between cost, sales and volume of put and break even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company.  Apart from the above, numerous managerial decisions can be taken with the help of marginal costing, some of which, may be as follows:o Make or buy decisions, o Exploring foreign markets, o Accept an order or not, o Determination of selling price in different conditions, o Replace one product with some other product, o Optimum utilization of labour or machine hours, o Evaluation of alternative choices, 139

o o o o

Subcontract some of the production processes or not, Expand the business or not, Diversification, Shutdown or continue.

1.4.3 Disadvantages of Marginal Costing  Difficult Analysis of Cost: The separation of costs into fixed and variable present„s technical difficulties and no variable cost is completely variable nor is a fixed cost completely fixed.  Under Valuation of Stock: Under the marginal cost system, stock of finished goods and work-in-progress are understated. After all, fixed costs are incurred in order to manufacture products and as such, these should form a part of the cost of the products. It is, therefore, not correct to eliminate fixed costs from finished stock and work-in-progress.  Affect the profit: The exclusion of fixed manufacturing overhead from the valuation of inventories affects the Profit and Loss Account. Unless adjustments are made in the financial accounts at the end of the period, this way it can produces an unrealistic and conservative Balance Sheet.  Misleading: During the earlier stages of a period of recession, the low profits or increase in losses, as revealed in a magnified way in the marginal costs statements, may unduly create panic and compel the management to take action that may lead to further depression of the market.  Useful for short term: Though for short-term assessment of profitability marginal costs may be useful, long term profit is correctly determined on full costs basis only.  Ignore cost of developments: With increased automation and technological developments, the impact on fixed costs on products is much more than that of variable costs. A costing system which ignores fixed costs of these developments is therefore, less effective because a major portion of the cost, such as not taken care of.  No evaluation of performance: Marginal Costing does not provide any standard for the evaluation of performance. A system of budgetary control and standard costing provides more effective control than that obtained by marginal costing.

1.4.4 Income Determination under Marginal Costing The income statement is prepared as shown below: Income Statement under Marginal Costing Particulars Sales 140

Rs.

Rs. XXXX

Less:

Add: Less:

Add:

Less:

Variable Manufacturing Costs Direct Material Consumed Direct Labour Variable Manufacturing Overhead Cost of goods produced Opening stock of finished goods (valued at variable cost of previous period) Closing stock of finished goods (valued at variable cost of Current period) Cost of goods sold Variable Office and Administration Overhead Variable Selling and Distribution Overhead Total Variable Cost Contribution (Sales-Total Variable Cost) Fixed Production Overhead Fixed Administration Overhead Fixed Selling and Distribution Overhead Net Profit

XXXX XXXX XXXX XXXX XXXX (XXXX) XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX

XXXX XXXX

1.5 STATEMENT OF RECONCILIATION Reconciliation of Profit under Marginal Costing with the Profit under Absorption Costing Particulars (a) Profit under Marginal Costing (b) Add: Fixed Manufacturing Overhead included in Closing Stock (c) Less: Fixed Manufacturing Overhead included in Opening Stock (d) Profit under Absorption Costing

1.6 DIFFERENCE BETWEEN MARGINAL COSTING Basis Classification of costs

Product Costs

Period Costs

ABSORPTION

Absorption Costing Costs are classified according to functional basis such as production cost, administration cost, selling and distribution cost. All variable manufacturing and fixed production overheads are treated as product cost and charged to product, processes or operations. Only administration, selling and distribution overheads are treated

141

COSTING

Rs. XXXX XXXX XXXX XXXX

AND

Marginal Costing Costs are classified according to variability i.e. Fixed and Variable.

Only variable manufacturing costs are treated as product costs and hence, are charged to products, processes or operations. All fixed costs i.e. Production/ Administration/ Selling/ Distribution

Basis

Valuation of Stock

Profit Calculation

Over/ Under Absorption

Basis of Managerial Decisions

Absorption Costing as period costs and are written off against the profits in the period in which they arise. Stock of work-in-progress and finished goods are valued at full or total cost. Fixed cost is carried over from one period to another period which distorts cost comparison. The difference between sales and total cost constitute profit.

Marginal Costing Overheads are treated as period costs and are written off against profits in the period in which they arise. Stock of work-in-progress and finished goods are valued at marginal cost. This facilitates cost comparison.

The excess of sales revenue over variable cost is known as contribution when fixed cost is deducted from contribution, it results in profit. The fixed overheads are charged directly to the Costing Profit and Loss Account and not absorbed in the product units. Therefore there is no question of under/ over absorption of overheads.

The fixed overhead absorption may create some problems like over/ under absorption. This happens because of the overhead absorption rate which is predetermined. Suitable corrective entries are to be made to rectify the over/under absorption of overheads; otherwise the cost of production will be distorted. Managerial Decisions are based Managerial Decisions are based on on total profit i.e. excess of total contribution i.e. excess of sales sales revenue over total costs. revenue over variable costs.

1.7 DIFFERENCE IN PROFIT UNDER ABSORPTION COSTING AND MARGINAL COSTING Profit under these two systems may be different because of difference in valuation method of stock. The impact on profits can be summarized as under: When Production Quantity is Equal to Sales Quantity More than Sales Quantity  When there is no opening When production is more and closing stock. So, than sales, it is a situation there will be no when closing stock will be difference between more than opening stock. profits under Absorption Then the profit as per Costing and Marginal absorption costing will be more than that shown by Costing.  When opening stock is variable costing. This is due equal to closing stock, to the reason that in then also there will be no absorption costing a part of 142

Less than Sales Quantity When production is less than sales, it is a situation when closing stock will be less than opening stock. Then the profit as per absorption costing will be less than that shown by variable costing. This is due to the reason that in absorption costing a part of

difference between profits under Absorption Costing and Marginal Costing.

fixed overhead included in closing stock value is carried forward to next period in the form of opening stock.

fixed overhead from the preceding period is added to the current year‟s cost of goods sold in the form of opening stock.

Practical Questions: Illustration 1: Prepare income statements under marginal costing from the following information for the year 2003-04: Opening stock Fixed cost Output Sales

500 units valued at Rs. 35,000 including variable cost of Rs. 50 per unit Rs. 1,00,000 5,000 units, variable cost: Rs. 60 per unit 3,000 units @ Rs. 100 per unit

Closing stock is valued on the basis of FIFO. Also explain the reason for difference in profits in both the cases. [B.Com (Hons), Delhi] Solution:

INCOME STATEMENT UNDER ABSORPTION COSTING

Particulars Sales (3,000 units @ Rs. 100) Less: cost of sales: Opening stock (500 units @ Rs. 70 p.u.) Add: Cost of output Fixed cost Variable cost

Rs.

Rs. 3,00,000

35,000

Less: closing stock (FIFO) 2,500 units @ 80 per unit Profit

1,00,000 3,00,000 4,35,000 2,00,000

2,35,000 65,000

INCOME STATEMENT UNDER MARGINAL COSTING Particulars Sales (3,000 units @ Rs. 100) Less: Variable cost of sales : Opening stock (500 units @ Rs. 50 each) Add: cost of output (5,000 units @ Rs. 60 per unit) Less: closing stock (2,500 units@ Rs. 60 each) Contribution (S - V) Less: Total fixed cost Profit

143

Rs.

Rs. 3,00,000

25,000 3,00,000 3,25,000 1,50,000

1,75,000 1,25,000 1,00,000 25,000

Reasons for difference in profit: the reason for difference in two profits is due to valuation of opening and closing stock i.e. (35,000 - 25,000) and (2,00,000 - 1,50,000). Illustration 2: Onkar Ltd. has a production capacity of 12,500 units and normal capacity utilization is 80%. Opening inventory of finished goods on 1-1-1999 was 1,000 units. During the year ending 31-12-1999, it produced 11,000 units while it sold only 10,000 units. Standard variable cost per unit is Rs. 6.50 and standard fixed factory cost per unit is Rs. 1.50. Total fixed selling and administration overhead amounted to Rs. 10,000. The company sells its product at Rs. 10 per unit. Prepare Income Statements under Absorption Costing and Marginal Costing. Explain the reasons for difference in profit, if any. [B.Com (Hons), Delhi] Solution:

INCOME STATEMENT (ABSORPTION COSTING)

Particulars Sales (10,000 units @ Rs. 10) Variable factory cost (11,000 units @ Rs. 6.50) Fixed factory cost (11,000 units @ Rs. 1.50) Add: opening stock (1,000 units @ Rs. 8) Less: closing stock (2,000 units @ Rs. 8) Less: over absorption of fixed factory overheads (1,000 units @ Rs. 1.50) Add: fixed selling and administration overhead Cost of sales Profit (Sales - cost of sales)

Rs. 1,00,000 71,500 16,500 88,000 8,000 96,000 16,000 80,000 1,500 78,500 10,000 88,500 11,500

INCOME STATEMENT (MARGINAL COSTING) Particulars Sales (10,000 units @ 10 ) Variable cost (11,000 units @ Rs. 6.50) Add: opening stock (1,000 units @ Rs. 6.50) Less: closing stock (2,000 units @ Rs. 6.50) Variable cost of goods manufactured Contribution (1,00,000 - 65,000) Less: Fixed cost Factory 15,000 Selling and administration 10,000 Profit

144

Rs. 1,00,000 71,500 6,500 78,000 13,000 65,000 35,000

25,000 10,000

Reasons for difference in profits: The difference in two profit figures arises due to differences in the basis of stock valuation. Under absorption costing, stock is valued at total production cost per unit inclusive of the fixed manufacturing overheads per unit whereas in marginal costing stock is valued at variable production cost per unit. The difference is explained by the following statement: Reconciliation statement Rs. Profit as per absorption costing Add: under valuation of opening cost in marginal costing Less: under valuation of closing stock in marginal costing Profit as per marginal costing

11,500 1,500 13,000 3,000 10,000

1.8 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) Marginal costing technique helps the management in deciding… (a) Pricing (b) To accept fresh orders at low price (c) To make or buy (d) All of the above (2) The term contribution refers to… (a) The difference between selling price and fixed cost (b) The difference between selling price and variable cost (c) Profit (d) None of these (3) The term gross margin refers to… (a) Total profit (b) Contribution (c) Profit before tax (d) Profit before interest and tax (4) Sales Rs. 1,00,000, variable cost Rs. 60,000 and net profit ratio is 10% on sales, find out fixed cost. (a) 40,000 (b) 60,000 (c) 50,000 (d) The data inadequate

145

(5) Under absorption costing, profit is ascertained (a) On the basis of difference between sales and total cost. (b) By computation as per desired rate of profit on sales or cost (c) Both (a) and (b) (d) None of the above. (6) Under absorption costing among fixed expenses (a) Fixed manufacturing expenses are included in unit cost (b) Fixed non-manufacturing expenses are included in unit cost (c) Both (a) and (b) (d) None of the above (7) Absorption costs helps in (a) Difference between product cost and period cost (b) Charged of fixed factory overheads on inventory (c) Both (a) and (b) (d) None of the above (8) Marginal costs is taken as equal to (a) Prime Cost plus all variable overheads (b) Prime Cost minus all variable overheads (c) Variable overheads (d) None of the above (9) Marginal cost is computed as (a) Prime cost + All Variable overheads (b) Direct material + Direct labor + Direct Expenses + All variable overheads (c) Total costs - All fixed overheads (d) All of the above Answers: (1) (d), (2) (b), (3) (b), (4) (c), (5) (c), (6) (a), (7) (c), (8) (a), (9) (a) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) The technique of marginal costing is based on classification of cost into ____________ costs. (b) ___________ cost not related to manufacture of a product. (c) ______________ cost is production costs incurred in the manufacture of a product. (d) In marginal costing stock of finished goods is valued at ____________ (e) Both fixed and variable costs are charged to products in _____________ (f) Contribution is the difference between sales and _________________ 146

Answers: (a) Fixed and Variable; (b) period; (c) product; (d) marginal cost; (e) absorption cost; (f) Variable cost Q2. True/False Statement: (a) Profit under marginal costing and absorption costing may differ even if there are no opening and closing stocks. (b) Variable costing is used mainly for internal reporting (c) Absorption costing is not as suitable for decision-making as marginal costing. (d) Absorption costing is a total cost technique. (e) Variable costing is more widely used than absorption costing for external reporting. (f) When opening stock is more than closing stock, variable costing shows higher profit than absorption costing. (g) All variable cost is included in marginal cost. Answers: (a) F, (b) T, (c) T, (d) T, (e) F, (f) F, (g) T Q3. Write short notes on: (a) Absorption costing (b) Variable costing (c) Period cost (d) Product cost (e) Contribution (f) Differential cost EXERCISE 3: LONG ANSWER QUESTIONS Q1. Distinguish between marginal costing and absorption costing. Q2. “Marginal costing rewards sales whereas absorption costing rewards production.” Comment. Q3. Which costs are to be inventorised in absorption costing for external reporting. Give reason for your answers. Q4. “Absorption costing income exceeds variable costing when the number of units sold exceeds the number of units produced.” Do you agree. Q5. Nagarro Ltd. released the figures given ahead from its record for Year 1 and Year 2: Year 1 2,40,000 2,40,000 20

Sales (units) Production (Units) Selling price per unit (Rs.) 147

Year 2 2,40,000 4,00,000 20

Year 1 Variable manufacturing cost per unit (Rs.) Actual fixed manufacturing cost (Rs.) Variable marketing and administration cost per unit (Rs.) Fixed marketing and administration cost (Rs.)

Year 2 12 12,00,000 1.25 4,20,000

12 12,00,000 1.25 4,20,000

(a) Prepare income statements for both years, using full-absorption costing. (b) Prepare income statement for both years, using variable costing (c) Comment on the different operating profit figures. [B.Com (Hons), Delhi] Answers: (1) Profit under absorption costing Year 1 Nil; Year 2 Rs. 4,80,000 (2) Profit under Variable Costing Year 1 Nil; Year 2 Rs. Nil Q6. The following is the cost information of a product: Variable manufacturing costs: Rs. 4 per unit Fixed manufacturing costs: Rs. 2,00,000 per year The normal capacity is set at 2,00,000 units. There are no work-in-progress inventories. Last year the firm produced 2,10,000 units and sold 90% at a price of Rs. 7 per unit. In the current year, the firm produced 2,10,000 units and sold 2,15,000 units at the same price. Prepare income statements for both the years based on (a) Absorption Costing (b) Variable Costing

[B.Com (Hons), Delhi, 2013]

Answers: Absorption Costing: Operating Income: Previous year Rs. 3,60,000, Current year Rs. 4,40,000 Variable Costing: Operating Income: Previous year Rs. 3,40,000, Current year Rs. 4,45,000 Q7. You are given the following information relating to the year 2005-06 and 2006-07: 2005-06 Opening stock (units) Production (units) Fixed cost Variable cost Sales (units) Selling price (in Rs. per unit) Closing stock (units)

1,200 Rs. 2,00,000 Rs. 1,50,000 900 400 300

2006-07 300 1,400 Rs. 2,10,000 Rs. 2,80,000 1,100 500 600

Prepare Profit and Loss Account using FIFO under marginal costing and under absorption costing. [B.Com (Hons), Delhi 2007] 148

Answers: (1) Profit under Marginal Costing 2005-06 Rs. 47,500; 2006-07 Rs. 1,42,500 (2) Profit under Absorption Costing 2005-06 Rs. 97,500; 2006-07 Rs. 1,82,500 Q8. Your company has a production capacity of 2,00,000 units per year. Normal capacity utilization is reckoned as 90%. Standard variable production costs are Rs. 11 per unit. The fixed costs are Rs. 3,60,000 per year. Variable selling costs are Rs. 3 per unit and fixed selling costs are Rs. 2,70,000 per year. The unit selling price is Rs. 20. In the year just ended on 30th June, 2017, the production was 1,60,000 units and sales were 1,50,000 units. The closing inventory on 30.06.09 was 20,000 units. The actual variable production costs for the year were Rs. 35,000 higher than the standard. (a) Calculate the profit for the year: (1) By the absorption costing method (2) By the marginal costing method (b) Explain the difference in the profit. Answers: (a) (1) Rs. 2,64,375, (2) Rs. 2,39,375

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LESSON 2 COST-VOLUME-PROFIT ANALYSIS 2. STRUCTURE 2.0 Learning Objectives 2.1 Meaning of Cost-Volume-Profit Analysis 2.1.1 Assumptions 2.2 Formula of Marginal Cost and Contribution 2.3 P/V Ratio or Contribution/Sales Ratio 2.4 Break Even Point 2.4.1 Break-Even Chart 2.4.2 Assumptions of Break Even Point 2.4.3 Limitations of Break-Even Analysis 2.4.4 Cash Break-Even Point 2.5 Margin of Safety 2.6 Angle of Incidence 2.7 Cost Indifference Point 2.8 Key Factor 2.9 Self-Test Questions

2.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn the meaning of CVP Analysis (b) Understand the Practical applications of marginal costing (c) Learn the utilizes of P/V ratio, BEP, margin of safety, angle of incidence and cost indifference point (d) Explain the concept of key factor

2.1 MEANING OF COST-VOLUME-PROFIT ANALYSIS Managers are concerned about the impact of their decisions on profit. The decisions they make are about volume, pricing, or incurring a cost. Therefore, managers require an understanding of the relations among revenues, costs, volume, and profit. The cost accounting department supplies the data and analysis, called cost-volume-profit (CVP) analysis, which support these managers.

