COM 112
MANAGEMENT ACCOUNTING - II
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Msharashtra
Copyright © Yashwantrao Chavan Maharashtra Open
University, Nashik.
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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Vice-Chancellor : Dr. M. M. Salunkhe
Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh
State Level Advisory Committee
Dr. Pandit Palande
Hon. Vice Chancellor
Dr. B. R. Ambedkar University
Muaaffarpur, Bihar
Dr. Suhas Mahajan
Ex-Professor
Ness Wadia College of Commerce
Pune
Dr. V. V. Morajkar
Ex-Professor
B.Y.K. College, Nashik
Dr. Mahesh Kulkarni
Ex-Professor
B.Y.K. College, Nashik
Dr. J. F. Patil
Economist Kolhapur
Dr. Ashutosh Raravikar
Director, EDMU,
Ministry of Finance
New Delhi
Dr. A. G. Gosavi
Professor
Modern College, Shivaji Nagar, Pune
Dr. Madhuri Sunil Deshpande
Professor
Swami Ramanand Teerth Marathwada
University, Nanded
Dr. Prakash Deshmukh
Director (I/C)
School of Commerce & Management
Y.C.M.O.U., Nashik
Dr. Parag Saraf
Chartered Accountant Sangamner
Dist. AhmedNagar
Dr. S. V. Kuvalekar
Associate Professor and
Associate Dean (Training)(Finance )
Dr. Surendra Patole
Assistant Professor
School of Commerce & Management
National Institute of Bank Management
Y.C.M.O.U., Nashik
Pune
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Author
Editor
Instructional Technology Editing &
Programme Co-ordinator
1) Dr. Mahesh A. Kulkarni
Prof. V. V. Morajkar
Research Guide,
10, Vidya Society, Shikhare Wadi,
BYK College of Commerce,
Nashik Road - 422 101.
Nashik - 422 005.
2) Dr. Suhas Mahajan
Research Guide,
Ness Wadia College of Commerce,
Pune - 411 001.
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Production
Shri. Anand Yadav
Manager, Print Production Centre
Y.C.M. Open University, Nashik - 422 222.
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
(First edition developed under DEC development grant)
First Publication
:
September 2015
Type Setting
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Cover Print
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Printed by
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Publisher
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CONTENTS
TOPIC 1 Budget and Budgetary Control
UNIT 1 Budget and Budgetary Control : Meaning and Objectives
1-12
1.0 Introduction 1.1 Unit Objectives 1.2 Budget and Budgetary Control 1.3
Objectives of Budgetary
Control 1.4 Advantages of Budgetary Control 1.5 Limitations of Budgetary Control 1.6 Scope of Budget
and Budgetary Control 1.7 Requirement of a Good Budgeting System 1.8 Procedure in Budget Preparation
1.9 Budgetary Control Process 1.10 Summary 1.11 Key Terms 1.12 Questions and Exercises
1.13 Further Reading
UNIT 2 Types of Budgets : Fixed and Flexible Budgets
13-34
2.0 Introduction 2.1 Unit Objectives 2.2 Types of Budget 2.3 Fixed and flexible Budget 2.4 Fixed
Budget 2.4.1 Meaning and Definition 2.5 Flexible Budget 2.5.1 Meaning and Definition 2.5.2 Distinction
between fixed budget and flexible Budget 2.5.3 Preparation of flexible Budget 2.5.4 Uses of flexible
Budget 2.5.5 Proforma of Flexible Budget 2.5.6 Illustrations 2.6 Summary 2.7 Key Terms 2.8 Questions
and Exercises 2.9 Further Reading
UNIT 3 Types of Budget : Functional Budgets
35-66
3.0 Introduction 3.1 Unit Objectives 3.2 Functional Budget 3.3 Purchase Budget 3.3.1 Illustrations 3.4
Production Budget 3.4.1 Illustrations 3.5 Production Cost Budget 3.5.1 Illustration 3.6 Sales Budget
3.6.1 Illustration 3.7 Summary 3.8 Key Terms 3.9 Questions and Exercise 3.10 Further Reading
UNIT 4 Types of Budget : Revenue, Cash and Master Budget
67-106
4.0 Introduction 4.1 Unit Objectives 4.2 Revenue Budget 4.2.1 Principal Budget 4.2.2 Secondary Budget
4.2.3 Summary Budget 4.3 Cash Budget 4.3.1 Necessity of cash Budget 4.3.2 Methods of Preparation
of Cash Budget 4.3.3 Proforma of Cash Budget 4.3.4 Illustrations 4.4 Capital Budget 4.5 Master Budget
4.5.1 Preparation of Master Budget 4.5.2 Format of Master Budget 4.6 Summary 4.7 Key Terms 4.8
Questions and Exercises 4.9 Further Reading
TOPIC 2 Marginal Costing and Break-Even Analysis
UNIT 5 Meaning, Concept of Marginal Costing
107-122
5.0 Introduction 5.1 Unit Objectives 5.2 Meaning of marginal Cost and Marginal Costing 5.2.1 Concept
of Marginal Cost 5.2.2 Concept of Marginal Costing 5.3 Features of Marginal costing 5.4 Difference
between Marginal Costing And Absorption Costing 5.5 Advantages of Marginal Costing 5.6 Limitations of
Marginal Costing 5.7 Illustrations 5.8 Summary 5.9 Key Terms 5.10 Questions Exercises 5.11 Further
Reading
UNIT 6 Fixed and Variable cost and Break-Even Analysis
123-158
6.0 Introduction 6.1 Unit Objectives 6.2 Fixed and variable cost 6.3 Determination of Marginal cost
(SVOHES) 6.4 Contribution 6.5 Break Even Analysis 6.5.1 Meaning and Definition of Break Even point
6.5.2 Determination of Break Even point 6.6 Illustrations 6.7 Summary 6.8
Key Terms
6.9
Questions Exercises 6.10 Further Reading
UNIT 7 Break-Even Chart and P V Ratio
159-208
7.0 Introduction 7.1 Unit Objectives 7.2 Break Even Chart : A graphic Presentation 7.3 The Profit Graph/
Profit Volume Graph 7.4 Assumptions of Break - Even Analysis 7.5 Usefulness of Break - Even Analysis
7.6 Limitations of Break- Even Analysis 7.7 Margin of Safety 7.8 Profit Volume Ratio 7.9 Limiting Factor
7.10 Marginal Cost Equations 7.11 Illustrations 7.12 Summary 7.13 Key Terms 7.14 Questions Exercises
7.15 Further Reading
TOPIC 3
Standard Costing
UNIT 8 Concept of Standard Costing
209-224
8.0 Introduction 8.1 Learning Objectives 8.2 Concept of Standard Costing 8.3 Establishment of Cost
Standards & Desired Behaviour 8.4 Steps Involved in Standard Costing 8.5 The Standard Costing System
8.5.1 The Standard Costing system 8.6 Cost Control using Standard Costing 8.7 Advantages of Standard
Costing 8.8 Limitations of Standard Costing 8.9 Summary 8.10 Key Terms 8.11 Questions Exercises
8.12
Further Reading
UNIT 9 Variance Analysis : Material Variance
225-246
9.0 Introduction 9.1 Unit Objectives 9.2 Classification of Variances 9.3 Material Variance 9.3.1 Material
Price Variance 9.3.2 Material usage Variance 9.4 Material Cost Variance 9.5 Illustrations 9.6 Summary
9.7 Key Terms 9.8 Questions Exercises 9.9 Further Reading
UNIT 10 Variance Analysis : Labour Variance
247-264
10.0 Introduction 10.1 Unit Objectives 10.2 Labour Variance 10.2.1 Labour Rate Variance 10.2.2 Labour
Efficiency Variance 10.2.3 Labour Cost Variance 10.2.4 Labour Mix Variance 10.2.5 Labour Idle Time
Variance 10.2.6 Labour Yield Variance 10.3 Illustrations 10.4 Summary 10.5 Key Terms 10.6 Questions
and Exercises 10.7 Further Reading
UNIT 11 Variance Analysis : Overhead Cost Variance
265-288
11.0 Introduction 11.1 Unit Objectives 11.2 Overhead Cost Variance 11.2.1 Classification of Overhead
Variances 11.3 Overhead Cost Variance 11.4 Variable Overhead Variance 11.4.1 Illustrations 11.5
Fixed Overhead Variance 11.6 Managerial Uses of Variances 11.7 Summary 11.8 Key Terms 11.9
Questions and Exercises 11.10 Further Reading
UNIT 12 Responsibility Accounting
289-316
12.0 Introduction 12.1 Learning Objectives 12.2 Meaning of Responsibility Accounting 12.3 Objectives
and Structure of Responsibility Accounting as a Divisional Performance Measurement 12.3.1 Measurement
of Performance 12.3.2 Reporting to Different Levels of Management 12.3.3 Objects of Reporting 12.3.4
Purposes and Characteristics of Responsibility Reporting 12.3.5 Important Assumptions 12.4 Benefits of
Responsibility Accounting System 12.5 Limitations of Responsibility Accounting 12.6 Types of Responsibility
Centres 12.6.1 Cost/ Expenses Centres 12.6.2 Profit Centre 12.6.3 Investment Centre 12.7 Illustrations
12.8 Summary 12.9 Key Points 12.10 Questions and Exercises 12.11 Further Reading
INTRODUCTION
This book of self-instructional material is based on the syllabus for the subject
“Management Accounting” (COM 112). This book is written as per the revised
syllabus prescribed for M.Com. Part I students of Yashwantrao Chavan
Maharashtra Open University, Nashik from June, 2015. We do hope that this
book will definitely help to meet the emmerging and growing requirements of
distance education students of Management Accounting from the school of
commerce. This book adopts a moderate and novel approach towards the study
of Management Accounting in view with the specific and upcoming requirements
of the readers and practitioners of this subject.
All the topics included in the revised syllabus are explained in simple but apt
language. Equal stress is also given for necessary basic accounting theories and
wide variety of practical problems. Authors have taken appropriate care to
incorporate basic management accounting concepts, accounting control techniques
and tabular representation of classified accounting statements and reports. Proper
emphasis has also being given on graphical presentation to simplify the accounting
theories and modern practices. This book has been designed to serve as a self
sufficient text for M. Com students. Never-the-less, we do not rule out the
possibility of certain shortcomings or miss-prints still remaining, we will greatful to
the reader if such errors are pointed out from time to time. Any criticism or valuable
suggestions for further improvement of this book will be greatfully acknowledged
and highly appreciated.
The authors have also kept in mind the fact that the students concerned are
the distance education students spread over a large territory, different enviornment
and do not have regular interaction with the teachers. Therefore authors have
taken utmost efforts to simplify the matter without affecting scientific quality and
precision.
The editor and authors are greatful to the authorities of YCMOU for
guidence and co-operation.
Editor
Authors
TOPIC 1
Budget and Budgetary Control
UNIT 1
Budget and Budgetary Control :
Meaning and Objectives
UNIT 2
Types of Budgets : Fixed and
Flexible Budgets
UNIT 3
Types of Budget : Functional Budgets
UNIT4
Types of Budget : Revenue,
Cash and Master Budget
UNIT1
Budget and Budgetary Control :
Meaning and Objectives
Budget & Budgetary Control
: Meaning & Objectives
Structure
NOTES
1.0
Introduction
1.1
Unit Objectives
1.2
Budget and Budgetary Control
1.3
Objectives of Budgetary Control
1.4
Advantages of Budgetary Control
1.5
Limitations of Budgetary Control
1.6
Scope of Budget and Budgetary Control
1.7
Requirement of a Good Budgeting System
1.8
Procedure in Budget Preparation
1.9
Budgetary Control Process
1.10 Summary
1.11 Key Terms
1.12 Questions and Exercises
1.13 Further Reading
1.0
Introduction
Managerial control becomes essential in case of public limited companies
and Government undertakings which are run by hired managerial personnel with
little interest in the results of such enterprises. The proprietors have, therefore, to
think of a device which may encourage the management to work with greater
care and caution to serve the interests of all by optimising the use of investments
in the form of man, money, machines and materials. Budgeting is one such device
which helps the management to understand the business programmes in their
right perspective and take steps to achieve the business objectives.
Budgeting means planning for future. It involves the preparation of
departmental budgets, budgetary control and related issues. The Budgetary
Control is concerned with the management of business activities with the help of
budgets. In this way, budgets serve as a control device.
Management Accounting - II
1
Budget & Budgetary Control
: Meaning & Objectives
1.1
Unit Objectives
After going through this unit you will be able to :
NOTES
•
Understand the concept of Budget and Budgetary control.
•
Describe the objectives of Budgetary control.
•
Appreciate the advantages of Budgetary control.
•
Identify the scope and limitations of Budgetary control.
•
List out requirements of good Budgetary system.
•
Workout procedure in Budget preparation.
•
Identify Budgetary control process.
1.2
Budget And Budgetary Control
A Budget is a plan which relates to a definite period of time and which is
expressed in quantitative terms. It is thus a predetermined statement which
incorporates the policy of the management during a given period and serve as a
standard for comparing the actual results. Thus, a Budget is a tool in the hands
of the management which serves as a guide to all the employees in achieving
their goals objectives and targets.
A Budget helps in planning and co-ordination with all the employees and
departments, but the most important factor is that it is used for control purpose at
all levels of management.
Difference between Budget and Budgetary Control :
There is a difference between Budget and Budgetary Control. As we have
seen, a Budget is a quantitative statement prepared in advance and keeping it as
the base, the actuals are compared. Budgetary Control on the other hand means
use of the budgets. Thus, Budgetary Control involves use of the budgeting
techniques to help the management for carrying out the various functions viz.
Planning, Organising, Co-ordinating and Controlling the activities of a business.
The Budgetary technique includes :
(i)
Establishment of Budgets for each department.
(ii)
Variance Analysis is done for taking suitable action.
(iii)
To see that the mistake of the past are not repeated in future.
(iv)
Comparing the budgets with the actual which is known as Variance.
According to ICMA, England, Terminology, a Budget is “a financial
and/or quantitative statement, prepared and approved prior to a defined period of
2
Management Accounting - II
time of the policy to be pursued during that period for the purpose of attaining a
given objective”.
Budgetary Control is defined by ICMA, England Terminology as “the
establishment of budget relating to the responsibilities of executives to the
requirements of a policy and the continuous comparison of actual with the budgeted
results, either to secure by individual action the objectives of that policy, or to
provide a basis for its revision”.
1.3
Budget & Budgetary Control
: Meaning & Objectives
NOTES
Objectives Of Budgetary Control
Generally Budgetary Control is concerned with three aspects viz. planning,
co-ordination and control. All these factors depend on each other and hence we
cannot isolate them.
(i)
Planning : A Budget is nothing but a plan. Without planning any modern
business cannot function, planning is related to production sales, stocks, requirement
of labour, etc. The advantage of planning is to anticipate the problems before
hand. Planning through budgetary control is necessary at all levels of management
there is the process of thinking which enables to provide new ideas to the
management.
(ii) Co-ordination : It means co-operation by the different people in the
organisation to achieve the common goal. To have co-ordination, there should be
proper communication. Communication can be through the budgets. Planning helps
co-ordination and hence if the planning is good, there is effective co-ordination. A
detailed Budgetary control system is one where the plans are made and are
circulated to all the levels of management.
(iii) Control : It ensures that the goals of the management as stated in the
Budgetary control system have been achieved. For this purpose fixing of standards
is necessary. Thus, through the budgets the standards are fixed which enables the
management to control the activities so that the goals are achieved. Thus, through
budgetary control, it is possible to compare the standards with the actuals and the
analysis of the variances can made and corrective action taken wherever necessary.
It encourages research and development as budgetary control schedules are usually
based on past experiences.
1.4
Check Your Progress
How, Budgetary Control is
concerned with
(i) Planning
(ii) Co-ordination &
(iii) Control.
Advantages Of Budgetary Control
(i)
It locates the inefficient areas and persons in the business.
(ii)
It helps to increase the efficiency, reduce wastages and control costs.
(iii)
It helps to co-ordinate the activities of the various employees, departments
and thus helps to achieve the goal of the management.
(iv)
With the help of budgeting, the responsibilities of the managers can be fixed
Management Accounting - II
3
Budget & Budgetary Control
: Meaning & Objectives
NOTES
for planning, so that they can think ahead, anticipate and be prepared to
meet the challenges ahead.
(v)
Maximisation of profits is possible through budgeting.
(vi)
It helps to introduce the standard costing technique.
(vii)
It helps to ensure cash flow and hence bank credit can be obtained.
(viii) It creates cost consciousness in the minds of all the employees in the
organisation.
(ix)
Authority can be delegated and responsibilities fixed.
(x)
It rewards the efficient workers and the managers can show their efficiency
by achieving the goals fixed by the management through the budgets.
(xi)
It ensures that the capital of the firm is utilized in a proper way and that
there is no misutilization of funds.
(xii)
Vital decisions can be taken by the management based on the budgets.
(xiii) Actual results can be compared with the budgets so that corrective action
can be taken in time.
(xiv) It is like a barometer which enables us to study the changes in the business
conditions.
1.5 Limitations of Budgetary Control
Though there are many advantages of Budgetary Control System, it suffers
from many defects also. Hence, the persons using the budgets should be very
careful and should be fully aware of the limitations. The following are certain
important limitations.
(i)
Budgetary control does not replace management : It cannot replace
the management because in business all vital decisions have to be taken by the
management.
(ii) Too much reliance on budgets is harmful : Budgetary control is only a
technique and tool in the hands of the management. To execute the budget, all the
employees must take active part and co-operate with each other so that the
budgetary goal can be achieved. But the budgets should not be taken as the only
means through which the business should run. Though sometimes, through
budgetary control it is possible to have utmost success in business, it should not be
depended upon it totally.
(iii) Less flexibility : A Budgetary control system should be more flexible and
should be changed according to the changing circumstances. The alternative
systems should be added, deleted, improved, replaced or compared with the present
system of budgetary control.
4
Management Accounting - II
(iv) Budgets are based on estimated figures : Budgets are prepared in
anticipation of various factors. These factors are estimated by knowing the past
and forecasting for the future. Hence, forecasting is done which may or may not
happen in actual life. Thus, it is not an exact prediction of figures, but based on
estimates.
(v) Costly system : The installation of the system and its execution is expensive
affair. This is because specialized persons have to be appointed and extra costs
have to be incurred for carrying out the operations. Hence, small scale units cannot
go in for budgetary control system.
Budget & Budgetary Control
: Meaning & Objectives
NOTES
(vi) Budgetary control deals with quantitative data only : In budgetary
control system, only the figures are considered and hence the quantitative data
i.e. the facts are not considered. e.g. if a worker is inefficient, were should analyse
the various reasons for his inefficiency as he may be inefficient because of the
conditions or environment where the works are not suitable to his health. Here
budgets are of no use because, budgets will only measures his efficiency in terms
of quantity produced and will not considered other factors.
1.6
Scope Of Budget And Budgetary Control
Normally, a budget statement is expressed in both the terms-currency and
quantitative units. Currency refer to the cost or value and quantity refers to the
activity level or volume of function. Certain budgets can be expressed only in
currency as the function cannot be quantified. A budget is a statement of estimated
performance for a specific period of time. The natural means of performances
evaluation is the comparison between the ideas and the actual. Here, the ideas
are the budgeted or standard specifications which are set before the budget period
begins. So the actual performance is compared with the standard performance
and such comparison gives and idea about the degree of success as a result of the
actual performance. The scope of budgetary control is very wide and broad based
and it includes within its fold, a variety of aspects of business operations. The
scope of budgetary control extend to cover the operation of a department of the
whole organisation. e.g. budgets are prepared for production department, selling
and distribution department, purchase department, research and development
department etc. and also for the whole company. Therefore, budgetary control is
more extensive in tis scope. Budgetary control can be applied over to a part of the
business. Budgetary control system can be operated without standard costing.
Budgetary Control system involve the following steps :
(i)
Preparation of various types of budgets i.e. :
(a)
According to Time :
(i)
Long-term
(ii) Short-term
(iii) Current Budget
Management Accounting - II
5
Budget & Budgetary Control
: Meaning & Objectives
(b)
On the Basis of Flexibility :
(i)
Static or Fixed Budgets
(ii) Flexible or Variable Budgets
(c)
NOTES
According to Functions :
(i)
Purchase
(ii) Production
(iii) Production Cost
(iv) Sales
(v) Cash
(vi) Labour
(vii) R & D
(vii) Overhead
(ix) Capital Expenditure Budget
(x) Master Budget
(d)
Management Control Instruments :
(i)
Programme Budgeting
(iii) Revenue Budgets and
Check Your Progress
Why budgetary control is
described as “forwarding
costing” ?
(ii) Performances Budgeting
(iv) Zero Base Budgeting.
(ii)
Measurement of actual performance at the end of the budget period.
(iii)
Comparison of actual performance with the budgetary performance to find
out whether the company has achieved the target set in the budget.
(iv)
Analysis of the reason for not achieving the target so that remedial measures
may be taken.
Budgetary control is largely a matter of management action which is taken
on the basis of information on variances. It could be described as ‘forwarding
costing’, establishment of budgets and then their application with a view to
monitoring and controlling the activities of a concern.
In recent years, there have been some notable changes in the concept and
techniques of budgets. These are zero base budgeting and performance budgeting.
These approaches are particularly useful in government and non-profit organisations
where benefits cannot be traced to the costs.
6
Management Accounting - II
1.7
Requirement of A Good Budgeting System
Budget & Budgetary Control
: Meaning & Objectives
The following are the requirements of a good budgeting system.
(i)
Sound Organisation : A good organisation is absolutely necessary to carry
out the plans and policies of the management. It means that the organisational
structure should be such that each one knows what the management expects
from him and also his responsibilities.
(ii)
Cost Factor : The cost benefit analysis should be made before the budget
is introduced. It means that the cost of operation of the budget should be
less than the benefits derived out of it.
(iii)
Interpersonal Relationship : The management should develope
interpersonal relationship, which means that the management should be
able to know the personal difficulties of the executives and managers in
implementing the budgets. This will ensure that the budget is not imposed
on anyone without studying his ability to undertake the responsibility.
(iv)
Systematic Accounting Systems : It is necessary so that the management
can hold the concerned person responsible in the organisation in terms of
monetary consideration. Accountability should be clearly mentioned.
(v)
High Profits : The main aim or goal of the management should be to earn
maximum profits and this factor should be kept in mind while preparing the
budget.
(vi)
Goals Should be Achievable : The management should fix the goals in
such a way that they should be attainable, otherwise there will be confusion
in the organisation.
NOTES
Check Your Progress
Identify various requirements
of a good budgeting system.
(vii) Constant Review : Constant review of the performance should be made
to evaluate the actual results as compared with the budgets so that corrective
action can be taken at the right time.
(viii) Fixing of Responsibilities and Preparation of Budget : It should be
noted that the person who will execute the budget should be made responsible
for the preparation of it.
(ix)
Budget Committee : A budget committee is necessary to carry out the
policies effectively so that the committee consisting of the directors and the
executives of various departments are responsible for its implementation.
(x)
Involvement of Top Management : Unless the top management
co-operates in implementing the budget in true spirit, the budgetary control
system cannot be successfully implemented. It means that the top
management should carry out the plans and policies as laid down in the
budget strictly.
Management Accounting - II
7
Budget & Budgetary Control
: Meaning & Objectives
1.8
Procedure In Budget Preparation
When control through budgets is desired the budgetary control organisation
has to be busy with the following preliminaries.
NOTES
(i)
Establishment of budget centres
(ii)
Preparation of an organisation chart
(iii)
Preparation of adequate accounting records
(iv)
Formation of Budget Committee
(v)
Preparation of budget manual
(vi)
Fixation of budget period
(vii)
Determination of governing factors.
(i)
Establishment of Budget Centres : A budget centre is a section of the
organisation of an undertaking defined for each of which a budget will be set with
the help of the head of department concerned e.g. labour budget, production cost
budget etc. by the accountant in conjunction with production managers and other
executives.
(ii) Preparation of an Organisation Chart : An organisation chart when
property drafted will show the functional responsibilities of each member of
management and ensure that he knows his position in the organisation and his
relationship to other members. The organisation chart may have to be adjusted to
ensure that each centre is controlled by an appropriate member of the staff. The
Figure 5.1 shows the specimen of organisational chart for implementation of
budgetary control system.
Check Your Progress
Chief Executive Officer (CEO)
Explain an organisational
chart for implementation of
budgetary control system.
Budget Officer
Personnel
Purchase
Production
Financial
Sales
Manager
Manager
Manager
Manager
Manager
• Labour Budget • Purchase Budget • Material Budget • Financial Budget • Sales Budget
(Human Resource
• Production Budget• Capital Expenses •Advertisement
Budget)
• Plant Utilisation • Production Cost Budget
Budget
• Administrative
• Selling and
Cost Budget
Distribution
• Master Budget
8
Management Accounting - II
Fig. 1.1 : Organisational Chart
Cost Budget
(iii) Preparation of Adequate Accounting Records : It is essential that the
accounting system should be able to record and analyse the transactions involved
a “accounts code “ should be maintained which may be linked with the budget
centres for establishments of budgets and finally control through budgets.
(iv) Formation of Budget Committee : In small sized organisations a budget
officer may establish budget and co-ordinate all the work involved, but in large
organisations a budget committee consisting of chief executive, budget officer
and heads of departments or budget centres, is established. The main functions
of a budget committee are as follows :
•
To accept and scrutinise all budgets.
•
To decide over all policy to be followed.
•
To suggest revision of functional budgets, where necessary.
•
To approve finally revised budgets.
•
To receive and deal with budget and comparison statements.
•
To recommend action to be taken under the different situations.
Budget & Budgetary Control
: Meaning & Objectives
NOTES
(v) Preparation of Budget Manual : A budget manual is a document setting out
the responsibilities of the persons engaged in the routine of and the forms and
records required for, budgetary control. A budget manual helps in standardising
methods and procedures and the risk of overlapping of functions is eliminated.
(vi) Fixation of Budget Period : A budget period is the period of time for which
a budget is prepared and employed. Except in case of Capital Expenditure Budget,
the budget period is generally the accounting year sub-divided into four quarters
or twelve months.
(vii) Determination of Governing Factors : A governing factor or key factor
or principal budget factor is that factor the extent of whose influence must be
assessed first in order to ensure that functional budgets are reasonably capable of
fulfilment. The key factor serves as a staring point for preparation of budget.
Generally, sales become the key factor, but other factors of production, such as
men, material, machine, capital etc. may also be factors.
1.9
Budgetary Control Process
The top management appoints an officer to supervise and guide the Budget
Committee in the discharge of its functions. This officer is various designated as
Budget Officer, Budget Director, Co-ordinator or Budgetary Controller in different
organisations. He is generally a controller a chief accountant well versed with
accounting and budgeting matter. The budgetary controller is attached to the chief
executive to whom he is accountable in matters of budgeting. He is expected to
performance the following functions:
(i)
To call meetings of the departmental heads and educate them in the
Check Your Progress
What type of functions the
budgetary controller has to
perform in budgeting ?
Management Accounting - II
9
Budget & Budgetary Control
: Meaning & Objectives
NOTES
mechanism of budgeting.
(ii)
To prepare budget programme and budget schedules.
(iii)
To develope necessary forms for the preparation of budgets and other
reports.
(iv)
To review and maintain budget manual.
(v)
To co-ordinate the efforts of departmental heads who are involved in budget
preparation.
(vi)
To act as the secretary or co-ordinator of Budget committee and guide its
functioning.
(vii)
To prepare summary budgets for the consideration of the Budget Committee.
(viii) To get the budgets approved by the Board of Management before they are
passed on to the departmental heads for execution.
(ix)
To consider the proposals of the departments in the Budget Committee.
(x)
To conduct special studies needed for the preparation and finalization of
budgets. It should be noted that the functions of the Budget Committee and
that of Budgetary Controller are not different. In fact, the functions of
Budget of his functions through the Budget Committee. However, the
budgetary controller is responsible and accountable to management for the
smooth functioning of the Budgetary control system. He seeks the instructions
of the Board which formulates Budget policies and set business objectives.
1.10 Summary
• Budget : A budget is a plan which relates to a definite period of time and which
is expressed in quantitative terms. Budget is a tool in the hands of management
which serves as a guide to all the employees in achieving their goals, objectives
and target.
• Budgetary control : Budgetary control involves use of the budgeting techniques
to help the management for carrying out the various functions viz. planning,
organising co-ordinating and controlling the activities of a business.
• Objectives of Budgetary Control : Generally, Budgetary control is concerned
with three aspects viz. planing, co-ordination & control.
• Scope of Budgetary control : The scope of budgetary control extend to cover
the operation of a department of the whole organisation. Budgetary control is
more extensive in its scope. Budgetary control can be applied over to a part of
the business.
• Requirement of a good budgetary system :
10 Management Accounting - II
(i) Sound organisation (ii) Cost factor (iii) Interpersonal relationship (iv) Systematic
accounting system (v) High profit (vi) Goals shall be achievable (vii) Constant
review (viii) Fixing of responsibility and preparation of Budget. (ix) Budget
committee (x) Involvement of top management
Budget & Budgetary Control
: Meaning & Objectives
• Procedure in Budget preparation :
(i) Establishment of Budget centre (ii) Preparation of an organisation chart (iii)
Preparation of Adequate accounting Record (iv) Formation of Budget committee
(v) Preparation of Budget manual (vi) Fixation of Budget period (vii) Determination
of governing factors.
NOTES
1.11 Key terms
(1) Budget : A financial and /or qualitative statement prepared and approved
prior to a defined period of time the policy to be persued during that for the purpose
of attaining a given objective.
(2) Budget centre : It is a section of the organisation of an undertaking
defined for the purpose of budgetory control.
(3) Budget manual : It is document which set out the responsibilities of the
period engaged in, the routine of , and the forms and records required for budgetory
control.
(4)
Budgeting : It is the ultimate process of building up the specific budget.
1.12 Questions And Exercises
I - Objective questions
A)
Multiple choice questions
(1)
The first in preparing a budget is ....forecast.
(a) sales, (b) cash, (c) production, (d) purchase
(2)
A section of an organisation of an undertaking defined for the purpose of
budgetory control is a budget.....
(a) comittee, (b) centre, (c) manual, (d) programme
(3)
Budgetory control helps to introduce the technique of .....
(a) uniform costing , (b) target costing, (c) standard costing, (d) productivity
costing
(4)
Budgeting is simply a process of .....planning.
(a) systematic, (b) action, (c) scientific, (d) profit
Ans : (1-a), (2-b), (3-c), (4-d)
Management Accounting - II
11
Budget & Budgetary Control
: Meaning & Objectives
NOTES
II - Long answer questions
(1)
What is ‘Budget’? How it differs from Budgeting and Budgetory control ?
(2)
Define the concepts, a) Budget, b) Budgeting, and c) Budgetory control .
(3)
Differentiate clearly between Budget and Budgetory control.
(4)
What is ‘budgetory control’ ? Explain the advantages and limitations of
system of Budgetory control.
(5)
Define ‘Budget’. Explain in brief the scope of Budget and Budgetory control.
(6)
What do you understand by ‘Budgetory control’ ? State the requirements
of a good budgeting system.
(7)
Explain necessary steps involved in the preparation of a Budget.
(8)
Explain the following terms :
a) Budget centre, b) Organisation chart, c) Budget committee, d) Budget
manual, e) Budget period
(9)
State the functions to be performed by the Budgetory controllar.
1.13 Further Reading
12 Management Accounting - II
•
Bhar B.K. - Cost Accounting methods and problems - Kolkata- Academic
Publishers -2012
•
Jawahar Lal - Cost Accounting - New Delhi- Tata McGraw-Hill Publishing
co. ltd.-2010
UNIT 2 Types of Budgets : Fixed and
Flexible Budgets
Types of Budgets :
Fixed & Flexible Budgets
Structure
2.0
Introduction
2.1
Unit Objectives
2.2
Types of Budget
2.3
Fixed and flexible Budget
2.4
Fixed Budget
2.4.1
2.5
Meaning and Definition
Flexible Budget
2.5.1
Meaning and Definition
2.5.2
Distriction between fixed Budget and Flexible Budget
2.5.3
Preparation of Flexible Budget
2.5.4
Uses of Flexible Budget
2.5.5
Proforma of Flexible Budget
2.5.6
Illustrations
2.6
Summary
2.7
Key Terms
2.8
Questions and Exercises
2.9
Further Reading
2.0
NOTES
Introduction
Planning is the key of success of any organisation. A budget is merely a
plan expressed in quantitative terms. So it can be assumed that a budget is a plan
and “can be regarded as the statement of what an account is expected to look like
after the events that have been planned for a given period of time”. It is very
useful for keeping control on all departments; accordingly it keeps the departments
together harmoniously.
According to time budgets can be of three types viz (i) Long Terms Budgets,
ii) Short-term budgets and (iii) Current Budgets. On the basis of flexibility, budgets
are classified in to two categories, viz (i) Fixed Budget and (ii) Flexible or Variable
Budget.
Short-term budgets are prepared mainly for the purposes of exercising
Management Accounting - II
13
Types of Budgets :
Fixed & Flexible Budgets
NOTES
effective control on the other hand, long term budgets are concerned with long
term planning activities such as plant expansion, huge amount of capital expenditure,
research and development programme, new product promotional activities etc.
Fixed Budget is one which rigidly specifies the targets for a particular level of
activity. Flexible Budget is one which permits the change in accordance with the
changes in the level of activity.
2.1
Unit objectives
After going through this unit you will be able to :
•
Describe various types of Budgets
•
Classify the Budgets in to different categories
•
Explain the concept of Fixed Budget
•
Explain the concept of Flexible Budget
•
Prepare Flexible Budget
•
Distinguish between Fixed and Flexible Budget
2.2
Types Of Budgets
Classification of budget can be shown with the help of Figure 2.1 as follows:
Check Your Progress
Budget
Explain the classification of
budget with the help of chart.
According to
On the basis of
According to
Management
Time
Flexibility
Functions
Control
Instruments
•Long-Term Budget •Static or Fixed Budget •Purchase Budget
•Progamme Budgeting
•Short-Term Budget •Flexible or Variable
•Production Budget •Performance
•Current Budget
•Production Cost
Budgeting
Budget
•Zero Base Budgeting
•Sales Budget
•Revenue Budget
Budgets
•Cash Budget
•Labour Budget
•R & D Budget
•Overhead Budget
•Capital Expenditure Budget
•Master Budget
14 Management Accounting - II
Fig. 2.1 : Classification of Budget
Budgeting in an undertaking may be done for a particular segment or it may
cover all the activities depending upon the need and resources of the enterprise.
The large scale business enterprises prepare different types of budgets covering
almost all activities where control is desired. In order to understand the nature of
budgets, it is desirable to know their classification which is usually done on time,
functions and flexibility basis.
According to time, budgets can be of three types viz. (i) Long-term budgets
(ii) Short-term Budgets, and (iii) Current Budgets. Long-term budgets are concerned
with planning activities for a long-period-a period of five to ten or more years
whereas short-period budgets cover a period of one two years. Current budgets
relate to the current period within a short-period of one year. An yearly budget is
generally broken on monthly, quarterly or half yearly basis for effective
implementation of the same.
Types of Budgets :
Fixed & Flexible Budgets
NOTES
According to functional classification, a budget relates to a particular activity
which can be a selling, production, purchasing or any other activity. The budgets
prepared according to functions are known as functional budgets. The popular
functional budgets prepared in a large scale enterprise are :
(i)
Sales Budget
(ii) Production Budget
(iii)
Purchase Budget
(iv) Capital Expenditure Budget
(v)
Overhead Cost Budgets
(vi) Cash Budget
(vii)
Research and Development Budget
Check Your Progress
How many types of functional
budgets you know ?
(viii) Production Cost Budget
(ix)
Labour Budget
(x) Master Budget
On the basis of flexibility, budgets are grouped into two categories, viz.(i)
Fixed budget, and (ii) Flexible or Variable budget.
Budget as management control instrument can be classified as programme
budgeting, performance budgeting, zero base budgeting and revenue budgets.
Budgetary Control Organization :
Budgets provide relevant control information to the management for future
decisions and actions. With the budgetary system in existence, control of
performance and evaluation of results become more purposeful and goal-oriented.
The budgetary system should be organised for maximising the benefits of such a
system. A budget centre is invariably located without the framework of the
organisation. Budget centre must be clearly demarcated to facilitate the formulation
of various budgets with the help of the heads of the departments concerned. A
chart of accounts in conformity with budget centres should be maintained so as to
facilitate recording and analysis of information required for the operation of the
‘feedback’ for the management. An organisation chart highlighting the functional
responsibilities of each member of the management team helps a member to
know his position in the organisational hierarchy vis-a-vis his relationship to other
members. Each official in the organisation knows precisely whom he should obey
and whom he can command in the day-to-day administration.
Management Accounting - II
15
Types of Budgets :
Fixed & Flexible Budgets
2.3
Fixed and Flexible Budgets
On the basis of flexibility, budgets are classified into two categories i.e.
static or fixed budgets and flexible or variable budgets.
NOTES
Check Your Progress
Distinguish between Fixed
Budget and Flexible Budget in
brief.
A Fixed Budget is one which rigidly specifies the targets for a particular
level of activity. The targets are not revised during the budget period, irrespective
of the fact that the actual level of activity attained is much different from the
budgeted figure. Consequently, the variances are violent and it becomes difficult
to isolate the reasons for variances due to change in the level of activity. Fixed
Budgets can serve the purpose only if the budgets can be prepared with high
degree of accuracy and budget period is short because the forecast for short
period can be made with responsible degree of accuracy. On the other hand, a
Flexible Budget is one which permits the change in accordance with the changes
in the level of activity. According to Flexible Budgeting, budgets for different
levels of activity are prepared and the management enjoys the benefit of adopting
any one of them according to changes in the attainment of the level of activity.
Thus, the Flexible Budget has a series of fixed budgets for different levels of
activity. It is always preferable to prepare flexible budget particularly, when the
economic conditions frequently change and it is difficult to forecast with any fair
degree of accuracy.
2.4
Fixed Budget
2.4.1 Meaning And Definition
Fixed Budgets are prepared for only one level of activity under the same
conditions. It is unchangeable, is drawn on the assumption that the level of activity
will remain the same. Hence, the changes in the expenses due to changes in the
conditions are not provided for in this budget. Thus, a fixed budget becomes useful
when the actual level of activity is equal to the budgeted level of activity. However,
in real life, the level of activity and business conditions due to the internal constraints
as well as external factors like changes in the demand, price, shortage of materials,
cut in the electricity, etc. go on changing. Thus, a fixed budget is not that successful
because it does not consider the variable, semi-variable and fixed costs as separate
items and also does not consider change in costs due to the change in the level of
activity.
ICMA, London, defines Fixed Budget as, “a budget which is designed
to remain unchaged irrespective of the volume of output or turnover
achieved.”
The reasons why fixed budgets are not considered to be useful are given
below :
(i)
16 Management Accounting - II
In fixed budgets the manager becomes helpless as they cannot do anything
beyond the budget.
In case of Fixed Budgets, if the actual level differs widely as compared to
the fixed budget, we find large variances.
(ii)
In real life, we find that the cost of material, labour and overheads go on
changing. Hence, fixed budgets are not useful because these changes do
not have any effect on the budgeted figures.
(iii)
Since it is fixed in nature, it is not suitable for long-term planning.
2.5
Types of Budgets :
Fixed & Flexible Budgets
NOTES
Flexible Budget
2.5.1 Meaning And Definition
A Flexible Budget is one which is designed to change, according to the level
actually achieved. The budgeted figures can be changed according to the changing
conditions. Hence, a Flexible Budget is just the opposite of a fixed budget. Thus,
it is more elastic, practical and useful in the real life. These budgets are prepared
for the purpose of cost control.
ICMA, London, Terminology defines a Fixed Budget as “one which
by recognising the difference between fixed, semi-fixed and variable costs,
is designed to change in relation to the level of activity attained”. Generally,
Flexible budget are prepared under the following situations :
(i)
Where the business depends upon some scarce material.
(ii)
Where the exact demand cannot be estimated, for e.g., in new business.
(iii)
Where the business depends upon nature, for e.g., rainfall.
(iv)
In some business, where the sales cannot be predicted.
(v)
Where sufficient labour force is necessary for running the business smoothly.
Management Accounting - II
17
Types of Budgets :
Fixed & Flexible Budgets
2.5.2 Distinction between Fixed and Flexible Budgets
Fixed Budget
NOTES
Flexible Budget
1.
It is prepared for a particular level 1.
of activity.
It is designed to change in
accordance with the level of
activity actually attained.
2.
It is prepared only one level of 2.
activity.
It is prepared for any level of
activity.
3.
It is static and does not change 3.
with the changes in the level of
activity attained.
It is variable and can change on the
basis of activity level to be
achieved.
4.
Here, costs are not classified 4.
according to behaviour.
Here, costs are classified according
to the behaviour i.e. fixed, variable
and semi variable.
5.
Formation of budget equation is not 5.
neccessary.
Budget equation is formed for each
and every cost.
6.
It is difficult to ascertain the cost 6.
under changing circumstances.
It is possible to ascertain cost at
different levels of activity.
7.
Fixation of price do not give a 7.
correct picture.
It facillitates fixation of selling
price.
8.
It has very limited use in controlling 8.
costs.
It is a more useful technique for
cost control.
9.
Tendering quotations do not give 9.
correct picture.
It helps a lot in tendering
quotations.
10. It is not useful for performance 10. It is useful for performanace
evaluation.
evaluation.
2.5.3 Preparation Of Flexible Budget
A Flexible Budget can be prepared in the following manner :
At first, a number of fixed budgets are prepared for each manufacturing
budget centre. Within the limits of these budgets, the flexible budgets are prepared.
In Flexible budgets, clear differences are drawn between fixed, semi-fixed and
variable costs.
There are three methods of preparing Flexible Budgets which are as follows
(a)
18 Management Accounting - II
Tabular Method :
In this method, a table is prepared wherein different capacities are
shown in horizontal columns and the budget, the budgeted figures are shown
against different capacities in the vertical columns. The expenses are
recorded as variable, semi-variable and fixed. Various capacity levels showing
different volumes of production are shown in the flexible budgets.
(b)
Charting Method :
In this method, the expense are analysed, according to their nature of
behavior i.e. variable, semi-variable and fixed. The budgeted expenses are
prepared and these are plotted on a graph paper against different levels of
activity. The budgeted expences relating to the level of activity actually
attained can be read from this chart.
(c)
Types of Budgets :
Fixed & Flexible Budgets
Ratio Method :
If the activities of a company are standardised and the expences are of
uniform nature, most of the expences can be worked out as a percentage
level of activity. The method is that the common cost are estimated. For the
normal production, i.e. the normal level of activity. From this we can work
out various ratios which show the relationships of each expenses with each
increase in the level of activity. Then, the budgeted cost for any level activity
can be ascertained by using these ratios.
NOTES
Check Your Progress
Which methods are used in
preparation of Flexible
Budget ?
2.5.4 Uses Of Flexible Budget
(i)
It is more realistic and has great practical utility in the business.
(ii)
The efficiency of the managers can be measured.
(iii)
It helps to control the costs.
(iv)
It is more realistic than a fixed budget because a fixed budget deals with
only one level of activity of condition.
(v)
The figures in a flexible budget can be changed according to the change in
the volume of activity.
Management Accounting - II
19
Types of Budgets :
Fixed & Flexible Budgets
2.5.5 Proforma Of Flexible Budget
In the books of a Company
FLEXIBLE BUDGET
Normal Activity : Units
NOTES
Capacity : %
Production
Capacity
Units
-
-
-
%
-
-
-
Particulars
Unit Total Unit Total Unit Total
Cost Cost Cost Cost Cost Cost
`
(A)
(B)
Check Your Progress
Fixed Expences :

Salaries

Depreciation

Insurance

Rent
Variable Expences :

Direct Material

Direct Labour

Direct Expenses

Indirect Material / Labour/
List out the semi variable
expenses items.
Expenses

(C)
Variable Overheads
Semi-variable Expenses :

Electricity

Repairs and Maintenance

Administrative Expenses

Selling Expenses

Distribution Expenses (+)
 Total Cost
Add :
20 Management Accounting - II
Profit
Less :
Loss

Sales
(+)
(-)
`
`
`
`
`
The preparation of Flexible Budget can be understood with the help of following
illustrations.
Types of Budgets :
Fixed & Flexible Budgets
2.5.6 Illustrations
ILLUSTRATION 1
The statement given below the Flexible Budget at 60 % capacity of Finolex
Cable Ltd., Faizpur. Prepare a tabulated statement giving the budget figures at 75
% and 90 % capacity where no indication has been given. Make your own
classification of expenses between fixed, variable and semi-variable expenses.
Particulars
NOTES
60 % capacity
`
Prime Cost Materials
1,60,000
Depriciation
60,000
Productive Wages
40,000
Rent
12,000
Indirect Materials
48,000
Insurance of Machinery
12,000
Indirect Labour
40,000
Electric Power (40% Fixed)
Repairs and Maintenance (60% Fixed)
8,000
20,000
Management Accounting - II
21
Types of Budgets :
Fixed & Flexible Budgets
SOLUTION
In the books of Finolex Cable Ltd., Faizpur
Flexible Budget
Normal Activity : Units
NOTES
Capacity : 60 %
Production
Units
Capacity
%
Particulars
-
-
-
60
75
90
Total
Total
Total
Cost
Cost
Cost
`
`
`
(A) Fixed Expences :
(i)
Depreciation :
60,000
60,000
60,000
(ii)
Rent
12,000
12,000
12,000
(iii)
Insurance of Machinery
12,000
12,000
12,000
1,60,000
2,00,000
2,40,000
(B) Variable Expenses :
(i)
Prime Cost Materials
(ii)
Productive Wages
40,000
50,000
60,000
(iii)
Indirect Materials
48,000
60,000
72,000
40,000
50,000
60,000
3,200
3,200
3,200
3,200
(+) 4,800
4,800
6,000
7,200
12,000
12,000
12,000
12,000
(+) 8,000
8,000
10,000
12,000
(iv) Indirect Labour
(C) Semi-Variable Expenses
(i) Electric Power
• Fixed-40 %
• Variable-60%
8000
(ii) Repairs and Maintenance
• Fixed-60 %
• Variable-40%
 Total
22 Management Accounting - II
20,000
4,00,000 4,75,000 5,50,400
Types of Budgets :
Fixed & Flexible Budgets
ILLUSTRATION 2
The expenses budgeted for production at 100% capacity of Infosys Ltd.,
Islampur, are given below.
Particulars
At 100 % capacity
Rs.
Direct Materials
6,00,000
Variable Works Overheads
2,00,000
Basic Wages
2,00,000
Fixed Production Overheads
80,000
Productive Expenses-Marginal
40,000
Administrative Expenses-Rigid
40,000
Selling Overheads (10% Fixed)
1,20,000
Distribution on Cost (80% Variable)
NOTES
60,000
Prepare a Flexible Budget for the production at 60% and 80% capacity
showing separately (i) Prime Cost, (ii) Works Cost, (iii) Cost of Production, (iv) Cost of Turnover.
Management Accounting - II
23
Types of Budgets :
Fixed & Flexible Budgets
SOLUTION
In the Books of Infosys Ltd., Islampur
Flexible Budget
Normal Activity : Units
NOTES
Capacity : 100%
Production
Units
Capacity
%
Particulars
Direct Materials
Add : Basic Wages
Add : Productive Expenses-Marginal
Prime Cost
(i)
-
-
-
60
75
100
Total
Total
Total
Cost
Cost
Cost
`
`
`
3,60,000
4,80,000
6,00,000
1,20,000
1,60,000
2,00,000
24,000
32,000
40,000
5,04,000 6,72,000 8,40,000
Add : Factory Overheads
(i) Variable Works Overheads
(ii) Fixed Production Overheads
Works Cost
Add :
(ii)
Administrative Expenses - Rigid
Cost of Production
(iii)
1,20,000
1,60,000
2,00,000
80,000
80,000
80,000
7,04,000 9,12,000 11,20,000
40,000
40,000
40,000
7,44,000 9,52,000 11,60,000
Add : Selling and Distribution Overheads
(i) Selling Overheads -
• Fixed - 10%
1,20,000
12,000
12,000
12,000
12,000
• Variable-90% (+) 1,08,000
64,800
86,400
1,08,000
12,000
12,000
12,000
28,800
38,400
48,000
(ii) Distribution on Cost -
• Fixed - 20 %
60,000
12,000
• Variable- 80% (+) 48,000(iv)
Cost of Turnover
24 Management Accounting - II
8,61,600 11,00,800 13,40,000
Types of Budgets :
Fixed & Flexible Budgets
ILLUSTRATION 3
From the following information relating to Castrol Ltd., Cochin, prepare a
Flexible Budget at 60 % and 80 % capacity.
Particulars
70 % Capacity
`
NOTES
(A) Variable Overheads :
• Indirect Material
5,000
• Indirect Labour
15,000
(B) Semi-variable Overheads :
• Electricity
50,000
Variable
-
60%
Fixed
-
40%
• Repairs and Maintenance
5,000
Variable
-
65%
Fixed
-
35%
(C) Fixed Overhead :
• Salaries to Staff
10,000
• Depriciation on Machines
14,000
• Insurance on Machines

Total
(+) 6,000
1,05,000
The company estimated the direct labour hours to be worked at 70%
capacity as 70,000 hours, Also calculate the overhead recovery rate at 60%, 70%
and 80% capacities.
Management Accounting - II
25
Types of Budgets :
Fixed & Flexible Budgets
SOLUTION
In the Books of Castrol Ltd., Cochin
Flexible Budget
Normal Activity : Units
NOTES
Capacity : 70 %
Production
Units
Capacity
%
Particulars
-
-
-
60
70
80
Total
Total
Total
Cost
Cost
Cost
`
`
`
(A) Variable Overheads :
(i) Indirect Material
4,286
5,000
5,714
(ii) Indirect Labour
12,857
15,000
17,143
(B) Semi-variable Overheads :
(i) Electricity
50,000
• Variable - 60%
30,000
25,714
30,000
34,286
• Fixed - 40 %
20,000
20,000
20,000
20,000
(ii) Repairs and Maintenance
5,000
• Variable - 65 %
3,250
2,786
3,250
3,714
• Fixed - 35 %
1,750
1,750
1,750
1,750
(i) Salaries to Staff
10,000
10,000
10,000
(ii) Depreciation on Machines
14,000
14,000
14,000
6,000
6,000
6,000
(C) Fixed Overheads :
(iii) Insurance on Machines
 Total
97,393
1,05,000 1,12,607
Calculation of Overhead Recovery Rate
on the basis of Direct Labour Hours :
=
Total Overheads
Direct Labour Hours
`97,393 `1,05,000
`1,12,607
=
=
60,000 Hrs. 70,000 Hrs. 80,000 Hrs.
=
= ` 1.62
26 Management Accounting - II
= ` 1.50
= ` 1.41
Types of Budgets :
Fixed & Flexible Budgets
ILLUSTRATION 4
Dupont Chemicals Ltd., Delhi, has submitted the actual cost data working
on two capacity levels as follows :
Particulas
Capacity -
60%
70%
Cost -
Total
Total
`
`
Distribution on Cost
30,000
40,000
Prime Cost Labour
3,00,000
3,50,000
Factory Overheads
2,00,000
2,20,000
Chargeable Expenses
1,20,000
1,40,000
Raw Materials
3,60,000
4,20,000
60,000
70,000
1,00,000
1,00,000
Amount -
Selling Expenses
Office on Cost (Rigid)
NOTES
Prepare a Flexible Budget at 80%, 90% and 100% capacity showing clearly
(i) Direct Cost, (ii) Works Cost, (iii) Cost of Production, and (iv) Total Cost.
The Costs have a rising tendency, according to the change in the capacity
levels.
SOLUTION
Working Notes :
(i)
Raw Materials Cost increases by ` 60,000 per 10% increase in capacity.
(ii)
Prime Cost Labour increases by ` 50,000 per 10% increase in capacity.
(iii)
Factory Overheads increases by ` 20,000 per 10% increase in capacity.
(iv)
Office on Cost are rigid, hence remain fixed at various capacity levels.
(v)
Selling Expenses and Distribution on Cost increases by ` 10,000 per 10%
increase in capacity.
Management Accounting - II
27
Types of Budgets :
Fixed & Flexible Budgets
In the Books of Dupont Chemicals Ltd., Delhi
Flexible Budget
Normal Activity : Units
Capacity : 60% and 70%
NOTES
Production
Units
Capacity
Particulars
-
-
-
-
-
60
70
80
90
100
Total
Total
Total
Total
Total
Cost
Cost
Cost
Cost
Cost
`
`
`
`
`
Raw Materials
3,60,000 4,20,000 4,80,000 5,40,000 6,00,000
Add : Prime Cost Labour
3,00,000 3,50,000 4,00,000 4,50,000 5,00,000
Add : Chargeable Expenses
1,20,000 1,40,000 1,60,000 1,80,000 2,00,000

Direct Cost (i)
Add : Factory Overheads
Works Cost
7,80,000 9,10,000 10,40,000 11,70,000 13,00,000
2,00,000 2,20,000 2,40,000 2,60,000 2,80,000
(ii)
Add : Office-on-Cost
9,80,000 11,30,000 12,80,000 14,30,000 15,80,000
1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Cost of Production(iii) 10,80,000 12,30,000 13,80,000 15,30,000 16,80,000
Add : Selling Expenses
60,000
70,000
80,000
90,000 1,00,000
Add : Distribution on Cost
30,000
40,000
50,000
60,000
Total Cost
2.6
28 Management Accounting - II
(iv)
70,000
11,70,000 13,40,000 15,10,000 16,80,000 18,50,000
Summary
•
In order to understand the nature of budgets, it is desirable to know their
classification which is usually done on time, flexibility, functions and
management control instrument basis.
•
According to time : Based on time factor budgets can be classified in to
three types such as Short-term budget, Long-term budget and current budget
etc.
•
According to Flexibility : On the basis of flexibility budgets can be
classified into two types such as fixed budgets and Flexible Budgets.
•
Methods of Preparing Flexible Budgets which are as follows :
(i) Tabular Method
(ii) Charity Method
Types of Budgets :
Fixed & Flexible Budgets
(iii) Ratio Method
2.7
Key Terms
NOTES
(1)
Fixed Budget : A Fixed Budget is one which rigidly specifies the targets
for a particular level of activity.
(2)
Flexible Budget : A Flexible Budget is one which permits the charges in
accordance with the changes in the level of activity.
(3)
Short term Budget : Short term budget are prepared mainly for the
purpose of exercising effective control.
(4)
Long Term Budget : These budgets are concerns with long term planning
activities such as plant expansion, development programme, new product
promotional activities etc.
2.8
Questions And Exercises
I.
Objective Questions
A)
Multiple Choice Questions
(1)
A budget which is prepared for changing level of activity is -----(a) Fixed Budget
(b) Variable Budget
(c) Master Budget
(d) Cash Budget
(2)
A budget which do not change when production level changes is -----(a) Fixed Budget
(b) Flexible Budget
(c) Production Budget
(d) Cash Budget
3)
A budget that provides expense goals for the managers of responsibility
centres during the period covered by the profit plan is -----(a) Master Budget
(b) Flexible Budget
(c) Fixed Budget
(d) Production Budget
Management Accounting - II
29
Types of Budgets :
Fixed & Flexible Budgets
(4)
The budget which is not suitable for long term planning is -----(a) Cash Budget
(b) Master Budget
(c) Variable Budget
NOTES
(d) Fixed Budget
Ans : (1 - b), (2 - a), (3 - b), (4 - d)
II.
Long Answer Questions
(1)
What is Budget ? Classify the budgets according to flexibility ?
(2)
Explain in brief the types of budgets on the basis of flexibility.
(3)
Define ‘Fixed Budget’. How they differ from Flexible Budget ?
(4)
What is ‘Flexible Budget’. Explain the methods of preparing Flexible Budget.
(5)
Define ‘Flexible Budget’ state the uses of Flexible Budget.
(6)
What do you understand by ‘Flexible Budget’ ? How does the fixed cost
per unit vary in case of a budget for varying levels of activity ?
(7)
Explain the term ‘Flexible Budget’. How it differs from Fixed Budget.
(8)
Outline the plan for and utility of ‘Flexible Budget’.
(9)
A Flexible Budget is one that is prepared for changing level of activity’.
Discuss.
III.
Practical Problems
(1) From the following cost data made available by Ambuja Metals Co. Ltd.,
Ahmednagar, for a quarterly period, forecast the results by preparing a Flexible
Budget at 70%, 80% and 90% capacity level, where the estimated turnover
amounted to ` 1,26,000, ` 1,34,000 and ` 1,42,000 respectively. It is assumed
that (i)
Marginal expenses varies due to change in production capacity level,
(ii)
Rigit expenses remains constant at various production capacity level and
(iii)
Semi-fixed expenses are constant between 55% and 75% capacity, increases
by 10% between 75% and 85% capacity and increases by 20% between
85% and 90% capacity.
The expenses and sales at 60% capacity level are as under :
30 Management Accounting - II
Particulars
---
`
Types of Budgets :
Fixed & Flexible Budgets
(A) Fixed Expenses :
(i)
Workshop Salary
---
9,300
(ii) Office Rent
---
6,100
(iii) Machinery Depriciation
---
8,600
---
24,000
(ii) Direct Labour
---
9,000
(iii) Productive Expense
---
3,000
---
10,000
(ii) Telephone Charges
---
6,000
(iii) Indirect Labour
---
(+) 4,000
NOTES
(B) Variable Expenses :
(i)
Basic Materials
(C) Semi-Variable Expenses :
(i)
Repairs and Maintenance
Total Cost of Sales

