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Faculty Development Program 09 - 2010

Costing of Apparel Product

[Type the document subtitle]

Manish Solanki 5/14/2010

Chapter 1

Introduction to Cost Accounting (a) Objectives and scope of Cost Accounting (b) Cost centres and Cost units (c) Cost classification for stock valuation, Profit measurement, Decision making and control (d) Coding systems (e) Elements of Cost (f) Cost behaviour pattern, Separating the components of semi-variable costs (g) Installation of a Costing system (h) Relationship of Cost Accounting, Financial Accounting, Management Accounting and Financial Management Learning Objectives When you have finished studying this chapter, you should be able to Understand the objective and importance of Cost Accounting. Understand the cost accounting terminology. Differentiate between cost accounting and financial accounting Understand the relationship between Cost Accounting, Financial Accounting, Management Accounting and Financial Management. Understand the concept of codes and the process of codification. Understand the various types and methods of cost accounting

Definition of Costing, Cost Accounting and Cost Accountancy: Costing is defined as the technique and process of ascertaining costs. Cost Accounting is defined as "the process of accounting for cost which begins with the recording of income and expenditure or the bases on which they are calculated and ends with the preparation of periodical statements and reports for ascertaining and controlling costs." Cost Accountancy has been defined as the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of information derived there from for the purpose of managerial decision making. OBJECTIVES OF COST ACCOUNTING The main objectives of Cost Accounting are as follows : (i) Ascertainment of cost. (ii) Determination of selling price. (iii) Cost control and cost reduction. (iv) Ascertaining the profit of each activity. (v) Assisting management in decision-making. Ascertainment of Cost: There are two methods of ascertaining costs, viz., Post Costing and Continuous Costing. Post Costing means, analysis of actual information as recorded in financial books. It is accurate and is useful in the case of Cost plus Contracts where price is to be determined finally on the basis of actual cost. Continuous Costing, aims at collecting information about cost as and when the activity takes place so that as soon as a job is completed the cost of completion would be known. This involves careful estimates being prepared of overheads. In order to be of any use, costing must be a continuous process. Cost ascertained by the above two methods may be compared with the standard costs which are the target figures already compiled on the basis of experience and experiments.

Determination of selling price: Though the selling price of a product is influenced by market conditions, which are beyond the control of any business, it is still possible to determine the selling price within the market constraints. For this purpose, it is necessary to rely upon cost data supplied by Cost Accountants. Cost control and cost reduction: as The guidance and regulation, by executive action of the cost of operating an undertaking. The word guidance indicates a goal or target to be guided; regulation indicates taking action where there is a deviation from what is laid down; executive action denotes action to regulate must be initiated by executives i.e. persons responsible for carrying out the job or the operation; and all this is to be exercised through modern methods of costing in respect of expenses incurred in operating an undertaking. To exercise cost control, broadly speaking the following steps should be observed: (i) Determine clearly the objective, i.e., pre-determine the desired results; (ii) Measure the actual performance; (iii) Investigate into the causes of failure to perform according to plan; and (iv) Institute corrective action. The target cost and/or targets of performance should be laid down in respect of each department or operation and these targets should be related to individuals who, by their action, control the actual and bring them into line with the targets. Actual cost of performance should be measured in the same manner in which the targets are set up, i.e. if the targets are set up operation-wise, then the actual costs should also be collected operation-wise and not cost centre or department-wise as this would make comparison difficult. Cost Reduction may be defined "as the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for the use intended or diminution in the quality of the product." Cost reduction should not be confused with Cost control. Cost saving could be a temporary affair and may be at the cost of quality. Cost reduction implies the retention of the essential characteristics and quality of the product and thus it must be confined to permanent and genuine savings in the cost of manufacture, administration, distribution and selling, brought about by elimination of wasteful and inessential elements from the design of the product and from the techniques carried

out in connection therewith. In other words, the essential characteristics and quality of the products are retained through improved methods and techniques and thereby a permanent reduction in unit cost is achieved. The definition of cost reduction does not, however, include reduction in expenditure arising from reduction in taxa-tion or similar Government action or the effect of price agreements. The three-fold assumptions involved in the definition of cost reduction may be summarised as under : (a) There is a saving in unit cost. (b) Such saving is of permanent nature. (c) The utility and quality of the goods and services remain unaffected, if not improved. Ascertaining the profit of each activity : The profit of any activity can be ascertained by matching cost with the revenue of that activity. The purpose under this step is to determine costing profit or loss of any activity on an objective basis. Assisting management in decision making : Decision making is defined as a process of selecting a course of action out of two or more alternative courses. For making a choice between different courses of action, it is necessary to make a comparison of the outcomes, which may be arrived under different alternatives. Such a comparison has only been made possible with the help of Cost Accounting information. IMPORTANCE OF COST ACCOUNTING TO BUSINESS CONCERNS Management of business concerns expects from Cost Accounting a detailed cost information in respect of its operations to equip their executives with relevant information required for planning, scheduling, controlling and decision making. To be more specific, management expects from cost accounting - information and reports to help them in the discharge of the following functions : (a) Control of material cost : Cost of material usually constitute a substantial portion of the total cost of a product. Therefore, it is necessary to control it as far as possible. Such a control may be exercised by ( i) Ensuring un-interrupted supply of material and spares for production. ( ii) By avoiding excessive locking up of funds/capital in stocks of materials and stores. ( iii) Also by the use of techniques like value analysis, standardisation etc. to control material cost. (b) Control of labour cost : It can be controlled if workers complete their work within the standard time limit. Reduction of labour turnover and idle time too help us, to control labour cost.

(c) Control of overheads : Overheads consists of indirect expenses which are incurred in the factory, office and sales department ; they are part of production and sales cost. Such expenses may be controlled by keeping a strict check over them. (d) Measuring efficiency : For measuring efficiency, Cost Accounting department should provide information about standards and actual performance of the concerned activity. (e) Budgeting : Nowadays detailed estimates in terms of quantities and amounts are drawn up before the start of each activity. This is done to ensure that a practicable course ofaction can be chalked out and the actual performance corresponds with the estimated or budgeted performance. The preparation of the budget is the function of Costing Department. (f) Price determination: Cost accounts should provide information, which enables the management to fix remunerative selling prices for various items of products and services in different circumstances. (g) Curtailment of loss during the off-season: Cost Accounting can also provide information, which may enable reduction of overhead, by utilising idle capacity during the off-season or by lengthening the season. (h) Expansion: Cost Accounts may provide estimates of production of various levels on the basis of which the management may be able to formulate its approach to expansion. (i) Arriving at decisions: Most of the decisions in a business undertaking involve correct statements of the likely effect on profits. Cost Accounts are of vital help in this respect. In fact, without proper cost accounting, decision would be like taking a jump in the dark, such as when production of a product is stopped. VARIOUS REPORTS PROVIDED BY COST ACCOUNTING DEPARTMENT

Following reports may be provided by a Cost Accounting Department for the use of its executives: (a) Cost sheets setting out the total cost, analysed into various elements, giving comparative figures for the previous period and for other plants under the same management. (b) Consumption of material statements, showing total quantity of materials issued for production, materials actually embodied in production and wastage. (c) Labour utilisation statements providing details about the total number of hours paid for, standard hours for the output, idle time (and amount involved) and causes thereof.

(d) Overheads incurred compared with budgets; overheads actually charged to production and the difference between the amount actually incurred and the amount so charged. (e) Sales effected compared with budgets, showing the difference between the two because of quality being different from those taken into account while budgeting. (f) Reconciliation of actual profit earned with estimated or budgeted profit. (g) The total cost of abnormally spoiled work in the factory and abnormal losses in the store. (h) The total cost of inventory carried, analysed into raw materials in chief stores and other stores. The number of months for which stocks would be sufficient (on the basis of average consumption being worked out). (i) Labour turnover, and the cost of recruitment and training of new employees. (j) Expenses incurred on Research and Development as compared with the budgeted amount. Reports about particular departments and operations (like transport or power generation) may also be compiled and submitted to the departmental manager concerned. ADVANTAGES OF A COST ACCOUNTING SYSTEM Important advantages of a Cost Accounting System may be listed as below : 1. A good Cost Accounting System helps in identifying unprofitable activities, losses or inefficiencies in any form. 2. The application of cost reduction techniques, operations research techniques and value analysis technique, helps in achieving the objective of economy in concerns operations. Continuous efforts are being made by the business organisation for finding new and improved methods for reducing costs. 3. Cost Accounting is useful for identifying the exact causes for decrease or increase in the profit/loss of the business. It also helps in identifying unprofitable products or product lines so that these may be eliminated or alternative measures may be taken. 4. It provides information and data to the management to serve as guides in making decisions involving financial considerations. Guidance may also be given by the Cost Accountant on a host of problems such as, whether to purchase or manufacture a given component, whether to accept orders below cost, which machine to purchase when a number of choices are available.

