accounting for management_unit iv

8/11/2019 Accounting for Management_unit IV

1/87

Accounting for Management

S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: [email protected] Page 1

Semester I

UNIT IV COST ACCOUNTING

Cost Accounts Classification of Manufacturing Costs Accounting for Manufacturing Costs Cost Accounting Systems: Job Order Costing ProcessCosting Activity Based Costing Costing and the Value Chain Target Costing

Marginal Costing including Decision Making Budgetary Control & Variance Analysis Standard Cost System

COST ACCOUNTS

Meaning of Cost: Costs that are usually considered an expense of the current periodmay not be recorded as such because of special circumstances. Cost is the total spentfor goods or services including money, time and labor. Cost is the value of money thathas been used up to produce something, and hence is not available for use anymore.

Cost: It is the amount of resources given up in exchange for some goods or services.The resources given up are expressed in monetary terms. Cost is defined as theamount of expenditure (actual or notional) incurred on or attributable to a given thingor to ascertain the cost of a given thing.

According to ICMA London , Cost is the amount of expenditure (actual or notional)incurred on, or attributable to, a specified thing or activity or cost unit.

Expenses: Expenses are costs which have been applied against revenue of particularaccounting period in accordance with the principle of matching cost to revenue e.g.cost goods-sold, office salaries of the period in which they are incurred.

Loss: It represents diminution in ownership equity other than from withdrawal ofcapital for which no compensating value has been received e.g. destruction of property

by fire. Loss denotes sacrifice for which there is no corresponding return whereascost implies sacrifices for the sake of and accompanied by the securing of some othervalue.

Meaning of Cost Accounting: Cost accounting is concerned with cost and therefore, itis appropriate to understand the meaning of the term cost in a proper perspective. Ingeneral cost means the amount of expenditure (actual or nominal) incurred on, orattributable to a given thing. Its interpretation depends upon (a) the nature of the

business or industry and (b) the context in which it is used.

Meaning of Costing: Costing is a technique and process of ascertaining costs. Thistechnique consists of principles and rules which govern the procedure of ascertainingthe cost of products/services. The process of costing includes routines of ascertaining

cost by historical or conventional costing, standard costing or marginal costing.


2/87



According to Charles T Horngren, Cost Accounting is a quantitative method thataccumulates, classifies, summarizes and interprets information for three major

purposes: (i) Operational Planning and Control, (ii) Special Decision and (iii) ProductDecision.

Cost ConceptsA cost accountant is mainly concerned with the following cost concepts:

Concept of Objectivity: It is this concept gives direction to the activities relatingto cost finding, cost analysis, recording and cost reporting.

Concept of M ateri ality: This concept that stress accuracy must be tempered bygood judgment, if no distortion of product cost is likely to result.

Concept of Ti me Span: All assumptions relating to different cost exercise remainvalid only during related time span.

Concept of Relevant Range of Activity: Relevant range of activity represents thespan of volume over which the cost behavior is expected to remain valid.

Concept of Relevant Cost and Benef it: This concept is vital for decision-making purposes.

Objectives of Cost AccountingThe main objectives of cost accounting can be summarized as follows:

To determining selling price To determining and controlling efficiency To facilitating preparation of financial and other statements To Providing basis for operating policy

Elements of CostMere knowledge of total cost cannot satisfy the needs of management. For propercontrol and managerial decisions, management is to be provided with necessary datato analyze and classify costs. For its purpose, the total cost is analyzed by elements ofcost i.e. by the nature of expenses. Strictly speaking and the broad elements of costare three i.e. Materials, Labour and Other expenses.

These elements of cost are further analyzed into different elements such as Directmaterial, Indirect material, Direct labour, Indirect labour, Direct Expenses, Indirect

Expenses and Overheads.

CLASSIFICATION OF MANUFACTURING COSTS

The term manufacturing costs usually refers to material used, direct labour incurred,and overhead incurred in a manufacturing business. Material used, direct labour andmanufacturing overhead at the time incurred are not expenses, rather they incurredcosts. In the manufacturing process, material labour, and overhead do not expire;rather through manufacturing activity they become transformed from one type ofutility to another.


3/87



All costs related to production of goods are called manufacturing costs; they are alsoreferred to as product costs. The following are the classification of costs associatedwith manufacturing.

(1) Direct Materials: Direct materials are those materials which can be identified inthe product and can be conveniently measured and directly charged to the

product. These materials directly enter the production and form a part of thefinished goods. Thus, the substance from which the product is made known asmaterial.

For example, timber in furniture making, cloth in dress making and bricks in building a house. The following are normally classified as direct materials.

(a) All raw materials like jute in the manufacture of gunny bags, pig iron infoundry and fruits in canning industry.

(b) Materials specifically purchased for a specific job, process or order likeglue for book binding, starch powder for dressing yarn etc.

(c) Parts or components purchased or produced like batteries for transistor-radios and tyres for cycles.

(d) Primary packing materials like cartons, wrappings, cardboard boxes, etc.used to protect finished product from climatic conditions or for easyhandling inside the factory.

Indirect Material: The materials which are not classified as direct materials arecalled indirect materials. These materials are used for purposes ancillary to the

business and which cannot be conveniently assigned to specific physical unitsis termed as Indirect Material. Indirect material may be used in the factory,office or selling and distribution divisions. Consumable stores, oil and waste,

printing and stationery material, etc. are few examples of indirect materials.

(2) Direct Labour: All labour expended in altering the construction, composition,confirmation or condition of the product. In simple words, it is that labourwhich can be conveniently identified or attributed wholly to a particular job,

product or process or expended in converting raw materials into finishedgoods. Wages of such labour are known as direct wages. Human effort isneeded for conversion of materials into finished goods, such human effort iscalled labour.

Indirect Labour: Labour employed for the purpose of carrying out tasksincidental to goods produced or services provided, is indirect labour. Wages ofstore-keepers, foremen, time- keepers, directors fees, salaries of salesmen, etc.are the examples of indirect labour costs. Indirect labour may relate to thefactory, office or selling and distribution divisions.

(3) Direct Expenses: All expenses which can be identified to a particular costcentre and hence directly charged to the centre are known as direct expenses. Inother words, all expenses incurred specifically for a particular product, job are


4/87



called direct expenses. These are directly charged to the product. Forexample, royalty, excise duty, hire charges of a specific plant and equipmentetc.

Indirect Expenses: These are expenses which cannot be directly, convenientlyand wholly allocated to cost centres or cost units. Examples of such expensesare rent, lighting, insurance charges, etc.

(4) Overheads: Overheads may be defined as the aggregate of the cost of indirectmaterials, indirect labour and such other expenses including services as cannotconveniently be charged direct to specific cost units. Thus overheads are allexpenses other than direct expenses. The main groups into which overheadsmay be sub-divided are (i) Manufacturing Overheads, (ii) AdministrationOverheads, (iii) Selling and Distribution Overheads and (iv) Research andDevelopment Overheads.

By grouping the elements of cost, the following divisions of cost are obtained:Direct material + Direct labour + Direct expenses = Prime cost

Prime cost + Factory overheads = Factory cost

Factory cost + Administrative overheads = Production cost

Production cost + Selling & Distribution overheads = Total cost (or)

Ultimate cost

Elements of Cost

Materials Labour Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Overheads

Production or Administration SellingDistributionWorks Overheads Overheads OverheadsOverheads


5/87



ACCOUNTING FOR MANUFACTURING COSTS

A manufacturing firm maintains separate inventory accounts to accumulate productcosts associated with inventories at various stages of completion.

Raw Materials Inventory Account The raw materials inventory account includes the cost of raw materials purchased but not yet transferred to the factory floor; the manufacturing firmrecords purchases of raw materials as debits to the raw materials inventoryaccount.

When the manufacturer physically transfers raw materials to the factory floor,it also transfers the cost of the raw materials from raw materials inventoryaccount to the work-in-process inventory account.

It records this transfer as a credit to the raw material inventory account for thecost of the raw materials transferred and a debit to the work-in-processinventory account.

The balance in raw materials inventory is the cost of raw materials on hand inthe storeroom or warehouse.

Work-in-Process Inventory Account The work-in-process inventory account accumulates the cost of raw materials

transferred to the factory floor, the cost of direct labour used in production, andmanufacturing overhead costs.