80,000
Value of Sales
1,10,000
Also find out the percentage of profit to sales and submit a report to the
management indicating your critical comments on the position at various production
capacity level.
(2) In Burma Plastics Co. Badalpur, the cost of an article at a capacity level of
5,000 units is given under ‘A’ below for a variation of 25% in capacity above or
below this level, the individual vary as indicated ‘B’ below.
Particulars
‘A’
‘B’
`
Variation
Raw Materials
25,000
100% varying
Direct Labour
15,000
100% varying
1,000
100% varying
10,000
100% varying
Repairs and Maintenance
2,000
75% varying
Power
1,250
80% varying
500
20% varying
Office Overheads
5,000
25% varying
Selling on Cost
3,000
25% varying
Stores Overhead
Productive Expenses
Inspection
Management Accounting - II
31
Types of Budgets :
Fixed & Flexible Budgets
Prepare a flexible budget at production levels of 4,000 units and 6,000 units.
(3) Thomas Cook Ltd., Talegaon, provides the following cost data for a 60%
working capacity, from which you are required to prepare a Flexible Budget for
the production at 80% and 100% capacity level.
NOTES
Current Production
Unit 600
Selling Price (Fixed) per unit
` 300
Process Material Cost per unit
` 100
Productive Wages per unit
` 40
Prime Cost Expenses
` 10
Total Works Overheads (40% Fixed)
`40,000
Total Office, Selling and Distribution Overheads ` 30,000 (50% Variable)
(4) Activa Co. Ltd., Anand, produces computer hardware. The estimated unit
cost is as under :
Particulars
`
Direct Material
15
Direct Wages
10
Direct Expenses
Variable Overheads
Total
4
(+) 6
35
The Fixed Overheads are estimated at ` 1,00,000. The semi-Variable
Overheads are ` 50,000 at 100% capacity i.e. 10,000 units. The semi-variable
expenses vary in stages of ` 4,000 for each change in output of 1,000 units.
Selling Price per unit ` 70. You are required to prepare a Flexible Budget at 50%,
70%, 90% and 100% capacities and determine the profit at each level.
(5) The expenses for all the production at 5,000 units at 50% capacity in Baroda
Chemicals Ltd., Bhavnagar, are given as follows :
Unit Cost
`
Material
50
Labour
20
Variable Overheads
15
Fixed Overheads ( ` 50,000)
10
Administrative Expenses (5% Variable)
10
Selling Expenses (20% Fixed)
Distribution Expenses (10% Fixed)
32 Management Accounting - II
Total Cost of Sales
6
(+) 5
116
You are required to prepare a budget for 70% and 90% production capacity,
assuming that 90% capacity cost of materials will increase by 10% whereas labour
cost will decrease by 5%.
Types of Budgets :
Fixed & Flexible Budgets
(6) Crysta Ltd., Cohin, is currently working at 50% capacity and produces
1,000 units at a cost of Rs. 180 per unit as per the details shown below.
Unit Cost
NOTES
`
Direct Materials
100
Direct Labour
30
Factory Overhead (40% Fixed)
30
Administrative Overhead (50% Fixed)
20
The current selling price is ` 200 per unit. At 60% working capacity, raw
material cost increases by 2% and selling price falls by 2%. At 80% working
capacity, material cost increases by 5% and selling price falls by 5%. Estimate
profits of the company at 60% and 80% capacity by preparing Flexible Budgets
and offer your critical comments.
(7) Sudarshan Co., Satara, is engaged in manufacturing Full Scape Note Books
is working currently at 40% capacity and produces 10,000 note books per month.
The cost and price details for one note book is as under :
Particulars
Unit Cost and Price
`
On Cost (40% Variable)
5
Productive Expenses
1
Direct Labour Cost
2
Basic Materials Cost
10
Market Price
20
You are required to prepare a Flexible Budget showing separately the profit
at 50% and 90% capacities and the break-even points at the production capacity
levels assuming that (i)
at 50% capacity the invoice price falls by 3% and
(ii)
at 90% capacity the selling price falls by 5%
accompanied by a similar fall in the price of Direct Material.
Management Accounting - II
33
Types of Budgets :
Fixed & Flexible Budgets
NOTES
34 Management Accounting - II
2.9
Further Reading
•
Bhar B. K. - Cost Accounting methods and problems - Kolkata - Academic
Publishers - 2012.
•
Jawaharlal - Cost Accounting - New Delhi - Tata MC Graw-Hill Publishing
Co. Ltd. - 2010.
UNIT 3
Types of Budgets : Functional Budgets
Types of Budgets :
Functional Budgets
Structure
3.0
Introduction
3.1
Unit Objectives
3.2
Functional Budget
3.3
Purchase Budget
3.3.1
3.4
Illustrations
Production Cost Budget
3.5.1
3.6
Illustrations
Production Budget
3.4.1
3.5
NOTES
Illustration
Sales Budget
3.6.1
Illustrations
3.7
Summary
3.8
Key Terms
3.9
Questions and Exercises
3.10 Further Reading
3.0
Introduction
Without planning there can be no budgeting ‘For good planning and good
budgeting go hand in hand”. Budget and planning are correlates terms however,
it should be noted that budgets cannot guarantee success towards the desired
objectives. The success of the same depends upon a number of factors of which
most vital is the performance factor. Budget of an organisation in incorporates all
the functions for the future expansion programme. All types of functional budgets
are of prime importance in developing the company’s master budget. The proposal
made by various functional departments and layers of management are
incorporated in the budget.
Check Your Progress
Which types of budgets are
included in Functional
Budgets ?
A Functional Budget is one which relates any of the functions of an
organisation e.g. purchase, sales, production, personnel etc. The functional budgets
generally includes : (a) Purchase budget, (b) Sales budget, (c) Production budget,
(d) Production cost-Budget, (e) Administrative cost-Budget, (f) Personnel Budget,
Management Accounting - II
35
Types of Budgets :
Functional Budgets
(g) Research and Development Cost Budget, (h) Plant Utilisation Budget, (i) Capital
Expenditure Budget, (j) Selling and Distribution Cost Budget.
3.1
Unit Objectives
NOTES
After studying this unit you should be able to :
•
Understand the meaning of Functional Budget.
•
Define Purchase Budget and explain format of Purchase Budget.
•
Prepare Purchase Budget
•
Prepare Production Budget
•
Prepare Production Cost Budget
•
Prepare Sales Budget
•
Discuss the important factors requires for preparation of each and every
Functional Budget.
3.2
Functional Budgets
A Functional Budget is one which relates to any of the functions of an
organisation e.g. sales, production, personnel etc. The Master Budget is prepared
based on the functional budget. The following are generally the functional budgets
prepared(a) Sales Budget, (b) Selling and Distribution Cost Budget, (c) Production
Budget, (d) Production Cost Budget, (e) Plant Utilisation Budget, (f) Capital
Expenditure Budget, (g) Purchase Budget, (h) Personnel Budget, (i) Administrative
Cost Budget (j) Research and Development Cost Budget etc.
If all the above budget are prepared, it is possible to consolidate them and
prepare the Budgeted Profit and Loss Account and the Budgeted Profit and Loss
Appropriation Account. The next step would be to prepare the Cash budget and
Budgeted Balance Sheet.
3.3
Purchase Budget
Meaning and Definition :
36 Management Accounting - II
This budget is prepared by the purchase manager to show the purchases
which must be made during the budgeted period. It includes the direct and indirect
materials to be purchased and also the services required by the management. In
case of trading business where the finished goods are purchased for resale, goods
which are to be resold. Generally, it includes raw materials, works-in-progress
materials, components, spare parts, equipments, indirect materials etc. The purchase
budget is either shown in terms of quantity or money. The purchase budget is
mainly based upon : (i) Sales budget, (ii) Production cost budget, (iii) Estimated
requirements of raw materials, supplies or brought out components, (iv) Maximum,
Minimum and Economic Order Quantity.
A Purchase Budget is defined as, “the budget which shows the quantity
and value of goods to be purchased during the budget period to meet the day-today needs of the business”.
Types of Budgets :
Functional Budgets
NOTES
Purpose :
The basic purpose of preparing the Purchase Budgets are as follows :
(a)
To estimate the cash requirement for the purchases to be made during the
budgeted period.
(b)
To enable the purchase department to chalk out its future plans for timely
purchases.
Important Factors :
The following are the important factors to be taken into consideration while
preparing a purchase budget.
(i)
The estimates for various types of production to be made during the specified
period.
(ii)
The quality and quantity of each type of raw materials required for effective
production.
(iii)
The approximate percentage of each type of raw material cost to production
cost.
(iv)
The present stock position.
(v)
The sources of supply.
(vi)
The standard time lag between purchase of materials and their actual use
in production.
(vii)
The time lag between placement of purchase order and actual delivery of
materials.
Check Your Progress
Which important factors are
to
be
taken
into
consideration in preparation
of a Purchase budget ?
(viii) The transport facilities required.
(ix)
The purchase price and discount policy.
(x)
The available capacity for storage and stock levels for each type of materials.
(xi)
Seasonal and cyclical fluctuations in the demand for various products.
(xii)
Availability of cash for settlement of supplies account.
(xiii) The ordering cost per order.
Management Accounting - II
37
Types of Budgets :
Functional Budgets
(xiv) The production policies of the management.
(xv) The Economic Order Quantity of each material.
Format of Purchase Budget :
NOTES
The Purchase Budget can generally be prepared in the following format
In the books of a Company
Purchase Budget (in units)
for the period ended :
Material
Particulars
A
B
C
Units
Units
Units
Requirement of Material for the
production during the period
Add : Budgeted Closing Stock to be
maintained at the end of the
period.
(+)
Less : Estimated Opening Stock at the
beginning of the period

(-)
Quantity of Materials to be purchased
Purchase Budget (in value)
for the period ended...
Particulars
Materials Required
ABC Total
38 Management Accounting - II
(+)
Estimated
Estimated
Quantity
Unit Price
Units
`
Value
`
3.3.1 Illustrations
Types of Budgets :
Functional Budgets
The Preparation of purchase Budget can understood with the help of following
illustrations ILLUSTRATION 1
In Motherson Co. Ltd., Matunga the Sales Executive expects to sale to
60,000 units of Water Cooler for the year 2013. The Production Manager has
estimated the requirements of raw materials as i.e A- 4 units and B-6 units. For
producing one water cooler. The opening and closing balances of the finished
goods and raw materials estimated are as follows :
Item
Opening balance at
Closing balance at the end
the beginning of
of the next year
the next year
units
NOTES
units
Raw Material A
10,000
11,000
Raw Material B
15,000
17,000
Finished Goods
8,000
11,000
Prepare a purchase Budget showing the quantities of materials to be
purchased.
SOLUTION
First we have to prepare the Production Budget and from this we can
estimate the purchases and draw the Purchases Budget as shown below.
In the Books of Motherson Co. Ltd., Matunga
Production Budget for the year 2013
Particulars
Units
Estimated sales for the year 2013
Add : Closing balance (estimated)
60,000
(+)
11,000
71,000
Less : Opening balance (estimated)
Estimated Production
(-)
8,000
63,000
Management Accounting - II
39
Types of Budgets :
Functional Budgets
Purchase Budget for the year 2013
Particulars
Material A Material B
Units
NOTES
Annual requirement of materials
Units
2,52,000
3,78,000
11,000
17,000
2,63,000
3,95,000
10,000
15,000
2,53,000
3,80,000
A : 63,000 units x 4 units
B : 63,000 units x 6 units
Add : Stock to be maintained at the
end of the year
Less : Stock at the beginning of the year
(+)
(-)
Quantity to be Purchased
ILLUSTRATION 2
Nashik Soap Factory, Nashik Road uses the combination of two materials
X and Y which constitute 75% and 25% of the total output in units. They estimates
a sale of 500 quintals of soaps during the month of July 2013. The estimates for
the opening and closing stocks are as follows :
Particulars
Opening Stock Closing Stock
Quintals
Quintals
Raw Materials - X
100
140
Raw Materials - Y
80
300
Finished Goods
70
90
The expected purchase price of the two materials were : X : ` 600 per
quintal and Y : ` 500 per quintal
Prepare : (a) Production Budget, (b) Material Consumption Budget, (c) Purchase
Budget (in value), for the month ended 31st July 2013
40 Management Accounting - II
Types of Budgets :
Functional Budgets
SOLUTION
In the Books of Nashik Soap Factory, Nashik Road
Production Budget for the month ended 31st July 2013
Particulars
Quintals
Estimated Sales
Add :
NOTES
500
Closing Stock on Finished Goods
(+)
90
590
Less : Opening Stock of Finished Goods

(-)
70
Estimated Production
520
Material Consumption Budget for the month ended 31st July, 2013
Particular
Materials consumption for estimated production
X
Y
390
130
390
130
distributed in the ratio of 75% : 25%
(i.e. 520 Quintals x 3: 1)
(+)
 Materials Required
Purchase Budget for the month ended 31st July, 2013
Particular
Materials required for production
Add : Closing Stock
Less : Opening Stock
Materials to be purchased
Purchases price per quintal
Purchases Cost (X : 430 x `600) and
(+)
(-)
X
Y
Units
Units
390
130
140
300
530
430
100
80
430
350
`
`
600
500
2,58,000
1,75,000
(Y : 350 x ` 500)
Total Purchase Cost
4,33,000
Management Accounting - II
41
Types of Budgets :
Functional Budgets
NOTES
ILLUSTRATION 3
Fuji Plast Manufactures, Faridabad produces one unit of Product “Plasto”
by using four units of raw material ‘A’ and one units of raw material ‘B’. From the
following cost details available prepare a Purchase Budget in units and in value
separately for the year ended 31st March, 2014.
Budgeted Production of ‘Plasto’ for 2013-2014 - units 5,000 unit price of
Materials ‘A’ is ` 3.10 whereas for Material ‘B’ is `5.00 per unit. The budgeted
balances as an opening and Closing dates are as follows :
Particulars
42 Management Accounting - II
Balance of Stock
Balance of Stock
on
as on
01-04-2013
31-03-2014
Units
Units
Product ‘Plasto’
150
280
Raw Material ‘A’
180
320
Raw Material ‘B’
20
90
Material ‘A’ on order
760
2,120
Material ‘B’ on order
340
1,940
Types of Budgets :
Functional Budgets
SOLUTION
In the books of Fuji Plast Manufacturers, Faridabad
Purchase Budget (in units)
for the year ended 31st March, 2014
Particulars
NOTES
Raw Material
Requirement for Budgeted Production of ‘Plasto’
A
B
Units
Units
20,000
5,000
320
90
20,320
5,090
180
20
20,140
5,070
2,120
1,940
22,260
7,010
760
340
21,500
6,670
• Raw Material A : 4 units x 5,000 - Products
• Raw Material B : 1 unit x 5,000 - Products
Add :
Budgeted Closing Stock to be maintained
at the end of the year
Less :
(+)
Estimated opening Stock at the beginning
of the year
(-)
Quantity of materials to be purchased
Add :
Materials required to be on order at the end
of the year
Less :
(+)
Materials required to be on order at the
beginning of the year
(-)
 Materials required to be ordered.
Purchase Budget (in Value)
for the year ended 31st March, 2014
Particulars
Estimated
Estimated
Estimated
Quantity
Unit price
Value
( `)
( `)
Materials Required :
• Raw Material - A
• Raw material - B (+)
 Total Purchase Cost
21,500
3.10
66,650
6,670
5.00
33,350
1,00,000
Management Accounting - II
43
Types of Budgets :
Functional Budgets
3.4
Production Budget
Meaning and Definition :
NOTES
This budget is prepared after the sales budget because the sales to be made
are estimated in the sales budget so that how much quantity should be produced
can be known. Thus, a production budget is one which is an estimate for the
quantities of goods to be purchased during the budget period. It is expressed
either in units or standard hours.
Important Factors :
The following factors should be taken into consideration while preparing
the production budget.
(i) Forecast of Sales, (ii) Requirement of stock to be maintained, (iii) Plant
capacity, (iv) Spares and components to be purchased, (v) Make or by buy decisions,
(vi) Production cycle, (vii) Production policy of management.
Objectives :
A Production budget is to be prepared to achieve the following important objectives.
Check Your Progress
List out the important
objectives of a production
budget.
(i)
to produce quality products as planned in advance.
(ii)
to maintain the production scheduled.
(iii)
to make the output as per the requirement.
(iv)
to avoid excessive inventory of work-in-progress and finished goods
(v)
to make the production with the most economical process.
(vii)
efforts to be taken to reduce scraps and wastages.
(viii) to exercise control on material cost, labour cost and overhead cost.
(ix)
to facilitate preparation of cash budget.
Proforma of Production Budget :
The proforma of Production Budget can be drawn as follows :
44 Management Accounting - II
In the books of a Company
Types of Budgets :
Functional Budgets
Purchase Budget (in Units)
Particulars
Product
Sales
Add :
Closing Stock
(+)
Less : Opening Stock

(-)
Estimated Production
A
B
Units
Units
--------
------
--------
-------
--------
-------
--------
-------
---------
-------
NOTES
An analysis of the above factors will suggest the amount of goods that can
be produced within the factory. If the calculated production is less than the budgeted
sales, then the firm will not be in a position to maintain the sales budget and earn
sufficient profits for which potential exists. In such a situation, the firm should
explore the following possibilities before taking a final decision on production budget.
1.
Can the inventory level be reduced ?
2.
Can the plant utilization capacity be increased or additional plant installed
to fill the gap ?
3.4.1 Illustrations
The preparation of Production Budget can be understood with the help of
following Illustrations.
ILLUSTRATION 1
From the following cost data relating to various products produced by Alembic
Pharma Co., Aurangabad, prepare a Production Budget for the half year ended
30th September 2013
Particulars
Turnover- Estimated
Pharma Products
Anacin
Actified
Asparin
Aspro
Units
Units
Units
Units
12,340
16,590
20,430
24,170
2,650
1,260
1,080
1,640
990
850
510
810
Stock on 30-09-2013
Estimated Units
Stock on 01-04-2013
Estimated Units
Management Accounting - II
45
Types of Budgets :
Functional Budgets
SOLUTION
In the books of Alembic Pharma Co., Aurangabad
Production Budget for the half year ended 30th September, 2013
Particulars
NOTES
Pharma Products
Anacin Actified Asparin Aspro
Estimated Turnover for the period
Units
Units
Units
Units
12,340
16,590
20,430 24,170
2,650
1,260
14,990
17,850
990
850
14,000
17,000
Add: Estimated Stock as on
30-09-2007
(+)
Less : Estimated Stock as on (-)
 Estimated Production
1,080
1,640
21,510 25,810
510
810
21,000 25,000
ILLUSTRATION 2
OCL India Co . Ltd., Osmanabad has budgeted sales as under :
Months in 2013 /2014
July
Black Cement
White Cement
Units
Units
5,000
2,000
August
10,000
4,000
September
12,000
5,000
October
15,000
6,000
November
13,500
5,000
December
10,000
6,550
January
12,000
5,000
77,500
33,500
The Company maintains inventory equal to half of the sales for next month
and there is no work-progress at the end of any month.
Prepare the Production Budget for the half year ending on 31-12-2013
46 Management Accounting - II
SOLUTION
Closing Inventory (50% of next month)
Opening Inventory
Budgeted Production
Add :
Less :
   
Budgeted Sales
White Cement
Budgeted Productioin
Opening Inventories
Less :
(-)
(+)
(-)
Closing Inventories (50%of next month) (+)
Add :
Budgeted Sales
Black Cement
Product Y
3,000
5,500
1,000
6,500
4,000
1,000
2,500
4,000
11,000
2,000
2,000
7,500
5,000
16,000
10,000
2,500
6,000
10,000
Augutst
5,000
5,000
July
5,500
2,500
8,000
3,000
5,000
13,500
6,000
19,500
7,500
12,000
Sept.
Production Budget for the half year ending 31-12-2013
In the books of OCL India Co., Ltd., Osmanabad
5,500
3,000
8,500
2,500
6,000
14,250
7,500
21,750
6,750
15,000
Oct.
5,775
2,500
8,275
3,275
5,000
11,750
6,750
18,500
5,000
13,500
Nov.
5,775
3,275
9,050
2,500
6,550
11,000
5,000
16,000
6,000
10,000
Dec.
Types of Budgets :
Functional Budgets
NOTES
Management Accounting - II
47
Types of Budgets :
Functional Budgets
ILLUSTRATION 3
Padmini Ltd., Pandharpur estimates its sales quarterwise as under :
Ist Quarter IInd Quarter
NOTES
IIIrd Quarter IVth Quarter
VthQuarter
(Units)
(Units)
(Units)
(Units)
(Units)
1,00,000
1,20,000
1,32,000
1,44,000
1,68,000
The Opening Stock of the 1st quarter was 20,000 units. The Company has
decided to keep Closing Stock equal to 1/12th of the next quarter. Show what
should be the production in each quarter for the current year.
SOLUTION
1.
Note that there are four quarters in a year. The Vth quarter is shown of the
next year for calculation of the closing Stock. Hence, in the Production
Cost Budget only 4 quarters should be taken.
2.
The Closing Stock of each quarter becomes the Opening Stock of the next
quarter.
In the books of padmini Ltd., Pandharpur
Production Budget (units) for the quarter ended---Particulars
Sales
Add : Closing Stock
(+)
Less : Opening Stock (-)
 Estimated Production
3.5
Check Your Progress
Which budget is prepared after
the Production Budget ?
I st
Units
II nd
Units
IIIrd
Units
IVth
Units
1,00,000
1,20,000
1,32,000
1,44,000
10,000
11,000
12,000
14,000
1,10,000
1,31,000
1,44,000
1,58,000
20,000
10,000
11,000
12,000
90,000
1,21,000 1,33,000 1,46,000
Production Cost Budget
This budget is prepared after the production Budget. This budget shows
the details of the estimated cost which are required to be incurred as per the
quantities shown in the production budget. The details include materials cost,
labour cost and overheads. The overheds again include variable, semi-variable
and fixed costs. The costs are classified and analysed according to the products
or departments.
The Production cost budget depends upon :
48 Management Accounting - II
(i)
Production budget
(ii)
Estimated increase in wages, salaries and expenses
(iii)
Estimated increase/decrease in the price of raw materials and other supplies.
Types of Budgets :
Functional Budgets
Proforma of Production Cost Budget :
The proforma of Production Cost Budget can be drawn as follows :
In the books of a Company
Production Cost Budget (in value)
Particulars
Units to be Produced as per Production Budget
Cost :
Department
Total
----
----
`
`
(A)
Direct Material
----
(B)
Direct Labour
----
(C)
Direct Expenses
----
(D)
Factory Overheads :
(E)
NOTES
Periods
Variable
----
Semi-variable
----
----
Fixed
(+)
----
----
Total
(+)
-----
-----
Production Cost (A+B+C+D)
-----
3.5.1 Illustrations
The Preparation of production cost budget can be understood with the help
of following illustrations.
ILLUSTRATION 1
Rajdoot Co. Ltd., Ranchi gives the following production costs.
Particulars
`
Direct Material Cost
`
1,50,000
Direct Labour Cost
80,000
Factory Overheads :
• Variable
• Fixed
50,000
(+)
25,000
75,000
Management Accounting - II
49
Types of Budgets :
Functional Budgets
NOTES
The estimates made by the Production Manager for the next year about the
various changes are as below :
(a)
Production will rise by 10%.
(b)
There will be decrease in labour cost by 2% due to the more efficiency of
the laborers.
(c)
Direct material price will increase by 5%
Draw a Production Cost Budget.
SOLUTION
Working Notes :
1.
Computation of Revised Direct Material Cost :
`
Direct Material Cost
1,50,000
Actual Cost
Add : Increase in cost as production
will rise by 10% of `1,50,000
(+)
15,000
1,65,000
Add : Increase in cost as material
price will increase by 5% of `1,65,000
(+)
 Revised Direct Material Cost
2.
8,250
1,73,250
Computation of Revised Direct Labour Cost :
`
2. Direct Labour Cost
80,000
Actual Cost
Add : Increase in Cost as production
will rise by 10% of ` 80,000
(+)
8000
88,000
Less : Increase in cost as material
price will increase by 5% of `1,65,000
 Revised Direct Labour Cost
50 Management Accounting - II
(-)
1,760
86,240
Types of Budgets :
Functional Budgets
In the books of Rajdoot Co. Ltd., Ranchi
Production Cost Budget for the year ended--Particulars
Direct Material
Add : Direct Labour
(+)
Prime Cost
Original
Revised
Budget
Budget
`
`
1,50,000
1,73,250
80,000
86,240
2,30,000
2,59,490
50,000
55,000
25,000
25,000
3,05,000
3,39,490
NOTES
Add : Factory Overheads :
(i) Variable
(ii) Fixed
(+)
Total Cost
ILLUSTRATION 2
The information has been made available from records of Siemens India
Ltd., Sholapur for the last six months of 2013 (and of only the sales of January
2014) in respect of Product A.
(a)
The Units to be sold in different months are :
2013-2014
Sales
Months
Units
July
1,100
August
1,100
September
1,700
October
1,900
November
2,500
December
2,300
January
1,900
(b)
There will be no work-in-progress at the end of any month.
(c)
Finished units equal to half of sales for the next month will be in Stock at the
end of every month (including June).
(d)
Budgeted production and production cost for the year ending 31-12-2013.
Management Accounting - II
51
Types of Budgets :
Functional Budgets
Production
NOTES
Units
22,000
Direct Material per unit
`
10.00
Direct wages Per unit
`
4.00
Total Factory Overheads apportioned to Product
`
44,000
Prepare :
(a)
A Production Budget for each of the last six month of 2013.
(b)
A summarised production cost budget for the same period.
SOLUTION
In the Books of Siemens India Ltd., Sholapur
(a) Production Budget for six months ended 31-12-2013
Particulars
July
August Sept. Oct.
Units
Sales
Nov.
Dec.
Units Units Units Units Units
1,100 1,100
1,700 1,900 2,500
2,300
850
950 1,250 1,150
1,000
1,650 1,950
2,650 3,150 3,650
3,300
Add : Closing Stock i.e
Half of sales for
the next month
(+)
550
Less : Opening Stock
i.e last month Closing
Stock
(-)
Production in units
550
550
1,100 1,400
850
950 1,250
1,150
1,800 2,200 2,400 2,100
Total Six monthly production = 11,000 units.
(b)
Production Cost Budget for the six month ended 31-12-2013
Particulars
Amounts
`
Direct Material ( ` 10 x 11,000 units )
Add : Direct Wages ( ` 4 x 11,000 units )
1,10,000
(+)
 Prime Cost
Add : Factory Overheads ( ` 2 x 11,000 units)
 tal Cost
52 Management Accounting - II
44,000
1,54,000
(+)
22,000
1,76,000
Types of Budgets :
Functional Budgets
Working Notes :
1. Computation of Factory Overheads recovery rate on the basis of
Total Production :
If 22,000 units
    
1 Units
=
` 44,000 Factory Overheads
=
?
=
=
3.6
NOTES
1 unit x ` 44,000
22,000 units
` 2 per unit
Sales Budget
Meaning and Definition :
It is the basic foundation upon which other functional budgets are built up.
A Sales Budget is a statement expressed in phyiscal quantities or/and values of
anticipated sales during a specified period of time. Sales forecasting is the basic
step in the preparation of a sales budget. It is done by sales department under the
charge of a Sales Manager in Consultation and co-operation with the Budget
Controller. The Forecasting of sales is not an easy job. It requires a lot of skill and
knowledge in the techniques of sales forecasting, collection of relevant facts and
figure and an understanding of business environment in which the firm is placed.
The techniques of sales forecasting for new products are different from those
used for established products.
A Sales Budget is defined as, “ a statement of planned sales expressed
in term of quantity and value”.
In case of established products, historical data relating to sales quantities
and expenditure on selling campaign are available within the firm. The sales
department also possesses good knowledge about its market share, nature of
competition, availability of substitutes, consumers preferences etc. The sales
data for the last few years are complied in a form what is known as ‘Time Series’
which is statistically dealt to fit a trend line and extrapolate the sales figures for
future. This technique is quite simple and widely used by business firms for the
purpose of sales forecasting. However, it can be profitably used only if the Time
Series do not show violent fluctuations and corrections are rightly made for seasonal
and stochastic variations.
The amount of sales in any given period is much affected by the amount
spent on advertisement and other sales promotion techniques. A study of correlation
between expenditure on advertisement and amount of sales in different time
periods will reveal the degree of impace of advertising cost on amount of sales.
Thus, sales should be predicted only after due consideration to the advertisement
budget for the period for which sales budget is being prepared.
Management Accounting - II
53
Types of Budgets :
Functional Budgets
NOTES
It is the first budget which is prepared in most of the organisation, Sales
budget is the most difficult budget to prepare and the success of the budget system
of the whole organisation depends upon the sales budget. A sales Budget indicates
the number of units, to be sold, at what price and what types of products are to be
sold. The Sales Manager is responsible for the preparation of the sales budget.
He is supported by the salesmen and also the market research department.
Important Factors
Check Your Progress
Illustrates the important
factors related to Sales budget.
While preparing the sales budget the following factors are necessary to
consider :(i) Post sales, (ii) Future economic, industry and market conditions, (iii)
Threat of competition, (iv) Amount to be spent on advertisement, (v) Intuition of
the Sales Manager, (vi) Profitability of the product, (vii) Market research studies,
(viii) Pricing policies, (ix) Competitions, (x) Plant capacity, (xi) Sales trends of
other joint products if any.
The consideration of prevailing and expected economic environment within
and outside the industry is essential before any decision on budgeted sales is
taken. The management should give proper valuation in their estimation for sales
for factors such as the structure of national income, Government fiscal and monetary
policies, industrial policy, import-export policy, demographic structure etc. in so
far as they influence the demand for firm’s products.
In a modern age of competition, sales is generally a limiting factor. In case
of certain products, sales may not be a constraint and the estimated sales be much
higher than the production available within the firm. Under such a situation, the
possibilities of increasing production should be found out and the production budget
can be prepared first.
The data of budgeted sales can be arranged in a number of ways. They
can be grouped according to commodity, territory or salesman-wise. Consider the
following form of a sales budget according to commodity-wise.
Proforma of Sales Budget :
Sales Budget for the period ending...
Year
Months
54 Management Accounting - II
Product A
Product B
Total
Quantity
Value
Quantity
Value
Quantity
Value
Units
`
Units
`
Units
`
As the sales forecast provides necessary cost data for developing the other
functional budget viz. production budget, purchase budget, selling cost budget,
administration budget etc., it is absolutely essential to analyse the sales according
to the products and areas. Hence, for most of the business firms, sales budget is
considered to be a key budget.
Types of Budgets :
Functional Budgets
NOTES
3.6.1 Illustrations
The preparation of sales Budget can be understood with the help of following
illustrations.
ILLUSTRATION 1
Titan Ltd., Talegaon has estimated the sales of three products O, P and Q.
Following are the particulars of the three products.
Particulars
Products
O
P
Q
Quantities : Units
5,000
10,000
15,000
Selling price per units : `
1,500
2,000
2,500
Prepare a Sales Budget.
SOLUTION
In the books of Titan Ltd., Talegaon
Sales Budget for the period ended....
Product
Budgeted sales Selling Price per unit
value of sales
Units
`
`
O
5,000
1,500
75,00,000
P
10,000
2,000
2,00,00,000
Q
15,000
2,500
3,75,00,000
Total
30,000
-
6,50,00,000
Management Accounting - II
55
Types of Budgets :
Functional Budgets
NOTES
ILLUSTRATION 2
United Brew Ltd., Ulhasnagar sells its products in two regions i.e Mumbai
and Thane of the two products and X and Y. The budgeted sales for the six
months ended 30th June 2014 in each of the areas i.e Mumbai and than are as
follows :
Mumbai
Thane
X
2,000 Units
Y
1,000 Units
X
1,500 Units
Y
1,200 Units
The actual sales for the period ended 30th June 2014 were as follows :
Mumbai
Thane
X
2,500 Units
Y
1,100 Units
X
1,600 Units
Y
1,200 Units
The budgeted selling price and the actual price per unit were the same
which are as below :
For
X
by ` 8 per unit
Y
by ` 5 per unit
From the market survey report it is found that the sales of both the products
can be increased over the budgeted units of the 30th June 2014 for the next six
month ending 31-12-2014 as given below.
Mumbai
Thane
X
by 500 Units
Y
by 200 Units
X
by 100 Units
Y
by 80 Units
Prepare Sales Budget for six months for the period ended 31st December
2014 also find out the budgeted and actual sales for the period ended 30th June
2014.
56 Management Accounting - II
1,600
1,280
2,880
4,100
2,480
6,580
Y
Total
X
Y
Total
3,700
Total
X
1,200
Y
Thane
2,500
X
Mumbai
-
-
-
-
5
8
-
5
8
`
Units
45,200
12,400
32,800
19,200
6,400
12,800
26,000
6,000
20,000
`
Amount
5,700
2,200
3,500
2,700
1,200
1,500
3,000
1,000
2,000
Units
Quantity
-
-
-
-
5
8
-
5
8
`
Rate
30-06-2014
31-12-2014
Rate
Budgeted Sales
Sales Budget
39,000
11,000
28,000
18,000
6,000
12,000
21,000
5,000
16,000
`
Amount
Sales Budget for the six months ended 31-12-2014
In the books of United Brew Ltd., Ulhasnagar
Quantity
Product
Region
Particulars
SOLUTION
6,400
2,300
4,100
2,800
1,200
1,600
3,600
1,100
2,500
Units
Quantity
-
-
-
-
5
8
-
5
8
`
Rate
30-06-2014
Acutal Sales
44,300
11,500
32,800
18,800
6,000
12,800
25,500
5,500
20,000
`
Amount
Types of Budgets :
Functional Budgets
NOTES
Management Accounting - II
57
Types of Budgets :
Functional Budgets
ILLUSTRATION 3
Voltas Ltd., Vashi sell two products X and Y. The following estimates are
given for the year 2014
NOTES
Sales Budget-Units
Particulars
Ist Quarter
IInd Quarter
`
`
Product-X
1,00,000
1,40,000
90,000
1,20,000
Product-Y
90,000
1,20,000
1,00,000
1,10,000
IIIrd Quarter IVth Quarter
`
`
Product X is Sold @ `100 per units, while product Y is sold @ `200 per
unit. The Company incurs selling and distribution expenses @ 3% of the sales
Value. Bad debts amounts to 1% of the sales value.
You are required to prepare a Sales Budget for the year 2014
SOLUTION
In the books of Voltas Ltd., Vashi
Sales Budget for the year 2014
( ` in Thousands)
Particulars
I st
II st
IIIst
IVst
Quarter Quarter Quarter Quarter
`
Total
`
`
`
10,000
14,000
9,000
12,000
45,000
(+)
18,000
24,000
20,000
22,000
84,000
Total Sales
28,000
38,000
29,000
34,000
1,29,000
840
1,140
870
1,020
3,870
@ 1% of sales value(+)
280
380
290
340
1,290
(-)
1,120
1,520
1,160
1,360
5,160
26,880
36,480
27,840
32,640
1,23,840
Product X
Product Y
`
Less : Selling and
Distribution Expenses
@ 3% of Sales Value
Bad Debts
Net Sales
58 Management Accounting - II
Types of Budgets :
Functional Budgets
ILLUSTRATION 4
Wimco Ltd., Wardha manufactures two types of cement known as ‘Black’
and ‘White’. The cement is sold in the three states of Rajasthan, Haryana and
Punjab through stock dealers. From the following data relating to budget period
ended on 30th June, 2014 and the adjoining information, you are required to prepare
a Sales Budget for 6 months period beginning from 1th July and ending on 31th
December, 2014
Commodity
Rajasthan
Territories
Punjab
NOTES
Haryana
Budgeted Actual Budgeted Actual Budgeted Actual
(Bags)
(Bags)
(Bags)
(Bags)
Black Cement
25,000
24,000
20,000
18,000
White Cement
15,000
12,000
10,000
10,000
Total
40,000 36,000
30,000 28,000
(Bags)
(Bags)
10,000 10,000
5,000
4,500
15,000 14,500
Other Informations :
1.
The construction activity is expected to go up by 10% and accordingly the
demand in all states except in Punjab, is likely to increase in the budget
period. The Sales Department visualises a decrease in sales by 5% in
Punjab.
2.
The Company has decided to appoint few more dealers in Rajasthan and it
forecasts an additional sales of 5,000 bags of black cement through the
new dealer.
3.
With a vigorous advertisement campaign, the demand Haryana for both
black and white cement is likely to increase by 20% in addition to the 10%
as pointed out above.
4.
The Company expects to make direct supplies to local bodies in the States
of Rajasthan and Haryana. It opens to sell, 2,000 bags of black cement in
each of these states..
5.
Adequate production facilities exist and there is no limiting factors.
6.
The selling price per bag is estimated at `60 and 100 for black and white
cement respectively.
Management Accounting - II
59
60 Management Accounting - II
20,000
10,000
55,000
Punjab
Haryana
Total
52,000
10,000
18,000
24,000
(Bags)
(Bags)
25,000
Actuals
Budgeted
Black Cement
30,000
5,000
10,000
15,000
(Bags)
Budgeted
26,500
4,500
10,000
12,000
(Bags)
Actuals
White Cement
For 1th Jan. to 30th June 2014
65,500
15,000
17,100
33,400
(Bags)
Black
28,550
5,850
9,500
13,200
(Bags)
White
39,30,000
9,00,000
10,26,000
20,04,000
`
Black
28,55,000
5,85,000
9,50,000
13,20,000
`
White
For 1st July to 31th December, 2014
Sales Budget for the six months ended 31-12-2014
In the books of Wimco Ltd., Wardha
NOTES
Rajasthan
Territories
SOLUTION
Types of Budgets :
Functional Budgets
Types of Budgets :
Functional Budgets
Statement of Sales Forecast (Bags)
Particulars
Present Sale
Rajasthan
Punjab
Haryana
Black
White
Black White
Black
White
24,000
12,000
18,000
10,000
4,500
10,000
NOTES
Increase due to
construction activity
(10% of existing)
(+)2,400 (+)1,200
-
- (+)1,000 (+)450
Estimated decrease
for punjab (5%)
-
-
(-)900
(-)500
-
-
(+)5,000
-
-
-
-
-
-
-
-
- (+)2,000 (+)900
(+)2,000
-
-
- (+)2,000
Additional sales by
new dealers
Increase due to
massive advertising
Campaigan
(20% of existing)
Direct Supplies
Total
33,400 13,200 17,100
-
9,500 15,000 5,850
ILLUSTRATION 5
Yashwant Traders, Yeowatmal sells two products viz. Bee and Dee. The
following are the estimates regarding sales during 2014
Particulars
First
Second
Third
Quarter
Quarter
Quarter
Units
Units
Units
Fourth
Total
Quarter Units
Units
Product-Bee
9,000
23,000
30,000
8,000
70,000
Product-Dee
8,500
7,500
5,500
8,500
20,000
Both the products are sold on seasonal basis. Product-Bee tends to sell
better in summer while Product-Dee sells better in winter. Product-Bee is sold
@ 10 per unit whereas Product-Dee @ `20 per unit. Past experiences reveal
that the firm is unable to realise 1% of their total sales value and spends 2% of it
carriage and 3% of it for advertising purposes. Prepare a Sales Budget for the
year 2013 incorporating the above mentioned information.
Management Accounting - II
61
Types of Budgets :
Functional Budgets
SOLUTION
In the books of Yeshwant Traders, Yeowatmal
Sales Budget for the year 2014
NOTES
Particulars
First
Second
Third
Fourth
Quarter Quarter Quarter Quarter
`
Total
`
`
`
`
90,000
2,30,000
3,00,000
80,000
7,00,000
1,70,000
1,50,000
1,10,000
1,70,000
6,00,000
Actual Sales :
(i) Product Bee
@ `10 Per unit
(ii) Product Dee
@ `20 per unit(+)
Total Sales Value (A)
2,60,000 3,80,000 4,10,000 2,50,000 13,00,000
Less : Selling and
Distribution Expenses
(i) Bad Debts -
2,600
3,800
4,100
2,500
13,000
5,200
7,600
8,200
5,000
26,000
7,800
11,400
12,300
7,500
39,000
15,600
22,800
24,600
15,000
78,000
@ 1% of Total
Sales Value
(ii) Carriage Outward@ 1% of Total
Sales Value
(iii) Advertisement@ 3% of Total
Sales Value
(+)
Total Expenses (B)(-)
Total Sales(A-B) (C) 2,44,400 3,57,200 3,85,400 2,35,000 12,22,000
62 Management Accounting - II
3.7
Summary
Types of Budgets :
Functional Budgets
• Functional Budgets : A functional Budget is one which relates to any of the
functions of an organisation. The Master Budget is prepared based on functional
budget. The following are the functional budgets prepared - (a) Sales Budget, (b)
Selling and Distribution Budget, (c) Production Budget, (d) Production Cost Budget,
(e) Plant Utilisation Budget, (f) Capital Expenditure Budget, (g) Purchase Budget,
(h) Personnel Budget, (i) Administrative Cost Budget, (j) Research Development
Cost Budget.
NOTES
• Purchase Budget : “The budget which shows the quality and value of goods
to purchased during the budget period to meet the day to day needs of the business.”
• Production Budget : A Production Budget is one which is an estimate for
qualities of goods to be purchased during the budget period.
• Production Cost Budget : This budget is prepared after the production
budget. This budget shows the details of the estimated costs of material, labour
and overheads.
• Sales Budget : Sales forecasting is the basic step in the preparation of a sales
budget. It is done by the sales manager in consultation with the Budget Controller.
3.8
Key Terms
1. Function Budget : A functional Budget is one which relates to all types of
functions of an organisation (i.e purchase production, sales etc.)
2. Purchase Budget : A Purchase budget is a budget which shows the quantity
and value of goods or items to be purchased during the period of budget to meet
the daily requirements of the business.
3. Production Budget : A production budget is one which is an estimate for
quantities of goods or items to be purchased during the budget period.
4. Production Cost Budget : The budget which shows the details of the estimated
costs which are required to be incurred as per the quantities shown in the production
budget.
5. Sales Budget : A Sales budget is a statement expressed in physical quantities
or / and values of anticipated sales during a specified period of time.
Management Accounting - II
63
Types of Budgets :
Functional Budgets
3.9
I.
Questions And Exercises
Objective Questions
Multiple Choice Questions
NOTES
1)
Functional Budgets are subsidiary to -----------------budget.
(a) Master (b) Flexible, (c) Fixed (d) Varable.
2)
The estimated stock at the end of the year is 20,000 units, the budgeted
consumption during the year is 1,10,000 units and opening stock of material
is 15,000 units. Hence quantity of Materials to be purchased will be--(a) 1,15,000 units,
(b) 1,05,000 units
(c) 1,45,000 units
(d) 1.25.000 units
(3)
The most important budget which all other budgets are contingent up on, is
the ---------budget.
(a) purchase
(b) sales
(c) production
(d) fixed
(4)
Budgets are prepared for every production centre for comparison with --------- production.
(a) total
(b) departmental
(c) targeted
(d) actual
Ans : (1-a), (2-a), (3-b), (4-d)
64 Management Accounting - II
II.
Long Answer Questions :
(1)
What is Budget ? Explain in brief the types of budget according to functions.
(2)
What are ‘Functional Budgets’ ? Explain in brief the following functional
budgets
(a) Sales Budget
(b) Production Budget
(c) Purchase Budget and
(d) Production cost Budget
(3)
What is ‘Purchase Budget’ ? State the basic purposes of preparing a
‘Purchase Budget’.
(4)
Explain in brief the important factors to be taken into account while preparing
a ‘Purchase Budget’
(5)
What is’ Production Budget’ Explain in brief the important factors to be
taken into accounts while preparing a ‘Production Budget’
(6)
Define ‘Production Budget’ and state the important objectives of preparing
a ‘Production Budget’
(7)
What is ‘Production cost Budget’ ? How it difters from ‘Production Budget’ ?
(8)
What is ‘Sales Budget? State in brief the important factors to be taken into
account while preparing a ‘Sales Budget’
Types of Budgets :
Functional Budgets
NOTES
III - Practical Problems
(1) A Company estimates the sales of 25,000 units of a product for the year
2006. The raw material to be required are A-3 units and B- 4 units. The opening
and closing balances of finished goods and raw materials estimated are as follows
Items
Opening Balance at the
Closing Balance at the
beginning of next year
beginning of next year
A
8,000
10,000
B
10,000
14,000
Finished goods
5,000
18,000
Prepare Purchase Budget showing the quantities of materials to be
purchased.
(2) Ramalal and Co. Ratnagiri sells two products X and Y. The following are
the estimates for the year 2014.
Sales Budget (Units)
Particulars
Ist Quarter
IInd Quarter
Product X
50,000
60,000
40,000
1,10,000
Product Y
40,000
50,000
70,000
1,00,000
IIIrd Quarter IVth Quarter
Product X is sold at `8 per units while Product Y is sold at `15 per unit.
Ramalal incurs selling and Distribution Expenses @ 2% of the Sales value. Bad
debts amount to 1% of the Sales Value. Prepare a Sales Budget for the year
2014.
Management Accounting - II
65
Types of Budgets :
Functional Budgets
NOTES
66 Management Accounting - II
3.10 Further Reading
•
Bhar B.K - Cost Accounts Methods and Problems - Kolkata Academic
Publishers-2012
•
Jawaher Lal - Cost Accounting - New Delhi - Tata MC Graw Hill Publishing
Co. Ltd. -2010
UNIT4
Types of Budget : Revenue, Cash &
Master Budget
Types of Budgets :
Review, Cash &
Master Budget
Structure
NOTES
4.0
Introduction
4.1
Unit Objectives
4.2
Revenue Budget
4.3
4.2.1
Principal Budget
4.2.2
Secondary Budget
4.2.3
Summary Budget
Cash Budget
4.3.1
Necessity of cash Budget
4.3.2
Methods of Preparation of Cash Budget
4.3.3
Proforma of Cash Budget
4.3.4
Illustrations
4.4
Capital Budget
4.5
Master Budget
4.5.1
Preparation of Master Budget
4.5.2
Format of Master Budget
4.6
Summary
4.7
Key Terms
4.8
Questions and Exercises
4.9
Further Reading
4.1
Introduction
Revenue Budgets have three components : 1) Principal Budgets; (ii)
Secondary Budgets & (iii) Summary Budgets Principal Budget consist of Income
budget and Expenditure Budget. Income budget is father classified in to : i) order
Booking & Gross Profit Budget, (ii) Turnover and Gross Margins Budget & (iii)
Other Income Budget. On the other hand expenditure Budget is further classified
in to : (i) Direct selling Expenses Budget, (ii) Distribution Expenses Budget, (iii)
Promotion Expenses Budget & (iv) Other Marketing Service Budget seperately.
Management Accounting - II
67
Types of Budgets :
Review, Cash &
Master Budget
NOTES
With the help of all these four budget we can prepared Total Marketing Expenses
budget seperately. While preparing Total Marketing Expenses Budget, we have
to considered all types of variable expenses, semivariable expenses and Nonvariable expenses.
Secondary Budget is further classified in to : (i) Working Capital Budget
(ii) Demand Analysis or forecast. (iii) Expenses behaviour Analysis, (iv) Manpower
Planning and Personnel Budget. Summary Budget is further Supported by (i)
Activity wise Profit and Loss Budget and (ii) Overall Profit and Loss Budget. All
above mentioned budgets are the main components of Revenue Budget.
Cash itself has two function of its own - receipt and payment. Accordingly,
there are cash receiving budget and cash disbursement budget in general, may be
termed as Cash Budget. There are three methods of preparation of cash budget:
(i) Receipt and Payments Method (ii) Adjusted Profit and Loss Method
and (iii) Balance Sheet Method.
Master Budget is an overall budget of the firm which includes all other
small departmental budgets.
4.1
Unit Objectives
After studying this units you should be able to -
68 Management Accounting - II
•
Understand the components of Revenue Budgets.
•
Explain the term ‘Cash Budget’.
•
Discuss the necessity & Use of Cash Budget.
•
Discuss the two methods of preparation of Cash Budget.
•
Prepare Cash Budget as per Receipts and Payment Method.
•
Prepare Cash Budget as per Adjusted Profit and Loss Method.
•
Discuss the term Master Budget.
•
Prepare a Master Budget of an organisation.
4.2
Revenue Budget
Types of Budgets :
Review, Cash &
Master Budget
Revenue budgets have three components.
Principal Budgets, Secondary Budgets and Summary Budgets which are shown in
Figure 4.1
NOTES
Revenue Budgets
Principal
Secondary or
Summary
Budget
Subsidiary Budget
Budget
Earnings
Expenses
Working
Expenses
P&L
P&L
or
Budget
Capital
Behaviour
Budget
Budget
Budget
Analysis
(activity
(over all)
Income
Budget
wise)
Demand
Manpower
Analysis
Planning
or
& Personnel
Forecast
Budget
Check Your Progress
Identify
the
various
components of Revenue
budget and their importance.
Order
Booking
&
Gross
Profit
Budget
Turnover
& Gross
Margins
Budget
Other
Income
Budget
2
Variable
Expenses
a
Semi-variable
Expenses
b
Distribution
Expenses
Budget
2
Direct
Selling
Expenses
Budget
1
+
Promotion
Expenses
Budget
3
Other
Marketing
Services
Budget
4
3
+
+
Total
Marketing
Expenses
Budget
1
4
a
c
+
b
+
Fig. 4.1 : Components of Revenue Budgets
Non-variable
Expenses
c
Management Accounting - II
69
Types of Budgets :
Review, Cash &
Master Budget
NOTES
70 Management Accounting - II
4.2.1 Principal Budget
Principal Budget is that factor the extend of whose influence must first be
assessed in order to ensure that budgets are reasonably capable of fulfillment.
A)
Revenue Earning or Income Budget :
i)
Order Booking and Gross Profit Budgets : These budgets are specially
applicable to industrial, marketing or other such situations where there is a
distinct time lag between the booking of order and effecting actual delivery
and sales. This budget is a statistical budget and not an accounting one.
ii)
Turnover and Gross Margin Budgets : This is the main revenue income
budget and is in line with the financial accounting definition of sales and
gross margin. This budget has to be in conformity with the order booking
and gross margin. This budget has to be in conformity with the order booking
and gross profit budget. This budget can be prepared product wise.
iii)
Other Income Budgets :- This would cover income from scrap sales,
commission on third party sales, income out of after sales services beyond
warranty period, commission on imports and exports on behalf of others,
recovery of bad debts, income from brand name, non-operating incomes
etc.
B)
Marketing Expenses Budget :
(i)
Direct Selling Expense Budget : This will cover direct expenses on
salesman such as, salesmen’s commission, salesman’s stationery, salesman
postage and telegram, bad debts etc.
(ii)
Distribution Expense Budget : This includes expenses on maintenance
of sales depots and branches, expenses on transportation of goods and
expenses on outside transport and owned transport housing expenses,
licences and instance and such other expenses related to distribution.
(iii)
Promotional Expense Budget : This cover all expenses connected with
advertisement and sales promotion including media advertisement, payments
to advertising agencies and commerce.
(iv)
Other Marketing Service Budget : These include all expenses relating
to marketing director’s office, market planning activities, marketing research
and such other general marketing services. This also include budget for
special sales (i.e new areas being tapped, new lines being introduced, special
advertising campaign etc.)
(v)
Total Marketing Expenses Budget : This budget can be further classified
on the basis of cost behavior approach viz. fixed, semi-fixed and variable
costs. This budget will includes all marketing expenses which are mentioned
above (i.e. (i) + (ii) + (iii) + (iv) as above.)
4.2.2 Secondary Budget
There are various types of subsidiary budgets intended to provide supporting
data and analysis is with regard to the framing of the principal budgets mentioned
above, including the various expenses budgets. Following are the examples of
various types of subsidiary budgets.
(i)
Working Capital Budget :
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Initial working capital budget is prepared to show the expected fund during
the “lake of” period or gestation period. This in turn helps in the determination of
interest cost to be included in the expense budget and also the budgeted “Return
on Investment” in the marketing operations.
(ii)
Personnel Budget :
Personnel budget is prepared with reference to production budget. If wages
are paid according to price rate systems in all the departments preparation of
personnel budget is comparatively easy. When payment are made according to
time rate or price rate. Production in terms of ordinary units should be converted
into standard hours of production in different departments. In other cases,
requirements for skilled and unskilled labour time shall be budgeted. This budget
depends on the decisions taken by the management. While taking such decisions
the management attempts to simultaneously the goals of the organisation, and the
needs and value of their employees.
(iii)
Expenses Behavioural Analysis :
This requires isolation of fixed, semi-fixed and, variable expenses of marketing
operations. The expenses are grouped as : Variable, Semi-variable and Fixed.
The first is directly related with production, the second is partly related and the
third is unrelated with level of activity. Apart from variability with production,
likely change in rate of expenses should be considered. If expenses for each
department are to be shown separately, expenses are to be departmentalised in
the light of allocation of factory overheads. An analysis of expenses in this manner
facilitates precise estimates of various heads of expenses covered under expenses
budgets. It would be obvious that expense behavior analysis made and used at
the time of preparing budgets not only puts the budget estimation on a sounder
footing, but also helps in reviewing the various budget estimates. It also forms a
systematic basis for subsequent comparison between budgeted expenses and actual
expenses for the purpose of effective control. As the main purpose of budgeting is
control of budgeting is control of expenses by pin pointing responsibility, no useful
purpose is served by allocating expenses incurred under one responsibility over
various departments which are no control on them.
(iv) Sales Forecasting or Demand Analysis :
Sales forecast may be made in different ways. Best result is achieved
when there is arrangement of ‘Market Research’ Market Research be conducted
continuously’ by marketing research department or may be taken up periodically
with the help of specialized consultancy firms, when such services are available.
Management Accounting - II
71
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Whatever be the system followed, nature of the demand i.e. whether local or
restricted, whether it is within a state or national or international in character, must
be determined. The pattern of demand for different products, and how it is affected
by the substitutes, should be considered. In this connection now price, design
quality and packing influence, consumer preference should be studied in the context
of price and of the products of the competitors. The type of customers (i.e whether
one industry or group of industries, or whether public at large, or particular sections
of the public or any part of community etc.) require serious study. The trend and
seasonal influences in sales should be brought to light by mathematical, statistical
or other techniques. In short, this analysis establish a systematic basis for budgeting
order bookings as well as turnover in respect of scientific product or services
4.2.3 Summary Budget
We have seen how each revenue budget is prepared. After budgeting all
business functions, the owner is obviously eager to know the summarised result of
these revenue budgets. This result may be net business profit or net business
loss. So all the revenue budgets along with the development and finance budgets
have to integrated and summary budget are to be prepared. These are actually
summered profit and loss or revenue statement budgets prepared separately for
each important division or activity group, and also for the organisation’s total
operations.
In short, with the help of the above revenue budget a summary budget is
prepared. A summary budget is a budget which is prepared from and summarises,
all the functional budgets. The end products of summary budgets are :
Check Your Progress
What is Summary Budget ?
(a) The Budgeted Profit and Loss Account :
Summarising the budgeted income from the sales budget and the budgeted
costs from other functional budgets, a budgeted profit and loss account is build up.
(b) The Budgeted Balance sheet :
The summary budget thus prepared are reviewed, readjusted and re-budgeted
in order to get the maximum benefit from budgetary control. It will be observed
that once a summary is approved, it ceases to be merely a plan, it become also
the target for the concern during the budget period to be achieved by executive
directions.
72 Management Accounting - II
4.3
Cash Budget
Types of Budgets :
Review, Cash &
Master Budget
Cash Budget is the forecast of cash position for a particular period. It
represents the cash requirements of the business during the budget period. It is a
financial budget prepared after the preparation of all the functional budgets.
A Cash Budget is usually defined as, “an estimate of receipts and payments
for each month or any other relevant period forming part of the entire budget
period.”
NOTES
Thus, it is the future plan of receipts and payment of cash for the budget
period, analysed to show the monthly flow of cash drawn up in such a way that
the balance can be forecasted at regular intervals. It is a ‘means budget’ prepared
by the chief accountant in terms of money value. It may be prepared for a short
period or a long period depending on the requirements. e.g. weekly, fortnightly,
monthly, quarterly, half yearly, annually etc. A company may have divisional and
departmental cash budgets in addition to a cash budget for the overall organisation.
4.3.1 Necessity of cash Budget
Generally, a cash budget is prepared to achieve the following necessities :
(i)
To obtain necessary working capital easily from the banks and financial
institutions for smooth running of the business.
(ii)
To enable the top management to make necessary arrangements of cash in
case of emergency situations.
(iii)
To ensure that sufficient cash is made available throughout the financial
period to meet the required payments.
(iv)
To ascertain any expected shortage of cash and to make it available through
bank loan or sales of fixed assets.
Uses of Cash Budget:
A Cash budget is more useful to the organisation in the following manner.
(i)
It helps in co-ordinating activities of different divisions of a corporate sector.
(ii)
It helps the company to plan for dividend and interest payments.
(iii)
It helps in proper planning for long-term capital requirement.
(iv)
It helps the management to know the type of capital required to be raised.
(v)
It helps the management to raise the finance from economical sources.
(vi)
It is useful in knowing the flow of funds and their requirements.
(vii)
It helps in providing sufficient information on the probable profits to be
realised during the budgeted period.
(viii) It is useful in analysing the estimated changes in the receipts and planned
Check Your Progress
Identify
the
variance
components of venenue
budget and their importance.
Management Accounting - II
73
Types of Budgets :
Review, Cash &
Master Budget
payments in the budget period.
(ix)
It highlights the fluctuations in cash due to various financial transactions.
(x)
It indicates the surplus or deficiency of cash at the end of every budgeted
period.
NOTES
4.3.2 Methods of Preparation of Cash-Budget
Generally, a cash Budget can be prepared by any one of the three methods
viz. Receipts and Payments Method, Cash Flow Statement Method and the Balance
Sheet Method. But a Receipts and Payment Method seems to be more popular
because of its own advantages. As well as, the Receipts and Payments Method is
useful for short-term cash budget whereas the other two methods are used for
long-term cash budgets.
(i) Receipts and payments Method :
According to this method, Cash Budget includes all the cash receipts whether
they are on revenue account or capital account. Similarly, all expected capital and
revenue expenditures are brought in a cash budget. The accruals. i.e income
earned but not received and expenditure due but not paid are excluded from the
cash budget. Thus, a cash budget is a sort of cash account which records cash
receipts and cash payments and shows expeced cash balance at the end of the
budget period. The informations for cash budget are derived from other budgets.
For example, the sales budget will provide the amount of sales and the receipts
from sales and realization from debtors can be estimated by taking into account
the terms of sales. The raw materials purchase budget, labour budget and overhead
budget will provide information relating to payments for raw materials, wages
and overhead charges. The management can forecast payments on account of
capital expenditure, tax, dividend etc. The difference of cash receipts and cash
payments for a period is either positive or negative, which is carried to next period.
In this method, all the cash receipts which are expected and all the cash
payments which are expected to be made are taken into account. Thus, the cash
balance will represents the difference between the total cash receipts expected
(including the opening cash balance) and the total cash payments to be made.
The following are the sources and application of cash.
SOURCES :
74 Management Accounting - II
(a)
Collection from debtors i.e credit customers: This can be ascertained
from the Sales Budget. The terms and conditions of sales, lag in payments
and other factors should be considered while estimating the cash receipts.
(b)
Cash receipts from other sources viz., Dividends received interest on
investments, rent received, sale of investments, sale of fixed assets. etc.
APPLICATIONS :
(a)
Cash payments for purchase of raw materials, payment of wages and other
expenses are estimated from the various budgets viz. Purchase budgets
personnel budget and overhead/expenses budget. The suppliers credit period,
terms and conditions of purchases cash discount allowed, law in payment
of wages etc. should be considered
(b)
Cash payments for capital expenditure can be ascertained from the capital
expenditure budget.
(c)
Cash payments for dividends income tax etc.
Types of Budgets :
Review, Cash &
Master Budget
NOTES
EXAMPLE
From the following budgeted data relating to Zenith Industries
Ltd., Amaravati prepare cash Budget for three months from
February to April 2013.
2013
Sales
Purchases
Wages
Overheads
Months
`
`
`
`
January
85,000
48,000
10,000
12,500
February
90,000
52,000
11,000
13,500
March
1,20,000
60,000
14,000
15,000
April
1,30,000
62,000
14,000
16,000
Other Informations:
1.
20% Sales is for cash and the remaining amount is realised in the month
following that of sales.
2.
Suppliers Supply raw materials at one months credit.
3.
Wage-bill is paid in cash in the same month.
4.
Overheads are paid in first week of next month.
5.
Monthly rent payment is ` 1,000.
6.
Advance Income Tax of ` 15,000 is payable in April.
7.
Bonus of ` 10,000 is payable to workers in February.
8.
Plant Costing Rs. 80,000 is due to be installed in February. The part of the
bill will be paid in March amounting to ` 18,500.
9.
Half year interest on 12% ` 50,000 Debentures is to be received in February
and August every year.
10.
Cash at Bank on 1st February estimated at `5,000.
Management Accounting - II
75
Types of Budgets :
Review, Cash &
Master Budget
SOLUTION
In the books of Zenith Industries Ltd., Amaravati
Cash Budget for the three months ended 30th April 2013
Particulars
NOTES
Cash at Bank Opening
(A)
Feb
March
`
`
April
`
(+)5,000
(+)11,500
(+)10,000
18,000
24.000
26,000
68,000
72,000
96,000
 