150

Cost-volume-profit (CVP) analysis is a model which studies the inter relationship of these three factors namely cost of production, volume of production/sales and profit. In other words, it analyzes the behaviour of net income in response to changes in total revenue, total costs, or both. Businesses operate in a complex environment, so in this situation, it is a powerful tool in making managerial decisions including marketing, production, investment, and financing decisions. It is a model that reduces the complexity by using simplifying assumptions to focus on only the relevant relationships. Managers often perform CVP analysis to make various plans to increase company profitability and provide information about:  How many units of products must a firm sell to reach break-even point?  How many units of products must a firm sell to earn desired amount of profit?  Which products or services to emphasize?  Should a firm invest in highly automated machinery and reduce its labor force?  Whether to increase fixed costs? CIMA London has defined CVP analysis as, “the study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity and mix”.

2.1.1 Assumptions  Changes in the sales volume and production volume are same. The closing balances in all inventories are zero. Everything purchased is used in production; everything produced is sold.  Total costs can be classified into fixed (that does not vary with output level) or variable (that changes with respect to output level). All mixed costs are broken into their respective fixed and variable components. The fixed costs include both direct fixed costs and indirect fixed costs. The total variable costs include both direct variable costs and indirect variable costs.  When represented graphically, All cost behaviour is linear (that represents a straight line) in relation to output within a relevant volume range.  The selling price per unit, variable costs per unit, and total fixed costs and sales (or production) volume are known and constant.  This analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant, although the volume changes.  Time value of money is not considered. To know the cost, volume and profit relationship, a study of the following is essential:  Marginal Cost Formula and Contribution  Profit Volume Ratio (or) PV Ratio  Break-Even Analysis  Margin of Safety 151

 Angle of Incidence  Key Factors and  Sales Mix

2.2 FORMULA OF MARGINAL COST AND CONTRIBUTION Marginal Cost equation explains that the difference between sales and variable cost is the contribution towards fixed costs and profit. The Following are the important equations of Marginal Cost: Sales = Variable Cost + Fixed Expenses ± Profit or Loss (Or) Sales - Variable Cost = Fixed Cost ± Profit or Loss (Or) Sales - Variable Cost = Contribution Contribution = Fixed Cost + Profit Contribution is the excess of sales revenue over variable costs. A product whose selling price exceeds its variable cost is said to have: (a) Covering its variable cost and (b) Making a contribution, (i) Towards the firm‟s fixed cost and after these have been covered; (ii) Towards the firm‟s profit. By equation, the concept of contribution can be stated as follows: Contribution = Sales - Variable Cost Contribution = Fixed Expenses + Profit Contribution = Fixed Cost - Loss Sales - Variable Cost = Fixed Cost + Profit Sales - Variable Cost = Fixed Cost - Loss

2.3 P/V RATIO OR CONTRIBUTION/SALES RATIO P/V Ratio is also known as Contribution Sales Ratio or Marginal Income Ratio or Variable Profit Ratio. It is important for decision-making purpose. As this ratio involves two elements i.e. Contribution and Sales, it is used to measure the relationship between contribution and sales value. The following formula for calculating the P/V ratio is given below: P/V Ratio (in %)

= =

Contribution × 100 Sales Sales - Variable Cost × 100 Sales 152

= = = =

Fixed Cost + Profit × 100 Sales Change in Contribution × 100 Change in Sales Change in Profit × 100 Change in Sales 100 - Variable Cost× 100 Sales

Significance of PV Ratio:  P/V Ratio indicates the effect on profit for a change in the sales  The higher the P/V Ratio, the better it is for the business. If the business conditions are steady over a period of years, the P/V Ratio will also remain steady.  If P/V Ratio will be improved, it will result in higher profits. Improvement of PV Ratio:  By reducing variable cost or  By increasing the selling price or  By reducing variable cost and increasing the selling price or  By increasing the share of products with higher P/V Ratio in the overall sales mix Uses of PV Ratio:  To determine of variable costs for any volume of sales  To determine of Break-Even point  To determine of contribution for any volume of sales  To determine of the level of output required to earn a desired profit  Identification of minimum volume of activity that the enterprise must achieve to avoid incurring losses.  To decide the most profitable mix  To measure the efficiency of each product, operation, process etc. Illustration 1: A company has fixed expenses of Rs. 90,000 with sales at Rs. 3,00,000 and a profit of Rs. 60,000. Calculate the profit/ volume ratio. If in the next period, the company suffered a loss of Rs. 30,000. Calculate the sales volume.[B.Com (Hons), Delhi] Solution: Given: (i) Fixed expenses = Rs. 90,000, Sales = Rs. 3,00,000, Profit = Rs. 60,000 Variables = Sales - (fixed cost and profit) = Rs. 3,00,000 - 1,50,000 = Rs. 1,50,000 Profit / volume ratio = S - V × 100 S P/ V ratio = 3,00,000 - 1,50,000 × 100 = 50 % 3,00,000 153

(ii) In the next year, the company suffered a loss of Rs. 30,000. In other words, it would recover the fixed costs of Rs. 90,000 to the extent of only Rs. 60,000. Sales volume at Rs. 30,000 loss level =

Rs. 60,000 = Rs. 1,20,000 P/V ratio or 50%

2.4 BREAK EVEN POINT The concept of „Break Even Point‟ is very important for the decision making purpose in various areas. This concept is based on the behaviour of costs, i.e. fixed cost and variable costs. Fixed costs are those costs that remain constant irrespective of the changes in the volume of production. On the other hand, variable costs are the costs that vary with the change in the level of production. While fixed cost per unit is always variable, variable cost per units is always fixed. In addition to these two types of costs, there are semi variable costs that are partially fixed and partially variable. Semi variable costs thus have the features of both types of costs. They remain fixed up to a certain level of production and after crossing that level, they become variable. The Break Even Point is a level of production where the total costs (TC) are equal to the total revenue (TR), i.e. sales. Thus at the break-even level, there is neither profit nor loss situation. This is a point where contribution is equal to fixed cost. If Production level is below the break-even-point, it will result into loss while if production level is above break-even point, it will result in profits. This concept can be analyzed with the help of the following table. Suppose, the selling price of a product is Rs. 12 per unit, variable cost Rs. 7 per unit and fixed cost Rs. 10,000, the break-even level can be found out with the help of the following table.

Number of Units 800 1,000 1,500 1,800 2,000 2,500 3,000

Sales Value (Rs. 12 per unit) (Rs.) 9,600 12,000 18,000 21,600 24,000 30,000 36,000

Variable Cost (Rs. 7 per unit) (Rs.) 5,600 7,000 10,500 12,600 14,000 17,500 21,000

Fixed Cost (Rs. 10,000) (Rs.)

Total Cost (Variable + Fixed) (Rs.)

Profit/Loss (Sales value total cost) (Rs.)

10,000 10,000 10,000 10,000 10,000 10,000 10,000

15,600 17,000 20,500 22,600 24,000 27,500 31,000

-6,000 -5,000 -2,500 -1,000 0 2,500 5,000

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The above table shows that at the production level of 2,000 units, the total costs are equal to the total revenue and hence it is the break-even level. Production level and sales level below the break-even level results into loss as shown in the table while above the break-even level will result in profits. If the above table is analyzed, it will be seen that, when the production level was 800, the revenue from sales was not sufficient to cover the total cost i.e. sum of variable and fixed Cost. When the production level starts rising, the sales level starts rising but the total cost does not rise in the proportion as the fixed cost remains the same. Consequently the amount of loss starts decreasing and the trend continues till the break-even level is reached. After the break-even level is crossed, (at 2,500 units and 3,000 units of production) the sales revenue exceeds the total costs and hence it results in profits. Breakeven level can also be worked out with the help of the following formulae.

Break-even point [in units] Break-even point [in Rs.]

= =

Fixed Cost Contribution per Unit Fixed Cost P/V Ratio

Fixed Cost Selling Price per Unit- Variable Cost Per Unit Fixed Cost × Contribution Sales

2.4.1 Break-Even Chart A break-even chart is a graphical representation of Cost-Volume-Profit relationship. The chart depicts fixed costs, variable cost, break-even point, profit or loss, margin of safety and the angle of incidence. Break-even point is an important stage in the break-even chart which represents no profit no loss. From the break-even chart, we can understand the following points:

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        

Cost and sales revenue are represented on vertical axis, i.e., Y-axis. Volume of production or output in units is plotted on horizontal axis, i.e., X-axis. Fixed cost line is drawn parallel to X-axis. The sales line is plotted from the zero level, it represents sales revenue. The point of intersection of total cost line and sales line is called the break-even point which means no profit no loss. The margin of safety is the distance between the break-even point and total output produced. The area below the break-even point represents the loss area as the total sales are less than the total cost. The area above the break-even point represents the profit area as the total sales more than the cost. The sales line intersects the total cost line represents the angle of incidence represented by Theta (θ). The large angle of incidence indicates a high rate of profit and vice versa.

2.4.2 Assumptions of Break Even Point Break-even point is based on the following assumptions: (1) Production and sales are the same, which means that as much as is produced is sold out. Thus there is no inventory remaining at the end of the period. (2) Fixed cost remains same irrespective of the level of production volume. Fixed Cost per unit varies with the level of production. (3) Variable cost varies with the production volume. It varies directly with the level of production. Hence it has a linear relationship with the production. Variable cost per unit remains the same irrespective of change in the level of production. (4) Selling price per unit remains same.

2.4.3 Limitations of Break-Even Analysis Though break-even analysis is decision making tool for management, but there are some limitations against the utility of break-even analysis:    

Fixed costs do not always remain constant. Variable costs need not always vary proportionately Selling price may not be a constant factor. Break-even analysis is of doubtful validity when a number of products are produced. Different break-even charts need to be prepared, which involve a problem of apportionment of fixed expenses to each product.

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 This analysis ignores the capital employed in business, which is one of the important guiding factors in the determination of returns for decision making purpose.  Break-even analysis is based on the assumption that income is influenced by changes in sales so that changes in inventory would not directly affect income. If marginal costing is used, this assumption would hold good but in other cases, changes in inventory will affect income because the absorption of fixed costs will depend on production rather than sales.  Conditions of growth or expansion in an organization are not assumed under break-even analysis. In actual life of any business organization, the operation undergoes a continuous process of growth and expansion.

2.4.4 Cash Break-Even Point In cash break-even chart, only cash fixed costs are considered. Non-cash items like depreciation etc. are excluded from the fixed costs. Cash Break-Even Chart depicts the level of output or sales at which the sales revenue will be equal to total cash outflow. It is computed as under: Cash Break-Even Point =

Cash Fixed Costs Contribution per unit

Illustration 2: Following information is given for the manufacture of a product: Fixed expenses Material Labour Direct expenses: Fuel Carriage inwards Selling price

Rs. 4,00,000 Rs. 10 per unit Rs. 5 per unit Rs. 3 per unit Rs. 2 per unit Rs. 40 per unit

Calculate Break-Even point in terms of units. Also find out new B.E.P. if selling price is reduced by 10% per unit. (B.Com, Delhi) Solution: (1) Contribution Margin per unit = Selling price - Variable cost* = Rs. 40 - Rs. 20 = Rs. 20  Variable cost per unit Rs. Material 10 Labour 5 Fuel 3 Carriage Inwards 2 Total VC 20 157

Break Even point = (in terms of unit)

fixed expenses Contribution Margin Per unit

=

Rs. 4,00,000 Rs. 20 = 20,000 units (2) If selling price is reduced by 10% i.e. Rs. 40 - Rs. 4 = Rs. 36 The new B.E.P will be: = fixed expenses i.e. Rs. 4,00,000 (Rs. 36 - Rs. 20) =Rs. 16 = 25,000 units

2.5 MARGIN OF SAFETY Margin of safety is the difference between the Actual Sales and Break Even Point Sales. Sales beyond break-even volume brings in profits and that represents margin of safety. It is that level of sales which incurred after Break-Even Point and already covered Fixed Cost. Margin of safety is calculated as follows: Margin of Safety (in units)

Margin of Safety (in Rs.)

Margin of Safety (in % of sales)

= Total sales (units) - Break even sales (units) = Profit Contribution per unit = Total sales (in value) - Break even sales (in value) = Profit P/V Ratio = Profit × Contribution Sales = Margin of Safety × Selling Price = 100 - Break Even Sales (in %) = Profit × 100 Total Contribution

Other equations that can be made from above relations to calculate Profit: When Margin of Safety is given, Profit = Margin of Safety × P/V Ratio When Actual sales are given, Profit = M/S Ratio × P/V Ratio × Actual Sales

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Significance of Margin of Safety:  Till BEP, the contribution is sufficient to recover fixed costs. After BEP, the contribution is called Profit ( since fixed costs are fully recovered at BEP)  Profit is the contribution earned out of Margin of Safety Sales.  The soundness of a business is gauged by the size of the margin of safety.  A low margin of safety indicates that the firm has high fixed overheads and is more vulnerable to changes in sales.  A high margin of safety indicates that a slight fall in sales may not affect the business very much. Improvement in Margin of Safety:     

Reduction in fixed costs. Reduction in variable costs so as to improve marginal contribution. Increasing the sales volume, provided there is unused capacity. Increasing the selling price, provided market conditions permit, and Substituting or introduction of a product mix as to improve contribution and to have more profitable lines.

Illustration 3: From the following data, Compute Break Even Sales and Margin of Safety: Rs. Sales 10,00,000 Fixed cost 3,00,000 Profit 2,00,000 [B.Com (Pass), Delhi]

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Solution: Sales Fixed cost Profit

Rs. 10,00,000 3,00,000 2,00,000

Solving the following equation we find: Sales = (FC + VC) + Profit 10,00,000 = 3,00,000 + VC + 2,00,000 VC = 5,00,000 Profit Volume Ratio = S - V × 100 S = 10,00,000 - 5,00,000 ×100 10,00,000 = 50 % Breakeven Point = Fixed costs = P/V ratio

Rs. 3,00,000 50 %

i.e. 6,00,000

2.6 ANGLE OF INCIDENCE The angle formed by the sales line and the total cost line at the break-even point is known as Angle of Incidence. The angle of incidence shows the rate at which profits are being earned once the break-even point has been reached. A large angle of incidence indicates a high rate of profit and on the other hand a small angle of incidence means that a low rate of profit. Therefore the objective of management will be to have as large as possible.