At the completion of the manufacturing process, the firm physically transferscompleted units from the factory floor to the finished goods storeroom.

It also transfers the product costs of those completed units to finished goodsinventory.

The firm credits the work-in-process inventory account for the manufacturingcosts assigned to the finished units transferred to the finished goods storeroomand debits the finished goods inventory account.

Finished Goods Inventory Account The finished goods inventory account measures the total manufacturing cost of

units completed but not yet sold. The sale of manufactured goods to customer results in a transfer of their cost

from the finished goods inventory account to cost of goods sold, an expensereducing net income and ultimately retained earnings.

The journal entry is a debit to cost of goods sold and a credit to finished goodsinventory.

Presentation of Manufacturing and Non-Manufacturing Costs in Financial StatementsDistinguish between manufacturing and non-manufacturing costs in critical becausethe category determines where a cost will appear in the financial statements. Allmanufacturing costs (direct material, direct labor and manufacturing overhead) are

attached to inventory as an asset on the balance sheet until the goods are sold. Till


6/87



then the costs are transferred to cost of goods sold on the income statement as anexpense.

As noted earlier, non-manufacturing costs are also called period costs; because theyare expensed on the income statement in the time period in which they are incurred.Remember that the terms manufacturing cost and product cost are interchangeable, asare the terms non-manufacturing cost and period cost.

Costs and Timing of when the Costs are ExpensedManufacturing Costs(also called product costs)

Non-Manufacturing Costs(also called period costs)

1) Direct Materials 1) Selling

2) Direct Labor 2) General and Administrative

3) Manufacturing OverheadTiming of Expense: Costs areexpensed when goods are sold.

Timing of Expense: Costs areexpensed in the time period incurred.

COST ACCOUNTING SYSTEMS:

An accounting system is a formal means of gathering and communicating data to aidand coordinate collective decision in the light of overall goals or objectives of an

organization. The accounting system is the major quantitative information system inalmost every organization. Cost accounting is a formal means of gathering, measuring,analyzing, and reporting cost data to aid management in coordinating collectivedecisions in the achievement of the overall goals of an organization.

Need for Cost Accounting SystemAn effective accounting system provides information for two broad purposes:

1) The accumulation of cost data for external reporting.2) The collection of quantitative data for internal use by management in carrying-

out its functions of planning, control, decision-making and the formulation of

overall policies.

Components of a Cost Accounting System(a) An input measurement basis.(b) An inventory valuation method.(c) A cost accumulation method.(d) A cost flow assumption.(e) A capability of recording inventory cost flows at certain intervals.


7/87



F igur e: F ive Parts of a Cost Account in g System

Objectives of Cost Accounting System To arrive at the cost of production every unit and develop cost standards To indicate to the management any inefficiencies and the extent of various

forms of waste To reveal sources of economies in production To provide actual figures of cost for comparison with estimates To present comparative cost data for different periods To record the relative production results of each unit of plant and machinery

Factors of Consideration of Cost Accounting System1) Objectives2) Organizational Structure3) Technical Aspect4) Nature of product5) Cooperation of staff6) Collection of data7) Standardization of forms8) Control system9) Methods and techniques of costing

Cost Accounting System

InputMeasurement

Basis

InventoryValuationMethod

CostAccumulation

Method

Cost FlowAssumption

RecordingInterval

Capability

PureHistorical

FullAbsorption

Throughput

Direct(Variable) Normal

Historical

Standard

ActivityBased

Hybrid

Backflush

Process

Job Order SpecificIdentification

FIFO

WeightedAverage

Perpetual

Periodic


8/87



JOB ORDER COSTING

Job costing is the method of costing used to determine the cost of non-standard jobscarried out according to customers specifications. In this method cost units areseparately identified and are costed individually. This method is also known by other

names, such as Job Order Costing , Specific Order Costing , Terminal Costing and Production Order Costing . Here the idea is that each order placed with the firm for themanufacture of a product, or for doing a job for a customer in accordance with hisspecifications is different from the other.

For example, if Mr.A goes to the printers and asks him to print invitation cards for hismarriage, the card will be prepared according to his specifications, and the Invitationcard of Mr.X will not suit him. So the printing of the card Mr.A and Mr.Xs card aretwo different jobs, which can be termed as two separate cost units and which are to becosted individually. Job costing is applicable to job printers, engineers, furniture

makers, builders, contractors, hardware and machine manufacturing industries,repairing shops, etc.

Job costing is employed in the following cases: Where the production is against the order of the customer or jobs are executed

for different customers according to their specifications. Where each job needs special treatment and no two orders are necessarily alike. Where there is no uniformity in the flow of production from one department to

another. Where the work-in-progress differs from period to period on the basis of the

number of jobs in hand.

Job Order Costing is used in:1. Paper Boxes2. Wooden Furniture3. Toys and Novelties4. Cooking Utensils5. Caskets

6. Pianos7. Locomotives8. Office Machine Equipment9. Luggage10. Printing press

Characteristics of Job Costing

Custom Made Production Unique Nature of Work Work Flow Structure Predetermined Difference in Work-in-Progress Accumulation of Cost Ascertaining of Cost Short Duration of Work Valid for all Industry

Objectives of Job Costing

Cost of each job/order is ascertained separately. This helps in finding out the profit or loss on each individual job.


9/87



It enables the management to know those jobs which are more profitable andthose which are unprofitable.

It provides a basis for determining the cost of similar jobs undertaken in future.It thus helps in future production planning.

It helps the management in controlling costs by comparing the actual costs withthe estimated costs.

Job Costing ProcedureThe following steps are taken in jobs costing:

F igur e: Job Costing Procedure

Job Number: When an order has been accepted, an individual job number must beassigned to each job so that separate jobs are identifiable at all stages of production.Assignment of job numbers also facilitates reference for costing purposes in the ledgerand is conveniently short for use on various forms and documents.Production Order: The production control department then makes out a ProductionOrder thereby authorizing to start work on the job. Several copies of the productionorder are prepared, the copies often being in different colors to distinguish betweenthem more easily. These copies are passed on to the following:

All departmental foremen concerned with the job Storekeeper for issuance of materials Tool room for an advance notification of tools required

Production Order

Name of the Customer Job No. ..

Date of Commencement . Date ...

Date of Completion . Bill of Material No

Special Instructions ..... Drawing attached Yes/No..

Quantity Description Machines to beused

Tools Required

(Signature) . Production authorized by:Head of Production Control Dept.

F igur e: Production Order for Job

Job Number

Production Order

Job Cost Sheet


10/87



Job Cost Sheet: The unique accounting document under job costing is the job costsheet. Receipt of production order is the signal for the cost accountant to prepare a jobcost sheet on which he will record the cost of materials used and the labor andmachine time taken. Each concern has to design a job cost sheet to suit its needs. Jobcost sheet are not prepared for specified periods but they are made out for each jobregardless of the time taken for its completion. However, material labor and overheadcosts are posted periodically to the relevant cost sheet.

The materials, labor and overhead to be absorbed into jobs are collected and recordedin the following way:

i. Direct Materialsii. Direct Wages

iii. Direct Expensesiv. Overheads

A simple proforma of job cost sheet is given below.

Job Cost Sheet

Customer .. Job No...

Date of Commencement. .. Date of Completion. .

Material Cost Labor Cost Factory Overhead(Absorbed)

Date Material Req.No.

Amount(Rs.)

Date Hours Rate(Rs.)

Amount(Rs.)

Dept. Hours Rate(Rs.)

Amount(Rs.)

Total Total Total Profit/Loss (Rs.) Cost Summary Rs.Price Quoted

. Less: Cost

.

Profit/Loss

.

MaterialLabor

Prime CostFactory overheadWorks costAdministrative overheadCost of productionSelling and distribution overheadTotal cost

F igu re: Job Cost Sheet


11/87



Problem: Forge Machine Works collects its cost data by the job order costaccumulation procedure. For Job 642, the following data are available:

Direct Materials Direct Labor9/14 Issued Rs.1,200 Week of September 20 180 hours @ Rs.6.20/hr9/20 Issued 662 Week of September 26 140 hours @ Rs.7.30/hr9/22 Issued 480

Factory overhead applied at the rate of Rs.3.50 per direct labor hour. You are requiredto prepare (a) the appropriate information on a job cost sheet and (b) the sales price ofthe job, assuming that it was contracted with a mark-up of 40% of cost.