(B)
89,000
96,000
1,22,000
94,000
1,07,500
1,32,000
48,000
52,000
60,000
(ii) wage bill - One month credit
10,000
11,000
14,000
(iii) overheads - paid on same month
13,500
15,000
16,000
1,000
1,000
1,000
(v) Advance Income Tax Payable
-
-
15,000
(vi) Plant installation and payment of bill
-
18,500
-
10,000
-
-
82,500
97,500
1,06,000
 Cash Bank Closing (C-D) (E) (+)11,500
(+)10,000
(+)26,000
Add : Receipts :
(i) Cash Sales i.e. 20% of sales(ii) Collection from Debtors i.e. 80% of Sales
One month credit
(iii) Interest on Debentures received
@ 12% p.a. on Rs. 50,000 for six
month
 Actual Receipts
 
 Total Receipts
(A)+(B)(C)
Less : Payments :
(i) to suppliers for purchase of raw materials
One month credit
(iv) Monthly Rent
(vii) Bonus to workers
(+)
 Total Payments
(D)
(-)
76 Management Accounting - II
(ii) Adjusted Profit and Loss Method :
Under this method, the Profits as shown in the Profit and Loss Account
prepared in the conventional manner forms the basis for cash forecast. The profit
is adjusted by adding back to it the non-cash items such as depreciation, outstanding
expenses, other provisions etc. The other items which increase the total cash
inflows are the increase in share capital, debenture and loans, current liabilities
(creditors) and decrease in fixed assets, debtors and stock etc. Out of the total
cash-inflows calculated as above, the items which results in cash outflow are
subtracted to arrive at the cash position at the end of the period. The items which
reduce the cash position are accrued incomes, advance payment, dividend payment
redemption of debentures and loans, decrease in creditors, payment for fixed
assets, increase in debtors and stock etc. This method of cash forecast may also
be called as the Cash Flow Statement method as the net income as per the
conventional income statement is converted into a cash flow forecast. The main
sources of information for cash forecast as per this method are the profit and loss
account and balance sheet. This method is suitable to prepare cash budget for
long period.
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Check Your Progress
Which method is suitable to
prepare cash budget for long
period ?
EXAMPLE
From the following Balance Sheet and Projected Profit and Loss Account
of Aptech Ltd., Ahmedabad prepare the Cash Budget according to Adjusted Profit
and Loss Account method for the year ended 31st December, 2013
Balance Sheet as 31st December 2013
Liabilities
Share Capital
`
Assets
1,50,00,000 Land and Buildings
`
1,25,00,000
General Reserve
50,00,000 Plant and Machinery
80,00,000
Profit and Loss
25,00,000 Furniture and Fixtures
15,00,000
Debentures
80,00,000 Sundry Debtors
75,00,000
Creditors
1,00,00,000 Stock
Bills Payable
20,00,000 Bills Receivable
Outstanding Salaries
30,00,000 Prepaid Rent
Cash at Bank and in hand
4,28,00,000
50,00,000
10,00,000
3,00,000
70,00,000
4,28,00,00
Management Accounting - II
77
Types of Budgets :
Review, Cash &
Master Budget
Projected Profit and Loss Account
for the year ended 31st December 2013
Particulars
NOTES
`
To Opening Stock
Particulars
50,00,000 By Sales
To Purchases
2,25,00,000 By Closing Stock
To Gross Profit C/D
3,00,00,000
45,00,000
70,00,000
3,45,00,000
To Salaries
`
10,00,000
3,45,00,000
By Gross Profit B/D
70,00,000
Less : Last years
Outstanding (-) 3,00,000
7,00,000
Add :Outstanding
for current year (+) 1,00,000
To Commission
8,00,000
1,50,000
To Rent
9,00,000
Add : Last Years
Prepaid
(+)3,00,000
12,00,000
To Interest
8,00,000
To Establishment Charges
2,50,000
To Advertising Expenses
2,00,000
To Depreciation :
(i) Plant and Machinery 8,00,000
(ii) Land and Building 6,00,000
(iii) Furniture
(+)1,50,000
To Net Profit C/D
15,50,000
20,50,000
70,00,000
To Dividend
30,00,000 By Net profit C/D
20,50,000
To General Reserve
10,00,000 By Profit and Loss A/C
25,00,000
To Balance C/D
5,50,000
45,50,000
78 Management Accounting - II
70,00,000
45,50,000
On 31st December, 2013 the position of some of the items was as under :
`
Share Capital
2,00,00,000
Debentures
1,00,00,000
Creditors
80,00,000
Debtors
90,00,000
Bills Payable
25,00,000
Bills Receivable
Types of Budgets :
Review, Cash &
Master Budget
NOTES
8,00,000
Purchase of Plant of Machinery during 2013 amounted to `28,00,000 and
Purchase of Furniture and Fixtures `21,50,000.
ANSWER
In the books of Aptech Ltd., Ahmedabad
Cash Budget (Adjusted Profit and Loss Method)
for the year ended 31st December 2013
Particulars
`
`
`
Cash Balance as on 31st December, 2012
70,00,000
Add :
(i)
Net Profit for 2012
(ii)
Depreciation:
20,50,000
• Plant and Machinery
• Land and Building
• Furniture
(iii)
8,00,000
6,00,000
(+)
1,50,000
Decrease in Prepaid Rent
15.50,000
3,00,000
(iv) Decrease in Stock
5,00,000
(v) Decrease in Bills Receivable
2,00,000
(vi) Increase in Bills Payable
5,00,000
(vii) Issue of Share Capital
(Viii) Issue of Debentures
50,00,000
(+)
(+) 20,00,0000 1,21,00,000
(+) 1,91,00,000
Less :
(i)
Purchase of Plant and Machinery
28,00,000
(ii)
Purchase of Furniture and Fixtures
21,50,000
(iii) Dividend
30,00,000
(iv) Decrease in Outstanding Salaries
(V)
2,00,000
Increase in Debtors
(vi) Decrease in Creditors
15,00,000
(+)
20,00,000
(-) 1,16,50,000
 Cash Balance as on 31 December, 2013
st
74,50,000
Management Accounting - II
79
Types of Budgets :
Review, Cash &
Master Budget
NOTES
iii) Balance Sheet Method :
As per this method, a projected Balance Sheet is prepared in which cash
balance is not an estimated item but a different between total projected assets
and total estimated liabilities. In other words, the excess of projected assets over
projected liabilities, represents cash balance. If the liabilities are more than the
assets, the balance shows the overdraft.
EXAMPLE
Using the data of previous example of Aptech Ltd., Ahmedabad, prepare a
projected Balance Sheet as on 31st December, 2013 to show the cash position as
on that data:
ANSWER
In the books of Aptech Ltd., Ahmedabad
Projected Balance Sheet as on 31st December, 2013
Liabilities
Assets
`
`
Share Capital
2,00,00,000 Land and Buildings
1,25,00,000
Debentures
1,00,00,000 Less : Depreciation
(-)6,00,000
General Reserve
Profit and Loss A/c
60,00,000 Plant and Machinery
80,00,000
5,50,000 Less : Depreciation
(-)8,00,000
Creditors
80,00,000
Bills Payable
25,00,000 Add : Purchases
Outstanding Salaries
1,19,00,000
72,00,000
(+) 28,00,000
1,00,000 Furniture and Fixtures
Less : Depreciation
1,00,00,000
15,00,000
(-) 1,50,000
13,50,000
Add : Purchases
(+) 21,50,000
Debtors
Bills Receivable
35,00,000
90,00,000
8,00,000
Stock
45,00,000
Cash and Bank Balance
74,50,000
(Balancing Figure)
4,71,50,000
80 Management Accounting - II
4,71,50,000
4.3.3 Proforma of Cash Budget
The proforma of Cash Budget can be shown by two methods as follows:
Types of Budgets :
Review, Cash &
Master Budget
(I) Proforma of Cash Budget under Rolling Period Basis :
Budget Actual Comparison
Month - I
Budget
Particulars
Month
Month
Month
1
2
3
NOTES
Actual
(A) Sales Receipts:
(i) Cash Sales and Advances
(ii) Sundry Debtors Collection
(iii) Cash Subsidies, Rebate etc.(+)
Total
(A)
(B) Operations Distribution
(i) Cash Purchases & Advances
(ii) Sundry Creditors Payment
(iii) Wages, Salaries etc.
(iv) Rent, Electricity etc.
(v) Selling Expenses
(vi) Administrative Expenses
(vii) Income Tax paid
Total
(B)
(C) Cash Flow Through
Operations
(A-B)
(D) Miscellaneous Receipts:
(interest, Rent, Royalties etc.)
(E) Capital Receipts:
(i) Debenture issues
(ii) Term Loans
(iii) Issue of Share Capital
(iv) Sales of Assets
Total
(E)
(F) Non-Operating
Distributions
(i) Interest and Financial Cost
(ii) Donations
Management Accounting - II
81
Types of Budgets :
Review, Cash &
Master Budget
(iii) Dividends
(iv) Capital Expenditures
(v) Debt Redemption
Total
NOTES
(F)
(G) Net Cash Flow
(C+D+E-F)
Add :
Opening Balance
Cash Position
(+)
Less : Minimum Cash Required
Bank Loan (Increase)/
decrease
Cumulative Bank Position
(Drawing Power)
(II) Proforma of Cash Budget :
In the books of a Company
Cash Budget for the period ended...
Particulars
Opening Balance of Cash
January
February
March
Total
`
`
`
`
------
------
------
------
Add : Receipts :
•
Cash Sales
------
------
------
------
•
Receipts from Debtors
------
------
------
------
•
Issue of Share and Debentures
------
------
------
------
•
Dividends etc.
(+)
------
------
------
------
Total
(A)
------
------
------
------
Less : Payments :
•
Cash Purchase
------
------
------
------
•
Creditors
------
------
------
------
•
Wages
------
------
------
------
•
Capital Expenditure
------
------
------
------
•
Dividend Payable
------
------
------
------
•
Interest Payable
------
------
------
------
•
Income-Tax payable
------
------
------
------
------
------
------
------
------
------
------
------
Total
82 Management Accounting - II
Closing Cash Balance : (A-B)
(B)
4.3.4 Illustrations
The preparation of Cash Budget can be understood with the help of following
illustrations.
Types of Budgets :
Review, Cash &
Master Budget
NOTES
ILLUSTRATION 1
Summarised below are the income and expenditure forecasts for the month
of March to August 2014 of Flex Industries Ltd., Faridabad.
Month
Credit
Credit
Wages Manufacturing
Sales Purchases
Office
Selling
Expenses Expenses Expenses
`
`
`
`
`
`
March
60,000
36,000
9,000
4,000
2,000
4,000
April
62,000
38,000
8,000
3,000
1,500
5,000
May
64,000
33,000
10,000
4,500
2,500
4,500
June
58,000
35,000
8,500
3,500
2,000
3,500
July
56,000
39,000
9,000
4,000
1,000
4,500
You are given the following further information :
(a)
Plant Costing `16,000 is due for delivery in July 2014 payable 10% on
delivery and balance after three months.
(b)
Advance Tax of `8,000 each is payable in March and June, 2014
(c)
Period of credit allowed
(i) by suppliers 2 months and (ii) to customers one month
(d)
Lag in payment of manufacturing expenses half month.
(e)
Lag in payment of all other expenses one month.
You are required to prepare a Cash Budget for three months starting on 1st
May, 2014 when there was a cash balance of `8,000.
Management Accounting - II
85
Types of Budgets :
Review, Cash &
Master Budget
SOLUTION
In the Books of Flex Industries Ltd., Faridabad
Cash-Budget for three months ended on 31st July 2014
Particulars
NOTES
Cash Balance Opening :
May
June
July
`
`
`
(A)
8,000
15,750
12,750
(+)
62,000
64,000
58,000
Add Receipts:
(1)
Collection from customer
for Credit sales (1 month credit)

Actual Receipts

Total Receipts (A+B)
(B)(+) 62,000
64,000 58,000
(C) 70,000
79,750 70,750
Less : Payments :
(1)
Purchase of Plant
-
-
1,600
(2)
Advance-Tax
-
8,000
-
(3)
Payment to suppliers for credit
36,000
38,000
33,000
3,750
4,000
3,750
Purchase (2 months credit)
(4)
Payment to Manufacturing Expenses
(half month credit)
(1,500+2,250) (2,250+1,750) (1,750+2,000)
(5)
Wages (one month credit)
8,000
10,000
8,500
(6)
Office Expenses (one month credit)
1,500
2,500
2,000
(7)
Selling Expenses (one month credit)
5,000
4,500
3,500

Total Payments
(D) 54,250
67,000 52,350
 

86 Management Accounting - II
Cash Balance Closing (C-D)
(E) 15,750
12,750 18,400
ILLUSTRATION 2
From the following information relating to Gesco Ltd., Gurgaon prepare a
Cash Budget for half year ended 30th June, 2014
2014
Sales
Materials
Wages
Months
Selling
Works
Manufacturing
Expenses Overheads Expenses
`
Types of Budgets :
Review, Cash &
Master Budget
`
`
`
`
`
January 72,000
25,000
10,040
4,000
6,000
1,500
February 97,000
31,000
12,190
5,000
6,300
1,700
March
86,000
25,500
10,620
5,500
6,000
2,000
April
88,600
30,600
25,042
6,700
6,500
2,200
May
1,02,500
37,000
22,075
8,500
8,000
2,500
June
1,08,700
38,800
23,039
9,000
8,200
2,500
NOTES
The Cash balance on 1-1-2014 is `2,500 Assume that 50% of the total
sales are cash sales. Assets are to be acquired in the month of February and April
2014, hence, provision should be made for the payment of `8,000 and `25,000
respectively for the same. An application has been made to the bank for the grant
of a loan of `30,000 and it is expected that it will be received in May, 2014. It is
also anticipated that a dividend of `35,000 will be paid in June. Debtors are allowed
one months credit whereas creditors, for goods or overheads, grant one months
credit. Sales commission @ 3% on total sales is to be paid in the same month.
Management Accounting - II
87
88 Management Accounting - II
`
26,300
48,500
36,000
84,500
1,10,800
25,000
12,190
4,000
6,000
1,500
8,000
2,910
59,600
51,200
2,500
36,000
-
36,000
38,500
10,040
2,160
12,200
26,300
`
31,000
10,620
5,000
6,300
1,700
2,580
57,200
85,500
91,500
1,42,700
43,000
48,500
`
51,200
In the Books of Gesco Ltd., Gurgaon
Cash-Budget for the six month ended on 30thJune 2014
Jan
Feb
March
25,500
25,042
5,500
6,000
2,000
25,000
2,658
91,700
81,100
87,300
1,72,800
44,300
43,000
`
85,500
April
37,000
23,039
8,500
8,000
2,500
35,000
3,261
1,17,300
1,23,800
1,05,600
2,41,100
30,000
1,25,550
2,06,650
30,600
22,075
6,700
6,500
2,200
3,075
71,150
1,35,500
54,350
51,250
81,100
`
1,35,500
June
51,250
44,300
`
May
NOTES
Cash Balance - Opening
(A)
Add : Receipts :
1.
Cash Sales - 50% of Total Sales
2.
Collection from Debtors
50% of Total Sales one months credit
3.
Grant of Bank Loan
(+)
 Actual Receipts
(B) (+)
 Total Receipts (A + B)
(C)
Less : Payments
1.
Creditors for Purchase of Materials - One months credit 2.
Wages
3.
Creditors for Selling Expenses - One months credit
4.
Creditors for Works Overheads - One months credit
5.
Creditors for Office on Cost - One months credit
6.
Purchase of Asset
7.
Dividend
8.
Sales Commission @ 3% on Total Sales
(+)
 Total Payments
(D)(-)
Cash Balance - Closing (C-D)
(E)
Particulars
SOLUTION
Types of Budgets :
Review, Cash &
Master Budget
ILLUSTRATION 3
Prepare a Cash Budget of India Nippon Ltd., Indore for the three months
ended 30thJune 2014 in a columnar form using the following cost data.
2014
Total Sales
Months
`
`
`
`
January - Actual
80,000
45,000
20,000
5,000
February - Actual
80,000
40,000
18,000
6,000
March - Actual
75,000
42,000
22,000
6,000
April - Budgeted
90,000
50,000
24,000
7,000
May - Budgeted
85,000
45,000
20,000
6,000
June - Budgeted
80,000
35,000
18,000
5,000
Types of Budgets :
Review, Cash &
Master Budget
Total Purchase Wages Overheads
NOTES
Additional Information :
(1)
10% of the Purchases and 20% of the Sales are for cash.
(2)
The average collection period of the company is half a month and the credit
purchases are paid-off regularly after one month.
(3)
Wages are paid off half monthly and the taxes of `500 included in Overheads
are paid off on monthly basis.
(4)
Cash balance on 1st April, 2014 was `15,000 and the company has decided
to maintain it at the end of every month at the same amount, the excess
cash if any, be deposited into fixed deposit account.
Management Accounting - II
89
Types of Budgets :
Review, Cash &
Master Budget
SOLUTION
In the Books of India Nippon Ltd., Indore
Cash Budget for the three months ending 30thJune 2014
Particualars
NOTES
April
`
Cash Balance Opening :
(A)
15,000
May
June
`
`
15,000 15,000
Add : Receipts
(i)
Cash Sales i.e 20% of Total Sales
18,000
17,000
16,000
66,000
70,000
66,000
(ii) Collection from Debtors from
Credit Sales i.e 80% of Total Sales (a)
Average Collection period half a month
(30,000+ (36,000+ (34,000+
36,000)
34,000) 32,000)
87,000 82,000
(+)

Actual Receipts
(B)
84,000

Total Receipts : (A+B)
(C)
99,000 1,02,000 97.000
Less :Payments:
(i)
Cash Purchase i.e 10% of Total
5,000
4,500
3,500
37,800
45,000
40,500
23,000
22,000
19,000
Purchases
(ii) Payment to Creditors from Credit
Purchase i.e 90% of Total Purchases One month credit.
(iii) Wages - half a month credit
(11,000+
(iv) Overheads - Monthly basis
(12,000+ (10,000+
12,000)
10,000)
9,000)
6,500
5,500
4,500
500
500
(v) Taxes - Monthly basis
(+)
500

(D)
72,800
77,500 68,000
Actual Cash Balance Closing (C-D)(E) 26,200
24,500 29,000
Total Payments :
(-)

Less : Excess Cash deposited into
Fixed Deposit Account

90 Management Accounting - II
Required Cash Balance Closing:
(-)
11,200
15,000
9,500
14,000
15,000 15,000
ILLUTRATION 4
From the following forecast of income and expenditures of Forex Engineering
Co. Ltd.., Faizpur, prepare a Cash Budget for three months ended 31st August
2014
2014
Total Purchase Prime
MonthsTurnover
`
Works
Selling on
Cost
Overhead
Cost
Labour
`
`
Types of Budgets :
Review, Cash &
Master Budget
NOTES
`
April
50,000
39,700
5,000
20% of Direct Wages 5% of Market Price
May
80,000
49,600
5,000
20% of Direct Wages 5% of Market Price
June
60,000
51,050
6,000
20% of Direct Wages 5% of Market Price
July
70,000
38,340
6,000
20% of Direct Wages 5% of Market Price
August 60,000
28,910
7,000
20% of Direct Wages 5% of Market Price
The additional information made available is as follows :
(1)
One-fifth of the Sales are on cash basis. Of the remaining credit sales fifty
percentage are to be recovered in the next month whereas fifty percentage
are recovered after two months. Cash Sales are made at five percentage
cash discounts.
(2)
All Purchases are credit and the payment to suppliers is made after two
month.
(3)
Wages are paid fifteen days in arrears.
(4)
Overheads are paid in the same month.
(5)
A Texmo machine costing `60,000 is to be purchased in July 2014 Fifty
percentage of the total amount is to paid in the same month as down payment
whereas the remaining balance is to be paid in three equal installments
together with interest at eighteen percentage per annum.
(6)
On 31st May 2014 cash balance is estimated at `36,000.
Management Accounting - II
91
Types of Budgets :
Review, Cash &
Master Budget
SOLUTION
In the book of Forex Engineering Co. Ltd., Faizpur
Cash Budget for the three months ending 31st August, 2014
NOTES
Particualars
Cash Balance Opening :
June
July
August
`
`
`
(A) 36,000
50,000 29,000
Add : Receipts
(i) Cash Sales i.e 20% of Total Sales
Less : 5% Cash Discounts
11,400
13,300
11,400
52,000
56,000
52,000
(ii) Collection from Debtors -from
Credit Sales i.e 80% of Total Sales  Actual Receipts
(+)
(B) 63,400
69,300 63,400
(+)
 Total Receipts (A+B)
(C) 99,400 1,19,300 92,400
Less : Payments :
(i) Payment to Creditors from Credit
Purchases - Two months credit
39,700
49,600
51,050
5,500
6,000
6,500
(ii) Prime Cost labour i.e. Wages 15 Days in arrears
(2,500+
(3,000+ (3,000+
3,000
3,000
3,500)
1,200
1,200
1,400
3,000
3,500
3,000
(iii) Works Overhead - in the same month
i.e 20% of Direct Wages
(i.e actual Prime Cost Labour
(iv) Selling on Cost - in the same month
i.e 5% of market Price (i.e Total Turnover)
(v) Purchase of Machine and payment of down
30,000
payment and payment of equal instalment
together with interest of 18% p.a
------
--------
10,450
(+)
 Total Payments
(D) 49,400
90,300 72,400
(-)
 Cash Balance Closing (C-D)
92 Management Accounting - II
(E) 50,000
29,000 20,000
Types of Budgets :
Review, Cash &
Master Budget
Working Notes :
1. Calculation of Net Cash Sales :
Particualars
June
`
Actual Cash Sales
July August
`
`
12,000
14,000
12,000
600
700
600
NOTES
(i.e 20% of Total Sales)
Less :
Cash Discount)
(i.e 5% of Cash Sales)

(-)
Net Cash Sales
11,400 13,300 11,400
2. Calculation of Net Cash Collection from Debtors - from Credit Sales
i.e. 80% of Total Sales :
Particualars
(i)
June
July
August
`
`
`
32,000
24,000
28,000
20,000
32,000
24,000
52,000
56,000 52,000
50% of Credit SalesOne month Credit
(ii) 50% of Credit Sales Two months Credit
(-)

Net Cash Collection from Debtors
3. Calculation of instalment amount to be paid on purchase of machine :
`
• Cost price of “Texmo’ machine - July, 2014
60,000
• Down Payment i.e 50% of total amount
30,000
• Total Amount due on 31st July, 2014
30,000
• To be paid in three equal instillments of
10,000
• Together with interest @ 18% pa. (i.e 18% of
` 30,000 for one month)
Hence, total instalment to be paid in August will be
450
10,450
(i.e `10,000 + ` 450)
Management Accounting - II
93
Types of Budgets :
Review, Cash &
Master Budget
NOTES
4.4
Capital Budget
It is known “ Capital Expenditure Budget.” This budget shows the estimate
expenditure on fixed assets during the budget period. As the amount involved
capital expenditure is sometimes high, this requires carefully attention of top
management. This budget is based on the requisition for capital expenditure from
various departments and after understanding their profitability. Capital expenditure
is sanctioned and incorporates in the budget.
4.5
Master Budget
The master budget is expressed in financial terms and sets out management’s
plans for the operations and resources of the firm for a given period of time. It is
a summary of the budget schedule in capsule form made for the purpose of
presenting in one report the highlights of the budget period. The Institute of Cost
and Management Accounts, London defines it as, “The summary budget,
incorporating its component functional budget which is finally approved, adopted
and employed.
Davidson and other state : The master budget, sometimes called the
comprehensive budget is complete blueprint of the planned operations of the firm
for a period.
Thus, master budget is an overall budget of the firm which includes all other
small departmental budgets. It is an overall budget of the firm which includes all
other small departmental budgets. It is a network consisting of many separate
budgets that are interdependent. It co-ordinates various activities of the business
and puts them on correct lines. In fact, the master budgets contains consolidated
summary of all the budgets prepared by the organisation. Few top executive of
the business are supplies with the copies of the master budgets. Such budget is no
use of department executives. It draws the attention of the management to those
issues which must require immediate attention or which must be avoided without
any delays in the interest of the business.
4.5.1 Preparation of the Master Budget
Check Your Progress
Give the various steps
involves in preparation of a
Master Budget.
94 Management Accounting - II
Preparation of Master Budget is a complete process that requires much
time and effort by management at all levels. It includes the preparation of a
projected Profit and Loss Account (income Statement) and Projected Balance
Sheet. However, preparation of a master budget involves the following step:
(i)
Preparation of a Sales Budget.
(ii)
Preparation of a Production Cost Budget.
(iii)
Preparation of the Cost Budget.
(iv)
Preparation of the Cash Budget.
(v)
Preparation of Projected Profit and Loss Account on the basis of information
collected from above stated four steps.
(vi)
Preparation of Projected Balance Sheet from the information available in
lasts year’s Balance Sheet and with the help of five steps stated above.
A Master Budget is the summary of all the functional budgets taken together.
The Master Budget is finally approved, adopted and implemented by the
management. Thus when all the functional budgets are prepared and consolidated
into a master budget we can get the :
(i)
Budgeted Profit and Loss Account
(ii)
Budgeted Profit and Loss Appropriation Account
(iii)
Budgeted Balance Sheet.
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Thus a Master Budget shown an overall business plan and contains the
financial statements which we prepare as usual. But the only difference between
a Master Budget and the financial statement is that in case of a Master Budget,
the budgeted figure i.e. estimated amounts are taken, while in case of the financial
statements prepared by the account department, the past data is considered i.e.
the accounts are prepared from the vouchers for which the expenses have already
accrued.
The Master Budget is prepared by the Budget Committee on the basis of
the consolidated fuctional budgets. When the Master Budget is approved by the
management, it becomes the business plan of the company.
When the functional budget have been drawn up, a Master budget can be
built up by summarising all the functional budgets and expressing and incorporating
them under Budgeted Profit and Loss Account and a Budget Balance Sheet.
Such Master Budget must contain the budgeted Profit and Loss Account for the
current year as well as for previous year showing clearly why there has been a
change.
Management Accounting - II
95
96 Management Accounting - II
Factory Overheads
Variable
Fixed
Costs
Administrative, Selling and
Distribution Overheads
To Net profit C/D
Add :
(a)
(b)
Work
Add :
XXX
XXX
XXX
Add : Direct wages
Prime Cost
XXX
(-Unit @ `)
To Cost of Product
(as Per Production Cost Budget)
Direct Materials
Particulars
4.5.2 Format of Master Budget
( `)
XXX
XXXX
XXX
XXX
XXX
( `)
units @ `------
(b) Y Product ...
units @ `-----
By Sales
(As per Sales Budget)
(a) X Product ...
Table A
------------ Co., Ltd
Master Budget
(For the year ended as on ..........)
Projected Profit and Loss Account for the year ending--------Previous
Budgeted
Particulars
Period
Period
Amount
Amount
( `)
Previous
Period
Amount
XXXX
( `)
Budgeted
Period
Amount
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Equity Share Capital
•
Assets
Bank Loan
•
Total
Sundary Creditors
•
Inventories
•
Total
Cash in Hand and at Bank
Sundary Debtors
•
•
•
Bills Payable
•
Bills Receivable
Current Assets
Furniture
•
Current Liabilities :
Buildings
•
Plant and Machinary
•
Pref. Share Capital
•
( `)
Fixed Assets :
( `)
Previous Budgeted
Period
Period
Amount
Amount
Shareholder’s Equity
Liabilities
Budgeted Balance Sheet
TAble B
( `)
( `)
Previous Budgeted
Period
Period
Amount
Amount
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Management Accounting - II
97
Types of Budgets :
Review, Cash &
Master Budget
EXAMPLE
The following specimen of Budgeted Profit and Loss Account and the
Budgeted Balance Sheet with imagenary figures, provides the summary of all
revenue accounts and the summary of all capital items respectively.
NOTES
Master Budget (Figures are imaginary)
(A) Budgeted Profit and Loss A/c for the year ending 31st March, 20-Items
Budget Period Budget Period
Amount
%
`
Sales
Amount
%
`
50,000
100
40,000
100
30,000
60
28,800
62
20,000
40
15,200
38
Administrative
2,500
5
2,200
5.5
Selling and Distribution
3,500
7
3,000
7.5
1,000
2
1,000
2.5
Total (B)
7,000
14
6,200
15.5
Operating Profit (A-B)
13,000
26
9,000
22.5
Less : Cost of Production
(-)
Gross Profit (A)
Less : Operating Expenses
Advertisement
(-)
Add : Other Income
(Investments)
Net Profit Before Tax
(+)
600
1.2
600
1.5
13,600
27.2
9,600
24.0
Note : Appropriations are not shown in this account.
98 Management Accounting - II
1,92,000
Cash and Bank
•
1,84,000
Debtors
25,000
11,500
•
Creditors
•
Stock
•
Current Assets
Furniture & Fixtures
Plant and Machiery
Buildings
Current Liabilities
17,500
Profit and Loss
•
22,500
•
25,000
General Reserves
•
25,000
•
Reserves and Surplus
1,25,000
•
Equity Shares
1,25,000
`
`
•
Year
Year
Assets
Fixed Assets (Net)
Previous
Budgeted
Share Capital
Liabilities
(B) Budgeted Balance-Sheet
(+)
1,84,000
20,000
10,000
19,000
22,500
90,000
`
Year
Budgeted
1,92,000
10,000
12,500
20,000
25,000
25,000
1,00,000
`
Year
Previous
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Management Accounting - II
99
Types of Budgets :
Review, Cash &
Master Budget
4.6
Summary
• Revenue Budget : Revenue Budgets have three components :
(i) Principal Budget (ii) Secondary Budgets (iii) Summary Budgets.
NOTES
• Cash Budget : Cash Budget is the forecast of cash position for a particular
period. It represents the cash requirements of the business during the budget
period. There are three methods are used for preparation of Cash Budget :
(i) Receipts and payments Method
(ii) Adjusted Profit and Loss Method and
(iii) Balance Sheet Method
• Master Budget : The Master Budget is expressed in financial terms and sets
out management’s plan for the operations and resources of the firm for a given
period of time.
4.7
Key Terms
1) Principal Budget : Principal Budget is that factor the extent of whose influence
must first be assessed in order to ensure that budgets are reasonably capable of
fulfilment.
2) Cash Budget : “An estimate of receipts and payments for each month or any
other relevant period forming part of the entire budget period.” It is the future
plan of receipts and payment of cash for the budget period.
3) Receipt and Payments Method : According to this method, Cash Budget
includes all the cash receipts whether they are on revenue account or capital
account. Similarly, all expected capital and revenue expenditures are brought in a
cash budget.
4) Adjusted Profit and Loss Method : Under this Method, the profits as shown
in the Profit and Loss Accounts prepared in the conventional manner forms the
basis for cash forecast. The Profit is adjusted by adding back to it non-cash items
such as depreciation, outstanding expenses, other provisions etc.
5) Balance Sheet Method : As per this Method, a projected Balance-Sheet is
prepared in which cash balance is not an estimated item but a difference between
total projected assets and total estimated liabilities. In other words, The excess of
projected assets over projected liabilities represents cash balance.
6) Master budget : “ The summary budget, incorporating its component functional
budget which is finally approved , adopted and employed.”
100 Management Accounting - II
4.8
Questions And Exercises
Types of Budgets :
Review, Cash &
Master Budget
I. Objective Questions
(A)
Multiple Choice Questions
(1)
A Consolidated summary of the various functional budgets is the ---budget.
NOTES
(a) master
(b) fixed
(c) flexible
(d) revenue
(2)
A Cash Budget is a part of ----------budget
(a) functional
(b) financial
(c) Operational
(d) variable
(3)
All expenses connected with advertisement and publicity are to be
incorporated in ---------budget
(a) summary
(b) Secondary
(c) promotional expenses
(d) master
(4)
A-------------is nothing but a cash flow statement
(a) sales budget
(b) purchase budget
(c) production budget
(d) cash budget
Ans : (1 - a), (2 - b), (3 - c), (4 - d)
II - Long Answer Questions
1)
What is ‘Revenue Budget’ ? Explain the components of Revenue Budget.
2)
What is ‘Principal Budget’ ? State the various types of Principal Budget.
3)
What is ‘Subsidiary Budget’ Explain the utility of ‘Personnel Budget’.
Management Accounting - II
101
Types of Budgets :
Review, Cash &
Master Budget
NOTES
4)
What is cash Budget? Explain in brief the necessity of cash Budget.
5)
Define ‘Cash Budget’ ? How a Cash Budget is more useful to the
organisation.
6)
What do you understand by ‘Cash Budget’? Explain in brief the various
methods of preparing cash budget.
7)
What is Cash Budget ? Explain the Receipts and payments method of
preparing a Cash Budget
8)
Define ‘Master Budget’. Explain in brief the steps involved in the preparation
of Master Budget.
III
Practical Problems
ILLUSTRATION 1
Prepare a Cash Budget for three months ending 30th June, 2014 from the
following particulars relating to Atlas Cycle Co., Ajmer.
2014
Total
Months
Sales
January
Material Purchases Salary Selling on Cost
`
`
`
80,000
40,000
6,000
3,800
1,10,000
80,000
8,000
4,200
60,000
80,000
8,000
6,100
April
1,20,000
1,00,000
10,000
3,800
May
1,60,000
1,43,000
12,000
4,300
June
1,40,000
1,00,000
10,000
6,800
February
March
Additional Information :
102 Management Accounting - II
1)
30% of Credit Sales will be realised in the second month following whereas
remaining 70% of Credit Sales will the realised in the month following the
Sales.
2)
The Materials Purchases will be on credit and the Creditors to be paid in
the month following the purchases.
3)
Delay in payment of salary is half a month.
4)
Selling on costs are to be paid in the same month.
5)
The proportion of cash turnover to credit turnover is 1:3 in total turnover.
6)
Advance income tax is to be paid in the month of April amounting to
` 4,000.
7)
The Cash at Bank on 1st April 2014 estimated to ` 40,000.
ILLUSTRATION 2
Intel Co., Ltd., Indapur expects to have ` 37,500 Cash at Bank opening on
1 April, 2014 and requires you to prepare an estimate of cash position during the
three months enZded 30thJune, 2014. The cost data is made available to you is as
follows :
Types of Budgets :
Review, Cash &
Master Budget
st
2014
Months
Sales Purchases
`
`
Wages
`
Works Management Selling
Overhead on Cost Expenses
`
`
NOTES
`
February
75,000
45,000
3,000
7,500
6,000
4,500
March
84,000
48,000
9,750
8,250
6,000
4,500
April
90,000
52,500
10,500
9,000
6,000
3,500
May
1,20,000
60,000
13,500
11,250
6,000
2,250
June
1,35,000
60,000
14,250
14,000
7,000
7,000
Additional informations is as follows :
(i)
Period of Credit allowed by suppliers is two months.
(ii)
20% of Total Sales are for cash and period of credit allowed to customers
for credit sales is one month.
(iii)
Delay in payment of all other expenses is one month.
(iv)
Preference Share divided amounting to ` 57,500 is to be paid on 1st June,
2014.
(v)
The Company is pay bonus to workers or ` 22,500 in the month of April.
(vi)
Plant has been ordered to be received and paid in May, which will cost
` 1,20,000
(vii)
Income-tax of ` 15,700 is due to be paid in April, 2014.
ILLUSTRATION 3
Sunil Shetty has recently set up a modern restaurant in a prominent shopping
complex near Pune. His business is very good but because of heavy personal
withdrawls, he is facing liquidity problems. To get a better handle over his cash
flow, he requests you to prepare a Cash Budget for the next quarter, January
through March, 2014 for him. He has provided you with the following information.
(i)
Sales (i.e cash turnover) are expected to be as follows :
January - ` 50,000, February - ` 55,000 and March ` 60,000
Management Accounting - II
103
Types of Budgets :
Review, Cash &
Master Budget
NOTES
(ii)
His establishment purchases are estimated to be as follows:
January - ` 20,000, February - ` 22,000 and March - ` 25,000
Payments for purchases will be made after a lag of one month. Outstanding
on account of purchases in December last are ` 22,000.
(iii)
The monthly rent is `5,000 and his personal withdrawls per month are
amounting to ` 5,000
(iv)
Salaries and other expenses payable in cash are expected to be as follows:
January `15,000, February `18,000 and March `20,000.
(v)
He Plans to buy Furniture worth ` 25,000 and Cash payment is February.
(vi)
The Cash at Bank at present is ` 5,000. The target cash balance is however
` 8,000
What will be the surplus or deficit of cash in relation to his target cash
balance ?
ILLUSTRATION 4
Snowwhite Ltd., Surat provides following cost details from which you are
required to prepare a Cash Budget for three moths ended 30th September 2014
Particualars
June
July
August
`
`
`
1,20,000
1,40,500
1,52,000
81,000
Credit Sales - estimated 1,00,000
80,000
1,40,000
1,20,000
1,60,000
1,70,000
2,40,000
1,80,000
18,000
20,000
22,000
21,000
Cash Sales - actual
Total Purchases
Selling Overheads
September
`
Additional Information :
104 Management Accounting - II
(i)
Cash at Bank on 1st July, 2014 estimated to be ` 25,000.
(ii)
Credit Sales are collected 50% in the month of sale subject to 10% discount
and 50% in the month following subject to 5% discount.
(iii)
Wages, Salaries and all other revenue charges have been estimated at
`10,000 per month, including depreciation on Fixed Assets of ` 4,000 per
month.
(4)
10% of Total Purchases are in cash and balance is paid in next month.
(5)
The company intends to replace an asset at a cost of ` 1,08,000 during
September, 2014.
(6)
Delay in payment of selling overheads in one month.
4.9
Further Reading
•
Bhar B.k- Cost Accounts Methods and Problems - Kolkata Academic
Publishers -2012
•
Jawahar Lal - Cost Accounting - New Delhi - Tata MG Graw Hills publishing
Co. Ltd., 2010
Types of Budgets :
Review, Cash &
Master Budget
NOTES
Management Accounting - II
105
TOPIC 2
Marginal Costing and
Break-Even Analysis
UNIT 5
Meaning, Concept of
Marginal Costing
UNIT 6
Fixed and Variable cost and
Break-Even Analysis
UNIT 7
Break-Even Chart and
P V Ratio
UNIT 5
Meaning, Concept of Marginal Costing
Meaning, Concept Of
Marginal Costing
Structure
5.0
Introduction
5.1
Unit Objectives
5.2
Meaning of marginal Cost and Marginal Costing
5.2.1
Concept of Marginal Cost
5.2.2
Concept of Marginal Costing
5.3
Features of Marginal Costing
5.4
Difference between Marginal Costing and Absorption Costing
5.5
Advantages of Marginal Costing
5.6
Limitations of Marginal Costing
5.7
Illustrations
5.8
Summary
5.9
Key Terms
NOTES
5.10 Questions Exercises
5.11 Further Reading
5.0
Introduction
Every manufacturing concern would like to increase its profits by increasing
volume of production which will automatically involve additional cost. Such a
decision would require a detailed analysis of additional costs and its behavior as it
has a direct bearing on the profitability of the concern. Any increase in the level
of operation will diminish the firm’s marginal profit, if it is already at its optimum
level of existing operation. However, such a decision would definitely prove
financially worthy if there exists any unutilised operational capacity. Thus, to reach
at an accurate decision, management must know how costs will react to changes
in activity. The analysis of cost behavior reveals that the cost of a product can be
divided into two major categories the first is fixed cost and second is variable cost.
Decision making is a regular phenomenon of the business. Managers have
to analyse the relevant costs and other related factors to take right decisions. The
decision criterion most often used are cost minimisation profit maximisation and
contribution maximisation In marginal costing, when cost are analysed in to variable
and fixed suitable decision for short term is made possible. Thus, the most useful
contribution of marginal costing is the assistance that it render to the management
Management Accounting - II
107
Meaning, Concept Of
Marginal Costing
NOTES
in vital decision making. Hence, marginal costing is an invaluable aid to
managements decision-making.
5.1
Unit Objectives
After going through this units, you are able to :
•
Understand the concept of ‘Marginal Cost’ & ‘Marginal Costing’.
•
Appreciate the features of Marginal Costing.
•
Differentiate between ‘Marginal Costing’ and ‘Absorption Costing’.
•
Discuss the advantage of Marginal Costing.
•
Describe the limitations of Marginal Costing.
5.2
Meaning Of Marginal Cost And Marginal
Costing
Marginal Costing which is otherwise known as “Variable Costing” is
used as a tool for decision-making by the management. Marginal Costing is
also known as “Direct Costing” and this new concept is gaining wide popularity
in the field of accounting. Marginal Costing is a technique through which variable
costs are taken into account for the purposes of product costing, inventory valuation
and other important management decisions. The term “ Marginal Costing” is
commonly used in U. K. and other European Countries while the same is denoted
as “ Direct Costing” or “Variable Costing” In U.S.A Marginal Costing is also
known as variable or direct or differential costing. The term “Marginal Costing”
seems to be inappropriate since is has an exclusive meaning in Economics. Under
the above circumstances, the term ‘variable Costing’ seems to be more appropriate
and acceptable.
5.2.1 Concept of Marginal Cost
The term “Marginal Cost’’ is derived from the word “margin’’ which is a
well known terminology in economics. As is used in economic parlance, the term
“Marginal Cost’’ connotes the cost which arises from the production of additional
increment of output.
The Institute of Cost and works Accounts, London, in its Publication
“A Report of Marginal Costing” defines Marginal Cost as the amount at any
given volume of output by which aggregate costs are changed if the volume
of output is increased or decreased by one unit.” “Marginal cost”, according
to the Institute of Chartered Accountants, England, “is the very expense (whether
of production, selling or distribution) incurred by the taking of a particular decision.”
108 Management Accounting - II
Viewed from this angle, Marginal Costs in the short run will be synonymous
with variable cost, i.e., prime costs and variable overheads; but in the long run the
Marginal Costs will include fixed costs in planning production activities involving
an increase in the production capacity. It is clear that the Marginal Costs are
related to change in output under certain conditions.
Blocker and Weltmore defines Marginal Cost as “ the increase or
decrease in the total cost which results from producing or selling additional
or fewer units of a product or from a change in the method of production or
distribution such as the use of improved machinery, addition or exclusion of
product or territory, or selection of an additional sales channel.” Thus,
Marginal Cost is the cost incurred by a company for the additional output.
Meaning, Concept Of
Marginal Costing
NOTES
5.2.2 Concept of Marginal Costing
Marginal Costing is an accounting technique which ascertains marginal
cost by differentiating between fixed or period, and variable or product costs.
This technique aims to charge only those costs of the cost of the product that
very directly with sales volumes. Those costs would be direct material, direct
labour, and factory overhead expenses such as supplies, some indirect labour, and
power. The cost of the product would not include fixed or non-variable expenses
such as depreciation, factory insurance, taxes and supervisory salaries etc.
Marginal costing is defined by the National Association of Accountants,
as follows : This method proposes that fixed factory expenses be classified as
period expenses and be written off currently as is generally done with selling and
administration expenses, and that only the variable costs become the basis of
inventory value and profit determination.”
According to the Institute of Cost and Management Accounts, London. :
“Marginal Costing is the ascertainment of marginal costs and of the effect on
profit of changes in volume or type of output by differentiating between fixed
costs and variable costs. In this technique of costing only variable costs to be
written off against profits in the period in which they arise”.
In a nutshell, Marginal Costing is a costing technique that considers only
the cost that very directly with volume i.e direct materials, direct labour, and
variable factory overheads and ignores fixed cost in additional output decisions.
Thus, the technique of Marginal Costing lies in (i) differentiation between fixed
and variable costs, (ii) ascertainment of marginal cost, and (iii) finding out effect
on profit due to change in volume or type or output.
5.3
Features of Marginal Costing
The concept of marginal costing is evolved on the main distinction between
product cost and period cost. While product cost relates to the volume of output,
the period cost is mainly concerned with the period of time. Marginal Costing
considers all those manufacturing costs which vary directly with the volume of
output as product costs. This is in contradiction to the traditional system of costing
Management Accounting - II
109
Meaning, Concept Of
Marginal Costing
NOTES
under which all manufacturing costs - fixed as well as variable - are treated as
product costs. It should also be remembered that variability with the volume of
production is the basis for the classification of costs into product and period costs.
Thus, marginal costing necessitates classification of costs into fixed and variable.
Even the semi-variable costs have to be closely examined so as to separate fixed
and variable components there of depending upon the increase or decrease in the
volume of output. Thus, the marginal costs focuses the effect of costs on the
varying of output.
Marginal Costing has the following four important futures :
(i)
Under marginal costing, all types of operating costs (factory, selling and
administrative ) are separated into fixed and variable components and are
recorded separately.
(ii)
Variable cost elements are handled as product costs i.e. they are charged
to the product at the appropriate movements and follow the product through
the inventory accounts, and thus become treated as expenses when the
product is sold. Variable distribution costs normally are chargeable to product
at or near the moment of sale, and thus do not become inclined in inventory
values.
(iii)
Fixed costs (including fixed factory overheads) are handled as period
costs; i.e., they are written off as expenses in the period in which they are
incurred. They do not follow the inventories through the accounts but rather
are treated in the way which is traditional for selling and general
administrative expenses.
(iv)
Marginal Costing is a method of recording as well as reporting costs.
Unlike differential cost analysis and Break-Even analysis which utilise
traditional records, variable costing requires a unique method or recording
cost transactions as they originally take place.
Check Your Progress
What are the important
features of Marginal
Costing ?
Therefore, marginal costing is a technique which deals with the effect
on profits of changes in volume or type of output.
5.4
110 Management Accounting - II
Difference between Marginal Costing and
Absorption Costing
Marginal Costing is based on the assumption that initial investment is
productive factors and other facilities are required before commencement of
production. For instance, a factory building is hired for which rent is paid regularly,
plant is installed against which depreciation is charged periodically and payment is
made towards factory insurance, property taxes, salary of plant manager and
such other initial expenses. Thus, the fixed costs arising from the investment on
the above items are not product costs, but period costs. By nature these costs
must necessarily be incurred to establish a manufacturing unit and they will recur
every year. More precisely, the principle underlying variable cost is that the fixed
manufacturing overheads are not carried as part of the cost of the inventory; they
are period costs and must be compared against revenue of that year. On the other
hand absorption costing denotes that the manufacturing fixed overheads are part
of the cost of inventory; they are product costs and must be compared with the
revenue of that year in which sales are made.
It will be understood now that much of the work of allocating overhead
expenses in an absorption cost accounting system simply does not arise under
marginal costing. Under marginal costing, it becomes unnecessary to allocate
these expenses to departments, cost centres or products.
Meaning, Concept Of
Marginal Costing
NOTES
In marginal costing the product is charged only with those costs that are
directly affected by changes in volume, while under the absorption costing method
period costs (fixed costs) or these are a function of time and are not affected by
volume changes are also changed to the cost of production.
Under the absorption costing method, inventories will normally be reported
at a higher figure than the marginal costing method. This is due to the fact that
fixed costs, under the absorption method, are deferred by being included in the
cost of goods inventory. This element of fixed cost will not be reported as a
deduction from revenue until the goods are sold and then becomes an expense in
the cost of goods sold section of the income statement. Under the marginal cost
method, no fixed costs are differed; they are charged against revenue in the period
in which they are incurred.
It should be noted that where the firm’s operating capacity different from
the normal capacity, there will be capacity variance. This calls for certain
adjustments before determining the gross margin. If the capacity variance
favourable, the amount is to be deducted from the total cost of goods manufactured
and sold. But when the capacity variance is unfavorable, the amount is be added.
It is very clear from the following two figures. fig 5.1 and fig 5.2 that
everything is common except the fixed manufacturing overheads form part of
production costs with full costing whereas they are non-production costs in the
case of variable costing. More precisely in treatment of overheads other than
manufacturing viz., selling administrative etc., is the same under both the techniques,
fixed and variable.
Management Accounting - II
111
Meaning, Concept Of
Marginal Costing
Income Statement (as per Variable Costing)
Particulars
`
Sales revenue (No. of units sold x selling price)
NOTES
------
Less : Variable costs (production costs ) :
------
Direct material cost
------
Direct labour cost
------
Variable manufacturing overheads
(-)
Total cost of goods manufactured
-------------------
Add : Cost of inventory at the beginning of
the year
`
-----(+)
(No. of units x Variable cost)
Less : Cost of inventory at the end of the
year
-----(-)
(No. of units x Variable cost)
Cost of goods manufactured and sold
---------- ----------
Marginal contribution (Manufacturing)
Less : Variable non-production costs :
-----(-)
------
----------
Selling and distribution costs
Administrative costs
------
Other costs (specify)
---------- ----------
Marginal contribution (Final)
------
Less : Fixed costs :
------
Fixed production costs
------
Fixed non-production costs (specify
---------- ----------
individual items)
------
Net Income (before income-tax)
------
Less : Income tax
(-)
Net Income (after income-tax)
Fig. 5.1 : The Cost Flow Pattern of Variable Costing
112 Management Accounting - II
---------------
Meaning, Concept Of
Marginal Costing
Income Statement (as per Absorption Costing )
Particulars
`
Sales revenue (No. of units sold x selling price)
------
Less : Total cost of manufacturing :
------
Direct material cost
------
Direct labour cost
------
Variable manufacturing overhead
`
------
NOTES
----------
Fixed manufacturing overhead
------
Total cost f goods manufactured
----------
Add : Cost of inventory at the beginning of
the year (No. of units x Total cost)
Less : Cost of inventory at the end of the year
------
(No. of units x Total Cost ) Cost of
goods manufactured and sold
Gross margin (Manufacturing
unadjusted )
------
Total + Capacity variance
(+favourable; - unfavourable)
Gross margin (adjusted )
------
Less : Non -production Costs :
Selling and distribution costs
------
Administrative costs
------
Other costs ( specify)
------
------
----------
------
------
------
Net Income (before income-tax)
Less : Income tax
Net Income (after taxes)
----------
Fig. 5.2 : The Cost Flow pattern of Absorption Costing
Management Accounting - II
113
5.5
Meaning, Concept Of
Marginal Costing
Advantages of Marginal Costing
According to National Association of Accounts Marginal Costing has the
following advantages :
NOTES
Check Your Progress
(i)
Cost -Volume- profit relationship data wanted for profit purposes are readily
obtained from the regular accounting statements. Hence management does
not have to work with two separate sets of data to relate one to the other.
(ii)
The Profit for a period is not affected by changes in absorption fixed expenses
resulting from building or reducing inventory. Other things remaining equal
(e.g., setting prices, costs, saels mix) profit move in the same direction as
sales when marginal costing is in use.
(iii)
Manufacturing cost and income statements in the marginal cost form follow
management’s thinking more closely then does the absorption cost form for
these statements. For this reason, management finds it easier to understand
and use marginal cost report.
(vi)
Marginal costing ties in with such effective plans for cost control as standard
costs and flexible budgets. In fact, the flexible budget is an aspect of marginal
costing an many companies thus use marginal costing methods for this
purpose without recognising them as such.
(vii)
Marginal cost constitutes a concept of inventory cost which corresponds
closely with the current out of pocket expenditure necessary necessary to
manufacture the goods.
How marginal costing helpful
in cost controlling ?
5.6
Limitations of Marginal Costing
According to National Association of Accounts, Marginal Costing has the
following limitations :
(i)
Difficulty may be encountered in distinguishing fixed costs. In particular,
certain semi-variable costs may fall in a border line area and more or less
arbitrary classification may be considered necessary in order to arrive at a
practical determination of fixed and variable components.
(ii)
Complete manufacturing cost is not detemined in the process of costing
production and supplementary allocation of fixed overheads on normal or
some other volume base must be made to provide product costs of or longrange pricing and other long-range policy decisions.
(iii)
Serious taxation problems may be encountered if a change is made from
full cost to marginal cost for costing inventory and definite rulings are not
available for guidance.
Check Your Progress
Identify
one
limitations of
Costing.
or
two
Marginal
114 Management Accounting - II
In the Light of the above mentioned advantages and limitations of marginal
costing it can be concluded that this will prove to be an effective tool in the hands
of management wherver it can be applied fruithfully. At the same time, it must be
remembered that both marginal costing and absorption costing are eqully important,
variable costing for internal reporting and absorption costing for external users.
5.7
Illustrations
Meaning, Concept Of
Marginal Costing
Preparation of Income statement as per the technique of marginal costing
an Absorption costing can be understood with the help of following illustrations.
ILLUSTRATION 1
ABC Industrial Ltd., Nashik furnished the following details for the year
ended 31st December, 2013 for preparing the Comparative Income Statement of
the year under Marginal Costing and Absorption Costing :
Sales
: 2,000 units at `200 per unit
Fixed Manufacturing Cost
: ` 42,000
Variable Manufacturing Cost
: 2,100 units ` 120 per unit
Inventory at close
: 100 units
Fixed Selling and Administrative Expenses
: ` 10,000
NOTES
Variable Selling and Administrative Expenses : ` 14,000
SOLUTION
(A) Under Absorption Costing :
In the books of ABC Industrial Ltd., Nashik
Income Statement for the ended 31st December, 2013
Particulars
`
Sales 2,000 units at `200 each
`
4,00,000
Less : Cost of Sales
i) Variable Manufacturing Cost
2,100 units at `120 each
ii) Fixed manufacturing costs
2,52,000
(+)
42,000
(-)
2,94,000
Less : Inventory at Close :
100 Units at `14 each
14,000
Gross Margin or Profit
2,80,000
1,20,000
Less : Total selling an administrative expenses
• Fixed
14,000
• Variable
10,000
 Net Income
24,000
96,000
Management Accounting - II
115
Meaning, Concept Of
Marginal Costing
Working Note : The cost of the inventory at close, as well as the cost of each
unit inventory at close, have been calculated as follows :
Unit manufactured : 2,100
NOTES
Units of invetory at close : 100
Ratio of closing inventory to total production
=
Cost of Inventory at close
=
=
Thus, the cost of each unit of inventory at close
=
=
100 units
2,100 units
1
21
=
1
21
x ` 2,94,000
` 14,000
` 14,000
100 units
` 140 per unit
Under Marginal Costing :
Income statement for the year ended 31st December, 2013
Particulars
`
`
Sales 2,000 units at ` 200 each
4,00,000
Less : Variable Cost of Sales
2,40,000
i) Variable Manufacturing Cost
2,100 units at ` 120 each
2,52,000
Less : Inventory at Close :
100 Units at ` 120 each

