Dm Notes Mim Jbims 12 13

Cost and management Accounting MHRDM-MIM - JBIMS

Private & Confidential Page 1 By Dinesh Makani

COST: MEANING AND ITS ELEMENTS

The term cost means the amount of expenses [actual or notional] incurred on or attributable to specified thing or activity. As per Institute of

cost and work accounts (ICWA) India, Cost is measurement in monetary terms of the amount of resources used for the purpose of production of

goods or rendering services.

Elements of cost

Cost of production/manufacturing consists of various expenses incurred

on production/manufacturing of goods or services. These are the

elements of cost, which can be divided into three groups: Material,

Labour and Expenses.

COST SHEET: MEANING AND ITS IMPORTANCE

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 are termed as 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.

Importance of Cost Sheet

The importance of cost sheet is as follows:

_ Cost ascertainment

The main objective of the cost sheet is to ascertain the cost of a product.

Cost sheet helps in ascertainment of cost for the purpose of determining

cost after they are incurred. It also helps to ascertain the actual cost or

estimated cost of a Job.



_ Fixation of selling price

To fix the selling price of a product or service, it is essential to prepare the

cost sheet. It helps in fixing selling price of a product or service by

providing detailed information of the cost.

_ Help in cost control

For controlling the cost of a product it is necessary for every

manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in

the control of material cost, labour cost and overheads cost at every

point of production.

_ Facilitates managerial decisions

It helps in taking important decisions by the management such as:

whether to produce or buy a component, what prices of goods are to be

quoted in the tender, whether to retain or replace an existing machine

etc.

COMPONENTS OF TOTAL COST

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.



Illustration 1

Calculate prime cost from the following particulars for a production unit:

Rs.

Cost of material purchased 30,000

Opening stock of material 6,000

Closing stock of material 4,000

Wages paid 3,000

Rent of hire of a special machine for production 5,000

Solution:

Details

Amount

(Rs.)

Direct Material: Material Consumed

Opening stock of material 6,000

Add: Material Purchased 30,000

Material available for consumption 36,000

Less: Closing stock of material 4,000

Material consumed

Direct Labour: Wages

Direct Expenses: Rent of hire a special machine

Prime cost

32,000

3,000

5,000

40,000

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



Illustration 2

Calculate factory cost from the following particulars:

Rs.

Material consumed 60,000

Productive wages 20,000

Direct Expenses 5,000

Consumable stores 2,000

Oil grease/Lubricating 500

Salary of a factory manager 6,000

Unproductive wages 1,000

Factory rent 2,000

Repair and Depreciation on Machine 600

Solution:

Statement showing Factory cost

Details

Amount

(Rs.)


Direct Labour: Productive wages

Direct Expenses

Prime cost

60,000

20,000

5,000

85000



Add: Factory overheads

Indirect Material:

Consumable stores 2,000

Oil grease/lubricants 500

Indirect Labour:

Unproductive wages 1,000

Salary of a factory Manager 6,000

Indirect Expenses:

Factory rent 2,000

Repair and Depreciation on Machine 600

Factory cost

2,500

7,000

2,600

97,100

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

Illustration 4

From the following information calculate the total cost of production

Rs.

Direct material 90,000

Direct Labour 32,000


Factory overheads 25,000

Office and administration overheads 18,000



Solution:

Statement showing total cost of production

Details

Amount

(Rs.)


Direct Labour: Productive wages

Direct Expenses

PRIME COST

Factory overheads

FACTORY COST

Office and administration overheads

TOTAL COST OF PRODUCTION

90,000

32,000

9,000

1,31,000

25,000

1,56,000

18,000

1,74,000

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

Illustration 5

From the following information calculate the cost of goods sold.

Rs.

Total Cost of Production 1,22,000

Opening stock of finished goods 12,000

Closing stock of finished goods 16,000



Solution:

Cost of goods sold = Cost of Production + Opening stock of Finished

goods - closing stock of Finished goods

Cost of goods sold = Rs.1,22,000 + 12,000 16,000 = Rs.1,18,000

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

Illustration 6

From the following information calculate the total cost.

Rs.

Direct material 1,60,000

Direct Labour 52,000


Factory overheads 45,000

Office and administration overheads 28,000

Selling and distribution overheads 33,000

Solution:

Statement showing total cost

Details

Direct Material:

Direct Labour:

Direct Expenses

PRIME COST

Factory overheads

FACTORY COST

Office and administration overheads

TOTAL COST OF PRODUCTION

Selling and distribution overheads

Total cost = cost of sales

Amount

(Rs.)

1,60,000

52,000

19,000

2,31,000

45,000

2,76,000

28,000

3,04,000

33,000

3,27,000



Sales

If the profit margin is added to the total cost, sales are arrived at. Excess of

sales over total cost is termed as profit. When total cost exceeds sales, it is

termed as Loss.

Sales = Total Cost + Profit

Sometimes profit is calculated on the basis of given information in

percentage of cost or sales. In such a situation, the amount is assumed

100 in which the percentage is calculated. Then the Profit is calculated in

the following ways:

Case 1

If Cost is Rs.10,000 and profit on cost 10%. Assume the cost is Rs.100 and

profit on cost is Rs.10. Hence Profit on cost of Rs.10,000 is

10,000 10/100 = Rs.1,000

Thus the sales value is Rs 11000 (10,000 + 1000)

Case 2

If Cost is Rs.10,800 and profit on sales price is 10%. Assume sales price is

Rs.100. cost price is Rs.90 [i.e. Rs.100 Rs.10]. When profit on cost of Rs.90 is Rs.10. Hence profit on cost of Rs.10,800 is

10,800 10/90 = Rs.1,200

10,800 + 1200 = 12,000 sales value

Case 3

If sales price is Rs.12,100 and profit on cost is 10%. Assume Cost price is

Rs.100. Sales price is Rs.110 [i.e.100 + 10]. If sales price is Rs.110, profit is

Rs.10. Profit on sales price of Rs.12,100 is

12,100 10/110 = Rs.1,100 profit



Illustration 7

From the following information, calculate the value of goods sold.