5. Cost Accounting is quite useful for price fixation. It serves as a guide to test the adequacy of selling prices. The price determined may be useful for preparing estimates or filling tenders. 6. The use of cost accounting technique viz., variance analysis, points out the deviations from the pre-determined level and thus demands suitable action to eliminate such deviations in future. 7. Cost comparison helps in cost control. Such a comparison may be made from period to period by using the figures in respect of the same unit of firms or of several units in an industry by employing uniform costing and inter-firm comparison methods. Comparison may be made in respect of costs of jobs, processes or cost centres. 8. A system of costing provides figures for the use of Government, Wage Tribunals and other bodies for dealing with a variety of problems. Some such problems include price fixation, price control, tariff protection, wage level fixation, etc. The cost of idle capacity can be easily worked out, when a concern is not working to full capacity. 10. The use of Marginal Costing technique, may help the executives in taking short term decisions. This technique of costing is highly useful during the period of trade depression, as the orders may have to be accepted during this period at a price less than the total cost. 11. The marginal cost has linear relationship with production volume and hence in formulating and solving Linear Programming Problems, marginal cost is useful. ESSENTIAL FACTORS FOR INSTALLING A COST ACCOUNTING SYSTEM As in the case of every other form of activity, it should be considered whether it would be profitable to have a cost accounting system. The benefits from such a system must exceed the amount to be spent on it. This would depend upon many factors including the nature of the business and the quality of the management. Management, which is prone to making decisions on the basis of pre-conceived notions without taking into account the information and data placed before it, cannot derive much benefit from a costing system. On the other hand management, which is in the habit of studying information thoroughly before making decisions, would require cost accounting system. Before setting up a system of cost accounting the under mentioned factors should be studied: (i) The objective of costing system, for example whether it is being introduced for fixing prices or for insisting a system of cost control.

(ii) The areas of operation of business wherein the managements action will be most beneficial. For instance, in a concern, which is anxious to expand its operations, increase in production would require maximum attention. On the other hand for a concern, which is not able, to sell the whole of its production the selling effort would require greater attention. The system of costing in each case should be designed to highlight, in signifi-cant areas, factors considered important for improving the efficiency of operations in that area. (iii) The general organisation of the business, with a view of finding out the manner in which the system of cost control could be introduced without altering or extending the organ-isation appreciably. (iv) The technical aspects of the concern and the attitude and behaviour that will be successful in winning sympathetic assistance or support of the supervisory staff and workmen. (v) The manner in which different variable expenses would be affected with expansion or cessation of different operations. (vi) The manner in which Cost and Financial accounts could be inter-locked into a single integral accounting system and in which results of separate sets of accounts, cost and financial, could be reconciled by means of control accounts. (vii) The maximum amount of information that would be sufficient and how the same should be secured without too much clerical labour, especially the possibility of collection of data on a separate printed form designed for each process; also the possibility of instruction as regards filling up of the forms in writing to ensure that these would be faithfully carried out. (viii) How the accuracy of the data collected can be verified? Who should be made responsible for making such verification in regard to each operation and the form of certificate that he should give to indicate the verification that he has carried out ? (ix) The manner in which the benefits of introducing Cost Accounting could be explained to various persons in the concern, specially those in charge of production department and awareness created for the necessity of promptitude, frequency and regularity in collection of costing data. Essentials of a good Cost Accounting System: The essential features, which a good Cost Accounting System should possess, are as follows: (i) Cost Accounting System should be tailor-made, practical, simple and capable of meeting the requirements of a business concern.

(ii) The data to be used by the Cost Accounting System should be accurate; otherwise it may distort the output of the system. (iii) Necessary cooperation and participation of executives from various departments of the concern is essential for developing a good system of Cost Accounting. (iv) The Cost of installing and operating the system should justify the results. (v) The system of costing should not sacrifice the utility by introducing meticulous and unnecessary details. (vi) A carefully phased programme should be prepared by using network analysis for the introduction of the system. (vii) Management should have a faith in the Costing System and should also provide a helping hand for its development and success. MANAGEMENT ACCOUNTING AND FINANCIAL MANAGEMENT Cost Accounting is a branch of accounting, which has been developed because of the limitations of Financial Accounting from the point of view of management control and internal reporting. Financial accounting performs admirably, the function of portraying a true and fair overall picture of the results or activities carried on by an enterprise during a period and its financial position at the end of the year. Also, on the basis of financial accounting, effective control can be exercised on the property and assets of the enterprise to ensure that they are not misused or misappropriated. To that extent financial accounting helps to assess the overall progress of a concern, its strength and weaknesses by providing the figures relating to several previous years. Data provided by Cost and Financial Accounting is further used for the management of all processes associated with the efficient acquisition and deployment of short, medium and long term financial resources. Such a process of management is known as Financial Management. The objective of Financial Management is to maximise the wealth of shareholders by taking effective Investment, Financing and Dividend decisions. Investment decisions relate to the effective deployment of scarce resources in terms of funds while the Financing decisions are concerned with acquiring optimum finance for attaining financial objectives. The last and very important Dividend decision relates to the determination of the amount and frequency of cash which can be paid out of profits to shareholders. On the other hand, Management Accounting refers to managerial processes and technologies that are focused on adding value to organisations by attaining the effective use of resources, in dynamic and competitive contexts. Hence, Management Accounting is a distinctive form of resource management which

facilitates managements decision making by producing information for managers within an organisation. COST CONCEPTS AND TERMS Cost (a) The amount of expenditure (actual or notional) incurred on or attributable to a specified article, product or activity. (here the word cost is used as a noun) (b) To ascertain the cost of a given thing. (here the word cost is used as a verb) NOTE : The word Cost can rarely stand on its own and should be qualified as to its limitation (e.g., historical, variable etc.) and related to a particular thing or object of thought e.g., a given quantity or unit of goods made or services performed. Cost object Anything for which a separate measurement of cost is desired. Examples of cost objects include a product, a service , a project , a customer , a brand category , an activity , a department , a programme. Direct costs Costs that are related to the cost object and can be traced in an economically feasible way1.9.4 Indirect costs Costs that are related to the cost object but cannot be traced to it in an economically feasible way. Pre-determined - A cost which is computed in advance before production or operations start, on the basis of specification of all the factors affecting cost, is known as a pre-determined cost. Standard Cost - A pre-determined cost, which is calculated from managements expected standard of efficient operation and the relevant necessary expenditure. It may be used as a basis for price fixing and for cost control through variance analysis. Marginal Cost - 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. Note : In this context a unit may be a single article, an order, a stage of production, a process of a department. It relates to change in output in the particular circumstances organisation. Cost of Sales - The cost which is attributable to the sales made. under consideration within the capacity of the concerned

Note: It is not uncommon to use this in a restricted sense as the production cost of goods sold. Total Cost - The sum of all costs attributable to the cost object under consideration. Cost Centre - It is defined as a location, person or an item of equipment (or group of these) for which cost may be ascertained and used for the purpose of Cost Control. Cost Centres are of two types, viz., Personal and Impersonal. A Personal cost centre consists of a person or group of persons and an Impersonal cost centre consists of a location or an item of equipment (or group of these). In a manufacturing concern there are two main types of Cost Centres as indicated below : (i) Production Cost Centre : It is a cost centre where raw material is handled for conversion into finished product. Here both direct and indirect expenses are incurred. Machine shops, welding shops and assembly shops are examples of production Cost Centres. (ii) Service Cost Centre : It is a cost centre which serves as an ancillary unit to a production cost centre. Power house, gas production shop, material service centres, plant maintenance centres are examples of service cost centres. Cost unit - It is a unit of product, service or time (or combination of these) in relation to which costs may be ascertained or expressed. We may for instance determine the cost per tonne of steel, per tonne kilometre of a transport service or cost per machine hour. Sometime, a single order or a contract constitutes a cost unit. A batch which consists of a group of identical items and maintains its identity through one or more stages of production may also be considered as a cost unit. Cost units are usually the units of physical measurement like number, weight, area, volume, length, time and value. A few typical examples of cost units are given below Industry or Product Cost Unit Basis Automobile Number Cement Tonne/per bag etc. Chemicals Litre, gallon, kilogram, tonne etc. Power Kilo-watt hour Steel Tonne Transport Passenger kilometre Responsibility Centre - It is defined as an activity centre of a business organisation entrusted with a special task. Under modern budgeting and control, financial

executives tend to develop responsibility centres for the purpose of control. Responsibility centres can broadly be classified into three categories. They are : (a) Cost Centres ; (b) Profit Centres ; and (c) Investment Centres ; Profit Centres - Centres which have the responsibility of generating and maximising profits are called Profit Centres. Investment Centres - Those centres which are concerned with earning an adequate return on investment are called Investment Centres. Cost allocation - It is defined as the assignment of the indirect costs to the chosen cost object. Cost absorption - It is defined as the process of absorbing all indirect costs allocated to or apportioned over a particular cost centre or production department by the units produced. Hence, while allocating, the relevant cost objects would be the concerned cost centre or the concerned department, while, the process of absorption would consider the units produced as the relevant cost object. For example, the overhead costs of a lathe centre may be absorbed by using a rate per lathe hour. Cost absorption can take place only after cost allocation. In other words, the overhead costs are either allocated or apportioned over different cost centres and afterwards they are absorbed on equitable basis by the output of the same cost centres. Estimated cost - Kohler defines estimated cost as the expected cost of manufacture, or acquisition, often in terms of a unit of product computed on the basis of information available in advance of actual production or purchase. Estimated cost are prospective costs since they refer to prediction of costs. Differential cost - (Incremental and decremental costs). It represents the change (increase or decrease) in total cost (variable as well as fixed) due to change in activity level, technology, process or method of production, etc. For example if any change is proposed in the existing level or in the existing method of production, the increase or decrease in total cost or in specific elements of cost as a result of this decision will be known as incremental cost or decremental cost. Imputed costs - These costs are notional costs which do not involve any cash outlay. Interest on capital, the payment for which is not actually made, is an example of imputed cost. These costs are similar to opportunity costs.