SolutionForge Machine Works

Job Order Cost Sheet Job 642

Di rect M ateri als Di rect L abor Appli ed F actory Overhead Date Issued

Amount(Rs.)

Date(weekof)

Hours Rate(Rs.)

Cost(Rs.)

Date(weekof)

Hours Rate(Rs.)

Cost(Rs.)

9/149/209/22

1,200662480

9/149/20

180140

6.207.30

1,1161,022

9/149/20

180140

3.503.50

630490

Total 2,342 Total 2,138 Total 1,120

Sales Price of Job 642, contracted with a mark-up of 40% of cost

Particul ars Amount (Rs.)Direct MaterialsDirect LaborApplied Factory Overhead

Total Factory CostMark-up 40% of Cost

Sales Price

2,3422,1381,120

5,6002,2407,840

Completion of JobsWhen jobs are completed, the cost is transferred to cost of sales account. The totalcost of jobs completed during each period is set against the sales to determine the

profit or loss for the period.


12/87



ProblemThe following is the budget of ABC Engineering Corporation for the year 2008.

Particulars Rs.Factory overheadsDirect Labor CostDirect Labor HoursMachine Hours

62,00098,000

1,55,00050,000

(a) From the above figures, prepare the overhead application rates, using thefollowing methods: (i) Direct labor hour; (ii) Direct labor cost and (iii)Machine hour.

(b) Prepare a comparative statement of cost, showing the result of application ofeach of the above rates to Job Order 333 from the under mentioned data:

Particulars Rs.Direct Material CostDirect Labor WagesDirect Labor HoursMachine Hours

45.0050.0040.0030.00

Solution(a)

(i) Direct Labor Hour Rate = 62,000 / 1,55,000 = Re.0.40(ii) Direct Labor Cost = (62,000 / 98,000) 100 = 63.27%(iii) Machine Hour Rate = 62,000 / 50,000 = Rs.1.24

(b)Compar ative Statement of Cost

Basis of Overhead Absorption

Direct Labor Hours

Direct Labor Cost

Machine Hours

Direct Material CostDirect Labor CostOverhead CostTotal Cost

45.0050.0016.00

111.00

45.0050.0031.63

126.63

45.0050.0037.20

132.20

Advantages of Job Costing It provides a detailed analysis of cost of materials, wages and overheads

classified by functions, departments and nature of expenses which enablemanagement to determine the operating efficiency of the different factors of

production, production centers and the functional units. 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.


13/87



It provides a basis for estimating the cost of similar jobs taken up in future andthus helps in future production planning.

Determination of predetermined overhead rates in job costing necessitates theapplication of a system of budgetary control of overheads with all itsadvantages.

Identification of spoilage and defectives with the respective production ordersand departments may enable the management to take effective steps inreducing these to the minimum.

The detailed cost records of the past years are used for statistical purposes inthe determination of the trends of cost of the different types of jobs and theirrelative efficiencies.

Disadvantages of Job Costing 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 orderwhich adds to the cost of cost accounting and also increases the chances oferrors.

Determination of overhead rates may involve budgeting of overhead expensesand the bases of overhead apportionment and absorption but unless such

budgeting is complete i.e. extended to material, labor and expenses, itsadvantages are considerably reduced.

Job costing is a historical costing which ascertains the cost of a job or productafter it has been manufactured. It does not facilitate control of cost unless it isused with standard or estimated costing.

The costs compiled under job costing system represent the cost incurred underactual conditions of operation. The system does not have any scientific basis toindicate what the cost should be or should have been, unless standard costing isemployed.

In case of inflation, comparison of cost of a job for one period with that ofanother becomes meaningless. Distortion of cost occurs even when the batchquantities are different.

PROCESS COSTING

Process costing is a method of costing applied to industries where the material has to pass through two or more processes for being converted into a finished product. Thismethod is used in the manufacture of chemical products, soap, vegetable oil, paints,varnishes etc., where the production is continuous and the products has to pass fromone process to the other until completion.

Process costing is an accounting methodology that traces and accumulates direct costs,and allocates indirect costs of a manufacturing process. Costs are assigned to products,usually in a large batch, which might include an entire months production.Eventually, costs have to be allocated to individual units of product. It assigns averagecosts to each unit, and is the opposite extreme of Job costing which attempts tomeasure individual costs of production of each unit. Process costing is a type of


14/87



operation costing which is used to ascertain the cost of product at each process orstage of manufacture.

According to the Terminology of CIMA defines process costing as the costingmethod applicable where goods or services result from a sequence of continuous orrepetitive operations or processes. Costs are arranged over the units produced duringthe period.

Process costing is mostly used in industries produce the following:(1) Textile Mills (7) Food processing(2) Leather (8) Soap making(3) Chemical works (9) Sugar works(4) Steel Mills (10) Baby foods(5) Paper manufacture (11) Paint(6) Cement manufacture (12) Chemical products

Characteristics of Process Costing Costs Flow from one Process to Another Equivalent Production Computation Average Unit Cost Computation Normal and Abnormal Losses Work in Process at Year End Emergence of More than one Product Homogenous Products Uniformed Output Saleable Output

Application of Process CostingProcess costing is used by those firm which manufacture articles of uniform standards.These firms manufacture articles on a continuous flow basis. Manufacturingoperations or process is continuous when the arrangement of plant and machinery issuch that the production of an item of standard nature continues for a long period oftime without any stoppages.

Under the following conditions, process costing can be followed:1) Production of single product2) Processing of a single product for a certain period3) Production of several products of a standard design in the same plant4) Division of a factory into separate operations or process

Recording of Costs under Process CostingThe factory is divided into distinct process or operations and an account is kept foreach process, to which are debited all costs of materials, labor and overhead.

Material: Raw materials required for each process are drawn from stores by theissue of material requisitions. Where materials are issued in bulk, thedepartment-in-charge of the process should intimate the quantity of such


15/87



materials consumed during a particular period. With the help of these data,costs of raw materials are debited to the process concerned.

Labor: Wages paid to workmen and supervisory staffs engaged in particular process are allocated to the process. Where workers are engaged in more thanone process, the gross wages are distributed to different process on the basis oftime spent.

Direct Expenses: Expenses such as cost of electricity, depreciation and hirecharges of equipment are determined easily for each process and allocated tothe process concerned.

Overhead: Where expenses are incurred for two or more processes the total ofsuch expenditure may be apportioned to different processes on suitable basis.Sometimes overhead is recovered is recovered at predetermined rate based ondirect wages, prime costs, etc.

Steps in Process CostingThe key document in a typical process costing system is the production cost report,

prepared at the end of each period for each production process or department. The production cost report summarizes the number of physical units and equivalent unitsof a department, the cost incurred during the period and the cost assigned to both unitscompleted and transferred out and ending work-in-process inventories.

The preparation of a production cost report includes the five steps as follows: Step 1: Analyze Flow of Physical Units: Step 2: Calculate Equivalent Units: Step 3: Determine Total Costs to Account: Step 4: Compute Unit Costs: Step 5: Assign Total Manufacturing Costs:

Companies generally divide the five-step production cost report into three parts:1) Production Quantity I nformation: It includes Step1 Analyze flow of physical

units and Step2 Calculate equivalent units.2) Unit Cost Determi nation: It includes Step3 Determine total costs to account

for and Step4 Compute equivalent unit cost.3) Cost Assignment: It includes Step5 Assign total manufacturing cost (total cost

accounted for)

Problem: A product passes through three distinct processes to completion. These processes are numbered respectively 1, 2 and 3. During the week ended 31 st January,1000 units are produced. The following information is obtained:

Direct Costs Process1 Process2 Process3MaterialsLaborDirect Expenses

6,0005,0001,000

3,0004,000

200

2,0005,0001,000

The indirect expenses for the period was Rs.2,800 apportioned to the process on the basis of labor cost. Prepare process accounts showing total cost and cost per unit.


