Costing Semester 3 full syllabus
1. Define Cost accounting? Explain the scope objectives and importance of cost
Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories.
Financial Accounting, aims at finding out profit or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
Management Accounting helps the management to conduct the business in a more efficient manner.
As compared to the financial accounting, the focus of cost accounting is different. In the modern days of cut throat competition, any business organization has to pay attention towards their cost of production.
Computation of cost on scientific basis and thereafter cost control and cost reduction has become of paramount importance. Hence it has become essential to study the basic principles and concepts of cost accounting. These are discussed in the subsequent paragraphs.
Cost accounting is a branch of accounting that has evolved to overcome the limitations of financial accounting. It is the process of accounting for cost, which is concerned more with the ascertainment, allocation, distribution and accounting aspects of cost. It is that branch of accounting, which deals with the classification, recording, allocation, summation and reporting of current and prospective costs. Actually, it is the formal mechanism by means of which of products and services are ascertained and controlled.
It is an internal reporting systems that aims to assist the management for planning and decision-making it primary emphasizes on cost and deals with collection, analysis, interpretation and prospective for managerial decision making on various business problems.
Cost accounting is more concerned with short-tem planning and its reporting period is much losses that financial accounting. It deals with historic data but is also futuristic in approach. Cost accounting systems cannot be installed without proper financial accounting systems. Each organization can develop a costing systems best suited to its individual needs. In financial accounting the major emphasis is in cost classification based on types of transaction e.g., salaries, repairs, insurance, stores etc. but in cost accounting, the emphasis is laid on functions, activities, processes and on internal planning and control and information needs of the organization.
Similarly, according to national association of accountants USA'
From the above information definition, it can be concluded that cost accounting is accounting for cost aimed at providing cost data, statements and reports for the purposes to assists the managements in planning decision making and controlling.
Cost :- Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.
Costing :- Costing may be defined as ‘the technique and process of ascertaining costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the ascertainment of every order, job, contract, process, service units as may be appropriate. It deals with the cost of production, selling and distribution.
If we analyze the above definitions, it will be understood that costing is basically the procedure of ascertaining the costs. As mentioned above, for any business organization, ascertaining of costs is must and for this purpose a scientific procedure should be followed. ‘Costing’ is precisely this procedure which helps them to find out the costs of products or services.
Cost Accounting :- Cost Accounting primarily deals with collection, analysis of relevant of cost data for interpretation and presentation for various problems of management. Cost accounting accounts for the cost of products, service or an operation. It is defined as, ‘the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profitability or the social use of funds’.
Cost Accountancy :- Cost Accountancy is a broader term and is defined as, ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profitability as well as presentation of information for the purpose of managerial decision making.’
If we analyze the above definition, the following points will emerge,
A. Cost accounting is basically application of the costing and cost accounting principles.
B. This application is with specific purpose and that is for the purpose of cost control, ascertainment of profitability and also for presentation of information to facilitate decision making.
C. Cost accounting is a combination of art and science, it is a science as it has well defi ned rules and regulations, it is an art as application of any science requires art and it is a practice as it has to be applied on continuous basis and is not a one time exercise.
Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the scope of cost accounting is broader than that of costing. Following functional activities are included in the scope of cost accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is preferably done on the basis of double entry system.
2. Cost system: Systems and procedures are devised for proper accounting for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports form the basis for planning and control, performance appraisal and managerial decision making.
Objectives and Functions of Cost Accounting:
1. To ascertain the cost per unit of the different products manufactured by a business concern.
2. To provide a correct analysis of cost both by process or operations and by different elements of cost.
3. To disclose sources of wastage whether of material, time or expense or in the use of machinery, equipment and tools and to prepare such reports which may be necessary to control such wastage.
4. To provide requisite data and serve as a guide for fixing prices of products manufactured or services rendered.
5. To ascertain the profitability of each of the products and advise management as to how these profits can be maximised.
6. To exercise effective control if stocks of raw materials, work-in-progress, consumable stores and finished goods in order to minimise the capital locked up in these stocks.
7. To reveal sources of economy by installing and implementing a system of cost control for materials, labour and overheads.
8. To advise management on future expansion policies and proposed capital projects.
9. To present and interpret data for management planning, evaluation of performance and control.
10. To help in the preparation of budgets and implementation of budgetary control.
11. To organise an effective information system so that different levels of management may get the required information at the right time in right form for carrying out their individual responsibilities in an efficient manner.
12. To guide management in the formulation and implementation of incentive bonus plans based on productivity and cost savings.
13. To supply useful data to management for taking various financial decisions such as introduction of new products, replacement of labour by machine etc.
14. To help in supervising the working of punched card accounting or data processing through computers.
15. To organise the internal audit system to ensure effective working of different departments
IMPORTANCE OF COST ACCOUNTING
1. Costing helps in periods of trade depression and trade competition:-
In periods of trade depression the business cannot afford to have leakages which pass unchecked. The management should know where economies may be sought, waste eliminated and efficiency increased. The business has to wage a wax for its survival. The management should know the actual cost of their products before embarking on any scheme of reducing the prices on giving tenders. Adequate costing facilitates this.
2. Aids in price fixation:-
Though economic law & supply and demand and activities of the competitors, to a great extent, determine the price of the article, cost to the producer does play an important part. The producer can take necessary guidance from his costing records.
3. Helps in estimate:-
Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of over – rating or losing in the execution of a contract due to under – rating can be minimized. Thus, “ascertained costs provide a measure for estimates, a guide to policy, and a control over current production”.
4. Helps in channeling production on right lines:-
Costing makes possible for the management to distinguish between profitable and non-profitable activities profit can be maximized by concentrating on profitable operations and eliminating non-profitable ones.
5. Wastages are eliminated:-
As it is possible to know the cost of the article at every stage, it becomes possible to chock various forms of waste, such as time, expenses etc. or in the use of machine, equipment and tools.
6. Costing makes comparison possible:-
If the costing records are regularly kept, comparative cost data for different periods and various volumes of production will be available. It will help the management in forming future lines of action.
7. Provides data for periodical profit and loss accounts:-
Adequate costing records supply to the management such data as may be necessary for preparation of profit and loss account and balance sheet, at such intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial accounts thus helps in presentation of better information before the management.
8. Aids in determining and enhancing efficiency:-
Losses due to wastage of material, idle time of workers, poor supervision etc., will be disclosed if the various operations involved in manufacturing a product are studied by a cost accountant. The efficiency can be measured and costs controlled and through it various devices can be framed to increase the efficiency.
9. Helps in inventory control:-
Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods. (This has been explained in detail under the chapter “Materials”)
10. Helps in cost reduction:-
Costs can be reduced in the long run when alternatives are tried. This is particularly important ion the present day context of global competition cost accounting has assumed special significance beyond cost control this way.
11. Assists in increasing productivity
Productivity of material and labour is required to be increased to have growth and more profitability in the organisation costing renders great assistance in measuring productivity and suggesting ways to improve it.
2. Define Cost accounting? Explain the advantages and limitations of cost accounting
Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories.
Financial Accounting, aims at finding out profi t or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
Management Accounting helps the management to conduct the business in a more efficient manner.
As compared to the financial accounting, the focus of cost accounting is different. In the modern days of cut throat competition, any business organization has to pay attention towards their cost of production.
Computation of cost on scientific basis and thereafter cost control and cost reduction has become of paramount importance. Hence it has become essential to study the basic principles and concepts of cost accounting. These are discussed in the subsequent paragraphs.
Cost accounting is a branch of accounting that has evolved to overcome the limitations of financial accounting. It is the process of accounting for cost, which is concerned more with the ascertainment, allocation, distribution and accounting aspects of cost. It is that branch of accounting, which deals with the classification, recording, allocation, summation and reporting of current and prospective costs. Actually, it is the formal mechanism by means of which of products and services are ascertained and controlled.
It is an internal reporting systems that aims to assist the management for planning and decision-making it primary emphasizes on cost and deals with collection, analysis, interpretation and prospective for managerial decision making on various business problems.
Cost accounting is more concerned with short-tem planning and its reporting period is much losses that financial accounting. It deals with historic data but is also futuristic in approach. Cost accounting systems cannot be installed without proper financial accounting systems. Each organization can develop a costing systems best suited to its individual needs. In financial accounting the major emphasis is in cost classification based on types of transaction e.g., salaries, repairs, insurance, stores etc. but in cost accounting, the emphasis is laid on functions, activities, processes and on internal planning and control and information needs of the organization.
Similarly, according to national association of accountants USA'
From the above information definition, it can be concluded that cost accounting is accounting for cost aimed at providing cost data, statements and reports for the purposes to assists the managements in planning decision making and controlling.
Cost :- Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.
Costing :- Costing may be defined as ‘the technique and process of ascertaining costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the ascertainment of every order, job, contract, process, service units as may be appropriate. It deals with the cost of production, selling and distribution.
If we analyze the above definitions, it will be understood that costing is basically the procedure of ascertaining the costs. As mentioned above, for any business organization, ascertaining of costs is must and for this purpose a scientific procedure should be followed. ‘Costing’ is precisely this procedure which helps them to find out the costs of products or services.
Cost Accounting :- Cost Accounting primarily deals with collection, analysis of relevant of cost data for interpretation and presentation for various problems of management. Cost accounting accounts for the cost of products, service or an operation. It is defined as, ‘the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profitability or the social use of funds’.
Cost Accountancy :- Cost Accountancy is a broader term and is defined as, ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profitability as well as presentation of information for the purpose of managerial decision making.’
If we analyze the above definition, the following points will emerge,
A. Cost accounting is basically application of the costing and cost accounting principles.
B. This application is with specific purpose and that is for the purpose of cost control, ascertainment of profitability and also for presentation of information to facilitate decision making.
C. Cost accounting is a combination of art and science, it is a science as it has well defined rules and regulations, it is an art as application of any science requires art and it is a practice as it has to be applied on continuous basis and is not a one time exercise.
Moreover, the management at the maximum should accept the advises given by the cost accounting system. If so, the following advantages may be available to an organization.
Advantages of Cost Accounting
The extent of advantages derived from the cost accounting is based on the type, adequacy and efficiency of cost accounting system installation.
Moreover, the management at the maximum should accept the advises given by the cost accounting system. If so, the following advantages may be available to an organization.
1. Elimination of Wastes, Losses and Inefficiencies: A good cost accounting system eliminates wastes, losses and inefficiencies by fixing standard for everything.
2. Cost Reduction: New and improved methods of production are followed under cost accounting system. It leads to cost reduction.
3. Identify the reasons for Profit or Loss: A good cost accounting system highlights the reasons for increasing or decreasing profit. If so, the management can take remedial action to maintain profitability of the concern. There is no possibility of shutting down of any product or process or department.
4. Advises on Make or Buy Decision: On the basis of cost information, the management can decide whether make or buy a product in open market. The management can rightly choose the best out of many alternatives. Sometimes, spare capacity can be used profitably.
5. Price Fixation: The total cost of a product is available in the costing records. It is highly useful for price fixation of a product.
6. Cost Control: Budgets are prepared and standards are fixed under cost accounting system. The expenses are not permitted beyond the budget amount. The actual performance is compared with standard to find the variation. If there is any variation, reasons are find out and the management can exercise control. Period to period cost comparison also helps cost control.
7. Assist the Government: Government can collect reasonable tax from the company and exercise price control.
8. Help the Trade Union: Bonus calculation is very easy to the trade union. Reasonable remuneration is also fixed on the basis of cost accounting information.
9. Marginal Analysis of Cost: It is done for facilitating the short-term decisions especially during depression period.
10. Fixation of Responsibility: Responsibility centers is fixed under cost accounting system. If responsibility is fixed, it becomes difficult to evade responsibility of performance and leads to effective performance.
11. Helps to Prepare Financial Accounts: The information like value of closing materials, work in progress and finished goods are necessary to prepare financial accounts. This information is supplied by the costing records and helps to prepare financial accounts without any further delay.
12. Prevention of Frauds: Introducing cost audit can prevent frauds. If so, correct and reliable data was available from the costing records which are highly useful to the government, share holders, the creditors and the like.
Disadvantages or Limitations of Cost Accounting
The limitations or disadvantages of cost accounting are listed below:
1. Only past performances are available in the costing records but the management is taking decision for future.
2. The cost of previous year is not same in the succeeding year. Hence, cost data are not highly useful.
3. The cost is ascertained on the basis of full utilization of capacity. If capacity is partly utilized, the cost may not be true.
4. Financial character expenses are not included for cost calculation. Hence, the calculated cost is not correct always.
5. In cost accounting, costs are absorbed on pre-determined rate. It leads to over absorption or under absorption of overheads.
6. Cost Accounting fails to solve the problems relating to work study, time and motion study and operation research.
7. Installation of Cost Accounting System requires the maintenance of many costing records. If results in heavy expenditure.
8. Delay in receiving costing information does not result in taking quality decision by the management.
9. Rigid Cost Accounting System does not serve all purposes.
3. Differentiate between financial accounting and cost accounting.
Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories.
Financial Accounting, aims at finding out profit or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
Both cost accounting and financial accounting help the management formulate and control organization policies. Financial management gives an overall picture of profit or loss and costing provides detailed product-wise analysis.
No doubt, the purpose of both is same; but still there is a lot of difference in financial accounting and cost accounting. For example, if a company is dealing in 10 types of products, financial accounting provides information of all the products in totality under different categories of expense heads such as cost of material, cost of labor, freight charges, direct expenses, and indirect expenses. In contrast, cost accounting gives details of each overhead product-wise, such as much material, labor, direct and indirect expenses are consumed in each unit. With the help of costing, we get product-wise cost, selling price, and profitability.
The following table broadly covers the most important differences between financial accounting and cost accounting.
Point of Differences Financial Accounting Cost Accounting
Meaning Recoding of transactions is part of financial accounting. We make financial statements through these transactions. With the help of financial statements, we analyze the profitability and financial position of a company. Cost accounting is used to calculate cost of the product and also helpful in controlling cost. In cost accounting, we study about variable costs, fixed costs, semi-fixed costs, overheads and capital cost.
Purpose Purpose of the financial statement is to show correct financial position of the organization. To calculate cost of each unit of product on the basis of which we can take accurate decisions.
Recording Estimation in recording of financial transactions is not used. It is based on actual transactions only. In cost accounting, we book actual transactions and compare it with the estimation. Hence costing is based on the estimation of cost as well as on the recording of actual transactions.
Controlling Correctness of transaction is important without taking care of cost control. Cost accounting done with the purpose of control over cost with the help of costing tools like standard costing and budgetary control.
Period Period of reporting of financial accounting is at the end of financial year. Reporting under cost accounting is done as per the requirement of management or as-and-when-required basis.
Reporting In financial accounting, costs are recorded broadly. In cost accounting, minute reporting of cost is done per-unit wise.
Fixation of Selling Price Fixation of selling price is not an objective of financial accounting. Cost accounting provides sufficient information, which is helpful in determining selling price.
Relative Efficiency Relative efficiency of workers, plant, and machinery cannot be determined under it. Valuable information about efficiency is provided by cost accountant.
Valuation of Inventory Valuation basis is ‘cost or market price whichever is less’ Cost accounting always considers the cost price of inventories.
Process Journal entries, ledger accounts, trial balance, and financial statements Cost of sale of product(s), addition of margin and determination of selling price of the product.
4. How can costs be classified? Explain in detail.
Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.
Classification of Costs :- An important step in computation and analysis of cost is the classification of costs into different types. Classification helps in better control of the costs and also helps considerably in decision making. Classification of costs can be made according to the following basis.
There are three broad elements of cost:-
(a) Material
(b) Labour
(c) Expenses
(a) Material: - The substance from which the product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.
Direct Material: - All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed as “Direct Material”.
Following are some of the examples of direct material:-
(i) All material or components specifically purchased produced or requisitioned from stores.
(ii) Primary packing material (e.g. – cartoon, wrapping, cardboard, boxes etc.)
(iii) Purchased or partly produced components.
Direct material is also described as raw-material, process material, prime material, production material, stores material, constructional material etc.
Indirect Material: - All material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as “Indirect Material”.
Consumable stores, oil and waste, printing and stationery etc. are a few examples of indirect material
Indirect material may be used in the factory the office or the selling and distribution division.
(b) Labour: - For conversion of materials into finished goods, human effort is needed such human effort is called labour. Labour can be direct as well as indirect.
Direct labour: - Labour which takes an active and direct part in the production of a particular commodity is called labour. Direct labour costs are, therefore specially and conveniently traceable to specific products.
Direct labour is also described as process labour, productive labour, operating labour, manufacturing labour, direct wages etc.
Indirect labour:- labour employed for the purpose of carrying out tasks incidental to goods or services provided, is indirect labour such labour does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output wages of store – keepers, foreman, time – keepers, directors, fees, salaries of salesmen, etc. are all examples of indirect labour costs.
Indirect labour may relate to the factory the office or the selling and distribution division.
(c) Expenses: - Expenses may be direct or indirect.
Direct expenses: - These are expenses which can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are: hire of some special machinery required for a particular contract, cost of defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as “chargeable expenses”.
Indirect expenses:- these are expenses which cannot be directly, conveniently and wholly allocated to cost centers or cost units.
OVERHEADS:- It is to be noted that the term overheads has a wider meaning than the term indirect expenses overheads include the cost of indirect material, indirect labour besides indirect expenses.
Indirect expenses may be classified under the following three categories:-
(a) Manufacturing (works, factory or production) expenses:-
Such indirect expenses which are incurred in the factory and concerned with the running of the factory or plant are known as manufacturing expenses. Expenses relating to production management and administration are included there in. Following are a few items of such expenses:
Rent, rates and insurance of factory premises, power used in factory building, plant and machinery etc.
(b) Office and Administrative expenses
These expenses are not related to factory but they pertain to the management and administration of business such expenses are incurred on the direction and control of an undertaking example are :- office rent, lighting and heating, postage and telegrams, telephones and other charges; depreciation of office building, furniture and equipment, bank charges, legal charges, audit fee etc.
(c) Selling and Distribution Expenses:-
Expenses incurred for marketing of a commodity, for securing orders for the articles, dispatching goods sold, and for making efforts to find and retain customers are called selling and distribution expenses examples are:-
Advertisement expenses cost of preparing tenders, traveling expenses, bad debts, collection charges etc.
Warehouse charges packing and loading charges, carriage outwards, etc.
The above classification of different elements of cost can be presented in the form of the following chart:
or
Items excluded from cost accounts
There are certain items which are included in financial accounts but not in cost accounts. These items fall into three categories:-
Appropriation of profits
(i) Appropriation to sinking funds.
(ii) Dividends paid
(iii) Taxes on income and profits
(iv) Transfers to general reserves
(v) Excess provision for depreciation of buildings, plant etc. and for bad debts
(vi) Amount written off – goodwill, preliminary expenses, underwriting commission, discount on debentures issued; expenses of capital issue etc.
(vii) Capital expenditures specifically charged to revenue
(viii) Charitable donation
Matters of pure finance
(a) Purely financial charges:-
(i) Losses on sale of investments, buildings, etc.
(ii) Expenses on transfer of company’s office
(iii) Interest on bank loan, debentures, mortgages, etc.
(iv) Damages payable
(v) Penalties and fines
(vi) Losses due to scrapping of machinery
(vii) Remuneration paid to the proprietor in excess of a fair reward for services rendered.
(b) Purely financial incomes:-
(i) Interest received on bank deposits
(ii) Profits made on the sale of investments, fixed assets, etc.
(iii) Transfer fees received
(iv) Rent receivable
(v) Interest, dividends, etc. received on investments.
(vi) Brokerage received
(vii) Discount, commission received
Abnormal gains and losses:-
(i) Losses or gains on sale of fixed assets.
(ii) Loss to business property on account of theft, fire or other natural calamities.
In addition to above abnormal items (gain and losses) may also be excluded from cost accounts. Alternatively, these may be taken to costing profit and loss account.
b. Classification according to behavior :- Costs can also be classified according to their behavior. This classification is explained below.
i. Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume. These costs are called as fixed costs. The feature of these costs is that the total costs remain same while per unit fixed cost is always variable. Examples of these costs are salaries, insurance, rent, etc.
ii. Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production. Their variability is in the same proportion to the production. For example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the production. Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct materials, direct labor etc.
iii. Semi-variable Costs :- Certain costs are partly fixed and partly variable. In other words, they contain the features of both types of costs. These costs are neither totally fixed nor totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’.
C Classification according to functions :- Costs can also be classified according to the functions/ activities. This classification can be done as mentioned below.
iv. Production Costs :- All costs incurred for production of goods are known as production costs.
v. Administrative Costs :- Costs incurred for administration are known as administrative costs. Examples of these costs are office salaries, printing and stationery, office telephone, office rent, office insurance etc.
vi. Selling and Distribution Costs :- All costs incurred for procuring an order are called as selling costs while all costs incurred for execution of order are distribution costs. Market research expenses, advertising, sales staff salary, sales promotion expenses are some of the examples of selling costs. Transportation expenses incurred on sales, warehouse rent etc are examples of distribution costs.
vii. Research and Development Costs :- In the modern days, research and development has become one of the important functions of a business organization. Expenditure incurred for this function can be classified as Research and Development Costs.
c. Classification according to time :- Costs can also be classified according to time. This classification is explained below.
I. Historical Costs :- These are the costs which are incurred in the past, i.e. in the past year, past month or even in the last week or yesterday. The historical costs are ascertained after the period is over. In other words it becomes a post-mortem analysis of what has happened in the past. Though historical costs have limited importance, still they can be used for estimating the trends of the future, i.e. they can be effectively used for predicting the future costs.
II. Predetermined Cost :- These costs relating to the product are computed in advance of production, on the basis of a specification of all the factors affecting cost and cost data. Pre determined costs may be either standard or estimated. Standard Cost is a predetermined calculation of how much cost should be under specific working conditions. It is based on technical studies regarding material, labor and expenses. The main purpose of standard cost is to have some kind of benchmark for comparing the actual performance with the standards. On the other hand, estimated costs are predetermined costs based on past performance and adjusted to the anticipated changes. It can be used in any business situation or decision making which does not require accurate cost.
D .Classification of costs for Management decision making :- One of the important function of cost accounting is to present information to the Management for the purpose of decision making. For decision making certain types of costs are relevant. Classification of costs based on the criteria of decision making can be done in the following manner
I. Marginal Cost :- Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit. For example, suppose a manufacturing company produces 10,000 units and the aggregate costs are Rs. 25,000, if 10,001 units are produced the aggregate costs may be Rs. 25,020 which means that the marginal cost is Rs. 20. Marginal cost is also termed as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost is always fixed. Marginal cost can be effectively used for decision making in various areas.
II. Differential Costs :- Differential costs are also known as incremental cost. This cost is the difference in total cost that will arise from the selection of one alternative to the other. In other words, it is an added cost of a change in the level of activity. This type of analysis is useful for taking various decisions like change in the level of activity, adding or dropping a product, change in product mix, make or buy decisions, accepting an export offer and so on.
III. Opportunity Costs :- It is the value of benefit sacrificed in favor of an alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable. Opportunity cost of goods or services is measured in terms of revenue which could have been earned by employing that goods or services in some other alternative uses.
IV. Relevant Cost :- The relevant cost is a cost which is relevant in various decisions of management. Decision making involves consideration of several alternative courses of action. In this process, whatever costs are relevant are to be taken into consideration. In other words, costs which are going to be affected matter the most and these costs are called as relevant costs. Relevant cost is a future cost which is different for different alternatives. It can also be defined as any cost which is affected by the decision on hand. Thus in decision making relevant costs play a vital role.
V. Replacement Cost :- This cost is the cost at which existing items of material or fixed assets can be replaced. Thus this is the cost of replacing existing assets at present or at a future date.
VI. Abnormal Costs :- It is an unusual or a typical cost whose occurrence is usually not regular and is unexpected. This cost arises due to some abnormal situation of production. Abnormal cost arises due to idle time, may be due to some unexpected heavy breakdown of machinery. They are not taken into consideration while computing cost of production or for decision making.Controllable Costs :- In cost accounting, cost control and cost reduction are extremely important. In fact, in the competitive environment, cost control and reduction are the key words. Hence it is essential to identify the controllable and uncontrollable costs. Controllable costs are those which can be controlled or influenced by a conscious management action. For example, costs like telephone, printing stationery etc can be controlled while costs like salaries etc cannot be controlled at least in the short run. Generally, direct costs are controllable while uncontrollable costs are beyond the control of an individual in a given period of time.
VII. Shutdown Cost :- These costs are the costs which are incurred if the operations are shut down and they will disappear if the operations are continued. Examples of these costs are costs of sheltering the plant and machinery and construction of sheds for storing exposed property. Computation of shutdown costs is extremely important for taking a decision of continuing or shutting down operations.
VIII. Capacity Cost :- These costs are normally fixed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions. Capacity costs include the costs of plant, machinery and building for production, warehouses and vehicles for distribution and key personnel for administration. These costs are in the nature of long-term costs and are incurred as a result of planning decisions.
IX. Urgent Costs :- These costs are those which must be incurred in order to continue operations of the firm. For example, cost of material and labor must be incurred if production is to take place.
5. What is meant by cost sheet? Explain the importance of Cost Sheet with format.
Cost sheet is a statement, which shows various components of total cost of a product. It classifies and analyses the components of cost of a product. Previous periods data is given in the cost sheet for comparative study. It is a statement which shows per unit cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost presented in the form of a statement is termed as Cost sheet. It analysis and classified the expense on different items for a particular period in a tabular form.Additional columns may also be provided to show the cost per unit pertaining to each item of expenditure and the total cost per unit.In other word cost sheet is a periodical document of cost sheet is show the total cost and unit of cost of products in an analytical and detailed form.
Cost sheet may be prepared weekly , monthly, quarterly ,half yearly or yearly basis according to convenience.Cost sheet is prepared on the basis of actual data or on the basis of estimated data depending on the technique of costing.
Definition Of cost Sheet : ICMA london “Cost Sheet is a document which provide for the assembly of estimated detailed cost in respect of cost center or a cost of unit.”
According to WW Bigg ” The expenditure which has been incurred upon production for a period is extracted for the financial books and the store record and set out in memorandum statement .If this statement is confined in the disclosure of the cost of the unit produced during the period it is termed a cost sheet.”
Cost sheet is prepared on the basis of
: 1. Historical Cost
2. Estimated Cost
Historical Cost Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost prepared after incurring the actual cost is called Historical Cost Sheet.
Estimated Cost Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting the tender price of a job or a contract.
It depicts the following facts
1. It gives total cost and cost per unit for a particular.
2. It shows various element of cost such as prime cost factory csot production cost ,cost of goods sold total cost etc.
3. It s clears the percentage of every expenditure to total cost.
4. it help to management to compare the cost of any two period and ascertain the inefficiencies if any in production.
5. It gives information to management for cost control
It calculate and summarize a total cost of product
The Components of cost are shown in the classified and analytical form in the cost sheet.
Components of total cost are as follows:
Prime Cost It consists of direct material, direct wages and direct expenses. In other words “Prime cost represents the aggregate of cost of material consumed, productive wages, and direct expenses”. It is also known as basic, first, flat or direct cost of a product.
Prime Cost = Direct material + Direct Wages + Direct expenses
Direct material means cost of raw material used or consumed in production. It is not necessary that all the material purchased in a particular period is used in production. There is some stock of raw material in balance at opening and closing of the period. Hence, it is necessary that the cost of opening and closing stock of material is adjusted in the material purchased. Opening stock of material is added and closing stock of raw material is deducted in the material purchased and we get material consumed or used in production of a product. It is calculated as :
Material Consumed = Material purchased + Opening stock of material – Closing stock of material.
Factory Cost
In addition to prime cost it includes works or factory overheads. Factory overheads consist of cost of indirect material, indirect wages, and indirect expenses incurred in the factory. Factory cost is also known as works cost, production or manufacturing cost.
Factory Cost = Prime cost + Factory overheads
Adjustment for stock of work-in-progress
In the process of production, some units remain to be completed at the end of a period. These incomplete units are known as work-in-progress. Normally, the cost of incomplete units include direct material, direct Labour, direct expenses, and average factory overheads. Hence, at the time of computing factory cost, it is necessary to make adjustment of opening and closing stock of work in progress to arrive at the net Factory cost/works cost.
TOTAL COST AND COST SHEET
If office and administrative overheads are added to factory or works cost, total cost of production is arrived at. Hence the total cost of production is calculated as:
Total Cost of production = Factory Cost + office and administration overheads
Cost of goods sold
It is not necessary, that all the goods produced in a period are sold in the same period. There is stock of finished goods in the opening and at the end of the period. The cost of opening stock of finished goods is added in the total cost of production in the current period and cost of closing stock of finished goods is deducted. The cost of goods sold is calculated as:
Cost of goods sold = Total cost of production + Opening stock of Finished goods – Closing stock of finished goods
Total Cost i.e, Cost of Sales
If selling and distribution overheads are added to the total cost of production, total cost is arrived at. This cost is also termed as cost of Sales. Hence the total cost is calculated as:
Total Cost = Cost of Goods sold + Selling and distribution overheads
Preparation of cost sheet
The various components of cost explained above are presented in the form of a statement. Such a statement of cost consists of prime cost, works cost, cost of production of goods, cost of goods sold, total cost and sales and is termed as cost sheet. The Preparation of a cost sheet can be understood with the help of following illustration:
From the following information, prepare a cost sheet for period ended on 31st March 2006. Rs. Opening stock of raw material 12,500 Purchases of raw material 1,36,000 Closing stock of raw material 8,500 Direct wages 54,000 Direct expenses 12,000 Factory overheads 100% of direct wages Office and administrative overheads 20% of works cost Selling and distribution overheads 26,000 Cost of opening stock of finished goods 12,000 Cost of Closing stock of finished goods 15,000 Profit on cost 20%
IMPORTANCE OF COST ACCOUNTING
1. Costing helps in periods of trade depression and trade competition:-
In periods of trade depression the business cannot afford to have leakages which pass unchecked. The management should know where economies may be sought, waste eliminated and efficiency increased. The business has to wage a wax for its survival. The management should know the actual cost of their products before embarking on any scheme of reducing the prices on giving tenders. Adequate costing facilitates this.
2. Aids in price fixation:-
Though economic law & supply and demand and activities of the competitors, to a great extent, determine the price of the article, cost to the producer does play an important part. The producer can take necessary guidance from his costing records.
3. Helps in estimate:-
Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of over – rating or losing in the execution of a contract due to under – rating can be minimized. Thus, “ascertained costs provide a measure for estimates, a guide to policy, and a control over current production”.
4. Helps in channeling production on right lines:-
Costing makes possible for the management to distinguish between profitable and non-profitable activities profit can be maximized by concentrating on profitable operations and eliminating non-profitable ones.
5. Wastages are eliminated:-
As it is possible to know the cost of the article at every stage, it becomes possible to chock various forms of waste, such as time, expenses etc. or in the use of machine, equipment and tools.
6. Costing makes comparison possible:-
If the costing records are regularly kept, comparative cost data for different periods and various volumes of production will be available. It will help the management in forming future lines of action.
7. Provides data for periodical profit and loss accounts:-
Adequate costing records supply to the management such data as may be necessary for preparation of profit and loss account and balance sheet, at such intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial accounts thus helps in presentation of better information before the management.
8. Aids in determining and enhancing efficiency:-
Losses due to wastage of material, idle time of workers, poor supervision etc., will be disclosed if the various operations involved in manufacturing a product are studied by a cost accountant. The efficiency can be measured and costs controlled and through it various devices can be framed to increase the efficiency.
9. Helps in inventory control:-
Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods. (This has been explained in detail under the chapter “Materials”)
10. Helps in cost reduction:-
Costs can be reduced in the long run when alternatives are tried. This is particularly important ion the present day context of global competition cost accounting has assumed special significance beyond cost control this way.
11. Assists in increasing productivity
Productivity of material and labour is required to be increased to have growth and more profitability in the organisation costing renders great assistance in measuring productivity and suggesting ways to improve it.
Q6 . What do you understand by term Overheads .Briefly classify and explain the Treatment of specific items of overheads in cost accounts?
Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not directly identifiable or allocable to a cost object in an economically feasible way. Overheads are the indirect costs that are incurred during the course of manufacturing an item, rendering a service or running a department but cannot be debited directly or wholly to an item, services or departments. Suppose an organization produces three products: A, B and C. Material, labour and other direct expenses which an organization used for each product individually are the direct costs. Besides these, there are other expenses like rent, helper wages, salaries of office staff, rent of showroom; salaries of salesman etc. which are incurred for the benefit of the organization as a whole but cannot be charged separately for each product are overheads. Overheads are to be classified on the basis of functions to which the overheads are related, viz - Production overheads - Administrative overheads - Selling overheads - Distribution overheads Overheads may also be classified on the basis of behaviour such as variable overheads, semi-variable overheads and fixed overheads. Thus, overheads is the sum total of indirect material, indirect labour and indirect expenses.
Overhead appear at all levels of the Income statement
Expenses that qualify as overhead can appear under all major expense categories on the Income statement. And, not all overhead expenses on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.
The overhead role in costing, pricing, budgeting, and product management
Companies that sell products or services must know their per-unit product costs. This information is important when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.
In most cases analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.
The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.
Overhead plays an important role in competitive strategy
Business firms set overhead objectives when planning their own cost structures. This is because overhead targets are in fact a key component of the firm's high level business strategy .
In competitive industries, business firms rightly call the top-level business strategy acompetitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.
Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors, while charging the same prices as the competition.
Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. This is possible because low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.
Overheads can be classified as follows:
Function wise:
1) Factory/Manufacturing overheads – Factory overheads are the expenses that are common to all the products produced within the factory. It is that part of the product which is invisible. E.g. adhesive in the furniture, glue in the book binding etc.
2) Office and Administration overheads – Office and Administration overheads are the expenses that are incurred for carrying on the general office activities of the enterprise which includes policy formulation, controlling and maintenance of accounts. Example of office administration can be printing charges, postage and stationary used in administration department, director’s fees, insurance of office building, office staff salaries etc.
3) Selling and Distribution overheads – Selling overheads are those expenses which a company incurs on marketing activities in order to stimulate the demand for goods or services and to secure the orders. E.g. Sales manager’s salary, sales’ director’s salary, printing and stationary cost used in sales department. Distribution overheads are the costs which are incurred to move a product from the producer or manufacturer to the consumer. E.g. Delivery expenses, carriage outward, godown charges, packaging charges, insurance of delivery vans etc.
Variability Wise:
i. Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume. These costs are called as fixed costs. The feature of these costs is that the total costs remain same while per unit fixed cost is always variable. Examples of these costs are salaries, insurance, rent, etc.
ii. Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production. Their variability is in the same proportion to the production. For example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the production. Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct materials, direct labor etc.
iii. Semi-variable Costs :- Certain costs are partly fixed and partly variable. In other words, they contain the features of both types of costs. These costs are neither totally fixed nor totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’.
Nature wise:
a. Indirect material – Those materials which are used in manufacturing a product but cannot be recognized and directly charged to a specific department are called indirect materials. E.g. oil, rags, cons. stores etc.
b. Indirect labour – The labour that is not directly involved in producing a product but helps those labours who are engaged in manufacturing a product is known as indirect labour. E.g. Supervisor, foreman, watchman etc.
c. Indirect expenses – Those expenses which are not incurred for a specific product and cannot be charged directly to cost centers are known as indirect expenses. E.g. rent of building, repairs etc.
Control wise:
a. Controllable overheads – Those overheads which can be controlled by the action of the management are known as controllable overheads. E.g. direct material, direct labour etc.
b. Uncontrollable overheads – Those overheads which cannot be controlled by the action of the management are known as uncontrollable overheads. E.g., Rent, Insurance, Salary etc.