Capitalised costs These are costs which are initially recorded as assets and subsequently treated as expenses. Product costs - These are the costs which are associated with the purchase and sale of goods (in the case of merchandise inventory). In the production scenario, such costs are associated with the acquisition and conversion of materials and all other manufacturing inputs into finished product for sale. Hence, under marginal costing, variable manufacturing costs and under absorption costing, total manufacturing costs (variable and fixed) constitute inventoriable or product costs. Under the Indian GAAP, product costs will be those costs which are allowed to be a part of the value of inventory as per Accounting Standard 2, issued by the Council of the Institute of Chartered Accountants of India. Opportunity cost - This cost refers to the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action. For example, a firm financing its expansion plan by withdrawing money from its bank deposits. In such a case the loss of interest on the bank deposit is the opportunity cost for carrying out the expansion plan. Out-of-pocket cost - It is that portion of total cost, which involves cash outflow. This cost concept is a short-run concept and is used in decisions relating to fixation of selling price in recession, make or buy, etc. Outofpocket costs can be avoided or saved if a particular proposal under consideration is not accepted. Shut down costs - Those costs, which continue to be, incurred even when a plant is temporarily shutdown, e.g. rent, rates, depreciation, etc. These costs cannot be eliminated with the closure of the plant. In other words, all fixed costs, which cannot be avoided during the temporary closure of a plant, will be known as shut down costs. Sunk costs - Historical costs incurred in the past are known as sunk costs. They play no role in decision making in the current period. For example, in the case of a decision relating to the replacement of a machine, the written down value of the existing machine is a sunk cost and therefore, not considered. Absolute cost - These costs refer to the cost of any product, process or unit in its totality. When costs are presented in a statement form, various cost components may be shown in absolute amount or as a percentage of total cost or as per unit cost

or all together. Here the costs depicted in absolute amount may be called absolute costs and are base costs on which further analysis and decisions are based. Discretionary costs Such costs are not tied to a clear cause and effect relationship between inputs and outputs. They usually arise from periodic decisions regarding the maximum outlay to be incurred. Examples include advertising, public relations, executive training etc. Period costs - These are the costs, which are not assigned to the products but are charged as expenses against the revenue of the period in which they are incurred. All non-manufacturing costs such as general and administrative expenses, selling and distribution expenses are recognised as period costs. Engineered costs - These are costs that result specifically from a clear cause and effect relationship between inputs and outputs. The relationship is usually personally observable. Examples of inputs are direct material costs, direct labour costs etc. Examples of output are cars, computers etc. Explicit Costs - These costs are also known as out of pocket costs and refer to costs involving immediate payment of cash. Salaries, wages, postage and telegram, printing and stationery, interest on loan etc. are some examples of explicit costs involving immediate cash payment. Implicit Costs - These costs do not involve any immediate cash payment. They are not recorded in the books of account. They are also know as economic costs.



Direct materials : Materials which are present in the finished product(cost object) or can be economically identified in the product are called direct materials. For example, cloth in dress making; materials purchased for a specific job etc. Note: However in some cases a material may be direct but it is treated as indirect, because it is used in small quantities and it is not economically feasible to identify that quantity. Direct labour : Labour which can be economically identified or attributed wholly to a cost object is called direct labour. For example, labour engaged on the actual production of the product or in carrying out the necessary operations for converting the raw materials into finished product. Direct expenses : It includes all expenses other than direct material or direct labour which are specially incurred for a particular cost object and can be identified in an economically feasible way. Indirect materials : Materials which do not normally form part of the finished product (cost object) are known as indirect materials. These are Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.) Stores used by service departments like power house, boiler house, canteen etc. Indirect labour : Labour costs which cannot be allocated but can be apportioned to or absorbed by cost units or cost centres is known as indirect labour. Examples of indirect labour includes - charge hands and supervisors; maintenance workers; etc. Indirect expenses : Expenses other than direct expenses are known as indirect expenses. Factory rent and rates, insurance of plant and machinery, power, light, heating, repairing, telephone etc., are some examples of indirect expenses. Overheads : It is the aggregate of indirect material costs, indirect labour costs and indirect expenses. The main groups into which overheads may be subdivided are the following : (i) Production or Works overheads (ii) Administration overheads (iii) Selling overheads (iv) Distribution overheads

CLASSIFICATION OF COSTS It means the grouping of costs according to their common characteristics. The important ways of classification of costs are : (1) By nature or element (2) By functions (3) As direct and indirect (4) By variability (5) By controllability (6) By normality By Nature of Element - Under this classification the costs are divided into three categories i.e., materials cost, labour cost and expenses. This type of classification is useful to determine the total cost. By Functions - Under this classification, costs are divided according to the function for which they have been incurred. Some of the examples are : Production cost - The cost of sequence of operations which begins with supplying materials, labour and services and ends with primary packing of the product. Selling cost - The cost seeking to create and stimulate demand (sometimes termed marketing) and of securing orders. Distribution cost - The cost of the sequence of operations which begins with making the packed product available for despatch and ends with making the reconditioned returned empty package, if any available for re-use. Distribution costs include expenditure incurred in moving articles to and from prospective customers as in case of goods on sale or return basis. In the gas, electricity and water industry distribution means pipes, mains and services which may be regarded as the equivalent of packing and transportation. Administrative cost - The cost of formulating the policy, directing the organisation and controlling the operations of an undertaking which is not related directly to a production, selling and distribution, research or development activity or function. Research cost - The cost of researching for new or improved products, new applications of materials, or improved methods. Development cost - The cost of the process which begins with the implementation of the decision to produce a new or improved product or to employ a new or improved method and ends with commencement of formal production of that product or by that method.

Pre-production cost - The part of development cost incurred in making a trial production run preliminary to formal product. Note - This term is sometimes used to cover all activities prior to production including research and development, but in such cases the usage should be made clear in the context. Conversion cost - The sum of direct wages, direct expenses and overhead cost of converting raw materials to the finished stage or converting a material from one stage of production to the next. Purposes for computing product costs : The three different purposes for computing product costs are as follows : (i) Preparation of financial statements: Here focus is on inventoriable costs for complying with Accounting Standard 2 , issued by the Council of ICAI. (ii) Product pricing: It is an important purpose for which product costs are used. For this purpose, the cost of the other areas of the value chain should be included to make the product available to the customer. (iii) Contracting with government agencies: Normally such contracts are on a cost plus basis. For this purpose government agencies may not allow the contractors to recover research and development and marketing costs under cost plus contracts. By Variability - According to this classification costs are classified into three groups viz., fixed, variable and semi-variable. (a) Fixed costs - These are the costs which are incurred for a period, and which, within certain output and turnover limits, tend to be unaffected by fluctuations in the levels of activity (output or turnover). They do not tend to increase or decrease with the changes in output. For example, rent, insurance of factory building etc., remain the same for different levels of production. (b) Variable costs - These costs tend to vary with the volume of activity. Any increase in the activity results in an increase in the variable cost and vice-versa. For example, cost of direct labour, etc. (c) Semi-variable costs - These costs contain both fixed and variable components and are thus partly affected by fluctuations in the level of activity. Examples of semi variable costs are telephone bills, gas and electricity etc.

COST SHEET Cost sheet is a statement, which shows various components of total cost of a product. It classifies and analyses the components of cost of a product. Previous periods data is given in the cost sheet for comparative study. It is a statement which shows per unit cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost presented in the form of a statement is termed as Cost sheet. Cost sheet is prepared on the basis of : 1. Historical Cost 2. Estimated Cost Historical Cost Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost prepared after incurring the actual cost is called Historical Cost Sheet. Estimated Cost Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting the tender price of a job or a contract. Importance of Cost Sheet The importance of cost sheet is as follows: Cost ascertainment

The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet helps in ascertainment of cost for the purpose of determining cost after they are incurred. It also helps to ascertain the actual cost or estimated cost of a Job. Fixation of selling price

To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps in fixing selling price of a product or service by providing detailed information of the cost. Help in cost control

For controlling the cost of a product it is necessary for every manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in the control of material cost, labour cost and overheads cost at every point of production. Facilitates managerial decisions

It helps in taking important decisions by the management such as: whether to produce or buy a component, what prices of goods are to be quoted in the tender, whether to retain or replace an existing machine etc. The Components of cost are shown in the classified and analytical form in the cost sheet. Components of total cost are as follows: Prime Cost It consists of direct material, direct wages and direct expenses. In other words Prime cost represents the aggregate of cost of material consumed, productive wages, and direct expenses. It is also known as basic, first, flat or direct cost of a product. Prime Cost = Direct material + Direct Wages + Direct expenses Direct material means cost of raw material used or consumed in production. It is not necessary that all the material purchased in a particular period is used in production. There is some stock of raw material in balance at opening and closing of the period. Hence, it is necessary that the cost of opening and closing stock of material is adjusted in the material purchased. Opening stock of material is added and closing stock of raw material is deducted in the material purchased and we get material consumed or used in production of a product. It is calculated as: Material Consumed = Material purchased + Opening stock of material Closing stock of material. Factory Cost In addition to prime cost it includes works or factory overheads. Factory overheads consist of cost of indirect material, indirect wages, and indirect expenses incurred in

the factory. Factory cost is also known as works cost, production or manufacturing cost. Factory Cost = Prime cost + Factory overheads

Adjustment for stock of work-in-progress In the process of production, some units remain to be completed at the end of a period. These incomplete units are known as work-in-progress. Normally, the cost of incomplete units include direct material, direct Labour, direct expenses, and average factory overheads. Hence, at the time of computing factory cost, it is necessary to make adjustment of opening and closing stock of work in progress to arrive at the net Factory cost/works cost.