16/87



SolutionProcess1 Account

Output: 1000 Units Particulars Per

UnitTotal(Rs)

Particulars PerUnit

Total(Rs)

To MaterialsTo LaborTo Direct expensesTo Indirect expenses

6511

6,0005,0001,0001,000

By Output transferredto Process2

13 13,000

13 13,000 13 13,000

Indirect Expenses as a % of Labor = 2,800 1005,000 + 4,000 + 5,000

= (2,800 / 14,000) 100 = 20%

Process2 AccountOutput: 1000 Units

Particulars PerUnit

Total(Rs)

Particulars PerUnit

Total(Rs)

To Process1 (transfer)To MaterialsTo LaborTo Direct expensesTo Indirect expenses

13.003.004.000.200.80

13,0003,0004,000

200800

By Output transferredto Process3

21 21,000

21 21,000 21 21,000

Process3 AccountOutput: 1000 Units

Particulars PerUnit

Total(Rs)

Particulars PerUnit

Total(Rs)

To Process2 (transfer)To MaterialsTo LaborTo Direct expensesTo Indirect expenses

212511

21,0002,0005,0001,0001,000

By Output transferredto finished stock

30 30,000

30 30,000 30 30,000

F in ished Stock Account Particulars Units Rs. Particulars Units Rs.

To Process3(1,000 Units)

30 30,000 By Closing Stock 30 30,000


17/87



Methods of Process CostingThere are mainly two methods of process costing:

1) Weighted Average Method2) First-in-First-out Method

Weighted Average Costing Method: The weighted average process-costing methodassigns the average equivalent unit cost of all work done to date (regardless of when itwas done) to equivalent units completed and transferred out, and to equivalent units inending inventory. The weighted average cost is simply the average of variousequivalent unit costs entering the work-in-process account.

Steps involved in Weighted Average Costing Method Step 1: Physical Flow of the Units: Step 2: Equivalent Units of Production: Step 3: Costs to be Accounted for: Step 4: Cost per Equivalent Unit: Step 5: Costs Accounted for:

Problem : The following figures related to single industrial process:Opening stock (10,000 units):Material 2,250Wages 650Overhead 400Units introduced (40,000 units):Material 9,250Wages 4,600Overhead 3,100

3,300

16,950During the period 30,000 units were completed and 20,000 units remained in process.The degree of completion of closing stock or WIP as: Material 100% ; Labor 25% ;Overhead 25%. Make the necessary computations and prepare Process Account byusing average method.

Solution

Statement of Equi valent Production Input units Particulars Output

units Equivalent Production Material Labour and

overhead10,000

40,000

50,000

Opening work-in-progressUnits started and finished(40,000 20,000)Closing work-in-progress

10,000

20,00020,00050,000

10,000

20,00020,000

10,000

20,0005,000

Equivalent units 50,000 35,000


18/87



Statement of CostCost

Element(A)Openingcost (Rs.)

(B)Cost put in(Rs.)

(C)Total cost(A+B)

(D) Equivalent productionunits

(CD)Cost perunit(Rs.)

MaterialsWagesOverhead

2,250650400

9,2504,6003,100

11,5005,2503,500

50,00035,00035,000

0.230.150.10

Total cost per unit 0.48

Statement of Evaluati on Particulars Rs.Cost of finished godsClosing work-in-progress:Materials (100% complete)Labor (25% complete)Overheads (25% complete)Cost of Closing WIP

30,000 @ Rs.0.48

20,000@ Rs.0.235,000@ Rs.0.155,000@ Rs.0.10

14,400

4,600750500

5,850

Process Account Particulars Units Rs. Particulars Units Rs.To Opening WIPTo MaterialTo Wages

To Overhead

10,00040,000

3,3009,2504,600

3,100

By Completed andtransferredBy Closing work-in-

process

30,000

20,000

14,400

5,850

50,000 20,250 50,000 20,250

FIFO (First-In-First-Out) Costing Method: The First-In-First-Out process-costingmethod assigns the cost of the earliest equivalent units available (starting with theequivalent units in beginning work-in-process inventory. This method assumes thatthe earliest equivalent units in work-in-process Assembly accounts are completedfirst.

The First-In-First-Out method computes an average cost that is separate for the current period from the beginning inventory. FIFO method gives satisfactory results when prices of materials, rates of wages and overheads are relatively stable.

Steps involved in First-in-First-out Costing Method Step 1: Physical Flow of the Units: Step 2: Equivalent Units of Production: Step 3: Costs to be Accounted for: Step 4: Cost per Equivalent Unit: Step 5: Costs Accounted for:


19/87



Problem : From the following information, calculate equivalent production.Opening work-in-progress (30% complete)Put into the process during the monthTransferred to next processClosing work-in-progress (40% complete)

2,000 units20,000units18,000 units4,000 units

Solution Particulars Equivalent

UnitsOpening work-in-progress(70% unfinished work 2000 units)

No. of units introduced and completed during themonth:Units put into process 20,000

Less: Units not completed 4,000

Closing stock-work done (4000 40%) Equivalent production

The above calculation may be made by the followingalternative method:Units completed during the month

Add: Closing stock-work done (4000 40%)

Less: Opening stock-work already done (200030%)

Equivalent production

1,400

16,000

1,60019,000

18,0001,600

19,600600

19,000

FIFO Method versus Weighted Average Cost Method

Point of Reference First-in-First-out (FIFO) Method

Weighted Average Cost Method

Equivalent Units Equivalent units show the work

which has been done in the present period.

Equivalent units represent the

work performed till date; this isinclusive of the work which hasdone in the previous period onthe opening work in progress of

present period.Units Completed There is a difference in the

accounting treatment betweenunits which are carried forwardfrom the previous period andunits which are completely

processed in the present period.

No distinction is maintained between units completed fromopening work in progress orunits started during the present

period.

Cost of CompletedUnits

The cost of completed units isthe aggregate of: Cost of

The calculation of the cost ofcompleted units is done by


20/87



opening work in progress +Present cost which have beenapportioned to opening work in

progress + Present cost of unitscompletely processed in the

present period.

multiplying the units completed by cost per unit.

Cost per EquivalentUnit

Cost per equivalent unit = Costincurred in the present period Equivalent units

Cost per equivalent unit = Costincurred to date Equivalentunits

Advantages of Process Costingo Use for Comparisono Simple and Easyo Use for Controlo Accurate Cost Allocationo Standard Process

Disadvantages of Process Costing Historical Cost Error in Average Cost Problem of Apportionment Inaccurate WIP Inaccurate Average Costs

Distinction between Job Order Costing and Process Costing

Basis of Distinction Job Order Costing Process CostingSpecific Orders Job is performed against specific

ordersProduction is continuous

Nature Each job may be different Product is homogeneous andstandardized

Cost Centre The cost center is a job The cost center is a processCost Ascertainment Costs are collected and

ascertained for each jobseparately

Costs are collected andascertained for each processseparately

When costs arecalculated?

Job costs are calculated onlywhen a job is completed

Process costs are calculated atthe end of each period

WIP There may or may not be work-in-process

There is always some work in process because of continuous production

Degree of Control Higher degree of control isrequired because ofhomogeneous jobs

Lower degree of control isrequired because ofhomogeneous products andstandardized process

Transfer There are usually no transfersfrom one job to another unless

there is some surplus work.

The output of one process istransferred to another process as

input.


21/87



ACTIVITY BASED COSTINGActivity Based Costing system is used to determine product costs for specialmanagement reports. This system is ordinarily used as a supplement to the companysusual costing system. Activity Based Costing (ABC) is a costing model that identifiesactivities in an organization and assigns the cost of each activity resource to all

products and services according to the actual consumption by each activity.

The CIMA Official Terminology defines ABC as Cost attribution to cost units on the basis of benefit received from indirect activities, for example: ordering, setting up,assuring quality.

According to Horngren , ABC is a system that focuses on activities as fundamentalcost objects and utilizes cost of these activities as building blocks or compiling thecosts of other cost objects.

Activity Based Costing is only a generic approach and it can be a part of both ordercosting system and a process costing system. ABC is an accounting methodology thatassigns costs to activities rather than products or services. This enables resources andoverhead costs to be more accurately assigned to products and services that consumethem.

F igure: Activity Based Costing M odel

ResourceDrivers

Direct DirectTracing Tracing

ActivityCost Drivers

Characteristics of Activity Based Costing Activity based costing increases the number of cost pools used to accumulate

overhead costs. The number of pools depends upon the cost driving activities.