Treatment of Special Items of Overheads in Cost Accounts
Material Handling Expenses:
These expenses are incurred while unloading the raw materials received from supplier, storing the raw materials, handling the raw materials to work place, handling of work-in-progress, storage of finished goods etc. It also includes costs incurred for weighing salaries of personnel involved in material handling, wear and tear of weighing equipment.
These costs are apportioned on the basis of physical quantities of different materials and goods handled in the factory. The stores overhead costs are apportioned to raw materials and finished goods as a percentage of issue rates. Other handling expenses are recovered through overhead recovery rates.
Market Research Expenses:
Market research cost is an item of selling overhead, incurred for market intelligence to ascertain the tastes and habits, market penetration of product, increase in demand of existing products, competitive situation, trading practices, distribution channels, customers requirements, existing and potential market for the product etc.
If the market research expenses are incurred for a single product it is absorbed into that particular product cost. If it is incurred for the product range for the enterprise as a whole, then the market research expenses are to be apportioned to different products in the proportion of sales value and absorbed into respective product cost.
If the market research cost is substantial, it will be treated as deferred revenue expense and is taken into future period and absorbed when sales or production takes place. Sometimes market research expenses are incurred for raw material availability, such expenses will be allocated or apportioned to purchase department and it is recovered through overhead rate of purchase department.
Subscriptions and Donations:
The treatment suggested for subscriptions and donation in Cost Accounts as follows:
a) If these expenses are incurred for the benefit of or welfare of workers, it is treated as Production Overhead.
b) If subscriptions and donations for any technical and research institutions for obtaining data relating to technical, production or scientific nature, it is considered as Production Overhead.
c) If subscriptions to journals etc. for obtaining market data which help in increase of sales, it is considered as Selling Overhead.
d) If the subscriptions and donations not incurred for the benefit of employees or the organization, it should be excluded from the Cost Accounts.
After Sales Service Costs:
The costs are incurred for providing service to the customers after the sales took place during the warranty period. If the costs are incurred during the period of guarantee given to the customer, it is to be borne by the company, and hence it is treated as production overhead absorbed into product cost by applying predetermined absorption rates. If the after sales services costs are incurred after the guarantee period for which the organization will charge for the services rendered, then such costs are treated as Selling Overhead.
Royalties and Patent Fees:
The royalties and patent fees are payable for the use of technology, skill, brand, intellectual property rights etc. made in the form of periodical rent or based on the number of units produced or sold.
If it is based on sales, the expenditure is charged to Selling Overhead. If it is a fixed periodical rent, it is treated as Production Overhead. If it is payable on number of units produced, the expenditure is treated as a direct expense or chargeable expense and is forming part of the cost of the product.
Training Costs:
The training costs are incurred for training the workers, apprentices, office, administrative and selling staff. The training expenditure incurred for training the workers, apprentices and other production staff is treated as Production Overhead. If it is incurred for training the office and administrative staff, it is considered as Administration Overhead.
The expenses incurred for training the sales staff is treated as Selling Overhead. If there is any in-house training college or centre is giving training, cost of running the centre or college is apportioned to the cost centres based on the number of personnel trained or on the basis of wages and salaries paid etc.
Taxation:
Taxation is an appropriation of profit earned by the organization and any payment of taxes is excluded from the Cost Accounts. But the taxes will also be considered for planning and decision making exercises wherever it is necessary and appropriate for special purposes.
Financing Charges:
The finance charges like interest on working capital facilities from banks, interest on term loan for acquisition of fixed assets, interest on debentures etc. is payable by the company. Where financing charges are payable to outsiders on borrowings for acquisition of fixed assets, these charges are included in cost of Fixed Assets.
If the financing charges are payable for financing working capital, then these charges are included in Cost of Inventories. Interest on capital provided by the owners is excluded from Cost Accounts except for comparing or evaluating profitability of alternative investments. If the charges are payable for storing the materials like timber, wine etc. the charges are included in the cost of materials stored.
Major Repairs to Equipment:
The major repairs, if it prolong the useful life of an asset, the costs incurred on it is to be added to the existing value of assets and periodical depreciation is charged on the overall cost of the asset.
If the repair charges are incurred for upkeep and maintenance of the machinery and if it does not prolong the life of the asset, these expenses are treated as Production Overhead and is charged to the respective cost centre as repairs and maintenance and recovered from the current period production. If the amount incurred is substantial, it is treated as deferred revenue expenditure carried forward to the subsequent accounting periods for write off.
Cost of Tools:
Tools are classified into:
(a) Large tools, and
(b) Small tools.
The cost of large tools are capitalised like any other machine and depreciation is provided on it each accounting period over its useful economic life.
The cost of small tools are treated in any of the following three methods in Cost Accounts:
i. Capitalization Method:
Under this method, the cost of small tools is capitalised and depreciation is recovered as Production Overhead. If the life of small tools is relatively small, this method is not suitable.
ii. Revaluation Method:
Under this method, the small tools are revalued at the end of each accounting year and the difference between original cost and the revalued cost is charged as Production Overhead.
iii. Write off Method:
Under this method, the cost centre drawing such tools is debited with the value thereof. Alternatively, the total cost of tools is accumulated and apportioned to various cost centres on suitable basis.
Bad Debts:
When the company allow credit to its customers as part of its selling policy, some credit sales may turn bad due to default by the customers intentionally or otherwise. As a safeguard, a part of such default amount is treated as bad debt is recovered as selling overhead and absorbed into product cost. If the bad debt is abnormal in nature, the abnormal portion in excess of the standard normal portion should be excluded from cost accounts and transferred to Costing Profit & Loss Account.
Notional Rent:
Notional rent is a cost included in the Cost Accounts so as to represent a benefit enjoyed by the organization even though no actual cost is incurred for rent. The company owns premises does not pay rent, but it is considered as notional charge in the Cost Accounts for comparability of cost with different accounting periods and with other organizations. This would reflect the accurate cost of cost centre or cost unit. It is a reasonable or nominal charge included in the Cost Accounts for the owned premises as if it is a rented premises.
Packing Expenses:
The packing is classified into:
(i) Primary packing, and
(ii) Secondary packing.
The ‘primary packing’ is done when the material is packed in tins, bottles, jars, etc., without which a product cannot be sold. For example, jam is packed in bottles, baby food packed in tins, beverages in bottles etc. The costs incurred on primary packing material are treated as part of direct material cost.
If the packing is made to facilitate the transportation and distribution of the finished product, it is called ‘ secondary packing’ and the cost incurred for this is treated as Distribution Overhead. Sometimes, cost is incurred on packing the product to make it more attractive to the customers to increase sales. This cost is treated as advertisement cost and is included in Selling Overhead.
Data Processing Cost:
In the environment of processing information with the help of computers, the data processing cost represents the cost incurred for processing data relating to accounts, secretarial, personnel, finance, marketing, sales etc. This may be done either utilizing in house facilities or hiring outside facilities.
The cost incurred is accumulated for separate service centre if in-house facilities are made available. Where the costs of data processing centre or hiring charges are identifiable to a particular department or activity it should be charged with its portion of cost. In case of common costs incurred for service of all departments, the data processing cost should be apportioned to different departments on equitable basis.
Stores Overhead:
The stores department in an organization perform the function like receipt of material and stores items purchased, storing and issue of materials and stores items to different departments.
The stores is considered as a separate cost centre and the stores expenditure like rent of store, salaries and wages of stores personnel, freight, carriage inwards, insurance etc. are collected separately for the stores and will be apportioned to other cost centres.
The following bases are used in apportionment of stores overhead:
(a) Number of stores requisitions,
(b) Value of material requisitioned, and
(c) Standard predetermined stores overhead absorption rate.
Erection and Dismantling of Plant and Machinery:
The costs incurred on erection and dismantling of plant and machinery are treated in cost accounts as follows:
(a) The costs incurred on erection of plant and machinery is capitalised and treated forming part of capital cost and depreciation is recovered on the total cost
(b) If the plant and machinery is required to be shifted to different locations, the costs incurred in layout and shifting is treated as production overhead. When such costs are substantial, it may spread over a period of time as deferred revenue expenditure.
(c) If the asset is replaced, before its useful economic life, with a new machine, the written down value of the asset less the scrap value plus the cost on dismantling is treated as capital loss and charged to profit and loss account. However, the erection cost of new machine is capitalised.
(d) If expenses of dismantling and re-erection are incurred due to faulty planning or due to abnormal factors, then such expenses are charged to Costing Profit and Loss Account.
Transport Cost:
The classification of transport costs and their treatment in cost accounts is given below:
(a) The costs incurred to bring the materials to the production site is included in cost of materials.
(b) The costs incurred for bringing the plant and machinery, equipment etc. is added to the capital cost of respective asset and depreciation is recovered.
(c) The cost of dispatch of finished goods is treated as distribution overhead.
(d) The costs incurred for internal movements within work are initially charged to specific cost centres and thereafter apportioned to different production and service centres on the basis of services rendered.
Insurance Cost:
The treatment of insurance cost is categorized into the following:
(a) Insurance premium on storage-cum-erection and commissioning is capitalised to the asset value.
(b) Premium on transit of materials is included in cost of materials.
(c) Premium on transit of finished products is treated as distribution overhead.
(d) Premium on fire and breakdown of machinery policy is treated as production overhead.
(e) Premium on loss of profit policy due to fire and breakdown of machinery is treated as production overhead.
(f) Premium on miscellaneous policies like vehicles, burglary, accident etc. are treated as administration overhead.
(g) Premium on raw materials and stores is treated as production overhead.
(h) Premium on warehouse and finished stock is treated as distribution overhead.
Q7.What do you understand by term Overheads? What are stages and methods involved in distribution of overheads methods of absorption of overheads ? Explain treatment of under and over absorption of overheads
Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not directly identifiable or allocable to a cost object in an economically feasible way. Overheads are the indirect costs that are incurred during the course of manufacturing an item, rendering a service or running a department but cannot be debited directly or wholly to an item, services or departments. Suppose an organization produces three products: A, B and C. Material, labour and other direct expenses which an organization used for each product individually are the direct costs. Besides these, there are other expenses like rent, helper wages, salaries of office staff, rent of showroom; salaries of salesman etc. which are incurred for the benefit of the organization as a whole but cannot be charged separately for each product are overheads. Overheads are to be classified on the basis of functions to which the overheads are related, viz - Production overheads - Administrative overheads - Selling overheads - Distribution overheads Overheads may also be classified on the basis of behaviour such as variable overheads, semi-variable overheads and fixed overheads. Thus, overheads is the sum total of indirect material, indirect labour and indirect expenses.
Overhead appear at all levels of the Income statement
Expenses that qualify as overhead can appear under all major expense categories on the Income statement. And, not all overhead expenses on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.
The overhead role in costing, pricing, budgeting, and product management
Companies that sell products or services must know their per-unit product costs. This information is important when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.
In most cases analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.
The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.
Overhead plays an important role in competitive strategy
Business firms set overhead objectives when planning their own cost structures. This is because overhead targets are in fact a key component of the firm's high level business strategy .
In competitive industries, business firms rightly call the top-level business strategy acompetitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.
Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors, while charging the same prices as the competition.
Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. This is possible because low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.
There are three stages in the absorption of overheads which are discussed in detail below:
Stage I: Allocation and Apportionment of Overhead:
The first stage in the absorption of overhead costs is to identify and collect overhead costs for different production and cost centres. The first stage is known as ‘primary distribution.’
Primary Distribution:
Some overhead costs can be directly identified with a particular department or cost centre as having been incurred for that cost centre. These items of overhead cannot be traced to products or jobs but can be allocated specifically to departments. Examples of such overhead costs are repairs and maintenance expenses incurred in specific departments, supervision, indirect labour, overtime, indirect materials and factory supplies, equipment depreciation.
Expenses, such as power, light, rent, depreciation of factory building, expenses shared by all departments, cannot be charged directly to a department, be it production or service. They are incurred for all and must, therefore, be apportioned or prorated to any or all departments using such items. Cost apportionment is the process of charging expenses in an equitable proportion to the vari¬ous cost centres or departments.
The Institute of Cost and Management Accountant (U.K.) defines cost apportionment “as the allotment of proportions of items of cost to cost centres or cost units”. The apportionment should be done on some rational and equitable bases. In cost accounting this is known as primary distribution of overhead.
It would be difficult to give a comprehensive list of the bases of apportionment, but the following bases are in common use:
1. Floor Area Occupied:
Overheads such as lighting and heating, rent and rates, depreciation on building, building repairs, caretaking, watching and patrolling.
2. Capital Values:
Depreciation on plant and machinery, insurance on building, and plant and machinery, maintenance of plant and machinery.
3. Direct Labour Hours And /Or Machine Hours:
Insurance on Jigs, tools and fixtures, power, works management remuneration, repairs and maintenance cost.
4. Number of Workers Employed:
Canteen, accident insurance, medical, dental and first aid, pensions, personnel department expenses, profit sharing payments, recreation, supervision, time office, wages department.
5. Technical Estimate:
Fire prevention, oil and grease, steam, water without meter.
Example:
The Modern Company has four departments. A, B and C are the production departments and D is a servicing department.
The actual costs for a periods are as follows:
Stage II: Apportionment of Service Departments Overhead to Producing Departments:
In stage II, overhead costs of service departments are apportioned to production departments. Such apportionment is termed as ‘Secondary Distribution’.
Secondary Distribution:
The primary distribution of factory overhead apportions all overhead costs to the different departments or cost centres — production and service departments. It is necessary that overhead costs of service departments (accumulated through direct allocation or primary distribution) should be further assigned to producing departments.
This is due to the reason that service departments do not themselves manufacture anything and it is the production departments or cost centres which are involved in manufacturing activities. The reassignment or reapportionment of service departments overhead to producing departments or centres is termed as secondary distribution.
Secondary distribution is useful in the following matter:
1. It helps in determining the cost of products or jobs sold and inventory figures.
2. It helps in determining the effect of various managerial decisions and actions on the total cost of the business firm. For example, decisions as to add or to drop a product line require information about its cost effect which can be estimated after secondary distribution has been made.
3. It helps subsequently in determining the price of the product or job. In case of contracts based on cost in place of market price, secondary distribution helps in fixing a selling price which is advantageous to the parties concerned.
4. It promotes motivation among employees of the producing departments to take up service department activities.
Bases for Secondary Distribution:
It is difficult to suggest a sample list of service departments and equitable bases of distribution of overhead costs. The objective is to find the allocation base that best measures the causal or beneficial relationship between the department whose costs are being apportioned and the departments receiving the service.
The general basis for apportioning service department overheads to producing department are the following:
1. Service Rendered (Benefits Obtained):
This is perhaps the most popular method of apportioning service department costs. The service rendered to different departments, i.e., benefits obtained by them can be a suitable basis.
2. Ability to Pay:
This method suggests that a large share of servicing department’s overhead costs should be assigned to those producing departments whose product contributes the most to the income of a business enterprise. However, it is difficult to measure the ability to pay of different departments and also this method is not based on equity.
3. Survey or Analysis:
This method is applied where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.
4. Efficiency or Incentives:
This method uses standards and budgets and apportions the over¬head costs on the basis of a present budget or standard. Sometimes this method is used along with the bases of services rendered or ability to pay method.
In selecting a suitable base for apportioning service department overheads, consideration should be given to practicability, simplicity, economy, theoretical soundness and assistance in accurate costing and cost control. If a service department overhead is allocated on the basis over which the production manager has no control, the prorated cost may result in an inappropriate charge to the producing department.
The following list gives a few service departments and bases commonly used to apportion the respective overhead costs:
Stage III: Absorption of Overhead Costs:
After all service departments overhead costs have been apportioned to producing departments, the next step is to spread factory overhead to different products or jobs produced. This is termed as “Overhead absorption” in cost accounting. The Institute of Cost and Management Accounts (U.K.) define overhead absorption as “the allotment of overhead to cost units.” Known by different names, such as recovery, overhead application, overhead costing, levy, burden rate, etc. the term “absorption” implies that expenses pertaining to a producing department or cost centre are finally charged to or absorbed in the cost of products, jobs, etc. passing through it. As a result of absorption, the cost of each unit of product of the producing department includes an equitable share of the total overhead of that department.
Over / Under absorption of overhead
The overheads are absorbed on the basis of predetermined overhead absorption rate according to the actual production of goods throughout the accounting period or specific period. Budgeted overheads and budgeted output are used to determine overhead rate. If budgeted overhead and budgeted output differ from actual overhead and actual output, three is a difference between predetermined overhead rate and actual overhead rate.
If the overheads absorbed are higher than the actual overheads incurred, it is called over absorption. If the overhead absorbed is lower than the actual overheads incurred during the accounting period, it is called under absorption.
Reasons for Over or Under absorption of overhead
The reasons for over or under absorption of overheads are as follows.
1. The actual hours worked is more or less than the budgeted hours.
2. The actual overhead costs are different from budgeted overheads.
3. Both actual overhead costs and actual activity level are different from the budgeted costs and level.
4. The method of overhead absorption may be wrong.
5. Unexpected expenses may be incurred during the accounting period.
6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.
7. Major changes like replacement of manual labour with machines. This leads to increase in capacity levels.
8. Seasonal fluctuations in the overhead expenses from period to period.
Treatment of Over or Under absorbed overhead
The over or under absorbed overheads are treated in the cost accounts in any one of the following ways.
1. Application of Supplementary Rates
The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base. In case of over absorption, the over recovered amount will be adjusted by applying the supplementary rate and vice versa.
2. Adjustment to Cost of Sales
The over absorbed or under absorbed overheads is closed and transfers the same to the cost of sale account. This is done by the Cost Accountant at the end of every month or at the end of accounting period. If the transfer is made at the end of the accounting period, the over/under-absorbed overhead is carried forward from month to month treating it as deferred income if over applied and as deferred charges, if under applied.
3. Write off to Costing Profit and Loss Account
If the over or under absorbed overhead is small, and then it will be written off by transferring it to the costing profit and loss account. If so, the valuation of closing stock is over stated or under stated.
4. Adjusted to Gross Profit
The under or over absorbed overhead balances are closed by making the adjustment in gross profit.
5. Carry Forward to Subsequent Year
The under or over absorbed overhead may be carried forward to the subsequent accounting year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account. This Overhead Suspense Account or Overhead Reserve Account will appear in the Balance Sheet.
The debit and credit balances representing under/over absorbed overhead showing in the asset side or liabilities side of the Balance Sheet. The basic idea is to off set the under absorbed overhead in one year with over absorbed overhead in another year. But, many accountants oppose this idea. The reason is that balances of under/over-absorbed overhead should not be carried forward from one year to another year. This method is otherwise called as use of reserve account.
Marginal Costing
Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.
Marginal costing - definition
Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as:
‘the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making’. (Terminology.)
The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
CONTRIBUTION = SALES - MARGINAL COST
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.
Note
Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.
Theory of Marginal Costing
The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA, London is as follows:
In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in the following two steps:
1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of 3,000 and if by increasing the output by one unit the cost goes up to 3,002, the marginal cost of additional output will be 2.
2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is 1,045, the average marginal cost per unit is 2.25. It can be described as follows:
Additional cost =
Additional units 45 = 2.25
20
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.
Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods.
For example, if a manufacturing firm produces X unit at a cost of 300 and X+1 units at a cost of 320, the cost of an additional unit will be 20 which is marginal cost. Similarly if the production of X-1 units comes down to 280, the cost of marginal unit will be 20 (300–280).
The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point.
The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
The principles of marginal costing
The principles of marginal costing are as follows.
a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service the following will happen.
§ Revenue will increase by the sales value of the item sold.
§ Costs will increase by the variable cost per unit.
§ Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
Features of Marginal Costing
The main features of marginal costing are as follows:
1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
Advantages and Disadvantages of Marginal Costing Technique
Advantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.
Presentation of Cost Data under Marginal Costing and Absorption Costing
Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.
The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.
Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Marginal Cost Equations and Breakeven Analysis
From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal cost equation as follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,
P/V Ratio (or C/S Ratio) = Contribution (c) ......(4)
Sales (s)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)
Or, Sales = Contribution/ P/V ratio .....(6)
The above-mentioned marginal cost equations can be applied to the following heads:1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:
• Selecting product mix or sales mix for profit maximization
• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V ratio = Sales – Marginal cost of sales = Contribution =Changes in contribution = (Change in profit/Canges in sales)*100
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:
• Breakeven point
• Profit at any volume of sales
• Sales volume required to earn a desired quantum of profit
• Profitability of products
• Processes or departments
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
• Increasing selling price
• Reducing marginal costs by effectively utilizing men, machines, materials and other services
• Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.
a. Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following equation:
S BEP = F.S/S-V
b. Using P/V Ratio
Sales S BEP = Contribution at BEP = Fixed cost
P/ V ratio P/ V ratio
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:
Breakeven point = 400 x 2000 = 1000
2000 - 1200
Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%
800
= 400 / .4 = $. 1000
c. Using Contribution per unit
Breakeven point = Fixed cost = 100 units or 1000
Contribution per unit
4. Margin of Safety (MOS)
Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activity
P/V ratio
Margin of safety is also presented in ratio or percentage as follows: Margin of safety (sales) x 100 %
Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output
e. Modernization of production facilities and the introduction of the most cost effective technology
Problem 1A company earned a profit of 30,000 during the year 2000-01. Marginal cost and selling price of a product are 8 and 10 per unit respectively. Find out the margin of safety.
Solution
Margin of safety = Profit/ P/V ratio
P/V ratio = (Contribution/Sales) x 100
Breakeven Analysis-- Graphical Presentation
Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.
Construction of a Breakeven Chart
The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.
Uses of Breakeven ChartA breakeven chart can be used to show the effect of changes in any of the following profit factors:
• Volume of sales
• Variable expenses
• Fixed expenses
• Selling price
ProblemA company produces a single article and sells it at 10 each. The marginal cost of production is 6 each and total fixed cost of the concern is 400 per annum.
Construct a breakeven chart and show the following:
• Breakeven point
• Margin of safety at sale of 1,500
• Angle of incidence
• Increase in selling price if breakeven point is reduced to 80 units
Solution
A breakeven chart can be prepared by obtaining the information at these levels:
Output units 40 80 120 200
Sales .
400 800 1,200 2,000
Fixed cost 400 400 400 400
Variable cost 240 480 400 720
Total cost 640 880 1,120 1,600
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and angle of incidence.
a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of 1,000 or 100 units.
b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of (1,500 - 1,000), i.e. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.
d. At 80 units, total cost (from the table) = 880. Hence, selling price for breakeven at 80 units = 880/80 = 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of 10 per unit.
Limitations and Uses of Breakeven Charts
A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.
Multiple Product Situations
In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs
________________________________________
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:
B.E. point (in revenue) = Fixed cost
_______________________________________
Weighted average P/V ratio
Budget
Budget:
A plan which for a definite period, covers, all phases of operations in the future is known as a business budget. Policies, plans, objectives & goals are formally expressed by it & are laid down in advance for the concern as a whole & for each of its sub-divisions by the top management. Thus an overall budget will be there for the concern comprosed of several sub-budgets which are in the form of departmental budgets. Expense limitations are expressed by the budget in the expense budgets & in the sales budget, revenue goals are expressed & for the purpose of realizing the desired profit objective, these must be attained. Besides, plans relating to items such as levels of inventory, additions to capital assets, plans of production, plans of purchasing, requirements of labour, requirements of cash etc. are expressed by the budget. Thus, for a given period, budget is a formal management plans’ & policies’ statement which can be used in that period as a guide or blue print.
The basic elements of a budget are:
• (a) For a specified period of time, it’s a future plan of activity,
(b) Budget can be expressed in monetary or physical units or in both,
(c) Before the period during which the budget is supposed to operate, it is prepared i.e. it is prepared in advance.
(d) Before the preparation of the budget, it is necessary to lay down the objectives which are required to be attained & the policies which are required to be pursued for the achievement of those objectives.
Budgetary Control:
Throughout the budget period, the use of budgets & budgetary reports for the purpose of coordinating, evaluating & controlling day-to-day operations according to the goals which are specified by the budget is involved by budgetary control. The mere presentation of budget doesn’t have much value, its real value lies in the aspects of the planning & its utilization during the period for the purposes of control & coordination. Under budgetary control, actual results are constantly checked & evaluated & comparison of actual result is made with the budgeted goals & wherever indicated, corrective action should be undertaken. The following steps are involved in the process of budgetary control:
• (a) The objectives which are required to be achieved by the business should be defined & specified by budgetary control.
(b) For the purpose of ensuring that the desired objectives are accomplished, business plans are needed to be prepared by budgetary control.
(c) Budgetary control translates the plans into budgets & relates to particular sections of the budget, the responsibilities of individual executives & managers.
(d) Budgetary control constantly compares the actual results with the budget & the differences between the actual & budgeted performance are calculated.
(e) For the purpose of establishing the causes, the major differences are investigated by budgetary control.
(f) In a suitable form, budgetary control presents the information to the management, relating to variances to individual responsibility.
(g) In order to avoid a repetition of any over-expenditure or wastage, management takes corrective actions. Alternatively, where due to the change in circumstances, the budgeted targets cannot be achieved, the budget is revised.
Difference between Budget, Budgeting & Budgetary control:
Individual objectives of a department etc. are indicated by budget, whereas the act of setting the budgets is known as budgeting. All are embraced by budgetary control & also the science of planning the budgets themselves & as an overall management tool, the utilization of such budgets, for the purpose of business planning & control are included in budgetary control. Thus, the term by budgetary control is wider in meaning & both budget & budgeting are included in by budgetary control.
Objectives of Budgetary Control:
The objectives of budgetary control are:
• (1)Compel for planning: As management is forced to look ahead, responsible for setting of targets, anticipating of problems & giving purpose & direction to the organization, this feature is the most important feature of budgetary control.
(2)Communication of ideas & plans: Communication of ideas & plans to everyone 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 there is a formal system.
(3)Coordinating the activities: The budgetary control coordinates the activities of different departments or sub-units of the organization. The coordination concept implies, for example, on production requirements, the purchasing department should base its budget & similarly, on sales expectations, the production budget should in turn be4 based.
(4) Establishing a system of control: A system of control can be established by having a plan against which progressive comparison can be made of actual results.
(5) Motivating employees: Employees are motivated for improving their performances by budgetary control.
Requisites of an effective system of budgetary control:
(a) There should be a clearly defined organizational structure where are area of responsibility is emphasized.
(b) Within the budgeting process, the employees should participate.
(c) For the purpose of relying the measurement of performance, there should be adequate accounting records & procedures.
(d) Budgetary control needs to be flexible, so that the plans & objectives may be revised.
(e) An awareness of the uses of the budgetary control system should be spread by the management.
(f) An awareness regarding the problems of budgetary control & especially the individual’s reactions to budgets should be spread by the top management.
Advantages of Budgetary control:
The advantages of budgetary control system are as follows:
• (1) The objectives of the organization as a whole & the results which should be achieved by each department within this overall framework are defined by the budgetary control.
(2) When there is a difference between actual results & budget, then the extent by which actual results have exceeded or fallen short of the budget is revealed by the budgetary control.
(3) The variances or other measures of performance along with the reasons of difference between the actual results with those from budgeted is indicated by the budgetary control. Also, the magnitude of differences is established by it.
(4) As the budgetary control reports on actual performance along with variances & other measures of performance; for correcting adverse trends, a basis for guiding executive action is provided by it.
(5) A basis by which future budget can be prepared or the current budget can be revised is provided by the budgetary control.
(6) A system whereby in the most efficient way possible the resources of the organization are being used is provided by the budgetary control.
(7) The budgetary control indicates how efficiently the various departments of the organization are being coordinated.
(8) Situations where activities & responsibilities are decentralized, some centralizing control is provided by the budgetary control.
(9) The budgetary control provides means by which the activities of the organization can be stabilized, where the organization’s activities are subject to seasonal variations.
(10) By regularly examining the departmental results, a basis for internal audit is established by the budgetary control.
(11) The standard costs which are to be used are provided by it.
(12) For the purpose of paying a bonus to employees, a basis by which the productive efficiency can be measured is provided by the budgetary control.
Limitations of Budgetary Control:
The main limitations of budgetary control are:
(1) It used the estimates as a basis for the budget plan.
(2) In order to fit with the changing circumstances the budgetary programme must be continually adapted. Normally for attaining a reasonably good budgetary programme, it takes several years.
(3) A budget plan cannot be executed automatically. Enthusiastic participation is required by all levels of management in the programme.
(4) The necessity of having a management & administration will not be eliminated by any budgetary control system. The place of the management is not taken by it; rather it is a tool of the management.
Steps In Preparing A Budget
Steps in Preparing Budgets
The following steps are involved in the preparation of a budget:
1. Budget centers are needed to be established.
2. A clearly defined organizational chart is required to be prepared which will state, for each member of the management team, the functional responsibilities.
3. A budget manual is needed to be prepared.
4. A budget committee is required to be formed.
5. The limiting factor or key factor is needed to be determined.
6. The budget period is to be selected.
7. Objectives which are to be reached by the end of the period of the budget are to be set.
8. Forecast for the period is needed to be prepared.
9. The policies of the enterprise e.g. range of product, distribution channels, per week normal hours of work, appropriation of research & development, stocks, investments etc. are needed to be determined.
10. The requirements in terms of economic quantities which are needed to meet the objectives while complying with the policies are required to be computed from the forecasts & subsequently these quantities are to be converted into monetary values. Thus this will result in an initial provisional budget.
11. With respect to the planned budget, initial budget is to be reviewed & until an acceptable budget emerges, the objectives or policies or both needs to be reviewed repeatedly.
12. The budget when gets formally accepted becomes the master budget & as such is an executive order.
Budget Centre:
Budget center is that section or department of the organization which for the purposes of budgetary control, is identified & separated from the rest of the sections or departments of the organization. The departmental heads works like responsibility centers. There should be a separate budget for each budget centre & also independent comparison should be made with actual.
Budget Manual:
A budget manual is usually prepared for assisting everyone who is engaged in budgeting & budget administration. The procedures which are to be followed, the forms which are to be used & the responsibilities of various persons & the part that should be played by them in the budgeting process are specified by a budget manual.
A budget manual is very helpful because a reference source which the persons who are involved in budgeting & budgetary control may need is provided by it.
But there could be a radical difference between the current procedures & the written instruction in the manual; this is the danger of a budget manual.
Hence, preparation of budget manual should be in loose leaf form so that the amendments can be made easily for keeping the manual up-to-date.
Budget Committee:
In a large concern a frequent establishment of budget committee is needed. It is a useful device which coordinates & reviews the budget programme. The heads of the various departments or other high level executives should constitute the budget committee. It is generally advisory in nature.
The main functions of the budget committee are:
1. formulation of guidelines so that the budgets can be prepared;
2. receiving & reviewing of all the budgets;
3. suggesting of amendments & revisions;
4. approving of original, revised or amended budgets;
5. recommendation of actions which are needed to taken for the improvement of the effectiveness;
6. coordinating all the activities which are related to budgeting.
Limiting Factor:
In each organization, some factor by which scale of its activity are being governed is always there. Such a factor is called the ‘limiting factor’, ‘key factor’ or ‘principal budget factor’. Some examples of limiting factors are below:
1. capacity of production;
2. skilled labor’s shortage;
3. material’s shortage;
4. space’s shortage;
5. low demand for market;
6. lack of capital.
Always one factor, with this type of nature will be more dominant than the other factors but for each budget period that factor does not remain constant. However, once removal has been made of the factor which imposes limitation, that place is taken by another factor which then becomes the limiting factor.
When the budget is being prepared, the limiting factor is one of vital importance. Generally, demand for the products & that of production capacity are the two most important factors.
If producing 10000 units is the capacity of the production department but there is sales potential for 20000 units, then in that case excess sales potential is not of much consequence. Similarly, if selling capacity of the sales department is of 20000 units & production department has produced 35000 units, then such extra production is of no use. Therefore, the establishment of limiting factor & the limit imposed by it before the beginning of the functional budgets is very important. If level of demand is the main factor then before other functional budgets have been prepared, preparation has to be made of the sales budget. On the basis of the volume of goods that can be sold by the business, the production & other budgets should be prepared.
Budget Period:
The period of time for which the preparation & employment of budget is done is known as a budget period. Specifying the budget period at the outset of the preparation of the budget is necessary.
Depending upon the type of business & the uncertainties that are involved, budget periods will vary. Usually with the capital expenditure the long-range budgets are concerned, the span of which may be of five or more years. However, on the other hand, only a week or month is covered by short-term budgets e.g. cash budget. Master budgets by which an organization’s overall goals get consolidated, are usually prepared on an annual basis so that it can coincide with the financial year of the business. Annual budgets are usually sub divided into monthly or four-weekly period budget so that proper control can be exercised.
Distinction between Forecast & Budget:
Prediction of relevant future factors by which an entity & its environment gets affected so that the preparation of planning decisions can be facilitated is defined as a forecast. Budget is a plan which is set by the organization itself as a target regarding what should happen, whereas a forecast predicts what is likely to happen. A forecast is a judgement which anybody can make whereas budget is objective of an enterprise which only the authorized management can make. Basis for the budget is prepared by the forecast. It’s not necessary that the forecast of a function needs to be well coordinated. However, good coordination among various operations & functions of an organization is needed in budgeting so that the desired results can be attained. The period covered by the forecast may range from one to five years or in case of certain types of business, even longer. However, except in case of capital expenditure, the projection of budget is rarely done for more than a year in advance & often projection is made for only three months. Control of variances from the approved plan so that the desired result may be achieved is involved in budgeting whereas no such control is involved in forecasting.
Types of Budgets
Budgets can be categorized in various ways. Let us go through the types of budgets in detail.
Functional Budgets
It relates to any function of the firm such as sales, production, cash, etc. Following budgets are prepared in functional budgets:
• Sales Budget
• Production Budget
• Material Budget
• Manufacturing Budget
• Administrative Cost Budget
• Plant Utilization Budget
• Capital Expenditure Budget
• Research and Development Cost Budget
• Cash Budget
Flexible Budget
Estimation of future levels of activity with any accuracy is extremely difficult in some businesses because of presence of external incontrollable influences. For example, a business which provides luxury goods & services may be very sensitive to changes occurred in the economic climate. Weather may affect some business & prediction of weather conditions is difficult. In such cases, if comparison is done between actual results & budgeted figures, the result may be extremely misleading. It would not be clear without making detailed investigation, for example, whether either because of overspending or merely because the business activity level was above the budgeted level or both, there had arisen a large adverse cost variance. As a result, it becomes really difficult to control & appraisal of performance.
With the preparation of a flexible budget the problem can be solved. Thus, a flexible budget can be defined as a range of budgets which covers a number of different expected levels of activity. It becomes possible to draw up an appropriate ‘flexible’ budget from the range once actual production is known, also the expenses can be set out which would be appropriate to the achieved level of activity.
The main requirement of a flexible budget is that the analysis of expenses should be done into three distinct categories:
a. Fixed expenses, i.e. irrespective of the levels of activity, these expenses would be remaining the same.
b. Variable expenses, i.e. with the change in levels of activity, these expenses would change in proportion to that level.
c. Semi-variable expenses, i.e. analysis of these expenses into fixed & variable elements are needed to be done.
As already stated, the advantage of flexing a budget is that, for the purposes of control & appraisal of performance, the comparison can be done of the actual performance with the flexed budget.
Financial Budget:
The functional budget by which the whole packages of budgets are summarized is made up of the five individual budgets:
1. Cash Budget: Cash budget shows in respect of various functional budgets; the requirements of cash as well as the anticipated cash receipts. It is concerned with liquidity.
2. Budgeted Profit & Loss Account: The budgeted revenues during the period gets matched with the same period’s budgeted costs & the same is reflected by the budgeted profit & loss account. It is concerned with profitability.
