cost accounting

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1 Cost Accounting

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Page 1: Cost Accounting

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Cost Accounting

Page 2: Cost Accounting

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Definition

Chartered Institute Of Management Accountants ( CIMA London )

“Costing is the technique and process of ascertaining cost”

Page 3: Cost Accounting

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Cost Accounting

• Cost accounting measures and reports information relating to the cost of acquiring and utilizing resources

• Cost accounting provides information for management and financial accounting

• Cost management describes the approaches and activities of managers in short-run and long-run planning and control decisions

• These decisions increase value of customers and lower costs of products and services

• Cost management is an integral part of a company’s strategy

Page 4: Cost Accounting

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Cost Accounting

It provides information for both management accounting and financial accounting.

It measures and reports from financial and non financial data.

Page 5: Cost Accounting

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Financial Accounting

• Financial accounting measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP)

• Managers are responsible for the financial statements issued to investors, government regulators, and other parties outside the organization

• Financial accounting focuses on external parties

• Financial accounting reports on what happened in the past

Page 6: Cost Accounting

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An Introduction to Cost Terms

Page 7: Cost Accounting

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Costs and Cost Objects

Cost• a resource sacrificed or foregone to achieve a specific

objective

Cost Object• any product, machine, service or process for which

cost information is accumulated• cost objects can vary in size from an entire company,

to a division or program within the company, or down to a single product or service

Page 8: Cost Accounting

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Direct and Indirect Costs

Direct Cost• a cost which is related to a particular cost objective

and can be traced to it in an economically feasible way

Indirect Cost• a cost which is related a particular cost objective but

cannot be traced to it in an economically feasible way• indirect costs are allocated to cost objectives

Direct Cost

Indirect Cost

Cost

Object

Trace

Allocate

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Cost Drivers and Cost Management

Cost driver (cost generator or cost determinant)• a factor which causes the amount of cost incurred to

change• production costs are driven by the number of

products produced, labour costs, number of setups required, and the number of change orders

Cost Reduction Programs focus on two things:

1. Doing only value-added activities

2. Efficiently manage the use of cost drivers in those value-added activities

Page 10: Cost Accounting

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Variable and Fixed Costs

Variable Cost• a cost which is constant per unit

but changes in total in proportion to changes in the output

• materials (parts), fuel costs for a trucking company

Rs

Volume

Rs

Volume

Fixed Cost• a cost which does not change in

total as volume changes but changes on a per-unit basis as the cost driver increases and decreases

• amortization, insurance

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Total Costs and Unit Costs

Unit Cost (or Average Cost)• Total cost / some number of units

Average cost= Total manufacturing costs / Number of units produced= Rs980,000 / 10,000= Rs98 per unit

• Unit or average costs must be interpreted with caution• As volume increases, the unit or average cost falls as

the fixed costs are spread over a larger number of units

Page 12: Cost Accounting

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Types of Inventory

• Direct material inventory (stock awaiting use in the manufacturing process)

• Work-in process inventory (partially completed goods on the shop floor)

• Finished goods inventory (goods completed but not yet sold)

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Period and Product Costs

Period Costs• are expensed on the income statement as they are

incurred• also called operating costs (excluding cost of goods

sold)• examples: selling, general and administrative costs

Product Costs• are inventoried on the balance sheet and expensed

only when the product or service is sold• also called inventoriable costs• Examples: materials and labour (manufacturing)

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Costing System Terminology

Cost Object• anything for which a separate measurement of costs

is desired

Cost Pool• a grouping of individual cost items

Cost Allocation Base• a factor that is the common denominator for

systematically linking an indirect cost or group of indirect costs to a cost object

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Alternative Classifications of Costs

1. Business functiona. R&Db. Designc. Productiond. Marketinge. Distributionf. Customer service

2. Assignment to a cost objecta. Direct costsb. Indirect costs

3. Behaviour patterna. Variable costsb. Fixed costs

4. Aggregate or averagea. Total costsb. Unit costs

5. Assets or expensesa. Inventoriable costsb. Period costs

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Costs in a Manufacturing Company

Inventoriable

(Product)