Rs.

Total Cost of Production 1,45,000

Opening stock of finished goods 22,000

Closing stock of finished goods 6,000


Profit 22,000

Solution

Statement showing Sales

Details

Amount

(Rs.)

Total cost of production

Add: Opening stock of finished goods

Less Closing stock of finished goods

Cost of Goods sold


Total Cost

Profit

Sales

1,45,000

22,000

1,67,000

6,000

1,61,000

25,000

1,86,000

22,000

2,08,000



There is no prescribed format of a Cost sheet. It may change from industry

to industry. A specimen format of a Cost Sheet is given as under:

Particulars Total (Rs.)

A. Materials Consumed:

Purchases ..............

Add: Opening Stock of Raw material ..............

Expenses on Purchases ..............

Less: Closing Stock of Raw Material ..............

Direct Material consumed .............. ..............

B. Direct Labour (Wages) ..............

C. Direct Expenses ..............

D. Prime Cost (A + B + C) ..............

E. Factory/Works Overheads ..............

Add: Opening Stock of Work-in-Progress ..............

Less: Closing Stock of Work-in-Progress ..............

F. Works/Factory Cost (D + E) ..............

G. Office and administration overheads ..............

H. Total Cost of Production (F + G) ..............

Add: Opening Stock of finished Goods ..............

Cost of Goods available for sale ..............

Less: Closing Stock of finished Goods ..............

I. Cost of production of goods Sold or cost of good sold ..............

J. Selling and Distribution Overheads ..............

K. Total Cost (I + J) = Cost of Sales ..............

L. Profit ..............

M. Sales (K + L) ..............

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:

Illustration 8

From the following information, prepare a cost sheet for period ended on

31st March 2009.

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


Cost of opening stock of finished goods 12,000

Cost of Closing stock of finished goods 15,000

Profit on cost 20%



Solution:

Cost sheet

Details

Amount

(Rs.)

Direct Material: Material consumed 12500

Opening stock of raw material 136000

Add: Purchases 148500

Less: Closing stock of raw material 8500

Direct wages

Direct expenses

Prime cost

Factory overheads: 100% of direct wages

(i.e. 100 x 54000

100

Works cost

Office and administrative overheads

20% of works cost, (2,60,000 20/100

Total cost of production

Add: opening stock of finished goods

Cost of Goods available for sale

Less: Closing stock of finished goods

Cost of goods sold


Total Cost = cost of sales

Profit (20% On Cost i.e. 3,35,00 20/100)

Sales

1,40,000

54,000

12,000

2,06,000

54,000

2,60,000

52,000

3,12 000

12,000

3,24,000

15,000

3,09,000

26,000

3,35,000

67,000

4,02,000



Illustration 9

The following information is given to you from which you are required to

prepare Cost Sheet for the period ended on 31St march 2009:

Consumable material: Rs.

Opening stock 20,000

Purchases 1,22,000

Closing stock 10,000

Direct wages 36,000


Factory overheads 50 % of direct wages

Office and administration overheads 20% of works cost

Selling and distribution expenses Rs.3 per unit sold

Units of finished goods

In hand at the beginning of the period (Value Rs. 12500) 500

Units produced during the period 12,000

In hand at the end of the period 1,500

Find out the selling price per unit if 20% profit on selling price. There is no

work-in-progress either at the beginning or at the end of the period.



Solution:

Cost Sheet for the period ended on 31st March 2009 (output 12000 units)

Particulars Total cost Cost Per Unit

Material Consumed:

Opening Stock 20000

Add: Purchases 122000

142000

Less: Closing Stock 10000

Cost of R.M. consumed 132,000 132000 11.00

Direct wages 36000 3.00

Direct Expenses 24000 2.00

Prime Cost 192000 16.00

Factory Overheads

50% of Direct Wages (i.e. 12000 1.50) 18000 1.50

Works/Factory overheads 210000 17.50

Office overheads

20% of works cost 42000 3.50

Total Cost of production 252000 21.00

Add: Opening stock of finished goods

(500 units @ 25) 12500

Cost of goods available for sale (12000 + 500) 264500

Less: Closing stock of Finished goods @ 21per 31500

Unit (1500 units)

Cost of goods sold (12500 1500 = 11000 units) 233000 21.18

Add: Selling & Distribution overheads @ per unit 330001 3.00

Cost of Sales 266000 24.18

Add: Profit 20% On S. P. i.e. 25% of cost of sales 66500 6.04

Sales (266000 X 25/100) 332500 30.22



Components of Total Cost

Prime Cost = Direct material + Direct Wages + Direct expenses works/

factory cost;

Factory Cost = Prime cost + Factory overheads

Cost of production/office cost = Factory Cost + office and administration

overheads

Cost of production of goods sold = Cost of Production + Opening stock of

Finished goods closing stock of finished goods

Total Cost = Cost of Production of goods sold + Selling and distribution

overheads

Sales = Total Cost + Profit



CONTRACT COSTING

Contract costing is A form of specific order costing; attribution of costs to

individual contracts

A contract cost is Aggregated costs of a single contract; usually applies to

major long term contracts rather than short term jobs

Features of long term contracts

contract costing situations, we tend to mean long term and large

contracts: such as civil engineering contracts for building houses, roads,

bridges and so on. We could also include contracts for building ships, and

for providing goods and services under a long term contractual

agreement.

contract costing, every contract and each development will be

accounted for separately; and does, in many respects, contain the

features of a job costing situation.

is frequently site based.

Features of a Contract

The end product

The period of the contract

The specification

The location of the work

The price

Completion by a stipulated date

The performance of the product

Collection of Costs

Desirable to open up one or more internal job accounts for the collection

of costs. If the contract not obtained, preliminary costs be written off as

abortive contract costs in P&L In some cases a series of job accounts for

the contract will be necessary:

to collect the cost of different aspects

to identify different stages in the contract



Special features

Materials delivered direct to site.