2.7 COST INDIFFERENCE POINT Cost Indifference Point refers to that level of output where the total costs or the profits of the two alternatives are equal. The decision makers are indifferent as to which alternative needed to be opted, since both options will result in the same amount of profit. It is also known as Cost Break-Even Point. Profit of Option A Indifference Point Profit of Option B

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The formula for calculating is as follows: Cost Indifference Point (in units)

=

Difference in Fixed Cost Difference in contribution per unit Or = Difference in Fixed Cost Difference in Variable per unit

Cost Indifference Point (in Rs.)

=

Difference in Fixed Cost Difference in P/V ratio

Or = Difference in Fixed Cost Difference in Variable to Sales ratio

Indifference point is calculated in respect of two options. Where more than two options are considered, Indifference Point can be calculated on a comparative basis for two combinations. Significance of Indifference Point  When level of sales is below Indifference point, most profitable option will be that having lower fixed costs.  When level of sales is at Indifference point, both options will be equally profitable options.  When level of sales is above Indifference point, most profitable option will be that having higher P/V ratio.

2.8 KEY FACTOR Key Factor represents a resource whose availability is less than its requirement. It denotes the resources constraint situation. It is a factor, which at a particular time or over a period limits the activities of a firm. It is also called Critical Factor (since it is vital or critical to the firm‟s success) and Budget Factor (since budgets are formulated by reference to such limitations) Some examples of key factor are Shortage of Raw Material, Labour Shortage, Restrictions in Plant Capacity, Demand or Sales Expectancy, Cash Availability etc. The following steps are taken in case of Key Factor situation: (1) Identify the Key Factor (2) Compute Total Contribution or Contribution per unit of the product

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(3) Compute Contribution Per Unit of the Key Factor, i.e. Contribution per Direct Labour Hour, Contribution per kg of raw material (4) Rank the products on the basis of Contribution per unit of the key factor (5) Allocate the key resources based on Ranks given above and other conditions specified in the question. MISCELLANEOUS QUESTIONS Illustration 4: From the following information relating to Alpha Ltd. you are required to find out: (a) Contribution (b) Breakeven point (c) Margin of society (d) Profit Rs. Total Fixed Cost 4,500 Total Variable Cost 7,500 Total Sales 15,000 Units Sold 5,000 (units) (e) Also calculate the volume of sales to earn profit of Rs. 6,000 Solution: (a) Contribution = Sales - Variable cost = Rs. 15,000 - Rs. 7,500 (b) Breakeven point (in units) =

Fixed cost Contribution Margin* = 3,000 units

*Total Contribution = No. of units sold

Rs. 7,500 5,000

i.e. Rs. 1.50

(c) Margin of safety = Total Sales - BEP Sales = Rs. 15,000 - 3,000 ×(Rs. 15,000) (5,000) = Rs. 6,000 (d) Profit = Sales - Total cost Rs. 15,000 - (7,500 + 4,500) = Rs. 3,000. (e) Volume of Sales to earn a profit of Rs. 6,000 =F+P = Rs. 4,500 + Rs. 6,000 = Rs. 21,000 P/V Ratio [ 15,000 - 7,500 ] 15,000

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=

Rs. 4,500 Rs. 1.50

Illustration 5: The following figures are available for the records of Venus Enterprises as at 31st March -

Sales Profit

1988 Rs. Lakhs 150 30

1989 Rs. Lakhs 200 50

Calculate(a) the P/V ratio and total fixed expenses (b) the breakeven level of sales (c) sales required to earn a profit of Rs. 90 Lakhs (d) profit or loss that would arise if the sales were Rs. 280 Lakhs. Solution: (a) P/V ratio =

Change in profit × 100 Change in sales

=

Rs. 50 Lakhs - Rs. 30 Lakhs × 100 Rs. 200 Lakhs - Rs. 150 Lakhs

=

Rs. 20 Lakhs × 100 Rs. 50 Lakhs

= 40 % Fixed expenses = Contribution - Profit = P/V Ratio × Sales - Profit Fixed expenses (in the year 1988) = 40 % × Rs. 150 Lakhs - Rs. 30 Lakhs = Rs. 60 Lakhs - Rs. 30 Lakhs = Rs. 30 Lakhs Fixed expenses (in the year 1989) = 40 % × Rs. 200 Lakhs - Rs. 50 Lakhs = Rs. 80 Lakhs - Rs. 50 Lakhs = Rs. 30 Lakhs. (b) Breakeven level of sales = Fixed Expenses P/V Ratio = Rs. 75 Lakhs

= Rs. 30 Lakhs 40%

(c) Sales required to earn a profit of Rs. 90 Lakhs (or sales when contribution is Rs. 120 Lakhs) When contribution is Rs. 60 Lakhs then sale is Rs. 150 Lakhs When contribution is Rs. 1 Lakh then sale is Rs. 150 Lakhs Rs. 60 Lakhs

163

(CA Inter)

When contribution is Rs. 120 Lakhs then sale is Rs. 150 Lakhs × 120 lakhs Rs. 60 Lakhs = 300 Lakhs Or Fixed cost + Required Profit = Rs. 30 Lakhs + Rs. 90 Lakhs P/V Ratio 40 % = 300 Lakhs (d) Profit or Loss that would arise if the sales were Rs. 280 Lakhs Profit = Contribution - Fixed Expenses = P/V Ratio × Sales - Fixed Expenses = 40 % × Rs. 280 Lakhs - Rs. 30 Lakhs = Rs. 82 Lakhs Illustration 6: X, Y and Z are three similar plants under the same management who want them to be merged for better operation. The details are as under: Plant Capacity operated

X 100% Rs. Lakhs

Turnover Variable cost Fixed cost

Y 70% Rs. Lakhs 300 200 70

Z 50% Rs. lakhs 280 210 50

150 75 62

Find out: (i) the capacity of the merged plant for break-even (ii) the profit at 75% capacity of the merged plant (iii) the turnover from the merged plant to give a profit of Rs. 30,00,000.

(CS Inter)

Solution: At 100% capacity the position of merged plant will be as follows: Capacity utilisation (%) Turnover Variable cost Contribution Fixed costs Profit P/V Ratio =

X 100% Rs. (in lakhs) 300 200 100 70 30 Contribution × 100 Sales

(i) BEP of the merged plant =

Y 100% Rs. (in lakhs) 400 300 100 50 50 =

Z 100% Rs. (in lakhs) 300 150 150 62 88

Total 100% Rs. (in lakhs) 1,000 650 350 182 168

350 × 100 = 35 % 1,000

Fixed costs P/V Ratio

= 182 × 100 = Rs. 520 lakhs. 35

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% of capacity = 520 ×100 = 52% 1,000 (ii) if the merged plant works to 75% capacity: Capacity 75% Rs. (in Lakhs) Sales 750.00 Variable costs 487.50 Contribution 262.50 Fixed costs 182.00 Profit 80.50 (iii) Turnover required from the merged plant to give a profit of Rs. 30 lakhs: Contribution required = 182 + 30 = Rs. 212 lakhs P/V ratio = 35% Hence, Sales required = 212 × 100 = Rs. 605.71 35

2.9 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) Profit volume ratio establishes the relationship between… (a) Contribution and profit (b) Fixed cost and contribution (c) Profit and sales (d) Contribution and sales value (2) Contribution/sales is equal to… (a) P/V ratio (b) Net profit ratio (c) BEP (d) EPS (3) The P/V ratio can be increased by… (a) Reducing the variable cost (b) Increasing the selling price (c) Both (d) None (4) The factor which limits the volume of output of different products of an understanding at a particular point of time is known as… (a) Key factor (b) BEP (c) Contribution (d) None

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(5) The profit of an undertaking is affected by… (a) Selling price of the products (b) Volume of sales (c) Variable cost per unit and total fixed cost (d) All of the above (6) The break even chart helps the management in… (a) Forecasting costs and profits (b) Cost control (c) Long term planning and growth (d) All of the above (7)________ is the excess of sales over the break even sales. (a) Actual sales (b) Total sales (c) Margin of safety (d) Net sales (8)__________ indicates the extent of which the sales can be reduced without resulting in loss. (a) BEP (b) Key factor (c) Contribution (d) Margin of safety (9) Margin of safety can be improved by… (a) Increasing production (b) Increasing selling price (c) Reducing the costs (d) All of the above (10) The angle formed by the sales line and total cost line at the break-even point is known as… (a) Profit variable (b) Margin of safety (c) Angle of incidence (d) None Answers: (1) (d), (2) (a), (3) (d), (4) (a), (5) (d), (6) (a), (7) (c), (8) (d), (9) (d), (10) (c) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) P/V ratio shows the relationship between ______________and _____________. (b) Contribution is the difference between sales and _______________. (c) The break-even point is ________________ when selling price increases. 166

(d) The difference between actual sales and Break even sales is called ______________. (e) At break-even point, contribution will be equal to ________________. (f) In a profit volume graph, Break-even Point takes place where ___________ intersect each other. (g) When sales increase from Rs. 40,000 to Rs. 60,000 and profit increases by Rs. 5,000, the P/V ratio is ______________. Answers: (a) contribution and sales, (b) variable, (c) Decreased, (d) Margin of safety, (e) Fixed costs, (f) profit and sales line, (g) 25% Q2. True/False Statement: (a) Margin of safety can be improved by lowering the volume of sales. (b) Contribution is always equal to fixed costs. (c) P/V ration is the ratio of profit and the volume of output. (d) At break-even-point contribution margin equals variable cost. (e) Margin of safety is the excess of actual sales over break even sales (f) All direct costs are marginal costs. Answers: (a) F, (b) F, (c) F, (d) F, (e) T, (f) T EXERCISE 3: LONG ANSWER QUESTIONS Q1. What is break-even point? What are the limitations of break-even analysis? Q2. Explain the following: (a) Key Factor (b) P/V Ratio (c) Margin of Safety (d) Angle of Incidence (e) Break-even Point (f) Contribution (g) Marginal Costing Q3. What is P/V Ratio? Explain its uses. Q4. What is meant by angle of incidence and margin of safety and show these in a breakeven chart. Explain. Q5. Explain the ways by which P/V Ratio can be improved. Q6. From the following data, calculate: (a) P/V ratio 167

(b) Profit when sales are Rs. 20,000 (c) New break-even point if selling price is reduced by 20% Fixed Expenses

Rs. 4,000

Break-even Point

10,000

[B.com (Hons), Delhi]

Answers: (a) 40%, (b) Rs. 4,000, (c) Rs. 16,000 Q7. XYZ Ltd. manufacturers pressure cookers the selling price of which is Rs. 300 per unit. Currently the capacity utilization is 60% with a sales turnover of Rs. 18 Lakhs. The company proposes to reduce the selling price by 20% but desires to maintain the same profit position by increasing the output. Assuming that the increased output could be made and sold, determine the level at which the company should operate to achieve the desired objective. The following further data are available: (i) Variable cost per unit Rs. 60. (ii) Semi variable cost (including a variable element of Rs. 10 per unit) Rs. 1,80,000 (iii) Fixed cost Rs. 3,00,000 will remain constant up to 80% level. Beyond this an additional amount of Rs. 60,000 will be incurred. Answers: Profit at 60% capacity = Rs. 9,60,000; Required sales to maintain the same profit = 8,471 units. Q8. (a) When sales of a company decline from 9,00,000 to Rs. 7,00,000, its profit of Rs. 50,000 is converted into a loss of Rs. 50,000. Determine contribution margin ratio. (b) Sales at breakeven point in a company is Rs. 25,000 and its fixed cost is Rs. 10,000. What is its total contribution? Answers: (a) 50%

(b) Rs. 10,000

Q9. The following information is supplied to you: Rs. Fixed cost (total) Variable cost (total) Sales (total) Units sold

4,500 7,500 15,000 5,000

Calculate : (a) Contribution (b) B.E. point in units 168

(c) Margin of safety (d) Profit (e) Volume of sales to earn a profit of Rs. 6,000 Answers: (a) Rs. 7,500 (b) 3,000 units (c) Rs. 6,000 (d) Rs. 3,000 (e) Rs. 21,000 Q10. Taurus Ltd. produces three products: A, B and C from the same manufacturing facilities. The cost and other details of the three products are as follows: A Selling price/ unit (Rs.) Variable cost/unit (Rs.) Fixed expenses/ month (Rs.) 2,76,000 Maximum production per month (units) Total hours available for the month 200 Maximum demand per month (units)

B

C

200 120

160 120

100 40

5,000

8,000

6,000

2,000

4,000

2,400

The processing hours cannot be increased beyond 200 hours per month. You are required to: (a) Compute the most profitable product mix and (b) Compute the overall breakeven sales of the company for the month based on the mix calculated in (a) above. (C.A. Inter) Answers: (i) A - 2,000 units, B - 1,600 units, C - 2,400 units (ii) Rs. 6,72,000 Q11. After a study of cost-volume-profit relationship, the Flemingo Ltd. concluded that its cost for any given venue of sales could be expressed as Rs. 1,00,000 of fixed costs plus variable costs equal to 60% of sales. The company‟s range of volume was from zero to Rs. 8,00,000 of sales. Prepare a graph which will illustrate this cost volume relationship. Also draw a proper sales line to the graph form a breakeven point. Determine the breakeven point. A competitor operating a plant of the same size as that of Flemingo Ltd. also has fixed costs of approximately Rs. 1,00,000 but this breakeven point is Rs. 3,00,000 sales. What are probable causes of the difference between this breakeven point and that of the Flemingo Ltd. Answer: BEP Rs. 2,50,000 Q12. (a) Draw a breakeven chart form the following data: Fixed cost Selling price Variable cost

Rs. 5,000 Rs. 20 per unit Rs. 10 per unit 169

Show profit and margin of safety when sales are Rs. 20,000. (b) Draw another break even chart to show the effect of 20% decrease in fixed cost. Answers: (a) BEP Rs. 10,000; (b) Rs. 8,000

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LESSON 1

UNIT 5

DECISION MAKING AND VARIABLE COSTING 1. STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Steps Involved in Decision‐Making 1.3 Short Term Decision and Long Term Decision 1.4 Relevant and Irrelevant Costs for Decision Making 1.5 Classification of Cost for Decision Making 1.6 Decision Making and Variable Costing 1.6.1 Fixation of Selling Price 1.6.2 Exploring New Markets 1.6.3 Make or Buy Decisions 1.6.4 Product Mix Decisions 1.6.5 Operate Or Shut Down 1.7 Self-Test Questions

1.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn different types of cost for decision-making (b) Learn the concept of relevant and irrelevant costs for decision-making (c) Learn practical applications of marginal costing in fixation of selling price, Key or limiting factor, make or buy decisions, selection of a suitable product mix, effect of change in price, closing down activities and exploring new markets.

1.1 INTRODUCTION Understanding the behavior of costs is of vital importance to managers. Understanding how costs behave, whether costs are relevant to specific decisions, and how costs are affected by different factors allows managers to determine the impact of changing costs on a variety of decisions. Decision-making is the process of choosing the best course of action from among available alternative courses of action. Choice between alternative courses is an all pervading managerial function. Managers of business concern discharge their functions only by making decisions. Every manager regardless of level in which he operates is a decision maker.