3. Budgeted Balance Sheet: It is concerned with the asset’s structure & the liabilities’ pattern.
4. Budgeted Fund Flow statement: In the organizations’ objective-striving endeavor’s, budgeted fund flow statement is concerned with the sources of funds & the applications of funds.
5. Capital Budget: The capital budget is concerned with the questions relating to capacity & the direction which is strategic. The evaluation of alternative dispositions of capital funds as well as the choice of the capital structure which is the best is dealt with by the capital budget.
Cash Budget:
As the name implies, the summarization of the estimated cash receipts as well as the cash payments over the period of budget is done by the cash budget. Ensuring a balance between liquidity & profitability is its main object. The minimizing of the level of cash without, at the same time, running the risk that the organization will not be able to pay the bills when they become due, is the aim of the management. As the cash itself is unproductive, it is minimized. For sound financial management, it is absolute necessity that a carefully developed estimation of cash position & cash needs, is required to be done. Such estimates are required by the money-lending agencies before they can grant credit.
An evaluation of the probable position of cash for the immediate budget period becomes possible by the determination of probable cash receipts & probable cash payments. The cash positions’ evaluation in this manner may indicate- (a) some form of financing needs so that the anticipated cash deficits can be covered, or (b) the need for management planning so that the excess cash can be put to use profitably. There is a close relation between the cash budget & the forecast of sales, expenses budget & capital expenditure budget. However, a desirable cash position does not get automatically bought by the planning & controlling of these factors. An essential distinction between the cash budget & other budgets is suggested by cash budget. The timing of receipts & payments of cash (cash basis), is dealt with by the cash budget, whereas the timing or incurrence of the transactions themselves (accrual basis) is dealt with by the other assets.
Purposes Of Cash Budget:
The principal purposes of the cash budget are as follows:
a. Indication of the probable cash position resulting out of planned operations.
b. Indication of excess or shortages of cash.
c. Provision for co-ordination of cash in relation to (i) sales, (ii) investment, (iii) total working capital & (iv) debt.
d. Indication of the needs for the arrangement of short-term borrowing, or for the purpose of investment, the availability of idle cash.
e. For the purpose of obtaining credit; the establishment of sound basis.
f. Establishment of a sound basis for the purpose of current controlling of the cash position.
Methods of Preparing Cash Budget:
For the preparation of a cash budget, two methods are there: (a) receipts & payments method & (b) funds flow method.
(a) Receipts & Payments Method:
It is normally prepared in advance by month for the budget year. The preparation of cash budget starts with the forecast balance of cash at the commencement of the budget period, & with that, the budgeted receipts for each month gets added & then the budgeted payments gets deducted, for ascertaining the expected cash balance at each month’s end. The usual items which are to be included in cash budgets are as follows:
i. Sales revenue per the sales budget, plus any budgeted decrease in debtors or minus any budgeted increase in debtors, as the case may be.
ii. Production costs per the production cost budget, plus any stock increase, minus any creditors’ increase.
iii. Administration costs, selling & distribution costs & research & development costs, plus any stock increase, minus any creditors’ increase.
iv. Capital expenditure per the capital expenditure budget, & any cash, which on sale or scrapping of assets, will be received.
v. Dividends, interest & rent receipts.
vi. Tax payments.
vii. On long term contracts, expected payments of dividend & progress payments.
viii. Any cash which is to be received on issue of shares, debentures etc. or to be paid on redemption of preference shares or debentures.
It is possible to see whether there will be sufficient cash with the concern not only at the end of the year, but also all the times during the year, by scheduling receipts & payments by month & carrying forward from month to month, the cumulative balance. Hence, for raising any required additional funds or investing any temporary surplus, plans can be made.
(b) Funds Flow method: The fund flow method of cash budgeting substitutes, for items (i) to (iii); cash from operations. Items from (iv) to (viii) will appear in the same way as in receipts & payments method. By taking net profit as the basis & making adjustments for (a) depreciation, (b) non-operating incomes & expenses & (c) increase or decrease in current account items except cash, cash from operations can be determined.
The main problem with this method is that the provision of month wise information is not possible. Thus, mainly for long term cash budgeting, the fund flow method is used. On the other hand, the receipts & payments method is more useful for short-term cash budgeting
Master Budget:
The collection of a series of subsidiary or functional budgets into a total or master budget is the outcome of the budgeting process.
The master budget which covers a definite period of time, such as a year, represents the overall plan of operations which the management develops for the company. The master budget formally expresses the managerial policies & goals for a specified period which, with respect to functions & organizational responsibilities are broken down into details.
The master budget together with the subsidiary budgets on completion will be submitted for approval to the budget committee.
Constituent Elements of a Master Budget:
A master budget comprises a number of functional & financial budgets.
Functional Budget:
Functional budget is related to a major function of the business. The usual functional budgets are:
1. Sales Budget:The sales in terms of quantity & value which are analyzed by the product, by region, by month, by salesman & by distribution channels are shown by this budget.
2. Selling Expenses Budget: The salaries & commission of salesmen’s, expenses & other related costs is included in this budget.
3. Distribution Expenses Budget:Charges for transportation, charges for freight, warehousing, stock control, wages, expenses & related administrative costs is included in this budget.
4. Marketing Budget:Marketing budget, apart from details regarding advertising, activities related to promotion, market research, customers service, public relations & so forth; also includes a summery relating to sales, selling expenses & marketing expenses budgets.
5. Research & Development Budget:Materials, salaries, expenses, equipment & supplies & other costs which are related with design, development & technical research projects are included in research & development budget.
6. Production Budget:Production budget aims to supply specified quality of finished goods so that the marketing demands can be met. Levels of finished goods stock is specified by the distribution budget & for providing detailed production requirements this can be related with the sales budget. Following from this, consideration of a series of subsidiary budgets becomes necessary:
a. Raw Materials Budget:Appropriate attention to the desired levels of stock is paid by this budget.
b. Labour Budget:This budget ensures that at the right time the required number of employees with suitable skills & of suitable grade will be made available by the plan.
c. Manufacturing Overheads budget:Items such as consumable materials & waste disposal is covered by this budget.
7. Purchasing Budget:While preparing this budget along with the answers to the questions regarding when, where & at what price to buy & how often to buy, consideration has to given to raw materials, consumable items, office supplies & equipments & the whole range of requirements of an organization.
8. Administration Expenses Budget: Such expenses as salaries & upkeep of office, salaries of management, stationery, telephones, depreciation, postage etc. are dealt with by this budget.
9. Manpower Budget:An overall view of the need of the organization regarding manpower for all the areas of activity for a period of years-like manufacturing, administrative, sales, executive activities & so on, must be taken by the manpower budget
Flexible Budget Vs. Fixed Budget
Points Flexible Budget Fixed Budget
Flexibility Due to its nature of flexibility, it may be quickly re-organized according to the level of production. After the commencement of a period, fixed budget cannot change according to actual production.
Condition Flexible budget may change according to change in conditions. Fixed budget is based on the assumption that conditions will remain unchanged.
Cost Classification Classification of costs is done according to the nature of their variability. It is suitable for fixed costs only; no classification is done in fixed budget.
Comparison Comparisons of actual figures with revised standard figures are done according to change in the production level of a concern. If there is change in production level, then it is not possible to do a correct comparison.
Ascertainment of cost It is easy to ascertain costs even at different levels of activity. If there is change in the production level or circumstances, it is not possible to ascertain costs correctly.
Cost Control It is used as an effective tool to control costs. Due to its limitations, it is not used as cost control tool.
Zero Base Budgeting
Traditionally, on the basis of the targets which have been set in the last year, budgeting is done. In the last year’s budget, certain additions & deductions are done for arriving at the figures for the current budget. Thus, in making traditional budget, we have to depend on the last year’s targets as well as on the principles of incrementalism or decrementalism, for the purpose of deciding upon the additions or deletions which are required to be incorporated in the budget figures of the previous year so that the figures of the current budget can be arrived.
In case of Zero-base budgeting (ZBB), the assumption is made that there was no budget for the previous year & in the light of expected benefits & costs which are involved; independent evaluation are made of the proposals of the current budget. Thus, ZBB refers to the formulation of a budget without any reference made to the previous plans & achievement but particular reference is made to the justification of the proposed resources’ allocation. This is not done only once. Whenever a budget needs to be prepared, every time, the process of budgeting should start from zero & in terms of cost-benefit analysis, the proposed allocation of resources should be justified.
In the cases of planning & decision making, ZBB becomes ideal. Undertaking of previous type of work of which there is no previous experience is included in development planning. In these cases, on the basis of past targets which have been modified by certain additions & deletions, budgets can be prepared. On the basis of cost-benefit analysis, evaluation of every budget proposal is to be done. Identification of all proposed activities is to be done, as evaluation of decision packages is made by systematic analysis & ranking is done in order of priority. Upon the priority list, depends the decision making.
Main Features of ZBB:
The main features of ZBB are the following:
a. As the basis of budgeting, Zero (or scratch) is taken & not the previous budgets’ targets.
b. The fund demanded has to be justified by the management of each decision unit.
c. Grouping of all proposed activities has to be done into various decision packages.
d. According to priority, the adequate evaluation & arrangement of all decision packages are done.
e. After proper evaluation, consideration has to be given to the alternative decision packages.
f. On the merits of evaluation of all decision packages including the alternative decision packages, resources are finally allocated.
Difference between ZBB & Traditional Budgeting:
The distinction between the traditional budgeting & zero-base budgeting are the following:
a. In traditional budgeting, emphasis is given on previous level of expenditure, whereas, in ZBB, every time a budget is prepared, new economic appraisal is made.
b. Traditional budgeting is a function which is accounting oriented, whereas, ZBB is a function which is project or decision oriented.
c. For the preparation of a traditional project, rejustification of the existing programme is not needed, whereas, for the preparation of a zero-base budgeting, the justification of existing & new projects is needed to be done in the light of benefits & costs.
d. In the case of traditional budget, the justification regarding why, for a particular decision unit, a particular amount of expenditure is decided upon, is justified by the top management, whereas, in case of ZBB, the amount of expenditure is justified by the manager of the decision unit & not the top management.
e. In the case of traditional budgeting, the amount to added with or deleted from the figures of the previous budget figures is only taken into account, whereas, in case of ZBB, existing level of expenditure is appraised & the justification of future proposal for expenditure is done from different angles.
f. Preparation of a traditional budget is a simple job which is done year after year monotonously, whereas, preparation of a zero-base budgeting requires logical approach & many complex steps are involved for the establishment of logic behind a proposal.
Applicability of ZBB:
In planning & development areas particularly of the government & local bodies, ZBB is very suitably applicable. With reference to costs & benefits, thorough examination of the projects of every ministry is done. In respect of allocation of resources, upon the report of cost-benefit examination which is prepared by persons competent to do so, depends, which project of which ministry shall enjoy priority. ZBB becomes ideal in cases where the resources are limited but there are many development works which is needed to be done as in case of educational institutions, local bodies etc., because there is almost guarantee of the efficient use of limited resource.
In manufacturing concerns, for the purpose of controlling cost there are many devices like standard cost technique, work & motion study etc. The prime costs & production overhead gets controlled by these techniques because in these cases direct relationship between cost & output is there. But in manufacturing concerns production function gets supported by various other expenditures, but in these cases, relationship cannot be established between cost & output. For the application of ZBB, this area of expenditure is a suitable field. Expenditure like accounting, maintenance, electricity, rent of administrative office, postage, advertisement, research, development & many others covers this area.
Merits of ZBB:
The following are the merits of ZBB:
a. Careful examination of all projects-whether current or future is done with reference to cost & benefits & the project which is most efficient is accepted. Thus, ZBB is always a technique which is based on logic. The current projects, only if they are logically sound & efficient, are continued.
b. For rational planning, on the cost-benefit acceptability, the most efficient ones amongst the available alternatives are chosen. The managers of decision units are required by ZBB to find out cost effective ways for the implementation of the plans. Thus, with the help of ZBB, best planning is made & cost can also be controlled with the help of ZBB.
c. In respect of both existing & future projects, cost-benefit analysis is done. Ranking of the projects is done on the basis of the result of the analysis & allocation of funds is done in order of priority. Thus, ZBB helps in getting labour efficiently allocated.
d. In ZBB, for the purpose of using the available resources of the organization, the most useful alternatives are found out. Alternative ways are taken into consideration in performing an activity also. Similarly, consideration is also given to the alternative quantum of efforts which are to be put in. These help promoting new ideas so that an activity can be performed in the best possible way.
e. With regard to justifiability of continuing new undertaking on the basis of cost-benefit analysis, existing activities & new projects are appraised with equal importance.
f. In ZBB, reports are to be submitted by managers of all decision units on their claims of funds & justification of the claims. Thus, in the making of zero-base budget, it becomes compulsory for all managers of decision units to participate. Thus in allocation & utilization of funds, forthcoming of new ideas gets promoted by this.
g. Since in ZBB, existing activities gets appraised carefully, activities which fails to give desired results may be discontinued & thus by this way unproductive expenditure may be saved.
h. Since all managers adopt ZBB technique, they are obliged for making self evaluation of projects under their command. If there are any loopholes in the working progress, those are automatically detected & remedial measures are adopted. Efficiency in performance can be achieved by awareness of managers’ in respect of detection of errors & their rectification.
i. Automatic motivation is created by ZBB which helps forming a management team of individuals having skills & talents.
j. Top management gets linked with medium & lower level management with the help of ZBB. Thus, speedy communication helping expediting appropriate decision-making is ensured.
k. ZBB helps in introducing & implementing ‘Management by objective’ (or MOB). The objectives of the traditional budgeting can be fulfilled using ZBB; as other objectives can as well be fulfilled with its help.
Demerits of ZBB:
The following are the demerits of ZBB:
a. Time, energy & money is required in collecting & analyzing data of alternative future projects as well as existing activities.
b. If full co-operation amongst management staff is not forthcoming, then ZBB technique implementation becomes difficult.
c. As ideal standard of evaluation is not available, evaluation often becomes very difficult. Technical knowledge may be required in a desired manager’s evaluation which may not be available.
d. Managers are required to undergo continuous training. Implementation of ZBB cannot be expected in a right way if basis idea & objective of ZBB are not crystal clear to managers.
e. In case of ZBB, according to priority, ranking of projects need to be done. Irrational ranking of project may arise due to ego of top management (i.e. Irrespective of its merits, a project favored by the top management may be ranked high). Moreover, regarding the method of ranking which needs to be adopted, confusion may arise among the management staff.
f. Involvement of good number of individuals may be required by ZBB. Thus, complications may be created in communication system which results in difficulty in managing of the huge volume of data & voluminous paper work may be involved etc.
Meaning of Standard Costing
It is a method of costing by which standard costs are employed. According to ICMA, London, Standard Costing is “the preparation and use of standard costs, their comparison with actual cost and the analysis of variances to their causes and points of incidence”.
According to Wheldon, it is a method of ascertaining the costs whereby statistics are prepared to show:
(i) The standard cost;
(ii) The actual cost;
(iii) The difference between these costs which is termed the variance.
But W. Bigg expresses:
“Standard Costing discloses the cost of deviations from standards and clarifies these as to their causes, so that management is immediately informed of the sphere of operations in which remedial action is necessary.”
Thus, from the above, it becomes clear that Standard Costing involves:
(i) Ascertainment and use of Standard Costs;
(ii) Recording the actual costs;
(iii) Comparison of actual costs with standard costs in order to find out the variance;
(iv) Analysis of variance; and
(v) After analysing the variance, appropriate action may be taken where necessary.
Objectives of Standard Costing:
The objectives of Standard Costing for which it is implemented are:
(a) It helps to implement budgetary control system in operation;
(B) IT HELPS TO ASCERTAIN PERFORMANCE EVALUATION.
(c) It supplies the ways to utilise properly material, labour and also overhead which will be economic in character.
(d) It also helps to motivate the employees of a firm to improve their performance by setting up a ‘standard’.
(e) It also helps the management to supply necessary data relating to cost element to submit quotations or to fix up the selling price of a firm.
(f) It also helps the management to make proper valuations of inventory (viz., Work-in- progress, and finished products).
(g) It acts as a control device to the management.
(h) It also helps the management to take various corrective decisions viz., fixation of price, make-or-buy decisions etc. which will be more beneficial to the firm.
Development of Standard Costing:
Importance of Standard Costing cannot be ignored for the following and that is why the same is well-developed in the present-day world:
(i) Compilation of Historical Cost is very expensive and difficult:
A manufacturing firm making large number of parts requires too much clerical work which is required in order to compile the materials, labour and overhead charges to each and every cost of parts produced for ascertaining the average cost of the product.
(ii) Historical Costs are inadequate:
In order to measure the manufacturing efficiency, historical costs are not practically adequate. It fails to explain the reasons of increased cost or any change in cost structure.
(iii) Historical Costs are too old:
In many firms, costs are determined and selling prices are ascertained even before the production starts—which is not desirable.
(iv) Historical Costs are not typical:
This is due to the wide fluctuation in market for which there is no relation between the selling price per unit and cost price per unit.
Advantages of Standard Costing:
The following advantages may be derived from Standard Costing:
(i) Standard Costing serves as a guide to the management in several management functions while formulating prices and production policies etc.
(ii) More effective cost control is possible under standard costing if the same is reviewed and analysed at regular intervals for improvements and immediate action can be taken if deviations from standards are found out which, ultimately, leads to cost reduction.
(iii) Analysis of variance and its measurement helps to detect inefficiencies and mistakes which enable the management to investigate the reasons.
(iv) Since standard costs are predetermined costs they are very useful for planning and budgeting. It also helps to estimate the effect of changes in Cost-Price-Volume relationship which also helps the management for decision-making in future.
(v) As standard is fixed for each product, its components, materials, process operation etc. it improves the overall production efficiency which also ultimately reduces cost and thereby increases profit.
(vi) Once the Standard Costing System is implemented it will lead to saving cost since most of the costing work can be eliminated.
(vii) Delegation of authority and responsibility becomes effective by setting up standards for each cost centre as the supervisors or executives of each cost centre will know the standard which they have to maintain.
(viii) This system also helps to prepare Profit and Loss Account promptly for short period in order to know the trend of the business which helps the management to take decisions promptly.
(ix) Standard costing also is used for inventory valuation purposes. Stock can be valued at standard cost which can reduce the fluctuation of profit for different methods of valuation for the same.
(x) Efficiency of labour is promoted.
(xi) This system creates cost-consciousness among all employees, executives and top management which increase efficiency and productivity as well.
Disadvantages of Standard Costing:
The alleged disadvantages of Standard Costing are:
(i) Since Standard Costing involves high degree of technical skill, it is, therefore, costly. As such, small organisations cannot, introduce the system due to their limited financial resources. But, once introduced, the benefits achieved will be far in excess to its initial high costs.
(ii) The executives are liable for those variances that are found from actions which are actually controllable by them. Thus, in order to fix up the responsibilities, it becomes necessary to segregate variances into non-controllable and controllable portions although that is not an easy task.
(iii) Standards are always changing since conditions of the business are equally changing. So, standards are to be revised in order to make them comparable with actual results. But revision of standards creates many problems, particularly in inventory adjustment.
(iv) Standards are either too liberal or rigid since the same are based on average past results, attainable good performance or theoretical maximum efficiency. So, if the standards are very high, it will adversely affect the morale and motivation of the employees.
Variance Analysis: Material & Labour Variances!
The function of standards in cost accounting is to reveal variances between standard costs which are allowed and actual costs which have been recorded. The Chartered Institute of Management Accountants defines variances as the difference between a standard cost and the comparable actual cost incurred during a period. Variance analysis can be defined as the process of computing the amount of, and isolating the cause of variances between actual costs and standard costs. Standard costs provide information that is useful in performance evaluation. Standard costs are compared to actual costs, and mathematical deviations between the two are termed variances. Favorable variances result when actual costs are less than standard costs, and vice versa. The following illustration is intended to demonstrate the very basic relationship between actual cost and standard cost. AQ means the “actual quantity” of input used to produce the output. AP means the “actual price” of the input used to produce the output. SQ and SP refer to the “standard” quantity and price that was anticipated. Variance analysis can be conducted for material, labor, and overhead.
Variance analysis involves two phases:
(1) Computation of individual variances, and
(2) Determination of Cause (s) of each variance.
I. Material Variance:
The following variances constitute materials variances:
Material Cost Variance:
Material cost variance is the difference between the actual cost of direct material used and stand¬ard cost of direct materials specified for the output achieved. This variance results from differences between quantities consumed and quantities of materials allowed for production and from differences between prices paid and prices predetermined.
This can be computed by using the following formula:
Material cost variance = (AQ X AP) – (SQ X SP)
Where AQ = Actual quantity
AP = Actual price
SQ = Standard quantity for the actual output
SP = Standard price
Material Usage Variance:
The material quantity or usage variance results when actual quantities of raw materials used in production differ from standard quantities that should have been used to produce the output achieved. It is that portion of the direct materials cost variance which is due to the difference between the actual quantity used and standard quantity specified.
As a formula, this variance is shown as:
Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard Price
A material usage variance is favourable when the total actual quantity of direct materials used is less than the total standard quantity allowed for the actual output.
Example:
Compute the materials usage variance from the following information:
Standard material cost per unit Materials issued
Material A — 2 pieces @ Rs. 10=20 (Material A 2,050 pieces)
Material B — 3 pieces @ Rs. 20 =60 (Material B 2,980 pieces)
Total = 80
Units completed 1,000
Solution:
Material usage variance = (Actual Quantity – Standard Quantity) x Standard Price
Material A = (2,050 – 2,000) x Rs. 10 = Rs. 500 (unfavourable)
Material B = (2980 – 3000) x Rs. 20 = Rs. 400 (favourable)
Total = Rs. 100 (unfavourable)
It should be noted that the standard rather than the actual price is used in computing the usage variance. Use of an actual price would have introduced a price factor into a quantity variance. Because different departments are responsible, these two factors must be kept separate.
(a) Material Mix Variance:
The materials usage or quantity variance can be separated into mix variance and yield variance.
For certain products and processing operations, material mix is an important operating variable, specific grades of materials and quantity are determined before production begins. A mix variance will result when materials are not actually placed into production in the same ratio as the standard formula. For instance, if a product is produced by adding 100 kg of raw material A and 200 kg of raw material B, the standard material mix ratio is 1: 2.
Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix variance will be found. Material mix variance is usually found in industries, such as textiles, rubber and chemicals, etc. A mix variance may arise because of attempts to achieve cost savings, effective resources utilisation and when the needed raw materials quantities may not be available at the required time.
Materials mix variance is that portion of the materials quantity variance which is due to the difference between the actual composition of a mixture and the standard mixture.
It can be computed by using the following formula:
Material mix variance = (Standard cost of actual quantity of the actual mixture – Standard cost of actual quantity of the standard mixture)
Or
Materials mix variance = (Actual mix – Revised standard mix of actual input) x Standard price
Revised standard mix or proportion is calculated as follows:
Standard mix of a particular material/Total standard quantity x Actual input
Example:
A product is made from two raw materials, material A and material B. One unit of finished product requires 10 kg of material.
The following is standard mix:
During a period one unit of product was produced at the following costs:
Compute the materials mix variance.
Solution:
Material mix variance = (Actual proportion – Revised standard proportion of actual input) x Standard price.
(b) Materials Yield Variance:
Materials yield variance explains the remaining portion of the total materials quantity variance. It is that portion of materials usage variance which is due to the difference between the actual yield obtained and standard yield specified (in terms of actual inputs). In other words, yield variance occurs when the output of the final product does not correspond with the output that could have been obtained by using the actual inputs. In some industries like sugar, chemicals, steel, etc. actual yield may differ from expected yield based on actual input resulting into yield variance.
The total of materials mix variance and materials yield variance equals materials quantity or usage variance. When there is no materials mix variance, the materials yield variance equals the total materials quantity variance. Accordingly, mix and yield variances explain distinct parts of the total materials usage variance and are additive.
The formula for computing yield variance is as follows:
Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit
Example:
Standard input = 100 kg, standard yield = 90 kg, standard cost per kg of output = Rs 200
Actual input 200 kg, actual yield 182 kg. Compute the yield variance.
In this example, there is no mix variance and therefore, the materials usage variance will be equal to the materials yield variance.
The above formula uses output or loss as the basis of computing the yield variance. Yield vari¬ance can also be computed on the basis of input factors only. The fact is that loss in inputs equals loss in output. A lower yield simply means that a higher quantity of inputs have been used and the anticipated or standard output (based on actual inputs) has not been achieved.
Yield, in such a case, is known as sub-usage variance (or revised usage variance) which can be computed by using the following formula:
Sub-usage or revised usage variance = (Revised Standard Proportion of Actual Input – Standard quantity) x Standard Cost per unit of input
Example:
Standard material and standard price for manufacturing one unit of a product is given below:
Materials yield variance always equal sub-usage variance. The difference lies only in terms of calculation. The former considers the output or loss in output and the latter considers standard inputs and actual input used for the actual output. Mix and yield variance both provide useful information for production control, performance evaluation and review of operating efficiency.
Materials Price Variance:
A materials price variance occurs when raw materials are purchased at a price different from standard price. It is that portion of the direct materials which is due to the difference between actual price paid and standard price specified and cost variance multiplied by the actual quantity. Expressed as a formula,
Materials price variance = (Actual price – Standard price) x Actual quantity
Materials price variance is un-favourable when the actual price paid exceeds the predetermined standard price. It is advisable that materials price variance should be calculated for materials purchased rather than materials used. Purchase of materials is an earlier event than the use of materials.
Therefore, a variance based on quantity purchased is basically an earlier report than a variance based on quantity actually used. This is quite beneficial from the viewpoint of performance measurement and corrective action. An early report will help the management in measuring the performance so that poor performance can be corrected or good performance can be expanded at an early date.
Recognizing material price variances at the time of purchase lets the firm carry all units of the same materials at one price—the standard cost of the material, even if the firm did not purchase all units of the materials at the same price. Using one price for the same materials facilities management control and simplifies accounting work.
If a direct materials price variance is not recorded until the materials are issued to production, the direct materials are carried on the books at their actual purchase prices. Deviations of actual purchase prices from the standard price may not be known until the direct materials are issued to production.
Example:
Assuming in Example 1 that material A was purchased at the rate of Rs 10 and material B was purchased at the rate of Rs 21, the material price variance will be as follows:
Materials price variance = (Actual Price – Standard Price) x Actual Quantity
Material A = (10 – 10) x 2,050 = Zero
Material B = (21 – 20) x 2,980 = 2980 (un-favourable)
Total material price variance = Rs 2980 (un-favourable)
The total of materials usage variance and price variance is equal to materials cost variance.
Causes of material variances
Variance Favourable Adverse
Material Price • Poorer quality materials
• Discount given for buying bulk
• Change to a cheaper supplier
• Incorrect budgeting • Higher quality materials
• Change to a more expensive supplier
• Unexpected price increase encountered
• Incorrect budgeting
Material Usage • Higher quality materials
• More efficient use of material
• Change is product specification
• Incorrect budgeting • Poorer quality materials
• Less experienced staff using more materials
• Change is product specification
• Incorrect budgeting
Note: The material price variance and the material usage variance may be linked. For example, the purchase of poorer quality materials may result in a favourable price variance but an adverse usage variance.
Materials variances
Calculation
Causes of material variances
Variance Favourable Adverse
Material Price • Poorer quality materials
• Discount given for buying bulk
• Change to a cheaper supplier
• Incorrect budgeting • Higher quality materials
• Change to a more expensive supplier
• Unexpected price increase encountered
• Incorrect budgeting
Material Usage • Higher quality materials
• More efficient use of material
• Change is product specification
• Incorrect budgeting • Poorer quality materials
• Less experienced staff using more materials
• Change is product specification
• Incorrect budgeting
Note: The material price variance and the material usage variance may be linked. For example, the purchase of poorer quality materials may result in a favourable price variance but an adverse usage variance.
Material waste
Material waste may be a normal part of a process and could be caused by:
• evaporation
• scrapping
• testing
Waste would affect the material usage variance. Expected waste can be built into the standards used, so only excessive ("abnormal") waste would contribute towards the usage variance.
II. Labour Variances:
Direct labour variances arise when actual labour costs are different from standard labour costs. In analysis of labour costs, the emphasis is on labour rates and labour hours.
Labour variances constitute the following:
Labour Cost Variance:
Labour cost variance denotes the difference between the actual direct wages paid and the standard direct wages specified for the output achieved.
This variance is calculated by using the following formula:
Labour cost variance = (AH x AR) – (SH x SR)
Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate
1. Labour Efficiency Variance:
The calculation of labour efficiency or usage variance follows the same pattern as the computa¬tion of materials usage variance. Labour efficiency variance occurs when labour operations are more efficient or less efficient than standard performance. If actual direct labour hours required to complete a job differ from the number of standard hours specified, a labour efficiency variance results; it is the difference between actual hours expended and standard labour hours specified multiplied by the stand¬ard labour rate per hour.
Labour efficiency variance is computed by applying the following formula:
Labour efficiency variance = (Actual hours – Standard hours for the actual output) x Std. rate per hour.
Assume the following data:
Standard labour hour per unit = 5 hr
Standard labour rate per hour = Rs 30
Units completed = 1,000
Labour cost recorded = 5,050 hrs @ Rs 35
Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable) It may be noted that the standard labour hour rate and not the actual rate is used in computing labour efficiency variance. If quantity variances are calculated, changes in prices/rates are excluded, and when price variances are calculated, standard quantities are ignored.
(i) Labour Mix Variance:
Labour mix variance is computed in the same manner as materials mix variance. Manufacturing or completing a job requires different types or grades of workers and production will be complete if labour is mixed according to standard proportion. Standard labour mix may not be adhered to under some circumstances and substitution will have to be made. There may be changes in the wage rates of some workers; there may be a need to use more skilled or expensive types of labour, e.g., employ-ment of men instead of women; sometimes workers and operators may be absent.
These lead to the emergence of a labour mix variance which is calculated by using the following formula:
Labour mix variance = (Actual labour mix – Revised standard labour mix in terms of actual total hours) x Standard rate per hour
To take an example, suppose the following were the standard labour cost data per unit in a factory:
In a period, many class B workers were absent and it was necessary to substitute class B workers. Since the class A workers were less experienced with the job, more labour hours were used.
The recorded costs of a unit were:
Labour mix variance will be calculated as follows:
Labour mix variance = (Actual proportion – Revised standard proportion of actual total hours) x standard rate per hour
Revised standard proportion:
(ii) Labour Yield Variance:
The final product cost contains not only material cost but also labour cost. Therefore, gain or loss (higher or lower output than the standard output) should take into account labour yield variance also. A lower output simply means that final output does not correspond with the production units that should have been produced from the hours expended on the inputs.
It can be computed by ap¬plying the following formula:
Labour yield variance = (Actual output – Standard output based on actual hours) x Av. Std. Labour Rate per unit of output.
Or
Labour yield variance = (Actual loss – Standard loss on actual hours) x Average standard labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which is computed in terms of inputs, i.e., standard labour hours and revised labour hours mix (in terms of actual hours).
Labour efficiency sub-variance is computed by using the following formula:
Labour efficiency sub-variance = (Revised standard mix – standard mix) x Standard rate
2. Labour Rate Variance:
Labour rate variance is computed in the same manner as materials price variance. When actual direct labour hour rates differ from standard rates, the result is a labour rate variance. It is that portion of the direct wages variance which is due to the difference between actual rate paid and standard rate of pay specified.
The formula for its calculation is:
Labour rate variance = (Actual rate – Standard rate) x Actual hours
Using data from the example given above, the labour rate variance is Rs 25,250, i.e.,
Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250 (unfavourable)
The number of actual hours worked is used in place of the number of the standard hours speci¬fied because the objective is to know the cost difference due to change in labour hour rates, and not hours worked. Favourable rate variances arise whenever actual rates are less than standard rates; unfavourable variances occur when actual rates exceed standard rates.
3. Idle Time Variance:
Idle time variance occurs when workers are not able to do the work due to some reason during the hours for which they are paid. Idle time can be divided according to causes responsible for creat¬ing idle time, e.g., idle time due to breakdown, lack of materials or power failures. Idle time variance will be equivalent to the standard labour cost of the hours during which no work has been done but for which workers have been paid for unproductive time.
Suppose, in a factory 2,000 workers were idle because of a power failure. As a result of this, a loss of production of 4,000 units of product A and 8,000 units of product B occurred. Each employee was paid his normal wage (a rate of? 20 per hour). A single standard hour is needed to manufacture four units of product A and eight units of product B.
Idle time variance will be computed in the following manner:
Standard hours lost:
Product A = 4, 000/ 4 = 1,000 hr.
Product B = 8, 000 / 8 = 1,000 hr.
Total hours lost = 2,000 hr.
Idle time variance (power failure)
2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)
Labour variances
Calculation
Causes of labour variances
Variance Favourable Adverse
Labour rate • Lower skilled staff
• Cut in overtime/bonus
• Incorrect budgeting • Higher skilled staff
• Increase in overtime/bonus
• Incorrect budgeting
• Unforeseen wage increase
Labour efficiency • Higher skilled staff
• Improved staff motivation
• Incorrect budgeting • Lower skilled staff
• Fall in staff motivation
• Incorrect budgeting
Note: The labour rate variance and the labour efficiency variance may be linked. For example, employing more highly skilled labour may result in an adverse rate variance but a favourable efficiency variance.
Idle time
Idle time occurs when employees are paid for time when they are not working e.g. due to machine breakdown, low demand or stockouts.
If idle time exists an idle time labour variance should be calculated.
Controlling Idle time
Idle time can be prevented or reduced considerably by :
1. Proper maintenance of tools & machinery
2. Advanced production planning
3. Timely procurement of stores
4. Assurance of supply of power
5. Advance planning for machine utilisation
A consideration of labour variances can be extended to incorporate labour ratios as well
What is Job order costing? Advantages and disadvantages of Job order costing
Concept of job order costing
The act of producing goods and providing services according to the special demand or order of the customers is called a job. Now, it becomes necessary to ascertain the total costs of the job. Hence, the process of ascertaining the costs of job is called job order costing.
This technique can be used by repair workshop, tap and electricity connections, research center, Construction Company, advertising agency, auditing firm and other non-manufacturing organizations etc. under this method costs are accumulated for each job or work order separately. The jobs are usually carried out inside nether factory building and compete in short span of time. They can easily be distinguished from each other.
Character institute of management accountants (CIMA), London defines job order costing as "that form of specific order costing which is applied where is undertaken to customer's specific factory or workshop and moves through processes and operations as a continuously identifiable unit. The term may also be applied to work such as property repairs and the method may be used in costing of internal capital expenditure jobs."
From the above definition, it is clear that job order costing is a method of calculating the cost of a job that is carried against the specific demand of customer where the production process moves as a continuous identified unit.
Feature of job order costing
Following are the specific features of job order costing:
• Goods and services are produced according to the customers' orders. In other words, the goods are not produced for stocking in the warehouse.
• Each job bears some specific characteristics and needs special materials and labour.
• Each job is treated as a specific cost center.
• The cost of each job is calculated after the works is completed.
• It takes comparatively lesser time to complete a job.
• The supervisor of the materials and labour is easy
Objective of job order costing
The main objective/advantages of job order costing are presented below:
• To calculate the cost of each job by maintaining a separate account for each job order or order. It enables the calculation profit or loss from each job or order.
• It helps the management in estimating or quoting the price for an order or a job. Such estimations are made on the basis of the past cost records related to similar work.
• To help identify the profitable and non profitable job or order.
• To differentiate the cost of every job or order and production from one department to other.
• To compare actual costs and estimated cost for purpose of controlling the operational inefficiency.