Direct expenses

Stores transactions.

Use of plant on site

Two possible accounting methods:

1. Where a plant is purchased for a particular contract & has little

further value to the business at the end of the contract

2. Where a plant is bought for or used on a contract, but on

completion of the contract it has further useful life to the business

Alternatively the plant may be capitalised with Maintenance and running

costs charged to the contract."

Worked example

Contract ABC started on 1 July 2008. Costs to 31 December 2008, when

the company's accounting year ends, are derived from the following

information.

direct materials issued from store 40000

materials returned tos tore 1000

direct labour 36000

plant issued, at book value 1 July 2008 50000

written down plant value as at 31 December, 2008 30000

materials on site, 31 December, 2008 3000

overhead costs 5000

As at 31 December, 2008, certificates had been issued for work valued at

Rs.100,000 and the contractee had made progress payments of Rs.70,000.

The company has calculated that more work has been done since the

last certificates were issued, and that the cost of the work done but not

yet certified is Rs.14,000. The final contract price is Rs.175,000 and the

estimated total cost of the contract is Rs.130,000.

Prepare the contract account



Solution

Contract account Dr Cr

Materials 40000

materials returned 1000

Labour 36000

plant issued at book value 50000

Overheads 5000

plant c/d 30000

materials c/d 3000

cost of worjk done not certified 14000

cost of work certified 83000

131000 131000

Work certified account

turnover (profit and loss) 100000

contratee account 100000

Contractee account

work certified 100000

cash (progress payment) 70000

balance c/d 30000

100000 100000

Estimating profit

In the early stages, no profit will be accounted for; and in an exam

question, the profit taking method may be GIVEN.

Total anticipated profit

contract price 175000

costs incurred (14,000 + 83,000) 97000

estimated costs to complete (130,000 - 97,000) 33000 130000

Estimated profit 45000

Estimated degree of completion



Therefore, profit to date:

Sales basis = Rs.45,000 * 57.14% = Rs.25,714.29

cost basis = Rs.45,000 * 74.62% = Rs.33,576.92

Consider what the accountant's concept of conservatism might have to

say about these calculations.

Completing the profit and loss account:

turnover - value certified 100000

profit (sales basis) 25715

cost of sales 74285

costs incurred 97000

cost of sales 74285

WIP 22715

Balance sheet disclosure

Cost of sales 74285

cost of work done 97000

-22715

If this is negative, it is WIP, otherwise it is a provision for liabilities and

charges or creditors

Reconciliation of WIP:

value certified 100000

cost of work certified 83000

apparent profit to date 17000

profit recognised 25715

cost of work done but not certified 14000

-22715



Attributable Profit

That part of the total profit reflecting that part of the work performed at

the accounting date, attributable profit not be recognised until the

outcome of contract be assessed with reasonable certainty.

Terminology

Calculation of attributable profit

Taking total costs to date & total estimated further costs to completion,

also the estimated future costs of rectification & guarantee work, and any

other future work to be undertaken under the terms of the contract. Profit

accounted for needs:

1. to reflect the proportion of the work carried out at the accounting

date;

account any known inequalities of profitability in various stages of

contract for certainty of profit

Illustration

M/s New Century Builders have entered into contract to build an office

building complex for Rs.480 lakhs. The work started in April 1997 and it is

estimated that the contract will take 15 months to be completed. Work

has progressed as per schedule and the actual cost charged till March

1998 was as follows.



Particulars Amt in Lakhs

Material 112.20

Labor 162

Hire charges for equipment and other expenses 36

Establishment charges 32.40

The following information is available:

Particular Amt in lakhs

Material in hand 31st Mar 1998 10.50

Work certified (of which Rs 324 lakhs have been paid) as

on 31stMarch 1998

400.00

Work not certified as on 31st March 1998 7.50

As per Management estimates, the following further expenditure will be

incurred to complete the work.

Materials : Rs. 10.50 lakhs

Labor: Rs.16.00 lakhs

Sub-contractor: Rs 20.00 lakhs

Equipment hire and other charges: Rs 3.00 lakhs

Establishment charges: Rs 6.90 Lakhs

You are required to compute the value of work in progress as on March

31st, 1988 after considering a reasonable margin of profit and show the

appropriate accounts. Make a provision for contingencies amounting to

5% of the total costs



PROCESS COSTING

PROCESS COSTING IMPORTANCE: -

In process costing, particular attention is given to (a) cost relating to the

process, i.e., both direct and indirect cost, (b) period for which cost for the

process is collected, (c) complete units in the process at the end of the

period and (e) determining unit cost of the process for the period.

USE OF PROCESS COSTING: -

Process coasting is useful for industries with following characteristics:

(a) Continuous and mass production

(b) Loss of identity of production against a particular order.

(c) Homogeneous products

(d) Production involves different process and output of one process

forms input of another process.

(e) Other uses: bottling companies, canning plants, packing, breweries

and industries involved in processing milk products.

Process Costing under different inventory costing methods.

The effect of using FIFO method, LIFO method and average method will

be differentiates on cost per unit of the process.

FIFO METHOD. : -

It is also referred to as First-in-First out method of inventory costing. Under FIFO method it is presumed that units are completed in the order of

introduction to the process. Units at the beginning are completed first.

Then, newly introduced units are completed. Only after this, work is done

on closing inventory. According to this method, it is assumed that cost

incurred is used

(a) First to complete the units already in process,

(b) Then to complete the newly introduced units,



(c) For the work done to bring closing inventory to given stage of

completion.

If units completed are more than units representing opening inventory, it is

presumed under FIFO method that all unfinished units in opening inventory

have been completed. When FIFO method of inventory costing is

followed, units completed during the period are divided in two categories

for the purpose of statement of equivalent production:

(a) Work done for completing opening work in process, (b) Newly introduced units completed during the process,

LIFO METHOD. : -

It is also referred to as Last-in-First-out method of inventory costing. It is presumed under LIFO method that cost incurred is used:

(a) First to complete newly introduced units.