Costs

DirectMaterial

Purchases

Work inProcess

InventoryCost of Goods Sold

Revenue

Gross Margin

Marketing andAdministrative Costs

Operating Income

Period

Costs

Income Statement

Balance Sheet

MaterialsInventory

DirectLabour

IndirectManufacturing

Costs

Finished

GoodsInventory

Page 17: Cost Accounting

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Costing Systems

Job-CostingSystem

• Costs are assigned to a distinct unit or batch

• Resources are expended to bring a distinct product or service to market for a specific customer

• advertising campaign, audit, aircraft assembly

Process-CostingSystem

• Costs are assigned to a mass of similar units

• Resources are used to mass-produce a product or service and not for any specific customer

• Postal delivery, oil refining

Page 18: Cost Accounting

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Job Costing Approach

1. Identify the cost object(s)

2. Identify the direct costs for the cost object(s)

3. Select cost-allocation bases to use in allocating the indirect costs to the cost object(s)

4. Identify the indirect costs associated with each cost-allocation base

5. Compute the rate per unit of each cost-allocation base to allocate indirect costs to the cost object(s)

6. Compute the indirect costs allocated to the cost object(s)

7. Determine the cost of the cost object(s) by adding the direct and indirect costs

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Job Costing Overview

IndirectCost Pool

Manufacturing OverheadRs1,215,000

Rs45 per directManufacturing Labour Hours

Cost Object:

Direct + Indirect CostsDirect Material

Direct Labour

Cost

Allocation Base27,000 Direct Manufacturing Labour-

Hours

Page 20: Cost Accounting

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Job Costing System in Manufacturing

Cost of Goods Sold

Finished Goods

Inventory

Work-In-Process

Inventory

Materials

Inventory

Buy

Materials

Use

Materials

Incur Labour

Costs

Incur Overhead

Costs

Complete

Production

Sell

Goods

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Cost Sheet

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Cost SheetIt is a statement designed to show the output of a

particular accounting period along with breakup of cost.

• It is a memorandum statement

• It does not form part of double entry cost accounting records.

• It discloses the total cost and cost per unit.

• It helps

To fix Selling Price.

To submit quotation price.

To Control cost.

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• COST SHEET

Total Cost Cost Per unit

Direct Materials

Direct Labour

Prime Cost

Add: Works Overheads

Works Cost

Add: Administration overheads

Cost of Production

Add: Selling & Distribution Overheads

Total Cost or Cost of Sales

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Elements of Cost

Direct Material :-

Identify in the product

Easily measure & directly charge to the product

e.g. Timber in furniture making

Categories• raw material • Specifically purchased for specific job or process• Parts or components purchased.

e.g. tyres for cycles • Primary Packing material

to protect finished product

for easy handling inside the factory.

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Direct Labour :-

Labour engaged in • converting raw material into finished goods• Altering the construction• Actual Production• Composition of Product

i.e labour which can be attributed to a particular job,product or process

Exception :- Where the cost is not significant like

wages of trainees- their labour though directly

spent on product is not treated as direct Labour

Test:- • Easily Identify• Feasible to Identify

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Overheads :- It may be defined as the aggregate of the cost of indirect materials, indirect labour and such other expenses including services as can’t conveniently be charged direct to specific cost unit.

Categories:-• Manufacturing Overheads• Administration of machines• Selling & distribution of machines

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Standard Costing

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Why is Standard Costing Used?

A A standard standard is a preestablishedis a preestablishedbenchmark for desirable performance.benchmark for desirable performance.

A A standard cost systemstandard cost system is one in which a is one in which acompany sets cost standards and thencompany sets cost standards and then

uses them to evaluate actual performance.uses them to evaluate actual performance.

A A variance variance is the difference betweenis the difference betweenactual performance and the standard.actual performance and the standard.

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Favorable versus Unfavorable

An An unfavorableunfavorable variance occurs when actual variance occurs when actualperformance falls below the standard.performance falls below the standard.

A A standard standard is a preestablishedis a preestablishedbenchmark for desirable performance.benchmark for desirable performance.

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. . Standard cost is the Predetermined cost based on a technical estimate for material, labor and overhead for a selected period of time and for a specified set of working conditions.