DirectMaterials

DirectLabor

Overhead

PRODUCTS

ActivityCost Pools


22/87



Instead of accumulating overhead costs in single company-wise pool ordepartmental pools, the costs are accumulated by activities.

It charges overhead costs to different jobs or products in proportion to the costdriving activities in place of a blanket rate based on direct labor cost or directhours or machine hours.

It improves the traceability of the overhead costs, which results in moreaccurate unit cost data for management.

Identification of cost during activities and their causes not only help incomputation of more accurate cost of a product but also eliminate non-valueadded activities.

The elimination of non-value added activities would drive down the cost of the product.

In designing an ABC system, there are six essential steps, as listed in the following:1. Identify, define and classify activities and key attributes.2. Assign the cost of resources to activities.3. Assign the cost of secondary activities to primary activities.4. Identify cost objects and specify the amount of each activity consumed by

specific cost objects.5. Calculate primary activity rates.6. Assign activity costs to cost objects.

Basic Steps of Activity Based CostingThe ABC system can be established in an organization by taking several steps asfollows:

Core Areas of Activity Based CostingIn order to correctly associate cost with products and services, ABC assign cost toactivities based on their use of resources. It then assign cot to cost objects, such as

Identifying Major Activities

Assigning Cost to Activity Cost Centers

Selecting Cost Drivers for Allocating Cost toCost Drivers

Allocating the Cost of an Activity to CostObjects on the Basis of Cost Driver Rates

Identifying Activities and Cost Drivers


23/87



product or customers, based on their use of activities. ABC can track the flow ofactivities in organization by creating a link between the activity (resourceconsumption) and the cost object.

The flow is characterized through four core areas:1) Cost Object: It is an item for which cost measurement is required for example a

product or a customer.

2) Activities: These consist of the aggregate of different tasks and are concerned withfunctions associated with cost objects. There are two types of activities.

i) Support Activities : Support activities are, for example, schedule production,set up machine, purchase materials, inspect items, customer orders, supplierrecords etc.ii) Production Process Activities : Under the production process activitymachine products and assembled products are included within this production

process.

Activity cost centers are sometimes, similar to cost centers used undertraditional costing system. In case the purchasing department and purchasingactivity both the treated as cost centers, the support activity cost center also

become identical to cost centers taken under traditional costing system.

3) Cost Pool: It is another name given to a cost center and therefore, an activity costcenter may also be termed as an activity cost pool.

4) Cost D r ivers: The causes of incurrence of overhead cost are known as cost driver. Acost driver is a factor the change, of which results in a consequential change in thetotal cost of a related cost. If it changes, it brings a change in the level of total cost ofthe related cost object.

Following are some of the examples of cost drivers:i) Machine setupsii) Purchase ordersiii) Quality inspectors

iv) Production ordersv) Engineering change ordersvi) Shipmentsvii) Materials receiptsviii) Inventory movements

ix) Maintenance requestsx) Scrap / reword ordersxi) Machine time

xii) Power consumedxiii) Miles drivenxiv) Computer-hours loggedxv) Beds occupiedxvi) Flight-hours logged

The activity cost drivers can broadly be classified into following threecategories:i) Tr ansaction Dr iver : For example, the purchase order processed, customer

order processed, inspections performed and the set-ups undertaken, all

count the number of times an activity is performed.


24/87



ii) Dur ation Dr ivers: Mean the amount of time required to perform anactivity. Examples of duration drivers are set-up hours and inspectionhours.

iii) I ntensity D r ivers: It refers to drivers which directly charge for theresources used each times as activity is performed. Duration driversestablish an average hourly rate of performing an activity while intensitydrivers involve direct charging based on the actual activity resourcerelevant to a product.

The cost driver for business functions viz. Research and Development andCustomer Service are as below:

Bu sin ess F unctionsCost Drivers

Research and Development Numbers of research productsPersonnel hours on a projectTechnical complexities of projects

Customer Services Number of service calls Number of products servicesHours spent on servicing products

Advantages of Activity Based Costing

It helps understanding the behavior of overhead costs and their relationship to products, services, customers and market segments. It helps to allocate the resources to those activities that will increase the

shareholders vale. It links profitability analysis to operational decisions. It ensures that the cost of non-value added activities is visible to management. It provides the right information for performance measurement because it

focuses on activities rather than resources. The understanding of the cost driver for each activity gives better control over

the factors that cause costs.

It provides accurate information on profit margin and performancemeasurement for profit measurement. It gives business an opportunity to improve their competitive position through better informations.

Disadvantages of Activity Based Costing It is essentially not the panacea for all ills. It absorbs a lot of resources. Too much emphasis on customer viability can lead to problems such as cheaper

products and therefore, potentially lower sales.

It may lead to weaker customs segmentation. It takes no account of opportunity cost.


25/87



Difference between Activity Based Costing and Traditional CostingBasis ABC Costing Tr aditi onal Costin gCost Pools ABC systems accumulate

costs into activity cost pools.These are designed tocorrespond to the majoractivity or business processes.By design, the costs in eachcost pool are largely caused

by a single factor the costdriver.

Traditional costing systemsaccumulate costs into facility-wide or departmental cost

pools. The costs in each cost pool are heterogeneous theyare costs of many major

processes and generally arenot caused by a single factor.

Allocation Bases ABC systems allocate costs to products, services, and othercost objects from the activitycost pools using allocation

bases corresponding to costdrivers of activity costs.

Traditional systems allocatecosts to products usingvolume-based allocation

bases; units, direct labor input,machine hours and revenuedollars.

Hierarchy of Costs Allows for non-linearity ofcosts within the organization

by explicitly recognizing thatsome costs are not caused bythe number of units produced.

Generally estimates all of thecosts of an organization as

being driven by the volume of product or service delivered.

Cost Objects Focuses on estimating thecosts of many costs objects ofinterest: units, batches,

product lines, business process, customers, andsuppliers

Focuses on estimating the costof a single cost object unit of

product or service.

Decision Support Because of the ability to alignallocation bases with costdrivers, provides moreaccurate information tosupport managerial decisions.

Because of the inability toalign allocation bases withcost drivers, leads to over-costing and under-costing

problems.

Cost Control By providing summary costsof organizational activities,ABC allows for prioritizationof cost- management efforts.

Cost control is viewed as adepartmental exercise ratherthan a cross functional effort.

Cost Relatively expensive toimplement and maintain.

Inexpensive to implement andmaintain.


26/87



COSTING AND THE VALUE CHAIN

The value chain framework is an approach for breaking down the sequence (chain) of business functions into the strategically relevant activities through which utility isadded to products and services. Value chain analysis is undertaken in order to

understand the behavior or costs and the sources of differentiation.

According to CIMA Official Terminology , V alue analysis is defined as A systematicinterdisciplinary examination of factors affecting the cost of a product or service inorder to devise means of achieving the specified purpose most economically at therequired standard of quality and reliability .

Value chain analysis is relevant for most businesses, but especially those engaging intwo key types of activities:

1) Vertically Integrated Activities: Vertically integrated businesses engage in all

the activities necessary to convert raw materials into a final product. Valuechain analysis helps identify which activities a company performs relativelyefficiently. This analysis is especially useful when a company can substantiallyimprove or outsource low-return activities.

2) Activities Susceptible to Technological Change: Technology causes valuechains to disintegrate and allows companies to specialize in a narrow set ofactivities. Vertically integrated companies that rely on a handful of activitiesfor their profitability are at risk from specialized companies that perform thatactivity better.

Value Chain Approach / FrameworkThe framework of value-chain provides guidance for a systematic internal analysis ofthe firms existing or potential strengths and weakness. Systematic desegregation of afirm into certain distinct activity categories enables the strategies to identify the keyinternal factors, for closer examination, as potential sources of competitive advantage.

There are, for most business enterprises, two broad categories of value activities: Primary activities and Support activities . The former includes activities connectedwith the physical creation of the firms product or service, its marketing and delivery,and provision of after-sale support. The support activities are those, which provide

inputs or infrastructure for primary activities to be performed.