Advantages and disadvantages or job order costing
The advantages of job order costing are as following:
(i) It provides a detailed analysis of cost of materials, wages, and overheads classified by functions, departments and nature of expenses which enable the management to determine the operating efficiency of the different factors of production, production centres and the functional units.
(ii) It records costs more accurately and facilitates cost control by comparing actuals with estimates.
(iii) It enables the management to ascertain which of the jobs are more profitable than the others, which are less profitable and which are incurring losses.
(iv) It provides a basis for estimating the cost of similar jobs taken up in future and thus helps in future production planning.
(v) Determination of predetermined overhead rates in job costing necessitates the application of a system of budgetary control of overheads with all its advantages.
(vi) Identification of spoilage and defectives with the respective production orders and departments may enable the manager, lent to take effective steps in reducing these to the minimum.
(vii) The detailed cost records of the past years can be used for statistical purposes in the determination of the trends of cost of the different types of jobs and their relative efficiencies.
(viii) It is useful in quoting cost plus contract.
The disadvantages of job order costing are mentioned below:
(i) It involves a great deal of clerical work in recording daily the cost of materials issued, wages expended and overheads chargeable to each job or work order which adds to the cost of cost accounting. Thus it is expensive.
(ii) The scope of committing mistakes is enough as the cost of one job may be wrongly posted to the cost of other job.
(iii) Cost comparison among different jobs becomes difficult especially when drastic changes take place.
(iv) Determination of overhead rates may involve budgeting of overhead expenses and the bases of overhead apportionment and absorption but unless such budgeting is complete i.e., extended to material, labour and expenses, its advantages are considerably reduced.
(v) Job costing is historical costing which ascertains the cost of a job or product after it has been manufactured. It does not facilitate control of cost unless it is used with standard or estimated costing.
Procedures of job order costing
The following procedures are involved in a job order costing:
a. Inquiry from customer: since the works under job order costing, are carried after the order from the customer has been received, the detail information about the job like the price, quality, durations for supply and other terms and conditions should be accumulated form t customers.
b. After estimation: after taking the detailed information about the job, the cost of completing the job is estimated. The cost estimation is made on to basis of part information and the current price level change. The pried to be quoted for a job is ascertained by adding a certain profit on the cost.
c. Receiving order: the customer places an order, if he/she is satisfied with the price, quality and other terms and conditions. The work is started after receiving the order.
d. Production order: after receiving the order, the planning department sends an order to the production department to produce the stated goods or services. The production department does not inanities the production in the absence of such order. A production order includes the details about the goods. The specimen of a production order is given below:
e. Cost ascertainment: a job cost sheet is prepared to calculate the cost of goods or services to be produced according to the production order. Its specimen is as under.
Calculation of profit or losses: it is estimated by comparing the actual cost with the prices obtained.
f. Completion of job: after completing the job, the production department sends the information of the same to the cost accounting department. The cost accounting department compare the predetermined cost and actual cost to find the variance if any. It also determines the profit or loss by comparing the actual price of the job and the the total costs involves in it. For this, s statement is prepared which is called a cost sheet. The specimen of a cost sheet is given below:
1. What is job order costing?
He act of producing a proving to the special demand or order of the customers is called a job. Now, it becomes necessary to ascertain the total costs of the job. Hence, the process of ascertaining the costs of job is called job order costing.
This technique can be used by repair workshop tap and electricity connection, research center, Construction Company, advertising agency, auditing firm and other non-manufacturing organizations etc. under this method costs are accumulated for each job or work separately. The jobs are usually carried out inside the factory building and complete in short span of time. They can easily be distinguished from each other.
2. Mention the feature of Job Order Costing.
Following are the specific features of job order costing:
• Goods and services are produced according to the customer's order. In other words, the goods are not produced for stocking in the warehouse.
• Each job bears some specific characteristics and needs special material and labour.
• Each job is treated as a specific cost center.
• The cost of each job is calculated after the work is completed.
• It takes comparatively lesser time to complete a job.
• The supervisor of the material and labour is easy.
Contract Costing
Some firms such as builders, construction contractors, civil engineering firms, construction and mechanical engineering firms are engaged in construction works such as construction of buildings, bridges, roads and so on. A firmengaged in the construction works requires to know the total cost of the construction work done. The total costs of the work help to find out the profit earned from these works. The cost information about construction works helps to monitor and evaluate the performance of contract work and to determine the total contract cost. Such information is provided by a costing method known as contract costing.
Contract costing is the costing method applied to determine the cost of construction work performedas per a customer's specification. Contract costing is also called terminal costing as it terminates with the discharge of contract work. The construction work is undertaken at the site allotted by the client. The contract sites vary and are always outside the premises belonging to the clients. A separate code number is allotted to each site where a number of contract works are undertaken. A contract account is maintained for each contract work to record the contract costs under contract costing. Maintaining a contract account helps to find out the amount of profit earned during a particular period since financial books do not report it separately. Normally, a contract account is prepared at every year-end to determine the profit for the specified period.
Definition of Contract Costing
CIMA defines contract cost as the aggregated costs relative to a single contract designated a cost unit.
CIMA defines contract costing as that form of specific order costing which applies where work is undertaken to special requirements of customers and each order is of long term duration.
Types of Contract
The following are the types of contract.
1. Fisted price contract
2. Fisted price contract subject to Escalation Clause.
3. Cost plus contract.
There are three types of contract which are mentioned below:
a. Fixed price contract: the contract that is executed with the fixed price which is agreed by the contract and the contractee is called the fixed price contract. Under this contract, no modification is made in the agreed contract price irrespective of the changes in the price level of material and labour in feature. In such type of contract, the contractor is benefited when the price of material and labour decrease. In contrary to this, the contractee is benefited if the price of material and labour increase.
b. Fixed price contract with escalation and de-escalation clauses: escalation clause is a of agreement that that aims to reduce the risks that is causes due to the changes in the price of materials, labour and other services. Under this, the contract price is adjusted in accordance, with the changes in the price of material, labour and other services. The additional cost raised due to the increase in price is born by the contracted. Similarly, the contract price is reduced if the cost decreases below a certain percentage. It is called de-escalation or reverse clause. Escalation clause safe guides the interest of both the contractor and contractor against unfavorable price change in future. Such clause may also apply where material and labour utilization exceeds a particular limit. In this case, however, contractor will have to prove that excessive utilization is not because of decrease in efficiency. The contractor allows a rebate in the bills presented by him to the extent of the decrease in price.
c. Cost plus contract: the contract in which the contract price is determined by adding a certain percentage of profit on cost is known as cost plus contract. The cost plus contract is adopted to overcome with problem of fixing the contract price price caused due to nature of contract, duration of completion of contract, uncertainly of material, change in the price level, new technology etc. this type of contract is mostly followed by the government for production of special articles not usually manufactured, urgent repairs of vehicles, roads bridge etc. under this types of contract, the contract starts the work and payment is made by the contracted gradually on the basis of the cost incurred in the work completed plus certain percentage of profit.
Features of Contract Costing
The following are the features of contract costing.
1. A contract is undertaken according to the specific requirements of customers.
2. Generally, the duration of a contract is long period.
3. The contract is undertaken only at the site of the customer.
4. Contract work mainly consists of construction activities.
5. The specific order costing principles are applied in contract costing.
6. The size of a contract is usually large or bigger than jobs.
7. It requires a long time to complete a contract.
8. Each contract is an independent one, quite distinct from another.
9. A distinctive number is assigned to each contract to differentiate the contract from one another.
10. A separate account is maintained and prepared for each contract to find out the profit earned from each contract separately.
11. If a contract is not completed at the end of the accounting period, only a portion of profit is transferred to profit and loss account on the basis of stage of completion of a contract.
12. There is no problem of under absorption and over absorption of overheads.
13. Every conceivable expenditure is charged to the concerned contract.
14. If the materials, plants and other inputs are transferred from one contract to another, the transfer may be affected by giving debit and credit to the respective contracts.
15. The proportion of indecent costs to total cost of a contract is very small.
16. A contractor may appoint a sub — contractor(s) for the execution of the work of the main contract.
17. The contractee i.e. the customer pays money only on the basis of the work certified by the architect, engineer or surveyor.
18. Escalation clause may be incorporated in the agreement of the contract. It so, the contractor is protected from any rises in the prices of materials, labour and other inputs.
Procedure of Contract Costing
In contract costing, most of the expenses are direct in nature as in the form of materials, labour, expenses, plant, sub-contract charges and the like. Only a small portion of amount is charged as overheads which are apportioned on suitable basis. Accounting treatment of costs of contract costing is briefly explained below.
1. Materials
The value of materials used is debited in the concerned contract account. Materials may be specifically purchased from the open market, issued from the stores, transfer from other contracts or supplied by the contractee himself. If materials are returned to stores, the value of materials is credited in the concerned contract account.
Sometimes, materials may be transferred from one contract to another. If so, the value of materials is debited in the receiving contract account and credited in the transferring contract account. Whenever the materials are purchased from the open market, the values of materials are debited in the concerned contract account.
Similarly, if materials are issued from stores, the concerned contract account is debited and the stores control account is credited. Sometimes, some materials may be stolen or destroyed by fire, the value of materials is credited in the concerned contract as stores account and the same is transferred to profit and loss Account.
2. Labour
Generally, the contract is carried on only at the site of the contractee i.e., customer not within the company premises. Hence, labour is engaged at site to work on the contract. The amount paid to workers is wages which is directly debited in the concerned contract account. The details of information regarding wages are obtained from the records of time sheet and wages sheet. Equitable base method is usually adopted to apportion the wages of supervisors working on two or more contracts.
Likewise, the overheads are also apportioned on suitable basis. The accrued wages and outstanding expenses are calculated at the end of the accounting period and debited in the concerned contract account.
3. Direct Expenses
The direct expenses are debited in the concerned contract account as and when they are incurred. Examples of direct expenses are hire charges paid for the plant procured from outside, sub-contractor’s charges, architect’s fees, electricity, insurance and the like.
4. Plant and Machinery
The plant and machinery is treated in two ways. Under first method, the full value of plant and machinery is debited in the concerned contract account if the plant and machinery is specifically purchased for the contract. At the end of contract, the plant and machinery may be sold out in the market if it is not required further. If so, the sale proceeds are credited in the concerned contract account.
Sometimes, the plant and machinery may be required further, if so, the depreciated value or revalued amount of plant and machinery is credited in the concerned contract account. The net effect is that the contract account is debited with the amount of depreciation.
Under second method, the contract account is debited with the amount of depreciation of plant and machinery. The plant and machinery may be purchased specifically from the open market or issued from the stores. The amount of depreciation is calculated on the basis of daily use or hourly basis. Sometimes, a plant is procured on hire basis, if so, only hourly charges are debited in the contract account.
5. Overheads
Indirect costs cannot be directly charged to any contract account. These costs are apportioned to all the contract accounts only on the suitable basis. These are called as overheads. The term overheads includes payment made to engineers, supervisors, architects, managers, store keeper, central office, administrative expenses like staff salaries, telephone expenses, postage, rent, stationery, advertisement expenses etc.
Preparation of a contract account
Under the contract costing, a separate account is opened for each contract so as to ascertain the position of profit or loss. Such account is called a contract account. All the expenses incurred in the contract like material, wages, direct expenses, plant and machinery etc. are debited whereas material returned, and material at end, plant at end, work in progress or contract price in case of completion of the contract etc. are credited in the contract account. The difference between the debit and credit represents the loss or profit. The profit earned under the completion of the contract is regarded as net profit or net loss in case of loss. The profit earned from the contract which is in progress or not completed is called notional profit. When loss takes place in such a situation, it is called net loss. It is because that a loss can never be notional, it is always real. The specimen of a contract account is presented below:
a. When contract is totally competed: some contracts are small and can be completed within a year. In such a case, total contract price is show on the credit side of the contract account as contracture's account. In this case, if credit is heavy then balancing figure on debit side is called profit and if the debit side is heavy, then the balance figure on credit side will be called a loss.
b. When contract is incomplete: large contract take number of years to completion. In this situation, amount of work certified and uncertified are found in the contract. Such amount of work certified and uncertified should be shown on the credit side of the contract account under the head work-in progress account.
1. Work certified: the value of work completed and certified by contractee's engineers and architchets is called work certified. As per provision of the contract, a fixed percentage of such work certified is paid by contractee to contractor. Some percentage of work certified is retained money. The work certified included the portion of notional profit therefore, if the cost of certified is lower than the work certified, the different amount is called motioned ,profit, if the amount of cost of work certified is higher than the work certified, the different will be loss.
2. Work uncertified: on the date of preparation of contract account, there may be some competed but uncertified work. The work of contract which is completed but not certified by the engineers is called work uncertified. It is always recorded at cost price and not on contract prices so as to avoid any profit element in it. The work uncertified never includes the portion of notional profit.
Treatment of materials in contract account
The procedures of recording materials in a contract account are as follows:
Treatment of plant in contract account
The machinery used for a contract is recorded in a contract account through two ways. They are
i. The cost of machinery and equipment to be used for a longer period or purchase for the contract is shown in the debit side of a contract account. The book value of the machinery and equipment is shown in credit side. The book value is calculated by deducting the depreciation from the cost of the machinery and equipment.
j. If the machinery and equipment is used for a short time in the contract, the amount of depreciation charged is only debited in the contract account. In such a situation, the purchase price in the debited side and the book value in the credit side are not shown. This is generally done, if the plant and equipment are not used till the end of te accounting period.
The treatments of plant and machinery in a contract account under different conditions have been presented below:
Methods of transferring profit
The profit earned against the completion of a contract is assumed to be the net profit and transferred to profit and loss account. Generally, a contract is completed in a long-period of time and the profit/loss is to be calculated at the end of each accounting period. Out of the national profit i.e. the profit earned during the work in progress, only some portion is to be transferred to profit and loss account. The during the work in progress, only some portion is to be transferred to profit and loss account. The remaining part of the notional profit is transferred to reserve. Therefore reason. There are some factors which are to be considered to transfer the proportion of notional profit to profit and loss account and reserved. They are:
a. Work certified: the work of a contract completed by a contractor is supervised and certified by the engineer of the contractee. The portion of the work completed and certified by the contractee is called the work certified. The work completed but not certified due to different treasons is called the work uncertified. Work certified is one of the bases of transferring the national profit to the profit and loss account.
b. Cash received: the contractor received cash from the contracted depending on the level of work completed. He/she received cash on the basis of work certified. The whole amount of work certified is not paid to the contractor. The portion of work certified that is not paid to the contractor is known as retention money. The relationship between the work certified and cash receipts is shown below:
Cash received (Rs.) = work certified x % of cash received
% of cash received = 100% - Retention rate
Wok certified = cash received (Rs.) x 100/ % cash received
The ways of transferring notional profit and loss account are given below:
a. Transfer of profit of incomplete contracts
The methods of transferring the motioned profit when is in profess are given below:
b. Transfer of profit if contracts are almost completed
The contact in which it is possible to estimate the of contract completion and feature cost to be incurred to completed the work and more than 90% of the work has been completed is called the almost completed contract. The methods of ascertainment of profit and transferring the profit and loss account are given below:
Some other items used in costing account
a. Labour cost: all the workers engaged at the site of a particular contract, irrespective of the nature of the work performed by items, are treated as direct workers and the amount of wages paid to them as direct wages. Such wages are to be charged to the particular contract directly. In case a worker (generally the supervisory staff) is engaged at two or more contracts, his total wages may be apportionment to different contract on the basis of time devoted to each contract or on some other equipment basis' wages accrued or outstanding at the end of the accounting period should appear on the debit side of the contract account.
b. Direct expenses: all expenses (other than material cost and direct wages)
which have been incurred specifically for a particular contract are direct expenses and shall be debited to contract a/c. example of direct expenses are: here charges of special plant (not owned), carriage on materials purchase, travelling expenses relating to contract, etc.
c. Indirect expenses: there are certain expenses, which cannot be directly charged to a particular contract e.g., salary of general manager, salary of architect engaged at a number of contract simultaneously, salary of storekeeper, expenses of store and office expenses. Since these expenses are incurred for the business as a whole, they are to be apportioned to the different contract on some equitable basis.
d. Cost of sub-contracts: generally, the work of a specialized character e.g., road construction in a building, installation of lifts, electrical fittings, is passed on to some other contractor by the main contractor. In such cases, the work performed by the sub-contractor forms a direct charged to be contractor concerned and the sub-contractor price paid shall be debited to contract account.
e. Cost of extra work: sometimes, in case of a contract, some additional work o variations of the work originally contracted for may be required by the contractee. Since the additional work required will not be covered by the terms and condition of original contract, it will be the subject of a separate charge., if the additional work required by the contractee is quite substation, it should be treated as a separate contract and dealt with in a separate account to be opened for it. But in case the additional work is not substantial, the expenses incurred on extra work should be debited to contract account as 'cost of extra work' and the extra amount which the contractee has agreed to pay to the contractor should be added to the original contract price.
f. Contract price: the contract price is the agreed price at which the contractor undertakes to execute to contractor. The contractor account is credited with the contractor price if it has been completed. In such a case, the amount of contract price is debited to the 'contractee's personal account and credited to the 'contract account'. No entry is passed in respect of the contract price in case of incomplete contracts.
g. Retention money: generally, the terms of the contract provide that the whole of the amount shown by the archive's certificate shall not be paid to the contractor but a specified percentage or portion money (say 10% or 20%) thereof shall be retained by the contractee till the contract. Te money so retained is known as 'Retention money'. The cash received from the contractee is credited to his personal account. The value of work (certified and uncertified) is debited to work-in progress account. The work-in-progress account is shown as an asset in the balance sheet after deducting the amount received from the contractee. In the beginning of the next year the work-in-progress account is transferred to the debit side of the contract account. On competition of the contract, the contractee's account is debited and contract account is credited by total contract price.
Differences between job order and contract costing
The differences between job order contacts costing are mentioned below:
Similarities between job order and contract costing
The similarities between job order and contact costing are mentioned below:
• Both jobs and contracts are based on the specific requirements of customers. As a result, each job or contract is 'tailor-made' and there is no exact repetition of a job or contract.
• Both job and contract is terminal. Each job and contract can be identified from start to finish and, therefore, costs can be identified for each job a contract.
• The basic principles of contract costing are similar to those applied in job costing
What is Process costing? Advantages & Disadvantages of process costing?Normal loss,Abnormal loss and Gains
Process is a set of sequential steps followed to complete a certain activity. The way of maintaining the costing records of each process is called costing. It refers to the method of cost accounting under which cost are accumulated for every process which are interrelated to each other. Process costing is used in manufacturing concerns where the raw materials are converted to finished goods after passing through a number of processes. For example; in case of cotton textiles, the first process may be spinning, second process may be weaving and the final process may be finished.
CIMA defines Process Costing as “the costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes, costs are averaged over the units produced during the period.”
Process Costing is used where the production moves from one process or department to the next until its final completion and there is a continuous mass production of identical units through a series of processing operations. It is applied for various industries like chemicals and drugs, oil refining, food processing, paints and varnish, plastics, soaps, textiles, paper etc.
Process Costing method may also be adopted in firms that produce a variety of products, provided that the overall production process can be broken down into sub-operations of a continuous repetitive nature like automobile, toy, plastics etc.
Process costing is mostly used in manufacturing concerns. T determines the cost of a product at each stage of manufacturing or process. This method of costing is adopted by industries involved in the manufacturing of textiles, biscuits, cement, paper, oil refining, etc. the output of first process becomes the input of the second process and so on as shown in following figure.
Advantages of process costing
The following are the advantages of process costing:
a. It is simple and less expensive to find out the cost of each process.
b. It is easy to allocate the expense to process in order to have accurate costs.
c. Production activity in process costing is standardized. Hence, managerial control and supervision become easier.
d. In process costing, the products are homogeneous. As a result, costs per unit can be easily computed by averaging the total cost and price quotations become easier.
e. It is possible to determine process costs periodically at short integrals.
Disadvantages of process costing
The following are the disadvantages of process costing:
a. The cost obtained at the end of the accounting period is historical in nature and is of little use for effective's managerial control.
b. Since process cost is average cost, it may not be accurate for analysis, evaluation and control the performance of various departments.
c. Once an error is committed in one process, it is carried to the subsequent processes.
d. Process costing does not evaluate the efficiency of individual workers or supervisor.
e. The computation of average cost is difficult in those cases where more than one type of product is manufactured.
Features of Process Costing:
The distinctive features of Process Costing are as follows:
(a) The process cost centres are clearly defined and all costs relating to each process cost centre are accumulated.
(b) The cost and stock records for each process cost centre are maintained accurately. The records give clear picture of the units introduced in the process or received from the preceding process cost centre and also units passed to the next process.
(c) The total costs of each process are averaged over the total production of that process, including partly completed units.
(d) The charging of the cost of the output of one process as the raw materials input cost of the following process.
(e) Appropriate method is used in absorption of overheads to the process cost centres.
(f) The process loss may arise due to wastage, spoilage, evaporation etc.
(g) Since the production is continuous in nature, there will be closing work-in-progress which must be valued separately.
(h) The output from the process may be a single product, but there may also be by-products and/or joint products.
Elements of production cost
The following are the main elements of productions cost in process costing:
a. Direct materials: materials are used for manufacturing products. The materials required for production are issued to the first process. The output of first process is passed to the next process and so on. Hence, the output of first process becomes the input of second process and so on, sometimes; new materials may be introduced in the second and subsequent processes.
b. Direct labour: payment madden to the manpower involved in process work against their work is called labour cost. Generally, employees are engaged in one process and wages paid to them is debited in the concerned process account. But if the employs are engaged in more than one process, the total wages paid to them are apportioned among the process on equitable basis.
c. Direct expenses: cost of electricity, hire charges of machine, depreciation of machine are the cost that are directly attributable to a particular process. The process account is debited by such direct costs.
d. Production overhead: the overhead covers a significant portion of the total process cost. Great attention should be paid to ensure that each process is charged with a reasonable share of production overhead like store service, cafeteria services, services etc. are allocated on the basis of absorption rate. The overheads are debited to the process account.
Accounting for process costing
Process accounts
Under process costing, a separate account is maintained for each process. The account is debited with the value of materials, labour, direct expenses and overhead relating to the process. The value of by-products and scrap, if any, is credited to this account. The balance of this account, representing the cost of partially worked out product, is passed on to the next process and so on until the product is completed. Thus the finished product of one process becomes the raw material of the next process.
The following situations arise while preparing process accounts.
a. Process costing having no process loss and stock
All the costs like materials, direct, labour expenses and production overhead relating to the particular process are debited to the process accounts. Since there is no process loss, the output of a process is equal to the unit of input introduced in the process. The total cost of the process is transferred to the next process. The format of the process account having no process loss and stock is given below:
Process-I account
b. Process costing having process loss
It is rare that the output of a process is equal to its input. In most of the cases, the output of a process is less than the input. The difference between the input and output and output is called process loss. The process loss may be in the form of loss in weight, scrapes or wastes. These process losses may be classified into.
Normal loss
Normal loss or uncontrollable loss means the less of materials, which is inherent in the processing operations or in the nature of material. Normal loss includes loss of leakage and normal scrap. Normal loss is considered to be an integral part of process cost. It is unavoidable but efficient workers can reduce it to some extent. The accounting treatment of normal loss is as follows:
Abnormal loss
Any loss caused by unexpected or abnormal condition such as accident, carelessness, etc. is called abnormal loss. It is the excess of over the normal loss. For example, if 1,000 units of raw material are introduced in a process subject to wastage of 10 percent, i.e. the output of the process should be 900 units. But the actual output is 830 units; the extra losses of 70 units are abnormal loss. In other words, the excess loss of 70 units over the normal loss of 100 units is the abnormal loss.
Calculation of the unit and of abnormal loss:
Normal output/yield= inputs – normal loss/ scrap unit
Total normal cost = total cost of input – scrap value of normal loss
Abnormal loss unit = normal output unit – actual output unit
Normal cost per unit = total normal cost/ normal yield
Difference between normal loss and abnormal loss
The differences between the normal loss and abnormal loss are given below:
Difference between normal loss and abnormal loss
c. Process costing having abnormal gain
We know that margin allowed for normal loss is just an estimate and slight differences are bound to occur between the actual and anticipated output of a process. These differences do not always represent increased loss may be less than the expected. Thus, when actual loss in a increased loss, on occasions the actual loss may be less than the expected. Thus, when actual loss in a increased loss, in a process is lower than the expected, an abnormal gain results. The value of the gain is calculated in a similar manner to an abnormal loss.
Abnormal gain being the result of actual loss being less than the normal, the scrap realization shown against normal loss gets reduced by the scrap value of abnormal gain. Consequently, there is an apartment loss by way of reduction in the scrap realization attributable to abnormal gain. The loss is set off against abnormal gain by debiting this account. The balance of this account becomes abnormal gain and is transferred to costing profit and loss account. The balance of this account becomes abnormal gain normal yield or actual loss is less than normal loss.
Calculation of abnormal gain unit and value
Total normal cost= total cost of input – scrap value of normal loss
Normal output/ yield= input – normal loss/ scrap unit
Normal cost per unit = total normal cost/ normal yield
Sales account and income statement
Income statement is prepared to find out profit and loss. Income statement is based on sales account, if sales is recorded in related process account. Incomes statement is also prepared on the basis of profit and loss of every process. If sales are not recorded in related procuress account, incomes statement is prepared on the basis of total sales. Incomes statement can be prepared as follows:
a. When sales is included in the process account
Incomes statement or costing Protit and loss account
Interest process profit
The profit associated with the transfer of goods form one process to another is called inter process profit. Normally finished goods of one process are transferred to the immediate next process at cost of production basis. In some process industries, transfer of finished goods is made to the immediate next process by including some account of profit. The procedure is followed to demonstrate the department efficiency of concerned processes. It helps in recognizing the profit on each process of production. The profit so incorporated is called inter-process profit. The price fixed by adding nominal balance sheet for the transfer of the finished goods to the next process is called as transfer price. For balance sheet purpose, intern process profit cannot be included in stock, as a firm cannot make profit by trading itself. To avoid these complications a provision must be created to reduce the stock to actual cost price. This problem arises only in respect of stock on hand at the end of the period.
The following are the objectives of inter process profit.
• To assess the performance of process operation
• To assess whether the output can compete with the market.
• To decide whether the output can be sold without further processing.
Advantages of inters-process profit
• It shows whether the cost of production computers with the market price.
• By comparing the transfer prices with the corresponding market prices, the 'week' or strong' sports in the manufacturing activity can be located. As a result, measures can be adopted to improve the conditions wherever necessary.
• It makes each process stand on its own efficiency and economics.
Disadvantages of inter-process profit
• This system involves an unnecessary complication of the accounts.
• This systems shown unrealized profits in respect of unsold stocks on the closing date of the accounting period.
• In the balance sheet, stock is conventionally shown at 'cost or market price whichever is lower' to make it acceptable to auditors and tax authorities. Thus, the profit included in stocks has to be eliminated from the stock value before they are shown in final accounts and balance sheet.
Wastage, scrap, spoilage and diffractive unit
Wastage, scrap, spoilage and diffractive unit
Comparison & Differences between job costing and process costing
Comparison Chart
BASIS FOR COMPARISON JOB COSTING PROCESS COSTING
Meaning Job costing refers to calculating the cost of a special contract, work order where work is performed as per client's or customer's instructions. A costing method, in which the costs which are charged to various processes and operations is ascertained, is known as Process Costing.
Nature Customized production Standardized production
Assignment of cost Calculating cost of each job. First of all, cost is determined for the process, thereafter spread over the produced units.
Cost Center Job Process
Scope of cost reduction Less High
Transfer of Cost No transfer Cost is transferred from one process to another
Identity Each job is different from another. Products are manufactured consecutively and so they lose their identity.
Cost Ascertainment Completion of the job. End of the cost period.
Industry type Job costing is suitable for the industries which manufactures products as per customer's order Process costing is perfect for the industry where mass production is done.
Losses Losses are usually not segregated. Normal losses are carefully ascertained and abnormal losses are bifurcated.
Work-in-progress (WIP) WIP may or may not exist at the beginning or at the end of the financial year. WIP will always be present in the beginning or at the end of the accounting period.
The differences between job costing and process costing are as follow:
Key Differences Between Job Costing and Process Costing
The following are the major differences between job costing and process costing:
1. The costing method which is used for the ascertainment of the cost of each job is known as Job Costing. Conversely, by process costing, we mean the costing technique used to determine the cost of each process.
2. Job Costing is performed where the products produced of a specialized nature, whereas Process Costing is used where standardized products are produced.
3. In Job Costing, the cost is calculated for each job, but in Process Costing first of all the cost of each process is calculated which is then dispersed over the number of units produced.
4. In job costing the cost center is the job itself while the process is the cost center in case of process costing.
5. In job costing each job requires special treatment. On the other hand, no such special treatment is required for each process in process costing.
6. There is no transfer of cost in job costing, from one job to another. However, the cost of the last process is transferred to the next process in the process costing.
7. The possibility of cost reduction is very less in Job Costing. In contrast to Process Costing, the scope of cost reduction is comparatively high.
8. In Job Costing, the cost is ascertained after the completion of the job, but in Process Costing, the cost of each job is determined.
9. In job costing, losses are not bifurcated. On the contrary, in process costing normal losses are ascertained carefully, while the abnormal losses are bifurcated.
10. In job costing, WIP may or may or may not be present at the end of the financial year. As against this, WIP will always be present, irrespective of the quantity, in the beginning, or at the end of the accounting period, in process costing.
List of formula
Normal output/yield = inputs – normal loss/ scrap unit
Total normal cost = total cost of input –scrap value of normal loss
Normal cost per unit = total normal cost/ normal yield
Abnormal loss (unit) = normal output unit –actual output unit/ normal output unit – actual output unit
Abnormal loss (Rs.) = abnormal loss unit x normal cost per unit
Abnormal gain (units) = actual loss unit – actual loss unit
Abnormal gain (RS.) =abnormal gain unit x normal cost per unit
Inter process:
Cost of losing stock = given closing stock x total amount of cost column/ total amount of total column
Unrealized profit on closing stock = given closing stock – cost of closing stock
Calculation of inter process profit:
a. It percentage of item process is given on processing cost, then
Inter process profit = total cost x %profit
a. If percentage of inter process profit is given on transfer price , then
Inter process profit =total cost x %profit / 100- %profit
Actual released profit = gross profit + unrealized profit on opening stock – unrealized profit on closing stock
What is Operating Costing?
Operating costing is an extension and refined form of process costing. It is also more or less very similar to single or output costing. The operating costing gives more emphasis on providing services rather than the cost of manufacturing an article. The services provided may be for sale to the general public or they may be provided within an organization.
The operating costing is also called as service costing, period costing or terminal costing. Service costing means rendering service to the public or to an organization for which cost is accumulated and calculated. Period costing means the costs data collected and calculated for a specific period. Terminal costing means a bus or truck of a transport undertaking chartered for a specific trip.
Meaning of Operating Costing
Operating costing is a process and technique of accumulating and ascertainment of cost for providing a standardized service to the public or to an undertaking.
Definition of Operating Costing
ICMA, London,
Operating costing is that form of operation costing which applies where standardized services are provided either by an undertaking or by a service cost center within an undertaking.
Wheldon,
Operating costing is actually unit costing as applied to the costing of services.
Features of Operating Costing
The basic features of operating costing are presented below.
1. Uniform service is provided to all the customers.
2. The costs are classified into fixed and variable.
3. The fixed and variable cost classification is necessary to ascertain the cost of service and the unit cost of service.
4. There is no physical stock of article if an undertaking renders a service.
5. If a cost center is operating for an undertaking, there is no sale of service but render the service. In other words, if a cost center is operating for public, it sells its service to the public.
6. The cost unit may be simple in certain cases or composite or compound in other cases like transport undertakings.
7. Total costs are averaged over the total amount of service rendered.
8. The costs are collected from the authentic documents like daily log sheet, operating cost sheet, boiler house cost sheet, canteen cost sheets etc.
9. Operating cost is the cost of rendering service.
10. Operating costing is the method of ascertaining costs.
11. The productive enterprises can quote prices by ascertaining cost data.
Application of Operating Costing
Operating costing is applied by an organization, which provides service to the public as a whole instead of manufacturing an article, and sells the same. For example, Transport undertaking electricity, theatre, hospitals, schools and the like. Similarly, the same type of an organization or cost center renders service to production departments. For example, Electricity, powerhouse, canteen and the like.
The service cost in operating cost should be find out to understand whether an organization or cost center render services to others or sell the services to the general public. If the services are sold, the operating expenses and the extent of services rendered are taken into consideration to find out the service cost. On the other hand, if the services are sold, the service expenses should be apportioned to the production department on a suitable basis.
Generally, the basis may be the extent of service availed by the production departments. It may also become necessary to compare the cost of such a service with the cost of an outside service for deciding whether it is profitable to buy a service from outside rather than make the same available from within an organization.
How are services classified under Operating Costing?
The services may be classified into two categories under operating costing, namely
1. Internal service and
2. External service.
Internal service refers to rendering service to the production departments within an organization. External service refers to providing services to the general public uniformly. The object of both internal service and external service is the same.
Selection of Cost under Operating Costing
Cost is expressed in terms of the unit of service rendered. Though, operating cost is relating to units of costing the cost unit is not as tangible as a job or a contract. Any person cannot easily select a cost unit. Thus, the selection of cost unit requires more skill, technical and statistical talent on the part of the cost accountant.
The cost unit may be simple cost unit or composite cost unit. There is only one variable in the simple cost unit. For example, per bed in case of hospitals, a cup of tea or coffee in case of canteen, per room or per bed in case of lodge and the like. Two or more variables have a close relationship in the composite cost unit. Costs are collected in terms of composite cost units. For example, per tone km in case of transport (truck), per man show in case of cinema theatres, per passenger km in case of transport (passenger) and the like. Hence, the selection of suitable cost unit depends upon the nature of service.
The following table gives a clear picture on the cost unit along with the nature of service of the undertaking.
Nature of Service Undertaking Cost Unit
Goods Transport service (Lorry, goods train, air transport of goods, trucks etc. Per tone km.
Passenger Transport service (Bus, Mini Bus, Train, Boat, Passenger train, air transport etc. Per Passenger km.
Hospitals Per bed, per patient, per day
Electricity Supply Kwh, Horse power
Canteen Service Man-men/cup of tea or coffee
Boiler House Cubic centimeters
Road Maintenance Per Km
Private Transport (private car, private aeroplane etc) Running Hour, Trip Km
Hotel Per room, per bed
Street lighting Per point, per lamp
Gas Cubit meters, Kg
Water Supply Gallons, Liters
Cinema theatres Per man show
In case rail transport, more number of cost centers are functioning since the rail transport has more number of and complicated activities. For example, repairs and maintenance, routes, stations, go downs, yards, wagons, engines and the like. There is no method of costing except operating costing applicable to rail transport.
Objectives of Operating Costing
The objectives of operating costing are listed below:
1. To supply the information through which the efficiency in rendering service is improved.
2. To provide a basis for fixing accurate quotation and fare.
3. To ensure that the services are provided in proper time.
4. To control the fuel consumption and its expenses.
5. To ensure that the service equipments are properly maintained.
6. To provide cost comparison between own service and alternative service i.e. hiring.
7. To compare the cost of one service center with another.
8. To determine the apportionment cost if the services are provided within an organization.
9. To decide the price that can be charged for use of vehicle.
10. To control the cost of maintenance and repairs.
11. To select efficient and suitable routing of vehicles to reduce the costs to production departments that uses the service.
12. To avoid the under utilization of capacity and idle time of the work force.
13. To absorb the fixed costs proportionately and systematically that is allocated to the units of services.
Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories.