•Standard costing is the preparation of standard cost and

applying them to measure the variations from actual

costs and analyzing the causes of variations with a view

to maintain maximum efficiency in production

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Quantity and Price Standards

Quantity usedQuantity used

Price paidPrice paid

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Ideal versus Practical Standards

A standard that allows for the normalA standard that allows for the normalinefficiencies of production isinefficiencies of production iscalled a practical standard.called a practical standard.

A standard that allows for no inefficienciesA standard that allows for no inefficienciesof any kind is an ideal standard.of any kind is an ideal standard.

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The Standard Costing Process

Gather informationGather informationand set standards.and set standards.

Compare actualCompare actualperformance toperformance to

standard and preparestandard and prepareperformance reports.performance reports.

Determine whichDetermine whichvariances to investigate.variances to investigate.

Investigate theInvestigate thecause of variances.cause of variances.

Take corrective action.Take corrective action.

Determine ifDetermine ifcorrective actioncorrective action

is needed.is needed.

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Problems With Standard Costing

Employees may try to set low standardsEmployees may try to set low standardsto make them easier to achieve.to make them easier to achieve.

Using historical data to set standardsUsing historical data to set standardsmay build in past inefficiencies.may build in past inefficiencies.

Managers might focus on theManagers might focus on the““numbers” to the exclusionnumbers” to the exclusionof other important factors.of other important factors.

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Problems With Standard Costing

Focus on unfavorable variancesFocus on unfavorable variancesmay result in ignoring themay result in ignoring the

favorable variances.favorable variances.

Managers may loseManagers may losesight of the big picture.sight of the big picture.

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Comparison of Cost Systems

CostCostClassificationClassification

ActualActualCostCost

SystemSystem

NormalNormalCostCost

SystemSystem

StandardStandardCostCost

SystemSystem

DirectDirectMaterialMaterial

DirectDirectLaborLabor

ManufacturingManufacturingOverheadOverhead

ActualActual

ActualActual

ActualActual

ActualActual

ActualActual

EstimatedEstimated

EstimatedEstimated

EstimatedEstimated

EstimatedEstimated

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Analysis of variance

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Analysis of Variance may be done in respect of each element of cost and sales:

1.Direct Material Variance

2.Direct Labor Variance

3.Overhead Variance

4.Sales Variance

Analysis of Variance

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Material Variances

(Standard Price x Standard Rate)(Standard Price x Standard Rate)- ( Actual quantity x Actual Rate )- ( Actual quantity x Actual Rate )

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Direct Materials Variances

There are two variances calculatedThere are two variances calculatedfor material cost variance.for material cost variance.

The The material quantity variance material quantity variance(also called the usage variance) is a(also called the usage variance) is a

measure of the amount of materials used.measure of the amount of materials used.

The The material price variance material price varianceis a measure of the cost to buy theis a measure of the cost to buy the

various materials that were purchased.various materials that were purchased.

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Material Variances

( Standard material price – ( Standard material price – Actual material price)Actual material price)

× Actual material quantity× Actual material quantity

( Standard material quantity –( Standard material quantity –Actual material quantity)Actual material quantity)

× Standard unit price× Standard unit price

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Direct Materials Variances

Again Material Qt variances can be Again Material Qt variances can be divided into two varaincesdivided into two varainces

The material mix varianceThe material mix variance..

The material Yield varianceThe material Yield variance

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Material Mix Variances

Standard Cost of Standard MixStandard Cost of Standard Mix – –Standard Cost of Actual MixStandard Cost of Actual Mix

Std. Unit cost (SQ – AQ)Std. Unit cost (SQ – AQ)

Actual weight do not differ

Page 44: Cost Accounting

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Material Mix Variances

Actual weight differ

Total wt. Of actual mix X Std. Cost Total wt. Of actual mix X Std. Cost - - Std. CostStd. Cost

Total wt. Of standard of Std. Mix of actual mixTotal wt. Of standard of Std. Mix of actual mix mixmix

Page 45: Cost Accounting

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Material Variances

Standard Rate (Actual Yield Standard Rate (Actual Yield ––Standard Yield )Standard Yield )