(-)
12,000
Variable Gross Margin
1,60,000
Less : Variable Selling and Adminis Expenses

(-) 14,000
Operating Contribution Margin
Less : Fixed Costs
1,46,000
(-)
• Fixed Manufacturing Costs
52,000
42,000
• Fixed Selling and Admin Expenses
(+)
Net Income
116 Management Accounting - II
(-)
10,000
94,000
Meaning, Concept Of
Marginal Costing
Working Notes :
The cost of inventory at close as well as the cost of each unit of inventory at
close have been calculated as follows :
Ratio of closing inventory to total production
Cost of Inventory at close
=
=
=
Thus, the cost of each unit of inventory at Close
=
=
100 units
2,100 units
1
21
=
1
21
NOTES
x ` 2,52,000
` 12,000
` 12,000
100 units
` 120
Note : The difference of ` 2,000 in the net income calculated under the two
method, wholly due the difference between the cost of closing inventory which,
under absorption costing is ` 14,000 and under marginal costing ` 12,000.
ILLUSTRATION 2
From the following data parepare Statements of cost according to Absorption
Costing and Marginal Costing system.
Particulars
Sales
Product - X
`
Product - Y
`
15,000
40,000
Direct Material
6,000
18,000
Direct Labour
4,000
7,000
Factory Overheads :
•
Fixed
3,000
3.000
•
Variable
1,000
2,500
500
1,000
1,000
1,500
500
1,500
Administrative Overheads :
•
Fixed
Selling Overheads :
•
Fixed
•
Variable
Management Accounting - II
117
Meaning, Concept Of
Marginal Costing
SOLUTION
Statement of cost and Profit (as per Absorption Costing)
Particulars
NOTES
Product (X)
( `)
Product (Y)
( `)
Total
( `)
15,000
40,000
55,000
Direct Materials
6,000
18,000
24,000
Direct Labour
4,000
7,000
11,000
Factory Overheads
4,000
5,500
9,500
500
1,000
1,5000
1,500
3,000
4,500
16,000
34,500
50,500
(-) 1,000
5,500
4,500
Sales (A)
Less : Cost of Sales
Administrative Overheads
Selling Overheads
(+)
Total Cost (B)
Net Profit
(A-B)
Statement of Cost as per Marginal Costing
Particulars
Product (X)
( `)
Sales (A)
Product (Y)
( `)
Total
( `)
15,000
40,000
55,000
Direct Materials
6,000
18,000
24,000
Direct Labour
4,000
7,000
11,000
Variable Factory Overheads
1,000
2,500
3,500
500
1,500
2,000
11,500
29,000
40,500
Contribution (A-B)
3,500
11,000
14,500
Less : Fixed Cost
-
-
-
4,500
5,500
10,000
(-)1,000
5,500
4,500
Less : Cost of Sales
Variable Selling Overheads
(+)
Total (B)
(Factory, Administration &
Selling)
Net Profit
118 Management Accounting - II
(-)
When fixed costs are not traceable to different product, then the statement of
cost will be be prepared after contribution margin as under.
Meaning, Concept Of
Marginal Costing
Statement of Cost as per Marginal Costing
Particulars
Product (X) Product (Y)
( `)
( `)
Sales (A)
15,000
40,000
Total
( `)
55,000
Less : Cost of Sales
NOTES
Direct Materials
6,000
18,000
24,000
Direct Labour
4,000
7,000
11,000
Variable Factory Overheads
1,000
2,500
3,500
500
1,500
2,000
11,500
29,000
40,500
Contribution (A-B)
3,500
11,000
14,500
Less : Fixed Cost
-
-
-
(Factory,Administration & Selling) (-)
-
-
10,000
Variable Selling Overheads
(+)
Total (B)
Net Profit
5.8
4,500
Summary
• Marginal Costing : Marginal Costing is an accounting technique which
ascertains marginal cost by differntiating between fixed or period and variable or
product costs. This technique aim to charge only those costs of teh cost of the
product that vary directly with Sales Volumes.
• Features of Marginal Costing : Marginal Costing has the following important
features : - ii) Operating Cost iii) Variable Cost (iiii) Fixed Costs (iv) Reporting
Costs.
• Difference between Marginal Costing and Absorption Costing :
Marginal Costing is based on the assumption that initial investment is
produotive factor and other facilities are required before commencemeut of
prodaction. In marginal costing the product is charged only with those costs that
are directly affectes by changes in volume, while under the absorption costing
method period cost (fixed costs) or the scure a function of time and are not affected
by volume changes are also changed to the cost of production. Under the absorption
costing method inventories will normally be reported at a higher figure than the
marginal costing methods.
Management Accounting - II
119
Meaning, Concept Of
Marginal Costing
5.9
Key Terms
1) Marginal cost : It is variable cost of one unit or product or a servics i.e. a
cost which would be avoided if the unit was not produced or provided.
NOTES
2) Marginal costing : It is the ascertainment of marginal costs and of the effect
on profit of changes in volume or type of output by differentiating betweeen fixed
and variable costs.
5.10 Questions And Exercises
I. Objective Questions
(A)
Multiple Choice Questions
1)
Variable Cost does not include-------------------cost.
(a) fixed
(b) direct
(c) overhead
(d) indirect
2)
In marginal costing technique, stock is valued at ------------------cost.
(a) fixed
(b) marginal
(c) actual
(d) estimated
3)
The cost which arises from the producion of additional increment of output
is termed as -------------cost.
(a) production
(b) incremental
(c) marginal
(d) output
4)
Under the technique of Marginal costing variable costs are treated as -----------cost.
(a) period
(b) constant
(c) special
(d) product
120 Management Accounting - II
Ans. : (1 - a), (2 - b), (3 - c), (4 - d)
Meaning, Concept Of
Marginal Costing
II. Long Answer Questions
(1)
What is ‘Marginal Cost’ ? How it differes from ‘Fixed Cost’ ?
(2)
Define ‘Marginal Costing’ What are the important features of Marginal
costing ?
(3)
What is ‘Marginal Costing’ ? How it differs from Absorption Costing ?
(4)
What do you understand by ‘Marginal Costing ? Explain in brief the
advantages and limitations of Marginal Costing.
NOTES
III. Practical Problems :
(1) Biral Ltd., Baramati provides following cost details for the year ended 31st
March, 2014
Total Turnover
1,900 units at `300 per unit
Fixed selling Expenses
` 12,000
variable Administration Expenses
` 23,000
Fixed office Expenses
`8,000
Marginal Selling Expenses
` 7,000
Fixed Production Cost
Variable Manufacturing Cost
Inventory at the end
` 27,000
`2,000 units at ` 110 per unit
100 units
You are required to prepare a comparative Income statement for the year
ended 31stMarch 2014 under Marginal Costing and Absorption Costing separately.
5.11 Further Reading
•
Khan M. Y. and Jain P. K. - Management Accounting Text, problems and
coses - New Delhi -Tata McGraw- Hill Publishing Co. Ltd 2010
•
Bhar B.k - Cost Accounting Methods and Problems - Kolkata- academic
Publisheres -2010
Management Accounting - II
121
UNIT 6 Fixed and Variable Costs and
Break-Even Analysis
Fixed & Variable Cost
& Break-Even Analysis
Structure
6.0
Introduction
6.1
Unit Objectives
6.2
Fixed and Variable Costs
6.3
Determination of Marginal Cost (SVOHES)
6.4
Contribution
6.5
Break Even Analysis
6.5.1
Meaning and Defination of Break Even Point
6.5.2
Determination of Break Even Point
6.6
Illustrations
6.7
Summary
6.8
Key Terms
6.9
Questions and Exercises
NOTES
6.10 Further Reading
6.1
Introduction
As we know that fixed cost remains constant to a particular level of output
whereas variable cost has tendency to change proportionally with a change in the
level of output. The following example will further clarify the concept.
ABC Co., invited sale of 20,000 units @ `4000 per unit during the year
2012-2013 with the following details of expenditure on production.
(i)
Raw material required to produce one unit of finished product 2 kg @
`2 per kg.
(ii)
Wages ` 200 per unit.
(iii)
Rent of factory ` 50,000 per annum.
(iv)
Salary of executive ` 5,00,000 per annum.
In the above-mentioned example, the costs of raw-material and wages
change proportionately with the change in the level of output and, therefore are
known as variable costs. Whereas the rent of factory and salary of executive
are such costs that are not subject to change with the change in output. They
remain constant at every level of output and as such are known as fixed costs.
Management Accounting - II
123
Fixed & Variable Cost
& Break-Even Analysis
NOTES
On account of this reason, it is unlogic to apportion fixed costs to production.
Marginal costing is the technique which deals with the concept of variable cost i.e
marginal cost very carefully.
Break-even Analysis is a technique which determines the equilibrium point
of cost and revenue. Variations in the respective degree of constant revenue have
some impact on the area of the profit and loss of the business. The equilibrium
point so indicated reveals ‘no Profit no Loss stage’ Break even analysis is costing
technique that helps executives in profit planning.
6.1
Unit Objectives
After studying this unit you should be able to :
•
Understand the Meaning of fixed cost and variable cost.
•
Illustrate a number of methods for segregation of semi variable costs into
variable and fixed cost.
•
Discuss the term “contribution used in Marginal costing”.
•
Explain Relationship between Marginal cost and contribution
•
Understand the meaning of “Break Even point”.
•
Explain the term “Break Even Analysis”.
•
Discuss Algebric Method to determine Break Even Point.
•
Discuss “Contribution Margin Technique” and Equation Techniques.
6.2
Fixed And Variable Costs
The Classification of costs into fixed and variable is of special interest and
importance in marginal costing. These two types of cost behave differently with
changes in the volume of output.
(i)
Fixed Cost : These costs remain fixed in total amount and do not increase
or decrease when the volume of production changes. But the fixed cost per unit
increases when volume of production decreases and vice-versa. Fixed cost per
unit decreases when the volume of production increases. The behavior of fixed
cost is shown in Fig 6.1 The Line representing fixed cost per unit will not touch X
axis because the fixed cost can not be zero.
124 Management Accounting - II
Cost (Rs.)
Fixed & Variable Cost
& Break-Even Analysis
Total Fixed Cost
NOTES
Fixed Cost + Per unit
Volume of Production
Fig. 6.1 : Fixed Costs
To
t al
Cost (Rs.)
Va
ri
ab
le
Co
st
(ii) Variable Costs : Variable costs change in proportion to the volume of output.
In other words, when volume of output increases, total variable cost also increase
and vice-versa. When volume of output decreases, total variable cost also decreases.
But the variable cost per unit remain fixed. It is shown in Fig. 6.2.
Variable Cost Per Unit
Volume of Production
Fig. 6.2 : Fixed Costs
Semi fixed or semi-variable costs are also separated into fixed and variable
elements and added to their respective categories. Under marginal costing, fixed
and variable costs are kept separate for all purpose. Only variable costs are taken
into account for computing the cost of productions and thus are treated as “Product
Costs.” Fixed costs do not find place in the costs of products or in inventory
valuation, such costs are treated as “ Period Costs.”
Management Accounting - II
125
Fixed & Variable Cost
& Break-Even Analysis
NOTES
6.3
Determination of Marginal Cost (Segregation
of Semi Variable Costs or Semi Variable
Overhead Expenses (SVOHEs)
Costs, according to their reactions to changes in volume, are classified as
fixed, variable, or semi variable. But the utility of marginal costing depends on the
segregation of total costs only into variable and fixed costs. Total costs include a
significant portion of semi-variable element. Therefore, the effective application
of marginal costing depends to a large extent upon the accuracy with which semivariable costs are segregated into variable ad fixed elements. A number of methods
are available for segregation of semi-variable costs into variable and fixed costs.
The important methods are as under :
Check Your Progress
Which
methods
are
available for segregation of
semi-variable Costs into
variable and fixed costs ?
1.
Comparison by period of level of activity method
2.
Equation method
3.
Range method
4.
Analytical method
5.
Scattergraph method
6.
Least squares method
1. Comparison by period or Level of Activity Method :
In this method the level of output at two levels is compared with
corresponding level of expenses. Since the fixed costs remain constant, the variable
costs are arrived at by the ratio of change in expenses to change in output. Therefore,
variable element.
(i) Variable Overhead Expenses per unit (included in SVOHEs)
=
Difference in SVOHEs
Difference in Output
OR
(ii) Variable Element
=
Change in Amount of Expenses
Change in Activity of Quantity
This method is simple at it is clear from following examples but is not
scientific and accurate method.
126 Management Accounting - II
Fixed & Variable Cost
& Break-Even Analysis
EXAMPLE
ABC Ltd., submits the following information in respect of Semi variable
Costs.
Months in 2014
Production Units
Semi-variable costs
( `)
NOTES
January
25,000
1,50,000
February
15,000
1,32,000
March
40,000
2,00,000
April
30,000
1,70,000
May
50,000
2,30,000
June
35,000
1,90,000
During the month of July, 2014 the production was 20,000 units only.
Calculate the amount of fixed variable and total semi - variable expenses for the
month.
ANSWER
Taking the level of activity of any two months, say March and May, the
variable costs may be calculated as follows :
Months in
2014
March
May
Difference
(-)
Production Semi-variable
Variable
( `)
( `)
(Units)
( `)
40,000
2,00,000
80,000*
1,20,000*
50,000
2,30,000
80,000**
1,50000**
10,000
30.000
Therefore, Variable element
=
=
*
Fixed
Variable Overheads for March
\Fixed Overheads for March
Change in Amount
Change in Quantity
` 30,000
10,000 units
=
` 3.00 per unit
=
40,000 x `3.00
=
` 1,20,000
=
` 2,00,000 - ` 1,20,000
=
` 80,000
Management Accounting - II
127
Fixed & Variable Cost
& Break-Even Analysis
**
Overheads for May has been computed accordingly.
Calculated of fixed, variable and total semi-variable costs of ` 20,000
units for the month of July 2008.
NOTES
`
Variable Overheads for July
= 20,000 units x ` 3.00
=
60,000
Fixed Overheads
=
80,000
Total Semi-Variable Overheads = 1,40,000
2. Equation Method :
When cost and output figures for only two periods are given or available,
equation method may also be used. Here, the straight line or liner or liner equation
is used. The equation used for this purpose is as follows :
Y
=
MX + C
Y
=
Total semi - variable cost;
M
=
Variable cost per unit;
X
=
Output; and
C
=
Fixed cost included in semi-variable cost.
It is now possible to segregate the fixed and variable portions with the use
of the above given equations with respect to two periods.
EXAMPLE
Taking the figures for July and August from pervious example.
January 2014
:
1,50,000
= 50,0000 M + C
...(i)
February 2014
:
1,32,000
= 30,0000 M + C
...(ii)
Subtracting (i) from (ii) we get,
18,000
= 20,000 M
M
=
1.80
1,50,000
=
50,000 x 1.80 + C
1,50,000
=
45,000 + C
C
=
Rs. 1,05,000
Putting value of M in (i)
3. Range Method or High and Low Method :
128 Management Accounting - II
This is also known as High or Low method. In this method the levels of
highest and lowest expenses are compared with one another and related to output
attained in those periods. This method assumes a linear cost behaviour pattern
between these two points ; that is costs for all intermediate volumes are assumed
to fall along a straight line. Thus, it is similar to the two method except that only
the highest and lowest points are considered amount of various levels. In other
words, we can say that this method is an improvement over the comparison method
and the equation method can be used even when the data are given for more than
two periods. Once the selection of the periods is made then either the comparison
method or the equation method can be used. Because after the selection of periods,
the same procedure as per the comparison or equation method is used.
Fixed & Variable Cost
& Break-Even Analysis
NOTES
EXAMPLE
Considering the highest and lowest production from previous example.
Months in
Production Semi-variable
Variable
( `)
( `)
2014
(units)
( `)
February
15,000
1,32,000
90,000*
42,000*
50,000
2,30,000
90,000**
1,40,000**
35,000
98,000
May
Difference
(-)
Variable element
*
Fixed
Variable Overheads for August
\Fixed Overheads for August
=
` 98,000
Units 35,000
= ` 2.80 per unit
=
` 1,02,000
=
15,000 units x ` 2.80
=
` 42,000
=
` 1,32,000 - ` 42,000
=
`90,000
Accordingly the fixed and variable overheads for May 2014 has been
calculated.
Calculation of fixed, variable and total semi-variable costs of 20,000 units for
the month of July 2014
`
Variable Overheads for January
= 20,000 units x ` 2.80
= 56,000
Fixed Overheads
= 90,000
Total semi-variable Overheads
=1,46,000
4. Analytical Method :
This method consider the degree of variability for each item of semi-variable
expenses. Some semi-variable items have a 40 percent variability while other
may have 60 percent variability. This method is easy to calculate but there are
Management Accounting - II
129
Fixed & Variable Cost
& Break-Even Analysis
difficulties in estimating the degree of variability of an expenses.
EXAMPLE
NOTES
Taking the amount of any month of pervious example say April and assuming
60% degree of variability, the analysis shall be as under :
ANSWER
Variable element
Fixed element
=
60% of `1,70,000
=
` 1,02,000
=
` 1,70,000 - ` 1,02,000
=
` 68,000
Fixed element will remain constant, whereas variable element will vary
according to variation in production.
Thus, for July, fixed element is ` 68,000 and variable portion
=
=
1,02,000
60,000
x 20,000
` 34,000
Therefore, the total semi-variable expenses for 20,000 units
=
(34,000 x 2)
=
` 68,000 + ` 68,000
=
` 1,36,000
5. Scatter Graph Method :
The segregation of semi-variable overheads into fixed and variable overheads
can also be done graphically, i.e, in the scatter chart a “line of best fit”, could be
drawn through the observations and extended to the value of axis, thus indicating
the fixed cost. This method is widely sed in practice.
In the group, horizontal line represents the output or the levels of activity
and the vertical axis represents the costs. Let us use the following figures to
construct a scatter graph and to segregate the Semi Variable Costs (SVCs.)
Output (units)
Semi-Variable Costs `
130 Management Accounting - II
10,000
15,000
20,000
25,000
30,000
30,000
40,000
35,000
50,000
45,000
SVCs (in Rs.000)
Fixed & Variable Cost
& Break-Even Analysis
60
1.5 CM = 5000 Units ( X-axis)
50
1.5 CM = 10,000 Units (Y-axis)
•
40
SVC Line
•
•
NOTES
•
Variable portion
•
30
FC (Portion) Line
20
Fixed Portion
10
0
5000
1000
15000
20000
25000
30000
Output (Units)
Fig 6.5 : Scatter Graph
From the Fig. 6.5, it becomes obvious that by fitting a line and extending the same
till it touches the vertical axis, here we can find out the fixed element included in
the SVS (Rs. 22,500) The SVC at any level activity, of minus the fixed element
(as computed above) represents the variable portion included in the Semi-Variable
cost at the level of activity.
6. Least squares Method :
This methods is an improvement over the scatter graph method. Under-this
method the statistical technique of fitting an equation with the help of a number of
observations used to segregate semi-variable cost.
We know the straight line equation Y = MX + C Where ‘C’ represents the
fixed element and ‘M’ the degree of variability. From this basic equation and
given a set of observation ‘N’, two simultaneous linear equations can be sed to
determine the fixed cost element and the variable cost element per unit of activity.
the linear equations are:
Y =
(i)
Where,
(ii)
Na + bY
X =
Number of units
N =
Number of observations
b =
Variable cost
XY
=
aX + bn2
Y=
Total costs at a given production level
a =
Fixed cost
Management Accounting - II
131
Fixed & Variable Cost
& Break-Even Analysis
The application of the least squares method can be further clear from the
study of the example given below :
EXAMPLE
NOTES
ABC Ltd. submits the following information for a six months period ended
on 30 June 2014.
th
Months in 2014
Production Units
Semi-variable cost
( `)
January
20,000
20,000
February
40,000
30,000
March
60,000
40,000
April
80,000
50,000
May
1,00,000
60,000
June
1,20,000
70,000
Calculate the amount of fixed and variable element is semi-variable cost.
ANSWER
Months
Production
Semi-variable
in 2014
(units)
Expenses
( `)
X2
XY
( `)
( `)
January
20,000
20,000
4,00,000
4,00,000
February
40,000
30,000
16,00,000
12,00,000
March
60,000
40,000
36,00,000
24,00,000
April
80,000
50,000
64,00,000
40,00,000
May
1,00,000
60,000
100,00,000
60,00,000
June
1,20,000
70,000
144,00,000
84,00,000
Total
x=4,20,000
x=2,70,000
N
=
6
y
=
2,70,000
xy
=
2,24,00,000
y2=3,64,00,000 xy=2,24,00,000
x
=
4,20,000
x 2
=
3,64,00,000
Substitute these value in the two linear equations, we have
132 Management Accounting - II
y
xy
Fixed & Variable Cost
& Break-Even Analysis
=
Na + bx Rs. 2,70,000
=
6a + 4,20,000 b
=
ax + bx2 ` 2,24,00,000
...(i)
=
4,20,000 a + 3,64,00,000 b
...(ii)
In order to solve the equations, it will necessary to eliminate one of the
terms. The ‘a’ term can be eliminated by multiplying equation (i) by 70 and then
subtracting it from equation (ii) we get,
` 2,24,00,000
=
420 a + 3,64,00,000 b
` 1,89,00,000
=
420 a + 2,94,00,000 b
` 35,00,0000
=
70,00,000 b
b
=
35,00,000
NOTES
= Re. 0.50
70,00,000
Solve for ‘a’ by substituting ` 0.50 for ‘b’ in either equations.
` 2,70,00,000=a ÷ 4,20,000 X 0.50
` 2,70,00,000=6a + 2,10,000
6a
a
=
2,70,000 - 2,10,000
=
60,000
=
` 10,000 Fixed Cost
The computation for ‘a’ and ‘b’ establish the values for the fixed and
variable components in the semi- variable costs. Using the calculated values, a
= a Rs.10,000 fixed cost per month and b = Re. 0.50 variable cost per unit, the
composition of the semi-variable cost could be shown as follows :
`
6.4
4,20,000 units @ 0.50 per unit
=
2,10,000
(variable cost)
6 months @ `10,000 per month
=
60,000
(fixed cost)
Total Semi-variable Cost
=
2,70,000
Contribution
In marginal costing, Contribution has greater significance. The justification
for contribution lies in the fact that when two or mor products are manufactured
by a single unit, the apportionment of fixed costs to different product under marginal
costing is simplified. Contribution represents the difference between sales and
variable cost of sales and it often referred to as “Gross margin” It can be
considered as some sort of fund from and out of which all fixed costs are to be
Management Accounting - II
133
Fixed & Variable Cost
& Break-Even Analysis
NOTES
met. Again, the difference between contribution and fixed cost represents either
profit or loss as the case may be.
The concept of “Contribution” is of immense use in fixing the selling
prices, determining the break - even point; selecting the product mix for profit
maximisation and also ascertaining the profitability of the products departments
etc.
The difference between the marginal cost of the various products
manufactured and their respective selling price is the Contribution which each
product makes towards fixed or period costs and profit. According to Watter w.
Bigg, “Contribution may be defined as the difference between sales value and
the marginal cost of sales and no net profit arises until the contribution equal the
fixed overheads. When this level of output is achieved, the business is said to
break-even as neither profit nor loss occurs. Production in excess of that necessary
to break-even will result in a profit equivalent to the excess units multiplied by the
break-even, amounting to the short-fall of units multiplied by the “contribution”
per unit. Conversely, a loss is sustained if output is less than the required to breakeven, amounting to the short-fall of units multiplied by the contribution.” Thus,
Contribution is the difference between product revenue and variable cost of
product. It represents the excess of sales over marginal cost (variable cost) that
is the amount to meet fixed cost and profit expectation of an organisation. It can
be calculated as under.
(i)
Check Your Progress
(ii)
How
Contribution
is
calculated ? Give illustration.
Contribution = Sales - Variable cost
Contribution per unit = Selling Price per unit - Variable Cost per unit
(iii)
Contribution = Fixed Cost + Profit
(iv)
Contribution = Fixed Cost - Loss
Suppose, total sales revenue is ` 1,50,000 variable cost is ` 60,000 and sale in
terms of units are 1,000 then contribution will be :
Contribution
= `1,50,000 - ` 60,000
= ` 90,000
OR
contribution (per unit)
.
= ` 150 - ` 60
= ` 90
Marginal cost Equation : (Relationship between Marginal Cost and
Contribution )
The analysis of marginal cost statement and the contribution above reveals
that :
134 Management Accounting - II
(i)
Sales (-) Marginal cost
= Contribution
(ii)
Fixed cost (+) Profit
= Contribution
By combining the above two equations, we get the fundamental marginal cost
equation.
Sales - Marginal Cost
Fixed & Variable Cost
& Break-Even Analysis
= Fixed Cost ± Profit /Loss
Or
S -V
= F + P/L
NOTES
The marginal cost equation has practical utility in the sense that if any three
factors of the above equation are known, the fourth can be easily and find out or
computed.
Contribution and Profit
A product sells at ` 50 has a variable cost of ` 30 and during the period
ended 30 June 2008, 2,000 units were sold. Fixed costs for that period amounted
to ` 25,000. The contribution and profit would be calculated, as shown in following
table.
Particulars
Selling Price
Less : Variable costs
Contribution
(-)
Per Unit
2,000 units
( `)
( `)
50
1,00,000
30
60,000
60
20
40,000
40
Less : Fixed Costs
25,000
Profit
15,000
% of Sales
From above table it can be observed that the contribution goes towards the
recovery of the fixed overheads and profit. Marginal costing is a technique which
can be used as part of the decision making process to show the effect of possible
changes in demand and / or selling prices and / or variable costs. For example, it
can be used to identify the most profitable projects; in make or buy decision making
or in deciding whether or not accept a special contract. Variable costs include
only those costs which can be identified with and traced to products, e.g. direct
labour, direct materials, direct expenses and variable overheads. The fixed costs
are those which cannot be identified with and traced to the products. They tend
to vary more with time than output, and are treated as period costs. This means
that the fixed costs are not included in product costs. They are simply written off,
in total, against the total contribution (s) generated from the sale, of all the firm’s
products, for the period in which they were incurred (see Fig. 3.6). This treatment
of fixed costs also means that because they are not included in product costs they
are carried forward into the future as part of the valuation of the stocks of work
in progress and finished goods.
Management Accounting - II
135
Fixed & Variable Cost
& Break-Even Analysis
` 000
Products
A
B
C
D
Total
`
Contribution
NOTES
20
34
36
20
Less : Fixed Costs
110
(-)78
Profit
32
Fig 6.6 : A Multi - product environment
EXAMPLE
Compute the amount of fixed cost from the information given below :
Sales
:
` 2,40,00
Variable Cost
:
` 1,20,000
Profit
:
` 60,000
ANSWER
As Per Marginal cost equation
6.5
Sales - Variable Cost
=
Fixed Cost ± Profit / Loss

S -V
=
FC + P/L

` 2,40,000 - `1,20,000
=
Fixed Cost + ` 60,000

` 1,20,000
=
Fixed Cost + ` 60,000

Fixed Cost
=
`1,20,000 - ` 60,000

Fixed Cost
=
` 60,000
Break-Even Analysis
Break even analysis establishes the relationship between costs and profit
with sales volume. It represents a specific method of presenting and studying the
inter-relationship between costs, volume and profits. It also helps in the determination
of that volume of sales at which costs and revenues are in equilibrium. The
equilibrium point is often referred to as the ‘break-even point’. The break-even
point may be defined as that point of sales volume at which the total revenue is
equal to the total cost. Briefly, it is no-profit, no-loss point. It should be remembered
that the break-even point is purely incidental to the Cost Volume - Profit analysis.
If all costs are assumed to be variable with sales volume, the break-even point
would be at zero sales. on the other hand, if all costs remain fixed, profits would
vary disproportionately with sales and the break-even point would be at a point
where total sales revenue and fixed costs are in equilibrium.
136 Management Accounting - II
6.5.1 Meaning and definition of Break - Even point
Break-even analysis is a costing technique that helps executives in profit
planning. The narrow interpretation of break-even analysis limits is to the study of
break-even point. The break-even point is defined as the volume of activity at
which total sales revenue exactly equals total costs of the output produced or
sold. Since, at this level of operation sales revenue is adequate to cover all costs
to manufacture and sell the product leaving no amount as profit, and therefore,
this level is also known as no profit no loss level. Thus, in a situation where total
cost of the output consist of only variable costs, the break-even point would be at
zero of operation.
Fixed & Variable Cost
& Break-Even Analysis
NOTES
Break-even analysis need not be limited merely to seeking the break-even
point. In broader sense, break-even analysts refers to the study of relationship
between cost, volume and profit at different levels of sales or production which in
technical terminology is known as cost-volume profit analysis. Cost- Volume
Profit Analysis as a planning tool analysis the inherent relationship between prices,
cost structure, volume and profit, Ahmad Belkooni defines cost-volume-profit
analysis as “an examination of cost and revenue behavioural patterns and
their relationships with Profit The analysis separates costs into fixed and
variable components and determines the levels of activity where costs and
revenues are in equilibrium”
According to Schmiedicke and Nagy, “cost-volume profit analysis is
an analytical technique which used the degrees of cost variability for
measuring the effect of changes in volume or resulting profits. Such analysis
assumes that the plant assets of the firm will remain the same in the shortrun, therefore, the established level of fixed cost will also remain unchanged
during the period being studied”.
We define cost-volume-profit analysis as a mature model to study the interrelated relationship between cost, price and profit structure of a company. It is
formal profit planning approach based on established relationship between different
factors affecting profit. The usual starting point in such an analysis is the
determination of the company’s break-even point. Thus, break - even analysis
forms just one component of the total system of cost-volume profit analysis.
One of the important steps in cost-volume profit and break-even analysis is
that of segregation of cost into fixed and variable costs. If the break-even point is
to occur, it becomes essential that the business enterprise has some variable cost
and some fixed costs.
Check Your Progress
How break-even point is
related to variable and fixed
cost ?
6.5.2 Determination of Break- Even Point
The Break -Even Point can be determined by the two following methods :
1.
Algebric Methods. (Mathematical)
(a) Contribution Margin Technique and
Management Accounting - II
137
Fixed & Variable Cost
& Break-Even Analysis
(b) Equation Technique
2.
Graphic Presentation
(a) Break - Even Chart and
(b) Profit Volume Graph.
NOTES
The break-even point can be computed for a firm manufacturing single
product only, in terms of units of product. The BEP is reached when the total
proceeds of units sold are equivalent to the total cost incurred-fixed and variable.
Each unit of the product sold will cover its variable cost and leave the remainder
which is known as the contribution, to cover the fixed costs. The break-even
point will occur when adequate units are sold so that total contribution would
become equivalent to the total fixed costs. More precisely, contribution per unit
while total contribution is equal to unit contribution multiplied by the total units
sold. The profit of the unit is obtained by subtracting the fixed cost from the total
contribution. The following equation can easily be remembered.
Units Contribution
=
Selling Price per unit - Variable Cost per unit
Total Contribution
=
Unit Contribution x Number of units sold
Profit
=
Total Contribution - Fixed Costs
(1)
Algebric Methods (Mathematical) :
(a)
Contribution Margin Technique :
As has been stated earlier, contribution per unit represents the difference
between selling price per unit and variable cost thereof and the profit represents
the difference between the total contribution and the fixed costs. The BEP is
reached when the total proceeds of units sold are equivalent to the total costs
incurred - fixed and variable.
On an analysis of the above two statements, it would be clear that the
Break - Even point is reached when the profit is zero or more precisely when the
total contribution is exactly equivalent to the fixed costs. The same thing can be
represented in the form of equations as given below :
138 Management Accounting - II
1.
BEP (Units)
=
2.
BEP (Rs.)
=
3.
BEP (Rs.)
=
4.
P/V Ratio
=
Fixed Cost
Contribution per unit
(or)
FC
per unit
BEP (Units) x Selling Price Per unit
Fixed Cost
Profit Volume Ratio
(or)
FC
P/V Ratio
Marginal Contribution per unit
Selling Price per unit
From the above it is clear that Equation (3) is only the derivative of Equation
(1) Multiplying both the numerator and the denominator with the common factor
of sales, the following equation is obtained :
5.
BEP ( `)
Fixed Cost x Sales
=
(or)
Sales - Variable Cost
FC x S
Fixed & Variable Cost
& Break-Even Analysis
S - VC
Again by dividing both the numerator and the denominator of the equation
(5) by the common factor of sales, the following equation is obtained.
PC
6.
BEP ( `) =
Fixed Cost
1 -
Variable Cost
(or) 1 -
NOTES
VC
S
Sales
Despite the existence of the numerous formulae, it should be remembered
that the following three formulae are always adopted for calculating the breakeven point of the business rather than drawing a chart for ascertaining the same.
(i)
BEP =
FC x S
S - VC
(Or)
FC
P/V Ratio
FC
(Or)
1-
VC
S
(b) Equation Technique :
Under mathematical approach, break-even easily by computed by engaging
the technique of unit contribution which is developed on the basis of marginal cost
equation.
The equation can be stated as follows :
Sales
=
Variable cost + Fixed Cost + Profit
At the break even point, profit is absent, therfore, the same equation for this
purpose can be re-written as follows :
Sales
=
Variable cost + Fixed Cost
Or
Sales - Variable cost
=
Fixed Cost
Or
Contribution
=
Fixed Cost
The Study of the above equation reveals that sales revenue of each unit
leaves a certain amount in the shape of contribution margin to meet fixed costs.
Thus, in order to work out the required number of units to break - even (where the
amount of contribution will be sufficient to cover total fixed cost) the total fixed
cost must be divided by the unit contribution. Accordingly, the break- even point
can be calculated in terms of units by using the following equation :
Fixed Cost
FC
Break-Even Point (in terms of units ) =
=
Unit Contribution Margin
SP - VC
Where,
BEP
=
Break - Even Point
FC
=
Total Fixed Cost
Management Accounting - II
139
Fixed & Variable Cost
& Break-Even Analysis
NOTES
SP
=
Selling Price per unit
VC
=
Variable Cost per unit
On the same basis, the break even point in terms of rupees can be computed
with the help of the equation as given under :
BEP (In terms of rupees )
=
FC
CMR
Where,
FC
=
Total Fixed Cost.
CMR
=
Contribution Margin Ratio
Where, the selling price and variable cost per unit is not readily available,
the following equation is applied to compute break - even point
BEP (in terms of rupees)
=
FC
P/V Ratio
where,
FC
=
Total Fixed Cost
P/V ratio
=
Profit Volume Ratio
EXAMPLE
Calculate the Break - Even Point from the following information
Fixed Cost
:
` 1,200
Variable Cost
:
` 5,000
Sales in rupees
:
` 7,000
Sales in units
:
1,000 Units
ANSWER
BEP (in units)
=
BEP (in rupees)
=
Contribution Margin Ratio =
140 Management Accounting - II
FC
SP - VC
FC
CMR*
SP - VC
SP
=
=
=
` 1,200
`7-`5
` 1,200
` 0.285
`7-`5
`7
=
600 units
=
` 4,200
=
` 0.285
Fixed & Variable Cost
& Break-Even Analysis
Working Notes :
` 5,000
(i) Calculation of Variable cost =
(ii) Calculation of Selling Price (per unit) =
` 5.00
=
1,000 units
` 7,000
1,000 units
` 7.00
=
NOTES
EXAMPLE
Compute Break - Even Point from below given information :
Fixed Cost
:
` 3,600
Variable Cost
:
` 15,000
Sales
:
` 21,000
ANSWER
The Break Even Point will be calculated with the help of P/V Ratio
BER (in rupees)
=
FC
P/V Ratio
=
` 3,600
28.57/100
=
` 3,600
28.57
x 100
Working Note :
Calculation of Profit/Volume Ratio :
P/V Ratio =
6.6
Contribution
Sales
x 100 =
` 6,000
` 21,000
x 100 = 28.57 %
Illustrations
The concepts used in marginal costing can be understood with the help of
following illustrations.
ILLUSTRATION 1
Find out thee selling price per unit if Break-Even Point is to be brought
down to 9,000 units.
`
Marginal Cost per unit
Fixed Cost
Market Price per unit
75
2,70,000
100
Management Accounting - II
141
Fixed & Variable Cost
& Break-Even Analysis
SOLUTION
(1) Calculation of contribution per unit :
Where,
NOTES
BEP (units) =

Fixed Cost
Contribution per unit
Fixed Cost
Contribution per unit =
=
BEP (Units)
` 2,70,000
9,000 units
= ` 30 per unit
= ` 30 per unit
(2) Calculation of Selling Price per unit :
Where,

Contribution per unit = Selling Price per unit - Variable cost per unit

Selling Price per unit = Contribution per unit + Variable cost per unit
= `30 + ` 75
= ` 105 per unit
ILLUSTRATION 2
Gasco Ltd., Guragaon, provides you with the following additional cost data
regarding its operations for 2013-14
•
Invoice price
` 20 per unit
•
Works on Cost -Fixed
` 61,000 p.a
•
Production Cost- Marginal
` 11 per unit
•
Selling Overheads- Rigid
` 29,000 p.a
•
Distribution Overheads - Differential
` 3 per unit
Calculate -
142 Management Accounting - II
(i)
Break - even Point in amount of Sales in rupees
(ii)
Number of units to be sold to earn a profit of ` 30,000
Fixed & Variable Cost
& Break-Even Analysis
SOLUTION
• Calculate of contribution per unit :
Unit Cost
`
Invoice Price
20.00
NOTES
Less : Variable Cost
(i) Production Cost - Marginal
11.00
(ii) Distribution Overheads - Differential (+)3.00
(-)
 Contribution
14.00
06.00
(i) Break-even point in amount of Sales ( in rupee) :
=
Fixed Cost
Works on Cost
=
=
=
x Selling price per unit
Contribution per unit
` 61,000
+
Selling Overheads
`6
` 90,000
`6
=
=
x `20
x ` 20
` 3,00,000
(ii) Number of units to be sold to earn a profit of
=
` 29,000
` 30,000 per year :
Fixed Cost + Desired Profit
Contribution per unit
` 90,000
`6
15,000 units
ILLUSTRATION 3
From the following cost data, calculate :
(a)
BEP (units)
(b)
BEP (units), if selling price is reduced by 10%
(c)
Selling price per unit if BEP is 8,000 units
Fixed Cost - `1,00,000 Variable cost per unit - `10, Selling price per unit 20.
Management Accounting - II
143
Fixed & Variable Cost
& Break-Even Analysis
SOLUTION
(a) BEP (units)
=
NOTES
Fixed Cost
Contribution per unit
But,
Contribution per unit
=
Selling price per unit - Variable cost per unit
Fixed Cost
BEP (units)
=
=
=
Selling price per unit - Variable cost per unit
` 1,00,000
` 20 - ` 10
=
` 1,00,000
` 10
10,000 units
(b) BEP (units), if selling price is reduced by 10% :
Original selling price per unit -Reduction by 10% = New Selling price per unit
` 20 - ` 2 = ` 18
BEP (units) :
=
Fixed Cost
Contribution per unit
But,
Contribution per unit
=
BEP (Units)
=
Selling price per unit - Variable cost per unit
Fixed Cost
Selling price per unit - Variable cost per unit
=
=
` 1,00,000
` 18 - ` 10
=
12,500 units
(c) Selling price per unit if BEP is 8,000 units :
Let X’ be the selling price per unit
Where,
Fixed Cost
BEP (units)
But,
144 Management Accounting - II
=
Contribution per unit
` 1,00,000
`8
Contribution per unit
=
BEP (units)
=
Selling price per unit - Variable cost per unit
Fixed & Variable Cost
& Break-Even Analysis
Fixed Cost
Selling price per unit - Variable cost per unit
` 1,00,000
8,000 units
=
NOTES
X - ` 10
8,000 units x (X - ` 10) =
` 1,00,000

8,000 X - ` 80,000
=
` 1,00,000

8,000 X
=
`1,00,000 + ` 80,000

X
=
Selling price per unit
=
` 1,80,000
8,000 unit
= ` 22.50
` 22.50
ILLUSTRATION 4
Following cost details are made available by Indian Plastics Ltd., Indapur, for the
month October, 2014
Prime Cost Labour per unit
Fixed Overheads
Value of Turnover per unit
Productive Wages - Outstanding per unit
Basic Material Cost per unit
Variable Overheads - 100 % of Direct Labour Cost
` 3.50
` 20,000
` 20
` 0.50
`6
10%
You are required to calculate (i)
Break - even Point (Sales Value)
(ii)
Net Profit, if Sales are 10% and 15% above the Break even Volume.
Management Accounting - II
145
Fixed & Variable Cost
& Break-Even Analysis
SOLUTION
•
Calculation of Contribution per unit :
Where,
Units Cost
`
NOTES
Selling Price
( Value of Turnover
18.00
_
Trade Discount @ 10%
)
` 20
`2
Les s : Variable Cost
(i)
Basic Material Cost
6.00
(ii)
Direct Labour Cost
4.00
• Prime Cost Labour
3.50
Add : Productive Outstanding Wages (+) 0.50
(iii)

(i)
Variable Overheads
4.00
(100% of Direct Labour Cost i.e. ` 4)
14.00
Contribution
04.00
Break-even Point Units and Sales :
Total Fixed Cost
=
Contribution per unit
` 20,000
=
`4
=
` 5,000 Units
`
Gross Sales at Break - even
1,00,000
(5,000 Units x ` 20)
Les s : Trade Discount
10,000
(10% of ` 1,00,000)

(ii)
(-)
Net Sales at Break-even
90,000
(a) Net Profit, if Sales are 10 % above break-even volume :
Revised Sales are 10% above Break-even Volume i.e.
146 Management Accounting - II
=
5,000 units + (10 % of above i.e.) 500 unit
=
5,500 units
•
Calculation of Net Profit
Fixed & Variable Cost
& Break-Even Analysis
:
Where,
Contribution
=
Fixed Cost + Profit
Profit
=
Contribution - Fixed Cost
=
(5,500 units x ` 4) - ` 20,000
=
` 22,000 - ` 20,000
=
` 2,000

(b)
NOTES
Net Profit, if Sales are 15% above break - even volume :
Revised Sales are 15% above Break - even Volume i.e
•
=
5,000 units + (15% above i.e.) 750 unit
=
5,750 units
Calculation of Net Profit :
Where,
Contribution
=
Fixed Cost + Profit
Profit
=
Contribution - Fixed Cost
=
(5,700 units x ` 4) - ` 20,000
=
` 23,000 - ` 20,000
=
` 3,000

ILLUSTRATION 5
The following is a Cost Statement of a machine manufactured by Goyal
Machineries Ltd., Gondia, for the year ended 31st March 2014 During the year,
the company manufactured, 1,000 machines and sold it in the national market.
Particulars
`
Basic Materials
190
Add : Direct Wages
70
Add : Productive Expenses
(+)
40
Prime Cost
(1)
300
(+)
50
(2)
350
(+)
20
(3)
370
(+)
30
(4)
400
(5) (+)
100
Add : Fixed Manufacturing Overheads
Works Cost
Add : Constant Management Expenses
Cost of Production
Add : Rigid Selling and Distribution on Cost
Cost of Sales
Add : Profit
Selling Price
500
Management Accounting - II
147
Fixed & Variable Cost
& Break-Even Analysis
NOTES
You are required to find out,
(i)
Break-even Point (units)
(ii)
The number of machines to be produced and sold to earn the same amount
of profit, if the price is to be increased by ` 50.
SOLUTION
In the books of Goyal Machineries Ltd., Gondia
Profitability Statement for the year ended 31st March 2014
(Machines Produced and Sold - 1,000)
Particulars
`
Sales
500
Less : Variable Cost :
(i) Basic Materials
190
(ii) Direct Wages
(iii) Productive Expenses

70
(-)
40
Contribution
200
Less : Fixed Cost :
(i) Manufacturing Overheads
50
(ii) Management Expenses
20
(iii) Selling and Distribution Expenses

(i)
(-)
30
Profit
100
Break- even Point (units) :
=
=
Fixed Cost
Contribution per unit
Rs. 1,00,000
Rs. 200
= 500 units
(ii)
Number of machines to be produced and sold to earn the same amount of
profit, if the price is to be increased by ` 50 :
`
New Selling Price : (Rs. 500 + 50)
Less :
148 Management Accounting - II

Variable Costs
Contribution per unit
550
(-)
300
250
Fixed & Variable Cost
& Break-Even Analysis
Sales for desired profit in units :
=
Total Fixed Cost + Required in Profit
Contribution per unit
` 1,00,000
=
=
( ` 100 x 1,000 units)
+
` 1,00,000
NOTES
( ` 100 x 1,000 units)
` 250
` 2,00,000
` 250
= 800 units
ILLUSTRATION 6
Bokaro India Ltd., Badalpur - provides the following cost data relating to
one unit of output.
Productive Materials
` 50
Variable Works Overheads : 75% of Prime Cost Labour
Direct Labour
` 80
Fixed Establishment Overheads
` 2,40,000 p.a.
Market Price
` 230
You are required to calculate,
(a)
the number of units to be produced and sold in a year to break-even
(b)
the number of units to be manufactured and sold in a year to market a profit
of `80,000
(c)
the number of units to be produced and sold to break-even if the selling
price is reduced by ` 16 each.
Management Accounting - II
149
Fixed & Variable Cost
& Break-Even Analysis
SOLUTION
• Calculation of contribution per unit :
Where,
Unit Cost
NOTES
`
Market Price
230
Less : Variable cost
(i) Productive Materials
(ii) Direct Labour
(iii) Variable Works Overheads
50.00
(+) 80.00
60.00
(75% of Prime Cost labour i.e ` 80)
(-) 190
 Contribution
(a)
40
Number of units to be produced and sold in a year to break-even
where, Break-even Point (units) =
=
=
Fixed Cost
Contribution per unit
` 2,40,000
` 40
= 6,000 units
(b)
Number of units to be manufactured and sold in a year to make a profit of
` 80,000 ?
=
=
=
Fixed Cost + Desired Profit
Contribution per unit
` 2,40,000 + ` 80,000
` 40
` 3,20,000
` 40
= 8,000 units
(c)
150 Management Accounting - II
Number of units to be produced and sold to break- even, if the selling price
is reduced by ` 16 each.
Fixed & Variable Cost
& Break-Even Analysis
• Calculation of Revised Selling Price :
=
Old Selling Price
` 230
-
Reduction by
` 16
= ` 214
NOTES
• Calculation of Revised Selling Price :
Where,
Unit Cost
`
Market Price
Less :Variable Cost
214.00
(-)
 Contribution
190.00
24.00
Break-even Point (units) :
=
=
Fixed Cost
Contribution per unit
` 2,40,000
` 24
= 10,000 units
ILLUSTRATION 7
The Burma-Shell Ltd., has submitted the following data :
`
Selling Price per unit
20
Variable cost per unit
16
Total Fixed Cost
20,000
Calculate BEP (units) Also calculate the effect on BEP (units), if
(a) Selling price is increased by ` 1
(b) Selling price is decreased by ` 1
(c) Variable cost is increased by ` 1
(d) Variable cost is decreased by `1
(e) Fixed cost is increased by ` 5,000
(f) Fixed cost is decreased by ` 5,000
Management Accounting - II
151
Fixed & Variable Cost
& Break-Even Analysis
SOLUTION
BEP (units ) :
=
NOTES
Fixed Cost
Contribution per unit
But,
Contribution per unit =