Financial Accounting, aims at finding out profit or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
Management Accounting helps the management to conduct the business in a more efficient manner.
As compared to the financial accounting, the focus of cost accounting is different. In the modern days of cut throat competition, any business organization has to pay attention towards their cost of production.
Computation of cost on scientific basis and thereafter cost control and cost reduction has become of paramount importance. Hence it has become essential to study the basic principles and concepts of cost accounting. These are discussed in the subsequent paragraphs.
Cost accounting is a branch of accounting that has evolved to overcome the limitations of financial accounting. It is the process of accounting for cost, which is concerned more with the ascertainment, allocation, distribution and accounting aspects of cost. It is that branch of accounting, which deals with the classification, recording, allocation, summation and reporting of current and prospective costs. Actually, it is the formal mechanism by means of which of products and services are ascertained and controlled.
It is an internal reporting systems that aims to assist the management for planning and decision-making it primary emphasizes on cost and deals with collection, analysis, interpretation and prospective for managerial decision making on various business problems.
Cost accounting is more concerned with short-tem planning and its reporting period is much losses that financial accounting. It deals with historic data but is also futuristic in approach. Cost accounting systems cannot be installed without proper financial accounting systems. Each organization can develop a costing systems best suited to its individual needs. In financial accounting the major emphasis is in cost classification based on types of transaction e.g., salaries, repairs, insurance, stores etc. but in cost accounting, the emphasis is laid on functions, activities, processes and on internal planning and control and information needs of the organization.
Similarly, according to national association of accountants USA'
From the above information definition, it can be concluded that cost accounting is accounting for cost aimed at providing cost data, statements and reports for the purposes to assists the managements in planning decision making and controlling.
Cost :- Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.
Costing :- Costing may be defined as ‘the technique and process of ascertaining costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the ascertainment of every order, job, contract, process, service units as may be appropriate. It deals with the cost of production, selling and distribution.
If we analyze the above definitions, it will be understood that costing is basically the procedure of ascertaining the costs. As mentioned above, for any business organization, ascertaining of costs is must and for this purpose a scientific procedure should be followed. ‘Costing’ is precisely this procedure which helps them to find out the costs of products or services.
Cost Accounting :- Cost Accounting primarily deals with collection, analysis of relevant of cost data for interpretation and presentation for various problems of management. Cost accounting accounts for the cost of products, service or an operation. It is defined as, ‘the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profitability or the social use of funds’.
Cost Accountancy :- Cost Accountancy is a broader term and is defined as, ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profitability as well as presentation of information for the purpose of managerial decision making.’
If we analyze the above definition, the following points will emerge,
A. Cost accounting is basically application of the costing and cost accounting principles.
B. This application is with specific purpose and that is for the purpose of cost control, ascertainment of profitability and also for presentation of information to facilitate decision making.
C. Cost accounting is a combination of art and science, it is a science as it has well defi ned rules and regulations, it is an art as application of any science requires art and it is a practice as it has to be applied on continuous basis and is not a one time exercise.
Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the scope of cost accounting is broader than that of costing. Following functional activities are included in the scope of cost accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is preferably done on the basis of double entry system.
2. Cost system: Systems and procedures are devised for proper accounting for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports form the basis for planning and control, performance appraisal and managerial decision making.
Objectives and Functions of Cost Accounting:
1. To ascertain the cost per unit of the different products manufactured by a business concern.
2. To provide a correct analysis of cost both by process or operations and by different elements of cost.
3. To disclose sources of wastage whether of material, time or expense or in the use of machinery, equipment and tools and to prepare such reports which may be necessary to control such wastage.
4. To provide requisite data and serve as a guide for fixing prices of products manufactured or services rendered.
5. To ascertain the profitability of each of the products and advise management as to how these profits can be maximised.
6. To exercise effective control if stocks of raw materials, work-in-progress, consumable stores and finished goods in order to minimise the capital locked up in these stocks.
7. To reveal sources of economy by installing and implementing a system of cost control for materials, labour and overheads.
8. To advise management on future expansion policies and proposed capital projects.
9. To present and interpret data for management planning, evaluation of performance and control.
10. To help in the preparation of budgets and implementation of budgetary control.
11. To organise an effective information system so that different levels of management may get the required information at the right time in right form for carrying out their individual responsibilities in an efficient manner.
12. To guide management in the formulation and implementation of incentive bonus plans based on productivity and cost savings.
13. To supply useful data to management for taking various financial decisions such as introduction of new products, replacement of labour by machine etc.
14. To help in supervising the working of punched card accounting or data processing through computers.
15. To organise the internal audit system to ensure effective working of different departments
IMPORTANCE OF COST ACCOUNTING
1. Costing helps in periods of trade depression and trade competition:-
In periods of trade depression the business cannot afford to have leakages which pass unchecked. The management should know where economies may be sought, waste eliminated and efficiency increased. The business has to wage a wax for its survival. The management should know the actual cost of their products before embarking on any scheme of reducing the prices on giving tenders. Adequate costing facilitates this.
2. Aids in price fixation:-
Though economic law & supply and demand and activities of the competitors, to a great extent, determine the price of the article, cost to the producer does play an important part. The producer can take necessary guidance from his costing records.
3. Helps in estimate:-
Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of over – rating or losing in the execution of a contract due to under – rating can be minimized. Thus, “ascertained costs provide a measure for estimates, a guide to policy, and a control over current production”.
4. Helps in channeling production on right lines:-
Costing makes possible for the management to distinguish between profitable and non-profitable activities profit can be maximized by concentrating on profitable operations and eliminating non-profitable ones.
5. Wastages are eliminated:-
As it is possible to know the cost of the article at every stage, it becomes possible to chock various forms of waste, such as time, expenses etc. or in the use of machine, equipment and tools.
6. Costing makes comparison possible:-
If the costing records are regularly kept, comparative cost data for different periods and various volumes of production will be available. It will help the management in forming future lines of action.
7. Provides data for periodical profit and loss accounts:-
Adequate costing records supply to the management such data as may be necessary for preparation of profit and loss account and balance sheet, at such intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial accounts thus helps in presentation of better information before the management.
8. Aids in determining and enhancing efficiency:-
Losses due to wastage of material, idle time of workers, poor supervision etc., will be disclosed if the various operations involved in manufacturing a product are studied by a cost accountant. The efficiency can be measured and costs controlled and through it various devices can be framed to increase the efficiency.
9. Helps in inventory control:-
Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods. (This has been explained in detail under the chapter “Materials”)
10. Helps in cost reduction:-
Costs can be reduced in the long run when alternatives are tried. This is particularly important ion the present day context of global competition cost accounting has assumed special significance beyond cost control this way.
11. Assists in increasing productivity
Productivity of material and labour is required to be increased to have growth and more profitability in the organisation costing renders great assistance in measuring productivity and suggesting ways to improve it.
2. Define Cost accounting? Explain the advantages and limitations of cost accounting
Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories.
Financial Accounting, aims at finding out profi t or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
Management Accounting helps the management to conduct the business in a more efficient manner.
As compared to the financial accounting, the focus of cost accounting is different. In the modern days of cut throat competition, any business organization has to pay attention towards their cost of production.
Computation of cost on scientific basis and thereafter cost control and cost reduction has become of paramount importance. Hence it has become essential to study the basic principles and concepts of cost accounting. These are discussed in the subsequent paragraphs.
Cost accounting is a branch of accounting that has evolved to overcome the limitations of financial accounting. It is the process of accounting for cost, which is concerned more with the ascertainment, allocation, distribution and accounting aspects of cost. It is that branch of accounting, which deals with the classification, recording, allocation, summation and reporting of current and prospective costs. Actually, it is the formal mechanism by means of which of products and services are ascertained and controlled.
It is an internal reporting systems that aims to assist the management for planning and decision-making it primary emphasizes on cost and deals with collection, analysis, interpretation and prospective for managerial decision making on various business problems.
Cost accounting is more concerned with short-tem planning and its reporting period is much losses that financial accounting. It deals with historic data but is also futuristic in approach. Cost accounting systems cannot be installed without proper financial accounting systems. Each organization can develop a costing systems best suited to its individual needs. In financial accounting the major emphasis is in cost classification based on types of transaction e.g., salaries, repairs, insurance, stores etc. but in cost accounting, the emphasis is laid on functions, activities, processes and on internal planning and control and information needs of the organization.
Similarly, according to national association of accountants USA'
From the above information definition, it can be concluded that cost accounting is accounting for cost aimed at providing cost data, statements and reports for the purposes to assists the managements in planning decision making and controlling.
Cost :- Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.
Costing :- Costing may be defined as ‘the technique and process of ascertaining costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the ascertainment of every order, job, contract, process, service units as may be appropriate. It deals with the cost of production, selling and distribution.
If we analyze the above definitions, it will be understood that costing is basically the procedure of ascertaining the costs. As mentioned above, for any business organization, ascertaining of costs is must and for this purpose a scientific procedure should be followed. ‘Costing’ is precisely this procedure which helps them to find out the costs of products or services.
Cost Accounting :- Cost Accounting primarily deals with collection, analysis of relevant of cost data for interpretation and presentation for various problems of management. Cost accounting accounts for the cost of products, service or an operation. It is defined as, ‘the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profitability or the social use of funds’.
Cost Accountancy :- Cost Accountancy is a broader term and is defined as, ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profitability as well as presentation of information for the purpose of managerial decision making.’
If we analyze the above definition, the following points will emerge,
A. Cost accounting is basically application of the costing and cost accounting principles.
B. This application is with specific purpose and that is for the purpose of cost control, ascertainment of profitability and also for presentation of information to facilitate decision making.
C. Cost accounting is a combination of art and science, it is a science as it has well defined rules and regulations, it is an art as application of any science requires art and it is a practice as it has to be applied on continuous basis and is not a one time exercise.
Moreover, the management at the maximum should accept the advises given by the cost accounting system. If so, the following advantages may be available to an organization.
Advantages of Cost Accounting
The extent of advantages derived from the cost accounting is based on the type, adequacy and efficiency of cost accounting system installation.
Moreover, the management at the maximum should accept the advises given by the cost accounting system. If so, the following advantages may be available to an organization.
1. Elimination of Wastes, Losses and Inefficiencies: A good cost accounting system eliminates wastes, losses and inefficiencies by fixing standard for everything.
2. Cost Reduction: New and improved methods of production are followed under cost accounting system. It leads to cost reduction.
3. Identify the reasons for Profit or Loss: A good cost accounting system highlights the reasons for increasing or decreasing profit. If so, the management can take remedial action to maintain profitability of the concern. There is no possibility of shutting down of any product or process or department.
4. Advises on Make or Buy Decision: On the basis of cost information, the management can decide whether make or buy a product in open market. The management can rightly choose the best out of many alternatives. Sometimes, spare capacity can be used profitably.
5. Price Fixation: The total cost of a product is available in the costing records. It is highly useful for price fixation of a product.
6. Cost Control: Budgets are prepared and standards are fixed under cost accounting system. The expenses are not permitted beyond the budget amount. The actual performance is compared with standard to find the variation. If there is any variation, reasons are find out and the management can exercise control. Period to period cost comparison also helps cost control.
7. Assist the Government: Government can collect reasonable tax from the company and exercise price control.
8. Help the Trade Union: Bonus calculation is very easy to the trade union. Reasonable remuneration is also fixed on the basis of cost accounting information.
9. Marginal Analysis of Cost: It is done for facilitating the short-term decisions especially during depression period.
10. Fixation of Responsibility: Responsibility centers is fixed under cost accounting system. If responsibility is fixed, it becomes difficult to evade responsibility of performance and leads to effective performance.
11. Helps to Prepare Financial Accounts: The information like value of closing materials, work in progress and finished goods are necessary to prepare financial accounts. This information is supplied by the costing records and helps to prepare financial accounts without any further delay.
12. Prevention of Frauds: Introducing cost audit can prevent frauds. If so, correct and reliable data was available from the costing records which are highly useful to the government, share holders, the creditors and the like.
Disadvantages or Limitations of Cost Accounting
The limitations or disadvantages of cost accounting are listed below:
1. Only past performances are available in the costing records but the management is taking decision for future.
2. The cost of previous year is not same in the succeeding year. Hence, cost data are not highly useful.
3. The cost is ascertained on the basis of full utilization of capacity. If capacity is partly utilized, the cost may not be true.
4. Financial character expenses are not included for cost calculation. Hence, the calculated cost is not correct always.
5. In cost accounting, costs are absorbed on pre-determined rate. It leads to over absorption or under absorption of overheads.
6. Cost Accounting fails to solve the problems relating to work study, time and motion study and operation research.
7. Installation of Cost Accounting System requires the maintenance of many costing records. If results in heavy expenditure.
8. Delay in receiving costing information does not result in taking quality decision by the management.
9. Rigid Cost Accounting System does not serve all purposes.
3. Differentiate between financial accounting and cost accounting.
Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories.
Financial Accounting, aims at finding out profit or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
Both cost accounting and financial accounting help the management formulate and control organization policies. Financial management gives an overall picture of profit or loss and costing provides detailed product-wise analysis.
No doubt, the purpose of both is same; but still there is a lot of difference in financial accounting and cost accounting. For example, if a company is dealing in 10 types of products, financial accounting provides information of all the products in totality under different categories of expense heads such as cost of material, cost of labor, freight charges, direct expenses, and indirect expenses. In contrast, cost accounting gives details of each overhead product-wise, such as much material, labor, direct and indirect expenses are consumed in each unit. With the help of costing, we get product-wise cost, selling price, and profitability.
The following table broadly covers the most important differences between financial accounting and cost accounting.
Point of Differences Financial Accounting Cost Accounting
Meaning Recoding of transactions is part of financial accounting. We make financial statements through these transactions. With the help of financial statements, we analyze the profitability and financial position of a company. Cost accounting is used to calculate cost of the product and also helpful in controlling cost. In cost accounting, we study about variable costs, fixed costs, semi-fixed costs, overheads and capital cost.
Purpose Purpose of the financial statement is to show correct financial position of the organization. To calculate cost of each unit of product on the basis of which we can take accurate decisions.
Recording Estimation in recording of financial transactions is not used. It is based on actual transactions only. In cost accounting, we book actual transactions and compare it with the estimation. Hence costing is based on the estimation of cost as well as on the recording of actual transactions.
Controlling Correctness of transaction is important without taking care of cost control. Cost accounting done with the purpose of control over cost with the help of costing tools like standard costing and budgetary control.
Period Period of reporting of financial accounting is at the end of financial year. Reporting under cost accounting is done as per the requirement of management or as-and-when-required basis.
Reporting In financial accounting, costs are recorded broadly. In cost accounting, minute reporting of cost is done per-unit wise.
Fixation of Selling Price Fixation of selling price is not an objective of financial accounting. Cost accounting provides sufficient information, which is helpful in determining selling price.
Relative Efficiency Relative efficiency of workers, plant, and machinery cannot be determined under it. Valuable information about efficiency is provided by cost accountant.
Valuation of Inventory Valuation basis is ‘cost or market price whichever is less’ Cost accounting always considers the cost price of inventories.
Process Journal entries, ledger accounts, trial balance, and financial statements Cost of sale of product(s), addition of margin and determination of selling price of the product.
4. How can costs be classified? Explain in detail.
Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.
Classification of Costs :- An important step in computation and analysis of cost is the classification of costs into different types. Classification helps in better control of the costs and also helps considerably in decision making. Classification of costs can be made according to the following basis.
There are three broad elements of cost:-
(a) Material
(b) Labour
(c) Expenses
(a) Material: - The substance from which the product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.
Direct Material: - All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed as “Direct Material”.
Following are some of the examples of direct material:-
(i) All material or components specifically purchased produced or requisitioned from stores.
(ii) Primary packing material (e.g. – cartoon, wrapping, cardboard, boxes etc.)
(iii) Purchased or partly produced components.
Direct material is also described as raw-material, process material, prime material, production material, stores material, constructional material etc.
Indirect Material: - All material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as “Indirect Material”.
Consumable stores, oil and waste, printing and stationery etc. are a few examples of indirect material
Indirect material may be used in the factory the office or the selling and distribution division.
(b) Labour: - For conversion of materials into finished goods, human effort is needed such human effort is called labour. Labour can be direct as well as indirect.
Direct labour: - Labour which takes an active and direct part in the production of a particular commodity is called labour. Direct labour costs are, therefore specially and conveniently traceable to specific products.
Direct labour is also described as process labour, productive labour, operating labour, manufacturing labour, direct wages etc.
Indirect labour:- labour employed for the purpose of carrying out tasks incidental to goods or services provided, is indirect labour such labour does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output wages of store – keepers, foreman, time – keepers, directors, fees, salaries of salesmen, etc. are all examples of indirect labour costs.
Indirect labour may relate to the factory the office or the selling and distribution division.
(c) Expenses: - Expenses may be direct or indirect.
Direct expenses: - These are expenses which can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are: hire of some special machinery required for a particular contract, cost of defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as “chargeable expenses”.
Indirect expenses:- these are expenses which cannot be directly, conveniently and wholly allocated to cost centers or cost units.
OVERHEADS:- It is to be noted that the term overheads has a wider meaning than the term indirect expenses overheads include the cost of indirect material, indirect labour besides indirect expenses.
Indirect expenses may be classified under the following three categories:-
(a) Manufacturing (works, factory or production) expenses:-
Such indirect expenses which are incurred in the factory and concerned with the running of the factory or plant are known as manufacturing expenses. Expenses relating to production management and administration are included there in. Following are a few items of such expenses:
Rent, rates and insurance of factory premises, power used in factory building, plant and machinery etc.
(b) Office and Administrative expenses
These expenses are not related to factory but they pertain to the management and administration of business such expenses are incurred on the direction and control of an undertaking example are :- office rent, lighting and heating, postage and telegrams, telephones and other charges; depreciation of office building, furniture and equipment, bank charges, legal charges, audit fee etc.
(c) Selling and Distribution Expenses:-
Expenses incurred for marketing of a commodity, for securing orders for the articles, dispatching goods sold, and for making efforts to find and retain customers are called selling and distribution expenses examples are:-
Advertisement expenses cost of preparing tenders, traveling expenses, bad debts, collection charges etc.
Warehouse charges packing and loading charges, carriage outwards, etc.
The above classification of different elements of cost can be presented in the form of the following chart:
or
Items excluded from cost accounts
There are certain items which are included in financial accounts but not in cost accounts. These items fall into three categories:-
Appropriation of profits
(i) Appropriation to sinking funds.
(ii) Dividends paid
(iii) Taxes on income and profits
(iv) Transfers to general reserves
(v) Excess provision for depreciation of buildings, plant etc. and for bad debts
(vi) Amount written off – goodwill, preliminary expenses, underwriting commission, discount on debentures issued; expenses of capital issue etc.
(vii) Capital expenditures specifically charged to revenue
(viii) Charitable donation
Matters of pure finance
(a) Purely financial charges:-
(i) Losses on sale of investments, buildings, etc.
(ii) Expenses on transfer of company’s office
(iii) Interest on bank loan, debentures, mortgages, etc.
(iv) Damages payable
(v) Penalties and fines
(vi) Losses due to scrapping of machinery
(vii) Remuneration paid to the proprietor in excess of a fair reward for services rendered.
(b) Purely financial incomes:-
(i) Interest received on bank deposits
(ii) Profits made on the sale of investments, fixed assets, etc.
(iii) Transfer fees received
(iv) Rent receivable
(v) Interest, dividends, etc. received on investments.
(vi) Brokerage received
(vii) Discount, commission received
Abnormal gains and losses:-
(i) Losses or gains on sale of fixed assets.
(ii) Loss to business property on account of theft, fire or other natural calamities.
In addition to above abnormal items (gain and losses) may also be excluded from cost accounts. Alternatively, these may be taken to costing profit and loss account.
b. Classification according to behavior :- Costs can also be classified according to their behavior. This classification is explained below.
i. Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume. These costs are called as fixed costs. The feature of these costs is that the total costs remain same while per unit fixed cost is always variable. Examples of these costs are salaries, insurance, rent, etc.
ii. Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production. Their variability is in the same proportion to the production. For example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the production. Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct materials, direct labor etc.
iii. Semi-variable Costs :- Certain costs are partly fixed and partly variable. In other words, they contain the features of both types of costs. These costs are neither totally fixed nor totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’.
C Classification according to functions :- Costs can also be classified according to the functions/ activities. This classification can be done as mentioned below.
iv. Production Costs :- All costs incurred for production of goods are known as production costs.
v. Administrative Costs :- Costs incurred for administration are known as administrative costs. Examples of these costs are office salaries, printing and stationery, office telephone, office rent, office insurance etc.
vi. Selling and Distribution Costs :- All costs incurred for procuring an order are called as selling costs while all costs incurred for execution of order are distribution costs. Market research expenses, advertising, sales staff salary, sales promotion expenses are some of the examples of selling costs. Transportation expenses incurred on sales, warehouse rent etc are examples of distribution costs.
vii. Research and Development Costs :- In the modern days, research and development has become one of the important functions of a business organization. Expenditure incurred for this function can be classified as Research and Development Costs.
c. Classification according to time :- Costs can also be classified according to time. This classification is explained below.
I. Historical Costs :- These are the costs which are incurred in the past, i.e. in the past year, past month or even in the last week or yesterday. The historical costs are ascertained after the period is over. In other words it becomes a post-mortem analysis of what has happened in the past. Though historical costs have limited importance, still they can be used for estimating the trends of the future, i.e. they can be effectively used for predicting the future costs.
II. Predetermined Cost :- These costs relating to the product are computed in advance of production, on the basis of a specification of all the factors affecting cost and cost data. Pre determined costs may be either standard or estimated. Standard Cost is a predetermined calculation of how much cost should be under specific working conditions. It is based on technical studies regarding material, labor and expenses. The main purpose of standard cost is to have some kind of benchmark for comparing the actual performance with the standards. On the other hand, estimated costs are predetermined costs based on past performance and adjusted to the anticipated changes. It can be used in any business situation or decision making which does not require accurate cost.
D .Classification of costs for Management decision making :- One of the important function of cost accounting is to present information to the Management for the purpose of decision making. For decision making certain types of costs are relevant. Classification of costs based on the criteria of decision making can be done in the following manner
I. Marginal Cost :- Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit. For example, suppose a manufacturing company produces 10,000 units and the aggregate costs are Rs. 25,000, if 10,001 units are produced the aggregate costs may be Rs. 25,020 which means that the marginal cost is Rs. 20. Marginal cost is also termed as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost is always fixed. Marginal cost can be effectively used for decision making in various areas.
II. Differential Costs :- Differential costs are also known as incremental cost. This cost is the difference in total cost that will arise from the selection of one alternative to the other. In other words, it is an added cost of a change in the level of activity. This type of analysis is useful for taking various decisions like change in the level of activity, adding or dropping a product, change in product mix, make or buy decisions, accepting an export offer and so on.
III. Opportunity Costs :- It is the value of benefit sacrificed in favor of an alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable. Opportunity cost of goods or services is measured in terms of revenue which could have been earned by employing that goods or services in some other alternative uses.
IV. Relevant Cost :- The relevant cost is a cost which is relevant in various decisions of management. Decision making involves consideration of several alternative courses of action. In this process, whatever costs are relevant are to be taken into consideration. In other words, costs which are going to be affected matter the most and these costs are called as relevant costs. Relevant cost is a future cost which is different for different alternatives. It can also be defined as any cost which is affected by the decision on hand. Thus in decision making relevant costs play a vital role.
V. Replacement Cost :- This cost is the cost at which existing items of material or fixed assets can be replaced. Thus this is the cost of replacing existing assets at present or at a future date.
VI. Abnormal Costs :- It is an unusual or a typical cost whose occurrence is usually not regular and is unexpected. This cost arises due to some abnormal situation of production. Abnormal cost arises due to idle time, may be due to some unexpected heavy breakdown of machinery. They are not taken into consideration while computing cost of production or for decision making.Controllable Costs :- In cost accounting, cost control and cost reduction are extremely important. In fact, in the competitive environment, cost control and reduction are the key words. Hence it is essential to identify the controllable and uncontrollable costs. Controllable costs are those which can be controlled or influenced by a conscious management action. For example, costs like telephone, printing stationery etc can be controlled while costs like salaries etc cannot be controlled at least in the short run. Generally, direct costs are controllable while uncontrollable costs are beyond the control of an individual in a given period of time.
VII. Shutdown Cost :- These costs are the costs which are incurred if the operations are shut down and they will disappear if the operations are continued. Examples of these costs are costs of sheltering the plant and machinery and construction of sheds for storing exposed property. Computation of shutdown costs is extremely important for taking a decision of continuing or shutting down operations.
VIII. Capacity Cost :- These costs are normally fixed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions. Capacity costs include the costs of plant, machinery and building for production, warehouses and vehicles for distribution and key personnel for administration. These costs are in the nature of long-term costs and are incurred as a result of planning decisions.
IX. Urgent Costs :- These costs are those which must be incurred in order to continue operations of the firm. For example, cost of material and labor must be incurred if production is to take place.
5. What is meant by cost sheet? Explain the importance of Cost Sheet with format.
Cost sheet is a statement, which shows various components of total cost of a product. It classifies and analyses the components of cost of a product. Previous periods data is given in the cost sheet for comparative study. It is a statement which shows per unit cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost presented in the form of a statement is termed as Cost sheet. It analysis and classified the expense on different items for a particular period in a tabular form.Additional columns may also be provided to show the cost per unit pertaining to each item of expenditure and the total cost per unit.In other word cost sheet is a periodical document of cost sheet is show the total cost and unit of cost of products in an analytical and detailed form.
Cost sheet may be prepared weekly , monthly, quarterly ,half yearly or yearly basis according to convenience.Cost sheet is prepared on the basis of actual data or on the basis of estimated data depending on the technique of costing.
Definition Of cost Sheet : ICMA london “Cost Sheet is a document which provide for the assembly of estimated detailed cost in respect of cost center or a cost of unit.”
According to WW Bigg ” The expenditure which has been incurred upon production for a period is extracted for the financial books and the store record and set out in memorandum statement .If this statement is confined in the disclosure of the cost of the unit produced during the period it is termed a cost sheet.”
Cost sheet is prepared on the basis of
: 1. Historical Cost
2. Estimated Cost
Historical Cost Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost prepared after incurring the actual cost is called Historical Cost Sheet.
Estimated Cost Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting the tender price of a job or a contract.
It depicts the following facts
1. It gives total cost and cost per unit for a particular.
2. It shows various element of cost such as prime cost factory csot production cost ,cost of goods sold total cost etc.
3. It s clears the percentage of every expenditure to total cost.
4. it help to management to compare the cost of any two period and ascertain the inefficiencies if any in production.
5. It gives information to management for cost control
It calculate and summarize a total cost of product
The Components of cost are shown in the classified and analytical form in the cost sheet.
Components of total cost are as follows:
Prime Cost It consists of direct material, direct wages and direct expenses. In other words “Prime cost represents the aggregate of cost of material consumed, productive wages, and direct expenses”. It is also known as basic, first, flat or direct cost of a product.
Prime Cost = Direct material + Direct Wages + Direct expenses
Direct material means cost of raw material used or consumed in production. It is not necessary that all the material purchased in a particular period is used in production. There is some stock of raw material in balance at opening and closing of the period. Hence, it is necessary that the cost of opening and closing stock of material is adjusted in the material purchased. Opening stock of material is added and closing stock of raw material is deducted in the material purchased and we get material consumed or used in production of a product. It is calculated as :
Material Consumed = Material purchased + Opening stock of material – Closing stock of material.
Factory Cost
In addition to prime cost it includes works or factory overheads. Factory overheads consist of cost of indirect material, indirect wages, and indirect expenses incurred in the factory. Factory cost is also known as works cost, production or manufacturing cost.
Factory Cost = Prime cost + Factory overheads
Adjustment for stock of work-in-progress
In the process of production, some units remain to be completed at the end of a period. These incomplete units are known as work-in-progress. Normally, the cost of incomplete units include direct material, direct Labour, direct expenses, and average factory overheads. Hence, at the time of computing factory cost, it is necessary to make adjustment of opening and closing stock of work in progress to arrive at the net Factory cost/works cost.
TOTAL COST AND COST SHEET
If office and administrative overheads are added to factory or works cost, total cost of production is arrived at. Hence the total cost of production is calculated as:
Total Cost of production = Factory Cost + office and administration overheads
Cost of goods sold
It is not necessary, that all the goods produced in a period are sold in the same period. There is stock of finished goods in the opening and at the end of the period. The cost of opening stock of finished goods is added in the total cost of production in the current period and cost of closing stock of finished goods is deducted. The cost of goods sold is calculated as:
Cost of goods sold = Total cost of production + Opening stock of Finished goods – Closing stock of finished goods
Total Cost i.e, Cost of Sales
If selling and distribution overheads are added to the total cost of production, total cost is arrived at. This cost is also termed as cost of Sales. Hence the total cost is calculated as:
Total Cost = Cost of Goods sold + Selling and distribution overheads
Preparation of cost sheet
The various components of cost explained above are presented in the form of a statement. Such a statement of cost consists of prime cost, works cost, cost of production of goods, cost of goods sold, total cost and sales and is termed as cost sheet. The Preparation of a cost sheet can be understood with the help of following illustration:
From the following information, prepare a cost sheet for period ended on 31st March 2006. Rs. Opening stock of raw material 12,500 Purchases of raw material 1,36,000 Closing stock of raw material 8,500 Direct wages 54,000 Direct expenses 12,000 Factory overheads 100% of direct wages Office and administrative overheads 20% of works cost Selling and distribution overheads 26,000 Cost of opening stock of finished goods 12,000 Cost of Closing stock of finished goods 15,000 Profit on cost 20%
IMPORTANCE OF COST ACCOUNTING
1. Costing helps in periods of trade depression and trade competition:-
In periods of trade depression the business cannot afford to have leakages which pass unchecked. The management should know where economies may be sought, waste eliminated and efficiency increased. The business has to wage a wax for its survival. The management should know the actual cost of their products before embarking on any scheme of reducing the prices on giving tenders. Adequate costing facilitates this.
2. Aids in price fixation:-
Though economic law & supply and demand and activities of the competitors, to a great extent, determine the price of the article, cost to the producer does play an important part. The producer can take necessary guidance from his costing records.
3. Helps in estimate:-
Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of over – rating or losing in the execution of a contract due to under – rating can be minimized. Thus, “ascertained costs provide a measure for estimates, a guide to policy, and a control over current production”.
4. Helps in channeling production on right lines:-
Costing makes possible for the management to distinguish between profitable and non-profitable activities profit can be maximized by concentrating on profitable operations and eliminating non-profitable ones.
5. Wastages are eliminated:-
As it is possible to know the cost of the article at every stage, it becomes possible to chock various forms of waste, such as time, expenses etc. or in the use of machine, equipment and tools.
6. Costing makes comparison possible:-
If the costing records are regularly kept, comparative cost data for different periods and various volumes of production will be available. It will help the management in forming future lines of action.
7. Provides data for periodical profit and loss accounts:-
Adequate costing records supply to the management such data as may be necessary for preparation of profit and loss account and balance sheet, at such intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial accounts thus helps in presentation of better information before the management.
8. Aids in determining and enhancing efficiency:-
Losses due to wastage of material, idle time of workers, poor supervision etc., will be disclosed if the various operations involved in manufacturing a product are studied by a cost accountant. The efficiency can be measured and costs controlled and through it various devices can be framed to increase the efficiency.
9. Helps in inventory control:-
Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods. (This has been explained in detail under the chapter “Materials”)
10. Helps in cost reduction:-
Costs can be reduced in the long run when alternatives are tried. This is particularly important ion the present day context of global competition cost accounting has assumed special significance beyond cost control this way.
11. Assists in increasing productivity
Productivity of material and labour is required to be increased to have growth and more profitability in the organisation costing renders great assistance in measuring productivity and suggesting ways to improve it.
Q6 . What do you understand by term Overheads .Briefly classify and explain the Treatment of specific items of overheads in cost accounts?
Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not directly identifiable or allocable to a cost object in an economically feasible way. Overheads are the indirect costs that are incurred during the course of manufacturing an item, rendering a service or running a department but cannot be debited directly or wholly to an item, services or departments. Suppose an organization produces three products: A, B and C. Material, labour and other direct expenses which an organization used for each product individually are the direct costs. Besides these, there are other expenses like rent, helper wages, salaries of office staff, rent of showroom; salaries of salesman etc. which are incurred for the benefit of the organization as a whole but cannot be charged separately for each product are overheads. Overheads are to be classified on the basis of functions to which the overheads are related, viz - Production overheads - Administrative overheads - Selling overheads - Distribution overheads Overheads may also be classified on the basis of behaviour such as variable overheads, semi-variable overheads and fixed overheads. Thus, overheads is the sum total of indirect material, indirect labour and indirect expenses.
Overhead appear at all levels of the Income statement
Expenses that qualify as overhead can appear under all major expense categories on the Income statement. And, not all overhead expenses on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.
The overhead role in costing, pricing, budgeting, and product management
Companies that sell products or services must know their per-unit product costs. This information is important when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.
In most cases analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.
The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.
Overhead plays an important role in competitive strategy
Business firms set overhead objectives when planning their own cost structures. This is because overhead targets are in fact a key component of the firm's high level business strategy .
In competitive industries, business firms rightly call the top-level business strategy acompetitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.
Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors, while charging the same prices as the competition.
Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. This is possible because low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.
Overheads can be classified as follows:
Function wise:
1) Factory/Manufacturing overheads – Factory overheads are the expenses that are common to all the products produced within the factory. It is that part of the product which is invisible. E.g. adhesive in the furniture, glue in the book binding etc.
2) Office and Administration overheads – Office and Administration overheads are the expenses that are incurred for carrying on the general office activities of the enterprise which includes policy formulation, controlling and maintenance of accounts. Example of office administration can be printing charges, postage and stationary used in administration department, director’s fees, insurance of office building, office staff salaries etc.
3) Selling and Distribution overheads – Selling overheads are those expenses which a company incurs on marketing activities in order to stimulate the demand for goods or services and to secure the orders. E.g. Sales manager’s salary, sales’ director’s salary, printing and stationary cost used in sales department. Distribution overheads are the costs which are incurred to move a product from the producer or manufacturer to the consumer. E.g. Delivery expenses, carriage outward, godown charges, packaging charges, insurance of delivery vans etc.
Variability Wise:
i. Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume. These costs are called as fixed costs. The feature of these costs is that the total costs remain same while per unit fixed cost is always variable. Examples of these costs are salaries, insurance, rent, etc.
ii. Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production. Their variability is in the same proportion to the production. For example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the production. Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct materials, direct labor etc.
iii. Semi-variable Costs :- Certain costs are partly fixed and partly variable. In other words, they contain the features of both types of costs. These costs are neither totally fixed nor totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’.
Nature wise:
a. Indirect material – Those materials which are used in manufacturing a product but cannot be recognized and directly charged to a specific department are called indirect materials. E.g. oil, rags, cons. stores etc.
b. Indirect labour – The labour that is not directly involved in producing a product but helps those labours who are engaged in manufacturing a product is known as indirect labour. E.g. Supervisor, foreman, watchman etc.
c. Indirect expenses – Those expenses which are not incurred for a specific product and cannot be charged directly to cost centers are known as indirect expenses. E.g. rent of building, repairs etc.
Control wise:
a. Controllable overheads – Those overheads which can be controlled by the action of the management are known as controllable overheads. E.g. direct material, direct labour etc.
b. Uncontrollable overheads – Those overheads which cannot be controlled by the action of the management are known as uncontrollable overheads. E.g., Rent, Insurance, Salary etc.