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"Managerial Decision Making is the process by which managers‟ responds to opportunities and threats by analyzing options and making decision about goals and courses of action.” ‐ Warren Weber

1.2 STEPS INVOLVED IN DECISION‐MAKING Following steps are helpful in logical decision making: (1) Defining and Clarifying the Problem: The first step is to define problems clearly and precisely for decision making so that quantitative data that are relevant to its solution can be determined. The possible alternative solutions to the problem should be identified. At times, consideration of more alternative solutions may make the matters more complex. After that, proper scanning device will help to remove unattractive alternatives. (2) Collecting and Analyzing Data: In this regard, if the decision‐taker feels necessary, they may ask for further collection of information for better decision making process. In fact, a number of decisions improvised by acquiring further information and it is normally possible to obtain such information. (3) Analyzing the Problem: As earlier said, the problem of decision-making is that of choosing among alternatives. All alternatives have their own advantages and disadvantages. The decision taker has to take decisions on the basis of the problem intensity. Problem must be observed from different vantage points. (4) Ascertaining Alternatives: The decision maker needs to identify various alternatives by computing various cost structure and revenues under each of the options. So that later evaluation can be done of each available alternative. (5) Evaluating each Alternative: There are two types of aspects, viz. quantitative aspects and qualitative aspects. A decision maker observes all benefits and limitations of the various aspects to get a best option for enhancement of the company. (6) Selection of an Alternative: After defining, collecting, analyzing, determining various alternatives and evaluating them, the decision‐maker can select the best alternative on the basis of evaluation criteria. Different alternative may be ranked in order of priorities and may be chosen as per the requirements. (7) Appraisal of the Result: After executing the decisions, the decision maker should regularly seek an appraisal of the results. This will help him in correcting his mistake, modifying his target and making a better forecast in the times to come.

1.3 SHORT TERM DECISION AND LONG TERM DECISION Decision making involves two types of decisions i.e. long term decisions and short term decisions. Short‐term decisions are particular in nature. This chapter focuses on short term decisions. The information relevant for the decision making relies on the given situation calling for a decision. Here, such information is called the 'relevant data'. The 172

short term decisions are mostly affected within a year. Such short‐run decisions may involve decisions such as make or buy; domestic market or export; sell or process; accept or reject an order and other decisions. The long‐term decisions force the management to look beyond the current year. Time value of money and return on investment are major considerations in long term decisions. Uncertainty is an integral part of the decision‐ making. Hence, the task of decision‐making is quite difficult, crucial and critical.

1.4 RELEVANT AND IRRELEVANT COSTS FOR DECISION MAKING CIMA Official Terminology defines it as, “Costs and revenues appropriate to a specific management decision. These are represented by future cash flows whose magnitude will vary depending upon the outcome of the management decision made. If stock is used, the relevant cost, used in the determination of the profitability of the transaction, would be the cost of replacing the stock, not its original purchase price, which is a sunk cost. Abandonment analysis, based on relevant cost and revenues, is the process of determining whether or not it is more profitable to discontinue a product or service than to continue it.” The cost can be classified in a variety of ways according to their nature and information needs of the management. But when it comes to the managerial decision making, the managers are only concerned with relevant costs and relevant revenues. As not all the costs and revenues are relevant. Relevant means pertinent to the decision at hand. Relevant costs are those expected future costs that assist the decision makers in choosing a particular course of action, out of several alternatives.

1.5 CLASSIFICATION OF COST FOR DECISION MAKING Costs are important feature of many business decisions. For the purpose of decision making costs can be classified as follows: (1) Sunk Cost: CIMA Official Terminology defines Sunk cost as, “Cost that has been irreversibly incurred or committed and cannot therefore be considered relevant to a decision. Sunk costs may also be termed irrecoverable costs.” It is a cost which has already been incurred or sunk in the past. It is not relevant for decision-making. Thus, if a firm has obsolete stock of materials originally purchased for Rs. 40,000 which can be sold as scrap now for Rs. 8,000 or can be utilized in a special job, the value of stock already available Rs. 40,000 is a sunk cost and is not relevant for decision-making. Historical costs are sunk costs. They play no role in decision making in the current period. Sunk Cost do not affect future costs and cannot be changed by any current or future action, hence these costs are irrelevant in decision making. Eg. Spending on advertising during product launching is sunk for taking a decision on continuance of product.

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(2) Shut Down Cost: Sometimes it becomes necessary for a company to temporarily close down the factory or unit because of trade downturn with view to reopening it in the future. In this situation decisions are based on the variable cost analysis. If selling price is above the variable cost then it better to continue because the losses are minimized. By closing the manufacturing activity, some extra fixed expenses (e.g. Security) may be incurred and certain fixed expenses can be avoided (e.g. maintenance cost of plant). Such costs are also relevant. (3) Fixed Costs: The cost which always remains fixed irrespective of production volume is known as fixed costs. This cost remains constant whether production activity is increased or decrease. It is subject to change over a period of time. For short term managerial decision making, fixed cost may be relevant or irrelevant. When a particular decision is made that results in occurrence of fixed cost, it is relevant but if it occurs irrespective of any decision taken in a certain situation then it is irrelevant cost. (4) Committed Cost: CIMA Official Terminology defines committed cost as, “Cost arising from prior decisions, which cannot, in the short run, be changed. Committed cost incurrence often stems from strategic decisions concerning capacity with resulting expenditure on plant and facilities. Initial control of committed costs at the decision point is through investment appraisal techniques.” For example entering into irrevocable agreements for Rent, Technical Collaboration, etc. Committed Costs are not relevant for decision-making. (5) Discretionary Cost: CIMA Official Terminology defines discretionary cost as, “Cost whose amount within a time period is determined by a decision taken by the appropriate budget holder. Marketing, research and training are generally regarded as discretionary costs. Also known as managed or policy costs.” It is also known as “Avoidable” fixed costs. (6) Opportunity cost: CIMA Official Terminology defines opportunity cost as, “The value of the benefit sacrificed when one course of action is chosen in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action.” In other words, it is the opportunity cost lost by diversion of input factor from one use to another. It is the measure of the benefit of opportunity foregone. Opportunity cost is a pure decision‐making cost. It is an imputed cost, which does not require cash payout. The opportunity cost is helpful to managers in evaluating various alternatives available when multiple inputs can be employed for multiple uses. These inputs may nevertheless have a cost and this is measured by the sacrifice made by the alternative action in course of choosing another alternatives. (7) Marginal Cost: CIMA Official Terminology defines marginal cost as, “Assigns only variable costs to cost units while fixed costs are written off as period costs.” 174

Marginal costing is based on variable cost so that the management can take decisions on the basis of variable costs. Marginal costing is extremely useful for decision making. In fact, it is a major tool for decisions making. (8) Differential Cost: CIMA Official Terminology defines differential cost as, “Difference in total cost between alternatives. This is calculated to assist decision making.” In other words, it is the change in costs due to change in the level of activity or pattern or method of production. When the difference in cost of two alternatives results in increase in cost, it is called Incremental Cost, whereas the difference in cost of two alternatives results in decrease in cost, the difference is called Decremental costs. (9) Replacement Cost: CIMA Official Terminology defines replacement cost as, “Cost of replacing an asset. This is important in relevant costing because if, for example, material that is in constant use is needed for a product or service, the relevant cost of that material will be its replacement cost. Replacement cost has also been proposed as an alternate to historic cost accounting and it can, therefore, be an important concept with relevance to accounting for inflation or measuring performance where the value of assets is important.” (10) Imputed Cost: This is similar cost to the opportunity cost in that they are not recorded in the accounting books. However, they are hypothetical costs that must be taken into consideration if a correct decision is to be arrived at. In auditing it requires special treatment. Imputed cost comes from what one could have made from an asset if you had used it differently. These are Notional Costs appearing in the Cost Accounts only e.g. notional rent charges, interest on capital for which no interest has actually been paid. These are relevant costs for decision-making. (11) Out-of-Pocket Cost: Out‐of‐Pocket costs are those expenses which are current cash payments to the outsiders. All the explicit costs like payment of rent, wages, salaries, interest, transport charges etc. fall in category of out‐ of‐pocket costs. This cost is useful while taking decision like make or buy and price fixation during depression. This cost concept is a short-run concept and is used in various managerial decisions. (12) Future Cost: The past cost is historic and sunk cost which has already incurred and cannot be changed. So the only relevant cost for decision making is pre-determined or future costs. (13) Conversion Cost: CIMA Official Terminology defines conversion cost as, “Cost of converting material into finished product, typically including direct labour, direct expense and production overhead.” Appropriate use of this cost can be made in certain managerial decisions.

175

(14) Variable Costs: The cost which varies with the production volume is known as variable cost. It suggests that this cost varies with the increase or decrease in production. It is so because the input of raw material is used in the exact quantities needed for production process. From the viewpoint of their behavior, variable costs are also known as 'Engineered Cost'. Though it is believed that all variable costs are relevant, it is actually not so because if variable costs vary depending on different alternatives for decision making process.

1.6 DECISION MAKING AND VARIABLE COSTING The technique of marginal costing is largely use in the managerial decision making process. Marginal costing technique is used in providing assistance to the management in vital decision making, especially in dealing with the problems requiring short-term decisions where fixed costs are excluded. The application of marginal costing in the day to day decision making process is as follows:

1.6.1 Fixation of Selling Price Prices are more controlled by market conditions and other economic factors than by decisions of management team, but while fixing of selling prices the management should keep in mind all the factors that affect the area of selling price fixation specially the desired level of profit. Selling price need to be fixed differently under the different conditions: (a) Selling Price under normal circumstances: In the long run (to have reasonable amount of Profit), Selling Price > Total Cost (VC+FC) In the short run (temporarily in adverse conditions), Selling Price < Total Cost, but Selling Price > Variable Cost. (b) Selling Price in competition: In case of acute competition to avoid shut-down situation, Selling Price < Total Cost, but Selling Price > Variable Cost If Selling Price is equal to Variable cost, Loss = Fixed Cost (c) Selling Price under depression or recession: In case of depression or recession to avoid shut-down situation, Selling Price < Total Cost, but Selling Price > Variable Cost. Illustration 1: An umbrella manufactures makes an average profit of Rs. 2.50 per unit on a selling of Rs. 14.30 by producing and selling 60,000 units at 60% of potential capacity. His cost of sales per unit is as follows: Direct Material Rs. 3.50 Direct Wages Rs. 1.25 176

Factory Overhead Rs. 6.25 (50% fixed) Sales Overhead Rs. 0.80 (25% variable) During the current year, he intends to produce the same number but estimates that his fixed cost would go up by 10% while the rates of direct wages and direct material will increase by 8% and 6% respectively. However the selling price cannot be changed. Under this situation, he obtains an offer for a further 20% of his potential capacity. What minimum price would you recommend for acceptance of the offer to ensure the manufacture and overall profit of Rs. 1,67,300? Solution:

Statement of Marginal Cost and Profit

Sales Direct Material (3.50 + 6%) Direct Wages (1.25+8%) Variable Overhead - Fixed - Variable Variable Cost Contribution (Sales-Variable Cost) Fixed Cost* Profit

Per Unit 60,000 units Rs. Rs. 14.30 8,58,000 3.710 2,22,600 1.350 81,000 3.125 0.200 8.385

1,87,500 12,000 5,03,100 3,54,900 2,45,850 1,09,050

*Calculation of fixed overhead Factory Overhead - 60,000 units @ Rs. 3.125 = Rs. 1,87,500 Sales Overhead - 60,000 units @ Rs. 0.60 = Rs. 36,000 2,23,500 Add: 10% increase 22,350 Fixed Cost Rs. 2,45,850 Statement of Price Recommendation (for 20,000 units) Rs. Marginal Cost (Rs. 8.385 × 20,000 units) Additional profit required (1,67,300 - 1,09,050) Total sales value Selling price per unit (2,25,950/20,000) = Rs. 11.30 (approx.)

1,67,700 58,250 2,25,950

Selling Price at or below marginal cost: Some time it may become necessary to sell the goods at a price below the marginal cost some such situations are as follows:  Where materials are of perishable nature  To eliminate competitors from the market 177

 To export so as to earn foreign exchange  Where large quantities of stock are accumulated and whose market prices have fallen. This will save the carrying cost of stocks.  In order to popularize a new product.  In order to increase sales of those products having higher margin or profits. If the selling price is below the total cost but above the marginal cost, the contribution will leave on under recovering of fixed cost. If the selling price fixed is equal to marginal cost, there will be a loss which is equal to fixed cost. However, where the selling price is fixed is lesser than the marginal cost, the loss will be greater than fixed cost.

1.6.2 Exploring New Markets  Additional Order for utilizing unused plant capacity: As the fixed cost has already recovered from current sales at total cost plus profit and to utilize unused plant capacity, Selling Price > Variable Cost, but Selling Price < Total Cost. (it will earn additional profit for the company)  Export Sales: Additional order from a foreign market at below total cost but above marginal cost can be accepted (Selling Price > Variable Cost). While determining acceptance or rejection of Export Order, the following points need to be considered: (1) If Export sales result in additional costs, then that is relevant cost for the final decision. This additional cost should be deducted from the contribution to determine profit. (2) If Export Sales results in additional benefit, then that is relevant revenue for the final decision. This additional benefit should be added into the contribution to determine profit. Non-Cost Factors:  Foreign exchange earnings  Employment opportunities  Export status Illustration 2: Indo-British Company has a capacity to produce 5,000 articles but actually produce only 2,000 articles for home market at the following costs. Rs. 40,000 36,000

Material Wages Factory Overheads - Fixed - Variable

12,000 20,000 178

Administration Overhead - Fixed Selling and Distribution overheads - Fixed - Variable Total Cost

18,000 10,000 16,000 1,52,000

Solution: Statement of Marginal Cost and Contribution (of 3,000 articles for export) Material @ Rs. 20 per article Wages @ Rs. 18 per article Variable Overhead - Factory @ Rs. 10 per article - Selling and Dist. @ Rs. 8 per article Marginal cost of sales Sales (3,000 articles @ Rs. 65) Contribution Less: Additional Packing Cost Additional Profit

Rs. 60,000 54,000 30,000 24,000 1,68,000 1,95,000 27,000 3,000 24,000

Acceptance of this export order results in additional profit of Rs. 24,000 and thus the order should be accepted.