O r g a n

i z a

t i o n a l

A c t

i v i t i e

s

Firm Infrastructure (e.g. finance, planning)

MARGIN

Human Resource Management

Technology Development

ProcurementInboundLogistics

Operations(management)

OutboundLogistics

Marketingand Sales

After SalesServices

Operational Activiti es Figure: Value Chain Framework


27/87



Steps in Value Chain AnalysisValue chain analysis can be broken down into a three sequential steps:

1. Break down a market/organization into its key activities under each of themajor headings in the model.

2. Assess the potential for adding value via cost advantage or differentiation oridentify current activities where a business appears to be at a competitivedisadvantage.

3. Determine strategies built around focusing on activities where competitiveadvantage can be sustained.

Operational Activities (Primary Activities)Based on technological and strategic distinctness, the operational activities aregenerally divisible into five basic categories as follows:

1) I nbound L ogistics: 2) Operations: 3) Outboun d L ogistics: 4) M ark eting and Sales: 5) Service:

Organizational Activities (Support Activities)Support activities, which provide the infrastructure of primary activities, are alsorequired to be identified by isolating them on the basis of technological and strategicdistinctiveness. Four categories of organizational activities are generally distinguishedas follows:

1) Procurement2) Technology Development3) Human Resource Management4) Firm Infrastructure

Cost Advantage and the Value ChainA firm may create a cost advantage either by reducing the cost of individual valuechain activities or by reconfiguring the value chain. A cost analysis can be performed

by assigning costs to the value chain activities. The costs obtained from theaccounting report may need to be modified in order to allocate them properly to thevalue creating activities.

Porter identified ten cost drivers related to value chain activities.1) Economies of scale2) Learning3) Capacity Utilization4) Linkages among activities5) Interrelationship among

business units

6) Degree of vertical integration7) Timing of market entry8) Firms policy of cost or

differentiation9) Geographic location10) Institutional factors (regulation,

union activity, taxes, etc)


28/87



TARGET COSTING

Target costing a pricing method used by firms. It is defined as a cost managementtool for reducing the overall cost of a product over its entire life-cycle with the help of

production, engineering, researc h and design.

According to Cooper , Target Costing is a disciplined process for determining andrealizing a total cost which a proposed product with specified functionality must be

produced to generate the desired profitability at its anticipated selling price in thefuture.

Concept of Target CostingTarget Costing as it has been developed in Japan, was invented by Toyota in 1965.Thus, the use of target costing has a long tradition at Toyota. At Toyota, they talkabout cost control, i.e. influencing product costs during the design phase and keeping

the running costs as low as possible. Reducing cost through continuous improvement,cost kaizen, is becoming relatively less important , because the efforts madethroughout the company will inevitably lead to fewer opportunities to cut costs.

Target Costing is built on a comprehensive set of cost planning, cost management andcost control instruments which are aimed primarily at the early stages of product and

process design in order to influence product cost structures resulting from the market-derived requirements. The targets costing process requires the cost orient co-ordination of all product related functions.

Principles of Target CostingTarget costing can best be described as a systematic process of cost management and profit planning. The six key principles of target costing are:

1) Price-Led Costing: Market prices are used to determine allowable or target costs. Target costs are calculated using a formula similar to the following:

Market Price Required Profit Margin = Target Cost2) Focus on Customers: Customer requirements for quality, cost, and time are

simultaneously incorporated in product and process decisions and guide costanalysis. The value (to the customer) of any features and functionality built intothe product must be greater than the cost of providing those features and

functionality.3) Focus on Design: Cost control is emphasized at the product and process designstage. Therefore, engineering changes must occur before production begins,r esulting in lower costs and reduced time -to- market for new products.

4) Cross-Functional Involvement: Cross-functional product and process teams areresponsible for the entire product from initial concept through final production.

5) Value-Chain Involvement: All members of the value chain e.g. suppliers,distributors, service providers, and customers are included in the target costing

process.6) Life-Cycle Orientation: Total life-cycle costs are minimized for both the

producer and the customer. Life-cycle costs include purchase price, operatingcosts, maintenance, and distribution costs.


29/87



Objectives of Target Costing1) The fundamental objective of target costing is to enable management to use

proactive cost planning, cost management, and cost reduction practiceswhereby costs are planned and managed out of a product and business early inthe design and development cycle, rather than during the latter stages of

product development and product.2) Identify the cost at which the product must be manufactured as if it is to earn its

profit margin at its expected target selling price.3) Break the target cost down to its component level and have the suppliers find

way to deliver the components they sell at the set target prices while stillmaking adequate returns.

4) Target costing is intended to get managers thinking ahead and comprehensivelyabout the cost and other implications of the decisions they made.

5) Target costing is as much a significant business philosophy as it is a process to plan, manage, and reduce costs.

6) It emphasizes understanding the markets and competition; it focuses oncustomer requirements in terms of quality, functions and delivery, as well as

price etc.

Characteristics of Target Costing1) Target costing is a market-driven strategy and process.2) Target cost is then calculated by subtracting the desired profit margin from this

target price.3) The target cost is treated as an independent variable that must be satisfied along

with other customer requirements rather than the result of design decisions(dependent variable).

4) Target costing is a simple, straightforward process than can have significantimpact on the health and profitability of business.

5) Its mostly logical, disciplined common sense that can be imbedded into acompanys existing procedures and processes.

6) Target costing is a disciplined process that uses data and information in alogical series of steps to determine and achieve a target cost for the product.

7) Target costing is an integration of economic objectives and technologicalknowledge.

Basic Process of Target CostingDefi ne the Product This step answers the fundamental questions of What are youselling?, To whom?, What do they want it to do?. Set th e Product Second stage addresses the issue of What will they pay for it?What should it cos t to produce? Achi eve the Product It is concerned with How can we get there? Are we gettingthere? M aintaining Competiti ve Cost It deals with How can we stay ahead?


30/87



Steps of Target CostingThe following ten steps are required to install a comprehensive target costingapproach within an organization.

Advantages of Target Costingo Proper Deliveryo Minimizing Product-Line Complexityo Selecting Appropriate Product and Process Technologieso Lowering Design Churn (Mix) Late in the Innovation Processo Creative Competitive Futureo Eliminating Cost Overruns

Disadvantages of Target Costing Misuse of the Technique Stress on the Design Team Take Long Time Too Many Opinions

Re-orient Thinking

Establish Target Price

Determine Target Cost

Balance Target Cost

Establish Target Costing Process

Brainstorm and Analyze

Establish Product Cost

Use Tools

Reduce Indirect Cost

Measure Results and MaintainFoucs


31/87



MARGINAL COSTING INCLUDING DECISION MAKING

Marginal cost is the cost of producing an additional unit of output or service. It is nota system of costing like process or job costing, but it has been designed simply as anapproach to the presentation of accounting information. It adjudges profitability of anenterprise by carefully studying the impact of the range of costs according to theirrespective nature.

Marginal costing is the ascertaining of marginal costs, by differentiating betweenfixed costs and variable costs and of the effect on profit of changes in volume or typeof output.

The Institute of Cost and Management Accountants, London, has defined MarginalCosting as the ascertainment of marginal costs and of the effect on profit of changesin volume or type of output by differentiatin g between fixed costs and variable costs .

To ascertain the marginal cost, we need the following elements of cost:(a) Direct materials(b) Direct labor(c) Direct expenses and(d) Total variable overheads.

That is,Marginal Cost = Prime Cost + Total Variable Overheads

(or)Marginal Cost = Total Cost Fixed Cost

Thus, Marginal costing, we can say it as, direct costing, differential costing,incremental costing and comparative costing. Batty defines Marginal Costing as, atechnique of cost accounting which pays special attention to the behavior of costs withchanges in the volume of output .

For Example : Variable cost 800 @ Rs.50/- = Rs.40,000/-Fixed cost = Rs.10,000/-Total cost = Rs.50,000/-

If the production is increased by 10 units, then accordingly the cost varies:Variable cost 810 @ Rs.50/- = Rs.40,500/-Fixed cost = Rs.10,000/-Total cost = Rs.50,500/-

Less : Total cost of 800 units = Rs.50,000/-

** Marginal cost of one unit = Rs.500/10 = Rs.50/-

Marginal cost = Increase in total cost / Increase in total units


32/87



Main Features of Marginal Costing1. Marginal costing is a technique which is used in conjunction with other

methods of costing (process or job).2. Fixed and variable costs are kept separate at every state.3. As fixed costs are period costs, they are excluded from product cost and only

variable costs are considered as the cost of the product.4. The difference between the contribution and fixed costs is the net profit or loss.5. Cost-volume-profit relationship if fully employed to reveal the state of

profitability at various levels of activity.