Treatment of Special Items of Overheads in Cost Accounts
Material Handling Expenses:
These expenses are incurred while unloading the raw materials received from supplier, storing the raw materials, handling the raw materials to work place, handling of work-in-progress, storage of finished goods etc. It also includes costs incurred for weighing salaries of personnel involved in material handling, wear and tear of weighing equipment.
These costs are apportioned on the basis of physical quantities of different materials and goods handled in the factory. The stores overhead costs are apportioned to raw materials and finished goods as a percentage of issue rates. Other handling expenses are recovered through overhead recovery rates.
Market Research Expenses:
Market research cost is an item of selling overhead, incurred for market intelligence to ascertain the tastes and habits, market penetration of product, increase in demand of existing products, competitive situation, trading practices, distribution channels, customers requirements, existing and potential market for the product etc.
If the market research expenses are incurred for a single product it is absorbed into that particular product cost. If it is incurred for the product range for the enterprise as a whole, then the market research expenses are to be apportioned to different products in the proportion of sales value and absorbed into respective product cost.
If the market research cost is substantial, it will be treated as deferred revenue expense and is taken into future period and absorbed when sales or production takes place. Sometimes market research expenses are incurred for raw material availability, such expenses will be allocated or apportioned to purchase department and it is recovered through overhead rate of purchase department.
Subscriptions and Donations:
The treatment suggested for subscriptions and donation in Cost Accounts as follows:
a) If these expenses are incurred for the benefit of or welfare of workers, it is treated as Production Overhead.
b) If subscriptions and donations for any technical and research institutions for obtaining data relating to technical, production or scientific nature, it is considered as Production Overhead.
c) If subscriptions to journals etc. for obtaining market data which help in increase of sales, it is considered as Selling Overhead.
d) If the subscriptions and donations not incurred for the benefit of employees or the organization, it should be excluded from the Cost Accounts.
After Sales Service Costs:
The costs are incurred for providing service to the customers after the sales took place during the warranty period. If the costs are incurred during the period of guarantee given to the customer, it is to be borne by the company, and hence it is treated as production overhead absorbed into product cost by applying predetermined absorption rates. If the after sales services costs are incurred after the guarantee period for which the organization will charge for the services rendered, then such costs are treated as Selling Overhead.
Royalties and Patent Fees:
The royalties and patent fees are payable for the use of technology, skill, brand, intellectual property rights etc. made in the form of periodical rent or based on the number of units produced or sold.
If it is based on sales, the expenditure is charged to Selling Overhead. If it is a fixed periodical rent, it is treated as Production Overhead. If it is payable on number of units produced, the expenditure is treated as a direct expense or chargeable expense and is forming part of the cost of the product.
Training Costs:
The training costs are incurred for training the workers, apprentices, office, administrative and selling staff. The training expenditure incurred for training the workers, apprentices and other production staff is treated as Production Overhead. If it is incurred for training the office and administrative staff, it is considered as Administration Overhead.
The expenses incurred for training the sales staff is treated as Selling Overhead. If there is any in-house training college or centre is giving training, cost of running the centre or college is apportioned to the cost centres based on the number of personnel trained or on the basis of wages and salaries paid etc.
Taxation:
Taxation is an appropriation of profit earned by the organization and any payment of taxes is excluded from the Cost Accounts. But the taxes will also be considered for planning and decision making exercises wherever it is necessary and appropriate for special purposes.
Financing Charges:
The finance charges like interest on working capital facilities from banks, interest on term loan for acquisition of fixed assets, interest on debentures etc. is payable by the company. Where financing charges are payable to outsiders on borrowings for acquisition of fixed assets, these charges are included in cost of Fixed Assets.
If the financing charges are payable for financing working capital, then these charges are included in Cost of Inventories. Interest on capital provided by the owners is excluded from Cost Accounts except for comparing or evaluating profitability of alternative investments. If the charges are payable for storing the materials like timber, wine etc. the charges are included in the cost of materials stored.
Major Repairs to Equipment:
The major repairs, if it prolong the useful life of an asset, the costs incurred on it is to be added to the existing value of assets and periodical depreciation is charged on the overall cost of the asset.
If the repair charges are incurred for upkeep and maintenance of the machinery and if it does not prolong the life of the asset, these expenses are treated as Production Overhead and is charged to the respective cost centre as repairs and maintenance and recovered from the current period production. If the amount incurred is substantial, it is treated as deferred revenue expenditure carried forward to the subsequent accounting periods for write off.
Cost of Tools:
Tools are classified into:
(a) Large tools, and
(b) Small tools.
The cost of large tools are capitalised like any other machine and depreciation is provided on it each accounting period over its useful economic life.
The cost of small tools are treated in any of the following three methods in Cost Accounts:
i. Capitalization Method:
Under this method, the cost of small tools is capitalised and depreciation is recovered as Production Overhead. If the life of small tools is relatively small, this method is not suitable.
ii. Revaluation Method:
Under this method, the small tools are revalued at the end of each accounting year and the difference between original cost and the revalued cost is charged as Production Overhead.
iii. Write off Method:
Under this method, the cost centre drawing such tools is debited with the value thereof. Alternatively, the total cost of tools is accumulated and apportioned to various cost centres on suitable basis.
Bad Debts:
When the company allow credit to its customers as part of its selling policy, some credit sales may turn bad due to default by the customers intentionally or otherwise. As a safeguard, a part of such default amount is treated as bad debt is recovered as selling overhead and absorbed into product cost. If the bad debt is abnormal in nature, the abnormal portion in excess of the standard normal portion should be excluded from cost accounts and transferred to Costing Profit & Loss Account.
Notional Rent:
Notional rent is a cost included in the Cost Accounts so as to represent a benefit enjoyed by the organization even though no actual cost is incurred for rent. The company owns premises does not pay rent, but it is considered as notional charge in the Cost Accounts for comparability of cost with different accounting periods and with other organizations. This would reflect the accurate cost of cost centre or cost unit. It is a reasonable or nominal charge included in the Cost Accounts for the owned premises as if it is a rented premises.
Packing Expenses:
The packing is classified into:
(i) Primary packing, and
(ii) Secondary packing.
The ‘primary packing’ is done when the material is packed in tins, bottles, jars, etc., without which a product cannot be sold. For example, jam is packed in bottles, baby food packed in tins, beverages in bottles etc. The costs incurred on primary packing material are treated as part of direct material cost.
If the packing is made to facilitate the transportation and distribution of the finished product, it is called ‘ secondary packing’ and the cost incurred for this is treated as Distribution Overhead. Sometimes, cost is incurred on packing the product to make it more attractive to the customers to increase sales. This cost is treated as advertisement cost and is included in Selling Overhead.
Data Processing Cost:
In the environment of processing information with the help of computers, the data processing cost represents the cost incurred for processing data relating to accounts, secretarial, personnel, finance, marketing, sales etc. This may be done either utilizing in house facilities or hiring outside facilities.
The cost incurred is accumulated for separate service centre if in-house facilities are made available. Where the costs of data processing centre or hiring charges are identifiable to a particular department or activity it should be charged with its portion of cost. In case of common costs incurred for service of all departments, the data processing cost should be apportioned to different departments on equitable basis.
Stores Overhead:
The stores department in an organization perform the function like receipt of material and stores items purchased, storing and issue of materials and stores items to different departments.
The stores is considered as a separate cost centre and the stores expenditure like rent of store, salaries and wages of stores personnel, freight, carriage inwards, insurance etc. are collected separately for the stores and will be apportioned to other cost centres.
The following bases are used in apportionment of stores overhead:
(a) Number of stores requisitions,
(b) Value of material requisitioned, and
(c) Standard predetermined stores overhead absorption rate.
Erection and Dismantling of Plant and Machinery:
The costs incurred on erection and dismantling of plant and machinery are treated in cost accounts as follows:
(a) The costs incurred on erection of plant and machinery is capitalised and treated forming part of capital cost and depreciation is recovered on the total cost
(b) If the plant and machinery is required to be shifted to different locations, the costs incurred in layout and shifting is treated as production overhead. When such costs are substantial, it may spread over a period of time as deferred revenue expenditure.
(c) If the asset is replaced, before its useful economic life, with a new machine, the written down value of the asset less the scrap value plus the cost on dismantling is treated as capital loss and charged to profit and loss account. However, the erection cost of new machine is capitalised.
(d) If expenses of dismantling and re-erection are incurred due to faulty planning or due to abnormal factors, then such expenses are charged to Costing Profit and Loss Account.
Transport Cost:
The classification of transport costs and their treatment in cost accounts is given below:
(a) The costs incurred to bring the materials to the production site is included in cost of materials.
(b) The costs incurred for bringing the plant and machinery, equipment etc. is added to the capital cost of respective asset and depreciation is recovered.
(c) The cost of dispatch of finished goods is treated as distribution overhead.
(d) The costs incurred for internal movements within work are initially charged to specific cost centres and thereafter apportioned to different production and service centres on the basis of services rendered.
Insurance Cost:
The treatment of insurance cost is categorized into the following:
(a) Insurance premium on storage-cum-erection and commissioning is capitalised to the asset value.
(b) Premium on transit of materials is included in cost of materials.
(c) Premium on transit of finished products is treated as distribution overhead.
(d) Premium on fire and breakdown of machinery policy is treated as production overhead.
(e) Premium on loss of profit policy due to fire and breakdown of machinery is treated as production overhead.
(f) Premium on miscellaneous policies like vehicles, burglary, accident etc. are treated as administration overhead.
(g) Premium on raw materials and stores is treated as production overhead.
(h) Premium on warehouse and finished stock is treated as distribution overhead.
Q7.What do you understand by term Overheads? What are stages and methods involved in distribution of overheads methods of absorption of overheads ? Explain treatment of under and over absorption of overheads
Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not directly identifiable or allocable to a cost object in an economically feasible way. Overheads are the indirect costs that are incurred during the course of manufacturing an item, rendering a service or running a department but cannot be debited directly or wholly to an item, services or departments. Suppose an organization produces three products: A, B and C. Material, labour and other direct expenses which an organization used for each product individually are the direct costs. Besides these, there are other expenses like rent, helper wages, salaries of office staff, rent of showroom; salaries of salesman etc. which are incurred for the benefit of the organization as a whole but cannot be charged separately for each product are overheads. Overheads are to be classified on the basis of functions to which the overheads are related, viz - Production overheads - Administrative overheads - Selling overheads - Distribution overheads Overheads may also be classified on the basis of behaviour such as variable overheads, semi-variable overheads and fixed overheads. Thus, overheads is the sum total of indirect material, indirect labour and indirect expenses.
Overhead appear at all levels of the Income statement
Expenses that qualify as overhead can appear under all major expense categories on the Income statement. And, not all overhead expenses on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.
The overhead role in costing, pricing, budgeting, and product management
Companies that sell products or services must know their per-unit product costs. This information is important when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.
In most cases analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.
The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.
Overhead plays an important role in competitive strategy
Business firms set overhead objectives when planning their own cost structures. This is because overhead targets are in fact a key component of the firm's high level business strategy .
In competitive industries, business firms rightly call the top-level business strategy acompetitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.
Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors, while charging the same prices as the competition.
Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. This is possible because low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.
There are three stages in the absorption of overheads which are discussed in detail below:
Stage I: Allocation and Apportionment of Overhead:
The first stage in the absorption of overhead costs is to identify and collect overhead costs for different production and cost centres. The first stage is known as ‘primary distribution.’
Primary Distribution:
Some overhead costs can be directly identified with a particular department or cost centre as having been incurred for that cost centre. These items of overhead cannot be traced to products or jobs but can be allocated specifically to departments. Examples of such overhead costs are repairs and maintenance expenses incurred in specific departments, supervision, indirect labour, overtime, indirect materials and factory supplies, equipment depreciation.
Expenses, such as power, light, rent, depreciation of factory building, expenses shared by all departments, cannot be charged directly to a department, be it production or service. They are incurred for all and must, therefore, be apportioned or prorated to any or all departments using such items. Cost apportionment is the process of charging expenses in an equitable proportion to the vari¬ous cost centres or departments.
The Institute of Cost and Management Accountant (U.K.) defines cost apportionment “as the allotment of proportions of items of cost to cost centres or cost units”. The apportionment should be done on some rational and equitable bases. In cost accounting this is known as primary distribution of overhead.
It would be difficult to give a comprehensive list of the bases of apportionment, but the following bases are in common use:
1. Floor Area Occupied:
Overheads such as lighting and heating, rent and rates, depreciation on building, building repairs, caretaking, watching and patrolling.
2. Capital Values:
Depreciation on plant and machinery, insurance on building, and plant and machinery, maintenance of plant and machinery.
3. Direct Labour Hours And /Or Machine Hours:
Insurance on Jigs, tools and fixtures, power, works management remuneration, repairs and maintenance cost.
4. Number of Workers Employed:
Canteen, accident insurance, medical, dental and first aid, pensions, personnel department expenses, profit sharing payments, recreation, supervision, time office, wages department.
5. Technical Estimate:
Fire prevention, oil and grease, steam, water without meter.
Example:
The Modern Company has four departments. A, B and C are the production departments and D is a servicing department.
The actual costs for a periods are as follows:
Stage II: Apportionment of Service Departments Overhead to Producing Departments:
In stage II, overhead costs of service departments are apportioned to production departments. Such apportionment is termed as ‘Secondary Distribution’.
Secondary Distribution:
The primary distribution of factory overhead apportions all overhead costs to the different departments or cost centres — production and service departments. It is necessary that overhead costs of service departments (accumulated through direct allocation or primary distribution) should be further assigned to producing departments.
This is due to the reason that service departments do not themselves manufacture anything and it is the production departments or cost centres which are involved in manufacturing activities. The reassignment or reapportionment of service departments overhead to producing departments or centres is termed as secondary distribution.
Secondary distribution is useful in the following matter:
1. It helps in determining the cost of products or jobs sold and inventory figures.
2. It helps in determining the effect of various managerial decisions and actions on the total cost of the business firm. For example, decisions as to add or to drop a product line require information about its cost effect which can be estimated after secondary distribution has been made.
3. It helps subsequently in determining the price of the product or job. In case of contracts based on cost in place of market price, secondary distribution helps in fixing a selling price which is advantageous to the parties concerned.
4. It promotes motivation among employees of the producing departments to take up service department activities.
Bases for Secondary Distribution:
It is difficult to suggest a sample list of service departments and equitable bases of distribution of overhead costs. The objective is to find the allocation base that best measures the causal or beneficial relationship between the department whose costs are being apportioned and the departments receiving the service.
The general basis for apportioning service department overheads to producing department are the following:
1. Service Rendered (Benefits Obtained):
This is perhaps the most popular method of apportioning service department costs. The service rendered to different departments, i.e., benefits obtained by them can be a suitable basis.
2. Ability to Pay:
This method suggests that a large share of servicing department’s overhead costs should be assigned to those producing departments whose product contributes the most to the income of a business enterprise. However, it is difficult to measure the ability to pay of different departments and also this method is not based on equity.
3. Survey or Analysis:
This method is applied where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.
4. Efficiency or Incentives:
This method uses standards and budgets and apportions the over¬head costs on the basis of a present budget or standard. Sometimes this method is used along with the bases of services rendered or ability to pay method.
In selecting a suitable base for apportioning service department overheads, consideration should be given to practicability, simplicity, economy, theoretical soundness and assistance in accurate costing and cost control. If a service department overhead is allocated on the basis over which the production manager has no control, the prorated cost may result in an inappropriate charge to the producing department.
The following list gives a few service departments and bases commonly used to apportion the respective overhead costs:
Stage III: Absorption of Overhead Costs:
After all service departments overhead costs have been apportioned to producing departments, the next step is to spread factory overhead to different products or jobs produced. This is termed as “Overhead absorption” in cost accounting. The Institute of Cost and Management Accounts (U.K.) define overhead absorption as “the allotment of overhead to cost units.” Known by different names, such as recovery, overhead application, overhead costing, levy, burden rate, etc. the term “absorption” implies that expenses pertaining to a producing department or cost centre are finally charged to or absorbed in the cost of products, jobs, etc. passing through it. As a result of absorption, the cost of each unit of product of the producing department includes an equitable share of the total overhead of that department.
Over / Under absorption of overhead
The overheads are absorbed on the basis of predetermined overhead absorption rate according to the actual production of goods throughout the accounting period or specific period. Budgeted overheads and budgeted output are used to determine overhead rate. If budgeted overhead and budgeted output differ from actual overhead and actual output, three is a difference between predetermined overhead rate and actual overhead rate.
If the overheads absorbed are higher than the actual overheads incurred, it is called over absorption. If the overhead absorbed is lower than the actual overheads incurred during the accounting period, it is called under absorption.
Reasons for Over or Under absorption of overhead
The reasons for over or under absorption of overheads are as follows.
1. The actual hours worked is more or less than the budgeted hours.
2. The actual overhead costs are different from budgeted overheads.
3. Both actual overhead costs and actual activity level are different from the budgeted costs and level.
4. The method of overhead absorption may be wrong.
5. Unexpected expenses may be incurred during the accounting period.
6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.
7. Major changes like replacement of manual labour with machines. This leads to increase in capacity levels.
8. Seasonal fluctuations in the overhead expenses from period to period.
Treatment of Over or Under absorbed overhead
The over or under absorbed overheads are treated in the cost accounts in any one of the following ways.
1. Application of Supplementary Rates
The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base. In case of over absorption, the over recovered amount will be adjusted by applying the supplementary rate and vice versa.
2. Adjustment to Cost of Sales
The over absorbed or under absorbed overheads is closed and transfers the same to the cost of sale account. This is done by the Cost Accountant at the end of every month or at the end of accounting period. If the transfer is made at the end of the accounting period, the over/under-absorbed overhead is carried forward from month to month treating it as deferred income if over applied and as deferred charges, if under applied.
3. Write off to Costing Profit and Loss Account
If the over or under absorbed overhead is small, and then it will be written off by transferring it to the costing profit and loss account. If so, the valuation of closing stock is over stated or under stated.
4. Adjusted to Gross Profit
The under or over absorbed overhead balances are closed by making the adjustment in gross profit.
5. Carry Forward to Subsequent Year
The under or over absorbed overhead may be carried forward to the subsequent accounting year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account. This Overhead Suspense Account or Overhead Reserve Account will appear in the Balance Sheet.
The debit and credit balances representing under/over absorbed overhead showing in the asset side or liabilities side of the Balance Sheet. The basic idea is to off set the under absorbed overhead in one year with over absorbed overhead in another year. But, many accountants oppose this idea. The reason is that balances of under/over-absorbed overhead should not be carried forward from one year to another year. This method is otherwise called as use of reserve account.
Marginal Costing
Introduction
The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.
Marginal costing - definition
Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as:
‘the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making’. (Terminology.)
The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
CONTRIBUTION = SALES - MARGINAL COST
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.
Note
Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.
Theory of Marginal Costing
The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA, London is as follows:
In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in the following two steps:
1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of 3,000 and if by increasing the output by one unit the cost goes up to 3,002, the marginal cost of additional output will be 2.
2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is 1,045, the average marginal cost per unit is 2.25. It can be described as follows:
Additional cost =
Additional units 45 = 2.25
20
The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.
Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods.
For example, if a manufacturing firm produces X unit at a cost of 300 and X+1 units at a cost of 320, the cost of an additional unit will be 20 which is marginal cost. Similarly if the production of X-1 units comes down to 280, the cost of marginal unit will be 20 (300–280).
The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point.
The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
The principles of marginal costing
The principles of marginal costing are as follows.
a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service the following will happen.
§ Revenue will increase by the sales value of the item sold.
§ Costs will increase by the variable cost per unit.
§ Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.
Features of Marginal Costing
The main features of marginal costing are as follows:
1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
Advantages and Disadvantages of Marginal Costing Technique
Advantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.
Presentation of Cost Data under Marginal Costing and Absorption Costing
Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.
The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.
Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Marginal Cost Equations and Breakeven Analysis
From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal cost equation as follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,
P/V Ratio (or C/S Ratio) = Contribution (c) ......(4)
Sales (s)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)
Or, Sales = Contribution/ P/V ratio .....(6)
The above-mentioned marginal cost equations can be applied to the following heads:1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:
• Selecting product mix or sales mix for profit maximization
• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V ratio = Sales – Marginal cost of sales = Contribution =Changes in contribution = (Change in profit/Canges in sales)*100
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:
• Breakeven point
• Profit at any volume of sales
• Sales volume required to earn a desired quantum of profit
• Profitability of products
• Processes or departments
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
• Increasing selling price
• Reducing marginal costs by effectively utilizing men, machines, materials and other services
• Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.
a. Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following equation:
S BEP = F.S/S-V
b. Using P/V Ratio
Sales S BEP = Contribution at BEP = Fixed cost
P/ V ratio P/ V ratio
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:
Breakeven point = 400 x 2000 = 1000
2000 - 1200
Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%
800
= 400 / .4 = $. 1000
c. Using Contribution per unit
Breakeven point = Fixed cost = 100 units or 1000
Contribution per unit
4. Margin of Safety (MOS)
Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activity
P/V ratio
Margin of safety is also presented in ratio or percentage as follows: Margin of safety (sales) x 100 %
Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output
e. Modernization of production facilities and the introduction of the most cost effective technology
Problem 1A company earned a profit of 30,000 during the year 2000-01. Marginal cost and selling price of a product are 8 and 10 per unit respectively. Find out the margin of safety.
Solution
Margin of safety = Profit/ P/V ratio
P/V ratio = (Contribution/Sales) x 100
Breakeven Analysis-- Graphical Presentation
Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.
Construction of a Breakeven Chart
The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.
Uses of Breakeven ChartA breakeven chart can be used to show the effect of changes in any of the following profit factors:
• Volume of sales
• Variable expenses
• Fixed expenses
• Selling price
ProblemA company produces a single article and sells it at 10 each. The marginal cost of production is 6 each and total fixed cost of the concern is 400 per annum.
Construct a breakeven chart and show the following:
• Breakeven point
• Margin of safety at sale of 1,500
• Angle of incidence
• Increase in selling price if breakeven point is reduced to 80 units
Solution
A breakeven chart can be prepared by obtaining the information at these levels:
Output units 40 80 120 200
Sales .
400 800 1,200 2,000
Fixed cost 400 400 400 400
Variable cost 240 480 400 720
Total cost 640 880 1,120 1,600
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and angle of incidence.
a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of 1,000 or 100 units.
b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of (1,500 - 1,000), i.e. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.
d. At 80 units, total cost (from the table) = 880. Hence, selling price for breakeven at 80 units = 880/80 = 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of 10 per unit.
Limitations and Uses of Breakeven Charts
A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.
Multiple Product Situations
In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs
________________________________________
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:
B.E. point (in revenue) = Fixed cost
_______________________________________
Weighted average P/V ratio
Budget
Budget:
A plan which for a definite period, covers, all phases of operations in the future is known as a business budget. Policies, plans, objectives & goals are formally expressed by it & are laid down in advance for the concern as a whole & for each of its sub-divisions by the top management. Thus an overall budget will be there for the concern comprosed of several sub-budgets which are in the form of departmental budgets. Expense limitations are expressed by the budget in the expense budgets & in the sales budget, revenue goals are expressed & for the purpose of realizing the desired profit objective, these must be attained. Besides, plans relating to items such as levels of inventory, additions to capital assets, plans of production, plans of purchasing, requirements of labour, requirements of cash etc. are expressed by the budget. Thus, for a given period, budget is a formal management plans’ & policies’ statement which can be used in that period as a guide or blue print.
The basic elements of a budget are:
• (a) For a specified period of time, it’s a future plan of activity,
(b) Budget can be expressed in monetary or physical units or in both,
(c) Before the period during which the budget is supposed to operate, it is prepared i.e. it is prepared in advance.
(d) Before the preparation of the budget, it is necessary to lay down the objectives which are required to be attained & the policies which are required to be pursued for the achievement of those objectives.
Budgetary Control:
Throughout the budget period, the use of budgets & budgetary reports for the purpose of coordinating, evaluating & controlling day-to-day operations according to the goals which are specified by the budget is involved by budgetary control. The mere presentation of budget doesn’t have much value, its real value lies in the aspects of the planning & its utilization during the period for the purposes of control & coordination. Under budgetary control, actual results are constantly checked & evaluated & comparison of actual result is made with the budgeted goals & wherever indicated, corrective action should be undertaken. The following steps are involved in the process of budgetary control:
• (a) The objectives which are required to be achieved by the business should be defined & specified by budgetary control.
(b) For the purpose of ensuring that the desired objectives are accomplished, business plans are needed to be prepared by budgetary control.
(c) Budgetary control translates the plans into budgets & relates to particular sections of the budget, the responsibilities of individual executives & managers.
(d) Budgetary control constantly compares the actual results with the budget & the differences between the actual & budgeted performance are calculated.
(e) For the purpose of establishing the causes, the major differences are investigated by budgetary control.
(f) In a suitable form, budgetary control presents the information to the management, relating to variances to individual responsibility.
(g) In order to avoid a repetition of any over-expenditure or wastage, management takes corrective actions. Alternatively, where due to the change in circumstances, the budgeted targets cannot be achieved, the budget is revised.
Difference between Budget, Budgeting & Budgetary control:
Individual objectives of a department etc. are indicated by budget, whereas the act of setting the budgets is known as budgeting. All are embraced by budgetary control & also the science of planning the budgets themselves & as an overall management tool, the utilization of such budgets, for the purpose of business planning & control are included in budgetary control. Thus, the term by budgetary control is wider in meaning & both budget & budgeting are included in by budgetary control.
Objectives of Budgetary Control:
The objectives of budgetary control are:
• (1)Compel for planning: As management is forced to look ahead, responsible for setting of targets, anticipating of problems & giving purpose & direction to the organization, this feature is the most important feature of budgetary control.
(2)Communication of ideas & plans: Communication of ideas & plans to everyone 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 there is a formal system.
(3)Coordinating the activities: The budgetary control coordinates the activities of different departments or sub-units of the organization. The coordination concept implies, for example, on production requirements, the purchasing department should base its budget & similarly, on sales expectations, the production budget should in turn be4 based.
(4) Establishing a system of control: A system of control can be established by having a plan against which progressive comparison can be made of actual results.
(5) Motivating employees: Employees are motivated for improving their performances by budgetary control.
Requisites of an effective system of budgetary control:
(a) There should be a clearly defined organizational structure where are area of responsibility is emphasized.
(b) Within the budgeting process, the employees should participate.
(c) For the purpose of relying the measurement of performance, there should be adequate accounting records & procedures.
(d) Budgetary control needs to be flexible, so that the plans & objectives may be revised.
(e) An awareness of the uses of the budgetary control system should be spread by the management.
(f) An awareness regarding the problems of budgetary control & especially the individual’s reactions to budgets should be spread by the top management.
Advantages of Budgetary control:
The advantages of budgetary control system are as follows:
• (1) The objectives of the organization as a whole & the results which should be achieved by each department within this overall framework are defined by the budgetary control.
(2) When there is a difference between actual results & budget, then the extent by which actual results have exceeded or fallen short of the budget is revealed by the budgetary control.
(3) The variances or other measures of performance along with the reasons of difference between the actual results with those from budgeted is indicated by the budgetary control. Also, the magnitude of differences is established by it.
(4) As the budgetary control reports on actual performance along with variances & other measures of performance; for correcting adverse trends, a basis for guiding executive action is provided by it.
(5) A basis by which future budget can be prepared or the current budget can be revised is provided by the budgetary control.
(6) A system whereby in the most efficient way possible the resources of the organization are being used is provided by the budgetary control.
(7) The budgetary control indicates how efficiently the various departments of the organization are being coordinated.
(8) Situations where activities & responsibilities are decentralized, some centralizing control is provided by the budgetary control.
(9) The budgetary control provides means by which the activities of the organization can be stabilized, where the organization’s activities are subject to seasonal variations.
(10) By regularly examining the departmental results, a basis for internal audit is established by the budgetary control.
(11) The standard costs which are to be used are provided by it.
(12) For the purpose of paying a bonus to employees, a basis by which the productive efficiency can be measured is provided by the budgetary control.
Limitations of Budgetary Control:
The main limitations of budgetary control are:
(1) It used the estimates as a basis for the budget plan.
(2) In order to fit with the changing circumstances the budgetary programme must be continually adapted. Normally for attaining a reasonably good budgetary programme, it takes several years.
(3) A budget plan cannot be executed automatically. Enthusiastic participation is required by all levels of management in the programme.
(4) The necessity of having a management & administration will not be eliminated by any budgetary control system. The place of the management is not taken by it; rather it is a tool of the management.
Steps In Preparing A Budget
Steps in Preparing Budgets
The following steps are involved in the preparation of a budget:
1. Budget centers are needed to be established.
2. A clearly defined organizational chart is required to be prepared which will state, for each member of the management team, the functional responsibilities.
3. A budget manual is needed to be prepared.
4. A budget committee is required to be formed.
5. The limiting factor or key factor is needed to be determined.
6. The budget period is to be selected.
7. Objectives which are to be reached by the end of the period of the budget are to be set.
8. Forecast for the period is needed to be prepared.
9. The policies of the enterprise e.g. range of product, distribution channels, per week normal hours of work, appropriation of research & development, stocks, investments etc. are needed to be determined.
10. The requirements in terms of economic quantities which are needed to meet the objectives while complying with the policies are required to be computed from the forecasts & subsequently these quantities are to be converted into monetary values. Thus this will result in an initial provisional budget.
11. With respect to the planned budget, initial budget is to be reviewed & until an acceptable budget emerges, the objectives or policies or both needs to be reviewed repeatedly.
12. The budget when gets formally accepted becomes the master budget & as such is an executive order.
Budget Centre:
Budget center is that section or department of the organization which for the purposes of budgetary control, is identified & separated from the rest of the sections or departments of the organization. The departmental heads works like responsibility centers. There should be a separate budget for each budget centre & also independent comparison should be made with actual.
Budget Manual:
A budget manual is usually prepared for assisting everyone who is engaged in budgeting & budget administration. The procedures which are to be followed, the forms which are to be used & the responsibilities of various persons & the part that should be played by them in the budgeting process are specified by a budget manual.
A budget manual is very helpful because a reference source which the persons who are involved in budgeting & budgetary control may need is provided by it.
But there could be a radical difference between the current procedures & the written instruction in the manual; this is the danger of a budget manual.
Hence, preparation of budget manual should be in loose leaf form so that the amendments can be made easily for keeping the manual up-to-date.
Budget Committee:
In a large concern a frequent establishment of budget committee is needed. It is a useful device which coordinates & reviews the budget programme. The heads of the various departments or other high level executives should constitute the budget committee. It is generally advisory in nature.
The main functions of the budget committee are:
1. formulation of guidelines so that the budgets can be prepared;
2. receiving & reviewing of all the budgets;
3. suggesting of amendments & revisions;
4. approving of original, revised or amended budgets;
5. recommendation of actions which are needed to taken for the improvement of the effectiveness;
6. coordinating all the activities which are related to budgeting.
Limiting Factor:
In each organization, some factor by which scale of its activity are being governed is always there. Such a factor is called the ‘limiting factor’, ‘key factor’ or ‘principal budget factor’. Some examples of limiting factors are below:
1. capacity of production;
2. skilled labor’s shortage;
3. material’s shortage;
4. space’s shortage;
5. low demand for market;
6. lack of capital.
Always one factor, with this type of nature will be more dominant than the other factors but for each budget period that factor does not remain constant. However, once removal has been made of the factor which imposes limitation, that place is taken by another factor which then becomes the limiting factor.
When the budget is being prepared, the limiting factor is one of vital importance. Generally, demand for the products & that of production capacity are the two most important factors.
If producing 10000 units is the capacity of the production department but there is sales potential for 20000 units, then in that case excess sales potential is not of much consequence. Similarly, if selling capacity of the sales department is of 20000 units & production department has produced 35000 units, then such extra production is of no use. Therefore, the establishment of limiting factor & the limit imposed by it before the beginning of the functional budgets is very important. If level of demand is the main factor then before other functional budgets have been prepared, preparation has to be made of the sales budget. On the basis of the volume of goods that can be sold by the business, the production & other budgets should be prepared.
Budget Period:
The period of time for which the preparation & employment of budget is done is known as a budget period. Specifying the budget period at the outset of the preparation of the budget is necessary.
Depending upon the type of business & the uncertainties that are involved, budget periods will vary. Usually with the capital expenditure the long-range budgets are concerned, the span of which may be of five or more years. However, on the other hand, only a week or month is covered by short-term budgets e.g. cash budget. Master budgets by which an organization’s overall goals get consolidated, are usually prepared on an annual basis so that it can coincide with the financial year of the business. Annual budgets are usually sub divided into monthly or four-weekly period budget so that proper control can be exercised.
Distinction between Forecast & Budget:
Prediction of relevant future factors by which an entity & its environment gets affected so that the preparation of planning decisions can be facilitated is defined as a forecast. Budget is a plan which is set by the organization itself as a target regarding what should happen, whereas a forecast predicts what is likely to happen. A forecast is a judgement which anybody can make whereas budget is objective of an enterprise which only the authorized management can make. Basis for the budget is prepared by the forecast. It’s not necessary that the forecast of a function needs to be well coordinated. However, good coordination among various operations & functions of an organization is needed in budgeting so that the desired results can be attained. The period covered by the forecast may range from one to five years or in case of certain types of business, even longer. However, except in case of capital expenditure, the projection of budget is rarely done for more than a year in advance & often projection is made for only three months. Control of variances from the approved plan so that the desired result may be achieved is involved in budgeting whereas no such control is involved in forecasting.
Types of Budgets
Budgets can be categorized in various ways. Let us go through the types of budgets in detail.
Functional Budgets
It relates to any function of the firm such as sales, production, cash, etc. Following budgets are prepared in functional budgets:
• Sales Budget
• Production Budget
• Material Budget
• Manufacturing Budget
• Administrative Cost Budget
• Plant Utilization Budget
• Capital Expenditure Budget
• Research and Development Cost Budget
• Cash Budget
Flexible Budget
Estimation of future levels of activity with any accuracy is extremely difficult in some businesses because of presence of external incontrollable influences. For example, a business which provides luxury goods & services may be very sensitive to changes occurred in the economic climate. Weather may affect some business & prediction of weather conditions is difficult. In such cases, if comparison is done between actual results & budgeted figures, the result may be extremely misleading. It would not be clear without making detailed investigation, for example, whether either because of overspending or merely because the business activity level was above the budgeted level or both, there had arisen a large adverse cost variance. As a result, it becomes really difficult to control & appraisal of performance.
With the preparation of a flexible budget the problem can be solved. Thus, a flexible budget can be defined as a range of budgets which covers a number of different expected levels of activity. It becomes possible to draw up an appropriate ‘flexible’ budget from the range once actual production is known, also the expenses can be set out which would be appropriate to the achieved level of activity.
The main requirement of a flexible budget is that the analysis of expenses should be done into three distinct categories:
a. Fixed expenses, i.e. irrespective of the levels of activity, these expenses would be remaining the same.
b. Variable expenses, i.e. with the change in levels of activity, these expenses would change in proportion to that level.
c. Semi-variable expenses, i.e. analysis of these expenses into fixed & variable elements are needed to be done.
As already stated, the advantage of flexing a budget is that, for the purposes of control & appraisal of performance, the comparison can be done of the actual performance with the flexed budget.
Financial Budget:
The functional budget by which the whole packages of budgets are summarized is made up of the five individual budgets:
1. Cash Budget: Cash budget shows in respect of various functional budgets; the requirements of cash as well as the anticipated cash receipts. It is concerned with liquidity.
2. Budgeted Profit & Loss Account: The budgeted revenues during the period gets matched with the same period’s budgeted costs & the same is reflected by the budgeted profit & loss account. It is concerned with profitability.