TOTAL COST AND COST SHEET If office and administrative overheads are added to factory or works cost, total cost of production is arrived at. Hence the total cost of production is calculated as: Total Cost of production = Factory Cost + office and administration Overheads Cost of goods sold It is not necessary, that all the goods produced in a period are sold in the same period. There is stock of finished goods in the opening and at the end of the period. The cost of opening stock of finished goods is added in the total cost of production in the current period and cost of closing stock of finished goods is deducted. The cost of goods sold is calculated as: Cost of goods sold = Total cost of production + Opening stock of Finished goods Closing stock of finished goods Total Cost i.e, Cost of Sales If selling and distribution overheads are added to the total cost of production, total cost is arrived at. This cost is also termed as cost of Sales. Hence the total cost is calculated as:

Total Cost = Cost of Goods sold + Selling and distribution overheads Sales If the profit margin is added to the total cost, sales are arrived at. Excess of sales over total cost is termed as profit. When total cost exceeds sales, it is termed as Loss. Sales = Total Cost + Profit

Chapter 3
Material Cost Learning Objectives When you have finished studying this chapter, you should be able to Understand the need and importance of material control. Describe the procedures involved in procuring, storing and issuing material. Differentiate amongst the various methods of valuing material. Understand the meaning and the accounting treatment for normal and abnormal loss of material. Understand the meaning and the accounting treatment of waste, scrap, spoilage and defectives

INTRODUCTION We have acquired a basic knowledge about the concepts, objectives, advantages, methods and elements of cost. We shall now study each element of cost separately. The first element of cost is Direct Material Cost. Materials constitute a very significant proportion of total cost of finished product in most of the manufacturing industries. A proper recording and control over the material costs is essential because of the following : (a) The exact quality of specification of materials required should be determined according to the required quality of the finished product. If too superior quality of material is purchased, it would mean higher cost due to high prices; if the quality of materials purchased is too low, the product will be of inferior quality. (b) The price paid should be the minimum possible otherwise the higher cost of the finished products would make the product uncompetitive in the market. (c) There should be no interruption in the production process for want of materials and stores, including small inexpensive items like lubricating oil for a machine. Sometime their out of stock situation may lead to stoppage of machines. (d) There should be no over stocking of materials because that would result in loss of interest charges, higher godown charges, deterioration in quality and losses due to obsolescence (either due to manufacture of certain articles being given up or

the material previously required for the production not being required any longer due to a change in methods of production). (e) Wastage and losses while the materials are in store should be avoided as far as possible; and (f) Wastage during the process of manufacture should be the minimum possible. It may also be added that information about availability of materials and stores should be continuously available so that production may be planned properly and the required materials purchased in time. MATERIAL CONTROL The publication of the Institute of Cost and Management Accountants on Budgetary Control defines it as the function of ensuring that sufficient goods are retained in stock to meet all requirements without carrying unnecessarily large stocks. When the functions of indexing buying, receiving, inspection, storing and paying of the goods are separated it is essential that these should be properly co-ordinated so as to achieve the advantages of specialisation. 2.2.1 Objectives of system of material control : The objectives of a system of material control are the following : (i) Ensuring that no activity, particularly production, suffers from interruption for want of materials and stores-it should be noted that this requires constant availability of every item that may be needed howsoever small its cost may be. Lubricating oil may cost much less than the main raw material but, from the point of view of uninterrupted production, both have equal importance. (ii) Seeing to it that all the materials and stores are acquired at the lowest possible price considering the quality that is required and considering other relevant factors like reliability in respect of delivery, etc. (iii) Minimisation of the total cost involved, both for acquiring stocks (apart from the price paid to the supplier) and for holding them. (iv) Avoidance of unnecessary losses and wastages that may arise from deterioration in quality due to defective or long storage or from obsolescence. It may be noted that losses and wastages in the process of manufacture, concern the production department.

(v) Maintenance of proper records to ensure that reliable information is available for all items of materials and stores that not only helps in detecting losses and pilferages but also facilitates proper production planning. The fulfilment of the objectives mentioned above will require that standard lists of all the materials and stores required for the firms work be drawn up with the weekly consumption figures. Also the lead time for each item has to be determined which will then enable the firm to ascertain the minimum quantity for each items. It is also necessary to fix maximum quantity so that capital is not locked up unnecessarily and the risk of obsolescence is minimised. Costs are minimised through the use of ABC analysis (which means classification of the various items on the basis of investment involved into three categories, viz., A, B and C.) Requirements of material control - Material control requirements are as follows: 1. Proper co-ordination of all departments involved viz., finance, purchasing, receiving, inspection, storage, accounting and payment. 2. Determining purchase procedure to see that purchases are made, after making suitable enquiries, at the most favourable terms to the firm. 3. Use of standard forms for placing the order, noting receipt of goods, authorising issue of the materials etc. 4. Preparation of budgets concerning materials, supplies and equipment to ensure economy in purchasing and use of materials. 5. Operation of a system of internal check so that all transactions involving materials, supplies and equipment purchases are properly approved and automatically checked. 6. Storage of all materials and supplies in a well designated location with proper safeguards. 7. Operation of a system of perpetual inventory together with continuous stock checking so that it is possible to determine at any time the amount and value of each kind of material in stock. 8. Operation of a system of stores control and issue so that there will be delivery of materials upon requisition to departments in the right amount at the time they are needed.

9. Development of system of controlling accounts and subsidiary records which exhibit summary and detailed material costs at the stage of material receipt and consumption. 10. Regular reports of materials purchased, issue from stock, inventory balances, obsolete stock, goods returned to vendors, and spoiled or defective units. MATERIALS PROCUREMENT PROCEDURE If a concern can afford it, there should be a separate purchase department for all purchases to be made on behalf of all other departments. Purchasing should be centralised i.e. all purchases should be done by the purchasing department except for small purchases which may be done by the users department. What is needed is that there should be staff wholly devoted to purchasing. Such a staff is bound to become expert in the various matters to be attended to, for examples units of materials to be purchased and licences to be obtained, transport, sources of supply, probable price etc. The concerned officers in this department keep themselves in constant touch with the markets either by reading various trade magazines or by direct association, to have the latest information. If a concern has a number of factories requiring the same material and stores, there will be advantage in centralising purchases since important economies in prices and even transport may be obtained by placing large orders at a time. In such a case inspection at a source may also be possible. Of course, there will be a little delay in supply because of clerical processes and sometimes, there may be a misunderstanding resulting in supply of wrong articles. However, there is no advantage in centralised purchasing if different materials, and stores are required by different plants. Materials purchase department in a business house is confronted with the following issues: (i) What to purchase ? (ii) When to purchase ? (iii) How much to purchase ? (iv) From where to purchase. (v) At what price to purchase.

To overcome the above listed issues, the purchase department follows the procedure involving following steps : 1. Receiving purchase requisitions. 2. Exploring the sources of materials supply and selecting suitable material suppliers. 3. Preparation and execution of purchase orders. 4. Receipt and inspection of materials. 5. Checking and passing of bills for payment. Receiving purchase requisitions - Since the materials and stores purchased will be used by the production departments, there should be constant co-ordination between the purchase and production departments. A purchase requisition is a form used for making a formal request to the purchasing department to purchase materials. This form is usually filled up by the store keeper for regular materials and by the departmental head for special materials (not stocked as regular items). The requisition form is duly signed by either works manager or plant superintendent, in addition to the one originating it. At the beginning a complete list of materials and stores required should be drawn up, the list should have weekly consumption figures. It should be gone through periodically so that necessary deletion and addition may be made. If there is any change in the rate of consumption per week (say, due to extra shift being worked), the purchase department should be informed about the new figures. Once an item has been included in the standard list, it becomes the duty of the purchase department to arrange for fresh supplies before existing stocks are exhausted. But if the production department requires some new material, it should make out an indent well in time and send it to the purchase department for necessary action. Control over buying - For control over buying of regular stores materials it is necessary to determine their maximum, minimum, reorder level and economic order quantities. The use of economic order quantities and various levels constitutes an adequate safeguard against improper indenting of regular materials. In respect of special materials, required for a special order or purpose, it is desirable that the technical department concerned should prepare materials specifications list

specifying the quantity, size and order specifications of materials to be drawn from the store and those to be specially procured. In all cases, the starting point in the process for purchasing is the issue of a proper purchase requisition (form is given below). (Students may note that the forms suggested in this booklet as well as in the text books are illustrative in nature. The actual form may differ under different circumstances). It may originate either in the stores department in connection with regular stock of materials or in the production planning or in other technical departments concerned in respect of special materials. Its purpose is to request and authorise the purchase department to order to procure the materials specified inpurchasing department, the duplicate is kept by the storekeeper or the department which initates the requisition and the triplicate is sent to the authorising executive. suppliers: A source for the supply of each material may be selected after the receipt of the purchase requisition. Purchase department in each business house usually maintains a list of suppliers for each group of materials, required by their concern. Atleast three quotations are invited from such suppliers. On the receipt of these quotations a comparative statement is prepared. For selecting material suppliers the factors which the purchase department keeps in its mind areprice; quantity; quality offered; time of delivery; mode of transportation; terms of payment; reputation of supplier; etc. In addition to the above listed factors purchase manager obtains the necessary information from the statement of quotations; past records, buyer guides etc. for finally selecting material suppliers. Preparation and execution of purchase orders : Having decided on the best quotation that should be accepted, the purchase manager or concerned officer proceeds to issue the formal purchase order. It is a written request to the supplier to supply certain specified materials at specified rates and within a specified period. Copies of purchase order are sent to : (i) The supplier; (ii) Store or the order indenting department; (iii) Receiving department; and (iv) Accounting department.