(b) Then to complete units already in process.

If there is closing work in process, it is supposed in LIFO method that units

which represent opening inventory, remain in closing work in process at the end of the period, because units representing opening inventory are

attended to in the last. If units under closing inventory are more than units

under opening inventory, it will be presumed that all units, which

represented opening work in process, remain in closing work in process at the end of period.

Under FIFO method work completed is divided into two categories i.e. (i)

units lying under opening work in process but completed during the

period and, (ii) newly introduced units completed during the period.

When LIFO method is followed closing inventory is divided into two

categories i.e.,

(i) Units, which represent opening work in process, but are lying under

closing work in process at the end of the period.

(ii) Newly introduced units lyibg in closing stock.



Difference between Job Order Costing & Process

JOB ORDER COSTING / CONTRACT

COSTING

PROCESS COSTING

1 It is used in industries where production

is carried on according to specific job

order.

Process Costing is used in continuous

and mass production industries

producing like units of standard

specification.

2 Cost is collected for each individual

job worked.

Cost is collected according to

process and departments

3 Items of prime cost can be traced with

job order.

Items of prime cost cannot be

traced with a particular order due to

continuous production.

4 Job cost is computed, when the job is

completed

Process cost is computed at the end

of the cost period

5 There is no transfer of work from one

job to another job, till it is necessary to

transfer surplus work or excess

production.

Costs of one process are transferred

to cost of next process, until goods

are completely manufactured.

6 The cost of each unit in production is

separately identified

The total cost for production during

the period is specified over units

produced, as the separate identity

of units is lost due to continuous

production. This process cost per unit

represents average cost per unit for

the period.

7 The basis of cost collection is job order

or batch.

Cost is collected by period i.e., on

time basis.

8 There may or may not be work-in-

progress at the end of accounting

period.

There is always some work in progress

at the beginning as well as at the

end of the period



1) Example: Following information is available regarding process A for the

month of Dec. 2008

Production record Units

Units in process on 30th November 2008 (50% complete) 10000

New units started in process during the month

20000

30000

Production report shows the following results:

Units completed 25000

Units in Process on 31dt December 2008 (80% complete)

5000

Loss in process Nil

30000

Cost Record

Work in progress as on 1st Dec.2008:

Rs.

Material 3600

Labour 5000

Overhead 2800

Cost for December 2008:

Material 7200

Direct Labour 16000

Overhead 15200

Total Cost to be accounted for

49800

Prepare:

(a) Statement of equivalent production

(b) Statement of cost for each element.

(c) Statement of apportionment of cost.

(d) Process cost account under following circumstances:



(i) When, material is introduced at the beginning of the process

(ii) When material is continuously introduced throughout the process

(iii) When material is introduced at 30% stage of processing.

(iv) When material is introduced at the end of process

2) Example: - from the following information for May 2009 relating to SV

Company Ltd.

Prepare process cost accounts for process III: -

Opening stock in process III 1000 units at Rs 14400

Transfer from Process II 42600 units at Rs 330800

Direct material added in Process III Rs. 160720

Direct wages Rs. 79240

Production Overhead Rs. 39620

Units Scrapped 2200 units

Transferred to process IV 37800 units

Closing stock 3600 units

Degree of Completion:

Opening stock Closing stock scrap

Material 70% 80% 100%

Labour 50% 60% 80%

Overhead 50% 60% 80%

There was a normal loss of 5% production and units scrapped were

sold at Rs.3 each.



3) Example: Product Zenu is made by three sequential process, II, III, and I.

In process III a by-product arises and after further processing in process XY,

at a cost of Rs. 2 per unit, by-product, XYZ is produced. Selling and

distribution expenses of Re.1 per unit are incurred in marketing XYZ at a

selling price of Rs.9 per unit.

Process I Process II Process

III

Standard provided for

Normal loss in process of input, of 10% 5%

10%

Loss in process, having a scrap value, per unit, of Rs.1 Rs. 3 Rs. 4

For the month of Apr 1990 the following data are given:

Process I Process II Process III Process XY

Output, in units 8800 8400 7000 420

Of Zenu of XYZ

Costs Rs. Rs. Rs. Total Rs.

Direct materials: 20000 20000

Introduced (10000 units)

Direct Material added 6000 12640 23200 41840

Direct Wages 5000 6000 10000 21000

Direct Expenses 4000 6200 4080 14280

Budget production overhead for the month was Rs.84000

Absorption is based on a percentage of direct wages.

There are no stocks at the beginning of end of the month.

You are required, using the information given, to prepare accounts for

(a) Each process, I, I I, III;

(b) Process XY



STANDARD COSTING

Def: A predetermined cost which is calculated from managements

standards of efficient operations and the relevant necessary

expenditure. They are the predetermined costs on technical estimate of material labor and overhead for a selected period of time and for a

prescribed set of working conditions. In other words, a standard cost is a

planned cost for a unit of product or service rendered.

Advantages

Standard costing is a management control technique for every activity. It

is not only useful for cost control purposes but is also helpful in production

planning and policy formulation. It allows management by exception. In

the light of various objectives of this system, some of the advantages of

this tool are given below:

1. Efficiency measurement-- The comparison of actual costs with

standard costs enables the management to evaluate performance

of various cost centers. In the absence of standard costing system,

actual costs of different period may be compared to measure

efficiency. It is not proper to compare costs of different period

because circumstance of both the periods may be different. Still, a

decision about base period can be made with which actual

performance can be compared.

2. Finding of variance-- The performance variances are determined by

comparing actual costs with standard costs. Management is able

to spot out the place of inefficiencies. It can fix responsibility for

deviation in performance. It is possible to take corrective measures

at the earliest. A regular check on various expenditures is also

ensured by standard cost system.

3. Management by exception-- The targets of different individuals are

fixed if the performance is according to predetermined standards.