Advantages of Marginal Costing Simple to Operate and Easy to Understand Removes complexities of Under-Absorption of overheads Helps Management in Production Planning No possibility of Fictitious Profit by Over-Valuing Stocks Facilitates Calculation of Important Factors Aid to Management Facilitates the Study of Relative Profitability Complimentary to Standard Costing and Budgetary Control Helps in Cost Control Profit Planning

Advantages of Marginal Costingo Segregation into Fixed and Variable A Difficult Tasko Ignores Fixed Overheadso Not Appropriate for Job/Contract Costingo Assumption Regarding Behavior of Costso Problems in regard to Under or Over-Absorptiono Unable to Fix Selling Priceso Useful Only in Short Profit Planning and Decision-Makingo Non-Recognition from Government Authorities

Absorption Costing and Marginal CostingAbsorption costing is the practice of charging all costs, both fixed and variable tooperations, process or products. In marginal costing, only variable costs are chargedto production.

The Institute of Cost and Management Accountants (U.K) defines it as, the practiceof charging all costs, both variable and fixed to operations, processes or products.This explains why this technique is called full costing. Administrative, selling anddistribution overheads as much form part of total cost as prime cost and factory

burden.


33/87



Problem:The monthly cost figures for production in a manufacturing company are:

Variable Cost Rs.1,20,000Fixed Cost Rs. 35,000Total Cost Rs.1,55,000

Normally monthly sales figure is Rs.2,00,000Actual sales figures for three separate months are:

I Month II Month III MonthRs.2,00,000 Rs.1,65,000 Rs.2,35,000

Un der a system of marginal costing stock ar e valu ed as:I Month II Month III Month

Opening Stock Rs.84,000 Rs. 84,000 Rs.1,05,000Closing Stock Rs.84,000 Rs.1,05,000 Rs. 84,000

I f the margi nal costin g techni que were not used stock would be valued as fol lows:I Month II Month III Month

Opening Stock Rs.1,08,500 Rs.1,08,500 Rs.1,35,625Closing Stock Rs.1,08,500 Rs.1,35,625 Rs.1,08,500

Prepare two tabulation, side-by-side, to summarize these results for each of the threemonths, basing one tabulation on marginal cost and the other tabulation alongside onabsorption cost theory.

M argin al Costing Absorption Costin g

I M onthI I

MonthI I I

MonthI M onth

I IMonth

I I IMonth

Rs. Rs. Rs. Rs. Rs. Rs.Opening StockVariable CostFixed Cost

TotalLess: Closing Stock

Cost of SalesSales

ContributionLess: Fixed Cost

ProfitMargin % on SalesProfit on Sales

84,0001,20,000

---2,04,000

84,0001,20,0002,00,000

80,00035,00045,00040%

22.5%

84,0001,20,000

----2,04,0001,05,000

99,0001,65,000

66,00035,00031,00040%

18.8%

1,05,0001,20,000

-----2,25,000

84,0001,41,0002,35,000

94,00035,00059,00040%25%

108,5001,20,000

35,0002,63,5001,08,5001,55,0002,00,000

45,000----

45,00022.5%22.5%

1,08,5001,20,000

35,0002,63,5001,35,6251,27,8751,65,000

37,125----

37,12522.5%22.5%

1,35,6251,20,000

35,0002,90,6251,08,5001,82,1252,35,000

52,875----

52,87522.5%22.5%


34/87



Distinction Between Marginal Costing And Absorption CostingAbsorption Costin g M argin al Costin g

1. All costs fixed and variable arecharged to Product.2. Profit = Sales Cost of Goods Sold3. It does not reveal the cost volume

profit Relationship.4. Closing inventories are valued at fullcost. Absorption costing reveals more

profit since the inclusion of fixed costs ininventories.5. Costs are included in the products, thisleads to over or under-absorption.

1. Only variable costs are charged to products; fixed costs are transferred toP& L Account.2. Contribution margin = S VC and

Profit = Contribution FC3. Cost Volume Profit relationship is an

important part of marginal costing.4. Closing inventories are valued atvariable cost. Marginal costing revealsless profit when compared to absorptioncost.5. Fixed costs are not included in the

product; it will not lead to the problem ofunder-absorption.

Marginal Cost EquationsSales = Variable Cost + Fixed Cost Profit or LossSales Variable Cost = Fixed Cost Profit or LossSales Variable Cost = ContributionContribution = Fixed Cost + Profit

From the above equations we can understand that in order to earn profit, thecontribution must be more than the fixed cost. To avoid any loss, the contributionmust be equal to fixed cost.

Decision Making Under Marginal Costing SystemMarginal Costing is an extremely valuable technique with the management. The costvolume-profit relationship has served as a key to locked storehouse of solutions tomany situations. It enables the management to tackle many problems which are facedin the practical business. All the introduction of marginal cost principles does is togive the management a fresh and perhaps a refreshing, insight into the progress oftheir business.

Marginal Costing helps the management in decision-making in respect of thefollowing vital areas:

Cost Control Fixation of Selling Price Closure of a Department or

Discontinuing a Product Selection of a Profitable Product

Mix Profit Planning Decision to Make or Buy Decision to Accept a Bulk Order

Introduction of New Product Choice of Technique Evaluation of Performance

And Decision Making Maintaining a Desired Level of

Profit Level of Activity Planning Alternative Methods of Production Introduction of Product Line


35/87



PROFIT VOLUME RATIO (P/V RATIO)

Profit volume ratio, which is popularly known as P/V Ratio, expresses the relationshipof contribution to sales. Another name for this ratio is contribution-sales ratio or

marginal-income ratio or variable-profit ratio. The ratio, expressed as a percentage,indicated the relative profitability of different products.

The formula for computing the P/V Ratio is:P/V Ratio = Contribution [C/S]

Sales(or)

= Fixed Cost + Profit [F+P/S]Sales

(or)

= Sales Variable Cost [S V/S]Sales

It can be expressed in percentage. Normally, this ratio is expressed in percentage.When we know the P/V ratio, B.E.P. can be calculated, by using the formula:

B.E.P. (Sales Volume) = Fixed Cost [F / PV Ratio]P/V Ratio

The profit of the business can be increased by improving P/V ratio. As such

management will make efforts to improve the ratio. A higher ratio means greater profitability and vice versa. So management will increase the P/V Ratio:

(a) by increasing sales price per unit.(b) by decreasing variable cost(c) by increasing the production of products.

P/V ratio is very important in decision-making. It can be used for the calculation ofB.E.P. and in problems regarding profit sales relationship.

1. B.E.P. = Fixed Cost [F / PV Ratio]

P/V Ratio

2. Fixed Cost = B.E.P * P/V ratio3. Sales required in units to maintain a desired profit

= Fixed Cost + Desired Profit [F+P / PV Ratio]P/V Ratio

= Required contribution New contribution per unit

4. Contribution = Sales*P/V ratio5. Variable Costs = Sales (1 P/V ratio)


36/87



ProblemMarginal Cost Rs.2400Selling Price Rs.3000Calculate P/V ratio.

SolutionP/V ratio = Contribution / Sales * 100

= (3000-2400) / 3000*100= 600 / 3000*100

ProblemThe sales turnover and profit during two periods are as under:

Period I = Sales Rs.20 lakhs; Profit Rs.2 lakhsPeriod II = Sales Rs.30 lakhs; Profit Rs.4 lakhs

Calculate P/V ratio.

SolutionP/V ratio = Change in Profit / Change in Sales *100

= 2,00,000 / 10,00,000 *100= 20%

ProblemThe following data are obtained from the records of a company:

First Year Second YearSales Rs.80,000 Rs.90,000Profit Rs.10,000 Rs.14,000

Calculate the break-even point.