3. Budgeted Balance Sheet: It is concerned with the asset’s structure & the liabilities’ pattern.
4. Budgeted Fund Flow statement: In the organizations’ objective-striving endeavor’s, budgeted fund flow statement is concerned with the sources of funds & the applications of funds.
5. Capital Budget: The capital budget is concerned with the questions relating to capacity & the direction which is strategic. The evaluation of alternative dispositions of capital funds as well as the choice of the capital structure which is the best is dealt with by the capital budget.
Cash Budget:
As the name implies, the summarization of the estimated cash receipts as well as the cash payments over the period of budget is done by the cash budget. Ensuring a balance between liquidity & profitability is its main object. The minimizing of the level of cash without, at the same time, running the risk that the organization will not be able to pay the bills when they become due, is the aim of the management. As the cash itself is unproductive, it is minimized. For sound financial management, it is absolute necessity that a carefully developed estimation of cash position & cash needs, is required to be done. Such estimates are required by the money-lending agencies before they can grant credit.
An evaluation of the probable position of cash for the immediate budget period becomes possible by the determination of probable cash receipts & probable cash payments. The cash positions’ evaluation in this manner may indicate- (a) some form of financing needs so that the anticipated cash deficits can be covered, or (b) the need for management planning so that the excess cash can be put to use profitably. There is a close relation between the cash budget & the forecast of sales, expenses budget & capital expenditure budget. However, a desirable cash position does not get automatically bought by the planning & controlling of these factors. An essential distinction between the cash budget & other budgets is suggested by cash budget. The timing of receipts & payments of cash (cash basis), is dealt with by the cash budget, whereas the timing or incurrence of the transactions themselves (accrual basis) is dealt with by the other assets.
Purposes Of Cash Budget:
The principal purposes of the cash budget are as follows:
a. Indication of the probable cash position resulting out of planned operations.
b. Indication of excess or shortages of cash.
c. Provision for co-ordination of cash in relation to (i) sales, (ii) investment, (iii) total working capital & (iv) debt.
d. Indication of the needs for the arrangement of short-term borrowing, or for the purpose of investment, the availability of idle cash.
e. For the purpose of obtaining credit; the establishment of sound basis.
f. Establishment of a sound basis for the purpose of current controlling of the cash position.
Methods of Preparing Cash Budget:
For the preparation of a cash budget, two methods are there: (a) receipts & payments method & (b) funds flow method.
(a) Receipts & Payments Method:
It is normally prepared in advance by month for the budget year. The preparation of cash budget starts with the forecast balance of cash at the commencement of the budget period, & with that, the budgeted receipts for each month gets added & then the budgeted payments gets deducted, for ascertaining the expected cash balance at each month’s end. The usual items which are to be included in cash budgets are as follows:
i. Sales revenue per the sales budget, plus any budgeted decrease in debtors or minus any budgeted increase in debtors, as the case may be.
ii. Production costs per the production cost budget, plus any stock increase, minus any creditors’ increase.
iii. Administration costs, selling & distribution costs & research & development costs, plus any stock increase, minus any creditors’ increase.
iv. Capital expenditure per the capital expenditure budget, & any cash, which on sale or scrapping of assets, will be received.
v. Dividends, interest & rent receipts.
vi. Tax payments.
vii. On long term contracts, expected payments of dividend & progress payments.
viii. Any cash which is to be received on issue of shares, debentures etc. or to be paid on redemption of preference shares or debentures.
It is possible to see whether there will be sufficient cash with the concern not only at the end of the year, but also all the times during the year, by scheduling receipts & payments by month & carrying forward from month to month, the cumulative balance. Hence, for raising any required additional funds or investing any temporary surplus, plans can be made.
(b) Funds Flow method: The fund flow method of cash budgeting substitutes, for items (i) to (iii); cash from operations. Items from (iv) to (viii) will appear in the same way as in receipts & payments method. By taking net profit as the basis & making adjustments for (a) depreciation, (b) non-operating incomes & expenses & (c) increase or decrease in current account items except cash, cash from operations can be determined.
The main problem with this method is that the provision of month wise information is not possible. Thus, mainly for long term cash budgeting, the fund flow method is used. On the other hand, the receipts & payments method is more useful for short-term cash budgeting
Master Budget:
The collection of a series of subsidiary or functional budgets into a total or master budget is the outcome of the budgeting process.
The master budget which covers a definite period of time, such as a year, represents the overall plan of operations which the management develops for the company. The master budget formally expresses the managerial policies & goals for a specified period which, with respect to functions & organizational responsibilities are broken down into details.
The master budget together with the subsidiary budgets on completion will be submitted for approval to the budget committee.
Constituent Elements of a Master Budget:
A master budget comprises a number of functional & financial budgets.
Functional Budget:
Functional budget is related to a major function of the business. The usual functional budgets are:
1. Sales Budget:The sales in terms of quantity & value which are analyzed by the product, by region, by month, by salesman & by distribution channels are shown by this budget.
2. Selling Expenses Budget: The salaries & commission of salesmen’s, expenses & other related costs is included in this budget.
3. Distribution Expenses Budget:Charges for transportation, charges for freight, warehousing, stock control, wages, expenses & related administrative costs is included in this budget.
4. Marketing Budget:Marketing budget, apart from details regarding advertising, activities related to promotion, market research, customers service, public relations & so forth; also includes a summery relating to sales, selling expenses & marketing expenses budgets.
5. Research & Development Budget:Materials, salaries, expenses, equipment & supplies & other costs which are related with design, development & technical research projects are included in research & development budget.
6. Production Budget:Production budget aims to supply specified quality of finished goods so that the marketing demands can be met. Levels of finished goods stock is specified by the distribution budget & for providing detailed production requirements this can be related with the sales budget. Following from this, consideration of a series of subsidiary budgets becomes necessary:
a. Raw Materials Budget:Appropriate attention to the desired levels of stock is paid by this budget.
b. Labour Budget:This budget ensures that at the right time the required number of employees with suitable skills & of suitable grade will be made available by the plan.
c. Manufacturing Overheads budget:Items such as consumable materials & waste disposal is covered by this budget.
7. Purchasing Budget:While preparing this budget along with the answers to the questions regarding when, where & at what price to buy & how often to buy, consideration has to given to raw materials, consumable items, office supplies & equipments & the whole range of requirements of an organization.
8. Administration Expenses Budget: Such expenses as salaries & upkeep of office, salaries of management, stationery, telephones, depreciation, postage etc. are dealt with by this budget.
9. Manpower Budget:An overall view of the need of the organization regarding manpower for all the areas of activity for a period of years-like manufacturing, administrative, sales, executive activities & so on, must be taken by the manpower budget
Flexible Budget Vs. Fixed Budget
Points Flexible Budget Fixed Budget
Flexibility Due to its nature of flexibility, it may be quickly re-organized according to the level of production. After the commencement of a period, fixed budget cannot change according to actual production.
Condition Flexible budget may change according to change in conditions. Fixed budget is based on the assumption that conditions will remain unchanged.
Cost Classification Classification of costs is done according to the nature of their variability. It is suitable for fixed costs only; no classification is done in fixed budget.
Comparison Comparisons of actual figures with revised standard figures are done according to change in the production level of a concern. If there is change in production level, then it is not possible to do a correct comparison.
Ascertainment of cost It is easy to ascertain costs even at different levels of activity. If there is change in the production level or circumstances, it is not possible to ascertain costs correctly.
Cost Control It is used as an effective tool to control costs. Due to its limitations, it is not used as cost control tool.
Zero Base Budgeting
Traditionally, on the basis of the targets which have been set in the last year, budgeting is done. In the last year’s budget, certain additions & deductions are done for arriving at the figures for the current budget. Thus, in making traditional budget, we have to depend on the last year’s targets as well as on the principles of incrementalism or decrementalism, for the purpose of deciding upon the additions or deletions which are required to be incorporated in the budget figures of the previous year so that the figures of the current budget can be arrived.
In case of Zero-base budgeting (ZBB), the assumption is made that there was no budget for the previous year & in the light of expected benefits & costs which are involved; independent evaluation are made of the proposals of the current budget. Thus, ZBB refers to the formulation of a budget without any reference made to the previous plans & achievement but particular reference is made to the justification of the proposed resources’ allocation. This is not done only once. Whenever a budget needs to be prepared, every time, the process of budgeting should start from zero & in terms of cost-benefit analysis, the proposed allocation of resources should be justified.
In the cases of planning & decision making, ZBB becomes ideal. Undertaking of previous type of work of which there is no previous experience is included in development planning. In these cases, on the basis of past targets which have been modified by certain additions & deletions, budgets can be prepared. On the basis of cost-benefit analysis, evaluation of every budget proposal is to be done. Identification of all proposed activities is to be done, as evaluation of decision packages is made by systematic analysis & ranking is done in order of priority. Upon the priority list, depends the decision making.
Main Features of ZBB:
The main features of ZBB are the following:
a. As the basis of budgeting, Zero (or scratch) is taken & not the previous budgets’ targets.
b. The fund demanded has to be justified by the management of each decision unit.
c. Grouping of all proposed activities has to be done into various decision packages.
d. According to priority, the adequate evaluation & arrangement of all decision packages are done.
e. After proper evaluation, consideration has to be given to the alternative decision packages.
f. On the merits of evaluation of all decision packages including the alternative decision packages, resources are finally allocated.
Difference between ZBB & Traditional Budgeting:
The distinction between the traditional budgeting & zero-base budgeting are the following:
a. In traditional budgeting, emphasis is given on previous level of expenditure, whereas, in ZBB, every time a budget is prepared, new economic appraisal is made.
b. Traditional budgeting is a function which is accounting oriented, whereas, ZBB is a function which is project or decision oriented.
c. For the preparation of a traditional project, rejustification of the existing programme is not needed, whereas, for the preparation of a zero-base budgeting, the justification of existing & new projects is needed to be done in the light of benefits & costs.
d. In the case of traditional budget, the justification regarding why, for a particular decision unit, a particular amount of expenditure is decided upon, is justified by the top management, whereas, in case of ZBB, the amount of expenditure is justified by the manager of the decision unit & not the top management.
e. In the case of traditional budgeting, the amount to added with or deleted from the figures of the previous budget figures is only taken into account, whereas, in case of ZBB, existing level of expenditure is appraised & the justification of future proposal for expenditure is done from different angles.
f. Preparation of a traditional budget is a simple job which is done year after year monotonously, whereas, preparation of a zero-base budgeting requires logical approach & many complex steps are involved for the establishment of logic behind a proposal.
Applicability of ZBB:
In planning & development areas particularly of the government & local bodies, ZBB is very suitably applicable. With reference to costs & benefits, thorough examination of the projects of every ministry is done. In respect of allocation of resources, upon the report of cost-benefit examination which is prepared by persons competent to do so, depends, which project of which ministry shall enjoy priority. ZBB becomes ideal in cases where the resources are limited but there are many development works which is needed to be done as in case of educational institutions, local bodies etc., because there is almost guarantee of the efficient use of limited resource.
In manufacturing concerns, for the purpose of controlling cost there are many devices like standard cost technique, work & motion study etc. The prime costs & production overhead gets controlled by these techniques because in these cases direct relationship between cost & output is there. But in manufacturing concerns production function gets supported by various other expenditures, but in these cases, relationship cannot be established between cost & output. For the application of ZBB, this area of expenditure is a suitable field. Expenditure like accounting, maintenance, electricity, rent of administrative office, postage, advertisement, research, development & many others covers this area.
Merits of ZBB:
The following are the merits of ZBB:
a. Careful examination of all projects-whether current or future is done with reference to cost & benefits & the project which is most efficient is accepted. Thus, ZBB is always a technique which is based on logic. The current projects, only if they are logically sound & efficient, are continued.
b. For rational planning, on the cost-benefit acceptability, the most efficient ones amongst the available alternatives are chosen. The managers of decision units are required by ZBB to find out cost effective ways for the implementation of the plans. Thus, with the help of ZBB, best planning is made & cost can also be controlled with the help of ZBB.
c. In respect of both existing & future projects, cost-benefit analysis is done. Ranking of the projects is done on the basis of the result of the analysis & allocation of funds is done in order of priority. Thus, ZBB helps in getting labour efficiently allocated.
d. In ZBB, for the purpose of using the available resources of the organization, the most useful alternatives are found out. Alternative ways are taken into consideration in performing an activity also. Similarly, consideration is also given to the alternative quantum of efforts which are to be put in. These help promoting new ideas so that an activity can be performed in the best possible way.
e. With regard to justifiability of continuing new undertaking on the basis of cost-benefit analysis, existing activities & new projects are appraised with equal importance.
f. In ZBB, reports are to be submitted by managers of all decision units on their claims of funds & justification of the claims. Thus, in the making of zero-base budget, it becomes compulsory for all managers of decision units to participate. Thus in allocation & utilization of funds, forthcoming of new ideas gets promoted by this.
g. Since in ZBB, existing activities gets appraised carefully, activities which fails to give desired results may be discontinued & thus by this way unproductive expenditure may be saved.
h. Since all managers adopt ZBB technique, they are obliged for making self evaluation of projects under their command. If there are any loopholes in the working progress, those are automatically detected & remedial measures are adopted. Efficiency in performance can be achieved by awareness of managers’ in respect of detection of errors & their rectification.
i. Automatic motivation is created by ZBB which helps forming a management team of individuals having skills & talents.
j. Top management gets linked with medium & lower level management with the help of ZBB. Thus, speedy communication helping expediting appropriate decision-making is ensured.
k. ZBB helps in introducing & implementing ‘Management by objective’ (or MOB). The objectives of the traditional budgeting can be fulfilled using ZBB; as other objectives can as well be fulfilled with its help.
Demerits of ZBB:
The following are the demerits of ZBB:
a. Time, energy & money is required in collecting & analyzing data of alternative future projects as well as existing activities.
b. If full co-operation amongst management staff is not forthcoming, then ZBB technique implementation becomes difficult.
c. As ideal standard of evaluation is not available, evaluation often becomes very difficult. Technical knowledge may be required in a desired manager’s evaluation which may not be available.
d. Managers are required to undergo continuous training. Implementation of ZBB cannot be expected in a right way if basis idea & objective of ZBB are not crystal clear to managers.
e. In case of ZBB, according to priority, ranking of projects need to be done. Irrational ranking of project may arise due to ego of top management (i.e. Irrespective of its merits, a project favored by the top management may be ranked high). Moreover, regarding the method of ranking which needs to be adopted, confusion may arise among the management staff.
f. Involvement of good number of individuals may be required by ZBB. Thus, complications may be created in communication system which results in difficulty in managing of the huge volume of data & voluminous paper work may be involved etc.
Meaning of Standard Costing
It is a method of costing by which standard costs are employed. According to ICMA, London, Standard Costing is “the preparation and use of standard costs, their comparison with actual cost and the analysis of variances to their causes and points of incidence”.
According to Wheldon, it is a method of ascertaining the costs whereby statistics are prepared to show:
(i) The standard cost;
(ii) The actual cost;
(iii) The difference between these costs which is termed the variance.
But W. Bigg expresses:
“Standard Costing discloses the cost of deviations from standards and clarifies these as to their causes, so that management is immediately informed of the sphere of operations in which remedial action is necessary.”
Thus, from the above, it becomes clear that Standard Costing involves:
(i) Ascertainment and use of Standard Costs;
(ii) Recording the actual costs;
(iii) Comparison of actual costs with standard costs in order to find out the variance;
(iv) Analysis of variance; and
(v) After analysing the variance, appropriate action may be taken where necessary.
Objectives of Standard Costing:
The objectives of Standard Costing for which it is implemented are:
(a) It helps to implement budgetary control system in operation;
(B) IT HELPS TO ASCERTAIN PERFORMANCE EVALUATION.
(c) It supplies the ways to utilise properly material, labour and also overhead which will be economic in character.
(d) It also helps to motivate the employees of a firm to improve their performance by setting up a ‘standard’.
(e) It also helps the management to supply necessary data relating to cost element to submit quotations or to fix up the selling price of a firm.
(f) It also helps the management to make proper valuations of inventory (viz., Work-in- progress, and finished products).
(g) It acts as a control device to the management.
(h) It also helps the management to take various corrective decisions viz., fixation of price, make-or-buy decisions etc. which will be more beneficial to the firm.
Development of Standard Costing:
Importance of Standard Costing cannot be ignored for the following and that is why the same is well-developed in the present-day world:
(i) Compilation of Historical Cost is very expensive and difficult:
A manufacturing firm making large number of parts requires too much clerical work which is required in order to compile the materials, labour and overhead charges to each and every cost of parts produced for ascertaining the average cost of the product.
(ii) Historical Costs are inadequate:
In order to measure the manufacturing efficiency, historical costs are not practically adequate. It fails to explain the reasons of increased cost or any change in cost structure.
(iii) Historical Costs are too old:
In many firms, costs are determined and selling prices are ascertained even before the production starts—which is not desirable.
(iv) Historical Costs are not typical:
This is due to the wide fluctuation in market for which there is no relation between the selling price per unit and cost price per unit.
Advantages of Standard Costing:
The following advantages may be derived from Standard Costing:
(i) Standard Costing serves as a guide to the management in several management functions while formulating prices and production policies etc.
(ii) More effective cost control is possible under standard costing if the same is reviewed and analysed at regular intervals for improvements and immediate action can be taken if deviations from standards are found out which, ultimately, leads to cost reduction.
(iii) Analysis of variance and its measurement helps to detect inefficiencies and mistakes which enable the management to investigate the reasons.
(iv) Since standard costs are predetermined costs they are very useful for planning and budgeting. It also helps to estimate the effect of changes in Cost-Price-Volume relationship which also helps the management for decision-making in future.
(v) As standard is fixed for each product, its components, materials, process operation etc. it improves the overall production efficiency which also ultimately reduces cost and thereby increases profit.
(vi) Once the Standard Costing System is implemented it will lead to saving cost since most of the costing work can be eliminated.
(vii) Delegation of authority and responsibility becomes effective by setting up standards for each cost centre as the supervisors or executives of each cost centre will know the standard which they have to maintain.
(viii) This system also helps to prepare Profit and Loss Account promptly for short period in order to know the trend of the business which helps the management to take decisions promptly.
(ix) Standard costing also is used for inventory valuation purposes. Stock can be valued at standard cost which can reduce the fluctuation of profit for different methods of valuation for the same.
(x) Efficiency of labour is promoted.
(xi) This system creates cost-consciousness among all employees, executives and top management which increase efficiency and productivity as well.
Disadvantages of Standard Costing:
The alleged disadvantages of Standard Costing are:
(i) Since Standard Costing involves high degree of technical skill, it is, therefore, costly. As such, small organisations cannot, introduce the system due to their limited financial resources. But, once introduced, the benefits achieved will be far in excess to its initial high costs.
(ii) The executives are liable for those variances that are found from actions which are actually controllable by them. Thus, in order to fix up the responsibilities, it becomes necessary to segregate variances into non-controllable and controllable portions although that is not an easy task.
(iii) Standards are always changing since conditions of the business are equally changing. So, standards are to be revised in order to make them comparable with actual results. But revision of standards creates many problems, particularly in inventory adjustment.
(iv) Standards are either too liberal or rigid since the same are based on average past results, attainable good performance or theoretical maximum efficiency. So, if the standards are very high, it will adversely affect the morale and motivation of the employees.
Variance Analysis: Material & Labour Variances!
The function of standards in cost accounting is to reveal variances between standard costs which are allowed and actual costs which have been recorded. The Chartered Institute of Management Accountants defines variances as the difference between a standard cost and the comparable actual cost incurred during a period. Variance analysis can be defined as the process of computing the amount of, and isolating the cause of variances between actual costs and standard costs. Standard costs provide information that is useful in performance evaluation. Standard costs are compared to actual costs, and mathematical deviations between the two are termed variances. Favorable variances result when actual costs are less than standard costs, and vice versa. The following illustration is intended to demonstrate the very basic relationship between actual cost and standard cost. AQ means the “actual quantity” of input used to produce the output. AP means the “actual price” of the input used to produce the output. SQ and SP refer to the “standard” quantity and price that was anticipated. Variance analysis can be conducted for material, labor, and overhead.
Variance analysis involves two phases:
(1) Computation of individual variances, and
(2) Determination of Cause (s) of each variance.
I. Material Variance:
The following variances constitute materials variances:
Material Cost Variance:
Material cost variance is the difference between the actual cost of direct material used and stand¬ard cost of direct materials specified for the output achieved. This variance results from differences between quantities consumed and quantities of materials allowed for production and from differences between prices paid and prices predetermined.
This can be computed by using the following formula:
Material cost variance = (AQ X AP) – (SQ X SP)
Where AQ = Actual quantity
AP = Actual price
SQ = Standard quantity for the actual output
SP = Standard price
Material Usage Variance:
The material quantity or usage variance results when actual quantities of raw materials used in production differ from standard quantities that should have been used to produce the output achieved. It is that portion of the direct materials cost variance which is due to the difference between the actual quantity used and standard quantity specified.
As a formula, this variance is shown as:
Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard Price
A material usage variance is favourable when the total actual quantity of direct materials used is less than the total standard quantity allowed for the actual output.
Example:
Compute the materials usage variance from the following information:
Standard material cost per unit Materials issued
Material A — 2 pieces @ Rs. 10=20 (Material A 2,050 pieces)
Material B — 3 pieces @ Rs. 20 =60 (Material B 2,980 pieces)
Total = 80
Units completed 1,000
Solution:
Material usage variance = (Actual Quantity – Standard Quantity) x Standard Price
Material A = (2,050 – 2,000) x Rs. 10 = Rs. 500 (unfavourable)
Material B = (2980 – 3000) x Rs. 20 = Rs. 400 (favourable)
Total = Rs. 100 (unfavourable)
It should be noted that the standard rather than the actual price is used in computing the usage variance. Use of an actual price would have introduced a price factor into a quantity variance. Because different departments are responsible, these two factors must be kept separate.
(a) Material Mix Variance:
The materials usage or quantity variance can be separated into mix variance and yield variance.
For certain products and processing operations, material mix is an important operating variable, specific grades of materials and quantity are determined before production begins. A mix variance will result when materials are not actually placed into production in the same ratio as the standard formula. For instance, if a product is produced by adding 100 kg of raw material A and 200 kg of raw material B, the standard material mix ratio is 1: 2.
Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix variance will be found. Material mix variance is usually found in industries, such as textiles, rubber and chemicals, etc. A mix variance may arise because of attempts to achieve cost savings, effective resources utilisation and when the needed raw materials quantities may not be available at the required time.
Materials mix variance is that portion of the materials quantity variance which is due to the difference between the actual composition of a mixture and the standard mixture.
It can be computed by using the following formula:
Material mix variance = (Standard cost of actual quantity of the actual mixture – Standard cost of actual quantity of the standard mixture)
Or
Materials mix variance = (Actual mix – Revised standard mix of actual input) x Standard price
Revised standard mix or proportion is calculated as follows:
Standard mix of a particular material/Total standard quantity x Actual input
Example:
A product is made from two raw materials, material A and material B. One unit of finished product requires 10 kg of material.
The following is standard mix:
During a period one unit of product was produced at the following costs:
Compute the materials mix variance.
Solution:
Material mix variance = (Actual proportion – Revised standard proportion of actual input) x Standard price.
(b) Materials Yield Variance:
Materials yield variance explains the remaining portion of the total materials quantity variance. It is that portion of materials usage variance which is due to the difference between the actual yield obtained and standard yield specified (in terms of actual inputs). In other words, yield variance occurs when the output of the final product does not correspond with the output that could have been obtained by using the actual inputs. In some industries like sugar, chemicals, steel, etc. actual yield may differ from expected yield based on actual input resulting into yield variance.
The total of materials mix variance and materials yield variance equals materials quantity or usage variance. When there is no materials mix variance, the materials yield variance equals the total materials quantity variance. Accordingly, mix and yield variances explain distinct parts of the total materials usage variance and are additive.
The formula for computing yield variance is as follows:
Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit
Example:
Standard input = 100 kg, standard yield = 90 kg, standard cost per kg of output = Rs 200
Actual input 200 kg, actual yield 182 kg. Compute the yield variance.
In this example, there is no mix variance and therefore, the materials usage variance will be equal to the materials yield variance.
The above formula uses output or loss as the basis of computing the yield variance. Yield vari¬ance can also be computed on the basis of input factors only. The fact is that loss in inputs equals loss in output. A lower yield simply means that a higher quantity of inputs have been used and the anticipated or standard output (based on actual inputs) has not been achieved.
Yield, in such a case, is known as sub-usage variance (or revised usage variance) which can be computed by using the following formula:
Sub-usage or revised usage variance = (Revised Standard Proportion of Actual Input – Standard quantity) x Standard Cost per unit of input
Example:
Standard material and standard price for manufacturing one unit of a product is given below:
Materials yield variance always equal sub-usage variance. The difference lies only in terms of calculation. The former considers the output or loss in output and the latter considers standard inputs and actual input used for the actual output. Mix and yield variance both provide useful information for production control, performance evaluation and review of operating efficiency.
Materials Price Variance:
A materials price variance occurs when raw materials are purchased at a price different from standard price. It is that portion of the direct materials which is due to the difference between actual price paid and standard price specified and cost variance multiplied by the actual quantity. Expressed as a formula,
Materials price variance = (Actual price – Standard price) x Actual quantity
Materials price variance is un-favourable when the actual price paid exceeds the predetermined standard price. It is advisable that materials price variance should be calculated for materials purchased rather than materials used. Purchase of materials is an earlier event than the use of materials.
Therefore, a variance based on quantity purchased is basically an earlier report than a variance based on quantity actually used. This is quite beneficial from the viewpoint of performance measurement and corrective action. An early report will help the management in measuring the performance so that poor performance can be corrected or good performance can be expanded at an early date.
Recognizing material price variances at the time of purchase lets the firm carry all units of the same materials at one price—the standard cost of the material, even if the firm did not purchase all units of the materials at the same price. Using one price for the same materials facilities management control and simplifies accounting work.
If a direct materials price variance is not recorded until the materials are issued to production, the direct materials are carried on the books at their actual purchase prices. Deviations of actual purchase prices from the standard price may not be known until the direct materials are issued to production.
Example:
Assuming in Example 1 that material A was purchased at the rate of Rs 10 and material B was purchased at the rate of Rs 21, the material price variance will be as follows:
Materials price variance = (Actual Price – Standard Price) x Actual Quantity
Material A = (10 – 10) x 2,050 = Zero
Material B = (21 – 20) x 2,980 = 2980 (un-favourable)
Total material price variance = Rs 2980 (un-favourable)
The total of materials usage variance and price variance is equal to materials cost variance.
Causes of material variances
Variance Favourable Adverse
Material Price • Poorer quality materials
• Discount given for buying bulk
• Change to a cheaper supplier
• Incorrect budgeting • Higher quality materials
• Change to a more expensive supplier
• Unexpected price increase encountered
• Incorrect budgeting
Material Usage • Higher quality materials
• More efficient use of material
• Change is product specification
• Incorrect budgeting • Poorer quality materials
• Less experienced staff using more materials
• Change is product specification
• Incorrect budgeting
Note: The material price variance and the material usage variance may be linked. For example, the purchase of poorer quality materials may result in a favourable price variance but an adverse usage variance.
Materials variances
Calculation
Causes of material variances
Variance Favourable Adverse
Material Price • Poorer quality materials
• Discount given for buying bulk
• Change to a cheaper supplier
• Incorrect budgeting • Higher quality materials
• Change to a more expensive supplier
• Unexpected price increase encountered
• Incorrect budgeting
Material Usage • Higher quality materials
• More efficient use of material
• Change is product specification
• Incorrect budgeting • Poorer quality materials
• Less experienced staff using more materials
• Change is product specification
• Incorrect budgeting
Note: The material price variance and the material usage variance may be linked. For example, the purchase of poorer quality materials may result in a favourable price variance but an adverse usage variance.
Material waste
Material waste may be a normal part of a process and could be caused by:
• evaporation
• scrapping
• testing
Waste would affect the material usage variance. Expected waste can be built into the standards used, so only excessive ("abnormal") waste would contribute towards the usage variance.
II. Labour Variances:
Direct labour variances arise when actual labour costs are different from standard labour costs. In analysis of labour costs, the emphasis is on labour rates and labour hours.
Labour variances constitute the following:
Labour Cost Variance:
Labour cost variance denotes the difference between the actual direct wages paid and the standard direct wages specified for the output achieved.
This variance is calculated by using the following formula:
Labour cost variance = (AH x AR) – (SH x SR)
Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate
1. Labour Efficiency Variance:
The calculation of labour efficiency or usage variance follows the same pattern as the computa¬tion of materials usage variance. Labour efficiency variance occurs when labour operations are more efficient or less efficient than standard performance. If actual direct labour hours required to complete a job differ from the number of standard hours specified, a labour efficiency variance results; it is the difference between actual hours expended and standard labour hours specified multiplied by the stand¬ard labour rate per hour.
Labour efficiency variance is computed by applying the following formula:
Labour efficiency variance = (Actual hours – Standard hours for the actual output) x Std. rate per hour.
Assume the following data:
Standard labour hour per unit = 5 hr
Standard labour rate per hour = Rs 30
Units completed = 1,000
Labour cost recorded = 5,050 hrs @ Rs 35
Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable) It may be noted that the standard labour hour rate and not the actual rate is used in computing labour efficiency variance. If quantity variances are calculated, changes in prices/rates are excluded, and when price variances are calculated, standard quantities are ignored.
(i) Labour Mix Variance:
Labour mix variance is computed in the same manner as materials mix variance. Manufacturing or completing a job requires different types or grades of workers and production will be complete if labour is mixed according to standard proportion. Standard labour mix may not be adhered to under some circumstances and substitution will have to be made. There may be changes in the wage rates of some workers; there may be a need to use more skilled or expensive types of labour, e.g., employ-ment of men instead of women; sometimes workers and operators may be absent.
These lead to the emergence of a labour mix variance which is calculated by using the following formula:
Labour mix variance = (Actual labour mix – Revised standard labour mix in terms of actual total hours) x Standard rate per hour
To take an example, suppose the following were the standard labour cost data per unit in a factory:
In a period, many class B workers were absent and it was necessary to substitute class B workers. Since the class A workers were less experienced with the job, more labour hours were used.
The recorded costs of a unit were:
Labour mix variance will be calculated as follows:
Labour mix variance = (Actual proportion – Revised standard proportion of actual total hours) x standard rate per hour
Revised standard proportion:
(ii) Labour Yield Variance:
The final product cost contains not only material cost but also labour cost. Therefore, gain or loss (higher or lower output than the standard output) should take into account labour yield variance also. A lower output simply means that final output does not correspond with the production units that should have been produced from the hours expended on the inputs.
It can be computed by ap¬plying the following formula:
Labour yield variance = (Actual output – Standard output based on actual hours) x Av. Std. Labour Rate per unit of output.
Or
Labour yield variance = (Actual loss – Standard loss on actual hours) x Average standard labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which is computed in terms of inputs, i.e., standard labour hours and revised labour hours mix (in terms of actual hours).
Labour efficiency sub-variance is computed by using the following formula:
Labour efficiency sub-variance = (Revised standard mix – standard mix) x Standard rate
2. Labour Rate Variance:
Labour rate variance is computed in the same manner as materials price variance. When actual direct labour hour rates differ from standard rates, the result is a labour rate variance. It is that portion of the direct wages variance which is due to the difference between actual rate paid and standard rate of pay specified.
The formula for its calculation is:
Labour rate variance = (Actual rate – Standard rate) x Actual hours
Using data from the example given above, the labour rate variance is Rs 25,250, i.e.,
Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250 (unfavourable)
The number of actual hours worked is used in place of the number of the standard hours speci¬fied because the objective is to know the cost difference due to change in labour hour rates, and not hours worked. Favourable rate variances arise whenever actual rates are less than standard rates; unfavourable variances occur when actual rates exceed standard rates.
3. Idle Time Variance:
Idle time variance occurs when workers are not able to do the work due to some reason during the hours for which they are paid. Idle time can be divided according to causes responsible for creat¬ing idle time, e.g., idle time due to breakdown, lack of materials or power failures. Idle time variance will be equivalent to the standard labour cost of the hours during which no work has been done but for which workers have been paid for unproductive time.
Suppose, in a factory 2,000 workers were idle because of a power failure. As a result of this, a loss of production of 4,000 units of product A and 8,000 units of product B occurred. Each employee was paid his normal wage (a rate of? 20 per hour). A single standard hour is needed to manufacture four units of product A and eight units of product B.
Idle time variance will be computed in the following manner:
Standard hours lost:
Product A = 4, 000/ 4 = 1,000 hr.
Product B = 8, 000 / 8 = 1,000 hr.
Total hours lost = 2,000 hr.
Idle time variance (power failure)
2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)
Labour variances
Calculation
Causes of labour variances
Variance Favourable Adverse
Labour rate • Lower skilled staff
• Cut in overtime/bonus
• Incorrect budgeting • Higher skilled staff
• Increase in overtime/bonus
• Incorrect budgeting
• Unforeseen wage increase
Labour efficiency • Higher skilled staff
• Improved staff motivation
• Incorrect budgeting • Lower skilled staff
• Fall in staff motivation
• Incorrect budgeting
Note: The labour rate variance and the labour efficiency variance may be linked. For example, employing more highly skilled labour may result in an adverse rate variance but a favourable efficiency variance.
Idle time
Idle time occurs when employees are paid for time when they are not working e.g. due to machine breakdown, low demand or stockouts.
If idle time exists an idle time labour variance should be calculated.
Controlling Idle time
Idle time can be prevented or reduced considerably by :
1. Proper maintenance of tools & machinery
2. Advanced production planning
3. Timely procurement of stores
4. Assurance of supply of power
5. Advance planning for machine utilisation
A consideration of labour variances can be extended to incorporate labour ratios as well
What is Job order costing? Advantages and disadvantages of Job order costing
Concept of job order costing
The act of producing goods and providing services according to the special demand or order of the customers is called a job. Now, it becomes necessary to ascertain the total costs of the job. Hence, the process of ascertaining the costs of job is called job order costing.
This technique can be used by repair workshop, tap and electricity connections, research center, Construction Company, advertising agency, auditing firm and other non-manufacturing organizations etc. under this method costs are accumulated for each job or work order separately. The jobs are usually carried out inside nether factory building and compete in short span of time. They can easily be distinguished from each other.
Character institute of management accountants (CIMA), London defines job order costing as "that form of specific order costing which is applied where is undertaken to customer's specific factory or workshop and moves through processes and operations as a continuously identifiable unit. The term may also be applied to work such as property repairs and the method may be used in costing of internal capital expenditure jobs."
From the above definition, it is clear that job order costing is a method of calculating the cost of a job that is carried against the specific demand of customer where the production process moves as a continuous identified unit.
Feature of job order costing
Following are the specific features of job order costing:
• Goods and services are produced according to the customers' orders. In other words, the goods are not produced for stocking in the warehouse.
• Each job bears some specific characteristics and needs special materials and labour.
• Each job is treated as a specific cost center.
• The cost of each job is calculated after the works is completed.
• It takes comparatively lesser time to complete a job.
• The supervisor of the materials and labour is easy
Objective of job order costing
The main objective/advantages of job order costing are presented below:
• To calculate the cost of each job by maintaining a separate account for each job order or order. It enables the calculation profit or loss from each job or order.
• It helps the management in estimating or quoting the price for an order or a job. Such estimations are made on the basis of the past cost records related to similar work.
• To help identify the profitable and non profitable job or order.
• To differentiate the cost of every job or order and production from one department to other.
• To compare actual costs and estimated cost for purpose of controlling the operational inefficiency.