1.6.3 Make or Buy Decisions Very often management is confronted with the problem of deciding whether to buy a component or product from an outside source or to manufacture the same if it is economical as compared to the price quoted by a supplier. In deciding the absorption costing would mislead. If the decision is to buy from an external source the price quoted by the supplier should be less than marginal cost. If the decision is to make within the organization, the cost of production should include all additional cost such as depreciation on new plant interest on capita, etc. If this cost of production is less than the quotation price, it should be decided making the product rather than procure it from an external source. The following are the cost factors:  Availability of plant facility.  Quality and type of item which affects the production schedule  The space required for the production of item.  Any special machinery or equipment required.  Any transportation involved due to the location of production  Cost of acquiring special know how required for the item.  Cost of labour redundancies, if any  Technical obsolescence associated with the components 179

COST COMPARISON COST OF MAKE COST OF BUY Variable Cost Direct Purchase Cost + Specific Fixed Cost, if any + Purchase related cost + Opportunity Cost (in case of full capacity +Opportunity Cost if any operations) Decisions will be made as under:  If Cost of Make < Cost of Buy, then MAKE  If Cost of Make > Cost of Buy, then BUY  If Cost of Make = Cost of Buy, the company is indifferent The following are the non-cost factors:  In favour of making, the factors like Secrecy of company production, Ideal facility available, Tax considerations, Quality and stability of market supply etc.  In favour of buying factors like Assurance of quality of the product, Lack of capital required, Wide selection, Passing know how to suppliers or not, Uneven production of end product. Illustration 3: Vinayak manufacturers three components. These components pass through two of the company‟s departments P and Q. The machine hour capacity of each department is limited to 6,000 hours in a month. The monthly demand for components and cost data are as under. Components A B C Demand in units 900 900 1,350 Direct materials per unit Rs. 45 Rs. 56 Rs. 14 Direct labour per unit Rs. 36 Rs. 38 Rs. 24 Variable OH per unit Rs. 18 Rs. 20 Rs. 12 Fixed OH: P at Rs. 8 per hour Rs. 16 Rs. 16 Rs. 12 Q at Rs. 10 per hour Rs. 30 Rs. 30 Rs. 10 Total Rs. 145 Rs. 160 Rs. 72 Components A and C can be purchased from market at Rs. 129 each and Rs. 70 each respectively. Prepare a statement to show which of the components in what quantities should be purchased to minimize the cost. (CA Final) Solution:

Computation of Hours required to monthly demand of components

Components (a) Demand (units) (b) Hours per unit in Department P (given FOH/ Rs. 8) (c) Hours per unit in Department Q

A 900 units 2 hrs

B 900 units 2 hrs

C 1,350 units 1.5 hrs

3 hrs

3 hrs

1 hrs

180

D

(given FOH/ Rs. 10) (d) Total hrs required in Dept. P for production (a*b) (e) Total hrs required in Dept. Q for production (a*c)

1,800 hrs

1,800 hrs

2,025 hrs

5,625 hrs

2,700 hrs

2,700 hrs

1,350 hrs

6,750 hrs

 Available Hours = 6,000 each in Department P and Q. So, shortage in Department Q = 750 machine hours to produce the components as per demand specified above.  Department P has sufficient spare capacity of 375 hours, while time in department Q is the key factory. Particulars (a) Cost of buy (given) (b) Variable cost of make (Material + Lab + VOH) (c) Savings per unit, if made (a-b) (d) Hours required in Dept Q (WN 1c) (e) Savings per hour, if made (c/d) (f) Rank (preference for production) (g) Time required for production in Dept Q (h) Time allocated (i) Production Quantity (j) Purchase Quantity (900- 650 units)

A Rs. 129 Rs. 99

B NA Rs. 114

C Rs. 70 Rs. 50

Total

Rs. 30 3 hrs

NA 3 hrs

Rs. 20 1 hr

Rs. 10

NA

Rs. 20

III

I (no choice)

II

2,700 hrs

2,700 hours

1,350 hours

6,750 hrs

1,950 hrs (bal. fig) 650 units 250 units

2,700 hours

1,350 hours

6,000 hrs

900 units Nil

1,350 units Nil

Note: Since B cannot be bought outside, I Rank for production should be given for that component. Illustration 4: AB Ltd. has got a Machine No. 201. It manufactures product X with its selling price Rs. 100 and marginal cost Rs. 60. The machine takes 20 hours to produce it. The company uses a component „Y‟, that can be manufactured on Machine No. 201 in 3 hours at a marginal cost of Rs. 5. However, the component „Y‟ can be bought from the market at a price of Rs. 10. Should the component „Y‟ be made on Machine No. 201? [B.Com (Hons), Delhi] Solution: Contribution from Product X Selling Price Rs. 100 Less: Variable Cost 60 Contribution 40 Contribution per hour = 40/20 = Rs. 2

181

Cost of Producing Component Y Marginal Cost Cost due to loss of contribution from Product X (3 hrs.× 2) Total Cost Supplier‟s Price

Rs. 5 6 11 Rs. 10

The above computation shows that purchasing of component Y from the suppliers will result in a net gain of Re. 1 per component as compared to manufacturing it. Hence, it is better for the company to buy the component from outside supplier as compared to manufacturing it.

1.6.4 Product Mix Decisions Product mix decisions involve deciding upon the priority of products to be produced and sold so as to maximize the profit. That product‐mix which gives maximum contribution is to be considered the ideal product‐mix. Therefore, in order to determine the best product mix, the contribution of each product must be calculated. The product mix decision should be taken on the basis of contribution per unit of key factor. Assign the ranking on the basis of contribution per unit. The best product‐mix would be that which increase P/V. Ratio or which reduces break‐even point. In addition to relevancy of costs, the other factors that should be considered in deciding the product mix:  Volume of output  Available production capacity and limiting factors  Market demand of the products  Opportunity costs, if any. Illustration 5: Taurus Ltd. produces three products: A, B and C, from the same manufacturing facilities. The cost and other details of the three products are as follows: A Selling price/ unit (Rs.) Variable cost / unit (Rs.) Fixed expenses / month (Rs.) Maximum production per month(units) Total hours available for the month Maximum demand per month (units)

B 200 120 5,000 2,000

160 120 2,76,000 8,000 200 hours 4,000

C 100 40 6,000 2,400

The processing hours cannot be increased beyond 200 hours per month. You are required to: (a) Compute the most profitable product mix (b) Compute the overall break even sales of the company for the month based on the mix calculated in (a) above (CA Inter)

182

Solution: Working Notes: 1. Products A Selling price / unit Rs. (I) 200 Variable cost / unit Rs. (II) 120 Contribution / unit Rs. (I - II) 80 Maximum production per hour (units) 25 (5,000/ 200) Contribution per hour (Rs.) 2,000 (Maximum production per hour × Contribution per unit) Ranking 1 Units to be produced 2,000 Time required for the units to be produced (hrs.) 80

B 160 120 40 40 (8,000 / 200) 1,600

C 100 40 60 30 (6,000/200) 1,800

3 1,600

2 2,400

40

80

STATEMENT OF CONTRIBUTION

2. Products

Units

Selling price Per unit Rs.

A B C

2,000 1,600 2,400

200 160 100

V.C per unit Rs. 120 120 40 Total

Sales Variable Contribution Revenue cost (i) (ii) (iii) Rs. Rs. Rs. 4,00,000 2,40,000 1,60,000 2,56,000 1,92,000 64,000 2,40,000 96,000 1,44,000 8,96,000 5,28,000 3,68,000

M/ S Taurus Limited MOST PROFITABLE PRODUCT MIX

(a) Products

*No. of units to produced be

Contribution per unit Rs. 2,000 80 1,600 40 2,400 60 Total Less: fixed expenses Profit

A B C

Total contribution Rs. 1,60,000 64,000 1,44,000 3,68,000 2,76,000 92,000

(*refer to working note 1) (b) OVERALL BREAKEVEN SALES [based on the mix calculated in (a) part] Breakeven sales = =

fixed costs × sales Contribution Rs. 2,76,000 × Rs. 8,96,000* Rs. 3,68,000* 183

= Rs. 6,72,000 (*refer to working note 2)

Illustration 6: A limited manufacturers three different products and the following information have been collected from the books of accounts:

S Sales mix Selling price (Rs.) Variable cost (Rs.) Total fixed cost (Rs.) Total sales (Rs.)

35% 30 15

PRODUCT T 35% 40 20 1,80,000 6,00,000

Y 30% 20 12

The company has currently under discussion, a proposal to discontinue the manufacture of product Y and replace it with product M, when the following results are anticipated: S Sales mix Selling price (Rs.) Variable cost (Rs.) Total fixed cost (Rs.) Total sales (Rs.)

50% 30 15

PRODUCT T 25% 40 20 1,80,000 6,40,000

Y 25% 30 15

Will you advise the company to change over to production of M? Give reasons for your answers. (CS Inter) Solution:

EXISTING PRODUCTION S Rs.

Selling price Variable cost Contribution per unit P/V ratio (contribution/sales × 100) Sales mix Contribution per rupee of sales (P/V ratio × sales mix) Total contribution Total sales Total contribution (47% of Rs. 6,00,000) Fixed costs Profit at present production Breakeven point =

Fixed cost P/V ratio

30 15 15 50% 35% 17 ½ %

Products T Rs. 40 20 20 50% 35% 17 ½ %

47% Rs. 6,00,000 Rs. 2,82,000 Rs. 1,80,000 Rs. 1,02,000 =

Rs. 1,80,000 47%

184

= Rs. 3,83,000 (approx)

Y Rs. 20 12 8 40% 30% 12%

Proposed Production: S Rs. Selling price Variable cost Contribution per unit P/V ratio (contribution/sales × 100) Sales mix Contribution per rupee of sales (P/V ratio × sales mix) Total Contribution (6,40,000 × 50) Less: Fixed costs Profit Breakeven point =

30 15 15 50% 50% 25%

Products T Rs. 40 20 20 50% 25% 12 ½ %

M Rs. 30 15 15 50% 25% 12½ %

Rs. 3,20,000 Rs. 1,80,000 Rs. 1,40,000

Fixed cost = 1,80,000 P/V ratio 0.50

= Rs. 3,60,000

The proposal can be accepted because after replacement with product M: (i) Breakeven point is reached at a lower level of total sales and (ii) There is an increase of profit by Rs. 38,000. Illustration 7: A company running an orchard with an adequate supply of labour presents the following requests your advice about the area to be allotted for the cultivation of various types of fruits, which would result in the maximization of the profits. The company contemplates growing Apples, Lemons, Oranges and Peaches. Selling price per box (Rs.) Season‟s yield in boxed per acre Cost: Material per acre Labour: Growing per acre Packing per acre Transport per box

Apples 15 500 Rs. 270 300 1.50 3

Lemons 15 150 Rs. 105 225 1.50 3

The fixed costs in each season would be: Cultivation and growing Picking Transport Administration Land revenue

185

56,000 42,000 10,000 84,000 18,000

Oranges 30 100 Rs. 90 150 3 1.50

Peaches 45 200 Rs. 150 195 4.50 4.50

The following limitations are also placed before you: (a) The area available is 450 acres, but out of this, 300 acres are suitable for growing only oranges and lemons the balance of 150 acres is suitable for growing any of the four fruits. (b) As the produce may be hypothecated to banks, area allocated for any fruit should be demarcated in complete acres and not in fraction of an acre. (c) The marketing strategy of the company requires the compulsory production of all the four types of fruits in a season and the minimum quantity of any one type to be 18,000 boxes. Calculate the total profit that would accrue if your advice is accepted. [B.Com (Hons), Delhi] Solution:

STATEMENT OF COMPARATIVE PROFITABILITY

Particulars Selling price per box Season‟s yield (in boxes) per acre Average sales per acre Material per acre Labour cost per acre: Growing Picking and packing (500 × 1.50) (150 × 1.50) (100 × 3.00) (200 × 4.50) Transport (500 × 3.00) (150 × 3.00) (100 × 1.50) (200 × 4.50) Total marginal cost per acre Contribution per acre Priority as per contribution

Apples Rs. 15 500 7,500 270

Lemons Rs. 15 150 2,250 105

Oranges Rs. 30 100 3,000 90

Peaches Rs. 45 200 9,000 150

300

225

150

195

750 225 300 900 1,500 450 150 2,820 4,680 II

1,005 1,245 IV

Land Position Total area of Orchard Suitable for oranges and lemons Suitable for any fruit

450 acres 300 acres 150 acres

Marketing policy (a) all four types of fruits are to be produced in each season. (b) Minimum quantity of any one type = 18,000 boxes 186

690 2,310 III

900 2,145 6,855 I

Fruit Lemons Oranges

Boxes 18,000 18,000

Acres 120 180 300

Contribution priority revenue IV minority Qty. III minority Qty.

Balance 150 acres: Apples Peaches

18,000 boxes 22,800 boxes

36 acres 114 acres

Grand total

450 acres

II minimum Qty. I balance available contribution

for

maximum

STATEMENT SHOWING THE TOTAL PROFIT (MAXIMUM) Particulars Land in acres Season‟s yield (boxes) Contribution (Rs.) Less: fixed costs Total profit

Total

Apples Lemons Oranges Peaches 450 36 120 180 114 76,800 18,000 18,000 18,000 22,800 15,15,150 1,68,480 1,49,400 4,15,800 7,81,470 2,10,000 13,05,150

i.e. Maximum Profit: Rs. 13,05,150

1.6.5 Operate or Shut Down The management under certain circumstances might feel that plant shut down. That means operating or continuing is not a better alternative in comparison to shut down. This point generally comes in the operation of business where a firm is indifferent to continuing operations and shutting down temporarily. Shutdown cost is that cost which the firm incurs when it temporarily stops its operations. These costs could be saved if the operations are allowed to continue. In addition to Fixed Costs, shutdown costs include the cost of sheltering plant and equipment, lay‐of‐expenses, employment and training of workers when the plant is restarted and above all loss of market. Temporary Shut Down is a short term measure. It occurs because of strikes, trade depression etc. Permanent Shut Down is taken only in worst situations when business is not in situation to earn sufficient return to cover the risk involved. While calculating shutdown costs, only that cost will be considered which would not occur if the firm continues its operations. As cost is not the only criterion for deciding in favour of shut down. The other nonfactors to be considered are: (a) In case of shutting down the business, other companies may get a chance to establish their product and business (b) If the production is suspended, the product would be lost from public memory and when the business restarts, it would take a heavy expenditure on marketing. 187

(c) Once the skilled workers are discharged it might be difficult to get experienced and skilled workers when the business resumes. (d) Risk of obsolescence of Plant and Machinery. (e) Closing down business for limited period or specific activity may leave and adverse impact on the company or sully its reputation. (f) Arrangement of finance for compensation payable on retrenchment of unskilled workers, if any. Illustration 8: The selling price per unit of a product is Rs. 14. For the forthcoming period, the demand will be only 5,000 units. The fixed expenses at 50% activity (5,000 units) will be Rs. 30,000. The company is thinking of shutting down operations, in which case an additional amount of Rs. 2,000 will have to be incurred for shutting down and only Rs. 20,000 of the above fixed costs can be avoided. What should be the variable cost per unit to be recommended a shut down? (CA Final) Solution: Let variable cost per unit be Rs. X Particulars (1) Revenue (2) Variable cost (3) Contribution (1-2) (4) Fixed costs

Continue operations 5,000 units× Rs. 14 = Rs. 70,000 5,000 X 70,000- 5,000 X 30,000

(5) Profit (3-4)

40,000 - 5,000 X

Shutdown Nil Nil Nil 30,000 - 20,000 + 2,000 = 12,000 (12,000)

For indifference between continue and close down options, the profits of the two options should be equal. So, 40,000 - 5,000 X = - 12,000, - 5,000 X = - 52,000 On solving, X = 10.40 = Desired variable cost p.u. Conclusion: if variable cost per unit is greater than Rs. 10.40, Shut Down Option is preferable. Illustration 9: Plant 3 Budgeted Income and cost estimates are follows: Sales (annual) Costs- Fixed Variable Head Office allocated Loss

Rs. 10,00,000 Rs. 4,00,000 Rs. 3,00,000 Rs. 3,50,000 Rs. 10,50,000 Rs. 50,000

Sales of plant 3 is under consideration. What is your recommendation based on the data given? Justify your recommendation. [B.Com (Hons), Delhi]

188

Solution:

Plant 3: Statement of Profit Sales Less: Variable Cost Contribution Own Fixed Cost Profit Head Office Allocated Fixed Cost Loss

Rs. 10,00,000 3,00,000 7,00,000 4,00,000 3,00,000 3,50,000 50,000

The above statement shows that profit by itself is giving a profit of Rs. 3,00,000. The loss is because of head office allocated expenses of Rs. 3,50,000. The head office has to justify charging of such heavy fixed expenses to the branch. It seems they are either on the higher side or not properly allocated. Hence, the branch should not be closed down but should continue its operations.