In this case, there is nothing to worry. The attention of the

management is drawn only when actual performance is less than

the budgeted performance. Management by exception means

that everybody is given a target to be achieved and management

need not supervise each and everything. The responsibilities are

fixed and every body tries to achieve his/her targets.

4. Cost control-- Every costing system aims at cost control and cost

reduction. The standards are being constantly analyzed and an

effort is made to improve efficiency. Whenever a variance occurs,

the reasons are studied and immediate corrective measures are

undertaken. The action taken in spotting weak points enables cost

control system.



5. Right decisions-- It enables and provides useful information to the

management in taking important decisions. For example, the

problem created by inflating, rising prices. It can also be used to

provide incentive plans for employees etc.

6. Eliminating inefficiencies-- The setting of standards for different

elements of cost requires a detailed study of different aspects. The

standards are set differently for manufacturing, administrative and

selling expenses. Improved methods are used for setting these

standards. The determination of manufacturing expenses will

require time and motion study for labor and effective material

control devices for materials. Similar studies will be needed for

finding other expenses. All these studies will make it possible to

eliminate inefficiencies at different steps.

Limitations of Standard Costing

1. It cannot be used in those organizations where non-standard

products are produced. If the production is undertaken according

to the customer specifications, then each job will involve different

amount of expenditures.

2. The process of setting standard is a difficult task, as it requires

technical skills. The time and motion study is required to be

undertaken for this purpose. These studies require a lot of time and

money.

3. There are no inset circumstances to be considered for fixing

standards. The conditions under which standards are fixed do not

remain static. With the change in circumstances, if the standards

are not revised the same become impracticable.

4. The fixing of responsibility is not an easy task. The variances are to

be classified into controllable and uncontrollable variances.

Standard costing is applicable only for controllable variances.

After setting the standard and standard costs for various elements of cost,

the next important step is to compute variance for each element of cost.

Variance is the difference between standard cost and actual cost. In

other words it is the difference between what the cost should have been

and what is the actual cost. Element wise computation of variance is

given in the following paragraphs.



A) Material Variance

Material Cost variance

Material price variance Material usage variance

Material Mix Variance Material yield variance

(A) MATERIAL COST VARIANCE =

(STANDARD UNIT X STANDARD PRICE) (ACTUAL UNIT X ACTUAL PRICE)

(B) MATERIAL PRICE VARIANCE =

(STANDARD PRICE ACTUAL PRICE) X ACTUAL QUANTITY

(C) MATERIAL (QUANTITY) USAGE VARIANCE =

(STANDARD QUANTITY ACTUAL QUANTITY) X STANDARD PRICE

(D) MATERIAL MIX VARIANCE =

(REVISED STANDARD QTY ACTUAL QTY) X STANDARD PRICE.

Revised Standard Qty =

Total weight of actual mix / Total weight of standard Mix X Std qty of material in question

(D) MATERIAL YIELD VARIANCE =

(TOTAL ACTUAL YIELD TOTAL STD YEILD) X STD YIELD RATE .

Where Std yield rate = Std cost of Std mix / Net Std output

(ii) Where actual mix differ from standard mix. The following formula is used in this situation.

Material yield variance = (Actual yield Revised std yield) X Std yield rate

Where Std yield rate = Std cost of revised Std mix / Net Std output



B) LABOUR VARIANCE

Labour Cost variance

Labour Rate or price variance Labour efficiency or usage variance

Labour Mix Variance Idle time variance

(A) LABOUR COST VARIANCE =

(ACTUAL HOURS X ACTUAL RATE) (STANDARD HOURS X STANDARD RATE)

(B) LABOUR RATE OR PRICE VARIANCE =

(STANDARD RATE ACTUAL RATE) X ACTUAL HOURS

(C) LABOUR EFFICIENCY OR USAGE VARIANCE =

(STANDARD HOURS ACTUAL HOURS) X STANDARD RATE

(C) IDLE TIME VARIANCE =

IDLE TIME VARIANCE = IDLE HOURS X STANDARD RATE

(D) LABOUR MIX VARIANCE OR GANG COMPOSITION VARIANCE=

(LABOUR MIX VARIANCE =(REVISED STD MIX OR TIME ACTUAL MIX OR TIME)*STD.

Revised Standard Mix or Time =

Total time of actual mix of workers / Total time of standard Mix of workers X Std time

of the respective category of workers



C) OVERHEAD VARIANCE

STANDARED FIXED OVERHEAD RATE=

BUDGETED FIXED OVERHEAD / NORMAL VOLUME

STANDARED VARIABLE OVERHEAD RATE =

BUDGETED VARIABLE OVERHEAD / NORMAL VOLUME

OVERHEAD VARIANCE

Variable overhead cost variance fixed overhead variance

Variable overhead expenditure variance variable overhead efficiency variance

Fixed overhead expenditure variance Fixed overhead volume variance Fixed overhead efficiency variance Fixed overhead capacity variance Calendar variance Seasonal variance

(A) VARIABLE OVERHEAD COST VARIANCE:

VARIABLE OVERHEAD COST VARIANCE = STANDERED OVERHEAD COST

RECOVERED ACTUAL OVERHEAD COST

(a) Variable overhead expenditure variance:

Based on rate per hour -

Variable overhead expenditure variance = (Std variable overhead absorption rate per hr

X Actual hrs worked) Actual Variable Overhead.

Based on rate per unit -

Variable overhead expenditure variance = (std variable overhead absorption rate per

unit - actual variable rate per unit) X Actual Output.



(b) Variable overhead efficiency variance:

Variable overhead efficiency variance= (Actual Hrs Std hours for actual output) X Std variable overhead absorption rate

Or = (Std Qty of output Actual qty of output) X Std rate per unit.