A copy of the purchase order, alongwith relevant purchase requisitions, is held in the file of the department to facilitate the follow-up, of the delivery and also for approving the invoice for payment. Receipt and inspection of materials: Under every system of stores organisation, a distinction is made between the function of receiving and storing, so that each acts as a check on the other. The receiving department or section is responsible for taking charge of the incoming materials, checking and verifying their quantities, inspecting them as regards their grade, quality or other technical specifications and if found acceptable, passing them on to the stores (or other departments for which these might have been purchased). In large organisation, a special inspection wing is often attached to the receiving department and, where it is not so, technical appraisal of the incoming supplies is carried out by the general inspecting staff. In case the quality is not the same as ordered, the goods are not accepted. If everything is in order and the supply is considered suitable for acceptance, the Receiving department prepares a Receiving Report or Material Inward Note or Goods Received Note. It is prepared in quadruplicate, the copies being distributed as under : (i) First copy is sent to the Purchase Department for verifying suppliers bill for payment. (ii) Second copy is sent to the store or the department that indents the material. (iii) Third copy is sent to the stores ledger clerk in the Cost Department. (iv) Fourth and the last copy is retained for use by the receiving department. A good plan would be that the receiving clerk sends all the three copies (meant for others) along with the materials to the store or the department that placed the order. The materials are then physically inspected and the particulars thereof as recorded in the Receiving Report are verified. If the quantity and quality are in order, the delivery of the same is accepted and copies of the report are signed; two copies of the report are forwarded to the Purchase Department and the third is kept on the file as documentary evidence of the quantities of stores received for storage or use, as the case may be. The Purchase Department in turn, enters the purchase price and forwards one copy to the Accounts Department and the second to the Cost Department. A specimen form of the receiving report is given below:

these have been received in the factory. Such returns may occur before or after the preparation of the receiving report. If the return takes place before the preparation of the receiving report, such material obviously would not be included in the report and hence not debited in the stores books and ledgers. In that case, no adjustment in the account books would be necessary. But if the material is returned after its entry in the receiving report, a suitable document must be drawn up in support of the credit entry so as to exclude from the Stores of Material Account the value of the materials returned back. This document usually takes the form of a Material outward return note. The Material outward return note is drawn up by the Stores or the Despatch Department. Five copies of it are usually prepared; two for the supplier (one of which is to be sent back by the supplier after he has signed the same), one for Store, one for Cost (stores) Ledger and one copy to be retained in the Material outward return book. (Please draw up the form yourself and then see the text book). Checking and passing of bills for payment : The invoice received from the supplier is sent to the stores accounting section to check authenticity and mathematical accuracy. The quantity and price are also checked with reference to goods received note and the purchase order respectively. The stores accounting section after checking its accuracy finally certifies and passes the invoice for payment. In this way the payment is2.4 MATERIAL ISSUE PROCEDURE Issue of material must not be made except under properly authorised requisition slip; usually it is the foreman of a department who has the authority to draw materials from the store. Issue of material must be made on the basis of first in first out, that is, out of the earliest lot on hand. If care is not exercised in this regard, quality of earliest lot of material may deteriorate for having been kept for a long period. Material requisition note : It is the voucher of the authority as regards issue of materials for use in the factory or in any of its departments. Where a Materials List has been prepared, either the whole of the materials would be withdrawn on its basis or separate materials requisitions would be prepared by the person or department and the material drawn upto the limit specified in the list. The Requisition Notes are made out in triplicate. The copies are distributed in the following manner : One copy for the Store-keeper. One copy for Cost department.

One copy for the Department requiring it. If no material list has been prepared, it is desirable that the task of the preparation of Material Requisition Notes be left to the Planning Department. If there is no Planning Department, (or although in existence, is unable to undertake this task), the Requisition Notes should be prepared by the person or department that requires the materials. Usually, a foremans authority is enough but, in the case of costly materials, it would be desirable to have such requisitions duly approved by some higher authority, like the Superintendent or Works Manager before these are presented to Stores. a schedule of standard quantities of materials required for any job or other unit of production. A comprehensive Materials List should rigidly lay down the exact description and specifications of all materials required for a job or other unit of production and also required quantities so that if there is any deviation from the standard list, it can easily be detected. The materials List is prepared by the Engineering or Planning Department in a standard form. The number of copies prepared vary according to the requirement of each business, but four is the minimum number. A copy of it is usually sent to each of the following department : (i) Stores department. (ii) Cost Accounts Department. (iii) Production Control department. (iv) Engineering or Planning department. The advantages of using bill of material, by the above departments may be summed up as follows: Stores Department : 1. A bill of material serves as an important basis of preparing material purchase requisitions by stores department. 2. It acts as an authorisation for issuing total material requirement. 3. The clerical activity is reduced as the stores clerk issues the entire/part of the material requirement to the users if the details of material asked are present in the bill of materials. Cost Accounts Department :

1. Bill of material, is used by Cost Accounts department for preparing an estimate/budget of material cost for the job/process/operation, it is meant. 2. It may be used as a device for controlling the excess cost of material used. This is done after determining material variances and ascertaining the reasons for their occurrence. Production Control Department : 1. Bill of material, may be used by this department for controlling usage of materials. 2. Its usage saves time which otherwise would have been wasted for preparing separate requisitions of material. Transfer of material: The surplus material arising on a job or other units of production may sometime be unsuitable for transfer to Stores because of its bulk, heavy weight, brittleness or some such reason. It may, however, be possible to find some alternative use for such materials by transferring it to some other job instead of returning it to the Store Room. It must be stressed that generally transfer of material from one job to another is irregular, if not improper, in so far it is not conducive to correct allocation and control of material cost of jobs or other units of production. It is only in the circumstances envisaged above that such direct transfer should be made, at the time of material transfer a material transfer note should be made in duplicate, the disposition of the copies of this note being are as follows : One copy for the Cost Department, and One copy for the department making the transfer. No copy is required for the Store as no entry in the stores records would be called for. The Cost Department would use its copy for the purpose of making the necessary entries. estimate of the material requirements or units of production. Besides, at times due to some technical or other difficulty, it is not practicable to measure exactly the quantity of material required by a department. In either case, material may have to be issued from stores in bulk, often in excess of the actual quantity required. Where such a condition exists, it is of the utmost importance from the point of view of materials control that any surplus material left over on the completion of a job should be promptly hand over to the storekeeper for safe and proper custody.

Unless this is done, the surplus material may be misappropriated or misapplied to some purpose, other than that for which it was intended. The material cost of the job against which the excess material was originally drawn in that case, would be overstated unless the job is given credit for the surplus arising thereon. The surplus material, when it is returned to the storeroom, should be accompanied by a document known either as a Shop Credit Note or alternatively as a Stores Debit Note. This document should be made out, by the department returning the surplus material and it should be in triplicate to be used as follows: One copy for the Store Room; One copy for the Cost Department; and One copy (book copy) for the department returning the surplus material. MATERIAL STORAGE Proper storing of materials is of primary importance. It is not enough only to purchase material of the required quality. If the purchased material subsequently deteriorates in quality because of bad storage, the loss is even more than what might arise from purchase of bad quality materials. Apart from preservation of quality, the store-keeper also must ensure safe custody of the material. It should be the function of store-keeper that the right quantity of materials always should be available in stock. 2.5.1 Duties of store keeper : These can be briefly set out as follows : 1. To exercise general control over all activities in Stores Department 2. To ensure safe keeping both as to quality and quantity of materials. 3. To maintain proper records. 4. To initiate purchase requisitions for the replacement of stock of all regular stores items whenever the stock level of any item of store approaches the minimum limit fixed in respect thereof. 5. To initiate action for stoppage of further purchasing when the stock level approaches the maximum limit. 6. To check and receive purchased materials forwarded by the receiving department and to arrange for the storage in appropriate places. 7. To reserve a particular material for a specific job when so required.

8. To issue materials only in required quantities against authorised requisition notes/material lists. 9. To check the book balances, with the actual physical stock at frequent intervals by way of internal control over wrong issues, pilferage, etc. Minimising the cost of purchasing and store-keeping : There are two types of costs which are involved in making a purchase and keeping the goods in the store. For placing each order, a certain amount of labour is required and, therefore, it will involve a certain sum of money as cost. It should be noted that the cost of making a purchase not only includes the cost incurred by the purchasing department but it also includes the cost of receiving and inspecting the goods. These costs will naturally increase if the number of order is large; there can be saving if the number of orders is reduced. The other type of cost is concerned with keeping the goods is stock, it comprises the money invested, the loss which is likely to take place if the goods are kept, the expenses incurred on looking after the items etc. Larger the stock, higher will be this type of cost. In order to reduce this cost, it is necessary to bring down level of the stock. It may be noted that the number of orders can be cut down only, if the quantity of each order is increased, but if that is done, the average quantity on hand will increase and, therefore, interest and the cost of store keeping will be higher. It is necessary, therefore to have balance between those two costs and to keep total of the two at the minimum level. With this objective in view, the economic order quantity is worked out. But different items for stock have to be treated differently. The name given to such classification is the ABC Analysis, or the Selective Inventory Control. Different classes of stores : Broadly speaking, there are three classes of stores viz., central or main stores, sub-stores and departmental stores. The central stores are the most common of all and in practice, factories generally have only a central store under the control of one store keeper. Such a store is centrally situated and is easily accessible to all departments. If receipts and issues of different items of stores are not large, and the various departments are close to each other, one central store for all purposes is sufficient. In big organisations, particularly in the case of collieries, tea gardens, etc., where the work spots are distributed over a large area, sub-stores are created. A sub-store is in fact a branch of the central store. It is generally created to facilitate easy accessibility to the various work spots or consumption centres. Only the essential items, as well

as those required urgently, are kept in them. The issues to sub-stores are not treated as con-sumption but only as a transfer, from one store (central) to another sub-store. The control in the matter of ordering or receiving rests with the central stores and the sub-stores do not generally receive any item directly. Departmental stores are created normally to minimise the time spent on drawing from stores. For example, a weeks supply may be drawn at one time and kept in a departmental store at a place marked for the purpose. Such stores, however, are essential where one or more production departments work in multiple shifts and the central store works for only one shift; also for the storage of work in progress and semi-finished components where these are large in number or in bulk. Unlike a sub store in the departmental store, the control rests with the department in charge. The materials are generally issued in bulk to the departmental store and it is the responsibility of the department-in-charge to keep proper accounts as regards issues and stock. If the bulk of materials is required for only one department, it is usually stored near the department under the charge of the super intendent concerned. Stores location : The location of store should be carefully planned. It should be near to the material receiving department so that transportation charges are minimum. At the same time, it should be easily accessible to all other departments of the factory, railway siding, roads etc. Planned location of the stores department avoids delay in the movement of materials to the departments in which they are needed. Stores layout : The store should be adequately provided with the necessary racks, drawers and other suitable receptacles for storing materials. Each place (for example, a drawer or a corner) where materials are kept is called a bin. Each bin should be serially numbered and for every item a bin should be allowed. All receipts of the item of the same type should be kept in the bin allotted, for convenience of access. The number of the bin should be entered in the Store Ledger concerned accounts. STORE RECORD The record of stores may be maintained in three forms: (a) Bin Cards (b) Stock Control Cards, (c) Stores Ledger.