BEP (units)
=
=
Selling Price per unit - Variable cost per unit
Fixed Cost
Selling Price per unit - Variable cost per unit
` 20,000
=
` 20 - ` 16
` 20,000
`4
= 5,000 units
Calculation of effect on BEP (units) if
(a) Selling Price is increased by ` 1 :
Original Selling Price per unit + Increase by ` 1= New Selling Price per unit
` 20
BEP (units)
` 20,000
` 21 - ` 16
+
=
=
`1
`21
Fixed Cost
Selling Price per unit- Variable cost per unit
` 20,000
=
`5
= 4,000 units
(b) Selling Price is decreased by ` 1 :
Original Selling Price per unit - Decrease by ` 1 = New Selling Price per unit
` 20
BEP (units)
` 20,000
` 19 - ` 16
=
=
`1
=
` 19
Fixed Cost
Selling Price per unit- Variable Cost per unit
` 20,000
`3
= 6,667 units
(c) Variable Cost is increased by ` 1 :
Original Variable Cost per unit + Increased by ` 1 = New Variable Cost per unit
` 16
BEP (units)
152 Management Accounting - II
+
=
`1
=
`17
Fixed Cost
Selling Price per unit- Variable Cost per unit
` 20,000
` 20,000
=
` 20 - ` 17
`6
= 6,667 units
Fixed & Variable Cost
& Break-Even Analysis
d) Variable cost is decreased by ` 1 :
Original Variable Cost per unit- Decrease by `1 = New Variable Cost per unit
` 16
-
BEP (units)
=
` 20,000
=
` 20 - ` 15
(e)
`1
=
NOTES
` 15
Fixed Cost
Selling Price per unit- Variable Cost per unit
` 20,000
`5
= 4,000 units
Fixed Cost is increased by Rs. 5,000 :
Original Fixed Cost
` 20,000
+
BEP (units)
=
` 25,000
=
` 20 - ` 16
(f)
Increase by
=
` 5,000
New Fixed Cost
` 25,000
Fixed Cost
Selling Price per unit - Variable Cost per unit
` 25,000
`4
= 6,250 units
Fixed Cost is decreased by `5,000 :
Original Fixed Cost
` 20,000
BEP (units)
` 15,000
` 20 - ` 16
6.7
Decrease by
-
=
` 5,000
=
=
New Fixed Cost
` 25,000
Fixed Cost
Selling Price per unit - Variable Cost per unit
` 15,000
`4
= 3,750 units
Summary
•
Fixed Cost : - These costs remain fixed in total amount and do not increase
or decrease when the volume of production changes. But the fixed cost
per unit increases when volume of production decreases and vice-versa.
•
Variable Cost :- Variable costs change in proportion to the volume of out
put. In other words, when volume of out put increase, total variable cost
also increases and vice-versa
Management Accounting - II
153
Fixed & Variable Cost
& Break-Even Analysis
NOTES
•
Determination of Marginal Cost : A number of methods are avail able
for segregation of semi variable costs in to variable and fixed costs. The
important methods are : (i) Comparison by period of level of activity method
(ii) Equation Method (iii) Range Method (iv) Analytical Method (v) Scatter
graph Method (vi) Least Squares Method.
•
Contribution :- The concept of ‘Contribution’ is of immense use in fixing
the selling prices, determining the break-even point, selecting the product
mix for profit maximisation and also ascertaining the profitability of the
products departments etc.
•
Break Even Analysis : - Break Even Analysis establishes the relationship
between costs and profit with sales volume. It represents a specific method
of presenting and studying the inter-relationship, between costs, volume
and profits.
•
The Break Even Point can be determined by the following methods :
(i) Algebric Method - (a) Contribution Margin Technique &
(b) Equation Technique
(ii) Graphic Presentation - (a) Break Even Chart &
(b) Profit Volume Graph
6.8
154 Management Accounting - II
Key Terms
(1)
Fixed Cost : It is cost which accrues in relation to the passage of time
and which, within certain out put and turnover limits, tends to be unaffected
by fluctuations in the level of the activity e.g rent, rates, insurance etc.
(2)
Variable Cost : It is a cost which in the aggregate, tends to vary in the
direct proportion to the changes in the volume of the production or the
turnover e.g. direct material direct labour direct expenses etc.
(3)
Break Even Analysis :- It is the analysis used to determine the probable
profit or loss at any level of operations.
(4)
Break Even Point : It is point at which total sales revenue equals the total
costs.
(5)
Contribution :- It is the excess selling price over the variable costs.
6.9
Questions And Exercises
Fixed & Variable Cost
& Break-Even Analysis
I - Objective Questions
(A)
Multiple Choice Questions
(1)
Contribution is the difference between the selling price and --------- cost
NOTES
(a) variable
(b) fixed
(c) semi-variable
(d) sales
(2)
Marginal Cost = Total Cost (-) ------------- Cost.
(a) semi-variable
(b) fixed
(c) variable
(d) selling
(3)
At break even point -------------- is equal to fixed costs.
(a) variable cost
(b) profit
(c) contribution
(d) sales
(4)
If nothing is produced, the total loss will be equal to ------------ cost
(a) variable
(b) total
(c) semi-variable
(d) fixed
Ans : (1 - a), (2 - b), (3 - c), (4 - d)
II - Long Answer Questions
(1)
How do you Classify the costs as per behavioural factor ?
(2)
What is ‘Fixed Cost’ ? Explain the important features of Fixed Costs.
(3)
What is ‘Variable Cost’ ? How it differs from Fixed Cost ?
(4)
Define ‘Marginal Cost . Explain the important features of Variable Cost.
Management Accounting - II
155
Fixed & Variable Cost
& Break-Even Analysis
NOTES
(5)
What is ‘Semi-Variable Cost’ ? Explain the various methods of segregating
semi-variable cost into fixed and variable.
(6)
What is ‘Contribution’ ? How it differs from ‘Profit’ ?
(7)
Explain the importance of following concepts in relation to Marginal Costing
(a) fixed cost (b) contribution (c) variable cost (d) Break-Even Point
III - Practical Problems
1.
The following are the budgeted cost data of Atlas Co. Ltd., Ahmedabad.
`
Total Turnover
6,00,000
Marginal Cost
3,00,000
Fixed Costs
1,50,000
Find out the Break-Even Point at (i) the budgeted data and (ii) 20% increase
in variable cost.
2.
The turnover and profits during the two periods were as follows :
Period
Sales
Profit
`
`
One
40,00,000
4,00,000
Two
60,00,000
8,00,000
Assuming that the cost structure and selling price remains the same in the
two periods. Calculate (a) Break- Even Point ( Sales value) (b) The sales
required to earn a profit of ` 10,00,000 (d) Margin of Safety in period two,
(d) Profit when Sales are ` 50,00,000
3.
From the following cost data Calculate - (a) Fixed Cost, (b) Break-even
Point, (c) The number of units to be sold to earn a profit of ` 40,000.
The selling price is ` 100 per unit
Period
4.
156 Management Accounting - II
Sales
Profit / Loss
(Units)
`
One
7,000
Loss - 10,000
Two
9,000
Profit - 10,000
From the following find out (a) Break-even Point (b) Net Profit, if the Sales
were ` 2,50,000 (d) Sales to earn a profit of ` 70,000.
Fixed & Variable Cost
& Break-Even Analysis
In the books of A Ltd.
Particulars
`
Value of Turnover
2,00,000
Less : Variable Cost
 Contribution
(-)
1,20,000
80,000
Less : Fixed Cost
(-)
20,000
 Profit
5.
NOTES
60,000
Morgan Ltd., Mahim, has prepared the following budget estimates for the
year 2013-14
Sales - 20,000 units
Sales value - ` 2,00,000
Variable Cost per units Rs. 5
Fixed Cost - ` 20,000
You are required to calculate (a) P/V Ratio, Break- even Point and Margin of Safety in each of the
following cases.
(6)
(7)
(i)
Decrease of 10% in selling price
(ii)
Increase of 10% in variable cost.
Calculate the Break - Even point in the following cases :
Sales ( estimated )
-
` 5,00,000
Fixed costs
-
` 2,00,000
Variable cost per unit
-
` 10
Selling price per unit
-
` 50
Amol Industries supply you with the following information :
Sales
-
` 2,00,000
Fixed costs
-
` 1,00,000
Variable cost
-
` 1,30,000
Find out the increase in sales required to break-even.
(8)
Chaby Ltd., furnishes you with the following information. Calculate the
break-even point
Sales (value)
-
`1,50,000
Sales (units)
-
15,000
Management Accounting - II
157
Fixed & Variable Cost
& Break-Even Analysis
NOTES
Fixed cost
-
` 50,000
Variable Costs
-
Direct Material
-
` 40,000
Direct Labour
-
` 45,000
Variable overheads
-
` 35,000
6.10 Further Reading
158 Management Accounting - II
•
Khan M.Y and Jain P. K - Management Accounting Text problems and
cases- New Delhi- Tata Mc Graw - Hill Publishing Co Ltd., 2010
•
Bhar B.K- Cost Accounting Methods and Problems -Kolkata- Academic
Publisheres 2010
UNIT 7 Break-Even Chart and P V Ratio
Break Even Chart &
P V Ratio
Structure
7.0
Introduction
7.1
Unit Objectives
7.2
Break Even Chart : A graphic presentation
7.3
The Profit Graph/ Profit Volume Graph
7.4
Assumptions of Break-Even Analysis
7.5
Usefulness of Break-Even Analysis
7.6
Limitations of Break-Even Analysis
7.7
Margin of Safety
7.8
Profit Volume Ratio
7.9
Limiting Factor
NOTES
7.10 Marginal Cost Equations
7.11 Illustrations
7.12 Summary
7.13 Key Terms
7.14 Questions and Exercises
7.15 Further Reading
7.0
Introduction
A Break-Even Chart is a graphical approach to the study of the relationship
of cost revenue and profit. The break-even analysis can also be demonstrated
graphically which is commonly known as Break-Even Chart. You can draw BE
chart on graphic paper. Output or volume or activity level can be plotted on ‘x’
axis and costs and revenues (Sales) are plotted on ‘y’ axis. First draw the fixed
cost line parallel to ‘x’ axis and variable cost line over the fixed cost line for the
different levels of output. Then join the variable cost line with fixed cost line at
zero level of output, it will be the total cost line. Thereafter sales (revenue) line
can be drawn by calculating the sales value for the different levels of output. the
Sales (revenue) line will make a 450 angle with the ‘x’ axis Then, it is significant
to observe that the point, where Total Cost line intersects The Sales line, is the
BEP.
Margin of Safety is the ‘‘excess of actual or budgeted Sales over the break
Management Accounting - II
159
Break Even Chart &
P V Ratio
NOTES
even Sales volume’’ The Margin of Safety indicated the drop in Sales volume
which can take place before profits disappear.
Profit-Volume Ratio (V Ratio) indicates a relationship between contribution
and sales. It should be noted in this context that this profit volume ratio aid
management to take its proper decision as to planning for profit.
7.1
Unit Objectives
After Studying this unit you should be able to :
•
Understand graphical presentation break even analysis.
•
Identify the relationship of cost, revenue and profit with the help of Break
Even chart.
•
Construct a Break Even Chart and Profit Volume graph.
•
Explain the concept of Margin of Safety (MoS).
•
List out the assumptions of Break Even Analysis.
•
Discuss usefulness of Break Even Analysis.
•
Compute Margin of Safety (Mos) with the help of organisational data.
•
Calculate Profit Volume Ratio.
•
Discuss the term limiting factors (Key factors).
7.2
Break- Even Chart : A Graphic Presentation
The break-even analysis can also be demonstrated graphically, which is
commonly known as Break- Even Chart. A Break- Even Chart is a graphical
approach to the study of the relationship of cost, revenue and profit. The graphic
instead of algebric approach is often used because it tends to be more easily
understood by persons whose acquaintance with mathematics is minimal and as it
provides an immediate view of variable costs, fixed costs and profit at any level of
activity.
Information for constructing a Break - Even Chart can be obtained from
the income statement of the concern. However, the total cost. i.e., fixed cost,
variable cost, and semi variable cost must be separated only into two categories
of costs : Fixed-Cost and Variable-Cost. A brief description of these costs is as
follows :
160 Management Accounting - II
(i) Fixed Cost : Fixed Costs are the costs which remain fixed for all practical
purposes to a certain level of activity. Once that level of activity is increased, the
fixed cost will also increase to a specific degree e.g. Cost of plant and machinery,
salaries, rent etc. These costs are shown on the graph by means of a straight line.
(ii) Variable Cost : These Cost vary in proportion to output. This means that
they increase directly with the volume of production. Cost of material, wages,
carriage etc. are some examples of variable cost. For graphic application, these
costs will be aggregated with the fixed cost.
(iii) Semi -Variable Cost : Semi- variable costs possess the characteristics of
both fixed and variable costs. These cost demand special attention from the
management in splitting them into fixed and variable costs.
Break Even Chart &
P V Ratio
NOTES
Constructing a Break-Even Chart :
(1) The Traditional Break-Even Chart
EXAMPLE
Construct a Break-Even Chart, using the following information :
Output
:
1,25,000 units
Sales
:
` 5,00,000
Check Your Progress
Variable Cost
:
` 2,50,000
How you descript Fixed and
Variable Cost ?
Fixed Cost
:
` 1,00,000
ANSWER
Sales and Costs ( ` 000)
First we will have to draw -up our chart and then insert the Sales line (see
Figure 7.1)
Y
500
Sales
`
400
(5,00,000)
300
200
100
0
25
50
75
100
Output (000 Units)
125
X
Fig. 7.1 : Sales
Next we will draw the fixed cost line which runs parallel to base of the
Management Accounting - II
161
Break Even Chart &
P V Ratio
chart (i.e the output ) (see Figure 7.2)
Y
NOTES
Sales and Costs (Rs. 000)
500
400
300
200
100
0
25
50
75
100
Output (000 Units)
125
X
Fig. 7.2 : Sales and Fixed Costs
Then, we include the variable costs by adding them on to the fixed costs.
This line isdraw n from ` 1,00,000 at 0 output to ` 3,50,000 at 1,25,000 units of
output. This line is the total cost line i.e, fixed cost `1,00,000 plus variable cost
` 2.50,000 = `3,50,000 total cost (see Fig. 7.3)
500
Breakeven Point
`2,00,000
400
Sales and Costs (`000)
Sales
` (5,00,000)
Total Cost
`(3,50,000)
300
200
100
Fixed Cost
`1,00,000
0
25
50
75
100
125
Output (000) Units
Fig. 7.3 : Break-Even Point
162 Management Accounting - II
Having Completed our break- even chart (Fig 7.3) we can read the breakeven point at `200,000 Sales and Costs and 50,000 units of output, the point at
which costs and revenue (sales/income ) are equal, i.e. where the sales line
intersects the total cost line.
After taking a closer look at the chart which we will complete finally showing
the following information (Fig 7.4)
Break Even Chart &
P V Ratio
Y
Sales ` (5,00,000)
500
Breakeven Point
`2,00,000
Sales and Costs (`000)
400
Profit `1,50,000
NOTES
Total Cost `3,50,000
300
Margin of
200
Variable Cost `2,50,000
Safety
100
Fixed Cost `1,00,000
X
0
25
50
75
100 125
(20%)(40%) (75%) (80%)(100%)
Output (000) Units (Level of Activity)
Fig. 7.4 : Conventional Break-Even Chart
1.
The logic of the calculations involved can be followed as per the right-hand
side of the chart, i.e. Sales ` 5,00,000 ( Less) Total Cost ` 3,50,000 =
Profit ` 1,50,000, Total Cost `3,50,000 = Variable Cost ` 2,50,000 +
Fixed Cost `1,00,000
2.
Above the Break - Even Point we make a profit and below it we make a
loss.
3.
The margin of safety is the difference between the break-even point and
the selected output / level of activity. This indicates the extent to which the
level of activity must fall before a loss making situation is reached.
4.
The base of the chart can be expressed either in terms of output on level
of activity.
5.
By projecting a vertical line from the base line, e.g at 1,00,000 units of
output (80% level of activity ) we can use the chart to read the fixed cost,
total cost and sales applicable to this particular level of activity. We can see
that the vertical line drawn from 1,00,000 units of output (80% level of
activity ) cuts the fixed cost line at `1,00,000 the total cost line at `3,00,000
and the sales line at 4,00,000. The gap between sales and total cost of
`1,00,000 represents the profit which should be achieved at the 80% level
of activity.
Management Accounting - II
163
Break Even Chart &
P V Ratio
Calculating the Break - Even point
Particulars
NOTES
Sales
Less : Variable Cost
Unit Cost
1,25,000 units
`
`
(-)
Contribution
4
2
5,00,000
2,50,000
2
2,50,000 (50% P/V Ratio)
Less : Fixed Cost
(-)
1,00,000
Profit
1,50,000
Break- Even Point =
Fixed Cost
P/V Ratio
= `1,00,000 x
` 100
50
= `2,00,000
OR
=
Fixed cost
Contribution per unit
=
` 1,00,000
`2
= 50,000 units
The Contribution Break-Even Chart :
Check Your Progress
What is contribution BreakEven Chart ?
The Contribution Break-Even Chart is an alternative way of showing the
information which used to construct our traditional break-even Chart. Using the
same information relating to earlier example, we will look at its construction in
two phases. Firstly, we draw up the chart and then insert the sales line and the
variable cost line, both of which are drawn from the base line point (see Fig 7.5)
Sales ` 5,00,000
500
Contribution ` 2,50,000
Sales and Costs (`000)
400
Variable Cost ` 2,50,000
300
200
100
0
20
40
65
80
100
Output (Level of Activity) (%)
Fig. 7.5 : Contribution, Sales and Variable Cost
164 Management Accounting - II
This income break- even chart (Fig 7.5) specifies that Sales ` 5,00,000 less
variable cost ` 2,50,000 = contribution ` 2,50,000. The principal advantage of
this chart is that it shows, very clearly, the contribution which is being generated at
different levels. of activity. The Fixed Costs of ` 1,00,000 are then added to the
Variable Costs and the Total Cost line drawn from 1,00,000 at 0% level of activity
to 3,50,000 at 100% level of activity, the Fixed Costs are plotted parallel to the
Variable Costs. (See Fig 7.6)
Y
NOTES
Sales ` (5,00,000)
500
Breakeven Point
`2,00,000
400
Sales and Costs (`000)
Break Even Chart &
P V Ratio
300
Total Cost
`3,50,000
Fixed Cost
`1,00,000
200
Profit
`1,50,000
+
Fixed Cost
`1,00,000
Contribution
`2,50,000
Variable Cost
`2,50,000
100
0
25
50
75
100
125
X
Output (Level of Activity) (%)
Fig. 7.6 : Contribution Break-Even Chart
Observations :
(i)
This Chart shows that below the break - even point the fixed costs are not
being covered. When the contribution generated has covered fixed costs,
the remainder is profit
(ii)
The final contribution break-even chart (Fig 7.6) illustrates that the
contribution ` 2,50,000 (Less) Fixed Cost ` 1,00,000 = Profit `1,50,000.
7.3
The Profit Graph/ Profit Volume Graph
This is an alternative type of break - even chart and helps to understand the
profit volume ratio more clearly. To draw it you need to know any two of the
three figures : Fixed Cost, Profit and Break-Even Point. Again using the same
figures as related to earlier example the graph would be as shown in Fig 7.7
Management Accounting - II
165
Break Even Chart &
P V Ratio
(`000)
200
Break
Even Point
Profit
NOTES
100
Profit
`1,50,000
0
100
200
Fixed 100
Cost
(Loss)
300
400
500
Sales ( `000)
Fig. 7.7 : Profit Graph/Profit Volume Graph
Observations :
(i)
The line which joins the Fixed Costs to the Profit is, in fact, the Contribution
Line, i.e. it represents Fixed Cost `1,00,000 + Profit `1,50,000 = `2,50,000
Contribution.
(ii)
The Break-Even Point is again `2,00,000
EXAMPLE
From the following particulars relating to the Ahmednagar Engineer
Construction Ltd., Ahmednagar draw a Break-Even Chart, and indicate the BreakEven Point.
Particulars
`
Sales (10,000 units at `20 per unit)
`
2,00,000
Variable Costs :
(i)
Direct Material
30,000
(ii)
Direct Labour
50,000
(iii) Factory Overheads
20,000
(iv) Administrative and Selling Overheads (+)
(-) 1,20,000
Contribution
80,000
Fixed Costs :
166 Management Accounting - II
(i)
Factory Overheads
20,000
(ii)
Administrative and Selling Overheads (+)
20,000
Net Profit
(-) 40,000
40,000
Break Even Chart &
P V Ratio
ANSWER
Y
` 20 Actual Sales
16
12
+
NOTES
++
+ +
+
+
+
+
+ +
++++
+ ++
+
++ +
++
+
Sa
les
Li
ne
Costs and Revenue (`10,000)
20
t
ofi
Pr
` 16 Total Costs
` 12 Total Variable Costs
Angle of incidence
ine
L
t
s
Co
tal
o
Fixed Cost Safety
T
ss
Lo
Margin of Safety
8
4
` 4 Total Fixed Cost
X
0
(Sales ` 10,000
4
8
12
16
20
10 (Sales 1,000 Units)
2
4
6
8
10
20% 40% 60% 80% 100% 100% (Percent of Capacity)
Fig. 7.8 Break-Even Chart
In Fig. 7.8 the Fixed Cost line is represented as the horizontal line parallel to
the X-axis, whereas the Variable Cost line is represented by the area covered
between the Total Cost and the Fixed Cost. The point of intersection between the
Sales and the Total Cost lines represents the break- even point indicated as BEP
It acquires at a Sales Volume of 5,000 units and Total Sales worth `1,00,000
(5,000 units x `20) The angle of incidence. The greater the angle of incidence,
the lower will be the break- even point and vice-versa. While the area to the right
of the break- even point represents the profit area, that to left of it represents the
loss area which only reveals the uncovered fixed costs. The excess of actual
sales over the break-even sales is known as the margin of safety.
Alternative Form :
In Fig. 7.8, the Fixed Costs line is drawn first starting from the fixed cost
point. It focuses the attention on the fact that Fixed Cost remains constant for
different levels of sales. An alternative method of constructing the break-even
chart is to draw the variable cost line followed by the total cost line from the fixed
cost point. This total cost line will be parallel to the variable cost line.
Management Accounting - II
167
NOTES
Y
Y
` 20
Actual Sales
16
Lin
e
Cost and Revenue (`10,000)
20
BEP
12
8
ta
To
os
lC
e
in
tL
` 16
Total Costs
Sa
les
Break Even Chart &
P V Ratio
nt
Co
io
ut
ir b
` 12
Variable
Costs
n
4
Margin of Safety
X
0
4
8
12
16
20
Fig 7.9 Alternative form of Break - Even Chart
The alternative form of break-even chart discloses certain additional
information not given by the first form. The fixed costs are indicated by the
intercept of the total cost line on the vertical axis. There are three distinctive
benefits of the alternative form. Firstly, the variable costs are shown for different
sales levels. Secondly, the marginal contribution at different, sales levels is clearly
represented by the difference between sales line and variable line. Thirdly, the
break-even chart clearly discloses the recovered as well as unrecovered amount
of fixed costs at different levels of activity.
Y
16
BEP
12
+
+
+
+
+
+
+
+
++
+
+
+
+
+
Sa
les
Li
ne
Pr
of
it
ar
ea
Costs and Revenue (`10,000)
20
+
+
+
+
++ +
++
+
Fixed Costs
e
Lin
t
s
Co a
tal
To Are
ss
Lo
8
4
Factory Overheads
Director Labour
X
0
4
8
12
16
20
Sales (In ` 10,000)
168 Management Accounting - II
Fig. 7.10 : Alternative Break-Even Chart
It can be seen from the Fig 7.9 that when the sales are ` 80,000 (i.e. 40%
of the capacity) the amount of contribution available to cover the fixed cost of
`40,000 is only `32,000 Thus, the amount of fixed cost left unrecovered which
represents loss to the business unit at this level of Sales is `8,000 (`40,000`32,000) The third alternative is to construct a break-even chart portraing all the
details of the components of fixed as well as Variable Costs as shown in Fig. 7.10.
Margin of Safety ( MOS)
The margin of safety represents the difference between actual sales and
break even sales in Fig 7.8 the margin of safety is indicated as `1,00,000 the
difference between actual sales of `2,00,000 and the break-even sales of
`1,00,000.
Break Even Chart &
P V Ratio
NOTES
Check Your Progress
Give the examples of margin
of safety.
EXAMPLE
ABC Co. Ltd., Nashik manufactures 5,000 units with the existing plant and
premises. An analysis of cost accounts indicates that :
(i)
The expenditure on fixed overheads is `1,000
(ii)
The variable costs are `0.60 per unit
(iii)
Selling price per unit is `1.
The management is anxious to increase production and ascertain that the
following increase in fixed expenses will occur if production is increased.
•
Exceeding 5,000 units and not exceeding 10,000 units - `2,000 per annum.
•
Exceeding 10,000 units - `2,000 per annum.
Incorporate the above information in Break-Even Chart.
Break Even
Point
15,000
15,000
Break Even
Point
10,000
5,000
10,000
Variable Costs
Break Even
Point
5,000
15,000
12,500
10,000
7,500
0
5,000
Fixed Overheads
2,500
Revenue and Costs (In Rupees)
ANSWER
Output (In Units)
Fig. 7.11 Break-Even Chart
Management Accounting - II
169
Break Even Chart &
P V Ratio
Mathematical Verification :
BEP at Sales of 5,000 units Variable Costs remain at ` 0.60 per unit, Fixed
Overheads at Rs. 1,000 and Selling Price at `1 per unit
NOTES
(i)
BEP =
PC x S
S
=
5,000 units x ` 1 = `5,000
S - VC
PC
=
`1,000 and VC = 5,000 units x `0.60
=
`3,000
=
=
(ii)
` 2,000
` 2,500
PC x S
S
=
10,000 units x ` 1 = `10,000
S - VC
PC
=
` 3,000 and VC = 10,000 units x `0.60
=
` 6,000
=
=
` 3,000 x ` 10,000
` 10,000 - ` 6,000
=
` 3,00,00,000
`4,000
` 7,500
BEP at Sales of `15,000 units, costs remain at `0.60 per unit, Fixed
Overheads at ` 5,000 and Selling Price at `1 per unit
BEP =
PC x S
S
=
15,000 units x ` 1 = `15,000
S - VC
PC
=
` 5,000 and VC = 15,000 units x ` 0.60
=
` 9,000
=
=
170 Management Accounting - II
`5,000 - `3,000
` 50,00,000
=
BEP at Sales of `10,000 units, costs remain at `0.60 per unit, Fixed
Overheads at `3,000 and Selling Price at `1 per unit
BEP =
(iii)
`1,000 x `5,000
` 5,000 x ` 15,000
` 15,000 - ` 9,000
`12,500
=
`7,50,00,000
`6,000
7.4
Assumptions of Break - Even Analysis
Break Even Chart &
P V Ratio
Break-Even Analysis data are based upon certain assumed conditions which
are rarely found in practice.
Some of these basic assumptions are given below :
(i)
Costs can be classified into their fixed and variable components.
(ii)
The principle of cost variability is valid.
(iii)
Variable Costs vary proportionately with the volume changes.
(iv)
Fixed Costs remain constant irrespective of the level of activity.
(v)
Selling price does not change with the volume changes.
(vi)
There is no change in the general price level.
(vii)
There is only one product or in the case or multiple products sales mix
remains constant.
(viii) There is synchronisation between production and sales.
(ix)
Productivity per worker remains constant.
(x)
Revenue and costs are being compared with a common activity base, e.g.
units produced or sales value of production
(xi)
Plant capacity and efficiency remain unaffected.
NOTES
Check Your Progress
List out the various
assumptions of BE Analysis.
It is clear that a change in any one of the above factors will later the break
- even point such that profits are effected by changes in factors other than volume.
7.5
Usefulness of Break-Even Analysis
Break-even analysis is considered to be the most useful technique of profit
planning and control. It is an important device to explain the relationship between
cost, volume and profit. The usefulness of the break-even analysis is as follows :
(i)
It is simple tool employed to graphically represent complicated accounting
data.
(ii)
It is a more useful diagnostic tool.
(iii)
It provides basic information facilitating further studies on improving the
profit .
(iv)
It is also used for analysing the risk implication of alternative actions.
(v)
It is useful in marketing strategies also.
Check Your Progress
How Break-Even Analysis
useful in cost accounting ?
The break-even analysis serves as a useful tool for considering the risk
implications of alternative actions. The problem of risk evaluation can be solved
Management Accounting - II
171
Break Even Chart &
P V Ratio
NOTES
by considering the effects of the alternative actions on break-even point. While
taking a decision, the business unit should not only consider the profits arising
from the alternatives but also the probability of reaching the break - even point.
7.6
Limitations of Break-Even Analysis
(i)
The application of break-even analysis to a multi - product firm becomes
very difficult.
(ii)
Since the break-even analysis is a short-run concept, it has a limited
application in the long range planning.
(iii)
The break-even tool is a static tool with very limited practical application.
(iv)
It is very difficult if not impossible to separate costs into fixed and variable
components.
(v)
The assumption that the total fixed cost remains constant over the entire
volume range does not stand to reason.
7.7
Margin of Safety
The amount by which the current volume of sales exceeds the break-even
sales volume, either in units or rupees represents margin of safety. This is the
difference between the total sales figures and the amount of sales at break-even
point. It indicates the extend to which sales may decrease before the company
suffers a loss. A margin of safety is calculated as follows :
M/S
=
SA-S B or MoS = AS - BS
M/S
=
Margin of safety
SA
=
Actual volume of Sales
SB
=
Break- even volume of sales
MoS
=
Margin of Safety
AS
=
Actual volume of Sales
BS
=
Break-even volume of Sales
where,
Margin of safety may be expressed as a percentage based either on units
or rupee value. For this purpose, the following formulas are used :
172 Management Accounting - II
M/S (in rupees) =
Profit
P/V Ratio
M/S (in units)
=
Break Even Chart &
P V Ratio
Profit
Contribution per unit
The high margin of safety is the sign of prosperity of the business. A low
margin would indicate high fixed cost. Such a critical situation calls for : Increase
in selling price, decrease in variable costs, replacement of existing product line by
a more profitable line and increase in volume of production.
7.8
NOTES
Profit Volume Ratio (P/V Ratio)
The Profit/Volume Ratio also knows as ‘contribution ratio’ or ‘marginal
ratio’ expresses the relationship between contribution and sales. In other words.
it, is the contribution per rupee of sales. The P/V Ratio may be expressed as
under.
P/V ratio =
Sales
=
Contribution
Sales
Contribution per unit
x 100 OR
Selling price per unit
x 100
Contribution (FC + Profit)
Check Your Progress
How you expressed P/V Ratio
in Equation ?
P/V Ratio
OR
Contribution
=
Fixed Expenses + Profit
Contribution
=
Selling Price - Variable Costs
Since contribution is equal to sales (-) variable cost and also represents the
amount of fixed cost and profit expectations, therfore, P/V ratio can also be
expressed as
(i)
(ii)
P/V Ratio =
P/V Ratio =
Sales - Variable Cost
Sales
Fixed Cost + Profit
Sales
=
=
S-V
S
F+P
S
As discussed earlier, the fixed cost remains constant in the short-term period,
therfore any increase in contribution after the recovery of fixed cost would result
straight way in the increase of profit. Thus,
P/V Ratio
=
Change in Profit
Change in Sales
Management Accounting - II
173
Break Even Chart &
P V Ratio
NOTES
Check Your Progress
How you define Key Factor ?
7.9
Limiting Factor (Key Factor)
Every business organisation tries to achieve maximum profit but there are
always certain factors which do not allow the organisation to earn more profits.
These are the constraints of the business. For example, company have very good
sales. network and can sell all the items produced. But there may be shortage of
raw materials, which will limit the production to a certain extent. Sometimes, all
other factors may be favourable, while sales becomes the problem. In this case,
sales becomes the limiting/key factor.
A key factor can, therefore, be defined as that factor which limits the desired
volume of production. When there is a key factor, the contribution per unit of that
key factor is maximised so that we get the maximum advantage. To do this,
ascertainment of the key factor is essential. If there is any mistake in finding out
the key factor the decision based on it will go wrong. In dealing with a limiting
factor problem the steps to be taken are as follows :
1.
Identify the possibility that-there may be a limiting factor other than sales
demand. There may be the maximum availability of one (or more) resources,
so that sales demand cannot be met. This is done simply as follows
(i) Calculate the volume of resources required to produce enough unit to
satisfy sales demand.
(ii) Calculate the volume of resources available.
(iii) Compare the two totals. If (a) exceeds (b) there is limiting factor.
2.
If there is only one such limiting factor, the next step is to calculate the
contribution earned by each product per unit of the scarce resource. The
product(s) with the highest contribution per unit of scarce resource should
receive priority in the allocation of the resource in the production budget.
If we know both the key factors as well as the contribution, we can find out
the relative profitability of different products with the help of the following formula:
Profitability
=
Contribution
Key Factor
For example, if labour hour is the key factor, the profitability is found out as
follows :
Profitability
174 Management Accounting - II
=
Contribution
Labour hour per unit
Thus, when a limiting factor is in operation, the contribution per unit of such
a factor should be criterion to judge the profitability of a line of activity. When two
or more limiting factors are in operation simultaneously , it is necessary to take all
of them into consideration to determine the profitability if it is the question of
selecting a suitable product mix when a number of limiting factor operate, the
technique of linear, programming should be used.
7.10 Marginal Cost Equations
(a)
(b)
(c)
(d)
(e)
(f)
Break Even Chart &
P V Ratio
Sales or Selling Price or Market Price or Value of Turnover or
Invoice Price or Inflated Price or Loaded Price :
=
Total Cost + Profit
=
Variable Cost + Fixed Cost + Profit
=
Contribution / P/V Ratio
=
Contribution + Variable Cost
=
Marginal Cost / Marginal Cost Ratio
NOTES
Profit or Net Margin or Net Income :
=
Sales - Total Cost
=
Sales - (Variable Cost + Fixed Cost)
=
Contribution - Fixed Cost
=
Margin of Safety x P/V Ratio
=
Total Cost - Sales
=
Fixed Cost - Contribution
Loss:
Check Your Progress
Write all necessary equations
of Marginal Cost useful in
cost accounting.
Contribution or Gross Margin or Marginal Contribution :
=
Sales - Variable Cost
=
Fixed Cost + Profit
=
Sales x P/V Ratio
=
Fixed Cost - Loss
=
Fixed Cost / Break-even Units
Fixed Cost, Rigid Cost or Constant Cost :
=
Total Cost - Variable Cost
=
Contribution - Profit
=
Contribution + Loss
=
Sales - (Variable Cost + Profit)
Variable Cost or Marginal Cost or Differential Cost :
=
Total Cost - Fixed Cost
=
Sales - Contribution
Management Accounting - II
175
Break Even Chart &
P V Ratio
NOTES
(g)
=
Sales - (Fixed Cost + Profit)
=
Direct Material + Direct Labour + Direct Expenses
+ Variable Overheads
Break-Even Point i.e. BEP (in units) or (in output) :
=
=
(h)
Total Fixed Cost
Contribution per unit
Break-even Sales in Rs.
Selling Price per unit
Break-Even Point i.e. BEP (Sales in Rupees) :
=
=
=
=
Total Fixed Cost
Contribution per unit
Total Fixed Cost
(i)
Total Fixed Cost
Profit/Volume Ratio
Total Fixed Cost
=
=
Variable Cost
Sales
)
Break-Even Point (Units) x Selling Price per unit
Contribution
Sales
x 100
Change in Profits
Change in Sales
x 100
Change in Contribution
Change in Sales
x 100
Margin of Safety :
MS =
MS =
176 Management Accounting - II
(
Profit/Volume Ratio or Contribution to Sales Ratio or Contribution
Ratio i.e. P/V Ratio :
=
(j)
x Total Sales
Total Contribution
1=
x Selling Price per unit
Actual Sales - Break-Even Sales
Profit
P/V Ratio
(k)
MS Ratio
=
MS Ratio
=
P/V Ratio
Break Even Chart &
P V Ratio
x 100
Margin of Safety
Actual Sales
x 100
Sales volume to earn required profit (in value) or Sales for desired
profit (in units) :
=
(l)
Profit
NOTES
Total Fixed Cost + Required Profit
Contribution per unit
Sales volume to earn required profit (in value) or Sales for desired
profit (in `) :
=
=
(Total Fixed Cost + Required Profit) x Sales
Total Contribution
Total Fixed Cost + Required Profit
P/V Ratio
7.11 Illustrations
The concept of margin of safety, Profit Volume Ratio and Limiting Factor
can be understood with the help of following illustrations.
ILLUSTRATION 1
From the following information, find out :
(a) P/V Ratio
(b) BEP (Sales) (c) Profit when Sales are `1,20,000
(d) Sales required to earn a Profit of `60,000.
`
Fixed Cost per unit
Variable Cost per unit
Sales
Selling Price per unit
40,000
2
2,00,000
10
Management Accounting - II
177
Break Even Chart &
P V Ratio
SOLUTION
(a)
P/V Ratio :
=
NOTES
Contribution per unit
Selling Price per unit
x 100
But,
Contribution per unit
=
 P/V Ratio
=
=
(b)
Selling Price per unit - Variable Cost per unit
Selling Price per unit
` 10 - ` 2
x 100 =
` 10
`8
` 10
x 100
=
Fixed Cost
P/V Ratio
` 40,000
80%
= ` 40,000 x
100
80
= ` 50,000
Profit, when Sales are `1,20,000 :
where,
P/V Ratio
But, Contribution
 P/V Ratio
=
=
=
Contribution
Sales
Fixed Cost + Profit
Fixed Cost + Profit
Sales
 P/V Ratio x Sales =
Fixed Cost + Profit

=
(P/V Ratio x Sales ) - Fixed Cost
=
(80% x `1,20,000) - ` 40,000
=
` 96,000 - ` 40,000
=
` 56,000
Profit

(d )
Sales required to earn a profit of `60,000 :
where,
178 Management Accounting - II
= 80%
BEP (Sales) :
=
(C)
Selling Price per unit - Variable Cost per unit
P/V Ratio
=
Contribution
Sales
x 100
But, Contribution
=
 P/V Ratio
=

=
Sales
=
=
Break Even Chart &
P V Ratio
Fixed Cost + Profit
Fixed Cost + Profit
Sales
Fixed Cost + Profit
NOTES
P/V Ratio
` 40,000 + ` 60,000
80%
= ` 40,000 x
100
80
`1,25,000
ILLUSTRATION 2
The following information is obtained from Godrej Ltd., for the year ended 31-3-2014.
`
Sales (1,00,000 Units)
1,00,000
Marginal Cost
60,000
Fixed Cost
30,000
Calculate :
(a)
P/V Ratio,
(b)
BEP (Sales Ratio)
(c)
Sales to earn a profit of `15,000
(d)
Profit when sales amounted to ` 1,40,000.
SOLUTION
(a)
P/V Ratio :
=
Contribution
Sales
x 100
But,
Contribution
=
 P/V Ratio
=
=
=
=
Sales - Variable Cost
Sales - Variable Cost
Sales
` 1,00,000 - ` 60,000
` 1,00,000
` 40,000
` 1,00,000
40 %
x 100
x 100
x 100
Management Accounting - II
179
Break Even Chart &
P V Ratio
(b)
BEP (Sales value) :
=
NOTES
=
(C)
Fixed Cost
P/V Ratio
` 30,000
40%
= ` 30,000 x
100
40
= ` 75,000
Sales to earn a profit of `15,000 :
where,
P/V Ratio
But, Contribution
=
=
 P/V Ratio
=
Sales
=

=
=
(d )
Contribution
Sales
Fixed Cost + Profit
Fixed Cost + Profit
Sales
Fixed Cost + Profit
P/V Ratio
` 30,000 + ` 15,000
40%
= ` 40,000 x
` 1,12,500
Profit when Sales amounted to `1,40,000 :
where,
P/V Ratio
But, Contribution
 P/V Ratio
=
=
Contribution
Sales
Fixed Cost + Profit
Fixed Cost + Profit
Sales
 P/V Ratio x Sales =
Fixed Cost + Profit

=
(P/V Ratio x Sales ) - Fixed Cost
=
(40% x `1,40,000) - ` 30,000
=
` 56,000 - ` 30,000
=
` 26,000

180 Management Accounting - II
=
Profit
100
40
Break Even Chart &
P V Ratio
ILLUSTRATION 3
Ashoka Ltd., Aurangabad, furnishes you with the following cost data for
the year 2013-2014.
Process Material per unit
`3
Sales
10,000 units
Operating Labour per unit
`3
Fixed Cost
` 60,000
Chargeable expenses per unit
`1
Value of Sales per unit
` 25
NOTES
Variable Overheads - 100% of Direct Labour.
You are requested to find out,
(a) P/V Ratio, (b) BEP (Sales), (c) Margin of Safety.
SOLUTION
Calculation of Total Variable Cost per unit :
Particulars
`
Variable Overheads :
(i)
Process Material
3.00
(ii)
Operating Labour
3.00
(iii)
Chargeable Expenses
1.00
(iv)
Variable Overheads
3.00
(100% of Direct Labour i.e. ` 3)
 Variable Cost per unit
(a)
10.00
P/V Ratio :
=
Contribution per unit
Selling Price per unit
x 100
But,
Contribution per unit
=
 P/V Ratio
=
Selling Price per unit - Variable Cost per unit
Selling Price per unit - Variable Cost per unit
Selling Price per unit
x 100
Management Accounting - II
181
Break Even Chart &
P V Ratio
=
(b)
` 25
x 100 =
` 15
` 25
x 100 = 60%
BEP (Sales) :
NOTES
=
=
(c)
` 25 - ` 10
Fixed Cost
P/V Ratio
` 60,000
60%
= ` 60,000 x
100
60
= ` 1,00,000
Margin of Safety :
=
Actual Sales - BEP (Sales)
=
(` 25 x 10,000 units) - ` 1,00,000
=
` 2,50,000 - ` 1,00,000 = ` 1,50,000
ILLUSTRATION 4
From the following cost data relating to Force India Ltd., Faizpur, you are
required to calculate (i)
Sales at Break-even,
(ii)
Profit at budgeted sales,
(iii)
Profit, if actual sales be at 80% capacity.
Budgeted Sales for the year 2007-2008
` 12,00,000
(At 100% Capacity)
Rigid cost in total
182 Management Accounting - II
` 1,00,000
Chargeable Expenses
02% of Sales
Variable Manufacturing Overheads
10% of Sales
Administrative and Selling on Cost - Variable
08% of Sales
Direct Materials
35% of Sales
Prime Cost Labour
20% of Sales
Break Even Chart &
P V Ratio
SOLUTION
In the books of Force India Ltd., Faizpur
Profitability Statement for the year ended 2013-2014
(Normal Capacity - 100 %)
Particulars
`
Budgeted Sales
Less :
(i)
NOTES
12,00,000
Variable Cost :
Chargeable Expenses
24,000
(02% of Sales i.e. `12,00,000)
(ii)
Variable Manufacturing Overheads
1,20,000
(10% of Sales i.e. `12,00,000)
(iii)
Administrative and Selling on Cost-Variable
96,000
(08% of Sales i.e. `12,00,000
(iv)
Direct Materials
4,20,000
(35% of Sales i.e. `12,00,000
(v)
Prime Cost Labour
2,40,000
(20% of Sales i.e. `12,00,000)
(+)
(-)

Less :
(i)
Contribution
9,00,000
3,00,000
Fixed Cost
Rigid Cost
(-)
Profit at Budgeted Sales
1,00,000
2,00,000
Calculation of P/V Ratio :
where,
P/V Ratio
=
=
=
Contribution
Sales
` 3,00,000
` 12,00,000
x 100
x 100
25%
Management Accounting - II
183
Break Even Chart &
P V Ratio
(i)
Sales at Break-even :
where,
Break-even Point
Sales
NOTES
Fixed Cost
=
P/V Ratio
` 1,00,000
=
(ii)
25%
=
` 1,00,000 x
=
` 4,00,000
100
25
Profit at Budgeted Sales :
where,
Contribution
=
Fixed Cost + Profit
Profit
=
Contribution - Fixed Cost
=
` 3,00,000 - ` 1,00,000
=
` 2,00,000

(iii) Profit, if actual sales be at 80% capacity :
•
Calculation of actual sales at 80% capacity
If 100% Capacity
=
` 12,00,000 Actual Sales
80% Capacity
=
?

=
80 x `12,00,000
100
= ` 9,60,000
•
Calculation of profit if actual sales are ` 9,60,000
where,
P/V Ratio
=
Contribution
=
P/V Ratio
=
 P/V Ration x Sales
=
Contribution
Sales
But,
184 Management Accounting - II
Fixed Cost + Profit
Fixed Cost + Profit
Sales
Fixed Cost + Profit
Profit
Break Even Chart &
P V Ratio
= (P/V Ratio x Sales) - Fixed Cost
= (25% x ` 9,60,000) - ` 1,00,000
= ` 2,40,000 - ` 1,00,000
= ` 1,40,000
NOTES
ILLUSTRATION 5
From the following data, calculate,
(a)
Total Profits
(b) BEP (Sales)
(c) Margin of Safety
Number of units sold
units - 20,000
Fixed Overheads
` 50,000
Selling Price per unit
` 10
Variable Overheads per unit
`6
SOLUTION
(a)
Total Profits :
Sales
=
Total Cost + Profit
Total Cost
=
Fixed Overheads + Variable Cost

Sales
=
Fixed Overheads + Variable Cost + Profit

Profits
=
Sales - (Fixed Overheads + Variable Cost)
=
20,000 units x ` 10 - ( ` 50,000
But,
+ 20,000 units x ` 6)
(b)
=
` 2,00,000 - ( `50,000 + `1,20,000)
=
` 2,00,000 - ` 1,70,000
=
` 30,000
BEP (Sales) :
=
Fixed Cost
Contribution per unit
x Selling price per unit
But,
Contribution per unit

Sales
=
=
Selling price per unit - Variable Cost per unit
Fixed Cost
Selling
x price
Selling price per unit - Variable cost per unit per unit
Management Accounting - II
185
Break Even Chart &
P V Ratio
=
NOTES
(c)
` 50,000
x ` 10 =
` 10 - ` 6
=
` 12,500 x ` 10
=
` 1,25,000
` 50,000
`4
x ` 10
Margin of Safety :
=
Actual Sales - BEP (Sales)
=
(20,000 units x `10) - `1,25,000
=
` 2,00,000 - `1,25,000
=
` 75,000
ILLUSTRATION 6
You are given following cost data :
Total Sales
` 4,00,000
Total Variable Cost
` 2,00,000
Total Fixed Cost
` 1,00,000
Total Units sold
Units 1,00,000
Calculate,
(i)
Contribution per unit
(ii)
BEP - units and Sales
(iii)
Margin of Safety
(iv) Profit
(v)
Units to be sold to earn a profit of ` 1,40,000.
SOLUTION
(i)
Contribution per unit :
where,
Contribution
=
Sales - Variable Cost
=
` 4,00,000 - ` 2,00,000
=
` 2,00,000
But,
Contribution per unit :
=
186 Management Accounting - II
=
Total Contribution
Total units sold
` 2,00,000
1,00,000 units
= ` 2 per unit
(ii)
Break Even Chart &
P V Ratio
BEP (units) :
=
=
Total Fixed Cost
Contribution per unit
` 1,00,000
= 50,000 units
`2
NOTES
Calculation of Selling price per unit :
Total Sales
Total units sold
BEP (Sales)
=
=
=
=
(iii)
(iv)
` 4,00,000
= ` 4 per unit
1,00,000 units
Total Fixed Cost
Contribution per unit
` 1,00,000
`2
x Selling price per unit
x `4
50,000 units x `4 = ` 2,00,000
Margin of Safety :
=
Actual Sales - BEP (Sales)
=
` 4,00,000 - ` 2,00,000
=
` 2,00,000
=
Fixed Cost + Profit
=
Contribution - Fixed Cost
=
` 2,00,000 - ` 1,00,000
=
` 1,00,000
Profit :
where,
Contribution

(v)
Profit
Units to be sold to earn a profit of Rs. 1,40,000 :
Sales volume to earn required profit (units) :
=
=
=
Total Fixed Cost + Required Profit
Contribution per unit
` 1,00,000 + ` 1,40,000
`2
=
` 2,40,000
`2
1,20,000 units
Management Accounting - II
187
Break Even Chart &
P V Ratio
ILLUSTRATION 7
Kiddy Toy’s Manufacturing Co., provides the following costing data :
NOTES
% of Sales
`
Marginal Cost
80%
8,00,000
Fixed Cost
10%
1,00,000
Profit
10%
1,00,000
Sales
100%
10,00,000
You are required to calculate :
(a) P/V Ratio
(b)
BEP (Sales)
(c) Margin of Safety
(d)
Margin of Safety Ratio
SOLUTION
(a)
P/V Ratio :
=
Contribution
Sales
x 100
But,
Contribution
=
 P/V Ratio
=
=
=
=
(b)
Sales - Variable Cost
Sales
x 100
` 10,00,000 - ` 8,00,000
` 10,00,000
` 2,00,000
` 10,00,000
x 100
x 100
20%
BEP (Sales) :
=
=
=
188 Management Accounting - II
Sales - Variable Cost
Fixed Cost
P/V Ratio
` 1,00,000
20%
` 5,00,000
= ` 1,00,000 x
100
20
(c)
=
=
(d)
Break Even Chart &
P V Ratio
Margin of Safety :
Profit
P/V Ratio
` 1,00,000
NOTES
20%
=
` 1,00,000 x
=
` 5,00,000
100
20
Margin of Safety Ratio :
=
=
=
=
Actual Sales - BEP (Sales)
Actual Sales
` 10,00,000 - ` 5,00,000
` 10,00,000
` 5,00,000
` 10,00,000
x 100
x 100
x 100
50%
ILLUSTRATION 8
The Sales and profits during the last two years of Ashoka Ltd., were as
follows :
Year
Sales
Profits
`
`
2012-13
15,00,000
2,00,000
2013-14
17,00,000
2,50,000
Annual fixed cost is ` 1,75,000. You are required to calculate,
(a)
P/V Ratio
(b)
BEP (Sales
(c)
The profits made, when Sales are ` 25,00,000.
(d)
The sales required to earn a profit of ` 4,00,000.
Management Accounting - II
189
Break Even Chart &
P V Ratio
SOLUTION
(a)
P/V Ratio :
=
NOTES
=
=
=
(b)
Change in Sales
x 100
` 2,50,000 - ` 2,00,000
` 17,00,000 - ` 15,00,000
` 50,000
` 2,00,000
x 100
x 100
25%
BEP (Sales) :
=
=
(c)
Change in profits
Fixed Cost
P/V Ratio
` 1,75,000
25%
=
` 1,75,000 x
=
` 7,00,000
100
25
The profits made, when sales are ` 25,00,000
where,
P/V Ratio
=
Contribution
Sales
But,
Contribution
=
 P/V Ratio
=
P/V Ratio x Sales
=
Fixed Cost + Profit
=
(P/V Ratio x Sales) - Fixed Cost
=
(25% x ` 25,00,000) - ` 1,75,000
=
` 6,25,000 - ` 1,75,000
=
` 4,50,000

190 Management Accounting - II
Profit
Fixed Cost + Profit
Fixed Cost + Profit
Sales
(d)
The sales required to earn a profit of
Break Even Chart &
P V Ratio
` 4,00,000 :
where,
P/V Ratio
=
Contribution
Sales
NOTES
But,
Contribution
=
 P/V Ratio
=

Sales
=
=
Fixed Cost + Profit
Fixed Cost + Profit
Sales
Fixed Cost + Profit
P/V Ratio
` 1,75,000 + ` 4,00,000
25%
=
` 5,75,000 x
=
` 23,00,000
100
25
ILLUSTRATION 9
From the following comparative cost data of Joel India Ltd., Jabalpur, for
2013 and 2014 you are required to find out : (i) P/V Ratio, (ii) Break-even Point,
Sales Value and (iii) Margin of Safety, separately.
Particulars
2013
2014
`
`
Rigid Expenses
4,000
4,000
Direct Materials
22,000
30,000
Cash Sales
10,000
15,000
Production Wages
10,000
12,000
Credit Sales
50,000
75,000
Prime Cost Expenses
4,000
3,000
Indirect Costs - Fixed
11,000
14,000
Management Accounting - II
191
Break Even Chart &
P V Ratio
SOLUTION
In the books of Joel India Ltd., Jabalpur
Profitability Statement for the period ended ...........
Particulars
NOTES
Sales :
Cash + Credit
2013 :
` 10,000 + ` 50,000
2014 :
` 15,000 + ` 75,000
Less :
Variable Cost
(i)
`
60,000
90,000
22,000
30,000
(ii)
Productive Wages
10,000
12,000
(iii)
Prime Cost Expenses
4,000
3,000
24,000
45,000
4,000
4,000
11,000
14,000
9,000
27,000
Contribution
Less :
Fixed Cost
(i)
Rigid Expenses
(ii)
Indirect Costs - Fixed
(-)
(-)
Net Profit
Profit Volume Ratio :
2013
=
2014
=
Contribution
Sales
` 24,000
` 60,000
` 45,000
` 90,000
x 100
x 100 = 40%
x 100 = 50%
Break-even Point, Sales Value :
=
192 Management Accounting - II
`
Direct Materials
=
(ii)
2014
(i)


2013
2013
=
2014
=
Fixed Cost
P/V Ratio
` 15,000
40 %
` 18,000
50 %
= ` 37,500
= ` 36,000
(iii)
Break Even Chart &
P V Ratio
Margin of Safety
=
2013
=
2014
=
Profit
P/V Ratio
` 9,000
40 %
` 27,000
50 %
= ` 22,500
NOTES
= ` 54,000
ILLUSTRATION 10
The sales (units) and profit/loss during the last two periods were as follows
Period
Sales
Profit/Loss
units
`
I
7,000
10,000 (Loss)
II
9,000
10,000 (Profit)
The selling price per unit was ` 100. Calculate,
(a)
Fixed Cost
(b)
BEP (Sales)
(c)
The number of units to be sold to earn a profit of ` 40,000
(d)
The amount of profits, when sales are ` 20,000 units.
SOLUTION
The additional sales of ` 2,00,000 in Period II (2,000 units x ` 100) has
given an additional contribution of ` 20,000 (i.e. change in profits ` 20,000),
which has wiped off the loss of `10,000 of Period I and gave a profit of
` 10,000 for Period II.
(a)
Fixed Cost :
(i)
Calculation of P/V Ratio
=
=
=
=
Change in Profits
Change in Sales
x 100
` 10,000 (P) - ` 10,000 (L)
` 9,00,000 - ` 7,00,000
` 20,000
` 2,00,000
10 %
x 100
x 100
Management Accounting - II
193
Break Even Chart &
P V Ratio
(ii)
Calculation of Contribution of Period I
where,
Contribution
NOTES
(iii)
=
Sales x P/V Ratio
=
`7,00,000 x 10 %
=
` 70,000
Calculation of Fixed Cost of Period I
where,
(b)
Contribution
=
Fixed Cost - Loss
 Fixed Cost
=
Contribution + Loss
=
` 70,000 + ` 10,000
=
` 80,000
BEP (Sales) :
=
=
(c)
Fixed Cost
P/V Ratio
` 80,000
10 %
= ` 80,000 x
100
= ` 8,00,000
10
The number of units to be sold to earn a profit of
` 40,000 :
where,
P/V Ratio
=
Contribution
Sales
But,
Contribution
=
 P/V Ratio
=

=
Sales
=
194 Management Accounting - II
Fixed Cost + Profit
Fixed Cost + Profit
Sales
Fixed Cost + Profit
P/V Ratio
` 80,000 + ` 40,000
10 %
=
` 1,20,000 x
=
` 12,00,000
100
10
=
` 1,20,000
10 %
Sales Units
=
=
(d)
Total Sales
=
Selling price per unit
` 12,00,000
Break Even Chart &
P V Ratio
` 100
12,000 units
The amount of profits, when Sales are 20,000 units
(i.e. 20,000 units x
NOTES
` 100 = ` 20,00,000)
where,
P/V Ratio
=
Contribution
Sales
But,
Contribution
=
 P/V Ratio
=
 P/V Ratio x Sales =

Profit

Fixed Cost + Profit
Fixed Cost + Profit
Sales
Fixed Cost + Profit
=
(P/V Ratio x Sales) - Fixed Cost
=
(10% x ` 20,00,000 ) - ` 80,000
=
` 2,00,000 - ` 80,000
=
` 1,20,000
ILLUSTRATION 11
Rally Industries produce two different products ‘X’ and ‘Y’. The standard
time taken to produce them is 4 hours and 5 hours respectively. Recommend
which product you would suggest, when
(a) Labour is the key factor
(b) Sales in the key factor
The data of ‘X’ and ‘Y’ is as follows
Particulars
Product
Product X
Product Y
`
`
Direct Materials
40
80
Operating Labour
20
25
24
30
200
300
( ` 5 per hour)
Variable Overheads
( ` 6 per hour)
Selling Price
Management Accounting - II
195
Break Even Chart &
P V Ratio
SOLUTION
(1)
Calculation of Contribution per product :
Contribution per product = Selling price per unit - Variable cost per unit
NOTES
(2)
Product ‘X’
: ` 200 - ` 84 = ` 116
Product ‘Y’
: ` 300 - ` 135 = ` 165
Calculation of Contribution per labour hour :
=
Contribution per product
Labour hours per product
Product ‘X’
=
Product ‘Y’
` 16
=
Hrs. 4
= ` 29 per hour
(3)
` 165
Hrs. 5
= ` 33 per hour
Calculation of Contribution per Rupee of Sales :
=
Contribution per product
Selling price per product
Product ‘X’
=
` 116
` 200
= ` 0.58/- per rupee
Product ‘Y’
=
` 165
` 300
= ` 0.55/- per rupee
Recommendations :
196 Management Accounting - II
(a)
When labour is the key factor, Product ‘Y’ is recommended, because
contribution per labour hour of ‘Y’ is more than ‘X’.
(b)
When Sales is the key factor, Product ‘X’ is recommended, because
contribution per rupee of Sales of ‘X’ is more than ‘Y’.
Break Even Chart &
P V Ratio
ILLUSTRATION 12
From the following data, which product would you recommend to be manufactured in the factory, time being the key factor.
Particulars
Per Unit of
Per Unit of
Product A
Product B
Direct Material
`
24
14
Basic Labour
`
2
3
`
4
6
`
100
110
2
3
NOTES
(` 1 per hour)
Variable Overheads
(` 2 per hour)
Selling Price
Standard time to produce
Hrs.
SOLUTION
(1)
Calculation of P/V Ratio :
=
Contribution per unit
Selling price per unit
x 100
But,
Contribution per unit
=