(B) FIXED OVERHEADS VARIANCE:

Fixed overheads variance= (Std Hrs for Actual output X Std fixed overhead rate) X

Actual Fixed Overheads

(a) Fixed overhead expenditure variance: = (budgeted Qty X Std fixed Oh. rate per unit)

Actual fixed Oh

= (Budgeted fixed Overheads Actual fixed Overhead)

(b) Fixed Overheads volume variance = (Actual Qty Budgeted Qty) X Standard rate

Of fixed Oh volume variance = (std hrs for Actual production Actual hrs worked) X Std fixed Oh rate

(c) Fixed Overheads efficiency variance = (Actual Qty of production STD Qty of production for Actual capacity) X Std fixed Oh absorption rate

per unit or

(STD Hrs for Actual production Actual Hrs Worked) X Std fixed Oh rate

(d) Fixed Overheads Capacity variance = (STD Qty of production Revised budgeted Qty of production) X Std fixed Oh rate per unit or

(STD Hrs for Actual production Actual Hrs of the period) X Std fixed Oh rate per unit.



(e) Calendar Variance = (STD Unit Revised budgeted unit) X Std fixed Oh rate per unit or

(Std number of working days or Hrs Possible number of working days or Hrs) X Std. Fixed Oh rate per day or Hour.

Calendar Variance = (Budgeted Hrs Actual Hrs) X Std rate.



What Is Inventory?

Inventory is defined as assets that are intended for sale, are in process of

being produced for sale or are to be used in producing goods.

Beginning Inventory + Net Purchases - Cost of Goods Sold

(COGS) = Ending Inventory

How Do We Value Inventory?

The accounting method that a company decides to use to determine the

costs of inventory can directly impact the balance sheet, income

statement and statement of cash flow

There are five basic approaches to valuing inventory

1. Standard: Under the Standard costing method approach, both

inventory and the cost of goods sold are based on the standard

fixed cost assigned to the items within the item manager at the time

of reporting.

2. First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based

upon the cost of material bought earliest in the period, while the

cost of inventory is based upon the cost of material bought later in

the year. This results in inventory being valued close to current

replacement cost. During periods of inflation, the use of FIFO will

result in the lowest estimate of cost of goods sold among the three

approaches, and the highest net income.

3. Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based

upon the cost of material bought towards the end of the period,

resulting in costs that closely approximate current costs. The

inventory, however, is valued on the basis of the cost of materials

bought earlier in the year. During periods of inflation, the use of LIFO

will result in the highest estimate of cost of goods sold among the

three approaches, and the lowest net income.



4. Weighted Average: Under the weighted average approach, both

inventory and the cost of goods sold are based upon the average

cost of all units currently in stock at the time of reporting. When

inventory turns over rapidly this approach will more closely resemble

FIFO than LIFO.

5. Average: Under the average approach, both inventory and the

cost of goods sold are based upon the average cost of all units

received in stock.

If prices are rising, each of the accounting methods produces the

following results:

FIFO gives us a better indication of the value of ending inventory

(on the balance sheet), but it also increases net income because

inventory that might be several years old is used to value the cost of

goods sold. Increasing net income sounds good, but remember

that it also has the potential to increase the amount of taxes that a

company must pay.

LIFO isn't a good indicator of ending inventory value because the

left over inventory might be extremely old and, perhaps, obsolete.

This results in a valuation that is much lower than today's prices. LIFO

results in lower net income because cost of goods sold is higher.

Average cost produces results that fall somewhere between FIFO

and LIFO.



BUDGET & BUDGETORY CONTROL

A budget is a plan expressed in quantitative, usually monetary term,

covering a specific period of time, usually one year. In other words a

budget is a systematic plan for the utilization of manpower and material

resources.

In a business organization, a budget represents an estimate of future costs

and revenues. Budgets may be divided into two basic classes: Capital

Budgets and Operating Budgets.

Capital budgets are directed towards proposed expenditures for new

projects and often require special financing. The operating budgets are

directed towards achieving short-term operational goals of the

organization, for instance, production or profit goals in a business firm.

Operating budgets may be sub-divided into various departmental of

functional budgets.

The main characteristics of a budget are:

1. It is prepared in advance and is derived from the long-term strategy

of the organization.

2. It relates to future period for which objectives or goals have already

been laid down.

It is expressed in quantitative form, physical or monetary units, or both.

Different types of budgets are prepared for different purposed e.g. Sales

Budget, Production Budget, Administrative Expense Budget, Raw-material

Budget etc. All these sectional budgets are afterwards integrated into a

master budget, which represents an overall plan of the organization.

ADVANTAGES OF BUDGETS

A budget helps us in the following ways:

1. It brings about efficiency and improvement in the working of the

organization.

2. It is a way of communicating the plans to various units of the

organization. By establishing the divisional, departmental, sectional

budgets, exact responsibilities are assigned. It thus minimizes the

possibilities of buck passing if the budget figures are not met.

3. It is a way or motivating managers to achieve the goals set for the

units.



4. It serves as a benchmark for controlling on-going operations.

5. It helps in developing a team spirit where participation in budgeting

is encouraged.

6. It helps in reducing wastage and losses by revealing them in time for

corrective action.

7. It serves as a basis for evaluating the performance of managers.

8. It serves as a means of educating the managers.

BUDGETARY CONTROL

No system of planning can be successful without having an effective and

efficient system of control. Budgeting is closely connected with control.

The exercise of control in the organization with the help of budgets is

known as budgetary control. The process of budgetary control includes:

1. Preparation of various budgets.

2. Continuous comparison of actual performance with budgetary

performance.

3. Revision of budgets in the light of changed circumstances.

A system of budgetary control should not become rigid. There should be

enough scope of flexibility to provide for individual initiative and drive.

Budgetary control is an important device for making the organization.

More efficient on all fronts. It is an important tool for controlling costs and

achieving the overall objectives.

Budget Controller

Although the chief executive is finally responsible for the budget

programme, it is better if a large part of the supervisory responsibility is

delegated to an official designated as Budget Controller or Budget

Director. Such a person should have knowledge of the technical details of

the business and should report directly to the president or the Chief

Executive of the organization.