The first two forms of accounts are records of quantities received, issued and those in balance, but the third one is an account of their cost also. Usually, the account is kept in both the forms, the quantitative in the store and quantitative-cum-financial in the Cost Department. Bin Cards and Stock Control Cards : These are essentially similar, being only quantitative records of stores. The latter contains further information as regards stock on order. Bincards are kept attached to the bins or receptacles or quite near thereto so that these also assist in the identification of stock. The Stock Control Cards, on the other hand, are kept in cabinets or trays or loose binders. Advantages of Bin Cards : (i) There would be less chances of mistakes being made as entries will be made at the same time as goods are received or issued by the person actually handling the materials. (ii) Control over stock can be more effective, in as much as comparison of the actual quantity in hand at any time with the book balance is possible. (iii) Identification of the different items of materials is facilitated by reference to the Bin Card the bin or storage receptacle. Disadvantages of Bin Cards : (i) Store records are dispersed over a wide area. (ii) The cards are liable to be smeared with dirt and grease because of proximity to material and also because of handling materials. (iii) People handling materials are not ordinarily suitable for the clerical work involved in writing Bin Cards. Advantages of Stock Control Cards : (i) Records are kept in a more compact manner so that reference to them is facilitated. (ii) Records can be kept in a neat and clean way by men solely engaged in clerical work so that a division of labour between record keeping and actual material handling is possible. (iii) As the records are at one place, it is possible to get an overall idea of the stock position without the necessity of going round the stores.

Disadvantages of Stock Control Cards : (i) On the spot comparison of the physical stock of an item with its book balance is not facilitated. (ii) Physical identification of materials in stock may not be as easy as in the case of bin cards, as the Stock Control Cards are housed in cabinets or trays. The specimen forms of these cards may be studied from any text book. Stores Ledger: A Modern Stores Ledger is a collection of cards or loose leaves specially ruled for maintaining a record of both quantity and cost of stores received, issued and those in stock. It being a subsidiary ledger to the main cost ledger, it is maintained by the Cost Accounts Department. It is posted from Goods Received Notes and Materials requisition. The advantages of writing up Stores Ledger mechanically are: (1) It enables distribution of work among a number of clerks due to which receipts and issues are posted quickly and regularly. (2) It enables stock records to be centralised in case of an organisation having a number of depots. (3) The accuracy of posting can be mechanically tested more conveniently. (4) The records are clearer and neater. Also the recurring cost of maintaining them is much less than those kept manually. (5) If up-to-date records are available, the management will be able to exercise greater control over quantities held in stock from time to time which may result in a great deal of saving in both the amount of investment in stock and their cost. Now-a-days, mostly a duplicate record of issues and receipt of materials is kept one on Bin Cards in the Store and the second in the Stores Ledger in the stores. The form of ruling the Store Ledger and Bin Cards should be studied from the text book. Treatment of shortages in stock taking : At the time of stock taking generally discrepancies are found between physical stock shown in the bin card and stores ledger. These discrepancies are in the form of shortages or losses. The causes for these discrepancies may be classified as unavoidable or avoidable. Losses arising from unavoidable causes should be taken care of by setting up a standard percentage of loss based on the study of the past data. The issue prices

may be inflated to cover the standard loss percentage. Alternatively, issues may be made at the purchase price but the cost of the loss or shortage may be treated as overheads. Actual losses should be compared with the standard and excess losses should be analysed to see whether they are due to normal or abnormal reasons. If they are attributable to normal causes, an additional charge to overheads should be made on the basis of the value of materials consumed. If they arise from abnormal causes, they should be charged to the Costing Profit and Loss account. Avoidable losses are generally treated as abnormal losses. These losses should be debited to the Costing Profit and Loss Account. Losses or surpluses arising from errors in documentation, posting etc., should be corrected through adjustment entries. INVENTORY CONTROL The main objective of inventory control is to achieve maximum efficiency in production and sales with the minimum investment in inventory. Inventory comprises of stocks of materials, components, work-in-progress, and finished products and stores and spares. The techniques commonly applied for inventory control are as follows: Techniques of Inventory control : (i) Setting of various stock levels. (ii) ABC analysis. (iii) Two bin system. (iv) Establishment of system of budgets. (v) Use of perpetual inventory records and continuous stock verification. (vi) Determination of economic order quantity. (vii) Review of slow and non-moving items. (viii) Use of control ratios. Setting of various stock levels:

Minimum level - It indicates the lowest figure of inventory balance, which must be maintained in hand at all times, so that there is no stoppage of production due to non-availability of inventory. The main consideration for the fixation of minimum level of inventory are as follows: 1. Information about maximum consumption and maximum delivery period in respect of each item to determine its re-order level. 2. Average rate of consumption for each inventory item. 3. Average delivery period for each item. This period can be calculated by averaging the maximum and minimum period. The formula used for its calculation is as follows: Minimum level of inventory = Re-order level (Average rate of consumption average time of inventory delivery) Maximum level : It indicates the maximum figure of inventory quantity held in stock at any time. The important considerations which should govern the fixation of maximum level for various inventory items are as follows : 1. The fixation of maximum level of an inventory item requires information about itsre-order level. The re-order level itself depends upon its maximum rate of consumption and maximum delivery period. It in fact is the product of maximum consumption of inventory item and its maximum delivery period. 2. Knowledge about minimum consumption and minimum delivery period for each inventory item should also be known. 3. The determination of maximum level also requires the figure of economic order quantity. 4. Availability of funds, storage space, nature of items and their price per unit are also important for the fixation of maximum level. 5. In the case of imported materials due to their irregular supply, the maximum level should be high. The formula used for its calculation is as follows : Maximum level of inventory = Re-order-level + Re-order quantity (Minimum consumption Minimum re-order period)

Re-order level - This level lies between minimum and the maximum levels in such a way that before the material ordered is received into the stores, there is sufficient quantity on hand to cover both normal and abnormal consumption situations. In other words, it is the level at which fresh order should be placed for replenishment of stock. The formula used for its calculation is as follows : Re-order level = Maximum re-order period Maximum Usage (or) = Minimum level + (Average rate of consumption Average time to obtain fresh supplies). Average Inventory Level - This level of stock may be determined by using the following equal Average inventory level = Minimum level + 1/2 Re-order quantity (or) = maximum level + minimum level/2 Danger level - It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made. Danger level = Average consumption Lead time for emergency purchases Illustration - Two components, A and B are used as follows : Normal usage 50 per week each Maximum usage 75 per week each Minimum usage 25 per week each Re-order quantity A : 300; B : 500 Re-order period A : 4 to 6 weeks B : 2 to 4 weeks Calculate for each component (a) Re-ordering level, (b) Minimum level, (c) Maximum level, (d) Average stock level. Solution : (a) Re-ordering level : Minimum usage per week Maximum delivery period. Re-ordering level for component A = 75 units 6 weeks = 450 units

Re-ordering level for component B = 75 units 4 weeks = 300 units (b) Minimum level : Re-order level (Normal usage Average period) Minimum level for component A = 450 units 50 units 5 weeks = 200 units Minimum level for component B = 300 units 50 units 3 weeks = 150 units (c) Maximum level : ROL + ROQ (Min. usage Minimum period) Maximum level for component A = (450 units + 300 units) (25 units 4 weeks) = 650 units Maximum level for component B = (300 units + 500 units) (25 units 2 weeks) = 750 units (d) Average stock level : (Minimum + Maximum) stock level ABC Analysis: It is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of the investment involved. Usually the items are divided into three categories according to their importance, namely, their value and frequency of replenishment during a period. (i) A Category of items consists of only a small percentage i.e., about 10% of the total items handled by the stores but require heavy investment about 70% of inventory value, because of their high prices or heavy requirement or both. (ii) B Category of items are relatively less important; they may be 20% of the total items of material handled by stores. The percentage of investment required is about 20% of the total investment in inventories. (iii) C Category of items do not require much investment; it may be about 10% of total inventory value but they are nearly 70% of the total items handled by store. A category of items can be controlled effectively by using a regular system which ensures neither over-stocking nor shortage of materials for production. Such a system plans its total material requirements by making budgets. The stocks of materials are controlled by fixing certain levels like maximum level, minimum level and re-order level. A reduction in inventory management costs is achieved by determining economic order quantities after taking into account ordering cost and