Advantages and disadvantages or job order costing
The advantages of job order costing are as following:
(i) It provides a detailed analysis of cost of materials, wages, and overheads classified by functions, departments and nature of expenses which enable the management to determine the operating efficiency of the different factors of production, production centres and the functional units.
(ii) It records costs more accurately and facilitates cost control by comparing actuals with estimates.
(iii) It enables the management to ascertain which of the jobs are more profitable than the others, which are less profitable and which are incurring losses.
(iv) It provides a basis for estimating the cost of similar jobs taken up in future and thus helps in future production planning.
(v) Determination of predetermined overhead rates in job costing necessitates the application of a system of budgetary control of overheads with all its advantages.
(vi) Identification of spoilage and defectives with the respective production orders and departments may enable the manager, lent to take effective steps in reducing these to the minimum.
(vii) The detailed cost records of the past years can be used for statistical purposes in the determination of the trends of cost of the different types of jobs and their relative efficiencies.
(viii) It is useful in quoting cost plus contract.
The disadvantages of job order costing are mentioned below:
(i) It involves a great deal of clerical work in recording daily the cost of materials issued, wages expended and overheads chargeable to each job or work order which adds to the cost of cost accounting. Thus it is expensive.
(ii) The scope of committing mistakes is enough as the cost of one job may be wrongly posted to the cost of other job.
(iii) Cost comparison among different jobs becomes difficult especially when drastic changes take place.
(iv) Determination of overhead rates may involve budgeting of overhead expenses and the bases of overhead apportionment and absorption but unless such budgeting is complete i.e., extended to material, labour and expenses, its advantages are considerably reduced.
(v) Job costing is historical costing which ascertains the cost of a job or product after it has been manufactured. It does not facilitate control of cost unless it is used with standard or estimated costing.
Procedures of job order costing
The following procedures are involved in a job order costing:
a. Inquiry from customer: since the works under job order costing, are carried after the order from the customer has been received, the detail information about the job like the price, quality, durations for supply and other terms and conditions should be accumulated form t customers.
b. After estimation: after taking the detailed information about the job, the cost of completing the job is estimated. The cost estimation is made on to basis of part information and the current price level change. The pried to be quoted for a job is ascertained by adding a certain profit on the cost.
c. Receiving order: the customer places an order, if he/she is satisfied with the price, quality and other terms and conditions. The work is started after receiving the order.
d. Production order: after receiving the order, the planning department sends an order to the production department to produce the stated goods or services. The production department does not inanities the production in the absence of such order. A production order includes the details about the goods. The specimen of a production order is given below:
e. Cost ascertainment: a job cost sheet is prepared to calculate the cost of goods or services to be produced according to the production order. Its specimen is as under.
Calculation of profit or losses: it is estimated by comparing the actual cost with the prices obtained.
f. Completion of job: after completing the job, the production department sends the information of the same to the cost accounting department. The cost accounting department compare the predetermined cost and actual cost to find the variance if any. It also determines the profit or loss by comparing the actual price of the job and the the total costs involves in it. For this, s statement is prepared which is called a cost sheet. The specimen of a cost sheet is given below:
1. What is job order costing?
He act of producing a proving to the special demand or order of the customers is called a job. Now, it becomes necessary to ascertain the total costs of the job. Hence, the process of ascertaining the costs of job is called job order costing.
This technique can be used by repair workshop tap and electricity connection, research center, Construction Company, advertising agency, auditing firm and other non-manufacturing organizations etc. under this method costs are accumulated for each job or work separately. The jobs are usually carried out inside the factory building and complete in short span of time. They can easily be distinguished from each other.
2. Mention the feature of Job Order Costing.
Following are the specific features of job order costing:
• Goods and services are produced according to the customer's order. In other words, the goods are not produced for stocking in the warehouse.
• Each job bears some specific characteristics and needs special material and labour.
• Each job is treated as a specific cost center.
• The cost of each job is calculated after the work is completed.
• It takes comparatively lesser time to complete a job.
• The supervisor of the material and labour is easy.
Contract Costing
Some firms such as builders, construction contractors, civil engineering firms, construction and mechanical engineering firms are engaged in construction works such as construction of buildings, bridges, roads and so on. A firmengaged in the construction works requires to know the total cost of the construction work done. The total costs of the work help to find out the profit earned from these works. The cost information about construction works helps to monitor and evaluate the performance of contract work and to determine the total contract cost. Such information is provided by a costing method known as contract costing.
Contract costing is the costing method applied to determine the cost of construction work performedas per a customer's specification. Contract costing is also called terminal costing as it terminates with the discharge of contract work. The construction work is undertaken at the site allotted by the client. The contract sites vary and are always outside the premises belonging to the clients. A separate code number is allotted to each site where a number of contract works are undertaken. A contract account is maintained for each contract work to record the contract costs under contract costing. Maintaining a contract account helps to find out the amount of profit earned during a particular period since financial books do not report it separately. Normally, a contract account is prepared at every year-end to determine the profit for the specified period.
Definition of Contract Costing
CIMA defines contract cost as the aggregated costs relative to a single contract designated a cost unit.
CIMA defines contract costing as that form of specific order costing which applies where work is undertaken to special requirements of customers and each order is of long term duration.
Types of Contract
The following are the types of contract.
1. Fisted price contract
2. Fisted price contract subject to Escalation Clause.
3. Cost plus contract.
There are three types of contract which are mentioned below:
a. Fixed price contract: the contract that is executed with the fixed price which is agreed by the contract and the contractee is called the fixed price contract. Under this contract, no modification is made in the agreed contract price irrespective of the changes in the price level of material and labour in feature. In such type of contract, the contractor is benefited when the price of material and labour decrease. In contrary to this, the contractee is benefited if the price of material and labour increase.
b. Fixed price contract with escalation and de-escalation clauses: escalation clause is a of agreement that that aims to reduce the risks that is causes due to the changes in the price of materials, labour and other services. Under this, the contract price is adjusted in accordance, with the changes in the price of material, labour and other services. The additional cost raised due to the increase in price is born by the contracted. Similarly, the contract price is reduced if the cost decreases below a certain percentage. It is called de-escalation or reverse clause. Escalation clause safe guides the interest of both the contractor and contractor against unfavorable price change in future. Such clause may also apply where material and labour utilization exceeds a particular limit. In this case, however, contractor will have to prove that excessive utilization is not because of decrease in efficiency. The contractor allows a rebate in the bills presented by him to the extent of the decrease in price.
c. Cost plus contract: the contract in which the contract price is determined by adding a certain percentage of profit on cost is known as cost plus contract. The cost plus contract is adopted to overcome with problem of fixing the contract price price caused due to nature of contract, duration of completion of contract, uncertainly of material, change in the price level, new technology etc. this type of contract is mostly followed by the government for production of special articles not usually manufactured, urgent repairs of vehicles, roads bridge etc. under this types of contract, the contract starts the work and payment is made by the contracted gradually on the basis of the cost incurred in the work completed plus certain percentage of profit.
Features of Contract Costing
The following are the features of contract costing.
1. A contract is undertaken according to the specific requirements of customers.
2. Generally, the duration of a contract is long period.
3. The contract is undertaken only at the site of the customer.
4. Contract work mainly consists of construction activities.
5. The specific order costing principles are applied in contract costing.
6. The size of a contract is usually large or bigger than jobs.
7. It requires a long time to complete a contract.
8. Each contract is an independent one, quite distinct from another.
9. A distinctive number is assigned to each contract to differentiate the contract from one another.
10. A separate account is maintained and prepared for each contract to find out the profit earned from each contract separately.
11. If a contract is not completed at the end of the accounting period, only a portion of profit is transferred to profit and loss account on the basis of stage of completion of a contract.
12. There is no problem of under absorption and over absorption of overheads.
13. Every conceivable expenditure is charged to the concerned contract.
14. If the materials, plants and other inputs are transferred from one contract to another, the transfer may be affected by giving debit and credit to the respective contracts.
15. The proportion of indecent costs to total cost of a contract is very small.
16. A contractor may appoint a sub — contractor(s) for the execution of the work of the main contract.
17. The contractee i.e. the customer pays money only on the basis of the work certified by the architect, engineer or surveyor.
18. Escalation clause may be incorporated in the agreement of the contract. It so, the contractor is protected from any rises in the prices of materials, labour and other inputs.
Procedure of Contract Costing
In contract costing, most of the expenses are direct in nature as in the form of materials, labour, expenses, plant, sub-contract charges and the like. Only a small portion of amount is charged as overheads which are apportioned on suitable basis. Accounting treatment of costs of contract costing is briefly explained below.
1. Materials
The value of materials used is debited in the concerned contract account. Materials may be specifically purchased from the open market, issued from the stores, transfer from other contracts or supplied by the contractee himself. If materials are returned to stores, the value of materials is credited in the concerned contract account.
Sometimes, materials may be transferred from one contract to another. If so, the value of materials is debited in the receiving contract account and credited in the transferring contract account. Whenever the materials are purchased from the open market, the values of materials are debited in the concerned contract account.
Similarly, if materials are issued from stores, the concerned contract account is debited and the stores control account is credited. Sometimes, some materials may be stolen or destroyed by fire, the value of materials is credited in the concerned contract as stores account and the same is transferred to profit and loss Account.
2. Labour
Generally, the contract is carried on only at the site of the contractee i.e., customer not within the company premises. Hence, labour is engaged at site to work on the contract. The amount paid to workers is wages which is directly debited in the concerned contract account. The details of information regarding wages are obtained from the records of time sheet and wages sheet. Equitable base method is usually adopted to apportion the wages of supervisors working on two or more contracts.
Likewise, the overheads are also apportioned on suitable basis. The accrued wages and outstanding expenses are calculated at the end of the accounting period and debited in the concerned contract account.
3. Direct Expenses
The direct expenses are debited in the concerned contract account as and when they are incurred. Examples of direct expenses are hire charges paid for the plant procured from outside, sub-contractor’s charges, architect’s fees, electricity, insurance and the like.
4. Plant and Machinery
The plant and machinery is treated in two ways. Under first method, the full value of plant and machinery is debited in the concerned contract account if the plant and machinery is specifically purchased for the contract. At the end of contract, the plant and machinery may be sold out in the market if it is not required further. If so, the sale proceeds are credited in the concerned contract account.
Sometimes, the plant and machinery may be required further, if so, the depreciated value or revalued amount of plant and machinery is credited in the concerned contract account. The net effect is that the contract account is debited with the amount of depreciation.
Under second method, the contract account is debited with the amount of depreciation of plant and machinery. The plant and machinery may be purchased specifically from the open market or issued from the stores. The amount of depreciation is calculated on the basis of daily use or hourly basis. Sometimes, a plant is procured on hire basis, if so, only hourly charges are debited in the contract account.
5. Overheads
Indirect costs cannot be directly charged to any contract account. These costs are apportioned to all the contract accounts only on the suitable basis. These are called as overheads. The term overheads includes payment made to engineers, supervisors, architects, managers, store keeper, central office, administrative expenses like staff salaries, telephone expenses, postage, rent, stationery, advertisement expenses etc.
Preparation of a contract account
Under the contract costing, a separate account is opened for each contract so as to ascertain the position of profit or loss. Such account is called a contract account. All the expenses incurred in the contract like material, wages, direct expenses, plant and machinery etc. are debited whereas material returned, and material at end, plant at end, work in progress or contract price in case of completion of the contract etc. are credited in the contract account. The difference between the debit and credit represents the loss or profit. The profit earned under the completion of the contract is regarded as net profit or net loss in case of loss. The profit earned from the contract which is in progress or not completed is called notional profit. When loss takes place in such a situation, it is called net loss. It is because that a loss can never be notional, it is always real. The specimen of a contract account is presented below:
a. When contract is totally competed: some contracts are small and can be completed within a year. In such a case, total contract price is show on the credit side of the contract account as contracture's account. In this case, if credit is heavy then balancing figure on debit side is called profit and if the debit side is heavy, then the balance figure on credit side will be called a loss.
b. When contract is incomplete: large contract take number of years to completion. In this situation, amount of work certified and uncertified are found in the contract. Such amount of work certified and uncertified should be shown on the credit side of the contract account under the head work-in progress account.
1. Work certified: the value of work completed and certified by contractee's engineers and architchets is called work certified. As per provision of the contract, a fixed percentage of such work certified is paid by contractee to contractor. Some percentage of work certified is retained money. The work certified included the portion of notional profit therefore, if the cost of certified is lower than the work certified, the different amount is called motioned ,profit, if the amount of cost of work certified is higher than the work certified, the different will be loss.
2. Work uncertified: on the date of preparation of contract account, there may be some competed but uncertified work. The work of contract which is completed but not certified by the engineers is called work uncertified. It is always recorded at cost price and not on contract prices so as to avoid any profit element in it. The work uncertified never includes the portion of notional profit.
Treatment of materials in contract account
The procedures of recording materials in a contract account are as follows:
Treatment of plant in contract account
The machinery used for a contract is recorded in a contract account through two ways. They are
i. The cost of machinery and equipment to be used for a longer period or purchase for the contract is shown in the debit side of a contract account. The book value of the machinery and equipment is shown in credit side. The book value is calculated by deducting the depreciation from the cost of the machinery and equipment.
j. If the machinery and equipment is used for a short time in the contract, the amount of depreciation charged is only debited in the contract account. In such a situation, the purchase price in the debited side and the book value in the credit side are not shown. This is generally done, if the plant and equipment are not used till the end of te accounting period.
The treatments of plant and machinery in a contract account under different conditions have been presented below:
Methods of transferring profit
The profit earned against the completion of a contract is assumed to be the net profit and transferred to profit and loss account. Generally, a contract is completed in a long-period of time and the profit/loss is to be calculated at the end of each accounting period. Out of the national profit i.e. the profit earned during the work in progress, only some portion is to be transferred to profit and loss account. The during the work in progress, only some portion is to be transferred to profit and loss account. The remaining part of the notional profit is transferred to reserve. Therefore reason. There are some factors which are to be considered to transfer the proportion of notional profit to profit and loss account and reserved. They are:
a. Work certified: the work of a contract completed by a contractor is supervised and certified by the engineer of the contractee. The portion of the work completed and certified by the contractee is called the work certified. The work completed but not certified due to different treasons is called the work uncertified. Work certified is one of the bases of transferring the national profit to the profit and loss account.
b. Cash received: the contractor received cash from the contracted depending on the level of work completed. He/she received cash on the basis of work certified. The whole amount of work certified is not paid to the contractor. The portion of work certified that is not paid to the contractor is known as retention money. The relationship between the work certified and cash receipts is shown below:
Cash received (Rs.) = work certified x % of cash received
% of cash received = 100% - Retention rate
Wok certified = cash received (Rs.) x 100/ % cash received
The ways of transferring notional profit and loss account are given below:
a. Transfer of profit of incomplete contracts
The methods of transferring the motioned profit when is in profess are given below:
b. Transfer of profit if contracts are almost completed
The contact in which it is possible to estimate the of contract completion and feature cost to be incurred to completed the work and more than 90% of the work has been completed is called the almost completed contract. The methods of ascertainment of profit and transferring the profit and loss account are given below:
Some other items used in costing account
a. Labour cost: all the workers engaged at the site of a particular contract, irrespective of the nature of the work performed by items, are treated as direct workers and the amount of wages paid to them as direct wages. Such wages are to be charged to the particular contract directly. In case a worker (generally the supervisory staff) is engaged at two or more contracts, his total wages may be apportionment to different contract on the basis of time devoted to each contract or on some other equipment basis' wages accrued or outstanding at the end of the accounting period should appear on the debit side of the contract account.
b. Direct expenses: all expenses (other than material cost and direct wages)
which have been incurred specifically for a particular contract are direct expenses and shall be debited to contract a/c. example of direct expenses are: here charges of special plant (not owned), carriage on materials purchase, travelling expenses relating to contract, etc.
c. Indirect expenses: there are certain expenses, which cannot be directly charged to a particular contract e.g., salary of general manager, salary of architect engaged at a number of contract simultaneously, salary of storekeeper, expenses of store and office expenses. Since these expenses are incurred for the business as a whole, they are to be apportioned to the different contract on some equitable basis.
d. Cost of sub-contracts: generally, the work of a specialized character e.g., road construction in a building, installation of lifts, electrical fittings, is passed on to some other contractor by the main contractor. In such cases, the work performed by the sub-contractor forms a direct charged to be contractor concerned and the sub-contractor price paid shall be debited to contract account.
e. Cost of extra work: sometimes, in case of a contract, some additional work o variations of the work originally contracted for may be required by the contractee. Since the additional work required will not be covered by the terms and condition of original contract, it will be the subject of a separate charge., if the additional work required by the contractee is quite substation, it should be treated as a separate contract and dealt with in a separate account to be opened for it. But in case the additional work is not substantial, the expenses incurred on extra work should be debited to contract account as 'cost of extra work' and the extra amount which the contractee has agreed to pay to the contractor should be added to the original contract price.
f. Contract price: the contract price is the agreed price at which the contractor undertakes to execute to contractor. The contractor account is credited with the contractor price if it has been completed. In such a case, the amount of contract price is debited to the 'contractee's personal account and credited to the 'contract account'. No entry is passed in respect of the contract price in case of incomplete contracts.
g. Retention money: generally, the terms of the contract provide that the whole of the amount shown by the archive's certificate shall not be paid to the contractor but a specified percentage or portion money (say 10% or 20%) thereof shall be retained by the contractee till the contract. Te money so retained is known as 'Retention money'. The cash received from the contractee is credited to his personal account. The value of work (certified and uncertified) is debited to work-in progress account. The work-in-progress account is shown as an asset in the balance sheet after deducting the amount received from the contractee. In the beginning of the next year the work-in-progress account is transferred to the debit side of the contract account. On competition of the contract, the contractee's account is debited and contract account is credited by total contract price.
Differences between job order and contract costing
The differences between job order contacts costing are mentioned below:
Similarities between job order and contract costing
The similarities between job order and contact costing are mentioned below:
• Both jobs and contracts are based on the specific requirements of customers. As a result, each job or contract is 'tailor-made' and there is no exact repetition of a job or contract.
• Both job and contract is terminal. Each job and contract can be identified from start to finish and, therefore, costs can be identified for each job a contract.
• The basic principles of contract costing are similar to those applied in job costing
What is Process costing? Advantages & Disadvantages of process costing?Normal loss,Abnormal loss and Gains
Process is a set of sequential steps followed to complete a certain activity. The way of maintaining the costing records of each process is called costing. It refers to the method of cost accounting under which cost are accumulated for every process which are interrelated to each other. Process costing is used in manufacturing concerns where the raw materials are converted to finished goods after passing through a number of processes. For example; in case of cotton textiles, the first process may be spinning, second process may be weaving and the final process may be finished.
CIMA defines Process Costing as “the costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes, costs are averaged over the units produced during the period.”
Process Costing is used where the production moves from one process or department to the next until its final completion and there is a continuous mass production of identical units through a series of processing operations. It is applied for various industries like chemicals and drugs, oil refining, food processing, paints and varnish, plastics, soaps, textiles, paper etc.
Process Costing method may also be adopted in firms that produce a variety of products, provided that the overall production process can be broken down into sub-operations of a continuous repetitive nature like automobile, toy, plastics etc.
Process costing is mostly used in manufacturing concerns. T determines the cost of a product at each stage of manufacturing or process. This method of costing is adopted by industries involved in the manufacturing of textiles, biscuits, cement, paper, oil refining, etc. the output of first process becomes the input of the second process and so on as shown in following figure.
Advantages of process costing
The following are the advantages of process costing:
a. It is simple and less expensive to find out the cost of each process.
b. It is easy to allocate the expense to process in order to have accurate costs.
c. Production activity in process costing is standardized. Hence, managerial control and supervision become easier.
d. In process costing, the products are homogeneous. As a result, costs per unit can be easily computed by averaging the total cost and price quotations become easier.
e. It is possible to determine process costs periodically at short integrals.
Disadvantages of process costing
The following are the disadvantages of process costing:
a. The cost obtained at the end of the accounting period is historical in nature and is of little use for effective's managerial control.
b. Since process cost is average cost, it may not be accurate for analysis, evaluation and control the performance of various departments.
c. Once an error is committed in one process, it is carried to the subsequent processes.
d. Process costing does not evaluate the efficiency of individual workers or supervisor.
e. The computation of average cost is difficult in those cases where more than one type of product is manufactured.
Features of Process Costing:
The distinctive features of Process Costing are as follows:
(a) The process cost centres are clearly defined and all costs relating to each process cost centre are accumulated.
(b) The cost and stock records for each process cost centre are maintained accurately. The records give clear picture of the units introduced in the process or received from the preceding process cost centre and also units passed to the next process.
(c) The total costs of each process are averaged over the total production of that process, including partly completed units.
(d) The charging of the cost of the output of one process as the raw materials input cost of the following process.
(e) Appropriate method is used in absorption of overheads to the process cost centres.
(f) The process loss may arise due to wastage, spoilage, evaporation etc.
(g) Since the production is continuous in nature, there will be closing work-in-progress which must be valued separately.
(h) The output from the process may be a single product, but there may also be by-products and/or joint products.
Elements of production cost
The following are the main elements of productions cost in process costing:
a. Direct materials: materials are used for manufacturing products. The materials required for production are issued to the first process. The output of first process is passed to the next process and so on. Hence, the output of first process becomes the input of second process and so on, sometimes; new materials may be introduced in the second and subsequent processes.
b. Direct labour: payment madden to the manpower involved in process work against their work is called labour cost. Generally, employees are engaged in one process and wages paid to them is debited in the concerned process account. But if the employs are engaged in more than one process, the total wages paid to them are apportioned among the process on equitable basis.
c. Direct expenses: cost of electricity, hire charges of machine, depreciation of machine are the cost that are directly attributable to a particular process. The process account is debited by such direct costs.
d. Production overhead: the overhead covers a significant portion of the total process cost. Great attention should be paid to ensure that each process is charged with a reasonable share of production overhead like store service, cafeteria services, services etc. are allocated on the basis of absorption rate. The overheads are debited to the process account.
Accounting for process costing
Process accounts
Under process costing, a separate account is maintained for each process. The account is debited with the value of materials, labour, direct expenses and overhead relating to the process. The value of by-products and scrap, if any, is credited to this account. The balance of this account, representing the cost of partially worked out product, is passed on to the next process and so on until the product is completed. Thus the finished product of one process becomes the raw material of the next process.
The following situations arise while preparing process accounts.
a. Process costing having no process loss and stock
All the costs like materials, direct, labour expenses and production overhead relating to the particular process are debited to the process accounts. Since there is no process loss, the output of a process is equal to the unit of input introduced in the process. The total cost of the process is transferred to the next process. The format of the process account having no process loss and stock is given below:
Process-I account
b. Process costing having process loss
It is rare that the output of a process is equal to its input. In most of the cases, the output of a process is less than the input. The difference between the input and output and output is called process loss. The process loss may be in the form of loss in weight, scrapes or wastes. These process losses may be classified into.
Normal loss
Normal loss or uncontrollable loss means the less of materials, which is inherent in the processing operations or in the nature of material. Normal loss includes loss of leakage and normal scrap. Normal loss is considered to be an integral part of process cost. It is unavoidable but efficient workers can reduce it to some extent. The accounting treatment of normal loss is as follows:
Abnormal loss
Any loss caused by unexpected or abnormal condition such as accident, carelessness, etc. is called abnormal loss. It is the excess of over the normal loss. For example, if 1,000 units of raw material are introduced in a process subject to wastage of 10 percent, i.e. the output of the process should be 900 units. But the actual output is 830 units; the extra losses of 70 units are abnormal loss. In other words, the excess loss of 70 units over the normal loss of 100 units is the abnormal loss.
Calculation of the unit and of abnormal loss:
Normal output/yield= inputs – normal loss/ scrap unit
Total normal cost = total cost of input – scrap value of normal loss
Abnormal loss unit = normal output unit – actual output unit
Normal cost per unit = total normal cost/ normal yield
Difference between normal loss and abnormal loss
The differences between the normal loss and abnormal loss are given below:
Difference between normal loss and abnormal loss
c. Process costing having abnormal gain
We know that margin allowed for normal loss is just an estimate and slight differences are bound to occur between the actual and anticipated output of a process. These differences do not always represent increased loss may be less than the expected. Thus, when actual loss in a increased loss, on occasions the actual loss may be less than the expected. Thus, when actual loss in a increased loss, in a process is lower than the expected, an abnormal gain results. The value of the gain is calculated in a similar manner to an abnormal loss.
Abnormal gain being the result of actual loss being less than the normal, the scrap realization shown against normal loss gets reduced by the scrap value of abnormal gain. Consequently, there is an apartment loss by way of reduction in the scrap realization attributable to abnormal gain. The loss is set off against abnormal gain by debiting this account. The balance of this account becomes abnormal gain and is transferred to costing profit and loss account. The balance of this account becomes abnormal gain normal yield or actual loss is less than normal loss.
Calculation of abnormal gain unit and value
Total normal cost= total cost of input – scrap value of normal loss
Normal output/ yield= input – normal loss/ scrap unit
Normal cost per unit = total normal cost/ normal yield
Sales account and income statement
Income statement is prepared to find out profit and loss. Income statement is based on sales account, if sales is recorded in related process account. Incomes statement is also prepared on the basis of profit and loss of every process. If sales are not recorded in related procuress account, incomes statement is prepared on the basis of total sales. Incomes statement can be prepared as follows:
a. When sales is included in the process account
Incomes statement or costing Protit and loss account
Interest process profit
The profit associated with the transfer of goods form one process to another is called inter process profit. Normally finished goods of one process are transferred to the immediate next process at cost of production basis. In some process industries, transfer of finished goods is made to the immediate next process by including some account of profit. The procedure is followed to demonstrate the department efficiency of concerned processes. It helps in recognizing the profit on each process of production. The profit so incorporated is called inter-process profit. The price fixed by adding nominal balance sheet for the transfer of the finished goods to the next process is called as transfer price. For balance sheet purpose, intern process profit cannot be included in stock, as a firm cannot make profit by trading itself. To avoid these complications a provision must be created to reduce the stock to actual cost price. This problem arises only in respect of stock on hand at the end of the period.
The following are the objectives of inter process profit.
• To assess the performance of process operation
• To assess whether the output can compete with the market.
• To decide whether the output can be sold without further processing.
Advantages of inters-process profit
• It shows whether the cost of production computers with the market price.
• By comparing the transfer prices with the corresponding market prices, the 'week' or strong' sports in the manufacturing activity can be located. As a result, measures can be adopted to improve the conditions wherever necessary.
• It makes each process stand on its own efficiency and economics.
Disadvantages of inter-process profit
• This system involves an unnecessary complication of the accounts.
• This systems shown unrealized profits in respect of unsold stocks on the closing date of the accounting period.
• In the balance sheet, stock is conventionally shown at 'cost or market price whichever is lower' to make it acceptable to auditors and tax authorities. Thus, the profit included in stocks has to be eliminated from the stock value before they are shown in final accounts and balance sheet.
Wastage, scrap, spoilage and diffractive unit
Wastage, scrap, spoilage and diffractive unit
Comparison & Differences between job costing and process costing
Comparison Chart
BASIS FOR COMPARISON JOB COSTING PROCESS COSTING
Meaning Job costing refers to calculating the cost of a special contract, work order where work is performed as per client's or customer's instructions. A costing method, in which the costs which are charged to various processes and operations is ascertained, is known as Process Costing.
Nature Customized production Standardized production
Assignment of cost Calculating cost of each job. First of all, cost is determined for the process, thereafter spread over the produced units.
Cost Center Job Process
Scope of cost reduction Less High
Transfer of Cost No transfer Cost is transferred from one process to another
Identity Each job is different from another. Products are manufactured consecutively and so they lose their identity.
Cost Ascertainment Completion of the job. End of the cost period.
Industry type Job costing is suitable for the industries which manufactures products as per customer's order Process costing is perfect for the industry where mass production is done.
Losses Losses are usually not segregated. Normal losses are carefully ascertained and abnormal losses are bifurcated.
Work-in-progress (WIP) WIP may or may not exist at the beginning or at the end of the financial year. WIP will always be present in the beginning or at the end of the accounting period.
The differences between job costing and process costing are as follow:
Key Differences Between Job Costing and Process Costing
The following are the major differences between job costing and process costing:
1. The costing method which is used for the ascertainment of the cost of each job is known as Job Costing. Conversely, by process costing, we mean the costing technique used to determine the cost of each process.
2. Job Costing is performed where the products produced of a specialized nature, whereas Process Costing is used where standardized products are produced.
3. In Job Costing, the cost is calculated for each job, but in Process Costing first of all the cost of each process is calculated which is then dispersed over the number of units produced.
4. In job costing the cost center is the job itself while the process is the cost center in case of process costing.
5. In job costing each job requires special treatment. On the other hand, no such special treatment is required for each process in process costing.
6. There is no transfer of cost in job costing, from one job to another. However, the cost of the last process is transferred to the next process in the process costing.
7. The possibility of cost reduction is very less in Job Costing. In contrast to Process Costing, the scope of cost reduction is comparatively high.
8. In Job Costing, the cost is ascertained after the completion of the job, but in Process Costing, the cost of each job is determined.
9. In job costing, losses are not bifurcated. On the contrary, in process costing normal losses are ascertained carefully, while the abnormal losses are bifurcated.
10. In job costing, WIP may or may or may not be present at the end of the financial year. As against this, WIP will always be present, irrespective of the quantity, in the beginning, or at the end of the accounting period, in process costing.
List of formula
Normal output/yield = inputs – normal loss/ scrap unit
Total normal cost = total cost of input –scrap value of normal loss
Normal cost per unit = total normal cost/ normal yield
Abnormal loss (unit) = normal output unit –actual output unit/ normal output unit – actual output unit
Abnormal loss (Rs.) = abnormal loss unit x normal cost per unit
Abnormal gain (units) = actual loss unit – actual loss unit
Abnormal gain (RS.) =abnormal gain unit x normal cost per unit
Inter process:
Cost of losing stock = given closing stock x total amount of cost column/ total amount of total column
Unrealized profit on closing stock = given closing stock – cost of closing stock
Calculation of inter process profit:
a. It percentage of item process is given on processing cost, then
Inter process profit = total cost x %profit
a. If percentage of inter process profit is given on transfer price , then
Inter process profit =total cost x %profit / 100- %profit
Actual released profit = gross profit + unrealized profit on opening stock – unrealized profit on closing stock
What is Operating Costing?
Operating costing is an extension and refined form of process costing. It is also more or less very similar to single or output costing. The operating costing gives more emphasis on providing services rather than the cost of manufacturing an article. The services provided may be for sale to the general public or they may be provided within an organization.
The operating costing is also called as service costing, period costing or terminal costing. Service costing means rendering service to the public or to an organization for which cost is accumulated and calculated. Period costing means the costs data collected and calculated for a specific period. Terminal costing means a bus or truck of a transport undertaking chartered for a specific trip.
Meaning of Operating Costing
Operating costing is a process and technique of accumulating and ascertainment of cost for providing a standardized service to the public or to an undertaking.
Definition of Operating Costing
ICMA, London,
Operating costing is that form of operation costing which applies where standardized services are provided either by an undertaking or by a service cost center within an undertaking.
Wheldon,
Operating costing is actually unit costing as applied to the costing of services.
Features of Operating Costing
The basic features of operating costing are presented below.
1. Uniform service is provided to all the customers.
2. The costs are classified into fixed and variable.
3. The fixed and variable cost classification is necessary to ascertain the cost of service and the unit cost of service.
4. There is no physical stock of article if an undertaking renders a service.
5. If a cost center is operating for an undertaking, there is no sale of service but render the service. In other words, if a cost center is operating for public, it sells its service to the public.
6. The cost unit may be simple in certain cases or composite or compound in other cases like transport undertakings.
7. Total costs are averaged over the total amount of service rendered.
8. The costs are collected from the authentic documents like daily log sheet, operating cost sheet, boiler house cost sheet, canteen cost sheets etc.
9. Operating cost is the cost of rendering service.
10. Operating costing is the method of ascertaining costs.
11. The productive enterprises can quote prices by ascertaining cost data.
Application of Operating Costing
Operating costing is applied by an organization, which provides service to the public as a whole instead of manufacturing an article, and sells the same. For example, Transport undertaking electricity, theatre, hospitals, schools and the like. Similarly, the same type of an organization or cost center renders service to production departments. For example, Electricity, powerhouse, canteen and the like.
The service cost in operating cost should be find out to understand whether an organization or cost center render services to others or sell the services to the general public. If the services are sold, the operating expenses and the extent of services rendered are taken into consideration to find out the service cost. On the other hand, if the services are sold, the service expenses should be apportioned to the production department on a suitable basis.
Generally, the basis may be the extent of service availed by the production departments. It may also become necessary to compare the cost of such a service with the cost of an outside service for deciding whether it is profitable to buy a service from outside rather than make the same available from within an organization.
How are services classified under Operating Costing?
The services may be classified into two categories under operating costing, namely
1. Internal service and
2. External service.
Internal service refers to rendering service to the production departments within an organization. External service refers to providing services to the general public uniformly. The object of both internal service and external service is the same.
Selection of Cost under Operating Costing
Cost is expressed in terms of the unit of service rendered. Though, operating cost is relating to units of costing the cost unit is not as tangible as a job or a contract. Any person cannot easily select a cost unit. Thus, the selection of cost unit requires more skill, technical and statistical talent on the part of the cost accountant.
The cost unit may be simple cost unit or composite cost unit. There is only one variable in the simple cost unit. For example, per bed in case of hospitals, a cup of tea or coffee in case of canteen, per room or per bed in case of lodge and the like. Two or more variables have a close relationship in the composite cost unit. Costs are collected in terms of composite cost units. For example, per tone km in case of transport (truck), per man show in case of cinema theatres, per passenger km in case of transport (passenger) and the like. Hence, the selection of suitable cost unit depends upon the nature of service.
The following table gives a clear picture on the cost unit along with the nature of service of the undertaking.
Nature of Service Undertaking Cost Unit
Goods Transport service (Lorry, goods train, air transport of goods, trucks etc. Per tone km.
Passenger Transport service (Bus, Mini Bus, Train, Boat, Passenger train, air transport etc. Per Passenger km.
Hospitals Per bed, per patient, per day
Electricity Supply Kwh, Horse power
Canteen Service Man-men/cup of tea or coffee
Boiler House Cubic centimeters
Road Maintenance Per Km
Private Transport (private car, private aeroplane etc) Running Hour, Trip Km
Hotel Per room, per bed
Street lighting Per point, per lamp
Gas Cubit meters, Kg
Water Supply Gallons, Liters
Cinema theatres Per man show
In case rail transport, more number of cost centers are functioning since the rail transport has more number of and complicated activities. For example, repairs and maintenance, routes, stations, go downs, yards, wagons, engines and the like. There is no method of costing except operating costing applicable to rail transport.
Objectives of Operating Costing
The objectives of operating costing are listed below:
1. To supply the information through which the efficiency in rendering service is improved.
2. To provide a basis for fixing accurate quotation and fare.
3. To ensure that the services are provided in proper time.
4. To control the fuel consumption and its expenses.
5. To ensure that the service equipments are properly maintained.
6. To provide cost comparison between own service and alternative service i.e. hiring.
7. To compare the cost of one service center with another.
8. To determine the apportionment cost if the services are provided within an organization.
9. To decide the price that can be charged for use of vehicle.
10. To control the cost of maintenance and repairs.
11. To select efficient and suitable routing of vehicles to reduce the costs to production departments that uses the service.
12. To avoid the under utilization of capacity and idle time of the work force.
13. To absorb the fixed costs proportionately and systematically that is allocated to the units of services.
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