1.7 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) In make or buy decision, marginal costs as well as additional fixed costs are the factors to be considered. (a) True (b) False (2) If the marginal cost is _________ buying price, additional requirement of the component should be met by making rather than buying. (a) Equal to (b) More than (c) Less than (d) None of the above. (3) If the management decides to manufacture a product it in own factory, the focus should be on (a) Cost factors (b) All Non-cost factors (c) Both (a) and (b) (d) None of the above (4) If there are large fluctuations in demand, the component should be (a) Purchased from outside (b) Made in factory (c) Should be made in factory in peak season (d) Should be made in factory in off season 189

(5) In marginal costing profitability of each product is measured on the basis of its (a) Cost (b) Profit (c) Contribution (d) None of the above (6) While making key factor decision, if raw material is key factor then such product should be preferred which offer: (a) Highest contribution per hour (b) Highest contribution per unit (c) Highest contribution per unit of material (d) None of the above (7) Change in product mix decision should be merely based on contribution. (a) True (b) False (8) While selecting optimum product mix ___________ is the real index of profitability. (a) Contribution per unit (b) Contribution per unit of key factor (c) Profit and sales (d) None of the above (9) In a competitive market, the price is determined by the (a) Individual concern (b) Market forces (c) Both (a) and (b) (d) None of the above (10) While taking shut-down decisions, the amount of contribution should be compared with (a) Escapable fixed costs (b) Special costs (c) Net escapable fixed costs (d) None of the above (11) A decision regarding temporary closure should be made on (a) Cost data (b) Economic factors (c) Social factors (d) All of the above 190

Answers: (1) (b), (2) (c), (3) (a), (4) (a), (5) (c), (6) (c), (7) (b), (8) (b), (9) (b), (10) (c), (11) (d) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) Costs which are pertinent to decision-making are termed as _______________. (b) ___________ costs are those costs that require a definite outlays of funds. (c) ______________are those costs which are irrelevant for further decisions because the expenditure has already been made and cannot be changed regardless of the alternative that is selected. (d) Special decisions are defined as those decisions which are not _______________ (e) The cost which will be eliminated, if a segment of the business with which it is directly related, is discontinue is known as __________ (f) The process of choosing among alternatives is regarded as _______________ Answers: (a) Relevant cost, (b) out-of-pocket, (c) sunk cost, (d) routine or recurring, (e) avoidable cost, (f) decision making Q2. True/False Statement: (a) Marginal costing is useful for long term planning (b) Opportunity cost is the value of benefit sacrificed in favour of an alternative course of action. (c) Relevant information is the information that differs between alternatives. (d) All fixed costs are sunk costs but all sunk costs are not fixed costs. (e) An opportunity cost is implied in making any decision. Answers: (a) F (b) T (c) T (d) F (e) T EXERCISE 3: LONG ANSWER QUESTIONS Q1. Write short notes on: (a) Relevant Cost (b) Differential Costing vs Marginal Costing (c) Out-of-Pocket Cost (d) Sunk Cost Q2. What are the cost and non-cost factors in accepting export orders? Q3. Write note on make or buy decision. Q4. What do you mean by relevant costs and irrelevant cost in decision making? Give example. 191

Q5. “The technique of variable costing is more used to provide a reasonable and sound basis for managerial decision decisions than to arrive at product cost.” Explain this statement with reference to the various types of decisions in which variable costing is useful. Q6. A mechanical toy factory presents the following information for the year 2012: Material cost (Rs.) Labour cost (Rs.) Fixed overheads (Rs.) Variable overheads (Rs.) Units produced Selling price per unit (Rs.)

1,20,000 2,40,000 1,20,000 60,000 12,000 50

The available capacity is a production of 20,000 units per year. The firm has an offer for the purchase of 5,000 additional units at a price of Rs. 40 per unit. It is expected that by accepting this offer there will be a saving of rupee on per unit in material cost on all units manufactured. The fixed overhead will increase by 35,000 and the overall efficiency will drop by 22% on all production. State whether offer is acceptable or not. Answers: Yes, the new offer is acceptable. Q7. Y Ltd. wants to merge three similar plants P, Q and R. The details are as under: Plant Capacity operated Turnover Variable cost Fixed cost

P 100% (Rs. in Lakhs) 300 200 70

Q 70% (Rs. in Lakhs) 280 210 50

R 50% (Rs. in Lakhs) 150 75 62

Find out: (i) The capacity of the merged plant for break even. (ii) The profit @ 75% capacity of the merged plant. (iii) The turnover from the merged plant to give a profit or Rs. 28 Lakhs. [B.com (Hons), Delhi] Answers: (i) B.E.P. = 52% (ii) Profit = Rs. 80.5 Lakh (iii) Turnover = Rs. 600 Lakh Q8. Present the following information to show to management: (i) The marginal product cost and the contribution per unit. (ii) The total contribution and profit resulting from of the each of the following sales mixtures.

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Particulars Direct material Direct materials Direct wages Direct wages Fixed expenses (Variable expenses are allotted to products as 100% of direct wages) Sales price Sales price

Product A B A B Rs. 800

Rs. per unit 10 9 3 2

A B

Rs. 20 Rs. 15

Sales mixture: (a) 100 units of product A and 200 of B (b) 150 units of product A and 150 of B (c) 200 units of product A and 100 of B

[B.Com (Hons), Delhi]

Answers: Total contribution (a) 800 (b) 900 (c) 1000. Sales mix (c) is the best. Q9. The Vinayak Ltd. Company manufactures a range of products and has just received a proposal from Shankar Ltd, Company that one of its products T, could be supplied to them advantageously at a price of Rs. 28 per unit. The cost of manufacturing in the Vinayak Ltd. Company is as under: Details Material Process 1 Process 2 TOTAL

Costs per unit (Rs.) 15 15 5 35

From further enquiries the following facts emerge: (i) Process 1 cost included an element of fixed overhead of approximately 40% (ii) Process 2 is a joint process producing three products in addition to T. The process costs would still be incurred if T were not produced by the company. Advise the management of the Vinayak Ltd. Company whether the proposal to purchase should be accepted or to continue manufacturing. [B.Com (Hons), Delhi] Answers: Proposal should not be accepted as variable cost of Rs. 24 is less than the purchase price of Rs. 28. Q10. Samson and Co. Annually manufacturers 10,000 units of a product at a cost of Rs. 4 per unit. There is home market for consuming the entire volume of production at the sale price of Rs. 4.25 per unit. In the next year, there is a fall in the demand for home market which can consume 10,000 units only at a sale price of Rs. 3.72 per unit. The analysis of the cost per 10,000 units is:

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Material Fixed overheads Wages Variable overheads

Rs. 15,000 8,000 11,000 6,000

The foreign market is explored and it is found that this market can consume 20,000 units of the product if offered at a sale of Rs. 3.55 per unit. It is also discovered that for additional 10,000 units of the product (over initial 10,000 units) the fixed overheads will increase by 10%. Is it worthwhile to try to capture the foreign market? (C.S. Inter) Answers: Order should be accepted because it will add Rs. 5,400 to profit. Total variable cost Rs. 64,000; Additional fixed cost Rs. 1,600 Q11. X Ltd. markets a single product and provides you the following data: Per unit (Rs.) Materials Conversion costs (variable) Dealer‟s margin Selling price Fixed cost Present sales Capacity utilization

16 12 4 40 Rs. 5 Lakhs 90,000 units 60 percent

There is acute competition, extra efforts are necessary to sell. Suggestions have been made for increasing sales: (a) By reducing sales price by 5 percent. (b) By increasing dealer‟s margin by 25 percent over the existing rate. Which of these two suggestions you would recommend, if the company desires to maintain the present profit? Give reasons. (C.S. Inter) Answers: Contribution per unit (a) Rs. 6.20 (b) Rs. 7. Present profit Rs. 2, 20,000; Suggestion (b) is recommended, sale 1,02,857 units

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LESSON 2

DECISION MAKING AND DIFFERENTIAL COST ANALYSIS 2. STRUCTURE 2.0 Learning Objectives 2.1 Decision Making and Differential Cost 2.2 Concept of Differential Revenue 2.3 Characteristics of Differential Costs 2.4 Difference between Marginal Costing and Differential Costing 2.5 Applications of Differential Cost Analysis 2.5.1 Determining Optimum Level of Production 2.5.2 Accepting a Special Order 2.5.3 Adding or Dropping a Product Line 2.5.4 Make or Buy Alternative 2.5.5 Further Processing of Joint Products 2.6 Qualitative or Non-Financial Considerations 2.7 Self-Test Questions

2.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn the uses of differential cost analyses (b) Differentiate between marginal costing and differential costing (c) Learn the practical applications of differential cost analyses for accepting a special order, make or buy decisions, adding or dropping a product line etc.

2.1 DECISION MAKING AND DIFFERENTIAL COST Decisions involve choosing between alternatives. Every alternative have their own certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in cost between any two alternatives is known as differential cost. A difference in revenue between any two alternatives is known as differential revenues. In Differential cost analysis, it is necessary to know both incremental cost and decremental cost. Those items that are the same under all alternatives can be ignored. The

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accountant's differential cost concept can be compared to the economist's marginal cost concept. Differential cost analysis is a special technique to help management in decisionmaking which shows how costs and revenues would be different under different alternative courses of action. In other words, Differential cost is the difference in cost between one alternative and another. This difference in cost may occur due to difference in fixed costs and variable costs, so differential cost is the aggregate of changes in fixed costs and variable costs which take place due to the adoption of an alternate course of action or change in the level of output.

2.2 CONCEPT OF DIFFERENTIAL REVENUE - This is regarded as future revenues which differ between the alternatives being considered. - When comparing different alternatives, three distinct situations may exist; these three basic situations are: (1) Operating at less than full capacity and the decision will have no effect on other product sales or revenue generating activities. - Simply compare the incremental revenues and cost of the different alternatives; no consideration of lost contribution which is presently being generated need be considered. (2) Operating at less than full capacity but the decision will effect on other product sales or revenue-generating activities. - must consider the revenues and costs of present products and activities which will be effected by the decision made as well as the estimated results directly generated from the decision. (3) Operating at full capacity as well as the decision will effect on other product sales or revenue-generating activities. - must consider the revenues and costs of present products or activities which will be effected by the decision made as well as the estimated results directly generated from the decision.

2.3 CHARACTERISTICS OF DIFFERENTIAL COSTS Following are the essential characteristics of differential costs:  Differential cost analysis is for internal purpose. That is why it is not prepared within the accounting records rather it is made outside the accounting records.  Total differential costs are considered in differential cost analysis. Cost per unit is not taken into consideration. It differs from action to action. 196

 Total differential revenues are compared with total differential costs before taking an alternate course of action. A change is recommended only if the outcome of the analysis shows that differential revenues exceed differential costs.  Those items which do not change with change in alternatives under consideration are ignored, only those items of costs are considered which shows change because differential costs analysis is concerned with changes in costs.  The changes in costs are measured from adopting a common base point which can be a present level of production.  Differential cost analysis is not related to past or historic cost rather it is related to the future course of action or future level of output, so it deals with future costs.  For decision making a choice is made from the various alternatives available, the alternative which gives the maximum difference between the incremental revenue and incremental cost is recommended to be adopted.

2.4 DIFFERENCE BETWEEN DIFFERENTIAL COSTING

MARGINAL

Marginal Costing It represents the increase or decrease in total cost which occurs with a small change in output.

COSTING

AND

Differential Costing It is the change (increase or decrease) in the total cost due to the change in level of activity, technology, production process or methods of production.

In this only variable cost changes due to a Here, variable as well as fixed cost change change in the level of activity. due to a change in the level of activity. Marginal costing wholly excludes fixed cost; some of the fixed cost may be taken into account as being relevant for the purpose of differential cost analysis.

Differential costing can be made in the case of both absorption costing as well as marginal costing.

Marginal costing may be embodied in the accounting system.

Differential costs are separately noted as analysis statements.

In Marginal Costing, margin of contribution and contribution ratios are the main yardsticks for the performance evaluation and for decision making.

In differential cost analysis, different costs are compared with the incremental or decremental revenues as the case may be.

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2.5 APPLICATIONS OF DIFFERENTIAL COST ANALYSIS 2.5.1 Determining optimum level of production The optimum level is that level of production where profit is the maximum. In order to arrive at a decision of this type, the differential costs are compared with incremental revenue at various levels of output. So long as the incremental revenue exceeds differential costs, it is profitable to increase the output. But as soon as the differential cost equals or exceeds increments revenue, it is no more profitable to increase the volume of output.

2.5.2 Accepting a special order Special orders are onetime orders that do not affect a company‟s normal sales. The profit from a special order equals the incremental revenue less the incremental costs. As long as the incremental revenue exceeds the incremental cost and present sales are unaffected, the special order should be accepted. - be sure to consider if the special order will have any effect on regular sales or revenues. - be sure you are not estimating the incremental costs from per unit cost data that includes allocated, indirect fixed costs which actually will not be increased by the taking of this order.

2.5.3 Adding or dropping a product line In multi-product company, a product line can be added only if the increase in Total Contribution Margin is greater than the increase in fixed cost. A segment should be dropped only if the decrease in Total Contribution Margin is less than the decrease in fixed cost. Some other points to be considered for decision making are follows: (a) Highly competitive nature of the product (b) Value of resources released on discontinuation (c) Contribution margin earned from that product

2.5.4 Make or Buy alternative Make or Buy alternatives can be analyzed on the basis of the comparison of differential cost and incremental revenues. Compare the incremental, out-of-pocket type costs of making the product internally with the definite out-of-pocket costs (price) of purchasing the product externally. Essentially in this analysis, costs which will be eliminated if the product is no longer produced internally (i.e., the benefits of not producing internally) must be compared with the costs (purchase price, freight charges, insurance, sales taxes, import duties, etc.) of an outside purchase.

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2.5.5 Further processing of joint products In some manufacturing processes, several intermediate products are produced from a single input. Such products are known as joint products. Management has to decide whether to further process Joint Product or sell By-Product. Sooner or later a decision often has made about selling a joint product as it is or after processing it further. Such decisions are taken on the basis of comparison of differential cost and incremental revenue.

2.6 QUALITATIVE OR NON-FINANCIAL CONSIDERATIONS In all decision making analysis, after the relevant monetary or financial measures of the different alternatives has been examined, then it is also required that necessary nonquantitative issues must be considered. Such factors as employee‟s morale, customer long-term response, governmental intervention, quality of the product that will be produced, the acceptable or appropriate amount of risk, dependency on particular vendors, legal violations, ethical considerations and meeting corporate social responsibilities must all be considered. In the final analysis, these qualitative or non-monetary considerations must be reviewed by the managers along with the economic or quantitative impact of any decision in arriving at a final decision. Always attempt to identify the qualitative or non-financial issues which need to be considered. Such non-monetary issues can sometimes outweigh or give more clarification which can be realized under the decision circumstances. Illustration 1: A company at present working at 90% capacity and producing 13,500 units per year. It operates a flexible budgetary control system. The following figures are obtained from its budget. 90% 100% Rs. Rs. Sales 15,00,000 16,00,000 Fixed expenses 3,00,500 3,00,600 Variable expenses 1,45,000 1,49,500 Semi fixed expenses 97,500 1,00,400 Units manufactured 13,500 15,000 Labour and material cost per unit is constant under present conditions. Profit margin is 10% of sales at 90% capacity. (a) You are required to determine the differential cost of producing 1,500 units by increasing capacity to 100%. (b) What price would you recommend for export of these 1,500 units, taking into account that overseas prices are lower than indigenous prices? [B.Com (H), Delhi] 199

Solution: The problem does not give the material and labour cost which is needed for computing differential cost. It is computed by working backward from sales as follows. At 90% capacity Rs. 15,00,000 1,50,000 13,50,000

Sales (13,500 units) Less: profit (10% of sales) Cost of goods sold Less: variable expenses Semi fixed expenses Fixed expenses Cost of labour and material(prime cost)

1,45,000 97,500 3,00,500

5,43,000 8,07,000

Labour and material costs are variable in nature and thus at 100% capacity these will be calculated as under: 8,07,000 ×100/90 = Rs. 8,96,667(approx) STATEMENT OF DIFFERENTIAL COST ANALYSIS

Production (units) Labour and material cost Variable expenses Semi fixed expenses Fixed expenses Total Differential cost per unit =

90% 13,500 Rs. 8,07,000 Rs. 1,45,000 Rs. 97,500 Rs. 3,00,500 13,50,000 Differential cost Differential units

100% DIFFERENTIAL 15,000 1,500 8,96, 667 89,667 1,49,500 4,500 1,00,400 2,900 3,00,600 100 14,47,167 97,167 =

Rs. 97,167 = Rs. 64.78 1,500 units

At a price of Rs. 64.78, there will be no additional profit. Therefore, any price above Rs. 64.78 which gives atleast reasonable profit should be acceptable for export, assuming that export will not affect the internal sales. Illustration 2: X Ltd. has been offered an order from A Ltd. For 10,000 units of output @ Rs. 100 each, which has a variable cost of Rs. 60 and will involve an outlay of Rs. 60,000 for set up, jigs and dies. At the same time there is another offer of an order from B Ltd. For 8,000 units of output at Rs. 110 each. Variable costs are estimated at Rs. 68 each and involve an outlay of Rs. 50,000 for set up, jigs and dies. Which order should the company accept? (Adatpted)

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Solution:

STATEMENT OF INCREMENTAL REVENUE AND COST A Ltd.