SolutionB.E.P. (Sales) = Fixed Cost

P/V ratio

P/V ratio = Change in Profit / Change in Sales *100

= 4000 /10,000 *100= 40%

Fixed Cost = Contribution Profit

Contribution = Sales * P/V ratio= 80,000 * 40% = 32,000

= 32,000 10,000 = 22,000

B.E.P. (Sales) = 22,000 = Rs.55,00040%


37/87



Break-Even Point AnalysisThe break-even point and break-even chart are two by-products of break-evenanalysis. In a narrow sense, it is concerned with the break-even point and in a broadsense it is concerned with break-even chart. Break-even analysis is also known ascost volume profit analysis. This analysis is a tool of financial analysis whereby theimpact on profit of the changes in volume, price, costs and mix can be estimated withreasonable accuracy. Break-even point is equilibrium point or balancing point of no-

profit no-loss. This is a point at which loss ceases and profit begins. This is a pointwhere income is exactly equal to expenditure.

Break-even pointBreak-even point is a point where the total sales are equal to total cost. In this pointthere isno profit or loss in the volume of sales. The formula to calculate break-even point is:

B.E.P. (in units) = Total Fixed CostContribution per unit

(or)= Fixed Cost

Selling price per unit Variable cost per unit

ProblemFrom the following particulars calculate the break-even point:

Variable cost per unit Rs.12Fixed expenses Rs.60,000Selling price per unit Rs.18

Solution


Selling price Variable cost = ContributionRs.18 Rs.12 = Rs.6


= Rs.60,000 / Rs.6 = 10,000 units

B.E.P. Sales = 10,000*Rs.18 = Rs.1,80,000


38/87



Margin of SafetyMargin of Safety is an important concept in Marginal Costing Approach. A total saleminus the sales at break-even point is known as the Margin of Safety (M/S). That isMargin of Safety is the excess of normal or actual sales over sales at break-even point.In other words, sales over and above break-even sales are known as Margin of Safety.The Margin of Safety refers to the amount by which sales revenue can fall before aloss is incurred. That is, it is the difference between the actual sales and sales at the

break-even point.

Break-even point can be compared to a Red Signal Point. If the Margin of Safety islarge, it is a sign of soundness of the business and vice versa. The Margin of Safetyserves as a guide, is a reliable indicator of the business strength and soundness.Margin of Safety can be expressed in absolute sales amount or in percentage. HighMargin of Safety indicates the soundness of a business because even with substantialfall in sale or fall in production, some profit shall be made. Small margin of safety onthe other hand is an indicator of the weak position of the business and even a smallreduction in sale or production will adversely affect the profit position of the business.

Margin of Safety can be increase by:(a) Decreasing the fixed cost;(b) Decreasing the variable cost;(c) Increasing the selling price;(d) Increasing output and sales;(e) Changing to a product mix that improves P/V Ratio.

Margin of Safety = Actual Sales Sales at BEP

(or) = Profit / PV ratio(or) = Profit / Contribution

As a percentage = Margin of Safety *100Total Sales

Problem: From the following details find out (a) Profit Volume Ratio, (b) B.E.P., (c)Margin of Safety.

Rs.Sales 1,00,000Total Costs 80,000Fixed Costs 20,000

Net Profit 20,000

Solution(a) P/V Ratio = Sales Variable expenses * 100

Sales= 1,00,000 60,000 * 100 = 40%

1,00,000


39/87



(b) B.E.P. = Fixed Cost = 20,000 *100 = Rs.50,000 P/V Ratio 40

(c) Margin of Safety = Profit = 20,000 *100 = Rs.50,000 P/V Ratio 40

(or)

Margin of Safety = Actual Sales Sales at BEP= 1,00,000 50,000 = Rs.50,000

ProblemThe following information was obtained from a Company in a certain year:

Sales Rs.1,00,000Variable Cost Rs. 60,000Fixed Cost Rs. 30,000

Find the P/V Ratio, Break-even Point and Margin of Safety.

SolutionP/V Ratio = S V *100 = 1,00,000 60,000 *100 = 40%

S 1,00,000

Break-Even Point = FC = 30,000 = Rs.75,000 P/V Ratio 40%

Margin of Safety = Profit = 10,000 = Rs.25,000 P/V Ratio 40%

(or) = Sales Break-Even Sales= 1,00,000 75,000 = Rs.25,000

Sales Mix DecisionPresuming that fixed costs will remain unaffected, decision regarding sales/productionmix is taken on the basis of the contribution per unit of each product. The productwhich gives the highest contribution should be given the highest priority and the

product whose contribution is the least, should be given the least priority. A productgiving a negative contribution should be discontinued or given up unless there areother reasons to continue its production.


40/87



ProblemFollowing information has been made available from the cost records of UnitedAutomobiles Ltd., manufacturing spare parts.

Direct Materials Per unitX Rs.8Y Rs.6

Direct WagesX 24 hours @ 25 paise per hourY 16 hours @ 25 paise perhour

Variable Overheads 150% of direct wagesFixed Overheads (total) Rs.750Selling Price

X Rs.25Y Rs.20

The directors want to be acquainted with the desirability of adopting any one of thefollowing alternative sales mixes in the budget for the next period.

(a) 250 units of X and 250 units of Y(b) 400 units of Y only(c) 400 units of X and 100 units of Y(d) 150 units of X and 350 units of Y

State which of the alternative sales mixes you would recommend to the management.

SolutionMARGINAL COST STATEMENT (PER UNIT)

Particulars ProductsX YRs. Rs.

Direct Materials 8 6Direct Wages 6 4Variable Overheads 9 6Marginal Cost 23 16Contribution 2 4Selling Price 25 20


41/87



SELECTION OF SALES ALTERNATIVE

(a) 250 units of X and 250 units of YContribution:Product X 250 units*2 Rs. 500Product Y 250 units*4 Rs.1000

Rs.1500Less: Fixed Overheads Rs. 750

Profit Rs. 750(b) 400 units of Y only

Contribution:Product Y 400 units*4 Rs.1600Less: Fixed Overheads Rs. 750

Profit Rs. 850

(c) 400 units of X and 100 units of YContribution:Product X 400 units*2 Rs. 800Product Y 100 units*4 Rs. 400


Profit Rs. 450

(d) 150 units of X and 350 units of YContribution:Product X 150 units*2 Rs. 300Product Y 350 units*4 Rs.1400


Profit Rs. 950

The alternative (d) is most profitable since it gives the maximum profit of Rs.950.

BUDGETARY CONTROL & VARIANCE ANALYSIS

Budget is a detailed plan of operations for some specific future period. It is anestimated prepared in advance of the period to which it applies. It acts as a business

barometer as it is a complete programme of activities of the business for the periodcovered.

According to George R Terry, A Budget is an estimate of future needs arrangedaccording to an orderly basis, covering some or all of the activities of an enterprise fordefinite period of time .


42/87



According to Crown and Howard , A budget is a pre -determined statement ofmanagement policy during a given period which provides a standard for comparisonwith th e results actually achieved.

Features of Budget One Years Duration Estimation of Business Units Profit Potential Appraisal of Performance Monetary Terms Alteration of Approved Budget under Specified Conditions Review and Approval by a Higher Authority Managerial Commitment

The following are the essentials of a budget:(a) It is prepared in advance and is based on a future plan of activities. (b) It relates to a future period and is based on objectives to be attained. (c) It is a statement expressed in monetary and physical units prepared for the

implementation of policy formulated by the management.(d) It expresses largely in financial terms, of managements plans for operating and

financing the enterprise during specific periods of time.

BudgetingBudgeting is the most common, useful and widely used standard device of planningand control. Budgeting or Planning has become the primary function of managementthese days. Most of the planning relates to individual situations and individual

proposals. However, this has to be supplemented and reinforced by overall periodic planning followed by continuous comparison of the actual performance with the planned performance.

Estimate, Forecast and Budget An estimate is predetermination of future events either on the basis of simple

guess work or following scientific principles. Forecast is an assessment of probable future events. Budget is based on the implications of a forecast and related to plan events.

Budgeting ControlThe budgetary control has now become an essential tool of the management forcontrolling costs and maximizing profit. Budgeting control is applied to a system ofmanagement and accounting control by which all operations and output are forecastedas far ahead as possible and actual results when known are compared with budgetestimates.

According to CIMA, London, defines budgetary control as the establishment of budgets relating to the responsibilities of executives to the requirements of a policyand the continuous comparison of actual with budgeted result either to secure by


43/87



individual action the objectives of that policy or to provide a firm basis for itsrevision.

The Essentials of Budgetary Control are:(a) Establishmen

accounting for management_unit iv

Documents