{If std. & actual mix are same}{If std. & actual mix are same}

Standard Rate = Std. Cost of Std. MixStandard Rate = Std. Cost of Std. Mix Net Std. OutputNet Std. Output (Gross output – Standard loss)(Gross output – Standard loss)

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Material yield Variances

{Standard Rate (Actual Yield {Standard Rate (Actual Yield ––Revised Standard Yield )Revised Standard Yield )

If std. & actual mix are not same}If std. & actual mix are not same}

Standard Rate = Std. Cost of Revised Std. MixStandard Rate = Std. Cost of Revised Std. Mix Net Std. OutputNet Std. Output (Gross output – Standard loss)(Gross output – Standard loss)

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Labor Variances

The labor cost variance is theThe labor cost variance is thedifference between actual cost of hourdifference between actual cost of hour worked and the standard cost allowed.worked and the standard cost allowed.

The labor rate variance is theThe labor rate variance is thedifference between the actual directdifference between the actual directlabor cost incurred and the standardlabor cost incurred and the standardcost for the actual hours worked.cost for the actual hours worked.

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St. Cost of labor – Actual cost of laborSt. Cost of labor – Actual cost of labor

Rate variance =Actual Time Rate variance =Actual Time Taken (Standard Rate Taken (Standard Rate ––Actual Rate)Actual Rate)

Labor Cost Variance

Labor Rate Variance

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Standard Rate (Standard time for actual Standard Rate (Standard time for actual Output - Actual time Paid for)Output - Actual time Paid for)

Total Labor Efficiency Variance

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Labor Variances

Total Labor efficiency variance are of two types

Labor Efficiency VarianceLabor Efficiency Variance

Labor Idle Time varianceLabor Idle Time variance

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Labor Variances

Labor Efficiency VarianceLabor Efficiency Variance

Labor Efficiency Variance = Standard rate(Standard time Labor Efficiency Variance = Standard rate(Standard time for actual output - Actual time worked)for actual output - Actual time worked)

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Labor Variances

Labor Idle Time variance = Abnormal Idle Time xLabor Idle Time variance = Abnormal Idle Time x Standard RateStandard Rate

Labor Idle Time varianceLabor Idle Time variance

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St. Cost of St CompositionSt. Cost of St Composition(Actual time taken)– Standard cost of actual (Actual time taken)– Standard cost of actual

Composition ( Actual time worked)Composition ( Actual time worked)

Labor Mix Variance

Labor Variances

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Standard Rate Standard Rate (Actual Yield –Revised (Actual Yield –Revised

Standard Yield)Standard Yield)

Labor Yield Variance

Labor Variances

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Overhead cost variance can be defined as the difference between the Standard cost allowed for the actual output achieved and the actual overhead cost incurred.

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Overhead :- According to terminology of cost Accountancy (ICWA London) Overhead is defined as “ The aggregate of indirect material cost, indirect wages (indirect Labor Cost) and indirect expenses.”

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Overhead Costs

• Overhead costs are significant for most organizations

Variable Overhead• Recall that variable overhead is allocated to

products and services using a budgeted variable overhead rate

Fixed Overhead• Recall that fixed overhead is allocated to products

and services using a budgeted fixed overhead rate

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Overhead Cost Variances

Variable Overhead Fixed Overhead

How theCost isPlanned

andControlled

How Costsare

Allocatedto

Products

Rs

Volume

Rs

Volume

Rs

Volume

Rs

Volume

Page 59: Cost Accounting

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Overhead cost Variance:-

Overhead Cost Variance

Variable overhead variance Fixed overhead variance

Expenditure Efficiency Expenditure Volumevariance variance variance variance

Capacity Calendar Efficiencyvariance variance variance

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Overhead Cost Variance :-

Overhead Cost Variance

( Actual output x Standard overhead Rate per unit )

– Actual overhead cost

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Overhead Cost Variances

Overhead Cost variancesvariances can be can be divided into two varaincesdivided into two varainces

1. Variable Overhead variance

..