(a) Size of order (units)

B Ltd. 10,000

Rs. (b) Price per unit (c) Variable cost per unit (d) Incremental revenue (a×b) (e) Incremental variable cost (a×c) (f) Contribution (d-e) (g) Outlay for set up, jigs etc. (h) Total incremental cost (e+ g) (i) Net incremental revenue(d-h) (j) P/V ratio (f/d) × 100

8,000 Rs.

100 60 10,00,000 6,00,000 4,00,000 60,000 6,60,000 3,40,000 40%

110 68 8,80,000 5,44,000 3,36,000 50,000 5,94,000 2,86,000 38%

Conclusion: it may be concluded from the above analysis that order from A Ltd. is more profitable because it gives a higher incremental revenue of Rs. 54,000 (Rs. 3,40,000 2,86,000). Order from A Ltd. Should it be accepted. P/V ratio from A Ltd. is also higher. Illustration 3: The following extracts are taken from sales budget of a company for a current year: Rupee in ‘000 1,000

Sales: 40,000 units @ Rs. Per unit Selling costs: Advertising Salesman‟s salaries Travelling expenses Rent of sales office Others

100 80 50 10 10

250

The management is considering a proposal to establish a new market in the eastern region in the next year. It is proposed to increase the advertising expenditure by 25% and appoint an additional sales supervisor at a salary of Rs. 30,000 per year to establish a market. This will involve additional travelling and travelling expense shall increase by 10%. Target annual sales volume at the existing selling price for the new market is 10,000 units. The estimated variable cost of production is Rs. 12 per unit. Should the company try to establish the new market?

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(ICWA Inter)

Solution:

Sales units (A) Sales Rs. „000 Costs: Advertising Sales Salaries Travelling Expenses Rent Others Variable costs of Production @ Rs. 12 per unit (B) Total Cost Profit (A-B)

Present Position 40,000 1,000 100 80 50 10 10 250 480

Proposed Position 50,000 1,250 125 110 55 10 10 310 600

Incremental Cost and Revenue 10,000 250 25 30 5 60 120

730 270

910 340

180 70

Conclusion: There is incremental cost of Rs. 1,80,000 against incremental revenue of Rs. 2,50,000 resulting in net additional income of Rs. 70,000 (i.e. Rs. 2,50,000 - 1,80,000). Therefore the proposal should be accepted.

2.7 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) __________ refers to changes in total costs that occur due to changes in volume of production or sales, product system, product mix or from the adoption of an alternative course of action. (a) Differential costs (b) Marginal costs (c) Absorption costs (d) None of the above (2) As per J.M. Clark, when a decision has to be made involving ___________, the difference in cost between two policies may be considered to be the cost really incurred on account of these n-units of business. (a) An increase of n-units of output (b) A decrease of n-units of output (c) An increase or decrease of n-units of output (d) None of the above

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(3) Pertaining to the differential cost systems, which of the following statements are true? (A) Differential cost plus differential income shows net loss or net income (B) Differential cost is ascertained by comparing total costs of each alternative (C) Differential cost related to differential investments is calculated every time. (a) Only A (b) Only B (c) Only C (d) A, B, C (4) Which of the following statements are true? (a) Differential cost is also known as relevant cost. (b) Differential costs are estimated future costs. (c) Differential costs include only those costs which change as a result of the decision making being considered. (d) All of the above (5) If direct labor is not affected by the change in the type of material, it will form a part of differential cost. (a) True (b) False (6) The basic data used for differential cost analysis are (a) Cost (b) Revenue (c) Investment data (d) All of the above (7) The alternative which shows ____ difference between the incremental revenue and the differential cost is the one considered to be the best choice for selection. (a) Maximum (b) Minimum (c) No (d) None of the above (8) Differential cost is a part of routine accounting records. (a) True (b) False (9) If there is no change in fixed cost at different levels of output, (a) Marginal costs > Differential cost (b) Marginal costs < Differential cost (c) Marginal cost and Differential cost are same (d) None of the above 203

(10) Differential costs are obtained on the basis of (a) Absorption costing (b) Marginal costing (c) Both (a) and (b) (d) None of the above (11) In the case of differential costing, ________ is the main criteria for decision making. (a) Contribution (b) Ratios (c) Incremental/decremental revenue (d) None of the above Answers: (1) (a), (2) (c), (3) (b), (4) (d), (5) (b), (6) (d), (7) (a), (8) (b), (9) (c), (10) (c), (11) (c) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: a) An _______________ cost is the difference between the total cost of available alternatives. b) Two general formats used to present relevant information for decision-making purpose are the ________ or ____________ approach and the __________ approach. c) ________________ cost is the difference in total cost that results from two alternative courses of action. Answers: (a) Incremental, (b) incremental cost or revenue; contribution margin, (c) differential EXERCISE 3: LONG ANSWER QUESTIONS Q1. What is differential costing? Explain its importance in decision-making. Q2. What is meant by Differential Cost Analysis? Explain the essential features and points of similarity and difference between Differential Cost Analysis and Marginal Costing. Q3. What do you understand by Differential Cost Analysis? Explain (a) the essential features of differential costing, and (b) its practical applications. Q4. Distinguish between marginal costing and differential costing.

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Q5. A company is at present working at 90% capacity and producing 13,500 units per year. It operates a flexible budgetary control system. The following figures are obtained from its budget: 90% Rs. 15,00,000 3,00,500 1,45,000 97,500 13,500

Sales Fixed expenses Variable expenses Semi fixed expenses Units manufactured

100% Rs. 16,00,000 3,00,500 1,49,000 1,00,500 15,000

Labour and material cost per unit are constant under present conditions. Profit margin is 10 percent. (a) You are required to determine the differential cost of producing 1,500 units by increasing capacity to 100 percent. (b) What would you recommend for an export price for these 1,500 units taking into account that overseas prices are much lower than indigenous prices? Answers: (i) Differential cost of producing 1,500 units = Rs. 97,167 (ii) Minimum price for exports = Rs. 64.78 Q6. Lahore Ltd. is at present operating at 80% capacity level, the production being 15,000 units per annum. It operates a flexible budgetary control system. The following relevant cost data are obtained from the company‟s budget at different capacity utilization levels:

Sales Variable overheads Semi variable overhead Fixed overheads Output (in units)

Capacity utilization level 80% 100% Rs. 20,00,000 Rs. 25,00,000 Rs. 2,25,000 Rs. 2,50,000 Rs. 1,05,000 Rs. 1,11,000 Rs. 4,00,000 Rs. 4,70,000 15,000 18,750

Material and labour cost per unit are constant under the present conditioned. The management expects a profit margin of 10% on sales. You are required to compute the differential cost of producing the additional 3,750 units by increasing the capacity utilization level to 100 percent. Answer: Differential cost Rs. 3,68,500.

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Q7. In a factory the rated capacity is 30,000 units. The following data is supplied:

Fixed cost Variable cost per unit Sales revenue per unit

Output upto 15,000 units Rs. 15,000 3 4

From 25,001 – 30,000 units Rs. 19,500 3.25 3.80

From 15,001 25,000 units Rs. 16,000 3 3.80

What is the most profitable level of output? Use differential cost analysis. Answer: 25,000 units Q8. A company has a capacity of producing 50,000 units of a certain product in a month. The sales department reports that the following schedule of selling prices is possible: Volume of sales (% capacity)

Unit selling price Rs. 50% 60% 70% 80% 90% 100%

2.00 1.90 1.85 1.80 1.70 1.60

The variable cost of manufacture between the above levels is Re. 1 per unit and the total amount of fixed cost is Rs. 20,000 p.m. at 100% capacity level. Prepare a statement showing incremental revenue and differential cost at each of the above levels of production and sales. At which level the profit will be maximum? Answer: 80% Q9. Walia machines Co. Manufacturers had operated sewing machines. Prepare a schedule showing the total differential costs and increments in revenue from the following data. At what volume the company should set its level of production? Output ( in Lakhs) 0.60 1.20 1.80 2.40 3.00 3.60

Setting price per machine (Rs.) 240 220 200 180 160 140

Total semi fixed cost (Rs. in Lakhs) 30 30 34 34 40 40

Answer: 3 Lakh unit 206

Total variable cost (Rs. in Lakhs) 83.5 163.6 255.6 315.6 355.6 380.4

Total fixed (Rs. in Lakhs) 28.40 28.40 28.40 28.40 28.40 28.40

LESSON 1

UNIT 6

RESPONSIBILITY ACCOUNTING AND DIVISIONAL PERFORMANCE MEASUREMENT 1. STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Meaning and Definition of Responsibility Accounting 1.3 Pre-Requisites of Responsibility Accounting 1.4 Features of Responsibility Accounting 1.5 Steps Involved in Responsibility Accounting 1.6 Advantages of Responsibility Accounting 1.7 Limitations of Responsibility Accounting 1.8 Responsibility Centre 1.9 Types of Responsibility Centre 1.10 Divisional Performance Measurement 1.10.1 Introduction 1.10.2 Financial Methods for Evaluation of Divisional Performance 1.10.3 Non-Financial Methods for Evaluation of Divisional Performance 1.11 Self-Test Questions

1.0 LEARNING OBJECTIVES After reading this lesson, the students will be able to: (a) Learn the meaning, features and pre-requisites for responsibility accounting (b) Learn the concept of responsibility centre and types of responsibility centre (c) Learn to measure performance of divisions (d) Learn different methods to evaluate divisional performance

1.1 INTRODUCTION Responsibility Accounting is not a new branch of accounting like financial accounting or cost accounting. It is a controlling device by which costs are traced to individual managers and relevant for measurement of performance of an organization. In this sense, responsibility accounting is a supplementary cost control device. Responsibility accounting involves a company's internal accounting and budgeting. Responsibility accounting is a system of control under which managers are given decision

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making authority and are made responsible for their area assigned activity occurring within a specific department/division of the company.

1.2 MEANING AND DEFINITION OF RESPONSIBILITY ACCOUNTING Responsibility Accounting is a system of dividing a large diversified organization into small manageable units, each of which is to be assigned particular responsibilities. These units may be in the form of divisions, segments, departments, branches, product lines and so on. Each department is comprised of a manager who is held responsible for particular tasks or managerial functions. The managers of various departments should ensure that all the employees in their department are doing their best to achieve the goal. It also refers to the various tools and techniques used by managers to measure the performance of individual unit/division/departments in order to ensure that the achievement of the goals set by the top management. According to CIMA, London

Eric. L. Kohler Schaltke, R.W and Jonson H.G

Landouceur AG

“Responsibility Accounting is a system of management Accounting under which accountability is established according to the responsibility delegated to various levels of management and management information and reporting system instituted to give adequate feedback in terms of delegated responsibility. Under this system divisions or units of an organization under specified authority in a person are developed as responsibility centers and evaluated individually for their performance. A good system of transfer pricing is essential to establish at the performance and result of each responsibility center. Responsibility accounting is thus used as control technique." He defines Responsibility accounting as “method of accounting in which costs are identified with persons assigned to their control rather than with product or function." “Responsibility accounting system is a system of accounting in which costs and revenue are accumulated and reported to managers on the basis of manager‟s control over these costs and revenues. The managerial accounting system that ties budgeting and performance reporting to a decentralized organization is called responsibility accounting.” “Responsibility Accounting for most part is a change in emphasis from conventional product accounting to the cost control aspects of accounting and management control, wherein the statement flowing throughout the management hierarchy on a vertical basis or throughout the various components of the organization emphasize measurement of performance based on decision variable identified with the particular level of the segment. In this respect RA has provided a tool which did

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Charles T Horngren

Robert N Antony

not exist on a systematized basis prior to 1950.” “Responsibility accounting is a system of accounting that recognizes various responsibility centres throughout the organization and reflects the plans and actions of each of these centres by assigning particular revenues and cost to the one having the pertinent responsibility. It is also called profitability accounting and activity accounting.” “Responsibility accounting as that type of management accounting that collects and reports both planned and actual accounting information in terms of responsibility centre”.

Hence, responsibility accounting focuses on responsibility centres. The managers of different activity centres are responsible for controlling the costs of their respective centres. Information about costs incurred for different activities are supplied to the head that is accountable for his/her centre. The performance is measured by comparing the actual performance to the standard one and this process is very useful in exercising cost control. Responsibility accounting is different from cost accounting in the sense that the former lays emphasis on cost control whereas the latter lays emphasis on cost ascertainment.

1.3 PRE-REQUISITES OF RESPONSIBILITY ACCOUNTING  To implement a responsibility accounting system, the business must have a sound and well organization structure so that responsibility is assignable to individual managers.  The various managers and their lines of responsibility and authority should be fully defined.  The organization should be divided into various defined responsibility centers.  The organization chart is usually used as a basis for responsibility reporting.  The managers are held responsible only for those activities over which they exercise significant degree of control.  While decision-making power may be delegated for many items, some decisions (related to particular revenues, expenses, costs or actions) may remain exclusively under the control of top management.  The responsibility accounting system so adopted should have full support from the higher authorities of the organization.  Goals for each area of responsibility should be attainable with efficient performance.  A conducive organizational environment and progressive management attitude should exist.