Fixation of the budget period

Budget period mean the period for which a budget is prepared and

employed. The budget period depends upon the nature of the business

and the control techniques. For example, a seasonal industry will budget

for each season while an industry requiring long periods to complete work

will budget for four, five or even larger number of year. However, it is

necessary of control purposes to prepare budgets both for long as well as

short periods.



Budget Procedures

Having established the budget organization and fixed the budget period,

the actual work or budgetary control can be taken upon the following

pattern:

STEPS IN BUDGETARY CONTROL

1. Organization for budgeting

2. Budget manual + Theory

"A document which sets out, inter alias, the responsibilities of the persons

engaged in, the routine of and forms and records required for budgetary

control."

The budget manual is a written document or booklet that specifies the

objectives of budgeting organization and procedures. Following are some

of the important matters covered in a budget manual:

3. A statement regarding the objectives of the organization and how

they can be achieved through budgetary control.

4. A statement regarding the functions and responsibilities of each

Executive by designation both regarding preparation and

execution of budgets.

5. Procedures to be followed for obtaining the necessary approval of

budgets.

6. The authority of granting approval should be stated in explicit terms.

7. Whether one, two or more signatures are to be required on each

document

8. Should also be clearly stated.

9. Timetable for all stages of budgeting.

10. Reports, statements, forms and other records to be maintained.

11. The accounts classification to be employed. It is necessary that the

framework within which the costs, revenues and other financial

amount are classified must be identical both in accounts and the

budget departments.

There are many advantages attached to the use of budget manual. It is a

formal record defining the functions and responsibilities of each

executive.

The methods and procedures of budgetary control are standardized.

There is synchronization of the efforts of all which result in maximization of

the profits of the organization.



Making a forecast

Consideration of alternative combination of forecasts:

Alternative combinations of forecasts are considered with a view to

contain the most efficient overall plan so as to maximize profits. When the

optimum -profit combination of forecasts is selected, the forecasts should

be regarded as being finalized.

Sales budget

Past sales figures and trend. The record of previous experience forms the

most reliable guide as to future sales as the past performance is related to

actual business conditions. However the other factors such as seasonal

fluctuations, growth of market, trade cycles etc., should not be lost sight

of salesmen's estimates. Salesmen are in a position to estimate the

potential demand of the customers more accurately because they come

in direct contact with the customers. However, proper discount should be

made for over-optimistic or too conservative estimates of the salesmen

depending upon their temperament.

Plant Capacity. It should be the endeavor of the business to ensure proper

utilization of plant facilities and that the sale budget provides an

economic and balanced production on the factory.

General trade prospects. The general trade prospects considerable affect

the sales. Valuable information can be gathered in this connection from

trade papers and magazines.

Orders on hand. In case of industries where production is quite a lengthy

process, orders on hand also have a considerable influence in the

amount of sales.

Proposed expansion of discontinuance of products. It is affects sales and

therefore, it should also be considered.

Seasonal fluctuations. Past experience will be the best guide in this

respect. However, efforts should be made to minimize the effects of

seasonal fluctuations by giving special concessions or off-season discounts

thus increasing the volume of sales.

Potential market. Market research should be carried out for ascertaining

the potential market, for the company's products. Such an estimate on

the basis of expected population growth, purchasing power of consumers

and buying habits of the people.



Availability of material and supply. Adequate supply of raw materials and

other supplies must be ensured before drafting the sales programme.

Financial aspect. Expansion of sales usually require increase in capital

outlay also, therefore, sales budget must be kept within the bounds of

financial capacity.

Production budget

Inventory policies. Inventory standards should be predetermined as that

neither there is a shortage nor over-stocking of goods.

Sales requirements. The quantity of goods to be sold would decide to a

great extent how much is to be produced. Therefore, this budget

depends upon the sales budget.

Production stability. For reduction of costs, stability in employment and

better utilization of plant facilities, the production should be evenly

distributed throughout the year. In case of seasonal industries, since it is

not possible to have stable levels of production or inventory, an effort

should be made to have the optimum balance between the two.

Plant capacity. How much can be produced depends upon the

available plant capacity. There must be sufficent capacity to procede

the annual requirements and also to meet seasonal high demands.

5. Availability of material and labour. Adequate and timely supply of raw

material and labour should have an important effect on the planning of

production.

6. Time taken in production process. The production should commence

well in time deeping in view how much time it would take in the factory to

translate the raw materials into finished goods.

Capital Expenditure Budget

The budget provides a guidance as to the amount of capital that may be

Needed for procurement of capital assets during the budget period. The

budget is prepared after taking into account the available productive

capacitates, probable reallocation of existing assets and possible

improvement in production techniques. If necessary separte budgets may

be prepared for edach item o assets, such a building budget, a plnat and

equipment budget etc.



Cash budget

The cash budget can be prepared by any of the following methods;

1. Receipts and payments method

2. The adjusted profit and loss method

3. The balance sheet method.

1. Receipts and payments method : In case of this method the cash

receipts from various sources and the cash payments to various agencies

are estimated. In the opening balance of cash , estimated cash receipts

are added and From the total, the total of estimated cash payments are

deduted to find out the closing balance.

2. The adjusted profit and loss method : In case of this method the cash

budget is prepared on the basis of opening cash and bank balances,

projected profit and loss account and the balances of the various assests

and liabilities.

3. The balance sheet methos : With the helop of budget balances at the

end except cash and bank balances, a budgeted balance sheet can be

prepared and the balancing figure would be the estimated closing cash/

bank balance.

Thus under this method, closing balances other than cash/bank will have

to be found out first to be put in the budgeted balance sheet. This can be

done by adjusting the anticipated.

Research and Development Budget

Research and development costs are to be incurred so that the products

or the methods of the concern do not become out of date. The research

and development budget is a forecast of all such expenses.

Zero-Based Budgeting ZBB A method of budgeting in which all expenses must be justified for each new period. Zero-based budgeting starts from a zero base and every function within an organization are analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether the budget is higher or lower than the previous one. ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization, where costs can be first grouped, then measured against previous results and current expectations.