carrying cost. To avoid shortage and to minimize heavy investment in inventories, the techniques of value analysis, variety reduction, standardisation etc., may be used. In the case of B category of items, as the sum involved is moderate, the same degree of control as applied in A category of items is not warranted. The orders for the items, belonging to this category may be placed after reviewing their situation periodically. For C category of items, there is no need of exercising constant control. Orders for items in this group may be placed either after six months or once in a year, after ascertaining consumption requirements. In this case the objective is to economise on ordering and handling costs. Advantages of ABC analysis : The advantages of ABC analysis are the following : (i) It ensures that, without there being any danger of interruption of production for want of materials or stores, minimum investment will be made in inventories of stocks of materials or stocks to be carried. (ii) The cost of placing orders, receiving goods and maintaining stocks is minimised specially if the system is coupled with the determination of proper economic order quantities. (iii) Management time is saved since attention need be paid only to some of the items rather than all the items as would be the case if the ABC system was not in operation. (iv) With the introduction of the ABC system, much of the work connected with purchases can be systematized on a routine basis to be handled by subordinate staff. 2.7.3 Two bin system: Under this system each bin is divided into two parts - one, smaller part, should stock the quantity equal to the minimum stock or even the reordering level, and the other to keep the remaining quantity. Issues are made out of the larger part; but as soon as it becomes necessary to use quantity out of the smaller part of the bin, fresh order is placed. Two Bin System is supplemental to the record of respective quantities on the bin card and the stores ledger card. 2.7.4 Establishment of system of budgets: To control investment in the inventories, it is necessary to know in advance about the inventories requirement during a specific period usually a year. The exact quantity of various type of

inventories and the time when they would be required can be known by studying carefully production plans and production schedules. Based on this, inventories requirement budget can be prepared. Such a budget will discourage the unnecessary investment in inventories. 2.7.5 Use of perpetual inventory records and continuous stock verification Perpetual inventory represents a system of records maintained by the stores department. It in fact comprises: (i) Bin Cards, and (ii) Stores Ledger. Bin Card maintains a quantitative record of receipts, issues and closing balances of each item of stores. Separate bin cards are maintained for each item. Each card is filled up with the physical movement of goods i.e. on its receipt and issue. Like bin cards, the Store Ledger is maintained to record all receipt and issue transactions in respect of materials. It is filled up with the help of goods received note and material issue requisitions. A perpetual inventory is usually checked by a programme of continuous stock taking. Continuous stock taking means the physical checking of those records (which are maintained under perpetual inventory) with actual stock. Perpetual inventory is essential for material control. It incidentally helps continuous stock taking. The success of perpetual inventory depends upon the following: (a) The Stores Ledger(showing quantities and amount of each item). (b) Stock Control cards (or Bin Cards). (c) Reconciling the quantity balances shown by ( a) & (b) above. (d) Checking the physical balances of a number of items every day systematically and by rotation. (e) Explaining promptly the causes of discrepancies, if any, between physical balances and book figures. (f) Making corrective entries where called for after step ( e) and (g) Removing the causes of the discrepancies referred to in step ( e) Advantages The main advantages of perpetual inventory are as follows : (1) Physical stocks can be counted and book balances adjusted as and when desired without waiting for the entire stock-taking to be done.

(2) Quick compilation of Profit and Loss Account (for interim period) due to prompt availability of stock figures. (3) Discrepancies are easily located and thus corrective action can be promptly taken to avoid their recurrence. (4) A systematic review of the perpetual inventory reveals the existence of surplus, dormant, obsolete and show-moving materials, so that remedial measures may be taken in time. (5) Fixation of the various stock levels and checking of actual balances in hand with these levels assist the Store keeper in maintaining stocks within limits and in initiating purchase requisitions for correct quantity at the proper time. Continuous stock verification The checking of physical inventory is an essential feature of every sound system of material control. Such a checking may be periodical or continuous. Annual stock-taking, however, has certain inherent shortcomings which tend to detract from the usefulness of such physical verification. For instance, since all the items have to be covered in a given number of days, either the production department has to be shut down during those days to enable thorough checking of stock or else the verification must be of limited character. Moreover, in the case of periodical checking there is the problem of finding an adequately trained contingent. It is likely to be drawn from different departments where stock-taking is not the normal work and they are apt to discharge such temporary duties somewhat perfunctorily. The element of surprise, that is essential for effective control is wholly absent in the system. Then if there are stock discrepancies, they remain undetected until the end of the period. It means that the figures of stock during the period continue to be supplied incorrectly. Often, the discrepancies are not corrected. The system of continuous stock-taking consists of counting and verifying the number of items daily throughout the year so that during the year all items of stores are covered three or four times. The stock verifiers are independent of the stores, and the stores staff have no foreknowledge as to the particular items that would be checked on any particularAdvantages The advantages of continuous stock-taking are : 1. Closure of normal functioning is not necessary.

2. Whole time specialised staff can be engaged for the purpose since the work is spread throughout the year. In smaller concerns, duties may be assigned to various officers of middle rank by rotation to the checking, say, of 20 items. This would be easy because the store ledger card and the bin card will bear the bin number. The officers concerned need only walk up to the particular bin number, count, weigh or measure the article lying there and enter the quantity on the form provided for the purpose. The rest of the work (comparison with book figures) can be done by the stores ledger clerk. 3. Stock discrepancies are likely to be brought to the notice and corrected much earlier than under the annual stock-taking system. 4. The system generally has a sobering influence on the stores staff because of the element of surprise present therein. 5. The movement of stores items can be watched more closely by the stores auditor so that chances of obsolescence buying are reduced. 6. Final Accounts can be ready quickly. Interim accounts are possible quite conveniently. Economic Order Quantity (EOQ): Purchase department in manufacturing concerns is usually faced with the problem of deciding the quantity of various items which they should purchase. If purchases of material are made in bulk then inventory carrying cost will be high. On the other hand if order size is small each time, then the ordering cost will be high. In order to minimise ordering and carrying costs it is necessary to determine the order quantity which minimises these two costs. The size of the order for which both ordering and carrying cost are minimum is known as economic order quantity. Assumptions underlying E.O.Q.: The calculation of economic order of material to be purchased is subject to the following assumptions: (i) Ordering cost per order and carrying cost per unit per annum are known and they are fixed. (ii) Anticipated usage of material in units is known. (iii) Cost per unit of the material is constant and is known as well. (iv) The quantity of material ordered is received immediately i.e. the lead time is zero.

The famous mathematician Wilson derived the formula which is used for determining the size of order for each of purchases at minimum ordering and carrying costs. The formula given by Wilson for calculating economic order quantity is as follows : EOQ = where, A = Annual usage units S = Ordering cost per order C = Annual carrying cost of one unit, i.e., carrying cost percentage cost of one unit. Review of slow and non-moving items : Sometimes, due to high value of slow moving and non-moving raw materials, it appears that the concern has blocked huge sum of money unnecessarily in raw materials. To overcome this problem, it is necessary to dispose-off as early as possible, the non-moving items or make arrangements for their exchange with the inventories required by the concern. Besides this no new requisition should be made for the purchase of slow moving items, till the existing stock is exhausted. Computation of inventory turnover ratio may help in identifying slow moving items. Use of control ratios : (i) Input output ratio : Inventory control can also be exercised by the use of input output ratio analysis. Input-output ratio is the ratio of the quantity of input of material to production and the standard material content of the actual output. This type of ratio analysis enables comparison of actual consumption and standard consumption, thus indicating whether the usage of material is favourable or adverse. (ii) Inventory turnover ratio : Computation of inventory turnover ratios for different items of material and comparison of the turnover rates, provides a useful guidance for measuring inventory performance. High inventory turnover ratio indicates that the material in the question is a fast moving one. A low turnover ratio indicates overinvestment and locking up of the working capital in inventories. Inventory turnover ratio may be calculated by using the following formulae:Inventory turnover ratio = cost of mat consumed during the period/cost of avg stock held during the period Average stock = 1/2 (opening stock + closing stock)

By comparing the number of days in the case of two different materials, it is possible to know which is fast moving and which is slow moving. On this basis, attempt should be made to reduce the amount of capital locked up, and prevent overstocking of the slow moving items. VALUATION OF MATERIAL RECEIPTS The invoice of material purchased from the market sometime contain items such as trade discount, quantity discount, freight, duty, insurance, cost of containers, sales tax, excise duty, cash discount etc. Under such a situation, the general principal is that all costs incurred upto the point of procuring and storing materials should constitute the cost of materials purchased. The amount of trade discount, quantity discount and excise duty (under MODVAT credit scheme) being credit items and are thus deducted from the invoice of material purchased. The transport charges (carriage and freight), sales tax, insurance, cost of containers, customs and excise duty (without MODVAT credit) should be included in the invoice cost of material. The cash discount is considered as financial gain, so it is kept outside the domain of material cost. In case the containers are returnable, their resale value should also be taken in the invoice price of material to correctly ascertain the cost of material purchased. The cost of material purchased so determined may be used for the entry of material in the Stores Ledger. VALUATION OF MATERIAL ISSUES Materials issued from stores should be priced at the value at which they are carried in stock. But the value attached to the stock of any item of material, at any particular point of time may be the result, not of one purchase rate or price but of different purchase rate or prices. In other words, the same material may have been acquired at different prices and its stock at any particular time may comprise materials of more than one lot so that there would be a problem of determining the appropriate rate at which to price out the issues of materials. Several methods of pricing material issues have been evolved in an attempt to satisfactorily answer the problem. These methods may be grouped and explained as follows : Cost Price Methods: (a) Specific price method.