2. Fixed Overhead variance

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Variable Overhead Variance

1. Variable Overhead variance

(Actual output x Standard variable overhead rate)

– (Actual variable overheads)

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Variable Overhead Variances

Variable Overhead variancesvariances can be can be divided into two variancesdivided into two variances

1. Variable Overhead Expenditure variance

..2. Variable Overhead Efficiency variance

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(A) Variable overhead (spending) expenditure

variance

= (Actual hours worked x standard variable

overhead rate) – Actual variable overheads

(B) Variable overhead efficiency variance

= Standard variable overhead rate(standard

Hours for Actual output – Actual Hours)

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2. Fixed overhead variance

Fixed overhead variance

(Actual output x standard fixed overhead rate)

– Actual fixed overheads

Fixed overhead variance can be categorized into:-

a) Expenditure variance = Budgeted Fixed overheads – Actual fixed overheads

b) Volume variance = actual output x Standard rate – Budgeted fixed overheads

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b) Capacity variance= standard rate( Revised Budgeted units – Budgeted units)

c) Calendar variance

= (Decrease or increase in number of units produced due to the difference of budgeted and actual days x standard rate per unit)

e) Efficiency Variance = Standard Rate (Actual Production – Standard Production)

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Using Standard Cost Variances

A performance report should be preparedA performance report should be preparedon a periodic basis for the managerson a periodic basis for the managers

who are responsible for thewho are responsible for thestandard cost variances.standard cost variances.

The management by exception conceptThe management by exception conceptwould then be used by the managerswould then be used by the managersto focus their attention on the mostto focus their attention on the most

significant cost variances.significant cost variances.

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Marginal Costing

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Marginal Costing:-

Chartered Institute of Management Accountant, England-

“Marginal costing is the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed cost and variable costs”.

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Features of Marginal Costing:

Cost is classified into :

Fixed Cost

Variable Cost•Variable cost is only charged to production•Fixed cost is recovered from contribution•Valuation of stock of WIP and F.G. is done on the basis of marginal cost.•Selling price is based on marginal cost and contribution•It is technique used to ascertain the marginal cost & to know the impact of V.C. on volume of output•Profit is calculated by deducting marginal cost and fixed cost from sales•C-V-P analysis is one of integral part of marginal costing

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Costs

• Fixed (Indirect/Overheads) – are not influenced by the quantity produced but can change in the long run e.g., insurance costs, administration, rent, some types of labour costs (salaries), some types of energy costs, equipment and machinery, buildings, advertising and promotion costs.

• Variable (Direct) – vary directly with the quantity produced, e.g., raw material costs, some direct labour costs, some direct energy costs.

• Semi-fixed – Where costs not directly attributable to either of the above, for example some types of energy and labour costs.

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Costs

• Total Costs (TC) = Fixed Costs (FC)+ Variable Costs (VC)

• Average Costs = TC/Output (Q)AC (unit costs) show the amount it costs to produce

one unit of output on average

• Marginal Costs (MC) – the cost of producing one extra or one fewer units of production

MC = TCn – TCn-1

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Revenue

• Total Revenue – also known as turnover, sales revenue or ‘sales’ = Price x Quantity Sold

• TR = P x Q

• Price – may be a variety of different prices for different products in the portfolio

• Quantity – Units sold

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Profit

Profit = TR – TC

• Normal Profit – the minimum amount required to keep a business in a particular line of production

• Abnormal/Supernormal Profit – the amount over and above the amount needed to keep a business in its current line of production

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Marginal Cost Equation

•Sales = Variable Cost + Fixed Cost + Profit/Loss

•Sales - Variable Cost = Fixed Cost + Profit/Loss

•Sales - Variable Cost = Contribution

Therefore,

Contribution = S.P. – V.C. or

Contribution = Fixed Cost + Profit

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Cost-Volume-Profit(CVP) Analysis

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Cost volume Profit Analysis

Cost volume Profit Analysis is a logical extension of marginal costing

• C.V.P. analysis examines the relationship of cost & profit to the volume of business to maximize profits

• Indicates direct relationship between volume & profit

• Indicates Indirect relationship between volume & cost per unit (Inverse)

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Cost-Volume-Profit Assumptionsand Terminology

1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold.

2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output.