=
(2)
P/V Ratio
A
=
B
=
Selling price per unit - Variable cost per unit
Selling price per unit - Variable cost per unit
Selling price per unit
` 100 - `30
` 100
` 110 - ` 23
` 110
x 100 =
x 100 =
` 70
` 100
` 87
` 110
x 100
x 100 = 70%
x 100 = 79.09%
Calculation of Profitability per hour :
=
A
=
B
=
Contribution per unit
Standard time per unit
` 70
Hrs. 2
` 87
Hrs. 3
= ` 35 per hour
= ` 29 per hour
Management Accounting - II
197
Break Even Chart &
P V Ratio
NOTES
Recommendations :
Since Product ‘B’ has higher P/V Ratio than Product ‘s’, the production of
‘B’ should be increased. But as time is the key factor, contribution per hour should
be the important factor to consider the profitability. Hence, Product ‘A’ is more
profitable and should be produced more, as it gives more contribution per hour
than product ‘B’, time being the key factor.
ILLUSTRATION 13
The following cost data is available from the records of Atlas Tyre Co.
manufacturing products ‘Cee’ and ‘Dee’.
Particulars
Product
‘Cee’
‘Dee’
Unit Cost
Unit Cost
`
`
Selling Price
100
200
Material @ z 10 per kg.
20
50
Wages @ ` 3 per hour
30
60
Marginal Overheads
10
20
Fixed Cost : ` 5,000
-
-
State which product is better to be produced and why in the following cases :
(i)
if the total sales in units is key factor.
(ii)
if total sales in value is key factor.
(iii)
if raw material is in short supply.
(iv)
if labour hours is the limiting factor.
(v)
if raw materials available is 2,000 kgs. and maximum sale of each product
is 500 units.
SOLUTION
(1)
Calculation of Contribution per unit :
where,
Contribution
‘Cee’ =
=
198 Management Accounting - II
=
Selling price per unit - Variable Cost per unit
` 100 - ` 60 i.e.
` 40 per unit
Materials
`20
+
Wages
`30
+
Marginal Overheads
`10
‘Dee’ =
=
(2)
` 200 - ` 130 i.e.
Materials
+
Wages
`50
+
Marginal Overheads
`60
Break Even Chart &
P V Ratio
` 20
`70 per unit
Calculation of P/V Ratio :
NOTES
where,
P/V Ratio
‘Cee’ =
Contribution per unit
=
` 40
` 100
Selling price per unit
x 100
x 100
= 40 %
‘Dee’ =
` 70
` 200
x 100
= 35 %
(3)
Calculation of Contribution per kg of raw material :
=
‘Cee’ =
Contribution per unit
Raw material consumption per unit
` 40
2 kg
(i.e. `20 / ` 10)
= ` 20 per kg.
‘Dee’ =
` 70
5 kg
(i.e. ` 50 / ` 10)
= ` 14 per kg.
(4)
Calculation of Contribution per Labour Hour :
=
‘Cee’ =
Contribution per unit
Labour Hours per unit
` 40
Hrs. 10
(i.e. `30 / ` 3)
= ` 4 per hour
Management Accounting - II
199
Break Even Chart &
P V Ratio
‘Dee’ =
` 70
Hrs. 20
(i.e. `60 / ` 3)
= ` 3.50 per hour
NOTES
Comment :
(i)
It total sales in units is the key factor, product ‘Dee’ is better because it
gives higher contribution per unit (i.e. ‘Dee’ ` 70 > ‘Cee’ ` 40).
(ii)
If total sales is value, it is a key factor, product ‘Cee’ is better because of its
higher P/V Ratio (i.e. ‘Cee’ - 40% > ‘Dee’ - 35%).
(iii)
If Raw Material is in short supply, product ‘Cee’ is better because it gives
higher contribution per kg of raw material (i.e. ‘Cee’ ` 20 > ‘Dee’ ` 14).
(iv)
If labour hours is the limiting factor, product ‘Cee’ is preferred as it gives
higher contribution per labour hour (i.e. ‘Cee’ ` 4 > ‘Dee’ ` 3.50).
(v)
If raw material available is 2,000 kgs. and maximum sale of each product is
500 units, product ‘Cee’ is to be produced first to the maximum limit of 500
units because its contribution per kg of raw material is higher (i.e. ‘Cee’
` 20 > ‘Dee’ ` 124) and remaining material will be used to produce
product ‘Dee’.
ILLUSTRATION 14
Swojus India Ltd., Surat, is producing 10,000 units of a component at a cost
of ` 40 per unit including fixed cost of ` 1,50,000. The same component is
available in the market at a reasonable price of ` 30 per unit, should the co.
continue producing the component by themselves or buy it from outside market ?
200 Management Accounting - II
Break Even Chart &
P V Ratio
SOLUTION
In the books of Swojus India Ltd., Surat
Statement showing computation of unit variable cost
for the period ended ....
Particulars
NOTES
`
Total cost of producing 10,000 units
@ ` 40 per unit
4,00,000
(10,000 units x ` 40)
Less : Fixed Cost
 Total Variable Cost
Unit Variable Cost :
=
=
=
(-)
1,50,000
2,50,000
25.00
Total Variable Cost
Number of units produced
` 2,50,000
10,000 units
` 25.00
As the purchase price of the unit component of ` 30 is much higher than
the unit variable cost of ` 25, it is advisable that the company should continue
producing the components by themselves instead of buying it from outside market.
ILLUSTRATION 15
Aqua Cement Ltd., Ajmer, is selling 5,000 units of a product at `40 per unit
having variable cost of ` 25 per unit and a fixed cost amounting to `20,000. A
suggestion to increase sales volume by 20% with a decrease in price by 10% is
under consideration. Do you recommend this change ?
Management Accounting - II
201
Break Even Chart &
P V Ratio
SOLUTION
In the books of Aqua Cement Ltd., Ajmer
Profitability Statement for the period ended ......
Particulars
NOTES
Present
Present
Position
Position
`
`
2,00,000
2,16,000
1,25,000
1,50,000
Fixed Cost
75,000
66,000
Profit
20,000
20,000
55,000
46,000
Sales :
•
Present Position : 5,000 units x ` 40
•
Proposed Position : 6,000 units x ` 36
(5,000 units + 20% ) ( `40 - 10%)
increase
Less :
decrease
Variable Cost
•
Present Position : 5,000 units x ` 25
•
Proposed Position : 6,000 units x ` 25

Less :