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1.4 FEATURES OF RESPONSIBILITY ACCOUNTING  Positional Accounting: Responsibility Accounting is different from functional or product accounting. It is a positional accounting system in which responsibilities are delegated in favour of individual for execution of plans. Under this system, the individual responsibility can be measured only when his/her authority to influence the cost and/ or revenue can be identified and assigned to with reasonable clarity which is not possible in conventional accounting system.  Focus on controllable and non-controllable cost differentiation: Responsibility Accounting system is based on delegation of authority at the discretion of the individual responsible for execution of a plan. More the delegation, more the controllability of cost at the discretion of the individual and more the scope of accounting the responsibility of the individuals.  Control rather than mere accounting: Responsibility accounting is a concept that aims at helping achieve a fit between planning and control system and managerial responsibility. Through this conventional system of cost accounting an individual in charge of cost center is burdened with a large number of overheads over which he may have little control. Hence, the system of responsibility accounting is recommended whereby, the person controlling or initiating a particular cost should be held responsible for it.  Not an accounting by Itself: Responsibility accounting as a concept of cost control uses various accounting and cost control techniques like budgeting, standard costing, financial trend line analysis, operating leverage and pricing techniques with only difference that it has a bias towards fixation of responsibility of individual as against a product or function. It just makes use of different financial accounting and costing tools to assess the performance of the person who can best influence the cost and revenue of a business unit he is responsible for.  Transfer Pricing: Responsibility accounting divides the organization in different autonomous responsibility centres or subunits. In such circumstances, product or service of one division or unit can be transferred to another division or unit within the same organization charging a transfer price. This creates an inter-competitive environment to make each subunit of the organization more profitable and efficient.  Performance Evaluation: Responsibility accounting establishes a sound and fair system of performance evaluation of each manager and personnel. The performance of each responsibility center is measured and presented periodically on performance report.  Drop or Continue Decision: If the organization is divided into subunits, it becomes possible to measure division wise or product wise profitability of the organization. If saving in costs exceeds the foregone revenues, the center can be discontinued. 210

1.5 STEPS INVOLVED IN RESPONSIBILITY ACCOUNTING Responsibility accounting encompasses the following steps: (1) Identifying the Responsibility Centres: The basis of responsibility accounting system is the designation of each sub-unit in the organization as a particular type of responsibility center. A responsibility center is a sub-unit in an organization whose manager is held accountable for specific financial results of sub-unit's activities. The important criteria for creating a responsibility center is that the unit of the organization should be separable and identifiable for operating purposes and its performance measurement should be possible. An organization can be broadly subdivided into four main responsibility centres as cost center, revenue center, profit center and investment center. (2) Delegation of Authority and Responsibility or Decentralization: To increase managerial and operational efficiency, the manager of each subunit should be assigned specific authority and responsibility for the activity of that division. No one can be held accountable without having any prior responsibility and responsibility always accompanies corresponding authority. Responsibility centers are the decision centers also, and the decision requires the power or authority. (3) Controllable of the Object: The manager of a cost center can be held accountable only for the costs, which are controllable by him. Therefore, it is an essential part of responsibility accounting to identify the controllable and non-controllable costs. The same thing applies in the case of revenues, profits and investment. (4) Establishing Performance Evaluation Criteria: Main purpose of responsibility accounting is to measure the divisional or subunit performance. Performance evaluation is a yardstick measurement of whether the results are obtained as ought to be or not. Most often the following criteria are applied for divisional performance evaluation:  Standard Costing  Budgetary control  Profitability ratios  Valuation measures (5) Electing Cost Allocation Bases: Divisional profitability heavily depends on the bases of allocation of joint overheads and corporate overheads. Switching from one method to another of cost allocation over the products or divisions, product wise profitability change to a great deal. Remember that for decision-making purpose, such allocated overheads should be carefully treated and well understood.

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1.6 ADVANTAGES OF RESPONSIBILITY ACCOUNTING  Provides a way to manage a large diversified organization. Better decisions can be made at the local level.  Provides incentives to department managers and individuals to optimize their individual performances.  Provides managers with the freedom to make local decisions  Provides top management with more time to make policy decisions and engage in strategic planning.  Allows management to avoid understanding the system by using top down remote control based on accounting measurements  Supports management and individual specialization based on comparative advantage

1.7 LIMITATIONS OF RESPONSIBILITY ACCOUNTING The basic idea of responsibility accounting concept is that dividing an organization into small units provides an adequate way to manage a large diversified organization. However, responsibility accounting causes some problems as indicated below. As Responsibility Accounting can never be a substitute of good management. It is simply a tool of management. Responsibility accounting suffers from the following limitations which are listed below: (1) The pre-requisites for a successful responsibility accounting system are follows: (a) A sound organizational structure where organization can be divided into small units which can be regarded as responsibility centres. (b) Proper delegation of work and responsibility. (c) A proper system of reporting. If these conditions are absent it is difficult to have a responsibility accounting system. (2) The traditional way of classification of expenses needs to be subjected to a further analysis which becomes difficult. (3) In introducing the system certain managers may require additional classification particularly if the responsibility reports are different from routine reports.

1.8 RESPONSIBILITY CENTRE Responsibility accounting is an underlying concept of accounting performance measurement systems. It traces costs, revenues, or profits to the individual managers who are primarily responsible for making decisions about the costs, revenues, or profits in question and taking action about them. Responsibility accounting is suitable where top management has delegated authority to make decisions. The idea behind responsibility 212

accounting is that each manager's performance should be judge by how well he or she manages those items under his or her control. A responsibility center is an organizational unit headed by a manager, who is responsible for its activities and results. In responsibility accounting, revenues and cost information are collected and reported on by responsibility centers. A Responsibility Centre “is a division of the organization for which a manager is held responsible”. CIMA London defined Responsibility Centre as “a segment of the organization, where an individual manager is held responsible for its segment‟s performance.” In the words of Horngren, “a responsibility centre is a part, segment or sub-unit of an organization whose manager is accountable for a specified set of activities.”

1.9 TYPES OF RESPONSIBILITY CENTRE Responsibility Centres are of four types: cost centre, revenue centre, profit centre and investment centre. Together they form basis of Responsibility Accounting. COST CENTER A cost center in the CIMA’s official terminology is defined as “a product, services, functions or items of equipment of which cost may be attributed to cost unit." Cost center denotes a location, function or items of equipment in respect of which cost may be ascertained and related to cost units for the purpose of control. It is the smallest of organizational sub-unit for which separate cost allocation is attempted. It may be a personal or impersonal cost center. Whether it is personal or impersonal, cost center represented organizational span for which separate cost determination is aimed at for deciding the needs of the management. Managers of functional departments like production, personnel and marketing are treated as heads of the respective cost center and made responsible for their cost. If the responsibility is measured in financial terms, the performance statement should analyze the cost (a) which are directly attributable/controllable by the concerned cost center and (b) which may not be the result of significance influence by the cost center manager, but the management wants him to be concerned with such cost. REVENUE CENTER It emanates from the act of divisionalisation of earning. Thus, a revenue center may be defined as an operational responsibility that is devoted to raising revenue with no direct accountability for the cost of goods or services sold by this operation. Marketing and sales center can therefore be rightly categorized as revenue centers with the expectation that the concerned manager‟s effort will proportionately increase or decrease the revenue.

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The committee employed by the Indian Railway for identification of cost/profit centers and the related financial issues, have introduced and described the concept of revenue center. According to the committee the majority of responsibility centers of Indian Railway (IR) i.e. the functional units of all service departments performs activities that eventually contribute to the production of transport services and related activities. For example a permanent way inspector (PWI) of the civil engineering department is responsible for the upkeep of the permanent way and so on. In the absence the concept of transfer pricing, the services provided by the functional units of various department incurs only cost and no revenue of their own. Hence, they have been termed as cost centers. Similarly, the functional units that are responsible for booking and handling the traffic for carriage such as goods sheds, passenger and parcel booking office etc. are the units that are responsible for the booking all traffic and collecting the revenue. The costs incurred by these units are for those functions are very small as compared to the revenue generated. In other words, in the case of such centers, revenue predominates cost. The revenue thus generated at those functional units adds up to the total revenue of the IR or at least the bulk of it. Hence, they have been termed as revenue centers. The revenue generated by each sub-activity center is accounted for through various returns prepared by it. PROFIT CENTER According to CIMA, London, a profit centre is “A part of a business accountable for costs and revenues. It may be called a business centre, business unit, or strategic business unit.” A profit center may be construed as the smallest possible functional unit for which both revenue and expenditure can be worked out in actual terms. This would enable determination of accountability right from the grass root level, especially when the organization is vast, multi-location and multi-product in nature. For a profit center organization to be established, it is necessary to have units of an organization to which both revenue and cost can be separately attributed. Managers of profit centers should be responsible both for the revenue as well as cost, which implies that there should be sufficient decentralization of authority within the organization to permit the profit center managers to make decisions about the selling prices and the output level at those prices. A profit center performance report measured in absolute terms would show profit as the bottom line. A profit center may have sub-profit centers within it. How a responsibility center may take the form of Profit Center has been explained by Anthony Robert N when he says “A given responsibility center is a profit center only if the top management decides to measure its output in monetary terms and believes it to be a good idea to do so. No accounting principle requires that revenue be measured for individual responsibility centers within the company. With some ingenuity, practically, any cost (or expenses) center could be turned into a profit centers can be found. The question is whether there are sufficient positive benefits in doing so.”

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INVESTMENT CENTER According to CIMA, London, Investment centre is defined as “A profit centre whose performance is measured by its return on capital employed.” As noted by Manohar Bhatia, "Another concept related to profit center concept is the “Investment Center”. An investment center is a unit or division of the company, which is responsible to the top management for its profitability in relation to its investment base. As in profit centers, revenue and expenses are measured but in addition the assets employed in the division are also measured with a view to determining its investment base. Thus, an investment center is an extension of profit center idea. Profit is measured in both, but only in investment center is this profit related to the size of the investment involved." Thus, a factory or an erection function as Business Units can be considered as investment center to measure the return on investment. In fact, even Profit Centers, where there is no significant amount of tangible investment, still can be measured in terms of Investment center because, all the Business Units need some value of investment as input resources and working capital requirement is one of them.

1.10 DIVISIONAL PERFORMANCE MEASUREMENT 1.10.1 Introduction Many companies have business activities in more than one country. In fact, the operations of some large corporations involve so many different countries that they are called multinational businesses. The problems of managing and accounting for a company that has international operations can be very complex, and detailed study of these issues should be required. Because of the complexity of companies operations, it is difficult for top management to directly control operations. Therefore a company is divided into divisions and is allowed divisional managers to operate with a great deal of independence. When autonomous divisions are created there can be risk that divisional managers might not able to achieve the objectives that are in the best interests of the company as a whole. At the strategic business unit level operating profit, return on investment, residual income and economic value added were examined, and these measures should be used for measuring divisional performance.

1.10.2 Financial Methods for Evaluation of Divisional Performance Following are some of the important financial measures applied for performance evaluation: (1) Divisional Profit (2) Return on Investment (ROI) (3) Residual Income (RI)

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(4) Variance Analysis (1) Profit: Profit is the absolute measure of performance. It is easy to calculate, understand and evaluate the performance of division on the basis of profit. However, it is not considered to be a very reliable measure of performance because the profit is arrived at after deducting the apportioned head office expenses, which at times are arbitrarily charged to the division. (2) Return on Investment (ROI): Instead of focusing on the absolute measure, division‟s profits, most companies focus on the return on investment (ROI) of a division (that is, profit as a percentage of the investment in a division). ROI expresses divisional profit as a percentage of firm‟s capital employed in the division. ROI =

Divisional Profit × 100 Capital Employed

ROI =

Turnover × Profit × 100 Capital Employed Turnover

Advantages:  ROI is relative measure of performance as it is expressed in %  Measuring returns on invested capital focuses managers‟ attention on the impact of levels of working capital on the ROI.  ROI is easy to understand and interpret.  ROI denominator for comparing the returns of dissimilar businesses, such as other divisions within the group or outside competitors.  ROI has been most widely used financial measure for many years in all types of companies. Disadvantages:  Divisional ROI can be increased by actions that will make the company as a whole worse off.  Evaluating divisional managers on the basis on ROI may not encourage goal congruence.

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(3) Residual Income (RI): To overcome some of the dysfunctional consequences of ROI, the residual income (RI) approach can be used. RI is defined as the profit of a division less a cost of capital charge on the investment controllable by the divisional manager. Residual Income = Divisional Profit - (Divisional Investment × Rate of Charge) A reason cited in favour of RI over the ROI measure is that RI is more flexible, because different cost of capital percentage rates can be applied to investments that have different levels of risk. Not only will the cost of capital of divisions that have different levels of risk differ - so may the risk and cost of capital of assets within the same division. RI suffers from the disadvantages of being difficult to determine the rate for calculating the cost of capital. Illustration 1: Compute Residual Income: Rs. Sales 10,00,000 Variable Costs 6,00,000 Fixed Costs 2,00,000 Imputed Interest on Investment 1,00,000 Solution: Sales Less: Variable Cost Contribution Less: Fixed Cost Profit Less: Imputed Interest Residual Income

Rs. 10,00,000 6,00,000 4,00,000 2,00,000 2,00,000 1,00,000 1,00,000

Illustration 2: Wagon Ltd. has three division X, Y and Z. the operating results of the three divisions are as follows: Divisions X Y Z Rs. Rs. Rs. Sales 10,00,000 10,00,000 20,00,000 Less: Cost 8,00,000 6,00,000 12,00,000 Profit 2,00,000 4,00,000 8,00,000 Investment 6,00,000 10,00,000 30,00,000 (1) You are required to determine ROI of the three divisions and rank these divisions on the basis of their performance. 217

(2) Determine residual income (RI) of the three divisions and rank them assuming cost of capital is 15% Solution: (1) Return on Investment Method

ROI=

Profit × 100 Investment

X = 2,00,000 × 100 6,00,000 = 33.33% II

Division Y = 4,00,000 × 100 10,00,000 = 40% I

Z = 8,00,000 × 100 30,00,000 = 26.67% III

(2) Residual Income Method

Investment Profit Less: Cost of Capital @ 15% on Investment Residual Income Ranking

X Rs. 6,00,000

DIVISION Y Rs. 10,00,000

Z Rs. 30,00,000

2,00,000 90,000

4,00,000 1,50,000

8,00,000 4,50,000

1,10,000 III

2,50,000 II

3,50,000 I

(4) Variance Analysis: In this technique, actual performance is compared standard performance. This has been discussed in details in the chapter of standard costing. Variance analysis should be undertaken for each cost centre and revenue centre to measure the performance of each such centres.

1.10.3 Non-Financial Methods for Evaluation of Divisional Performance    

Development of Human Resources Leadership Qualities Marketability of Divisional Product Attitudes of the Employees and Colleagues

1.11 SELF-TEST QUESTIONS EXERCISE 1: MULTIPLE CHOICE QUESTIONS (1) The responsibility accounting stresses on _________ (a) Decentralization (b) Centralization (c) Both (a) and (b) 218

(d) None of these (2) In responsibility accounting system… (a) Budgets are prepared (b) Actual performance is recorded (c) The performance is reported (d) All of the above (3) The responsibility accounting emphasizes the performance of ____ (a) System (b) Men (c) Both (d) None of these (4) The responsibility accounting is a controlling tool for… (a) Top‐level management (b) Lower level management (c) Middle level management (d) None of these (5) The subdivision of responsibility centre is… (a) Expense centre (b) Profit centre (c) Investment centre (d) All of the above Answers: (1) (a), (2) (d), (3) (b), (4) (a), (5) (d) EXERCISE 2: SHORT ANSWER QUESTIONS Q1. Fill in the blanks: (a) Market based transfer price is useful in evaluating the performance of ______________ (b) A system of accounting that aggregates revenue and costs into areas of personal responsibility in order to assess the performance attained by persons to whom authority has been assigned in known as _________ (c) A centre in which both inputs and outputs/costs and revenues are measured in monetary terms is termed as ________________. Answers: (a) different division (b) responsibility accounting (c) profit centre Q2. True/False statement: (a) Responsibility accounting is more suitable in diversified companies. (b) Some indirect costs are controllable costs in a specific responsibility centre.

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(c) When output cannot be measured but costs are incurred, the segment of the organization is usually called a cost centre. (d) Return on investment is a function of function of income earned and the assets used in order to earn that income. Answers: (a) T, (b) F, (c) F, (d) T EXERCISE 3: LONG ANSWER QUESTIONS Q1. Discuss responsibility accounting in brief. Q2. What is responsibility centre? Discuss briefly the nature and various types of responsibility centres. Q3. Write explanatory note on Responsibility Accounting. Q4. Write short notes on responsibility centres - cost centre and profit centre. Q5. What are the different methods of measurement of divisional performance? Q6. Explain the following methods of measuring performance of responsibility centres and evaluate them: (a) Return in Investment (b) Residual Income Q7. Compute return on investment in respect of Division “A” of a company on the basis of the following information: Rs. Fixed assets Current assets Current liabilities Equity share capital Sales Cost goods sold Administration expenses Interest on Long term loan

15,000 70,000 20,000 1,50,000 2,00,000 1,20,000 20,000 5,000

Answer: 36.67%

[B.Com (Hons), Delhi 2015]

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