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Cost-Volume-Profit Assumptionsand Terminology

3. When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range (and time period).

4. The unit selling price, unit variable costs, and fixed costs are known and constant.

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Abbreviations

SP = Selling price

VCU = Variable cost per unit

CMU = Contribution margin per unit

CM% = Contribution margin percentage

FC = Fixed costs

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Abbreviations

Q = Quantity of output units sold(and manufactured)

OI = Operating income

TOI = Target operating income

TNI = Target net income

Page 82: Cost Accounting

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Breakeven Point

SalesVariableexpenses

Fixedexpenses

– =

Total revenues = Total costs

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Break Even

• Point of No Profit and No Loss

• Occurs where Total Costs = Total Revenue

Fixed Costs• Break-Even Point = ---------------

Contribution

Page 84: Cost Accounting

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• Break even point ( Rs ) =Fixed Cost / P/V ratio

• Break Even point (Units) = Fixed Cost (Total)

-----------------------------

(S.P per unit – M.C per unit)

or( Contribution per Unit)

Cost-Volume-Profit Assumptionsand Terminology

•P/V Ratio = Profit / Sales•P/V Ratio = Contribution / Sales

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• Value of sales to earn desired amount of

profit:-

(Fixed Cost + Desired Profit)

------------------------------------------

P/ V ratio

Cost-Volume-Profit Assumptionsand Terminology

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•Variable Cost = Sales – (sales x P/V ratio)

•Profit= (sales x P/V ratio) – Fixed Cost

•Fixed Cost= (sales x P/v ratio) – Profit

•Margin of safety =

(Rs) = Profit/ P/V ratio or

= Actual sales – Break Even Sales

(Units) = Profit / Contribution per unit

Cost-Volume-Profit Assumptionsand Terminology

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Essentials of Cost-Volume-Profit(CVP) Analysis Example

Assume that the Furniture Shop can purchase Chairs for Rs32 from a local factory; other variable costs amount to Rs10 per unit.

The local factory allows the Furniture Shop toreturn all unsold Chairs and receive a full Rs32

refund per pair of Chairs within one year.

The average selling price per pair of Chairs is Rs70and total fixed costs amount to Rs84,000.

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Essentials of Cost-Volume-Profit(CVP) Analysis Example

How much revenue will the business receive if2,500 units are sold?

2,500 × Rs70 = Rs175,000

How much variable costs will the business incur?

2,500 × Rs42 = Rs105,000

Rs175,000 – 105,000 – 84,000 = (Rs14,000)

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Essentials of Cost-Volume-Profit(CVP) Analysis Example

What is the contribution margin per unit?

Rs 70 – Rs 42 = Rs 28 contribution margin per unit

What is the total contribution margin when2,500 pairs of Chairs are sold?

2,500 × Rs 28 = Rs70,000

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Essentials of Cost-Volume-Profit(CVP) Analysis Example

Contribution margin percentage (contributionmargin ratio) is the contribution margin per

unit divided by the selling price.

What is the contribution margin percentage?

Rs28 ÷ Rs70 = 40%

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Essentials of Cost-Volume-Profit(CVP) Analysis Example

If the business sells 3,000 pairs of Chairs,revenues will be Rs 210,000 and contributionmargin would equal 40% × Rs 210,000 = Rs 84,000.

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Equation Method

Rs70Q – Rs42Q – Rs84,000 = 0Rs28Q = Rs 84,000

Q = Rs84,000 ÷ Rs28 = 3,000 units

Let Q = number of units to be sold to break even

(Selling price × Quantity sold) – (Variable unit cost× Quantity sold) – Fixed costs = Operating income

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Contribution Margin Method

Rs84,000 ÷ Rs28 = 3,000 units

Rs84,000 ÷ 40% = Rs210,000

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Graph Method

04284

126168210252294336378

0 1000 2000 3000 4000 5000

Units

$(00

0) Revenue

Total costs

Breakeven

Fixed costs

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Target Operating Income

(Fixed costs + Target operating income)divided either by Contribution margin

percentage or Contribution margin per unit

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Target Operating Income

Assume that management wants to have anoperating income of Rs 14,000.

How many pairs of Chairs must be sold?

(Rs84,000 + Rs14,000) ÷ Rs 28 = 3,500

What sales are needed to achieve this income?