Contribution
P/V Ratio =
Contribution
Sales
x 100
=
` 75,000
` 2,00,000
=
` 66,000
` 2,16,000
x 100
= 37.50 %
x 100
= 30.55 %
After proposed price reduction and increase in sales volume.
(i)
the amount of profit has declined from ` 55,000 to ` 46,000 and
(ii)
the P/V Ratio has gone down from 37.50% to 30.55%.
Hence the suggestion to reduce the price and increase the sales volume
should not be recommended to the management.
202 Management Accounting - II
7.12 Summary
Break Even Chart &
P V Ratio
•
Break-Even Chart : A Break-Even Chart is a graphical approach to the
study of the relationship of cost, revenue and profit. Information for
constructing a Break-Even Chart can be obtained from the income statement
of the concern.
•
The Contribution Break Even Chart : The Contribution Break-Even
Chart is an alternative way of showing the information which used to
construct our traditional break-even chart.
•
Margin of Safety (MOS) : It can be,
NOTES
calculated by the following formulae :
Margin of Safety = Profit ÷
Sales - Variable Cost
Sales
(or)
Profit
P/V Ratio
The margin of safety represents the extent to which sales can decline
before the business unit sustains a loss. Larger the margin of safety, safer
it will be for the business unit. A lower margin of safety will result for the
business unit which has a low Profit-Volume (P/V) Ratio. When both the
margin of safety and the Profit-Volume (P/V) Ratio are low, the management
should either increase the selling price without adversely affecting the sales
volume or reduce the variable cost by affecting improvements in the
manufacturing process.
•
Profit Volume Ratio : Profit Volume Ratio expresses the relationship
between contribution and Sales. In other words, it is the contribution per
rupee of sales.
•
Limiting Factor (Key Factor) : When there is a key factor, the contribution
per unit of that key factor is maximised so that we get the maximum
advantage. To do this, ascertainment of the key factor is essential.
7.13 Key Terms
(1)
Break-Even Chart : A break-even chart is a graphical presentation of
Break-even analysis.
(2)
Margin of Safety : The margin of safety represents the difference between
actual and break-even sales.
(3)
P/V Ratio : P/V Ratio expresses the relationship between contribution and
sales. It is the contribution per rupee of sales.
(4)
Key-Factor : A key factor is a factor which limits the desired volume of
production.
Management Accounting - II
203
Break Even Chart &
P V Ratio
7.14 Questions and Exercises
I - Objective Questions
NOTES
(A)
Multiple Choice Questions
(1)
The size of ------------- is a valuable guide to the strength of business
(2)
(3)
(4)
(a)
Margin of safety
(b)
Break Even Point
(c)
P/V Ratio
(d)
Net Margin
At Break Even Point, total cost is equal to total ----------.
(a)
turnover
(b)
revenue
(c)
fixed cost
(d)
variable cost
The Break Even Point ---------- when selling price is increased.
(a)
increases
(b)
remains constant
(c)
decreases
(d)
get affected
A higher P/V Ratio reflects ----------- profitability.
(a)
lowering
(b)
constant
(c)
changing
(d)
greater
Ans. : (1 - a), (2 - b), (3 - c), (4 - d).
II - Long Answer Questions.
204 Management Accounting - II
(1)
What is Break Even Chart ? Construct a Suitable Break Even Chart using
the following cost information output - 1,00,000 units, sales - ` 4,00,000,
Fixed Cost - ` 75,000 and variable cost ` 2,25,000.
(2)
Explain the term ‘Profit Graph’. State the usefulness of Profit Graph in
Marginal Costing.
(3)
What is ‘Margin of Safety’ ? State the necessary steps to be taken to
increase the ‘Margin of Safety’.
(4)
What is ‘Break Even Chart’ ? State the important purposes of constructing
a Break Even Chart.
(5)
What do you understand by ‘Break Even Analysis’ ? Explain the basic
assumptions of Break Even Analysis.
(6)
Explain in brief the usefulness and limitations of Break Even Analysis.
(7)
What is ‘Profit-Volume Ratio’ ? Explain the importance of Profit Volume
Ratio.
(8)
Define the term ‘key factor’. Explain the necessary steps to be taken into
account in dealing with limiting factor.
Break Even Chart &
P V Ratio
NOTES
III- Practical Problems
(1)
From the following particulars, find out the (1) P/V Ratio, (2) BEP (Sales)
and (3) Margin of Safety.
`
Variable cost
Fixed cost
Profit
(2)
% of Sales
- 10,000
80%
- 5,000
5%
- 15,000
15%
30,000
100%
The sales and profit during the last two years are given below :
Sales
Profit
2013
- ` 20 lakhs
` 2 lakhs
2014
- ` 30 lakhs
` 4 lakhs
Calculate (a) P/V Ratio, (b) Sales required to earn a profit of `5 lakhs.
(3)
Ashim Ltd., gives you the following information :
Sales
- ` 50,000
Variable cost
- ` 25,000
Fixed cost
- ` 10,000
Calculate P/V Ratio, BEP and Margin of Safety. Also calculate the effect
of 20% increase in sales price and 20% decrease in sales price.
Management Accounting - II
205
Break Even Chart &
P V Ratio
(4)
The following are the figures obtained from the cost records of Neel
Industries :
`
NOTES
Sales
- 5,000 units @ ` 4 per unit
Direct material
-
4,000
Direct labour
-
5,000
Variable overheads -
+ 3,000
`
20,000
12,000
Fixed overheads
-
+ 4,000
16,000
Net Profit
4,000
The company has decided to reduce the selling price by 10%. What extra
units should be sold to obtain the same amount of profit ?
(5)
The P/V Ratio and Margin of Safety of Bardhan Industries are 50% and
40% respectively. The Company has a sales volume of Rs. 8,00,000.
Calculate the net profit.
(6)
The following are the details of Manoj Ltd. for the two products ‘A’ and ‘B’
‘A’
‘B’
Per unit
Per unit
`
`
Sales Price
-
100
120
Material (` 10 per kg)
-
20
40
Wages
-
30
20
Variable overheads
-
8
12
Total fixed costs
-
` 10,000
When material is the limiting factor, suggest which product should be
produced more.
(7)
The following two proposals are under consideration (a) 10% reduction in price to give an increase in sales volume from 5,000
units to 6,500 units.
(b) 10% increase in price with decrease in sales volume from 5,000 units
to 4,000 units.
206 Management Accounting - II
Break Even Chart &
P V Ratio
Following cost data is also being made available :
Variable Cost per unit - ` 50
Selling Price per unit - ` 100
Fixed Cost - ` 1,00,000
State which of the two proposals should be recommended to the
management, so as to get more profits.
(8)
NOTES
Godrej Ltd., Goregaon, are currently operating at full capacity, manufactures
and sells a product at ` 6 each. The existing production is 1,00,000 units
per year for which the cost structure is as follows :
`
Direct Materials
Prime Cost Labour
2,00,000
50,000
Variable on Cost
2,00,000
Fixed Overheads
50,000
Sales
6,00,000
There is an offer from a reputed buyer for 20,000 units at 5.50 per unit.
Acceptance of this order would result in additional fixed cost of ` 20,000
per year, for hire of special machinery and payment of overtime premium
of 20% for the extra direct labour required. Should the order be accepted ?
(9)
Domino Plastics Co., Dombivli, make plastic trays. An analysis of their cost
accounting record reveals the following :
Selling price per tray
` 80
Variable cost per tray
` 20
Fixed cost for the year
Production capacity per year
` 50,000
Trays - 2,000
You are required to find out (a)
Break-even Point (in units)
(b)
The number of trays to be sold to get a profit of ` 30,000.
(c)
If the company can produce 600 trays more per year with an additional
fixed cost of ` 2,000, what should be the new selling price of a tray to
maintain `30,000, as at the original data ?
(10) Two competing companies Honda Ltd., and Kinetic Ltd., produce and sell
the same type of product in the same market. For the year ended 31st
March, 2014, their forecasted Profit and Loss Account are as follows :
Management Accounting - II
207
Break Even Chart &
P V Ratio
Particulars
Honda Ltd.
Sales
NOTES
Less :
Variable Cost
Less :
Fixed Cost
Kinetic Ltd.
4,50,000
2,70,000
(+)
1,35,000
4,50,000
3,60,000
(+)
45,000
(-) 4,05,000
(-) 4,05,000
45,000
45,000
Forecasted Net Profit
You are required to calculate,
(a) Profit/Volume Ratio, (b) Break-even Point (Sales Value), (c) State
which company is likely to keep greater profit, in conditions of (i) low demand and (ii) high demand.
(11)
From the following data, which products would you recommend to produce
in a factory, time being the key factor.
Particulars
Product X
Product Y
Unit Cost
Unit Cost
Prime Cost Materials
`
24
14
Direct Labour @ ` 1 per hour
`
2
3
Variable Overheads @ ` 2 per hour
`
4
6
Selling Price
`
100
110
Hrs.
2
3
Standard time to produce
7.15 Further Reading
208 Management Accounting - II
•
Khan M. Y. and Jain P. K. - Management Accounting, Text, Problems and
Cases - New Delhi - Tata McGraw Hill Publishing Ltd. - 2010
•
Bhar B.k- Cost Accounts Methods and Problems - Kolkata Academic
Publishers -2012
TOPIC 3
Standard Costing
UNIT 8
Concept of Standard
Costing
UNIT 9
Variance Analysis :
Material Variance
UNIT 10
Variance Analysis :
Labour Variance
UNIT 11
Variance Analysis :
Overhead Cost Variance
UNIT 8 Concept of Standard Costing
Concept Of
Standard Costing
Structure
8.0
Introduction
8.1
Unit Objectives
8.2
Concept of Standard Costing
8.3
Establishment of Cost Standards & Desired Behaviour
8.4
Steps Involved in Standard Costing
8.5
The Standard Costing System
8.5.1
NOTES
Types of Standards
8.6
Cost Control using Standard Costing
8.7
Advantages of Standard Costing
8.8
Limitations of Standard Costing
8.9
Summary
8.10 Key Terms
8.11 Questions and Exercises
8.12 Further Reading
8.0
Introduction
The concept of control which is the third and final link in the managerial
process refers to the process of ensuring the accomplishment of predetermined
plans. Such a control over the destiny of an enterprise is accomplished through a
widely used technique called. “Standard Costing”.
In ordinary language, the Standard forms a yard - stick that is used to
measure weight, quantity, quality and value. It is a measure of acceptable cost
performance of a given activity under controlled conditions. The controlled
conditions means a situation where every activity of the task is performed as per
predetermined way and procedure. Thus, a standard cost is a scientific
predetermination of what a unit of product should cost.
Check Your Progress
Express, how standard cost
is
scientific
pre
determination of what a unit
of product should cost.
Management Accounting - II
209
Concept Of
Standard Costing
8.1
Unit Objectives
After going through this unit you are able to :
NOTES
•
Understand the concept of ‘Standard Costing’.
•
Know the meaning of ‘Establishment of Cost Standard’ and “Desired
Behaviour”.
•
Identify steps involved in standard costing.
•
Appreciate the Standard Costing System.
•
Explain types of standards.
•
Describe how control in standard costing is achieved by variable analysis.
•
Specify the advantages of Standard costing.
•
Identify the limitations of Standard costing.
8.2
Concept Of Standard Costing
Standard Costing is an important accounting- oriented tool which keeps
the cost at a minimum level by planning and controlling costs of each unit produced.
Under this system, the cost of each unit is predetermined on some scientific basis
and arrangements are made for costs not exceed pre-determined standard.
In the words of W. W. Biggs’, Standard Costing is system of costing
where “a comparison is made of the actual cost with a pre-arranged standard and
the cost of any deviations (called variances) is analysed by causes. This method
pen-nits management to investigate the reasons for these variances and to take
suitable corrective action. It is, therfore, a system of cost control as well as cost
ascertainment.”
According to the Institute of Cost and Work Accountants, London,
“standard costs are prepared and used to clarify the final results of a business,
particularly by measurement of the variations of actual costs from standard costs
and the analysis of the causes of variations for the purpose of maintaining efficiency
by executive action.”
M. C. Shukla and ‘I’.S Grewal States that “ Standard Costing is system
which seeks to control the cost of each unit or batch through determination before
hand of what should be the cost and then its comparison with actual costs.”
210 Management Accounting - II
In short, Standard Costing is procedure under which predetermined costs
are used to measure the efficiency of production. If refers to the determination of
standard costs and their application to managerial problems particularly those
problems relating to production costs, and departmental cost control. Thus, under
Standard Costing system predetermined costs are carefully computed which are
then compared with actual cost to aid in cost control.
Standard costs are part of cost accounting system whereby standard costs
are incorporated directly and formally into the manufacturing accounts. Standards
are performance expectations. Standards may be defined as measured quantity
which should be obtained in connection with some particular operation or activity.
Precisely standard costing is a control device and not a separate method of product
costing. It can be used, with any method of product costing, job costing or process
costing.
Logical dissimilarity between Estimated, Standard Budgeted Costs :
Even it might appears that standard and estimated costs are the same,
some dissimilarity exists. An estimated cost are determined on basis of the average
past performance and therfore, can be regarded as a reasonable assessment of
what a cost “will be’’.
Concept Of
Standard Costing
NOTES
Check Your Progress
How standard costs are part
of cost accounting system ?
On the other hand, standard costs are the costs that would be incurred
under the most efficient operating conditions and are forecast before the
manufacturing process begins. Thus, it is carefully predetermined costs used as
performance criteria - a measure what a cost should be. Whereas budgeted
costs are viewed as future costs (prediction, estimates, forecasts) that are formally
combined into an integrated plan of action. It is the standard cost per unit of the
budgeted quantity to be produced during a particular period.
8.3
Establishment of Cost Standards & Desired
Behaviour
The effectiveness of standard cost as a technique wholly depends upon the
establishment of the very cost standards. Care should be taken in setting the
standards considering all relevant factors such as the employees, their attitudes
and abilities the extent of control exercised over their operations and so on.
There are several method adopted for fixing the standards such as
engineering estimates, observed behaviour, predicted behaviour and desired
behaviour. The standard cost in a particular situation is based on two or more of
these bases.
When cost standards are determined on the basis of engineering estimates,
it is but proper to consider the specifications of the machinery for accurately
ascertaining the standard relationship between a given unit of output and a given
unit of input. On the basis of such technical specifications cost standards can be
fixed. The cost standards so fixed, represent only what can be accomplished.
Another technique employed for establishing cost standards is the past
experience Here, the principle involved is to consider the past achievement as
standard for the future. Of course, the past can provide a reliable guide for the
future as long as the processes and procedures of the past remain unchanged. If
changes occur in the processes and procedures, the observed behaviour can no
longer provide a reliable basis for establishing. cost standards.
Management Accounting - II
211
Concept Of
Standard Costing
NOTES
Check Your Progress
Explain the term “desired
behaviour”.
When certain technological changes are expected to take place they are
likely to have profound influence on the cost estimates. In such cases, the
predicated behaviour which represents what is most likely to happen, can be used
for setting cost standards. This calls for a minor adjustment to historical standard
cost.
Desired Behaviour
The desired behaviour can also be taken as the basis for setting cost
standards. The term “desired behaviour’ represents what the management actually
desires. Again, the desire of the management in turn, reflects the experience of
similar concerns or the industry as a whole.
It is clear that there are several techniques available for establishing cost
standards. But, the final basis adopted for the purpose depends on the management’s
judgement. The management should be careful while setting the standards. The
standards so set are very attainable with reasonable efforts. When standard set
are very high, they will be difficult to achieve resulting in all round demoralization.
On the other hand, if the standards set are very low, there may not be adequate
motivation to achieve them. Hence, it is essential that the standards set in
manufacturing organisation should be easily attainable standards.
8.4
Steps Involved In Standard Costing
Standard Costing system involve the following steps :
(i)
Determination of standard cost for each element of cost - direct material,
direct labour, and overhead;
(ii)
Recording of both standards and actual costs in appropriate books of
accounts;
(iii)
Computation of variance between standard cost and actual cost;
(iv)
Analysis and investigation of the variances; and
(v)
Feed correction and suggest modification where required. Corrective actions
are taken to ensure that future performance will be in accordance with
predetermined-standards.
The standard cost of product consists of :
212 Management Accounting - II
(i)
Quantitative Facts : Standard quantity of given material, standard labour
hours for specified operations, and standard machine hours for the stated
machines to be used; and
(ii)
Price Factors : Standard cost per rupee and per hour, by which the standard
quantities are converted to the standard product costs.
The quantitative factors are based on engineered specification tempered
by experience, and vice-versa whereas prices used are typically those which are
expected to be representative of actual prices during the period for which the
standard are established.
For control purposes, the various actual activities of a period; such as quantity
of each type of material used, labour hours worked, and machine hours involved,
as well as units of goods produced, are multiplied by appropriate unit standard
cost to establish standard cost totals for work performed by job or process, and by
department. The actual costs of these activities are then compared with the
standards costs and the resulting variances are examined as to cause;
(i)
To aid the interpretation of financial results for the period;
(ii)
To fix the responsibility for non- standard performance; and
(iii)
To focus attention on areas in which cost improvement should be sought.
8.5
Concept Of
Standard Costing
NOTES
The Standard Costing System
The standard costing system is designed to furnish management with a
measure that will help in making decisions regarding the efficiency of operation.
A sound standard costing system comprises of following main activities, viz.
(i)
(i)
Establishment of cost centre;
(ii)
Determination of quality of standard;
(iii)
Organization of standard costing;
(iv)
Setting of standards;
(v)
Actual cost accumulation and
(vi)
Analysis of variance.
Check Your Progress
What are the main activities
of Standard Costing System ?
Establishment of Cost Centre :
The Standard Costing system begins with the establishment of the cost
centre which is usually a process. or an operation or an item of equipment. etc. It
is unit of activity within the factory to which costs may be practically and equitably
assigned. Performance is assessed by comparing the actual costs with the
performance standard, which shows the costs centre should have incurred, given
their actual activity.
(ii)
Determination of Quality of Standard :
The next step is the establishment of standard costing system is determination
of quality of standard.
Management Accounting - II
213
Concept Of
Standard Costing
8.5.1 Types of Standards :
The types of standards are shown in Fig 8.1 as follows
NOTES
Ideal
standards
Current
standards
Normal
standards
Types of
standard
Attainable
standards
Check Your Progress
Basis
standards
How many standards your are
knowing ?
Fig. 8.1 : Types of Standards
Standard may broadly classified into five types. They are : (a) Ideal Standard,
(b) Normal Standards , (c) Basic Standards (d) Attainable Standard and (e) Current
Standard.
214 Management Accounting - II
(a)
Ideal Standards : Ideal standards are set at the level of maximum efficiency
representing conditions that can seldom if-ever be attainable. Such a standard
fails to pay any attention to normal materials spoilage and idle labour time.
This type of standard can be used as standard of perfection rather than a
standard for the measurement of practical results because conditions that
satisfy ideal standards are extremely rare. Ideal standards are more effective
for direct material costs and usage. The application of ideal standard makes
variance accounts less significant for control purposes.
(b)
Normal Standards : Normal standards are the standards that can be
achieved by efficient working and efficient management. Such standards
are set after taking into consideration the conditions that are expected to
prevail over a long period of time sufficient to reflect the effects of seasonal
and cyclical fluctuations. These standards are of great significance for
manufacturing overhead expenses.
(c)
Basic Standards : Basic standards provide a measuring scale for
performance over a long period of time. Such standards are not influenced
by any change in Material prices and labour rates and therefore, remain
unchanged for a number of years. Basic standards are useful for such
items of expenditures that are fixed in nature.
(d) Attainable Standards : Attainable standards based on past performance,
can be achieved with reasonable effort. Perhaps the standards should be
somewhat lower than what can be achieved by earnest effort. Such standards
are set as closely as possible to that level which represents anticipated
conditions. They allow for usual production problems, such as down time
for maintenance, employee errors, or occasional inventory shortages. These
standards are more realistic and satisfactory and thus represent desirable
performance. Attainable standards are particularly useful in setting price
standards for materials and labour.
(e)
Current Standard : Current standard is a standard which is established
for a limited period and is related to current conditions.
(iii)
Organization of Standards Costing :
Concept Of
Standard Costing
NOTES
The efficiency of standard costing system largely depends upon the accuracy
and reliability of the standards. In the past the job of standard setting was the
responsibility of the cost accountant. However, keeping in view the dynamic
conditions of the present business, it requires the combined thinking and expertise
of all persons who have responsibility over prices and quantities of inputs against
this background, almost in every big organization. At present, this function is
discharged by a standards committee comprising of representatives from various
concerned departments of the organization. The said committee establishes and
monitors standards for various costs and activities and is also responsible for
changing and updating the standards when requires.
(iv)
Setting of Standards :
The important components of standard costing system is the setting of
standards to be used for evaluation of actual results.
The terms standards cost refers to cost that should reasonably be incurred
in the manufacture of a product. The main components of standard costs are :
1.
Standard Direct Material Cost
2.
Standard Direct Labour Cost and
3.
Manufacturing Overheads.
Check Your Progress
What
are
the main
components of Standard
Cost ?
1. Standard Direct Material Cost :
The standard direct materials cost of a product incurred depends on price
and quantity standards. It can be ascertained by application of the following
formula :
Standard Direct Material Cost
= Standard Price of direct material x
Standard quantity of direct material
Management Accounting - II
215
Concept Of
Standard Costing
NOTES
(a) Standard Price of Direct Material : One of the important of costs is the
cost of direct material used in the manufacture of goods. An important element of
cost control is the price paid for the purchase of material. Another essential of
cost control is that the price paid should be reasonable. The material price standard
refers to the price which should be reasonably paid for a particular direct raw
material under the most favourable possible conditions. But the most favourable
possible conditions will differ from firm to firm depending upon the circumstances
of each case. It implies, therefore, that direct material price standard should be
set for each firm and not for the industry as a whole.
The standard price of the direct material should include all the components
of the amount spent in the acquisition of a particulars material. Where the price
differ for the goods of the same quality, the standard should be set based on the
lowest price. Again, Where the supplier who is prepared to sell the material at a
lowest price, is not a reliable one, there is no real savings to the firm. In such
cases, higher prices charged by more reliable suppliers will form the basis for
fixing the standard price. While fixing the standard price of direct material, freight
charges and import duties should be considered wherever applicable. Another
related aspect to be considered is that of discounts available for the purchases of
materials. This includes quantity discounts which are granted for purchase of
goods in bulk and cash discounts which are allowed for prompt payment. The
effect of discounts is lowering of the costs and hence, the standard price.
(b) Standard Quantity of Direct Material : The quantity of direct material is
another important factor affecting the cost of direct material. For setting the standard
cost of direct material, the quantity of materials used for the production of a
particular product should also be standardized. The standards of the quantity of
consumption of raw materials is referred to as standard quantity of materials or
material usage standards. Such standards can be determined on the basis of the
following factors :
(i)
The input-output relationship between raw - materials and final products
based on observation of actual experience and
(ii) The inherent loss of materials in the productive processes such as
shrinkage, evaporation, weight losses due to scrapping and
smoothing etc.
The total standard direct materials cost is computed by multiplying the
standard price with the standard quantity of direct material.
2. Standard Direct Labour Cost :
The second component of the total standard cost is standard direct labour
cost. It is calculated by multiplying the labour standard rate by the labour standard
time.
Labour Standard Rate :
216 Management Accounting - II
The payment made to labour for carrying out production represents wages.
The wages are calculated either on time basis (monthly, weekly or daily) or on
piece basic ( per piece of production). The term standard labour rate refers to the
conventional standard wage rate only, i.e in case of the time wage payment only.
I fact, these standard labour rates come into force either as a result of the
management of policy or due to negotiation between management and trade unions.
Moreover, there will be several wage rates depending upon the degree of skill, the
inherent risk involved, seniority and so on. Thus, it is clear that the labour standard
rates are quite different from material standard price. It should be remembered
that the standard labour rates are not under the control of the management.
Concept Of
Standard Costing
NOTES
Labour Standard Time :
The quantum of labour is measured in terms of the time consumed for the
completion of the particular piece of work. Hence, labour standard time refers to
the total time which particular operation should take. This is based on the observation
of actual operation and critical evolution of the whole performance. Time and
motion studies provide a popular example of this type. It is on this basis the labour
standard time is determined. While doing so sonic allowance must be given, since
human begins are not mechanical devices and cannot utilise the entire time for
production purpose. At the same time, it should also be remembered that while
setting the standards no allowance is made for prolonged periods of illness of the
workers.
Overheads Standards
Another component of cost standard is overhead. There is a basic
difference between the material and labour standards and overhead standards.
For the material and labour, standards are set on the basis of price and quantity
standards. This only establishes the functional relationship that exists between the
number of units of a product and the quantities of material and labour required for
producing the same with the underlying fact that each material has its standard
price and each worker has a standard wage rate. But no such functional
relationship exists between the units produced and the total overhead cost . Even
that part of the manufacturing overhead which varies with the volume of production
cannot be directly related to production in the same way as direct material and
direct labour. Therefore, the determination of overheads standards is completely
different from that of direct materials and direct labour.
Check Your Progress
What is basic difference
between the material and
labour standards & overhead
standards ?
The overheads are classified into (a) variable and (b) fixed. The Standard
variable overheads is fixed directly per unit of volume. the volume of measure
refers to some measure of input such as direct labour cost or hours. Standard
fixed rates. on the other hand are usually fixed at some volume representative of
the firm’s operations over a longer period.
Such standards are set after careful study of cost volume analysis.
(v) Actual Costs Accumulation :
The establishment of standards is followed by the accumulation of actual
cost which are then compared with standards in performance reports. For
accumulating actual manufacturing costs. firm use either a job order system or a
process cost system. The application of standard costing gets much information
Management Accounting - II
217
Concept Of
Standard Costing
from the cost data than is possible with just actual costs. A sound system of
standards costing will help management in determining the type of required cost
data and in reporting such data.
(vi) Analysis of Variance :
NOTES
Variance may be defined as the difference between the Actual Cost (AC)
and the Standard Cost (SC) But the variance analysis is the process of analysis of
variance of sub-dividing the total variance in such a way that management can fix
the responsibility for the divergence from the standard performance. If AC is less
than SC, it is considered to be a sign of efficiency and the difference is termed as
“favourable” variance. On the other hand, if AC is more than SC, it is considered
to be a sign of inefficiency and the difference is termed as “unfavourable’’
variance. Favourable variance is also referred to as “positive variance’’ while
unfavourable variance is also known as “negative variance.”
It should also be borne in mind that the words favourable/positive and
unfavourable/negative merely indicate the direction of variance from the SC, they
need not be construed as good or bad from the point of view of the firm. A real
quantitative evaluation can be effected only after determining the causes for the
variance. Again, the final result is also affected by the type of standards
predetermined by the firm. For, it the set standards are reasonable and accurate
and are revised from time to time, according to the changed circumstances, any
deviation would reflect true deviation. On the other hand, if the expected standards
are not reasonable and accurate, the deviations will be distorted.
8.6
Cost Control Using Standard Costing
Control in standard costing is achieved by variance analysis. Figure should
help you to understand how variance analysis works. At the end of the period
under review the actual cost is compared with the predetermined standards cost
for the actual level of activity which was attained. This difference is known as
the total or cost variance. All variances are the resulit of two factors, price and
quantity. Thus, the total or cost variance can be subdivided into that part of the
variance which arises from price differences and that part which arises from
differences in quantities. The names of these subversions may cause confusion,
but the principles remain unchanged. Following table should make the position a
little clearer.
Actual
Cost
218 Management Accounting - II
Less
Standard Cost
For the actual
level of activity
The Cost Variance
=
Price
Variance
Quantity
Variance
Total /Cost Variances
Price Variance
Quantity Variance
Material
Material Cost Variances
Material Price Variance Material Usage Variance
Labour
Labour Cost Variance
Labour Rate Variance Labour Efficiency Variance
Overheads Overheads Cost Variance Overheads Expenditure Overheads Volume of
Variance
Efficiency Variance
Sales
Sales Margin Variance
Sales Margin Price
Variance
Sales Margin Volume
Variance
Table : Variances : Materials, Labour, Overheads and Sales
8.7
Concept Of
Standard Costing
NOTES
Check Your Progress
How variance analysis
works ?
Advantages of Standard Costing
The important advantages of standard costing technique are enumerated below :
(i)
It provides continual incentive for management to keep costs and
performance in tune with predetermined objectives. The comparison
between actual costs and the predetermined standards are much more
effective than comparisons between current actual costs and actual costs
of prior periods.
(ii)
Under standard system, variances are determined normally at the end of
the month, or even weekly basis to allow for more timely action in correcting
inefficiencies.
(iii)
Standard costing system involves less clerical efforts than other costing
systems because actual costs are recorded and accumulated by cost centre
rather than by job.
(iv)
Standard costing system makes possible for the management to pay more
attention to weak areas that require control as it follows the principle of
management by exception.
(v)
Prices can be determined in anticipation of the actual production as standard
costs for various inputs are already available.
(vi)
The standard costing system makes possible to determine and compare the
efficiency of various operations.
(vii)
It eliminates wastage by detecting variances and suggesting corrective
measures for them.
Check Your Progress
Give any four advantages of
standard costing.
(viii) It ensures better control as the workers are known about the performance
criteria and naturally they take more interest in the work to achieve the
standard.
(ix)
It brings about an improvement in production methods as it requires a
continuous detailed examination of all important functions of the concern.
It also results in reduction of costs.
Management Accounting - II
219
Concept Of
Standard Costing
NOTES
Check Your Progress
8.8
Limitations of Standard Costing
In order to reap the maximum benefits of standard costing, the costing
department should keep the following points in their mind. Because, these can be
considered as precautions to be taken while implementing standard costing
technique. If organisation fails to take, note of these, the same will act as limitations.
The following are the limitations attached to standard costing system.
(i)
Fixation of standard in not possible for every type of work or operation.
(ii)
Wrong standards may result in wastage of time, money and energy.
(iii)
Standard must be reviewed from time to time; otherwise they lose importance
for our purpose.
(iv)
Determination of actual cost is must for certain purposes. For example,
preparation of cash budget, reconciliation of cost and financial accounts,
etc.
(v)
These is a difficulty in classifying the variances into controllable and noncontrollable.
(vi)
Since the setting up of standards require high degree of technical proficiency
and skill, it is alleged that the adaptation of standard costing is a costly and
time consuming exercise of standard costing is a costly and time consuming
exercise.
Listout any three limitations
of Standard Costing.
However, it should be remarkable that, despite of the above limitations, a
standard costing system is must for efficient control. The standards must be fixed
and implemented properly.
8.9
Summary
•
Standard Costing : Standard Costing is an important accounting-oriented
tool which keeps the cost at minimum level by planning and controlling costs of
each unit produced. Under this system the cost of each unit is predetermined on
some scientific basis and arrangements are made for cost not to exceed pre
determined standard.
•
Standard Costing System : A sound standard costing system comprises
of following main activities namely - (i) Establishment of cost centre (ii)
Determination of quality of standard (iii) Organisation of standard costing (iv)
Setting of standard cost (v) Actual cost accumulation & (vi) Analysis of Variance.
•
Types of Standard : (i) Ideal standards (ii) Normal Standard (iii) Basis
Standard (iv) Altainable standard (iv) Current-standards.
•
Main Components of Standards Cost : (i) Standard Direct Material
Cost (ii) Standard Direct Labour cost & (iii) Manufacturing overheads.
220 Management Accounting - II
•
Control in Standard Costing : is achieved by variance analysis At the
end of the period under review the actual cost is compared with the
predetermined standard cost for the actual level of activity which was attained.
This difference is known as the total or cost variance All variance are the result
of two factors, price and quantity.
8.10 Key Terms
(1)
Concept Of
Standard Costing
NOTES
Standard Cost :
These are the pre-determined costs based on a technical estimate for material
labour and overheads for a selected period of time and for a prescribed set of
working conditions.
(2)
Standard Costing :
It is the preparation and use of standard costs, their comparison with actual
cots and the analysis of variances to their causes and points of incidence.
(3)
Standard :
It is criterion which denotes the expectation regard to the performance of
pre planned activity.
(4)
Standard Hour :
It is hypothetical hour which measures the amount of work that should be
performed is one hour.
(5)
Standard Price :
It is a pre-determined price fixed on the basis of specification of all factors
affecting that price.
(6)
Desired behaviour :
Desired behaviour represents what the management actually desires.
8.11 Question And Exercises
I - Objective Questions
(A)
Multiple choice Questions
(1)
A Scientific Method of cost control as well as of cost ascertainment is
termed as --------- costing
(a) Process
(b) Marginal
(c) Job
(d) Standard
Management Accounting - II
221
Concept Of
Standard Costing
(2)
Cost Variance is the difference between the standard cost and ------------cost.
(a) actual
(b) budgeted
NOTES
(c) marginal
(d) fixed
(3)
Generally a standard cost is used -----------(a) to ascertain contribution.
(b) as a basis for price fixation and cost control.
(c) to ascertain break-even point.
(d) as a basis for cost accounting.
(4)
The standard which may be useful to the management in long term planning
and decision making are ----------------- standard.
(a) basic
(b) ideal
(c) normal
(d) historical
Ans : (1 - d), (2 - a), (3 - d), (4 - c).
II:-Long Answer Questions
222 Management Accounting - II
(1)
What is ‘Standard Cost’ ? Explain the importance of standard cost in the
technique of standard costing.
(2)
Define ‘Standard Costing’. Explain in brief the advantages and limitations
of standard costing.
(3)
What is ‘Standard Costing’ ? State the need for establishment of cost
standards and desired behaviour.
(4)
Enumerate the preliminary tasks required for introducing a ‘Standard Costing’
system in manufacturing industry.
(5)
Explain the concept of ‘standard costing’ and state the important activities
involved in a sound system of standard costing.
(6)
Explain in brief the types of standards used in Standard costing.
(7)
What is ‘setting of standards’ ? Explain in brief the importance of standard
direct material cost.
(8)
What is ‘standard costing’ ? How costs are controlled by using ‘standard
costing technique’ ?
(9)
Define ‘standard costing’. State the type of industries where a system of
standard costing can be employed more suitably.
8.12 Further Reading
•
Bhar B.K - Cost Accounting Methods and Problems - Kolkatta Academic
publishers -2010.
•
Prasad N.K and Prasad A.K. - Cost and Management Accounting - KolkataBook syndicate Pvt Ltd., 2010
Concept Of
Standard Costing
NOTES
Management Accounting - II
223
UNIT 9 Variance Analysis : Material
Variance
Variance Analysis :
Material Variance
Structure
9.0
Introduction
9.1
Unit Objectives
9.2
Classification of Variances
9.3
Material Variance
NOTES
9.3.1 Material Price Variance
9.3.2 Material Usage Variance
9.4
Material Cost Variance
9.5
Illustrations
9.6
Summary
9.7
Key Terms
9.8
Questions and Exercises
9.9
Further Reading
9.0
Introduction
Variance is the difference between a standard cost and the comparable
actual cost incurred during a period.
Variances may be segregated by department, by cost and by elements of
cost, e.g. price and quantity. It is common experience that different industries
make use of different variances. Despite the existence of a number of variances
the following are some basic variances found in practice :
1.
Direct Material Variance,
2.
Direct Labour Variance,
3.
Variable Overhead Variance,
4.
Fixed Overhead Variance,
(a) Based on units
(b) Based on standard hours.
Basically, there are two different types of variances : Price variance and
Volume variance. The price variances is closely to their price of materials, rates
of labour, expenditure on overheads or selling price of products. The volume
Management Accounting - II
225
Variance Analysis :
Material Variance
NOTES
variance has some thing to do with quantity and is related to quantity of units in
terms of raw materials consumed, number of hours worked or number of products
sold.
9.1
Unit Objectives
After studying this unit you should be able to :
•
Classify the different types of variances.
•
Discuss Material usage/ Quantity Variance.
•
Classify Material Usage Variance.
•
Discuss the concept of Material Mix Variance.
•
Discuss the concept of Material Yield Variance.
•
Explain the concept material Revised Usage Variance.
•
Explain the concept Material Cost Variance.
•
Present material cost variance by graph.
•
Calculate all types of Material Variances.
9.2
Classification of Variances
Classification of Variances based on price variances :
(1)
Material Price Variance,
(2)
Labour Price Variances,
(3)
Variable Overhead Expenditure Variances,
(4)
Fixed Overhead Expenditure Variance,
(6)
Sales Price Variance.
Classification of variances based on quantity :
(1)
Materials Usage Variance,
(2)
Labour Efficiency Variance,
Check Your Progress
(3)
Fixed Overhead Volume Variance,
How you classify variances
based on quantity ?
(4)
Sales Volume Variance.
It is clear that the cost variance comprises both price variance as well as
volume variance. Again, for sales there is a total variance called sales value variance
comprising the total of price variance and volume variance.
226 Management Accounting - II
The needs of the management cannot be met fully by the basic variances which
merely provide information regarding the extent of change in the volume. The
management should also ascertain the causes for such changes, so that they can
initiate corrective action whenever needed. Keeping this view, a simple variance
analysis may be extended as given below.
NOTES
1. Material- Cost Variance
Total Usage Variance
Either
Variance Analysis :
Material Variance
Price Variance
Mix Variance
Revised Usage Variance or Yield Variance
2. Labour - Cost Variance
Total Efficiency Variance
Idle Time Variance
Rate Variance
Either Revised Usage Variance
Rate Variance
or Yield Variance
3. Variance Overheads - Cost Variance - Expenditure Variance
4. Fixed Overheads - Cost Variance
Volume Variance
Efficiency Variance
Expenditure Variance
Capacity Variance
Calendar Variance
Management Accounting - II
227
Variance Analysis :
Material Variance
NOTES
9.3
Material Variance (MV)
Material variances are commonly referred to as Material Cost Variance
(MCV). The MCV represents the difference between the standard cost of standard
quantity of materials of actual output and the actual cost of materials consumed.
Symbolically :
Material Cost Variance (MCV) = Standard Cost (SC) - Actual Cost (AC)
From the above, it is clear that the MCV depends on two factors, viz., the
price paid for material and the actual quantity of materials used. Accordingly, the
MCV which represents a total variance can be divided into two sub-variances.
(a)
Material Price Variance (MPV)
(b)
Material Usage/Quantity Variance (MUV)
9.3.1 Material Price Variance (MPV) :
MPV occurs when the actual price paid for the materials used s different
from the standard price. The MPV is calculated by multiplying the difference
between the standard unit price and the actual unit price paid for the materials
used by the actual number of units or quantity of materials used in production.
Symbolically
Material Price Variance = Actual Quantity / Number of Units Purchased
(Standard Price - Actual Price)
MPA = AQ (SP - AP)
It should be remembered that, in the absence of specific information, the
actual number of units purchased can be considered synonymous with those used
in production.
MPV is caused by any one or combination of the factors such as changes
in the price of materials, excessive freight charges, increase in the rates of taxes
and customs duty, failure to avail cash discount or off-season low price, buying
uneconomic quantities and the like. From the above, it is clear that the purchasing
department may not always be held responsible for paying higher or lower than
the standard price, since some of the factors devolve on persons outside the
purchase department. It is but proper to institute a detailed analysis for the MPV
and then attribute the responsibility for such variance to the concerned department/
departments other than purchasing.
9.3.2 Material Usage/ Quantity Variance (MUV) :
228 Management Accounting - II
The material usage/quantity variance (MUV), the second component of
MCV, measures the extent of utilization of materials in production. The Mi 1 V
represents the difference between the actual quantity consumed in production
and the standard quantity that should have been used for actual output. The MUV
is calculated by multiplying the standard unit price of materials with the difference
between the actual quantity of material and the standard quantity.
Variance Analysis :
Material Variance
Symbolically :
Material Usage Variance (MUV) = Standard Price (SP) (Standard Quantity
(SQ) - Actual Quantity - AQ)
NOTES
The MUV arises due to any one or combination of the factors such as
carelessness in the handling of materials by workers, wastage due to inefficient
production methods or unskilled/untrained employees, low quality of materials used,
pilferage and spoilage due to poor storage, maintenance, use of defective materials
causing excessive consumption and the like. The overall responsibility of the MUV
lies with the production personnel. But this should not be taken as a general rule
always, as in the case of MPV. For instance, a favourable MUV may arise solely
on account of substitution of above standard materials resulting in less wastage
than was anticipated. Viewed from another angle, the purchase of above standard
materials will definitely result in unfavourable MPV, since higher quality materials
will cost more.
Classification of Material Usage Variance :
Where more than one type of material is used in the manufacture of products
in a factory, MUV can be further sub-divided into “Material Mix Variance” (MMV)
and “Material Yield Variance” (MYV).
Check Your Progress
Give the equations of :
(i) Material Price Variance
(ii) Material Usage Variance
Material Mix Variance (MMV) :
This is component of material usage/quantity variance and hence, it is also
called material mix sub-variance. This arises due to difference between the standard
and actual composition of mix. The MMV occurs only where more than one type/
grade of raw materials or combination of materials is used and when quantities
issued to production differ from pre-determined standard mix. MMV is calculated
by multiplying the standard price per unit of materials with the difference between
actual proportion of those materials in the actual total quantity used and the standard
proportions of those materials in actual quantity used. The standard proportions of
materials in the actual total quantity used are referred to as “Revised Standard
Quantity” (RSQ).
Symbolically :
Material Mix Variance (MMV) = Standard Unit Price (SP) (Revised
Standard Quantity (RSQ) - Actual
Quantity) - AQ
A favourable variance would arise, when the Revised Standard Quality
(RSQ) is more than the Actual Quantity (AQ) and vice versa.
Material Revised Usage Variance (MRUV) :
The word “Revised” is prefixed to ‘usage variance’ only to denote the
Management Accounting - II
229
Variance Analysis :
Material Variance
NOTES
residue left after segregating material mix variance. In other words, it represents
that portion of material total usage variance which is attributable to causes other
than the difference between the standard and actual proportion of actual quantity
used. MRUV is calculated by multiplying the standard price per unit of material
with the difference between the standard proportion of different types of materials
in the standard quantity and the standard proportion of those materials in actual
quantity used.
Symbolically :
Material Revised Usage Variance (MRUV) = Standard Unit Price SP
(Standard Quantity (SQ) Revised Standard Quantity (RSQ)
A favourable variance would arise, if the standard quantity is more than the
Revised Standard Quantity and vice-versa.
Material Yield Variance (MYN) :
Check Your Progress
What is normal and abnormal
loss ?
In all process industries, “loss in production” is usually inevitable. This loss
is classified into two types as ‘normal’ and ‘abnormal’. The normal loss is taken
into consideration while determining the standard for normal expected output or
yield. Quite frequently, the actual yield differs from the standard yield due to
abnormal loss sustained in the different processes of production. This difference
is designed as ‘Yield Variance”.
The yield variance represents that portion of the Material. Total Usage
Variance which arises as a result of difference between the standard yield and
the actual yield obtained. Again, the standard yield represents that output which
should have resulted from the actual input of materials based on the standard
expectations. It should also be remembered that while yield variance represents
output variance other variances like price, usage and mix variances are input
variances. MYV is calculated by multiplying the standard material; cost per unit
of output with the difference between the standard yield and the actual yield.
Symbolically :
Material Yield Variance MYV = Standard Material Cost (SMC) per unit of output
(Standard Yield - (SY) Actual Yield (AY))
230 Management Accounting - II
Variance Analysis :
Material Variance
Diagrammatic Representation of Material Variance :
I.
Here on type of material is used.
Cost Variance (SC - AC)
NOTES
Price Variance
AQ (SP - AP)
Either
Usage Variance (or Quantity Variance) SP (SQ - AQ)
or Yield Variance
Std. Material Cost (SY - AY) per unit of output
Verification :
Cost Variance = Price Variance + Either Usagae or Yield Variance
II.
Where more than one type of material is used.
Cost Variance (SC - AC)
Check Your Progress
How your verify the Cost
Variance ?
Price Variance
Total Usage Variance (or Quantity Variance
AQ (SP - AP)
SP (SQ - AQ)
Either
Mix Variance
SP (RSQ - AQ)
Revised Usage Variance
(SQ - RSQ)
or Yield Variance
Std. Material Cost
(SY - AY per unit of output)
Verification :
Cost Variance = Price Variance + Mix Variance + Either Revised
Usage Variance or Yield Variance
9.4
Material Cost Variance (MCV) :
Material cost variance represents the differences between the actual costs
and the standard costs of materials for a specified output. The actual cost is
computed by multiplying actual price with the actual quantity of material and in
Management Accounting - II
231
Variance Analysis :
Material Variance
NOTES
the same way standard cost is computed by multiplying the standard price with
the standard quantity of material. Cost analyst can also develop other variances
of material cost to meet specialised purposes of management. However such
variance may either be related to price, quantity or to the combination of price and
quantity. Material cost variance can be expressed in abbreviated form as shown
below.
MCV
=
(SP x SQ) - (AP x AQ)
SP
=
Standard Price
SQ
=
Standard Quantity
AP
=
Actual Price
AQ
=
Actual Quantity
where
Note : Standard quantity should be taken for actual output.
EXAMPLE
Compute Material Cost Variance for a output of 200 units from the
information given below :
Standard Quantity
=
3 Kg per unit of output
Standard Price
=
` 4 per Kg
Actual Quantity Consumed
=
550 kg
Actual Price
=
` 6 per kg
Material Cost Variance
=
(Total Standard Cost - Total Actual Cost)
MCV
=
(SP x SQ) - (AP - AQ)
=
(` 4 x ` 600) - (` 6 x ` 550)
=
` 900 (Unfavorable)
ANSWER
Material Price Variance (MPC) :
Check Your Progress
Is there is any difference
between Material Price
Variance and Material Uses
Variance ?
The material price variance attempts to measure the variation between the
actual cost of material and the standard cost expected to be paid for the material.
It reflects the actual unit cost of material above or below the standard unit cost,
multiplied by the actual quantity of function will attain standard price. The payment
of lower prices by the purchasing department for a given quantity would results
in favourable material price variance and thereby maintaining the required standard;
whereas purchasing department will fail to meet the standard if it pays higher
prices that will reflect an unfavourable material price variance. The material price
variance is computed as follows :
Material Price Variance (MPV) = (Standard Price (SP) - Actual Price (AP)) x
Actual Quantity (AQ)
232 Management Accounting - II
Variance Analysis :
Material Variance
EXAMPLE
Calculate Material Variance from the information as given in above example.
ANSWER
(Standard Price - Actual Price) x Actual
Quantity
Material Price Variance =
MVP
=
( ` 4 - ` 6) x 550 kg.
=
` 1100 (Unfavorable)
NOTES
Material Usage Variance (MUV) :
Material usages variance is deviation caused from the standard due to
difference in quantities used. It indicates the actual quantity of direct materials
used above or below the standard price.
Material Usage Variance (MUV) = (Standard Quantity (SQ) - Actual Quantity
(AQ) x Standard Price (SP)
This Variance can also be calculated as follows :
Material Usage Variance (MUV) = (Standard Price of Standard Quantity
(SPSQ) - Standard Price of Actual Quantity (SPAC))
EXAMPLE
With the help of information as given in above example, calculate Material
Usage Variance.
ANSWER
Check Your Progress
Material Usage Variance
=
(Standard Quantity - Actual Quantity) x
Standard Price
MUV
=
(600 kg- 550kg) x ` 4 = ` 200 (Favorable)
MUV
=
(Standard Price of Standard Quantity Standard Price of Actual Quantity)
=
` 2400 - ` 2200
=
` 200 (Favourable)
or
Give the equation of MUV.
EXAMPLE
Suba an engineering industrial enterprise manufactured 100 items of product
‘MCC’ compute material cost variances from the information given below
Standard quantity : 2 kg per item
Standard Price : `10 per kg
Actual quantity : 3 kg per item
Actual price
: ` 8 per kg solution
Management Accounting - II
233
Variance Analysis :
Material Variance
ANSWER
Material Cost Variance
=
(Standard Cost - Actual Cost)
MCV
=
(SQ x SP) - (AQ x AP)
=
(200 kg x Rs.10) - (300 kg x ` 8)
=
` 400 (Unfavourable)
Material Price Variance
=
(Standard Price - Actual Price) x Actual
Quantity
MPV
=
(` 10 - ` 8) x 300 kg.
=
` 600 (Favourable)
Material Usage Variance
=
(Standard Quantity - Actual Quantity) x
Standard Price
MUV
=
(200 kg. -300 kg.) x ` 10
=
` 1,000 (Unfavourable)
MCV
=
MVP +MUV
` 400 (U)
=
` 600 (F) + ` 1000 (U)
` 400 (U)
=
` 400 (U)
NOTES
Verification
Presentation of Material Cost Variance by graph
Standard Price and quantity
Actual Price and quantity
12
Cost Per Kg. ( `)
10
MPV = (SP - AP) x AQ
= `(10-8)x300 kg
= ` 600 (F)
8
6
4
2
50
100 150 200
Quantity (Kgs)
250
300
MUV = (SQ - AQ) x SP
= `(200-300)x `10
= ` 1000 (F)
` 400 (F)
Total Material cost
Variance (MCV)
X
350
Graph 9.1
234 Management Accounting - II
Here, we found that difference in material mix is the only cause responsible
for material usage variance. However when standard weight and actual weight
of material mix varies, the quantity variance shall be due to mix accompanied by
other reasons. Under such a situation. Material Usage Variance (MUV) would
be equal to Material Mix Variance (MMV) and Revised Material Usage Variance
(RMUV).
Revised Material Usage Variance (RMUV) = (Standard Quantity (SQ) Revised Standard Quantity (RSQ) ) x Standard Price (SP)
Variance Analysis :
Material Variance
NOTES
The variance will be favourable if standard quantity is greater than Revised
Standard Quantity and vice - versa.
Note : Generally Revised Material Usage Variance is calculated only
when question is silent about the output because under such a situation it is not
possible to calculate Material Yield Variance. Other wise Revised Material Usage
Variance is not usually calculated.
9.5
Illustrations
The computation of Material variances can be understood with the help of
following illustrations.
ILLUSTRATION 1
Calculate : (a) Material Usage Variance, (b) Material Mix Variance and (c)
Material Revised Usage Variance from the following information
Material
Standard
Actual
Quantity
Price
Value
Quantity
Price
Value
(Kg)
(` )
(` )
(Kg)
(` )
(` )
EXX
70
15
350
80
12
320
YA
30
18
180
40
21
280
SOLUTION
Material Usage Variance (MUV)= (SQ - AQ) x SP
For Material EXX = (70 kg- 80 kg.) x ` 15
For Material YA = (30 kg. - 40 kg.) x ` 8
Total MUV =
= Rs.150 (UF)
= ` 180 (UF)
` 330 (UF)
Management Accounting - II
235
Variance Analysis :
Material Variance
Material Mix Variance
(MMV) = (RSQ - AQ) x SP
For Material EXX = (70kg - 84 kg.) x ` 15
NOTES
= ` 210 (UF)
For Material YA = (30 kg. - 36 kg.) x ` 18
= ` 108 (UF)
Total RUV =
= ` 318 (UF)
Verification
Material Usages Variance= Material Mix Variance + Material Revised
Usage Variance
` 330 (UF) = ` 12 (UF) + ` 318 (UF)
` 330 (UF) = ` 330 (UF)
Material Yield Variance
Material Yield Variance is calculated with the help of the following formula :
Material Yield Variance
(MYV) = (Standard Yield - Actual Yield) x Standard Rate *
MYV = (Standard Loss of Actual Mix - Actual Loss of
Actual Mix) x Standard Cost per unit
* Standard Rate = Standard Cost of Standard Mix
Net Standard Output
ILLUSTRATION 2
ABC Ltd. which has adopted standard costing furnishes the following information
Material
XY
Standard
Actual
Quantity
Price
Value
Quantity Price Value
(Kg.)
(` )
(` )
(Kg.)
(` )
(` )
60
15
900
55
18
990
40
12
480
45
12
540
1,380
Loss
100
100
10
200
90
1,380
OR
236 Management Accounting - II
Calculate Material Yield Variance.
80
1,580
153
Variance Analysis :
Material Variance
SOLUTION
Material Yield Variance (MYV) = (Standard Yield - Actual Yield)
x Standard Rate
MYV = (90 kg. - 80 kg.) x ` 15.3 (Unfavourable)
As mentioned earlier, Material Yield Variance can also be calculated on the basis
of standard Loss and Actual Loss like :
NOTES
MYN = Standard Loss of Actual Mix - Actual
Loss on Actual Mix ) x (Standard Cost per
unit)
MYV = (10 kg. - 20 kg.) x ` 15.33
= ` 153.3 Unfavourable
Calculation of Standard Rate :
Standard Cost of Standard Mix
Standard Rate =
=
Net Standard Output
` 1380
90 kg.
= ` 15.33
ILLUSTRATION 3
The Standard Cost shows the following details to the materials needed to
produce 1 kg of groundnut oil :
Quantity of groundnut required
:
3 kg
Price of groundnut
:
` 2.50 per kg
Production during the week
:
1,000 kg
Quantity used
:
3,500 kg
Price of groundnut per kg.
:
`3
Actual production data
Calculate :
(a) Material Cost Variance;
(b) Material Price Variance; and
(c) Material Usage Variance
Management Accounting - II
237
Variance Analysis :
Material Variance
SOLUTION
(a) Material Cost Variance
NOTES
(b) Material Price Variance
=
(Standard Quantity for Actual Output x
Standard Price) - (Actual Quantity x
Actual Price)
=
(3,000 kg. x ` 2.50)-(3,500kg x `3)
=
` 3,000 (Adverse)
=
(Standard Price - Actual Price) x
Actual Quantity
=
(` 2.50 - ` 3) x 3,500 kg.
=
` 1,750 (Adverse)
(c) Material Usage Variance =
(Standard Quantity for Actual Output Actual Quantity) x Standard Price
(3,000 - 3,500) x ` 2.50
=
+ ` 1,250 (Adverse)
Alternative Method
Answer by the Worksheet Method
(1)
(2)
Applied input at Std.
Price and Std. Quantity
(3)
Flexible Budget Input a Std. Actual input incurred
Price and Actual Quantity
(Actual Quantity
(` 2.5 x 3,000 kg.)
(` 2.50 x 3,500 kg.)
Actual Price)
= ` 7,500
= ` 8,750
(` 300 x 3,500 kg.)
= ` 10,500
Material Usage Variance
Material Price Variance
` 1,250 (A)
` 1,750 (A)
Total Material Cost Variance `3,000 (A)
ILLUSTRATION 4
From the following, you are required to calculate :
(a) Material Price Variance
(b) Material Usage Variance
(c) Material Cost Variance
238 Management Accounting - II
Quantity of Material Purchased
:
3,000 units
Value of material purchased for
:
` 9,000
Standard of quantity material required for one tonne of finished product : 25 units.
Standard rate of material
:
` 2 per unit
Opening stock of material
:
100 per units
Closing stock of material
:
600 units
Finished production during the period
:
80 tones
Variance Analysis :
Material Variance
NOTES
SOLUTION
Standard quantity of material
=
80 ton x 25 units
=
2,000 units
=
Opening Stock + Material
Purchased - Closing Stock
=
100 units + 3,000 units - 600 units
=
2,500 units
Standard price per unit
=
`2
Actual Price per unit
=
` 9,000/3,000 units
=
`3
=
(Std. Price - Actual Price) Actual
Qty.
=
(` 2 - ` 3) x 2,500 units
=
` 2,500 (A)
=
(Std. Qty. - Actual Qty.) Std.
Rate
=
(2,000 units - 2,500 units x `2
=
` 1,000 (A)
=
(Total Std. Cost - Total Actual
Cost)
=
(S.P x Std. Qty.) - (A.P x A.
Qty.)
=
( `2 x 2,000 units - `3 x
2,500 units)
=
` 3,500 (A)
required for actual production
Actual quantity of material used
(a)
(b)
(c)
Material Price Variance
Material Usage Variance
Material Cost Variance
Management Accounting - II
239
Variance Analysis :
Material Variance
Verification :
NOTES
MCV
=
MUV + MPV
` 3,500 (A)
=
` 2,500 (A) + 1,000 (A)
` 3,500 (A)
=
` 3,500 (A)
ILLUSTRATION 5
M. A.K. Ltd. manufacturing a simple product, the standard mix of which is,
Material A
:
60% at ` 20 per kg.
Material B
:
40% at ` 10 per kg.
Normal loss in production is 20% of input. Due to shortage of Material A,
the standard mix was changed. Actual results for March 2007 were
Material A
:
105 kg. at ` 20 per kg.
Material B
:
kg. at ` 9 per kg.
Input
:
200 kg.
Loss
:
35 kg.
Output
:
165 kg.
Calculate :
(a) Material Price Per Variance
(b) Material Usage Variance
(c) Material Mix Variance
(d) Material Yield Variance
SOLUTION
(a)
Material Price Variance
=
(Standard Price - Actual Price)
x Actual Quantity
A
=
(` 20 - ` 20) x 105 kg.
=
Nil
=
(` 10 - ` 9) x 95 kg.
=
` 95 (Favourable)
Material Usage Variance
=
(Standard Quantity for Actual Output
- Actual Quantity) x Standard Price
A
=
(123.75 kg - 105 kg) x ` 20
=
` 375 (Favourable)
B
(b)
240 Management Accounting - II
B
=
(82.50 kg. - 95 kg.) x ` 10
=
` 125 (Adverse)
Variance Analysis :
Material Variance
Total ` 250 (Favourable)
(c)
Material Mix Variance
Standard proportion
of Actual Input
= (Standard Proportion of Actual
Input
- Actual Proportion) x Standard Price
Standard Proportion x Total Actual Input
=
Total Standard Quantity
120 kg. x 200 kg.
For A
=
For B
=
80 x 200
For A : (120 kg. - 105 kg.) x `20
=
` 300 (Favorable)
(8 kg. - 95 kg.) x ` 10
=
` 150 (Adverse)
Total
=
` 150 (Favourable)
For B :
(d)
Material Yield Variance
Actual Input
Less :
NOTES
Normal Loss @ 20% of Input
Standard Yield
MYV
200 kg.
= 120 kg.
80 kg. x 200 kg
200 kg.
.
= 80 kg
= (Standard Yield - Actual Yield)
x Standard cost per unit
200 kg.
40 kg.
160 kg.
= (160 kg. - 165 kg.)
3,200
160 kg.
= ` 100 (Favourable)
Verification
Particulars
`
Material Price Variance
95 Fav.
Material Mix Variance
150 Fav.
Material Yield Variance
100 Fav.
Material Usage Variance
250 Fav.
Material Cost Variance
`
250 Fav.
345 Fav.
Management Accounting - II
241
Variance Analysis :
Material Variance
9.6
•
Summary
Classification of Variances
(a) Classification of Variance based on price : (i) Material price Variance,
(ii) Labour price Variance, (iii) Variable overhead Expenditure Variance,
(iv) Fixed overhead expenditure Variance and (v) Sales price Variance.
NOTES
(b) Classification of Variance based on quantity : (i) Material Usage Variance,
(ii) Labour Efficiency Variance, (iii) Fixed Overhead Volume Variance,
(iv) Sales Volume Variance.
•
Material Variance :
Material Variance are commonly referred to as material cost variance
(MCV). The MCV which represent a total variance can be divided in to
two Sub-variances : (i) Material price Variance (ii) Material Usage
Variance.
•
Material Usage Variance : (MUV) :
Material Usage Variance can be further sub divided into “Material Mix
Variance (MMV) and Material Yield Variance (MYV).”
•
Material Cost Variance :
Material Cost Variance represents the difference between the actual costs
and the standard costs of material for a specified output.
9.7 Key Terms
242 Management Accounting - II
1)
Variance : It is a difference between a standard cost and the comparable
actual cost incurred during a period.
2)
Variance Analysis : It is that part of variance actually which relates to the
analysis into cash out parts of variance between planned and actual
performance.
3)
Material Revised Usage Variance (MRUV) : It represents that portion
of material total usage variance which is attributable to causes other than
the difference between the standard and actual proportion of actual quantity
used.
4)
Material Price Variance : Material price Variance attempts to measured
the variation between the actual cost of materials and the standard costs
expects to be paid for the material.
5)
Material Usage Variance : Material Usage Variance is deviation caused
from the standard due to difference in quantities used. It indicates the actual
quantity of direct materials used above or below the standard price.
9.8
Questions and Exercises
Variance Analysis :
Material Variance
I. Objective Questions
A) Multiple Choice Questions
i)
Variance is the difference between standard cost and ....... cost.
NOTES
(a) actual
(b) marginal
(c) fixed
(d) budgeted.
2)
When actual cost is less than standard cost it is know as ..... variance.
(a) unfavourable
(b) favourable
(c) negative
(d) adverse
3)
The variance that occurs due to hike in taxes and duties levied by the
Government is termed as material ... variance.
(a) cost
(b) price
(c) usage
(d) mix.
4)
Standard price of material per kg is ` 4. Standard usage per unit is 5 kg.
Actual usage of 16,000 kg. of material costs ` 52,000 for producing 3,000 unit.
Hence material cost variance is .....
(a) ` 8,000 Adverse
(b) ` 12,000 Favourable
(c) ` 7,000 Adverse
(d) ` 8,000 Favourable
Ans. : (1 - a), (2 - b), (3 - b), (4 - d)
II(1)
Long Answer Questions.
Explain the concept ‘Variance’ and ‘Variance Analysis’. How do you classify
total cost variance ?
Management Accounting - II
243
Variance Analysis :
Material Variance
NOTES
(2)
‘Variance Analysis is an integral part of standard costing system’ Discuss.
(3)
What is ‘Material Variance’ ? How do you classify Direct Material Cost
Variance ?
(4)
What is ‘Material Price Variance’ ? state the causes of ‘Material price
Variance’.
(5)
What is ‘Material Usage Variance’ ? What are the usual causes of ‘Material
Usage Variance’ ?
(6)
Explain the importance of Material Mix Variance and Material Yield Variance
in Material Variance.
(7)
Explain the meaning causes and computation of
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Quantity Variance
(d) Material Mix Variance
(e) Material Yield Variance
III - Practical Problem
(1)
A company produces product “A”. The following are the details of standard
and actual production.
Standard quantity of material per unit
Standard price
10 kgs.
` 8 per kg.
Actual number of units produced
500 units
Actual quantity of material used
2,500 kg.
Price of material
` 5 per kg.
You are required to calculate,
(a) Material Price Variance, (b) Material Usage Variance,
(c) Material Cost Variance.
(2)
Ankit Chemical Co., Ajmer, produces a certain chemical, the standard
material costs are :
30 % material ‘A’ @ ` 50 per kg.
70 % material ‘B’ @ ` 100 per kg.
Standard loss expected 10 % in production.
244 Management Accounting - II
During 2014 - 300 kgs of material ‘A’ and ‘B’ were mixed as below :
Variance Analysis :
Material Variance
185 kgs. of material ‘A’ @ ` 40 per kg.
115 kgs. of material ‘B’ @ ` 120 per kg.
The actual production was 200 kgs of chemical.
Calculate the following variances :
NOTES
(a) Material Price, (b) Material Mix, (c) Material Yield.
(3)
Tip Top Industries, Tarapur, furnish the following information.
Material
Standard
Actual
Quantity
Rate
Units
`
Material’X’
4
2.00
Material’Y’
3
Material ‘Z’
2
Total
9
Amount Quantity
Rate
Amount
Units
`
`
8.00
3
4.00
12.00
3.00
9.00
2
3.00
6.00
4.00
8.00
2
5.00
10.00
25.00
7
`
28.00
Compute Material Price, Material Usage and Material Variances.
(4)
Calculate :
(a) Material Cost Variance (b) Material Price Variance
(c) Material Usage Variance from the following particulars.
Material
(5)
Standard
Standard
Actual
Actual Price
Quantity
Price
Quantity
`
Kgs.
`
Kgs.
‘X’
15
5
18
4
‘Y’
20
4
24
3
The Standard mix of a product is as follows.
Material
Units
Price per unit
Ps.
‘A’
30
20
‘B’
20
15
‘C’
50
30
Standard loss in production is 10%
There is actual production of 8,000 unit from 90 mixes during July, 2014.
Management Accounting - II
245
Variance Analysis :
Material Variance
The actual purchases and consumption of materials during July, 2014, were
Material
Units
Price per unit
Ps.
NOTES
9.9
246 Management Accounting - II
‘A’
2,500
25
‘B’
1,600
10
‘C’
4,500
40
Further Reading
•
Bhar B. K. - Cost Accounting Methods and Problems - Kolkata - Academic
Publishers - 2010.
•
A Prasad N. K. and Prasad A. K. - Cost and Management Accounting Kolkata - Book Syndicate Pvt. Ltd. - 2010.
Unit 10 Variance Analysis : Labour
Variance
Variance Analysis :
Labour Variance
Structure
10.0 Introduction
NOTES
10.1 Unit Objectives
10.2 Labour Variances
10.2.1
Labour Rate Variance
10.2.2
Labour Efficiency Variance
10.2.3
Labour Cost Variance
10.2.4
Labour Mix Variance
10.2.5
Labour Idle Time Variance
10.2.6
Labour Yield Variance
10.3 Illustrations
10.4 Summary
10.5 Key Terms
10.6 Questions and Exercises
10.7 Further Reading
10.0 Introduction
The Concept ‘Variance’ discussed earlier is not only confined to material, it
can also be extended to the area of labour. However, basically, there are tow
types of variance - (a) Price Variance and (b) Volume Variance. These two types
of variance can be studied in the context of direct labour of the manufacturing
concern. The direct labour variance is similar to direct material variance.
Labour rate variance is similar to the material price variance, and is the
cost of having paid and actual wage higher or lower than standard rate. Labour
cost variance is the difference between the standard cost of direct labour and the
actual cost expended for it. Labour mix variance is like material mix variance and
is a part of labour efficiency variance. Labour yield variance is just like material
yield variance. It is the difference between the standard labour output and actual
output or yield.
Management Accounting - II
247
Variance Analysis :
Labour Variance
10.1 Unit Objectives
After studying this unit you should be able to :
NOTES
•
Understand the meaning and concept of labour variance.
•
Calculate labour rate variance.
•
Explain ‘Labour Efficiency Variance’ and calculate it.
•
Discuss ‘Labour Cost Variance’ and calculate it.
•
Calculate ‘Labour Mix Variance’.
•
Explain ‘Labour Yield Variance’ and calculate it.
•
Calculate ‘Labour Idle Time Variance’.
10.2 Labour Variance
The Direct labour or wage variance is similar to direct material variance.
But for the change of name, they parallel the material variance in concept and
calculation. Whenever difference occurs between the standards specified for direct
labour and the actual, labour variances arise necessitating their investigation and
remedy. The following are the principal labour variances calculate in practice.
1)
Labour Rate Variance.
Check Your Progress
2)
Labour Efficiency Variance.
List out principal labour
variances calculated in
practical.
3)
Labour Cost Variance.
4)
Labour Mixture Variance.
5)
Labour Yield Variance.
6)
Labour Idle Time Variance.
10.2.1 Labour Rate Variance
Labour rate variance is similar to the material price variance, and is the
cost of having paid and actual wage higher or lower than standard rate. It is the
difference between the standard rate of pay and the rate paid for the actual hours
worked. Since labour rate variance equals the time taken multiplied by the
difference between the standard and actual wage rate, the following formula
emerges
where,
248 Management Accounting - II
LRV
=
(SR - AR) x AH
SR
=
Standard wage rate per hour,
AR
=
Actual wage rate per hour,
AH
=
Actual direct labour hours worked.
Variance Analysis :
Labour Variance
If the standard rate is higher than the rate, it shall result in favourable variance
and vice-versa.
EXAMPLE
Standard wage rate
:
` 4 per hour
Standard hours
:
400 Hrs.
Actual hours
:
380 Hrs.
Actual wage rate
:
` 5 per hour
NOTES
Calculate wage rate variance.
ANSWER
Labour Rate Variance =
(Standard Rate - Actual Rate) x Actual Time
=
(` 4 - ` 5) x 380 Hrs.
=
` 380 (Adverse)
Check Your Progress
10.2.2 Labour Efficiency Variance
Give the equation of Labour
Efficiency Variance.
Labour efficiency variance, also called the labour usage or quantity variance,
It is the difference between the standard hours and the actual hours worked time
the standard wage rate. it is the cost of using excess or less hours over the standard
hours allowed for the units of products produced. Since labour efficiency variance
equals standard wage rate multiplied by the difference between the standard labour
hours specified and the actual labour hour expended, the formula is :
Labour Efficiency Variance =
(Standard time for Actual Output - Actual Time)
=
(SH - AH) x SR
SH
=
Standard hours
AH
=
Actual hours
SR
=
Standard wage rate per hour.
where,
EXAMPLE
Using the figures contained in above EXAMPLE, this variance will be as
under :
ANSWER
=
(400 Hrs. - 380 Hrs.) x ` 4
=
` 80 (Favourable)
The labour efficiency variance may be due to the following reasons :
(i) Inaccurate selection of employees,
Management Accounting - II
249
Variance Analysis :
Labour Variance
(ii) Inadequately trained operatives,
(iii) Labour turnover, i.e. constant training and breaking-in of new employees,
(iv) Inferior working conditions,
(v) Overtime hours,
NOTES
(vi) Length of production run,
(vii) Interruptions or delays in work,
(viii) Change in method of production,
(ix) Inaccurate recording of time or output,
(x) Higher rates of wages during seasonal or emergency operations.
10.2.3 Labour Cost Variance :
Check Your Progress
How you calculate LCV ?
Total Direct labour costs depend on the wage rate paid and the number of
hours worked. Similar to the material cost, labour cost variance is the difference
between the total standard amount of labour and the actual amount of labour
times the respective wage rates. In simple words, it is the difference between the
standard cost of direct labour and the actual cost expended for it. The formula for
the purpose is.
Labour Cost Variance (LCV)
=
(Std. Rate x Std. Time for Actual
Output) - (Actual Rate x Actual Time)
OR
=
Standard Cost for Actual Output - Actual
Cost
It should be noted that the labour rate and labour efficiency variances must
equal the total labour cost variance.
EXAMPLE
Using the figures contained in above example 1, labour cost variance would
be :
ANSWER
=
(` 4 x 400 Hrs.) - (` 5 x 380 Hrs.)
=
` 300 (Adverse)
=
Labour Rate Variance + Labour
Efficiency Variance
=
` 380 (A) + ` 80 (F)
Verification
Labour Cost Variance
` 300 (A)
250 Management Accounting - II
Variance Analysis :
Labour Variance
EXAMPLE
From the data given below calculate each of the variances for the two
departments
Particular
Actual gross wage
Standard hours produced
Standard rate per hour
Actual hours worked
Dept. X
Dept. Y
`
2,050
` 1,740
Hrs.
8,000
6,000
`
30
35
Hrs.
8,200
5,800
Labour Cost Variance
=
(SR x SH) - (AR x AH)
Dept. X
=
` 0.30 x 8,000 - ` 0.25 x 8,200 Hrs.
=
` 350 (Favourable)
=
` 0.35 + 6,000 - ` 0.30 x 5,800 Hrs.
=
` 360 (Favourable)
Labour Rate Variance
=
(SR - AR) x AH
Dept. X
=
(` 0.30 - ` 0.25) x 8,200 Hrs.
=
` 410 (Favourable)
=
(` 0.35 - ` 0.30) x 5,800 Hrs.
=
` 290 (Favourable)
=
(SH - AH) x SR
=
(` 0.30 - ` 0.25) 8,200 Hrs.
=
` 410 (Favourable)
=
(` 0.35 - ` 0.30) x 5,800 Hrs.
=
` 290 (Favourable)
Dept. Y
Dept. Y
Labour Efficiency Variance
Dept. X
Dept. Y
NOTES
Verification
Labour Cost Variance
= Labour Rate Variance + Labour Efficiency
Variance + Idle Time Variance (if any)
Dept. X
= ` 350 (R) = `410 (F) + `60 (A) = `350(F)
Dept. Y
= ` 360 (F) = ` 290(F) + ` 70 (F) = ` 360 (F)
Note
Actual Wage Rate
=
Actual gross wages paid
Actual hours worked
Management Accounting - II
251
Variance Analysis :
Labour Variance
Dept. X
=
` 2,050
8,200 Hrs.
= 2.5 paise
`
` 1,740
Dept. Y =
= 30 paise
5,800 Hrs.
NOTES
10.2.4 Labour Mix Variance
Labour mix variance is like materials mix variance and is a part of labour
efficiency variance. It arises when there is a change in the labour composition
during a particular period it is calculated in the same manner as the material mix
variance and, hence, also called gang composition variance. The following formula
are applicable.
Labour Mix Variance =
Standard Cost of Std. Composition - Standard
Cost of Actual Composition
In case there is a change in the labour composition due to shortage of one
category of labour but there is no change in the total standard time and actual time
spent, then :
Labour Mix Variance =
Check Your Progress
Give the equation of Labour
Mix Variance.
Std. Cost of Revised Std. Composition Standard Cost of Actual Composition
In case standard are revised and total standard time of labour differs from
the actual time of labour.
Labour Mix Variance =
(Revised Standard Time - Actual Time) x
Standard Rate
where,
Revised Standard Time=
Total time of actual workers
Total time of Std. workers
x Standard Time
10.2.5 Labour Idle Time Variance
It arises due to abnormal circumstances like strike, lockouts, power failures,
etc., and it is calculated as under
Idle Time Variance
=
Idle Hours x Standard Hourly Rate
For example, in a factory’s Idle time recorded was 40 hours and workers
were paid ` 15 per hour. Thus, Variance would be 40 Hrs. x ` 15 = ` 600.
This Variance will be always unfavourable.
10.2.6 Labour Yield Variance
252 Management Accounting - II
It is just like Material Yield Variance. It is the difference between the standard
labour output and actual output or yield. It is calculated as below
Labour Yield Variance
=
(Std. production for Actual Mix - Actual
Production) x Std. cost per unit.
Variance Analysis :
Labour Variance
If the actual production is more than standard production, the difference
would be a favourable variance and vice - versa, However, it should be noted that
the figure would be negative.
NOTES
10.3 Illustrations
The computation of labour variance can be understood with the help of
following illustration
ILLUSTRATION 1
Data relating to a job are as thus : c
Standard rate of wages per hour
` 10
Standard hours
300 Hrs.
Actual rate of wages per hour
`12
Actual hour
` 200
You are required to calculate
:
(a) Labour Cost Variance.
(b) Labour Rate Variance and
(c) Labour Efficiency Variance
SOLUTION
(a)
Labour Cost Variance = (Standard Ratex Standard Time) - (Actual Rate
x Actual Time)
= (` 10 x 300 Hrs.) - (` 12 x 200 Hrs.)
= ` 600 (Favourable)
(b)
Labour Rate Variance = (Standard Rate - Actual Rate) x Actual Time
Variance
= (` 10 - `12) x 200 Hrs.
= ` 400 (Adverse)
(c) Labour Efficiency Variance = (Standard Rate - Actual Time) x Standard Rate
= (300 Hrs. - 200 Hrs.) x ` 10
= ` 1,000 (Favourable)
Management Accounting - II
253
Variance Analysis :
Labour Variance
ILLUSTRATION 2
The standard time for unit component X are given below
NOTES
Standard hours per unit
:
15
Standard rate
:
`4 per hour
The actual data and related information are as under
Actual production
:
1,000 units
Actual hours
:
15,300 hours
Actual rate
:
` 3,90 per hour
Calculate :
(a) Labour Cost Variance
(b) Labour Efficiency Variance; and
(c) Labour Rate Variance
SOLUTION
(a)
Labour Cost Variance
= (SR x SH - AR x AH)
= (` 4 x 15,000 Hrs. - ` 3.90 x 15,300 Hrs.)
= ` 330 (F)
(b)Labour Efficiency Variance = (SH - AH) x SR
= (15,000 Hrs. - 15,300 Hrs.) x ` 4
= ` 1,200 (A)
(c)
Labour Rate Variance
= (SR - AR) x AH
= (` 4 - ` 3.90) x 15,300 Hrs.
= ` 1,530 (F)
Verification :
Labour Efficiency Variance
` 1,200 (A)
254 Management Accounting - II
Labour Rate Variance
Labour Cost Variance
` 1,530 (F)
` 330 (F)
Alternative Method :
Variance Analysis :
Labour Variance
Answer by the Worksheet Method
(1)
(2)
(3)
Applied input Standard
Flexible budget inputs
Actual inputs Actual
Labour Rate (SR) allowed Standard Labour Rate (SR)
For actual output times
Labour Rate (AR)
NOTES
Time Actual Hours (AH) Rate (AR) Times actual
Standard Hours (SH)
used
Hours (AH) used
(SR x SH)
(SR x AH)
(AR x AH)
(`4 x 15,000 Hrs.)
(` 4 x 15,200 Hrs.)
(` 3.90 x 15,300 Hrs.)
= ` 60,000
= ` 61,200
= ` 59,670
Labour Efficiency Variance
Labour Rate Variance
` 1,200 (A)
` 1,530 (A)
Total Labour Cost Variance ` 330 (A)
ILLUSTRATION 3
A gang of workers normally consists of 30 men, 15 women and 10 boys.
They are paid standard rates as under :
Men
:
` 0.80
Women
:
` 0.60
Boy
:
` 0.40
In normal working week of 40 hour, the gang is expected to produce, 2,000
units of output.
During the week ended 31st December, the gang consisted of 40 men, 10
women and 5 boys. The actual wages paid were @ ` 0.70, ` 0.65 and 0.30
respectively and 1,600 units were produced.
Calculate :
(a) Wages Variance
(b) Wages Rate Variance
(c) Labour Efficiency Variance
(d) Gang Composition Variance, i.e. Labour Mix Variance and
(e) Labour Revised Efficiency Variance.
Management Accounting - II
255
Variance Analysis :
Labour Variance
SOLUTION
Type of
Worker
NOTES
Men
Standard
Hours
Actual
Rate
Amount
`
`
30 x40 Hrs.
0.80
960
= 1,200 Hrs.
Women
15 x40Hrs.
10 x 40Hrs.
0.60
360
0.40
160
`
`
0.70
1,120
10 x40Hrs.
0.65
260
5 x 40Hrs.
0.30
60
= 200Hrs.
2,200 Hrs.
1,480
2,200 Hrs.
1,440
Hours
=
Number of workers x Weekely Hours
(a) Labour Cost Variance
=
(Standard Cost of Actual Output) - (Actual
Cost of Actual Output)
=
` 1,184 - ` 1,440 = ` 256 (Adverse)
SC of Actual Output
(b)
=
Labour Rate Variance =
Men
Women
Boys
LRV
1,600 units
2,000 units
Men
Women
x 1,480 = ` 1,184
(SR - AR) x AH
=
(` 0.80 - ` 0.70) x 1,600 Hrs.
=
` 160 (Favorable)
=
(` 0.60 - ` 0.65) x 400 Hrs.
=
` 20 (Adverse)
=
(` 0.40 - ` 0.30) x 200 Hrs.
=
` 200 (Favourable)
=
` 160 (Favourable)
(c) Labour Efficiency Variance =
256 Management Accounting - II
Amount
= 400Hrs.
= 400Hrs.
Total
40 x 40Hrs.
Rate
= 1,600Hrs.
= 600Hrs.
Boys
Hours
(SH - for Actual Output - AH) x SR
=
(960 Hrs. - 1,600 Hrs.) x ` 0.80
=
` 512 (A)
=
(480 Hrs. - 400 Hrs.) x ` 0.60
=
` 48 (F)
Boys
LEV
=
(320 Hrs. - 200 Hrs.) ` 0.40
=
` 48 (F)
=
` 416 (F)
Variance Analysis :
Labour Variance
Standard hours for actual output are calculated as follows
(d)
Men
=
Women
=
Boys
=
1,200 Hrs.
2,000 Units
600 Hrs.
2,000 Units
400 Hrs.
2,000 Units
NOTES
x 1,600 Hrs. = 960 Hrs.
x 1,600 Hrs. = 480 Hrs.
x 1,600 Hrs. = 320 Hrs.
Labour Mix Variance (Gang - Composition Variance)
Men
Women
Boys
LMV
=
(Revised Standard Hours - Actual Hours) x
Standard Rate
=
(1,200 Hrs. - 1,600 Hrs.) x ` 0.80
=
` 320 (A)
=
(600 Hrs. - 400 Hrs.) x ` 0.60
=
` 120 (F)
=
(400 Hrs. - 200 Hrs.) x ` 0.40
=
` 80 (F)
=
` 120 (A)
Revised Standard hour are total actual hour i.e. 2,200 Hrs. in the standard
proportion for men, women and boys. This is given in the table above.
(e)
Labour Revised Efficiency Variance
Men
Women
Boys
=
(Std. hours for actual output - Revised Std. Hrs.)
x Std. Rate
=
(960 Hrs. - 1,200 Hrs.) x ` 0.80
=
` 192 (A)
=
(480 Hrs. x 600 Hrs.) x ` 0,60
=
` 72 (A)
=
(320 Hrs. - 400 Hrs.) x ` 0.40
=
` 32 (A)
Management Accounting - II
257
Variance Analysis :
Labour Variance
LEV
=
` 296 (A)
Wage Variance
=
Rate Variance + Efficiency Variance
` 256 (A)
=
` 160 (F) + ` 416 (A)
Efficiency Variance
=
Mix Variance + Revised Efficiency Variance
` 416 (A)
=
` 120 (A) + ` 296 (A)
Standard Production
:
200 Units
Actual Producing
:
180 Units
Standard wage rate
:
`15 per hour
Standard time
:
2 Hrs. per unit
Standard cost per unit =
2 Hrs. x ` 15
Verification
NOTES
ILLUSTRATION 4
SOLUTION
Labour Yield would be
=
Labour Yield Variance =
=
` 30
(200 units - 180 units) x ` 30
` 600 (A)
ILLUSTRATION 5
From the following records of Apollo Bolt Nut Manufacturing Company,
you are required to compute material and labour variances :
An input of 100 kg. of material yield to a standard output of 10,00,000 units.
Standard price per kg. of material - ` 20
Actual quantity of material issued and used by production department 10,000 kg.
Actual price per kg. of material
:
` 21 per kg.
Actual output
:
9,00,000 units
Number of employees
:
200
Standard wage rate per employee per day
:
`40
Standard daily output per employee
:
100 units
Total numbers of days worked
:
50 days
(Idle time paid for and included in the above half day for each employee).
258 Management Accounting - II
Actual wage rate day
Variance Analysis :
Labour Variance
SOLUTION
Material Cost Variance
SQ
=
(SQ x SP) - (AQ x AP)
=
(9,000 units x ` 20) - (10,000 units x ` 21)
=
` 30,000 (A)
NOTES
100 kg.
=
x 9,00,000 units
10,000 kg.
=
9,000 kg.
(a) Material Price Variance =
(SP - AP) x AQ
=
(` 20 - ` 21) x 10,000 kg.
=
` 10,000 (A)
(b) Material Quantity Variance
= (SQ -AQ) x SP
=
(9,000 kg. - 10.000 kg.) x ` 20
=
` 20,000 (A)
Man days required for actual output
=
9,00,000 units
100 units
= 9,000 man-days
Idle time
=
1
2
of 200
= 100 Days
Actual Man-days
= 200 x 50 Days
= 10,000
(c) Labour Cost Variance
= Standard Cost - Actual Cost
= (9,000 Kg. x ` 40) - (10,000 Kg. x ` 45)
= ` 90,000 (A)
(d) Labour Rate Variance
= (SR - AR) x Actual Days
= (` 40 - ` 45) x 10,000 Kg.
= ` 50,000 (A)
(e) Labour Efficiency Variance
= (Std. days - Actual Days) x SR
= (9,000 kg. - 10,000 kg.) x ` 40
= ` 40,000 (A)
Management Accounting - II
259
Variance Analysis :
Labour Variance
(f)
Idle Time Variance
= Idle Time x SR
= 100 Days x ` 40
= ` 4,000 (A)
NOTES
10.4 Summary
•
Labour Variance : Whenever difference occurs between the standards
specified for direct labour and the actual, labour variances arise necessitating
their investigation and remedy. Following are the important labour variances
calculated in practice.
(i) Labour Rate Variance (ii) Labour Efficiency Variance (iii) Labour Cost
Variance (iv) Labour Mix Variance (v) Labour Yield Variance and (vi) Labour
Idle Time Variance.
•
Labour Rate Variance : Labour rate variance is similar to material price
variance, it is the difference between the standard rate of pay and the rate
paid for the actual hours worked.
•
Labour Efficiency Variance : It is the difference between the standard
hours and the actual hours worked time the standard wage rate. It is the
cost of using excess or less hours over the standard hours allowed for the
units of products produced.
•
Labour Cost Variance : It is the difference between the standard cost of
direct labour and the actual cost expended for it.
•
Labour Mix Variance : It is calculated in the same manner as the material