Advantages of zero-based budgeting

1. Efficient allocation of resources, as it is based on needs and benefits. 2. Drives managers to find cost effective ways to improve operations. 3. Detects inflated budgets. 4. Useful for service departments where the output is difficult to identify. 5. Increases staff motivation by providing greater initiative and responsibility

in decision-making. 6. Increases communication and coordination within the organization. 7. Identifies and eliminates wasteful and obsolete operations. 8. Identifies opportunities for outsourcing. 9. Forces cost centers to identify their mission and their relationship to

overall goals.

Disadvantages of zero-based budgeting

1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive.

2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.

3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.

4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.

5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.



MARGINAL COSTING AND ABSORPTION COSTING

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

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

are marginal, cost. Similarly if the production of X-1 units comes down to

280, the cost of marginal unit will be 20 (300280). 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.

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 years 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.

MARGINAL COSTING PRO-FORMA

Rs Rs

Sales Revenue xxxxx

Less Marginal Cost of Sales

Opening Stock (Valued @ marginal cost) xxxx

Add Production Cost (Valued @ marginal cost) xxxx

Total Production Cost xxxx

Less Closing Stock (Valued @ marginal cost) (xxx)

Marginal Cost of Production xxxx

Add Selling, Admin & Distribution Cost xxxx

Marginal Cost of Sales (xxxx)

Contribution xxxxx

Less Fixed Cost (xxxx)

Marginal Costing Profit xxxxx

OBSERVATION

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

......(6) P/V ratio

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

Sales Sales Changes in sales Change in sales

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

So, breakeven sales = 400 / 0.4 = 1000



c. Using 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

Breakeven point = Fixed cost

= 100 units or 1000 Contribution per unit



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 1

A company earned a profit of 30,000 during the year 2009-10. 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 x 100

Sales

Problem 2

A company producing a single article sells it at 10 each. The marginal cost

of production is Rs.. 6 each and fixed cost is Rs.. 400 per annum. You are

required to calculate the following:

Profits for annual sales of 1 unit, 50 units, 100 units and 400 units

P/V ratio

Breakeven sales

Sales to earn a profit of Rs.. 500

Profit at sales of Rs.. 3,000

New breakeven point if sales price is reduced by 10%

Margin of safety at sales of 400 units

Solution Marginal Cost Statement

Particulars Amount Amount Amount Amount

Units produced 1 50 100 400

Sales (units * 10) 10 500 1000 4000

Variable cost 6 300 600 2400

Contribution (sales-

VC) 4 200 400 1600

Fixed cost 400 400 400 400

Profit (Contribution FC)

-396 -200 0 1200



Profit Volume Ratio (PVR) = Contribution/Sales x 100 = 0.4 or 40%

Breakeven sales (Rs.) = Fixed cost / PVR = 400/ 40 x 100 = 1,000

Sales at BEP = Contribution at BEP/ PVR = 100 units

Sales at profit 500

Contribution at profit 500 = Fixed cost + Profit = 900

Sales = Contribution/PVR = 900/. 4 = 2,250 (or 225 units)

Profit at sales 3,000

Contribution at sale 3,000 = Sales x P/V ratio = 3000 x 0.4 = 1,200

Profit = Contribution Fixed cost = 1200 400 = 800

New P/V ratio = 9 6/9 = 1/3

Sales at BEP = Fixed cost/PV ratio = 400

= 1,200 1/3

Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %

(Actual sales BEP sales/Actual sales * 100)



DECISION MAKING

Cost accounting has long been used to help managers understand the

costs of running a business. Modern cost accounting originated during the

industrial revolution, when the complexities of running a large scale

business led to the development of systems for recording and tracking

costs to help business owners and managers make decisions.

In the early industrial age, most of the costs incurred by a business were

what modern accountants call "variable costs" because they varied

directly with the amount of production. Money was spent on labor, raw

materials, power to run a factory, etc. in direct proportion to production.

Managers could simply total the variable costs for a product and use this

as a rough guide for decision-making processes.

Some costs tend to remain the same even during busy periods, unlike

variable costs, which rise and fall with volume of work. Over time, the

importance of these "fixed costs" has become more important to

managers. Examples of fixed costs include the depreciation of plant and

equipment, and the cost of departments such as maintenance, tooling,

production control, purchasing, quality control, storage and handling,

plant supervision and engineering. In the early twentieth century, these

costs were of little importance to most businesses. However, in the twenty-

first century, these costs are often more important than the variable cost

of a product, and allocating them to a broad range of products can lead

to bad decision making. Managers must understand fixed costs in order to

make decisions about products and pricing.

For example: A company produced railway coaches and had only one

product. To make each coach, the company needed to purchase Rs.60

of raw materials and components, and pay 6 laborers Rs.40 each.

Therefore, total variable cost for each coach was Rs.300. Knowing that

making a coach required spending Rs.300, managers knew they couldn't

sell below that price without losing money on each coach. Any price

above Rs.300 became a contribution to the fixed costs of the company. If

the fixed costs were, say, Rs.1000 per month for rent, insurance and

owner's salary, the company could therefore sell 5 coaches per month for

a total of Rs.3000 (priced at Rs.600 each), or 10 coaches for a total of

Rs.4500 (priced at Rs.450 each), and make a profit of Rs.500 in both cases.

Decision making in today business is one of most difficult work of

manager. Decision making is the process to select best alternative out of

different alternative for solving business problems. A prudent cost

accountant can use different techniques of cost accounting and make it

the best tool of decision making in business.



We can see most common problems in business like to fix the price of

product, to reduce the cost of product and to increase overall profitability

of business.

Cost accounting provides cost sheet, statement of material and labour



utilization and some other reports like budget which can be used

immensely for comparing the standard cost. After this, businessman can

decide best price of products. We can also compile the following

information of cost accounting which can be used for business decision

making.

1. Cost Sheet

Cost Sheet is very helpful to find the cost of each unit. By comparing it

with previous year or previous month's cost sheet, manager

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