(Rs84,000 + Rs14,000) ÷ 40% = Rs245,000

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Target Net Incomeand Income Taxes Example

Proof:Revenues: 4,822 × Rs70 Rs337,540Variable costs: 4,822 × Rs42 202,524Contribution margin Rs135,016Fixed costs 84,000Operating income 51,016Income taxes: Rs51,016 × 30% 15,305Net income Rs 35,711

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Alternative Fixed/Variable CostStructures Example

What is the new contribution margin?

Decrease the price they charge from Rs32 to Rs25 andcharge an annual administrative fee of Rs30,000.

Suppose that the factory the Chairs Shop is using toobtain the merchandise offers the following:

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Alternative Fixed/Variable Cost Structures Example

Rs70 – (Rs25 + Rs10) = Rs35

Contribution margin increases from Rs28 to Rs35.

What is the contribution margin percentage?

Rs35 ÷ Rs70 = 50%

What are the new fixed costs?

Rs84,000 + Rs30,000 = Rs114,000

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Alternative Fixed/Variable Cost Structures Example

Management questions what sales volumewould yield an identical operating income

regardless of the arrangement.

28x – 84,000 = 35x – 114,000

114,000 – 84,000 = 35x – 28x

7x = 30,000

x = 4,286 pairs of Chairs

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Alternative Fixed/Variable Cost Structures Example

Cost with existing arrangement= Cost with new arrangement

.60x + 84,000 = .50x + 114,000

.10x = Rs30,000 x = Rs300,000

(Rs300,000 × .40) – Rs 84,000 = Rs36,000

(Rs300,000 × .50) – Rs114,000 = Rs36,000

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102

.

Financial accounting income statementemphasizes gross margin.

Contribution income statement emphasizescontribution margin.

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Application Of Marginal Costing

1. Cost Control

2. Profit planning

3. Evaluation of performance

4. Decision Making

• Fixation of selling Price

• Key or limiting factors

• Make or Buy Decision

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•Selection of suitable product mix•Effect of change in price•Maintained a desired level of Profit•Alternative methods of Production•Diversification of Products•Closing down of activities•Alternative course of action•Level of activity planning

Application Of Marginal Costing

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Typical Relevant Costing Decisions

• One-Time-Only Special Order (Pricing)

• Make or Buy Decisions (Outsourcing)

• Opportunity Costs

• Product Mix Decisions under Capacity Constraints

• Add or Drop a Product Line or Customer

• Equipment Replacement Decisions

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One-Time-Only Special Order

Without WithOrder Order Difference

Volume 30,000 35,000 5,000

Relevant revenues Rs600,000 Rs655,000 Rs55,000

Relevant costs:Variablemanufacturing (225,000) (262,500) (37,500)

Incremental income Rs17,500

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Outsourcing and Make/Buy Decisions

Make Buy Difference

Relevant costs:Outside cost of parts Rs160,000 Rs160,000Direct materials Rs80,000 (80,000)Direct labour 10,000 (10,000)Variable overhead 40,000 (40,000)Fixed purchasing, receiving and setup overhead 20,000 (20,000)

Incremental differenceIn favour of making Rs10,000

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Outsourcing and Opportunity Costs

Make Buy

Relevant cost to make Rs150,000

Relevant cost to buy Rs 160,000

Opportunity cost:Profit forgone becauseCapacity cannot be usedto make another product 25,000

Total relevant costs Rs175,000 Rs160,000

• Opportunity cost considers the profits lost by not following the next best alternative course of action

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Product Mix Decisions Under Constraint

Snowmobile BoatEngine

Engine

Contribution margin per unit Rs240 Rs375Machine hours required per unit 2 5Contribution margin per

machine hour Rs120 Rs75

• If machine hours are constrained, maximize income by first producing as many snowmobile engines as can be sold and then shift production to boat engines

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Customer Profitability Analysis

Keep DropAccount Account Difference

Relevant revenue Rs1,200,000 Rs800,000Rs(400,000)

Relevant costs:

Cost of goods sold 920,000 590,000 330,000

Material-handling labour 92,000 59,000 33,000

Marketing support 30,000 20,000 10,000

Order/delivery 32,000 20,000 12,000

Decline in operating incomeif drop account Rs(15,000)