mix variance and, hence also called gang composition variance.
•
Labour Idle Time Variance : It is arises to abnormal circumstances like
strike, lockouts, power failures etc.
•
Labour Yield Variance : It is the difference between the standard labour
output and actual output or yield.
10.5 Key Terms
x No. of Men
Standard Hour
(2)
Idle Time Variance : It shows that the standard cost of actual hours of
workers are idle due to certain reasons.
Idle Time
=
Quantity Produced or Actual Output
(1)
Standard Output per hour
= Standard Rate x Hour Idle
= SR x HI
260 Management Accounting - II
(3)
Mix Variance
: When actual grades of labour differ from the standard
the variance is said to be mix variance.
(4)
Standard Rate per Unit
(5)
Yield Variance
=
Standard Rate per hour
Variance Analysis :
Labour Variance
Standard Output per hour
= Standard Rate (Actual Yield - Standard Yield)
10.6 Questions And Exercises
NOTES
I - Objective Questions
(A)
Multiple Choice Questions
1.
Labour Idle Time Variance will always be ------------------(a) unfavourable
(b) favourable
(c) partly positive and partly negative
(d) nil
2.
The variance that shows the impact of time lost is ----------(a) Labour Rate Variance
(b) Idle Time Variance
(c) Labour Efficiency Variance
(d) Labour Yield Variance.
3.
Time and motion study is used basically to set ------------- standard.
(a) Labour Rate
(b) Labour Mix
(c) Labour Time
(d) Labour Yield
4.
Inaccurate selection of employees may be the cause of labour ------- variance.
(a) rate
(b) cost
(c) mix
(d) efficiency
Ans. : (1 - a), (2 - b), (3 - c), (4 - d)
Management Accounting - II
261
Variance Analysis :
Labour Variance
NOTES
II - Long Answer Questions
(1)
What is ‘Labour Variance’ ? Explain in brief the principal labour variance
calculated in actual practice.
(2)
What is ‘Direct Labour Cost Variance’ ? Explain the method for computation
of labour cost variance.
(3)
What is ‘Labour Rate Variance’ ? Explain the controllable and uncontrollable
causes for labour rate variance.
(4)
Define ‘Labour Usage Variance’. Explain the causes and responsibility for
labour efficiency variance.
(5)
What is ‘Idle Time Variance’ ? Why labour time variance is always adverse?
(6)
Explain the method for computation of Labour Mix Variance and Labour
Yield Variance.
(7)
Explain in brief the basic need for computation of labour variances under
the technique of standard costing.
III - Practical Problems
(1)
A medium scale unit worked for 50 hours a week. It has 100 worker. The
following are the other details.
Standard rate per hour
`2
Standard output per gang hour during a week
400 units
10 workers were paid
` 1.00 per hour
15 workers were paid
` 1.50 per hour
75 workers were paid
` 2.00 per hour
The actual production was
20,500 units
Calculate the labour variances.
(2)
From the data given below, calculate labour variances for the two
departments.
Particulars
‘A’
‘B’
`
2,000
1,800
Hrs.
8,000
6,000
Standard rate per hour
Ps.
30
35
Actual hours worked
Hrs.
8,200
5,800
Actual gross wages (direct)
Standard hours produced
262 Management Accounting - II
Department Department
(3)
In a factory, 100 workers are engaged and the average rate of wages is 50
ps. per hour. Standard working hours per week are 40 and the standard
performance is 10 units per gang hour.
During a week in March, 2014, wages paid for 50 workers were @
50 paise per hour, 10 workers @ 70 paise per hour and 40 workers at 40
paise per hour. Actual output was 380 units.
Variance Analysis :
Labour Variance
NOTES
The factory did not work for five hours, due to break-down of
machinery. Calculate appropriate labour variances.
(4)
In Cadbury India Ltd., Chalisgaon, Works Department employed 200
workers @ ` 5.50 per hour to manufacture a standard product. During
December, 2006, the factory is scheduled to run for 168 hours in a four
weekly period. The standard performance is fixed at 60 units per hour.
During the month, 18 workers were paid @ ` 5 per hour, 12 workers @
` 6 per hour and 8 workers @ ` 4 per hour. The factory remain idle for
two hours, due to electricity failure. The actual production for the month
was 10,100 units.
You are required to calculate,
(1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Labour Yield Variance. Verify your results.
(5)
The following labour cost details are made available by Dabur India Ltd.,
Dombivli.
Gross Direct Wages
Standard Hours produced
Standard Rate per hour
Actual Hours paid for
` 3,000
Hrs. 1,600
` 1.50
Hrs. 1,500
(of which abnormal idle time is 100 Hours)
Calculate (1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Idle Time Variance.
(6)
It is estimated that a specific job can be completed by employing 10 trained
workers for 8 hours and 12 untrained workers for 10 hours each to be paid
at a standard rate of ` 20 per hour and ` 15 per hour respectively.
Actually, 8 trained workers for 12 hours each and 10 untrained workers 8
hours each worked to complete the job @ ` 18 and ` 20 per labour hour
respectively.
You are required to calculate (1) Labour Cost Variance, (2) Labour Rate Variance, (3) Labour Efficiency
Variance, (4) Labour Mix Variance and (5) Labour Yield Variance.
Also verity your results.
Management Accounting - II
263
Variance Analysis :
Labour Variance
NOTES
264 Management Accounting - II
10.7 Further Reading
•
Bhar B. K. - Cost Accounting Methods and Problems - Kolkata - Academic
Publishers - 2010
•
Prasad N. K. and Prasad A. K. - Cost and Management Accounting Kolkata - Book Syndicate Pvt. Ltd. - 2010
UNIT 11 Variance Analysis :
Overhead Cost Variance
Variance Analysis :
Overhead Cost Variance
Structure
11.0 Introduction
NOTES
11.1 Unit Objectives
11.2 Overhead Cost Variance
11.2.1 Classification of Overhead Variances
11.3 Overhead Cost Variance
11.4 Variable Overhead Variance
11.4.1 Illustrations
11.5 Fixed Overhead Variance
11.6 Managerial Uses of Variances
11.7 Summary
11.8 Key Terms
11.9 Questions and Exercises
11.10 Further Reading
11.0 Introduction
The concept ‘Variance’ can also be extended to the area of variable
overhead. So any variance in variable overhead should be attributed to expenditure
variance. According to the Institute of cost and works Accountants of London,
variable cost is a cost which tends to vary directly with volume of out put. As it
varies directly with production, a change in expenditure can affect cost.
Overhead cost is the aggregate of indirect material cost, indirect wages
and indirect expenses. So it is clear that it includes all factory operating expenses
other than the direct material and direct labour.
Overhead variances are classified as : (1) Total fixed Overhead Variance
& (ii) Total variances overhead variances. Fixed overhead cost variances are
includes.
Check Your Progress
How you classify overhea
variances ?
(a) Expenditure variance (b) Volume variance (c) Efficiency variance (d) Capacity
variance (e) Calender variance.
The purpose of overhead variance analysis is to see whether the price paid
for and the quantity uses of indirect elements of cost vary or not us compares
Management Accounting - II
265
Variance Analysis :
Overhead Cost Variance
specified standard figures. Thus, it is the difference between the standard overhead
and actual overhead assigned to the products.
11.1 Unit Objectives
NOTES
After studying this unit you should be able to :
•
Understand the meaning of overhead cost variance.
•
Classify overhead variances.
•
Calculate overhead cost variance.
•
Explain variable overhead Expenditure variance.
•
Explain variable overhead Efficiency variance.
•
Explain the term ‘fixed overhead variance’.
•
Calculate Total fixed overhead cost variance.
•
Calculate fixed overhead Expenditure.
•
Calculate fixed overhead Efficiency variance.
•
Calculate fixed overhead capacity variance.
•
Explain the term “Calender Variance”
•
Analyse standard cost variances.
11.2 Overhead Cost Variance
Standard costs for factory overhead provide the third final cost element.
Special attention is given to them because they are different from direct materials
and direct labour costs. Factory overhead costs cannot be traced to individual
units of production, and then these are not strictly variable costs. Hence, the
budgetary and variance analysis procedures here are different.
Overhead costs are indirect costs of material, labour and other overhead
that contain both fixed and variable components. The analysis of overhead variances
are somewhat difficult than direct cost variances. The purposes of overhead
variance analysis is to see whether the price paid for and the quantity used of
indirect elements of cost vary or not as compared specified standard figures.
Thus, overhead variance represents the difference between the amount of overhead
applied to production during the period and the amount of actual overhead cost
incurred during the period. It is the difference between the standard overhead and
the actual overhead assigned to the products.
266 Management Accounting - II
11.2.1 Classification of Overhead Variances :
Variance Analysis :
Overhead Cost Variance
Overheads are classified into fixed variable. Fixed overheads are those
which do not change with the level of operation and remain fixed for a given
period. Variable overheads are those which change directly with the level of
operation. But this should be noted that in most circumstances, the largest proportion
or overhead incurred will be fixed and only a small proportion variable. Because
of the difference in the nature of variability, overhead costs are analysed separately
for fixed and variable overheads, and so are the variance. The overhead variances,
are classified as below :
NOTES
Overhead Cost Variance
Total Fixed Overhead Variance
Expenditure/Budget
Variance
Total Variable Overhead Variance
Volume Expenditure
Variance
Variance
Efficiency
Variance
Capacity Variance
Efficiency Variance
Calender Variance
Classification of Overhead Variance
11.3 Overhead Cost Variance
It is difference between standard overhead cost specified for the actual
production and actual overhead cost incurred. It is the total of both variable and
fixed overhead variances. The formula is given as follows.
Overhead Cost Variance =
Actual Output x Standard Overhead Rate
- Actual Output x Actual Overheads per
unit)
=
(Standard Hours for Actual output x
Standard Overhead Rate)
=
(Actual hours x Actual Overhead Rate per
hour)
=
Recovered Overheads - Actual Overheads
Management Accounting - II
267
Variance Analysis :
Overhead Cost Variance
11.3.1 Illustrations
The computation of different overhead variance can be understood with
the help of following illustrations.
NOTES
ILLUSTRATION 1
Particulars
Budgeted
Production
Actual
Units
10,000
8,000
Hrs.
5,000
4,500
Overheads
`
10,000
12,000
Fixed
`
6,000
6,000
Variable
`
4,000
6,000
Standard hours
Calculate Overhead Cost Variance.
SOLUTION
` 10,000
Unit Rate
=
Standard Hourly Rate
=
= `2
10,000 Hrs.
Overhead Cost Variance
=
Actual Output x Standard Rate -
(If unit rate)
(if hourly rate)
5,000 Units
= `1
` 10,000
Actual Overhead)
=
8000 Units x `1 - ` 12,000
=
` 8,000 - ` 12,000
=
` 4,000 (A)
=
Standard hour for Actual Output x Standard
hourly rate - Actual Overhead)
=
8,000 Units x 5,000 Hrs.
10,000 Units
=
x ` 2 - ` 12,000
` 4,000 (A)
or
Overhead Cost Variance
268 Management Accounting - II
=
Recovered Overheads - Actual Overheads
=
8,000 Units x ` 1 - ` 12,000
=
` 4,000 (A)
or
=
Recovered Overheads - Actual Overheads
=
4,000 Units x ` 2 - ` 12,000
=
` 4,000 (A)
It may be noted from the above illustration that overhead variances can be
calculated either by using standard hourly rate or by standard unit rate.
Variance Analysis :
Overhead Cost Variance
NOTES
As displayed in the chart the two major categories of overhead cost variance
are :
1. Variable overhead variances, and
2. Fixed overhead variance
11.4 Variable Overhead Variance
The variable overheads may be manufacturing, administration, selling and
distribution. The total variable overhead variance is the difference between the
standard variable overhead variance/charged to production (SC) and the actual
variable overheads incurred (AC).
= SC - AC
The actual cost per unit or output may vary from standard cost unit due to
: (i) Actual overhead incurred may be more or less than the standard overheads
on the basis of actual operation. (ii) Change in output per hour. Due to the-two
situations, variable overhead variances are classified into :
1. Variable Overhead Expenditure Variance : This variance occurs due to
actual expenditure being in excess or short of standard overhead. It is the difference
between the standard overhead allowed and actual overhead incurred for the
actual time taken. The formula is :
Check Your Progress
What is variable overhead
variance ?
Recovered Variable Overheads - Actual Overheads
= Standard Variable overhead on actual production - Actual Variable
Overheads
Standard variable Overhead on actual production in the product of actual
production for the period multiplied by the stand rate per unit.
If hourly rate is used, then it as (Actual Hours X Standard Rate - Actual
Overhead)
2. Variable Overhead Efficiency Variance : The variable overhead efficiency
variance is the difference between the standard hours of output (SH) and the
actual of input (AH) for the period multiplied by the standard variable overhead
rate (SR). Symbolically, it is :
(SH - AH) X SR
Management Accounting - II
269
Variance Analysis :
Overhead Cost Variance
The variance arise from the efficiency of labour. Consequently, the reasons
for the variance are the same as those which have been explained previously for
labour efficiency variance.
ILLUSTRATION 2
NOTES
Budgeted production for the month
:
2,500 Units
Actual production
:
2,200 Units
Budgeted Variable Overheads
:
` 10,000
Actual Hours Worked
:
` 9,000
Budgeted Man Hours
:
1,250 Hrs.
Actual Hours Worked
:
1,150 Hrs.
Calculate :
(a) Expenditure Variance
(b) Efficiency Variance and
(c) Variable Overhead Cost Variance
SOLUTION
Standard Hourly Rate
=
=
=
Standard Unit Rate
=
Standard Unit Rate
=
=
(a)
Expenditure Variance
(if hourly rate is used)
Expenditure Variance
270 Management Accounting - II
(if unit rate is used)
=
Budgeted Overheads
Budgeted Hours
` 10,000
1,250 Hrs.
`8
Budgeted Overheads
Budgeted Output in units
` 10,000
2,500 Hrs.
`4
Actual Hours x Standard Rate
- Actual Overheads
=
1,150 Hrs. hours x ` 8 - ` 9,000
=
` 200 (Favourable)
=
Standard Production at actual hours x
Standard Rate - Actual Overheads
=
=
(b)
Efficiency Variance
(if hourly rate is used)
=
=
=
Efficiency Variance
if unit rate is used
(c)
Variable Overhead Cost
Variance
=
1,150 Hrs. x 2,500 Units
1,250 Hrs.
` 200 (Favourable)
Standard Hours for Actual Hours x
NOTES
Standard Rate Actual Production
2,200 Units X 1,250 Hrs.
2,500 Units
x 1,150 x ` 8
` 400 (Adverse)
(Actual Production - Standard Production at
Actual Hours) x Standard Rate
1,150 Hrs.x 2,250 Units
=
2,200 Units -
=
` 400 (Adverse)
=
x ` 4 - ` 9,000
Variance Analysis :
Overhead Cost Variance
1,250 Hrs.
x`4
Recovered Variable Overhead - Actual
Variable Overhead
=
2,200 Units x ` 8 - ` 9,000
=
` 200 (Adverse)
=
Overhead Expenditure Variance + Overhead
Efficiency
=
` 200 (Adverse)
=
` 200 (Favourable)
=
+ ` 400 (Adverse)
Verification :
Overhead Cost Variance
Management Accounting - II
271
Variance Analysis :
Overhead Cost Variance
NOTES
11.5 Fixed Overhead Variance
The term ‘fixed overhead’ related to all items of expenditure which are more
or less constant, irrespective of fluctuations in the level of output. The standard
overhead rates are set according to rate per hour or rate per unit of output. The
actual fixed overhead cost per unit may vary from standard cost per unit due to :
i) Change in total actual overhead from budgeted overhead; ii) Change in actual
level of operation from budgeted level which may be expressed in outputs or
hours. iii) Change in production per hours.
(a) Total Fixed Overhead Cost Variance :
It is the difference between the standard overheads recovered or absorbed
or absorbed for actual output and the actual fixed overheads incurred. In other
words, it is the difference between the standard overhead charged to production
in a period and the overhead incurred. While computing the standard cost, it is
always necessary to take standard cost for the production actually achieved. For
this purpose, the standard hours for actual production should be multiplied by the
standard overhead rate per unit or per hour. The formula is :
Overhead Cost Variance = Recovered or Absorbed Overheads - Actual Overhead
OR
= Standard hours for actual output x Std. Overheads
Rate - Actual Overhead
(b) Fixed Overhead Expenditure :
Check Your Progress
Give the formula for Fixed
Overhead
Expenditure
Variance.
Also called fixed overhead spending variance, it is the difference between
the budgeted overhead and actual overhead. In other words, it represents the
difference between the budgeted fixed overhead for the period and the actual
overhead which was incurred. Put in the shape of a formula, it would appear as :
Fixed Overhead Expenditure Variance = Total Budgeted Fixed Overhead Total Actual Fixed Overhead.
It would be seen that both actual and budgeted overhead costs are shown
as total amount, not as unit costs related to activity level. If standard overheads
are more, it shall result in favourable and vice-versa.
Fixed Overhead Expenditure is the difference between budgeted
and applied fixed overhead. It shows the difference in overhead recovery due to
the budgeted quantity of products being greater or less than the actual production.
The expenses being fixed for the period, hourly rate changes with the change in
the level of operation. The higher the actual level of operation the lower will be
cost per unit. Simply defined, fixed overhead volume variances is the difference
between the budgeted and the actual output multiplied by the standard fixed
overhead rate. Symbolically, this variance is :
272 Management Accounting - II
(BP - AP) X SR
Variance Analysis :
Overhead Cost Variance
ILLUSTRATION 3
Standard Rate of fixed overheads
:
` 20 per unit
Budgeted Production for the month
:
250 Units
Actual Production for the month
:
220 units
Actual Overheads
:
` 5,200
NOTES
You are required to calculate total fixed overhead cost variance, Fixed
Expenditure variance and Fixed Volume Variance.
SOLUTION
Recovered Overheads = Actual Output x Standard Rate
= 220 Units x ` 20
= ` 4,400
Budgeted Overheads = Budgeted Output x Standard Rate
= 250 Units x ` 20
= ` 5,000
(i)
Total Fixed Overhead
= Recovered Overheads - Actual Overheads
Cost Variance
= ` 4,400 - ` 5,200 = ` 800 (Adverse)
(ii) Fixed Expenditure Variance = Budgeted Overheads - Actual Overheads
` 5,000 - ` 5,200 = ` 200 (Adverse)
(iii)
Fixed Volume Variance = Recovered Overheads - Budgeted
Overheads
= ` 4,400 - ` 5,000 = ` 600 (Adverse)
Verification :
Overhead Cost Variance = Expenditure Variance + Volume Variance
` 800 (A) = ` 200 (A) + ` 600 (Adverse)
ILLUSTRATION 4
In the above illustration of the time budgeted is 500 hours and the standard
rate overhead per hour is ` 15, calculate overhead variances.
Management Accounting - II
273
Variance Analysis :
Overhead Cost Variance
SOLUTION
Budgeted Overheads
= Budgeted hours x Std. Rate per hour
= 500 Hrs. x ` 15
= ` 7,500
NOTES
Recovered Overheads
= Standard Hours x Standard Hours rate for
actual production
Standard hours for actual
production
=
=
Budgeted hours x Actual output
Budgeted output
500 Hrs. x 220 Units
250 Units
= 2 Hrs. x 220 Units
= 440 Hours
Recovered Overheads
= 440 Hrs. x ` 15
= ` 6,600
(i)
Expenditure Variance
= Budgeted Overheads - Actual Overheads
= ` 7,500 - ` 5,200 - ` 2,300 (F)
(ii)
Volume Variance
= Recovered Overheads - Budgeted Overheads
= ` 6,600 - ` 7,500 = ` 900 (A)
The volume variance can be further subdivided into : (i) Efficiency
Variance, and (ii) Capacity Variance.
(i)
Fixed Overhead Efficiency Variance :
The actual output of quantity produced may be different from the standard
quantity of output fixed for the period. This may be for a variety of reasons. This
variance is the difference between the standard hours allowed for the actual
production and the actual hours taken multiplied by speed with which the labour
force has produced the output compared with the budgeted time allowed.
Symbolically it is : (SH - AH) x SR
Efficiency Variance = Standard Overheads - Recovered Overheads
(ii)
Fixed Overhead Capacity Variance :
This variance relates to capacity uitlisation of the plant and machinery.
The actual capacity utilised may be less or more than the standard capacity. This
variance is the difference between the budgeted hours of input and the actual
hours of input multiplied by standard fixed overhead rate.
Symbolically it is : (BH - AH) x SR
274 Management Accounting - II
It would be seen that total of overhead efficiency and capacity variance
would be equal to overhead volume variance.
Variance Analysis :
Overhead Cost Variance
ILLUSTRATION 5
From the following information, compute Fixed Overhead Cost, Expenditure
and Volume Variances : Normal capacity is 5,000 hours. Budgeted fixed overhead
rate is ` 10 per standard hour. Actual level of capacity utilised is 4,400 standard
hours. Actual fixed overheads ` 5,200.
NOTES
SOLUTION
Fixed Overhead Cost Variance = (Recovered Fixed Overhead - Actual Fixed
Overhead)
Fixed Overhead Expenditure
=
` 44,000 - ` 5,200 = ` 38,800 (Fav.)
=
(Budgeted Fixed Overhead - Actual Fixed
Variance
Fixed Overhead
Expenditure Variance
Fixed Overhead
Volume Variance
Overhead)
=
` 50,000 - ` 5,200 - ` 44,800 (Fav.)
=
(Budgeted Fixed Overhead - Actual Fixed
Overhead)
=
` 50,000 - ` 5,200 = ` 44,800 (Fav.)
=
=
(Recovered Fixed Overhead - Budgeted
Fixed Overhead)
` 44,000 - ` 50,000 = ` 6,000 (Adv.)
Calender Variance :
It is part of the capacity variance, and is attributed to the number of days
in a period being less or more than those budgeted, it arises to the hours worked
being more or less than the hours budgeted. As the number of hours worked are
normally within the control of management, the calender factor is not so
controllable. Therefore, it is the difference between the number of working days
anticipated in the budgeted period and the actual working days in the budgeted
period. For calculating standard overhead recovery rate, the working days for the
whole year are calculated, and the standard days so calculated are divided by 12,
so as to give standard equal days per month. But the actual days in a month may
be more or less than the standard day. The difference may be on account of
holidays, and the different days in different months, as per calendar, e.g. January
being 31, while February 28 or 29, and April 30, and so on.
It may be computed by applying the following formula :
Management Accounting - II
275
Variance Analysis :
Overhead Cost Variance
Calender Variance :
NOTES
=
Possible Overheads
= Budgeted Overhead
=
Possible Overheads
= Possible hours x Standard Rate per hour
=
Possible hours
= Actual number of days x Standard Hours
per day
In actual science calender variance is a self adjusting variance.
ILLUSTRATION 6
(a)
The Budget for a period indicates :
Works Overhead
:
` 50,000
Works Overhead Variable
:
` 1,50,000
Normal Activity
:
100 %
During the period the actual activity was only 70% of the normal load for
a total expenditure of ` 1,50,000. What are the budget and volume variances ?
(b)
Determine the budget and capacity variance from the following data :
Estimated Factory
Overhead
:
` 25,000
Estimated Direct Labour Hours :
5,000 Hrs.
Actual Overhead Expenses
:
` 26,500
Applied Overhead Expenses
:
` 22,500
SOLUTION
Budgeted Overhead for actual activity :
Fixed Overhead
: ` 50,000
For 100 % activity Standard Overhead ` 1,50,000
For 70% of actual activity :
` 1,50,000 x 70
: ` 1,05,000
100
: ` 1,55,000
Overhead recovered for actual activity :
Variable Overhead
Fixed Overhead : ` 50,000 x
276 Management Accounting - II
: ` 1,05,000
70
100
: ` 35,000
: ` 1,40,000
(a)
Overhead Budget Variance =
(Budgeted Overhead - Actual
Overhead)
=
` 1,55,000 - ` 1,50,000
=
` 5,000 (Fav.)
Overhead Volume Variance =
(Recovered Overhead - Budgeted
Variance Analysis :
Overhead Cost Variance
NOTES
Overhead)
(b)
=
` 1,40,000 - ` 1,55,000
=
` 15,000 (Adv.)
Overhead Budget Variance =
(Budgeted Overhead - Actual
Overhead)
=
` 25,000 - ` 26,500
=
` 1,500 (Adv.)
Overhead Capacity Variance =
(Standard hours for actual output Actual hours) x Standard Overhead
rate per hour
=
(4,500 Hrs. - 5,000 Hrs.) x ` 5
=
` 2,500 (Adv.)
ILLUSTRATION 7
In a factory the standard units of production for the year were fixed at
1,20,000 units and overhead expenditures were estimated to be :
Fixed : ` 13,080
and
Variable : ` 6,720
Actual production during April of the year was 8,000 units. Each month
has 20 working days.
During the month in question there was one statutory holiday.
The actual overheads amounted to
Fixed
and
: ` 1,305.20
Variable : ` 556.80
Find out the expenditure, volume and calender variances.
Management Accounting - II
277
Variance Analysis :
Overhead Cost Variance
SOLUTION
Standard fixed overhead rate (per unit)
=
` 13,080
1,20,000 units
= ` 0.109
NOTES
Standard variable overhead rate (per unit) =
` 6,720
1,20,000 units
= ` 0.056
` 13,080
Budgeted fixed overhead per month
=
120 months
= ` 1.090
Absorbed Overhead : Fixed
= 8,000 Units x `0.109 = ` 872
Variable
= 8,000 Units x `0.056 = ` 448
Total
Actual Overheads (Total)
` 1,320
= ` 1,305.20 + ` 556.80
= ` 1,862
Calculations of Variances :
Total Overhead Cost Variance
Overhead Volume
Variance (Fixed Overhead)
=
Absorbed Overhead - Actual Overhead
=
` 1,320 - ` 1,862
=
` 542 (A)
=
(Actual Output - Standard Output) x
Standard Fixed Overhead x Rate
=
(8000 Units - 10,000 Units) x ` 0.019
=
` 218 (A)
Overhead Expenditure Variance
=
Budgeted Overhead - Actual Overhead
For Fixed Overhead
=
` 1,090 - ` 1,320.20
=
` 215.20 (A)
=
(8,000 units X ` 0.056) - 556.80
=
` 215.20 (A) + ` 108.80 (A)
=
` 324 (A)
For Variable Overhead
278 Management Accounting - II
Variance Analysis :
Overhead Cost Variance
Results can be checked :
Cost Variance
` 542 (A)
= Volume Variance + Expenditure
Variance
= ` 218 (A) + ` 324 (A)
Calender Variance (Sub-variance of volume variance)
For Overhead absorbed per day
=
NOTES
` 13,080
240 days
= ` 54.50
Calendar Variance
(Loss due to one holiday)
= ` 54.50 (A)
11.6 Managerial Uses of Variances
The main objective of variance analysis is to determine the person(s)
responsible for each variance and to pinpoint the cause(s) for incurrence of these
variances. In practice, standard cost variances are useful tools in achieving
effective cost control.
Variances, as a control technique, are computed only to fix the responsibility
for the deviation from the SC and thus ensure perfect control over the standard
cost. For purposes of control, variances are classified into “controllable” and
“uncontrollable” variances.
If a variance can be located with the responsibility of a particular individual,
it is considered to be a “controllable” variance. If variances arise from causes
beyond the control of the responsible individuals, it is considered to beuncontrollable.” For instance an increase in the price of materials and increase in
the wage rates, are often referred to as “uncontrollable” variance, whilst excessive
inputs of material in production and more then standard hours taken by direct
labourers provide example of “controllable” variance. This distinction between
controllable and uncontrollable variance is important. This facilitates careful analysis
of the controllable variance and reporting to the management so as to enable it to
implement correction action as and when needed.
Check Your Progress
Illustrate the role of variances
as a control technique.
Analysis of Standard Cost Variances :
Analysis of standard cost variances is, therefore necessary by (i)
responsibilities, (ii) causes, which is shown in Fig. 11.1 as follows :
Management Accounting - II
279
Variance Analysis :
Overhead Cost Variance
Analysis
of
standard
cost
variances
NOTES
(b)
(a)
By
Causes
By
Responsibility
Fig. 11.1 : Analysis of standard cost variances
(a)
Analysis of Variance by Responsibilities :
Standard costs facilitates cost control by revealing exact degree of efficiency
in various operations through comparison of actual figures with standard figures.
Control over cost must be applied at the place and time where the cost
originates. Variances must be identified with the manager responsible for the costs
incurred who should be held responsible for the cost. The cost factors which are
directly controllable by operating supervision must be separated from those costs
factors for which executive management is responsible.
Define titles of individuals who are responsible for each type of variance
differ among business houses. But in general the following personnel are held
responsible for variances noted against them. Following table indicate cost variances
and personnel responsible for the same.
Personnel responsible for Cost Variance :
Sr. No. Variance
1.
Materials price variance
Personnel Responsible
Purchasing agent or purchasing manager
or purchase officer.
2.
Material quantity variance Plant superintendent, departmental
supervisors, machine operators, quality
control department and material handlers
or R. D. Department / Engineering Dept.
3.
Labour rate standard
Personnel (employment) department
manager, departmental supervisor and
plant superintendent or H. R. Dept.
4.
Labour efficiency variance Plant superintendent, departmental
supervisors, production scheduling
280 Management Accounting - II
department, quality control department,
material handlers and machine operators.
5.
Overhead expenditure
Variable portion is the responsibility of the
variance
individual foreman or supervisor, they are
Variance Analysis :
Overhead Cost Variance
expected to keep actual expenses within the
budget. Fixed portion is the responsibility of
NOTES
top management / top executives.
6.
Overhead efficiency
Same personnel who are responsible for
Variance
labour efficiency variance as mentioned
Check Your Progress
Which persons are responsible
for cost variance ?
above.
7.
Overhead volume variance Top management and production scheduler
and strategist.
(b) Analysis of Variances by Causes :
Variances reflect the effect on costs which certain events or conditions
have produced. Before management can take effective action for improving control
over costs, it is necessary to know what caused the variances to arise. Therefore,
causes for the variances should be determined and plans for necessary corrective
action made either by look at carefully, underlying data and records or by discussing
possible causes with supervisors.
In short, the analysis of variances by causes is therefore an important aspect
of the use of standard costs to attain effective cost control. Following are some of
practicable causes of standard cost variances.
Possible causes of Standard Cost Variances
(a)
Materials Price Variance
1.
Recent changes in purchase price of materials or current market price.
2.
Failure to purchase anticipated quantities when standards were established
in higher prices owing to non-availability of quantity purchase discounts.
3.
Not taking cash discount delivery changes / packing etc. anticipated at the
Check Your Progress
Listout the possible causes of
standard cost variances.
time of setting standards resulting in higher prices.
4.
Substituting raw material differing from original materials specifications.
5.
Freight cost changes and changes in purchasing and storekeeping costs if
these are debited to the materials cost.
(b)
Materials Quantity Variance
1.
Poor or weak material handling.
Management Accounting - II
281
Variance Analysis :
Overhead Cost Variance
NOTES
2.
Inferior workmanship by machine operator.
3.
Faulty or defective equipment.
4.
Cheaper, defective or imperfect raw material causing excessive scrap.
5.
Inferior quality control inspection.
6.
Pilferage.
7.
Wastage due to inefficient production method or production process.
(c)
Labour Rate Variances
1.
Recent labour rate change within industry.
2.
Employing a man of a grade different from the one laid down in the standard.
3.
Labour strike leading to utilization of unskilled help.
4.
Labour layoff causing skilled labour to be retained at higher rates, so as to
prevent resignations and job switching.
5.
Employee sickness and vacation time or gap between time keeping and
time booking.
6.
(d)
1.
Paying a higher overtime allowance than provided for in the standard.
Labour Efficiency Variance
Machine breakdown, use of defective machinery and equipment or use of
defective system.
2.
Inferior raw materials.
3.
Poor or weak supervision.
4.
Lack of timely material handling.
5.
Poor employee performance.
6.
Inefficient production scheduling - delays in the routing work, materials,
tools and instructions.
7.
Inferior engineering specifications.
8.
New inexperienced employees.
9.
Insufficient training of workers.
10.
Poor working conditions - inadequate or excessive heating, lighting, ventilation
etc.
282 Management Accounting - II
(e)
Overhead Volume Variance
Variance Analysis :
Overhead Cost Variance
(Factors causing either idle time or overtime of plant and facilities)
1.
Failure to utilize usual capacity.
2.
Lack of sales order.
3.
Too much idle capacity.
4.
Inefficient utilization of existing capacity.
5.
Machine breakdown or stopping of machine.
6.
Defective materials.
7.
Labour troubles or disturbances.
8.
Power failures / Load shading.
(f)
NOTES
Overhead Efficiency Variance
All the included causes which are listed under labour efficiency variances
as mentioned above.
Analysis of variances by product : The concept of ‘variance’ which is
the valuable contribution of standard costing to cost accounting literature, is the
pillar or basis of the principle - “Management by Exception”. The most common
methods of management in the area of Financial Management are :
(a)
Management by Exception and
(b)
Management by Objective.
The different aspects of variance analysis is related to management by
objective. The concept to variance analysis is the direct contribution to the idea of
Responsibility Accounting.
Since management usually wants currents true costs when decision are to
be made with respect to pricing and related questions, variances are often analysed
by products in order to arrive at current product costs. Companies producing nonstandard goods according to customer’s specification may also help analyse
variances by job orders.
11.7 Summary
•
Overhead Cost Variance
Overhead variance represents the difference between the amount of
overhead applied to production during the period and the amount of actual overhead
cost incurred during the period. It is the difference between the standard overhead
and the actual overhead assigned to products.
Management Accounting - II
283
Variance Analysis :
Overhead Cost Variance
•
Classification of Overhead Variance
Overhead variances are classified into :
(i)
Total Fixed Overhead Variance.
(ii) Total Variable Overhead Variance.
Total Fixed Overhead Variance further divided into :
NOTES
(i)
Expenditure Variance
(ii) Volume Variance
(iii)
Efficiency Variance
(iv) Capacity Variance
(v)
Calender Variance
Total Variable overhead variance further divided into :
(i) Expenditure variance & (ii) Efficiency variance.
•
Overhead Cost Variance
It is the difference between standard cost specified for the actual production
and actual overhead cost incurred.
•
Variable Overhead Variance
The total variable overhead variance is the difference between the standard
variable overhead variance / change to production and the actual variable overheads
incurred.
•
Fixed Overhead Cost Variance
It is the difference between standard overheads recovered or absorbed for
actual output and the actual fixed overheads incurred.
•
Fixed Overhead Efficiency Variance
It is the difference between the standard hours allowed for the actual
production and the actual hours taken multiplied by speed with which the labour
force has produced the output compared with budgeted time allowed.
•
Fixed Overhead Capacity Variance
It is the difference between the budgeted hours of input and the actual
hours of input multiplied by standard fixed overhead rate.
•
Calender Variance
It is the difference between the number of working days anticipated in
budgeted period and the actual working days in the budgeted period.
•
Analysis of Standard Cost Variances
Analysis of standard cost variance is by
(i) responsibilities and
284 Management Accounting - II
(ii) by causes
11.8 Key Terms
Variance Analysis :
Overhead Cost Variance
Specific Terms used in computing overhead variances :
While computing overhead variances, some specific terms are used these
terms are as follows :
1. Hourly Rate =
2. Unit Rate
=
NOTES
Budgeted Overheads
Budgeted Overheads
Budgeted Hours
Budgeted Output in units
3. Standard Hours for Actual Output =
4. Standard Output for Actual Time =
Budgeted Hours
Budgeted Output
Budgeted Output
Budgeted Hours
x Actual Output
x Actual Output
5. Recovered or Absorbed Overheads = Actual Output x Standard Rate per
hour
or
Standard Hours for Actual Output x Standard Rate per hour
6. Budgeted Overheads = Budgeted Output x Standard Rate per unit
or
Budgeted Hours x Standard Rate per hour
7. Standard Overheads = Actual Hours x Standard Rate per hour
or
8. Standard Output for Actual Time x Standard Rate per unit
9. Actual Overheads = Actual Hours x Actual Rate per hour
or
Actual Output x Actual Rate per unit
Important points to be noted :
(1) Overhead cost variances can be calculated using standard overhead rate per
hour or standard rate per unit or both, depending upon the availability of
information.
(2) It would also be seen that ‘Budgeted Overheads’ are used for budgeted output
or budgeted time while ‘Standard Overheads’ are used for actual time or
budgeted output in actual time.
Management Accounting - II
285
Variance Analysis :
Overhead Cost Variance
NOTES
3. Words like budgeted overhead rate per unit and standard overhead rate unit,
budgeted overhead rate per hour and standard overhead rate per hour, budgeted
output and standard output, budgeted hours and standard hours have been
used interchangeably.
10. Expenditure Variance : It is the difference between the Budgetary Expenditure
and Actual Expenditure.
11. Volume Variance : It is that part of fixed overhead cost variance which arises
due to difference in Actual volume of production and Budgeted Quantity of
Products.
12. Efficiency Variance : This arises due to the difference between standard
Quantity and actual Quantity. This is related to the Labour efficiency variance.
13. Capacity Variance : It is that part of profit variance which is arise due to the
difference in planes capacity and actual capacity.
14. Calender Variance : It is arises due to the under or over recovery of fixed
overhead that result from the difference between the standard allowed working
hours and actual possible working hours in the specified year, month, or a
week.
11.9 Questions and Exercises
I - Objective Questions
(A) Multiple Choice Questions
(1)
Overhead expense Standards are based on budgeted ........
(a) Output.
(b) Sales.
(c) Expense.
(d) Turnover.
(2)
Under fixed overhead volume variance, the total of monthly calender
variances in the whole year will be always .......
(a) positive.
(b) adverse.
(c) nil.
(d) plus.
(3)
286 Management Accounting - II
Actual units are 16,000, standard Rate is ` 1.50 per unit, Budgeted fixed
overhead are ` 30,000 and actual fixed overhead are ` 32,000. Hence
Expenditure variance is ........
(a) ` 6,000 Favourable
Variance Analysis :
Overhead Cost Variance
(b) ` 8,000 unfavourable
(c) ` 2,000 Negative
(d) ` 2,000 Positive
(4)
Overhead cost Variance is the difference between ....... overheads and
actual overheads for actual output.
NOTES
(a) Fixed
(b) Variable
(c) Office
(d) Absorbed
Ans : (1 - a), (2 - b), (3 - c), (4 - d)
II.
Long Answer Questions
(1)
What is ‘Overhead cost Variance’ ? State the classification of overhead
cost variance.
(2)
What is ‘fixed overhead variance’? Explain in brief the classification of
Fixed overhead Variance.
(3)
What is ‘Variable overhead variance’? Explain in brief the classification of
variable overhead variance.
(4)
Define fixed overhead volume variance. State the various causes of fixed
overhead volume variance.
(5)
Explain ‘fixed overhead capacity variance’. What are the usual causes of
fixed overhead capacity variance.
(6)
What is ‘fixed overhead calender variance’? state the various causes of
Fixed overhead calender variance.
(7)
Define ‘Variable Overhead Efficiency Variance’. State the various causes
of variable overhead Efficiency variance.
(8)
Explain the meaning, comp utation and causes of -
(9)
(a)
Variable overhead Budget Variance
(b)
Variable overhead Efficiency Variance
(c)
Fixed overhead Expenditure Variance
(d)
Fixed overhead volume Variance
What is ‘Variance Analysis’ ? Explain the managerial uses of variances.
Management Accounting - II
287
Variance Analysis :
Overhead Cost Variance
III - Practical Problems
(1)
NOTES
(2)
From the following cost information calculate overhead variances.
Particulars
Standard
Actual
a) Fixed Overheads
` 10,000
` 10,500
b) Variable overheads
` 13,500
` 13,000
c) Output
4,000 units
3,600 units
From the following cost data relating to March, 2014 calculate
(a) Fixed overhead Expenditure variance and
(b) Fixed overhead Volume Variance
Budgeted Production - 42,000 Units
Actual Production - 46,000 Units
Actual fixed overheads - ` 1,00,000
(3)
From the following cost details find out variable overhead variances for the
month of July 2014.
a)
Actual variable overheads - ` 4,600
b)
Budgeted variable overheads - ` 7,600
c)
Actual Production - 300 Units
d)
Budgeted Production - 400 Units
e)
Actual Hours Worked - 2,900
f)
Standard Time for one unit of production - 10 Hours
11.10
288 Management Accounting - II
Further Reading
•
Bhar B.K. - Cost Accounting Methods and Problems - Kolkata- Academic
Publishers -2012
•
Prasad N. K. and Prasad A. K. - Cost and Management Accounting Kolkatta - Book Syndicate Pvt. Ltd. - 2010.
TOPIC 4
Responsibility Accounting
UNIT 12
Responsibility Accounting
UNIT 12
Responsibility Accounting
Responsibility Accounting
Structure
12.0 Introduction
NOTES
12.1 Learning Objectives
12.2 Meaning of Responsibility Accounting
12.3 Objectives and Structure of Responsibility Accounting as a Divisional
Performance Measurement
12.3.1 Measurement of Performance
12.3.2 Reporting to Different Levels of Management
12.3.3 Objects of Reporting
12.3.4 Purposes and Characteristics of Responsibility Reporting
12.3.5 Important Assumptions
12.4 Benefits of Responsibility Accounting System
12.5 Limitations of Responsibility Accounting
12.6 Types of Responsibility Centres
12.6.1 Cost/ Expenses Centres
12.6.2 Profit Centre
12.6.3 Investment Centre
12.7 Illustrations
12.8 Summary
12.9 Key Points
12.10 Questions and Exercises
12.11 Further Reading
12.0 Introduction
One of the recent developments vitally affecting the outlook and canvas of
a cost accounting has been the growth of responsibility accounting. Trying to
control costs in terms of the persons responsibility for their incurrence, it has
emerged as a powerful concept leading to great improvements in the managerial
process. The impact of this development has been so wide-spread that responsibility
accounting is now being considered as the key stone of managerial accounting,
Management Accounting - II
289
Responsibility Accounting
NOTES
the sine qua non 9 an essential element) as it were, of accounting as a managerial
tool.
Responsibility accounting is a responsibility set-up for cost control purposes.
It is an approach to cost control that relies on the performance of persons responsible
for the implementation of decisions. It is an accounting system designed to control
costs by relating executives responsible for their incurrence. Tied closely to the
control over costs, this concept emphasises “ personalisation of costs “ by putting
questions as to where the cost was incurred and who was responsible for it.
An organisation of the business is divided into various units according to the
requirements and size of the oganisation. Each unit is entrusted with a particular
function and that unit is held responsible to carry out the function for which it is
meant. Such units are called or known as Responsibility Centres or Units. Each
centre or unit is headed by a responsible official, generally designated as manager.
Manager, being the head of his unit or centre, he is responsible for carrying out the
function which his unit is expected to do.
12.1 Unit Objectives
After going through this units, you will be able to :
290 Management Accounting - II
•
Understand the meaning of responsibility accounting.
•
Explain the objectives of structure of Responsibility Accounting.
•
Know the concept of “Measurement of Performance”.
•
Know how to report to different levels of management.
•
Identify the objects of reporting.
•
Describe purpose and characteristics of Responsibility Reporting
•
Clarify the important assumptions in Responsibility Accounting.
•
Specify benefits of Responsibility Accounting.
•
Explain the limitations of Responsibility Accounting.
•
Identify various types of Responsibility Centres.
•
Explain the concept - Cost / Expenses centre, Profit centre, & Investment
centre.
•
Identify the problems involved in transfer pricing between various responsi
bility centres.
12.2 Meaning of Responsibility Accounting
Responsibility Accounting
It would be easy for a company to control costs effectively, when it evolves
a system of placing responsibilities for the incurrence of costs on those who have
authority to influence them. Such a system which identifies costs with responsible
persons is called responsibility accounting. Thus, the responsibility accounting is a
technique of managerial control. It has assumed considerable significance among
the managerial control techniques. While the other control devices are applicable
to the organisation as a whole, responsibility accounting represents a method of
measuring the performance of various divisions of an organisation.
NOTES
The technique seeks to control costs at their starting point by fixing
responsibility. Broadly speaking, responsibility accounting is designing the accounting
system according to answerability of the managers. The accumulation, classification,
measurement and reporting of financial data is so arranged that it promotes the
fixing of precise responsibility on the persons within the managerial hierarchy.
Horngreen says, “Responsibility accounting is a system which is tailored to an
organisation “. That is, it focuses attention on people, not things, shifts emphasis
from product costing to responsibility accounting.
Responsibility accounting (also called activity, or profitability accounting) is
an information system that personalises control reports by accumulating and
reporting cost and revenue information accounting to defined responsibility areas
within a company.
In small organisations, decision-making and management of the business
are often undertaken by a single individual. However,
in large organisations, decision-making is delegated to different managers having
authority over a given area of operation. When the decision authority is delegated
to managers they, in turn, are held responsible for the consequences of their decision
making. The process of delegating decision authority and responsibility in an
organisation is known as decentralisation. Managers of decentralised operations
are given decision authority and must be held responsible for the results of their
decisions. The term “responsibility accounting” refers to the accounting process
that how managers have fulfilled their responsibility.
Management Accounting - II
291
Responsibility Accounting
NOTES
12.3 Objectives and Structure of Responsibility
Accounting as aDivisional Performance
Measurement
Responsibility accounting, as a control device, is relevant to divisional
performance measurement, whereas the other control devices are applicable to
the organisation as a whole. The objectives of divisional performance measurement
are : (i) to determine the contribution that a division makes to the total organisation,
(ii) to provide a basis for evaluating the quality of the divisional manager’s
performance, and (iii) to motivate the divisional manager to operate his division in
a manner consistent with the basic goals of the organisation as a whole.
• To determine the contribution
Objectives of
Divisional
Performance
Measurement
that a division makes to the total
organisation.
• To provide a basis for evaluating
the quality of the divisional
manager’s performance and
• To motivate the divisional
manager to operate his division in
a manner consistent with the basic
goals of the organisation as a
whole.
12.3.1 Measurement of Performance
Check Your Progress
What do you mean by ‘the
concept of value added’ ?
According to the Institute of Chartered Accounts of India, the term value
added refers to “ the increase in value of a product or service resulting from an
alteration in the form, location or availability excluding the cost of bought-out
materials and services.” The concept of Value Added is used for internal decision
and performance measurement.
The Value Added is a versatile measure for evaluating performance and
efficiency of an enterprise as compared to the “Profit figure” disclosed by the
Financial Statements. Profit is the measure of performance from the view point
of owners; while value added is a performance measure available to all parties
concerned . The society can judge the utility and efficiency of a business concern
from its ability to generate wealth.
12.3.2 Reporting to Different Levels of Management
Meaning and Need
292 Management Accounting - II
Information is data evaluated for a specific purpose. The accounts
department collects data and evaluates them for specific purposes and then they
become information. No planning and control procedure is complete without prompt
and accurate feedback of operating result. Management must know how actual
profit performance compares with the objective and with past performance having
been caused by various influencing factors. The main function of Management
Accounting is to make a available information to the management in proper form
and in proper time to enable the latter to take decisions as are appropriate.
The reports are required not only by the top management but they are
equally essential to the middle and the lower levels of management. However, the
shape, size, nature and contents of reports required by the different levels of
management differ according to the functions of the different levels and the
information required by them.
Responsibility Accounting
NOTES
12.3.3 Objects of Reporting
Objects of Reporting can be stated in brief as under :
1.
To assist the management to reach sound judgements on the basis of
operating results.
2.
To secure understanding and acceptance of the judgement by the people
engaged in various aspects of the organisation.
3.
To meet the requirements of information by management at different levels.
4.
To help the top management in planning and organisation by submitting
comprehensive and concise reports.
5.
To assist the co-ordinating executives in administering policies and in
appraising the performance.
6.
Operating supervisors need reports concerning the effectiveness of their
operations showing planned performance, actual performance and variations
from the plans.
7.
To assist the management to control business operations.
8.
To disclose causes of variances, if any.
9.
To enable the management at all levels to keep itself abreast of past
performance as well as developments and to keep a check on each individual
operating levels.
Check Your Progress
How reports are required not
only by the top management
but they are equally essential
to the middle and lower levels
of management ?
12.3.4 Purposes and Characteristics of Responsibility
Reporting
Responsibility reporting implies the reporting phase of responsibility
accounting. Responsibility reporting has two purposes :
1.
To determine the degree of performance in the area of responsibility for
which the responsibility manager is directly responsible.
2.
To formulate measures to improve the performance of the responsibility
centre manager.
Management Accounting - II
293
Responsibility Accounting
Matz and Usry have mentioned the following characteristics of responsibility
reporting :
1.
Reports should fit the organisation chart, that is, the report should be
addressed to the individual responsible for the items covered by it, who, in
turn will be able to control those costs under his jurisdiction. Managers
must be educated to use the results of the reporting system.
2.
Report should be prompt and timely. Prompt issuance of a report requires
that cost records be organised so that information is available when it is
needed.
3.
Reports should be issued with regularity. Promptness and regularity are
closely tied up with the mechanical aids used to assemble and issue reports.
4.
Reports should be easy to understand. Often they contain accounting
terminology that managers with little or no accounting training find difficult
to understand, and vital information may be incorrectly communicated.
Therefore, accounting terms should be explained or modified to fit the user.
Top management should have some knowledge of the kind of items
chargeable to an account as well as the methods used to compute overhead
rates, make cost allocations, and analyse variances.
5.
Reports should convey sufficient but not excessive details. The amount and
nature of the details depend largely on the management level receiving the
report. Reports to management should neither be flooded with immaterial
facts or so condensed that management lacks vital information essential to
carrying out its responsibilities.
6.
Reports should give comparative figures, i.e., a comparison of actual with
budgeted figures or of predetermined standards with actual results and the
isolation of variances.
7.
Reports should be analytical. Analysis of underlying papers, such as time
ticket, scrap tickets, work orders, and materials requisitions, provide reasons
for poor performance which might have been due to power failure, machine
breakdown, an inefficient operator, poor quality of materials, or many other
similar factors.
8.
Reports for operating management should if possible, be stated in physical
units as well as in terms of money since monetary information may give a
foreman not trained in the language of the accountant a certain amount of
difficulty.
9.
Reports may tend to highlight departmental efficiencies and inefficiencies,
results achieved, future goals or targets.
NOTES
294 Management Accounting - II
12.3.5 Important Assumptions
Responsibility Accounting
The responsibility accounting system makes the following important assumptions:
1.
The areas of responsibility are defined for which managers should be held
responsible.
2.
Managers are only charged with the items and responsibility over which
they can exercise a significant degree of direct control.
3.
Managers should actively participate in establishing the goals or budgets
against which their performance is measured.
4.
Goals defined for each area of responsibility should be attainable with
efficient and effective performance.
5.
Control (performance) reports should contain significant information related
to each area of responsibility.
6.
Responsibility centre managers should try to accomplish the budgets and
objectives established for their respective areas of responsibility.
NOTES
Check Your Progress
Identify some important
assumptions for responsibility
accounting system.
12.4 Benefits of Responsibility Accounting System
Responsibility accounting is an important component of management control
system. It is an invaluable support to modern management. The more complex
and decentralised the operations of an enterprise, the more the significance of
responsibility accounting. It contributed to the firm’s management by providing
relevant information on a continuous basis. Besides being an information system,
responsibility accounting accomplishes many other benefits.
1.
It necessitates the need of clearly defining and communicating the corporate
objectives and individual goals.
2.
It compels management to set realistic plans and budgets.
3.
It helps to improve the quality of decision making by maximising the principle
of management by exception.
4.
It provides a system of closer control.
5.
It measures the performance of individuals in an objective manner.
6.
It facilitates decentralization of decision-making.
7.
It fosters a sense of cost-consciousness among managers and their
subordinates.
8.
It recongnises various decision centres throughout an organisation and traces
costs to the individual managers.
9.
It refers to the accounting process that reports how well managers have
fulfilled their responsibility.
Check Your Progress
How
responsibility
accounting is simply a tool for
management ?
Management Accounting - II
295
Responsibility Accounting
NOTES
Modern managements have accepted responsibility accounting as a very
useful technique. However, it should be noted that responsibility accounting can
never be a substitute of good management. It is simply a tool and a tool is insert
until it is used.
12.5 Limitations of Responsibility Accounting
While implementing the scheme, following are the limitations of responsibility
accounting.
1.
It is not easy to draw clear-cut lines of responsibility and to delegate authority
necessary to carry out the responsibility assigned. Departments of the
organisation are so intermingled and are dependent on each other, that it is
usually impossible to draw distinct responsibility lines.
2.
The system may not be accepted willingly by the staff members or the
manages. It may lose its purpose, till it is judiciously applied.
3.
At times, it ignores the personal reactions of the people, who are involved
with its implementation.
4.
Due to employees ignorance, ambition, selfishness, laziness and weakness
the individual interest may conflict with organizational interest and serious
problems of implementation may occur.
12.6 Types of Responsibility Centres
Responsibility accounting focuses on responsibility centres. Responsibility
centre is a sub-unit of an organisation under the control of a manager who is
responsible for the activities of that responsibility centre. The important criterion
for creating responsibility centre is that the unit of the organisation should be
separable and identifiable for operating purposes and its performance evaluation.
For the purpose of measuring divisional performance, the responsibility centres
are divided into : (1) expense / cost centres, (2) profit centres, and (3) investment
centres. The modus-operandi of responsibility accounting is the comparison of
budgeted and actual performance.
296 Management Accounting - II
Responsibility Accounting
Cost /
Expenses
Centres
1
NOTES
Types of
Responsibility
Centres
Profit
Centres
2
3
Investment
Centres
Fig. 12.2 : Types of Responsibility Centres
12.6.1 Cost / Expenses Centres
Cost centre is a segment whose financial performance is measured in terms
of cost. The analysis of performance is restricted to the use of resources in the
division, and what has been achieved as a consequence of consuming those
resources is not considered. Cost, as an index of performance, and therefore, the
suitability of expense centre, as a divisional performance measure, is relevant in
situations in which the revenue of a responsibility centre cannot be reliably measured,
or the segment produces one single product, or if the divisional manager is to
produce a stated quantity of output at the lowest feasible cost.
It is defined as location, person or item of equipment (or group of these) for
which costs may be ascertained and used for the purpose of cost control. In other
words it is any significant unit around which cost is collected and controlled. It is
a natural activity centre of organisation. It should be a natural unit of cost and
performance control. It is a smaller segment of activity or area os responsibility
for which costs can be collected. Thus, it represents any head of account under
which costs are gathered and recorded to facilitate their control and distribution.
Characteristics :
A cost centre should have thus the following characteristics :
(i)
It should be readily identifiable.
(ii)
It should be natural activity centre of organisation.
(iii)
It should be a natural unit of cost and performance control.
Responsibility of this centre is limited to costs only and as such only and as
such only inputs (and not outputs) are measured in monetary terms. Thus, the
accounting system is required to record only the performance of the manager or
head of this centre is judged on the basis of the cost incurred in his department /
Check Your Progress
Why responsibility centres
are divided into (i) expenses
(ii) profit and (iii) investment
centres ?
Management Accounting - II
297
Responsibility Accounting
NOTES
division or centre, disregarding its output or revenue. As a result it is not possible
to measure its effectiveness, as it is related to outputs. A measure of efficiency
can, however, be developed in a cost centre since actual costs can be related or
compared with standard or budgeted costs and the variance, if any would throw
light on efficiency of the division or divisional manager. The lowest the consumption
of resources the most efficient is the manager of the cost centre.
Types of Cost Centres :
Cost Centres may be of different types :
1.
Personal Cost Centre representing a person e.g. foreman, salesman etc.
2.
Impersonal Cost Centre, representing an equipment e.g. lathe machine,
etc.
3.
Operation Cost Centre representing, the operation of a person or machine
carrying out similar operations.
4.
Process Cost centre representing a continuous series of operations e.g.
machines or persons engaged on a specific process or a continuous sequence
of operations.
The cost centre evaluation techniques include variance analysis, and job
costing systems. However, in general, the expense centre is not a useful basis for
measuring performance of responsibility centres.
12.6.2 Profit Centre
The profit centre is a division of an organisation in which financial
performance is measured on the basis of profit (revenue - expenses). With reference
to responsibility accounting, profit related performance measure must be developed
to suit the requirements of the divisional performance measurement. The traditional
income statement format can be modified to provide the criterion for profit centre
performance. Thus, this centre is a combination of both cost centre and revenue
centre. In cost centre, only cost considered for measurement of performance of
the centre but in a profit center both the elements i.e. input and output (i.e. cost
and revenue) are measured in monetary terms. Thus, in a profit centre the measure
of performance is broader than an expense or cost centre or revenue centre. The
term revenue is not used in the strict accounting sense in a profit centre. For the
purposes of profit centre performance, revenue represents a monetary measure
of the output of a profit centre in a given accounting period whether or no the
firms actually realise the revenue in that period.
Segment Profit Contribution :
298 Management Accounting - II
Segment profit contribution is the best direct measure of profit performance
attributable to and controllable by, a segment. Segment net income may also be a
useful measure as it emphasises the long-run ability of a segment to contribute to
the profits of an organisation. Segment profit Contribution and Segment net income
may be used for (i) evaluating segment performance in relation to predetermined
objectives, (ii) competitive ranking of segments, (iii) decisions relating to the
expansion, contractions, additions or discontinuation of segments.
Responsibility Accounting
Transfer Pricing :
Although the profit centre basis is superior to expense centre, as a criterion
for divisional performance measurement, this approach suffers from certain
operational problems. These relate to criteria for profit centres, measurement of
expenses and transfer prices. Of the three, transfer price is a critical aspect of
profit centre performance evaluation. The choice of transfer pricing system has
to reconcile the requirements of managerial decision-making on the one hand, and
performance evaluation, on the other.
NOTES
Alternative Transfer Prices for Performance Evaluation :
Alternative transfer prices for performance evaluation include market-based
prices, cost- based prices, cost plus normal mark-up, incremental cost, negotiated
prices and dual prices. All of these lack one or more of the desired transfer pricing
criteria of (i) objectivity, (ii) equivalence to the value of change, and (iii) compatibility
of decision-making with the goals of the segment and those of the organisation as
a whole.
Market Price of a Product :
The market price of a product, i.e. equivalent to the intermediate product,
being transferred between segments, is by and large, the most suitable for segment
performance evaluation although it has limited value for decision-making purposes.
The performance evaluation report is given in format as below :
Management Accounting - II
299
(` )
(` )
(` )
(` )
(` )
Net Income
Less : Common firm-wide Costs
Segment Profit Contribution
Less : Attributable Segment Costs
Controllable Segment Margin
Less : Controllable Fixed Costs
Controllable Contribution Margin
Less : Controllable Variable Costs
Sales Revenue
Note : Indicate whether variance is favorable or unfavorable.
(` )
(` )
(` )
(` )
Actual
Actual
Particulars
Budget
Variance
Budget
Division B
DivisionA
Format
Peformance Evaluation Report
Variance
Budget
Total
NOTES
Actual
Variance
Responsibility Accounting
12.6.3 Investment Centre
300 Management Accounting - II
Some portion of capital of the business is invested in the fixed assets of the
business and as such reasonable return is expected from such investment. The
Chartered Institute of Management Accountants defines investment centre as a
profit centre whose performance is measured by its return on capital employed. It
is a segment of activity or area held responsible for both profits and investments.
For planning purposes, the budget estimate is a measure of rate of return on
investment. For control purposes, performance evaluation is guided by a return on
investment variance. In short, the main object of this centre is to see that maximum
return is obtained from the investment. In a sense, investment centres may be
treated as separate firms where the manager has overall responsibility of managing
inputs, outputs and investment.
The investment centre approach is an extension of the profit centre approach.
The measure of performance in an investment centre is based on the relationship
between the segment profit contribution and segment assets. There are two ways
to relate segment profit contribution to segment resources : segment rate of return
on investment and segment residual income.
Responsibility Accounting
NOTES
The segment rate of return on investment (SROI) is determined using
Equations as follows :
1. SROI =
2. SROI =
Segment Profit Contribution (SPC)
Segment resources/Assets (SR/SA)
(SPC)
Segment Sales Revenue
x
x 100
Segment Sales Revenue
Segment Assets
Check Your Progress
How, the segment rate of
return on investment (SROI)
is determined ?
The other variants of SROI are calculated as per Equations 3 and 4
SPC before Interest
3. SROI (Operating) =
x 100
Segment Total Assets
4. SROI (Net) =
SPC after Interest
x 100
Segment Net Assets
The measurement of segment residual income (SRI) is shown by Equations as
follows :
5.
SRI = SPC - (SROI x SR).
The segment ROI, as a measure of divisional performance, has the merit of
being a generally accepted measured consistent with firm-wise rate of return
analysis. It is, moreover, a relative measure. It is conceptually easy to understand
and interpret, and it can provide incentive for optimal utilisation of the resources
of the firm.
Operational Problems :
In spite of its conceptual soundness and appeal, it suffers from certain
operational problems. These are :
(i)
determination of the segment investment base, and
(ii)
determination of the segment contribution.
The problem of measuring segment resources are basically problems of
allocation and valuation. The determination of contribution margin is associated
with the problem of transfer pricing and the treatments of tax and interest.
Management Accounting - II
301
Responsibility Accounting
NOTES
Advantage of Investment Centre Approach :
An alternative measure of financial performance in an investment centre is
the segment residual income. The main advantage of this approach is that it
encourages capital investment any time a divisional manager can earn more than
a required rate of return. It also allows different rates of return for different
divisions and, thus, is consistent with the decision-criterion in capital budgeting.
Thus, it overcomes some of the shortcoming of the SROI analysis.
In brief, among the approaches to measure performance in investment centre
analysis, segment residual income is conceptually superior but segment ROI is
more widely-used.
An investment centre is evaluated on the basis of rate of return which is
calculated as follows :
Check Your Progress
Return on Assets =
Earning of Investment Centre
Investment Centre Assets
How ROI is more widely used
in
investment
centre
approach ?
The actual return on assets compared with budgeted return on assets
indicates the financial performance of an Investment centre to different level of
management . The preparation of Responsibility Accounting Reports can be
understood with the help of following illustrations.
12.7 Illustrations
ILLUSTRATION 1
In Kohinoor Cotton Textile Mill, the spinning superintendent, weaving
superintendent and the processing superintendent report to the Mill Manager, who
along with the Chief Engineer reports to Director (Technical). The Sales Manager
along with Publicity Manager reports to Director (Marketing) who along with the
Director ( Technical ) reports to the Managing Director. The following data have
been extracted from the book for 2013-14.
Particulars
Budget
`
Travelling Expenses
`
40,000
2,000 A
Publicity Department Salaries and Administration
1,20,000
10,000 A
Sales Commission
2,00,000
10,000 F
Spinning Department Labour
8,00,000
40,000 A
Weaving Department Labour
6,00,000
20,000 A
28,00,000
1,20,000 A
Process House Material
7,00,000
60,000 F
Maintenance Stores
2,00,000
10,000 F
Raw Materials
302 Management Accounting - II
Variances
Processing Department Labour
5,00,000
12,000 A
Maintenance Department Labour
2,60,000
5,000 F
Utilities -
Spinning Department
1,50,000
15,000 A
Weaving Department
2,00,000
10,000 F
Processing Department
3,00,000
50,000 A
50,000
10,000 A
Weaving Materials
1,00,000
5,000 A
Sales Department Salaries and Administration
1,00,000
5,000 F
`Publicity Expenses
1,00,000
2,000 F
1,75,000
25,000 A
2,00,000
10,000 F
Administration
2,50,000
20,000 A
Mill Manager’s Salaries and Administration
1,00,000
5,000 A
1,00,00,000
12,00,000 A
Maintenance Department
Responsibility Accounting
NOTES
Director (Technical) Office Salaries and
Administration
Director (Marketing) Office Salaries and
Administration
Managing Director’s Office Salaries and
Sales
A = Adverse, F = Favorable
Prepare responsibility accounting reports for Managing Director, Director
(Marketing ), Director ( Technical ) and Mill Manager.
Management Accounting - II
303
Responsibility Accounting
SOLUTION
In the books of Kohinoor Textile Mill
Responsibility Accounting Reports for 2013-14
Particulars
NOTES
1.
For Mill Manager :
(A)
Spinning Superintendent :
`
`
`
2,92,000 1,20,000(A)
Labour
8,00,000
8,40,000
40,000(A)
Utilities
1,50,000
1,65,000
15,000(A)
37,50,000
39,25,000
1,75,000(A)
Materials
1,00,000
1,05,000
5,000(A)
Labour
6,00,000
6,20,000
20,000(A)
Utilities
2,00,000
1,90,000
10,000(F)
Weaving Superintendent :
9,00,000 9,15,000 15,000(A)
Processing Superintendent :
Raw Materials
7,00,000
6,40,000
60,000(F)
Labour
5,00,000
5,12,000
12,000(A)
Utilities
3,00,000
3,50,000
50,000(A)
15,00,000 15,02,000
2,000 (A)
Total C
(D)
Variance
28,00,00
Total B
(C)
Actual
Raw Materials
Total A
(B)
Budget
Mill Manager’s Salaries and
Administration :
1,00,000
1,05,000
5,000 (A)
Tortal for Mill Manager i.e.
A+B+C+D
2.
62,50,000 64,47,000 1,97,000 (A)
For Chief Engineer :
Maintenance
- Stores
2,00,000
1,90,000
10,000 (F)
- Labour
2,60,000
2,55,000
5,000 (F)
- Utilities
50,000
60,000
10,000 (A)
5,10,000 5,05,000
5,000 (F)
Total for Chief Engineer
304 Management Accounting - II
3.
Mill Manager
4.
Responsibility Accounting
For Director (Technical) :
62,50,000 64,47,000 1,97,000(A)
Chief Engineer
5,10,000
5,05,000
5,000(F)
Office Salary and Administration
1,75,000
2,00,000
25,000(A)
Total for Director (Technical)
69,35,000
71,52,000
2,17,000(A)
NOTES
For Director (Marketing) :
(A) Sales Manager :
Sales (Income)
1,00,00,000
Expenditure - Travelling
- Commission
88,00,000 12,00,000 (A)
40,000
42,000
2,000 (A)
2,50,000
2,40,000
10,000 (F)
1,00,000
95,000
5,000(F)
3,90,000
3,77,000
13,000 (F)
- Salary and
Administration
Total for A
(B) Publicity Manager :
Salary and Administration
1,20,000
1,30,000
10,000(A)
Public Expenses
2,00,000
1,98,000
2,000 (F)
3,20,000 3,28,000
8,000 (A)
Total for B
(C) Director - Marketing :
Sales Manager :
Income
1,00,00,000 88,00,000 12,00,000 (A)
Expenses
3,90,000
3,77,000
13,000 (F)
Publicity Manager Expenses
3,20,000
3,28,000
8,000 (A)
Office Salary and Administration
2,00,000
1,90,000
10,000 (F)
9,10,000 8,95,000
15,000 (F)
Total Expenses
5.
For Managing Director :
Office Staff
2,50,000
2,70,000
20,000(A)
Director Marketing
9,10,000
8,95,000
15,000(F)
Director Technical
69,35,000 71,52,000 2,17,000(A)
Total Expenses
80,95,000
83,17,000
2,22,000 (A)
Sales
1,00,00,000
88,00,000 12,00,000 (A)
Profit
19,05,000
4,83,000 14,22,000 (A)
Management Accounting - II
305
Responsibility Accounting
ILLUSTRATION
2
Nicefit Manufacturers ready-made garments by a simple process of cutting
the clothes in various shapes and sewing the corresponding pieces together to
form the finishes product.
NOTES
The Sewing Department and the Cutting Department report to the Production
Manager who along with the Engineering Manager report to the Director Manufacturing. The Sales Manager, Publicity Manager and the Credit Manager
report to the Director, Marketing who along with the Director, Manufacturing
report to the Managing Director of the company.
The Accounts Department reports the following for the last quarter of 2014
Particulars
Bad Debts Losses
Budgeted
Actual
(` )
(` )
5,000
3,000
Cloth used
31,000
36,000
Advertising
4,000
4,000
Audit Fees
7,500
7,500
Credit Reports
1,200
1,050
Sales Representative’s Traveling Expenses
9,000
10,200
Sales Commission
7,000
7,000
Cutting Labour
6,000
6,600
500
450
17,000
18,400
8,000
8,000
Cutting Utilities
800
700
Sewing Utilites
900
950
Salaries and Administration Expenses
20,000
21,400
Production Engineering Expenses
13,000
12,200
Sales Management Office Expenses
16,000
15,700
Production Manager Office Expenses
18,000
17,000
21,000
20,100
Thread
Sewing Labour
Credit Department Salaries
Director Marketing -
Director, Manufacturing - Salaries and
Administration Expenses
Using the above data, prepare responsibility accounting reporting reports
for the Director, Marketing ; the Director, Manufacturing and the Production
Manager.
306 Management Accounting - II
Responsibility Accounting
SOLUTION
In the books of Nicefit Manufacturers
Responsibility Accounting Reports
for the quarter ending 31st March 2014
Particular
Budgeted
Actual Variance
(` )
(` )
Remarks
NOTES
(` )
For the Production Manager
Cutting Department :
Cloth
31,000 36,000 5,000 (Unfavourable)
Cutting Labour
6,000
6,600
Cutting Utilities
800
700
Total Cutting Department (A)
600 (Unfavourable)
100
(Favourable)
37,800 43,300 5,500 (Unfavourable)
Sewing Department :
Thread
Sewing Labour
Sewing Utilities
Total Sewing Department (B)
Total (A + B)
For the Director, Manufacturing
500
450
50
(Favourable)
17,000 18,400 1,400 (Unfavourable)
900
950
50 (Unfavourable)
18,400 19,800 1,400 (Unfavourable)
56,200 63,100 6,900 (Unfavourable)
56,200 63,100 6,900 (Unfavourable)
Production Department
Production Engineering Expenses
13,000 12,200
800
(Favourable)
Production Manager, Office Expenses
18,000 17,000 1,000
(Favourable)
Total
87,200 92,300 5,100 (Unfavourable)
(As per Responsibility Accounting Report for the Production Manager).
For the Director, Marketing :
Sales representative
Travelling expenses
9,000 10,200 1,200 (Unfavourable)
Sales Commission
7,000
Total (A)
7,000
-
16,000 17,200 1,200
(Unfavourable)
Sales Management :
Office Expenses (B)
Advertising (C)
16,000 15,700
300
(Favourable)
4,000
4,000
-
8,000
8,000
-
Credit Reports
1,200
1,050
150
(Favourable)
Bad Debts Losses
5,000
3,000 2,000
(Favourable)
Credit Department :
Salaries
Total (D)
14,200 12,050 2,150 (Favourable)
Total (A+B+C+D)
50,200 48,950 1,250 (Favourable)
Management Accounting - II
307
Responsibility Accounting
ILLUSTRATION 3
Texmo Ltd. Manufacturing company has five plants A,B,C,D and E . Each
plant has a forming, cleaning and packing department. Each level of management
has responsibility over costs incurred as its level.
NOTES
The budget for the current year 2013-14 has been set up as follows :
Plant
Budgeted Cost
(` )
A
67,500
B
61,250
C
54,200
D
67,500
E
67,500
Budgeted information for Plant C is as follows :
Plant Manager’s Office
` 1,175
Forming Department
15,000
Cleaning Department
27,725
Packing Department
10,300
Budgeted information for Plant C forming Department is as follows :
Direct Materials
` 4,167
Direct Labour
7,500
Factory Overhead
3,333
The following additional budgeted data are available :
President, Office
8,125
Vice-President, Marketing
10,000
Vice-President, Manufacturing Office
2,084
The following actual costs are incurred during the year :
Plant
Actual Cost
(` )
308 Management Accounting - II
A
63,825
B
62,150
C
54,238
D
65,550
E
68,400
The actual cost for Plant C (Forming Department) were as follows :
Direct Materials
Responsibility Accounting
` 167 under budget
Direct Labour
2,000 under budget
Factory Overhead
167 over budget
NOTES
Actual costs for Plant C (Plant Manager) were :
Plant Manager’s Office
1,238
Cleaning Department
28,750
Packing Department
11,250
Forming Department
Actual Costs for the President’s level were :
President, Office
Vice-President, Marketing
Vice-President, Manufacturing
8,188
14,900
3,16,658
Prepare a responsibility accounting report for the year showing the details of the
budgeted, actual and variance accounts for the following areas :
Level 1
Forming Department - Plant C
Level 2
Plant Manager, Plant C
Level 3
Vice-President, Manufacturing
Level 4
President
Management Accounting - II
309
Responsibility Accounting
SOLUTION
In the books of Texmo Ltd.
Responsibility Accounting Report for the year 2013-14
Particulars
NOTES
Budgeted
(` )
Actual
(` )
Variance
(` )
President (Level 4)
President’s Office
8,125
8,188
63
10,000
14,900
4,900
3,20,034
3,16,658
(3,376)
3,38,159
3,39,746
1,587
2,084
2,495
411
Plant A
67,500
63,825
(3,675)
Plant B
61,250
62,150
900
Plant C
54,200
54,238
38
Plant D
67,500
65,550
(1,950)
Plant E
67,500
68,400
900
3,20,034
3,16,658
(3,376)
Vice-President, Marketing
Vice-President, Manufacturing
Total Controllable Costs
Vice-President, Manufacturing : (Level 3)
Vice-President, Manufacturing Office
Total Controllable Costs
Plant Manger, Plant C (Level 2)
Plant Manager’s Office
1,175
1,238
63
Forming Department
15,000
13,000
(2,000)
Cleaning Department
27,725
28,750
1,025
Packing Department
10,300
11,250
950
54,200
54,238
38
Direct Materials
4,167
4,000
(167)
Direct Labour
7,500
5,500
(2,000)
Factory Overhead
3,333
3,500
167
15,000
13,000
(2,000)
Total Controllable Costs
Forming Department, Plant C (Level 1)
Total Controllable Costs
310 Management Accounting - II
12.8 Summary
•
Responsibility accounting is an information system that personalised control
reports by accumulating and reporting cost and revenue information
according to defined responsibility areas within a company.
•
Objectives of Divisional Performance Measurement : (i) To determine the
contribution that a division make to the total organisation. (ii) To provide a
basis for evaluating the quality of the divisional manager’s performance
and (iii) To motivate the divisional manager to operate his division in a manner
consist with the basic goals of the organisation as a whole.
•
Responsibility reporting has two purposes : (i) To determine the degree of
performance in the area of responsibility for which the responsibility manager
is directly responsible. (ii) To formulate measures to improve the
performance of the responsibility centre manager.
•
Modern management have a accepted responsibility accounting as a very
useful technique. However, it should be noted that responsibility accounting
can never be substitute of good management. It is a tool and a tool is insert
until it is used.
•
The responsibility centres are divided in to : (i) expenses / cost centres (ii)
profit centres and (iii) investment centres.
Responsibility Accounting
NOTES
12.9 Key Terms
(1)
Responsibility Accounting : “Responsibility accounting is a system which
is tailored to an organisation so that costs are accumulated and reported by
levels of responsibility within the organisaton.”
(2)
Value Added : The term “value added refers to the increase in value of a
product or service resulting from an alternation in the form, location or
availability excluding the cost of bought-out materials and services.” The
concept of ‘Value Added’ is used for internal decision and performance
measurement.
(3)
Cost Centre : Cost Centre is a segment whose financial performance is
measured in terms of cost.
(4)
Profit Centre : The profit centre is a division of an organisation in which
financial performance is measured on the basis of profit (revenue(-))
expenses.
(5)
Investment Centre : CIMA defines investment centre as a profit centre
whose performance is measured by its return on capital employed.
Management Accounting - II
311
Responsibility Accounting
NOTES
12.10
Questions and Exercises
I.
Objective Questions
(A)
Multiple choice Questions
(1)
In a system of responsibility accounting each and every cost must
be assigned to ----
(a)
an individual
(b)
a department
(c)
a division
(d)
a profit centre
(2)
The important use of responsibility accounting focuses attention on
management by ----
(a)
exception
(b)
objective
(c)
control
(d)
supervision
(3)
The systematic accounting process that reports on how effectively
all managers have fulfilled their individual responsibility is termed
as ----
(a)
process accounting
(b)
human resource accounting
(c)
responsibility accounting
(d)
financial accounting
(4)
A profit centre whose performance is measured by its return on
capital employed is termed as ----
(a)
cost centre
(b)
budget centre
(c)
expense centre
(d)
investment centre
II. Long Answer Questions
(1)
312 Management Accounting - II
What is ‘Responsibility Accounting’? Explain the objectives and structure
of Responsibility Accounting as a divisional performance measurement.
(2)
Define ‘Responsibility Accounting. Explain the need and importance of
reporting to different levels of management.
(3)
Explain the term ‘Responsibility Accounting’. State the important objects
and characteristics of responsibility reporting.
(4)
What do you understand by ‘Responsibility Accounting System’? Explain
in brief the important assumptions of responsibility accounting.
(5)
What is ‘Responsibility Accounting’? State clearly the important benefits
of ‘Responsibility Accounting system’.
(6)
Explain in brief the benefits and limitations of responsibility accounting
system.
(7)
Define ‘Responsibility Accounting’. Explain the types of responsibility centre.
(8)
What is ‘Cost centre’? State the important types of cost centres.
(9)
What is ‘Profit Centre’ ? How performance evaluation report is related to
profit centre.
Responsibility Accounting
NOTES
(10) What is ‘Investment Centre’? State the method to calculate Segment Rate
of Return on Investment (SROI).
III. Practical Problems
(1)
A company operates a number of divisions located in different regions.
Division A has incurred losses in the first half of the current year. Relevant
Revenue and cost data pertaining to this division are as follows :
Sales Revenue
` 6,50,000
Controllable Fixed Costs
3,50,000
Controllable fixed Costs
2,00,000
Attributable Segment Costs
50,000
Common firm-wide costs allocated to Division A
60,000
Loss
(10,000)
You are required to (i) Prepare performance evaluation report of division A
in a proper format, and (ii) Advise the management whether its operations should
be continued or shut down.
Management Accounting - II
313
Responsibility Accounting
(2) The current year’s operating results of the Hypothetical Ltd.’s three divisions
(A, B, C,) are given below :
Particulars
NOTES
Divisions (amounts in ‘000 rupees)
Sales Revenue
Less : Expenses
Segment Profit Contribution
Segment Assets
A
B
C
400
400
2,000
360
200
1,800
40
200
200
200
800
4,000
Determine the rate of return for the three divisions and risk these divisions
assuming that the firm follows investment centre basis of performance
evaluation.
(3)
Western Division of a large multinational company has prepared the following
forecasts for 2014.
`
Profit before depreciation
1,00,000
Depreciation
25,000
Net Current Assets at 1.1.2014
50,000
Net value of Fixed Assets on 1.1.2014
2,00,000
The company cost of capital is 10%.
The division is considering selling a fixed assets with a net book-value of `
7,500 which, after depreciation of ` 600, generates a profit per annum of
` 3,000. The proceeds and a subsidy from head office would be used to
purchase a new machine for ` 20,000 which would generate an annual
profit of ` 6,000 after depreciation of ` 1,500.
Require :
(i)
(ii)
(4)
314 Management Accounting - II
Assuming Western division does not sell and replace the machine, using the
opening balance sheet values calculate :
-
the division’s return on investment.
-
the division’s residual on income.
If the machine is sold and replaced, calculate :
-
the division’s return on investment.
-
the division’s residual income.
A and B are two newly established divisions of SV Ltd. These two divisions
operate as independent units. They have agreed to a 20% per annum charge
for capital provided by SV Ltd. The budget for the two divisions are :
Responsibility Accounting
Division ( `Crores)
A
B
10
15
First year
1.9
3.2
Years 2 to 8 (per annum)
2.9
4.2
Initial investment
Expected net cash flow :
NOTES
In the first year of operation, A secured 5% increase in market share in sale
of its products at the cost of B.
Require :
(i)
Evaluation the performance of the two divisions as envisaged in the budget
using ROI and residual income bases.
(ii)
Calculate the net profit of the two divisions for the first year of operation
based on the achievement of market share increase of 5% for A with
corresponding reduction in market share for B.
(5) A company expects to have ` 37,500 cash hand on 1st April, 2014 and
requires you to prepare an estimate of cash position during the three months April
to June 2014. The following information is supplied to you.
2014
Sales
Purchase Wages
Months
Factory
Office
Expenses
Expenses
Selling
February
75,000
45,000
9,000
7,500
6,000
5,500
March
84,000
48,000
9,750
8,250
6,000
4,500
April
90,000
52,500
10,500
9,000
6,000
5,250
May
1,20,000
60,000
13,500
11,250
6,000
6,570
June
1,35,000
60,000
14,250
14,000
7,000
7,000
(i)
Period of credit allowed by suppliers - 2 months.
(ii)
20 % of sales is for cash and period of credit allowed to customers for
credit sales in one months.
(iii)
Delay in payment of all expenses - 1 month.
(iv)
Income tax of `57,500 is due to be paid on June 15, 2014
(v)
The company is to pay dividends to shareholders and bonus to workers of `
15,000 and ` 22,500 respectively in the month of April 2014.
(vi)
Plant has been ordered to receive and paid in May 2014 It will cost
1,20,000
`
Management Accounting - II
315
Responsibility Accounting
NOTES
316 Management Accounting - II
12.11
Further Reading
•
Rustagi R. P. - Fundamentals of financial Management - New Delhi Galgotia Publishing Co. - 2010
•
Sharan Vyuptakesh - Fundamentals of financial management - New Delhi
- Pearson Education Pvt. Ltd. 2010