(b) First-in First-out method. (c) Last-in-First-out method. (d) Base stock method. Average Price Methods : (e) Simple average price method. (f) Weighted average price method. (g) Periodic simple average price method. (h) Periodic weighted average price method. (i) Moving simple average price method. (j) Moving weighted average price method. Market Price Methods : (k) Replacement price method. (l) Realisable price method. Notional Price Methods : (m) Standard price method. (n) Inflated price methods. (o) Re-use Price Method. We may now briefly discuss all the above methods: (a) Specific Price Method - This method is useful, specially when materials are purchased for a specific job or work order, and as such these materials are issued subsequently to that specific job or work order at the price at which they were purchased. To use this method, it is necessary to store each lot of material separately and maintain its separate account. The advantages and disadvantage of this method are : Advantages : 1. The cost of materials issued for production purposes to specific jobs represent actual and correct costs. 2. This method is best suited for non-standard and specific products.

Disadvantage : This method is difficult to operate, specially when purchases and issues are numerous. (b) First-in-First out Method (FIFO) - It is a method of pricing the issues of materials, in the order in which they are purchased. In other words, the materials are issued in the order in which they arrive in the store or the items longest in stock are issued first. Thus each issue of material only recovers the purchase price which does not reflect the current market price. This method is considered suitable in times of falling price because the material cost charged to production will be high while the replacement cost of materials will be low. But, in the case of rising prices, if this method is adopted, the charge to production will be low as compared to the replacement cost of materials. Consequently, it would be difficult to purchase the same volume of material (as in the current period) in future without having additional capital resources. The advantages and disadvantages of the method may be stated as follows : Advantages : 1. It is simple to understand and easy to operate. 2. Material cost charged to production represents actual cost with which the cost of production should have been charged. 3. In the case of falling prices, the use of this method gives better results. 4. Closing stock of material will be represented very closely at current market price. Advantage : It is simple to understand and easy to operate. Disadvantages : 1. Materials issue cost does not represent actual cost price. Since the materials are issued at a price obtained by averaging cost prices, a profit or loss may arise from such type of pricing. 2. In case the prices of material fluctuate considerably, this method will give incorrect results. 3. The prices of materials issues used are determined by averaging prices of purchases without giving consideration to the quantity. Such a price determination is unscientific. (d) Weighted Average Price Method : This method gives due weights to quantities purchased and the purchase price, while, determining the issue price. The average

issue price here is calculated by dividing the total cost of materials in the stock by total quantity of materials prior to each issue. The advantages and disadvantages of this method are : Advantages : 1. It smoothens the price fluctuations if at all it is there due to material purchases. 2. Issue prices need not be calculated for each issue unless new lot of materials is received. Disadvantage : 1. Material cost does not represent actual cost price and therefore, a profit or loss will arise out of such a pricing method. (e) Periodic Simple Average Price Method : This method is similar to Simple Average Price Method except that the average price is calculated at the end of the concerned period. In other words, the price paid during the period for different lots of materials purchased are added up and the total is divided by the number of purchases made during the period. The rate so computed is then used to price all the issues made during the period, and also for valuing the closing inventory of the period. Advantages : 1. It is simple to operate, as it avoids calculation of issue price after every receipt. 2. This method can usefully be employed in costing continuous processes where each individual order is absorbed into the general cost of producing large quantities of articles. Disadvantages : 1. This method cannot be applied in jobbing industry where each individual job order is to be priced at each stage of its completion. 2. This method is unscientific as it does not take into consideration the quantities purchased at different prices. 3. This method also suffers from all those disadvantages of simple average cost method. (f) Periodic Weighted Average Price Method : This method is like weighted average price method, except that the calculations of issue prices are made

periodically (say, a month). The rate so arrived is used for the issues made during that period and also for valuing the inventory at the end of the period. Advantage : 1. This method is superior to the periodic simple average price method as it takes into account the quantities also. 2. It overcomes or evens out the effect of fluctuations. 3. In addition to above, the method also possesses all the advantages of the simple weighted average price method. Disadvantage : This method is not suitable for job costing because each job is to be priced at each stage of completion. (g) Moving Simple Average Price Method : Under this method, the rate for material issues is determined by dividing the total of the periodic simple average prices of a given number of periods by the numbers of periods. For determining the moving simple average price, it is necessary to fix up first period to be taken for determining the average. Suppose a six monthly period is decided upon and moving, average rate for the month of June is to be calculated. Under such a situation, we have to make a list of the simple average prices from January to June, add them up, and divide the total by six. To calculate the moving average rate for July, we have to omit simple average rate pertaining to January and add the rate relating to July and divide the total by six. Advantage : This method evens out price fluctuations over a longer period, thus stabilising the charges to work-in-progress. Thus the cost of production will be stable to a significant extent. Disadvantage : A profit or loss arises by the use of moving simple average cost. (h) Moving Weighted Average Price Method : Under this method, the issue, rate is calculated by dividing the total of the periodic weighted average price of a given number of periods by the number of periods. (i) Replacement Price Method: Replacement price is defined as the price at which it is possible to purchase an item, identical to that which is being replaced or revalued. Under this method, materials issued are valued at the replacement cost of the items. This method pre-supposes the determination of the replacement cost of materials at the time of each issue; viz., the cost at which identical materials could be currently purchased. Theproduct cost under this method is at current market price, which is the main objective of the replacement price method. This method is useful to determine true cost of production and to value material issues in periods of rising prices, because the cost of material considered in cost of production would be able to replace the materials at the increased price. Advantage: Product cost reflects the current market prices and it can be compared with the selling price. Disadvantage: The use of the method requires the determination of market price of material before each issue of material. Such a requirement creates problems. (j) Realisable Price Method: Realisable price means a price at which the material to be issued can be sold in the market. This price may be more or may be less than the cost price at which it was originally purchased. Like replacement price method, the stores ledger would show profit or loss in this method too.

(k) Standard Price Method: Under this method, materials are priced at some predetermined rate or standard price irrespective of the actual purchase cost of the materials. Standard cost is usually fixed after taking into consideration the following factors: (i) Current prices, (ii) Anticipated market trends, and (iii) Discount available and transport charges etc. Standard prices are fixed for each material and the requisitions are priced at the standard price. This method is useful for controlling material cost and determining the efficiency of purchase department. In the case of highly fluctuating prices of materials, it is difficult to fix their standard cost on long-term basis. Advantages: (1) The use of the standard price method simplifies the task of valuing issues of materials. (2) It facilitates the control of material cost and the task of judging the efficiency of purchase department. (3) It reduces the clerical work. Disadvantages: (1) The use of standard price does not reflect the market price and thus results in a profit or loss. (2) The fixation of standard price becomes difficult when prices fluctuate frequently.

Chapter 4 Types of Costing Activity Based Costing Marginal Costing Absorption Costing

Learning objectives When you have finished studying this chapter, you should be able to Understand the difference between absorption costing and marginal costing Understand the concept of contribution and contribution to sales ratio. Understand the method of computation of break-even point, both mathematically and also with the help of a graph. Understand the basic limitations of break even analysis

INTRODUCTION Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for managerial decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centres in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing, etc., or even with other techniques such as standard costing or budgetary control. In marginal costing, cost ascertainment is made on the basis of the nature of cost. It gives consideration to behaviour of costs. In other words, the technique has developed from a particular conception and expression of the nature and behaviour of costs and their effect upon the profitability of an undertaking. In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is the sum total of the cost of direct material, direct labour, direct expenses, manufacturing overheads, administration overheads, selling and distribution overheads. In this system, other things being equal, the total cost per unit will remain

constant only when the level of output or mixture is the same from period to period. Since these factors are continually fluctuating, the actual total cost will vary from one period to another. Thus, it is possible for the costing department to say one day that an item costs Rs. 20 and the next day it costs Rs. 18. This situation arises because of changes in volume of output and the manufacturing activity, and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence, the application of marginal costing has been given wide recognition in the field of decision making. THEORY OF MARGINAL COSTING The theory of marginal costing is that in relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with increase in output. Conversely, a decrease in the volume of output will normally be accompanied by a less than proportionate fall in the aggregate cost. The theory of marginal costing may therefore be explained in three steps: (i) If the volume of output increases, the average cost per unit will, in the normal circumstances, be reduced. Conversely, if the output is reduced, the average cost per unit will go up. If the factory produces 1,000 units at a total cost of Rs. 3,000 and if by increasing the output by one unit, the cost goes up to Rs. 3,002, the marginal cost of the additional output is Rs. 2. (ii) If the increase in output is more than one unit say 20 units, the total increase in cost to produce these units is Rs. 3,045, the average marginal cost is Rs. 2.25 per unit is as under: units Additionalcost Additional=units 2045 Rs.= Rs. 2.25 (iii) The ascertainment of marginal cost is based on the classification and segregation of costs into fixed and variable costs. Definitions: In order to appreciate the concept of marginal costing, it is necessary to study the definition of marginal costing and certain other terms associated with this technique. The important terms have been defined as follows:

1. Marginal costing : The ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. 2. Marginal cost: The amount at any given volume of output by which aggregate variable costs are changed if the volume of output is increased by one unit. In practice this ismeasured by the total variable cost attributable to one unit. Marginal cost can precisely be the sum of prime cost and variable overhead. Note: In this context a unit may be a single article, a batch of articles, an order, a stage of production capacity, a process or a department. It relates to the change in output in particular circumstances under consideration. 3. Direct costing: Direct costing is the practice of charging all direct cost to operations, processes or products, leaving all indirect costs to be written off against profits in the period in which they arise. Under direct costing the stocks are valued at direct costs, i.e., costs whether fixed or variable which can be directly attributable to the cost units. In general, the terms marginal costing and direct costing are used as synonymous. However, direct costing differs from marginal costing in that some fixed costs considered direct are charged to operations, processes or products, whereas in marginal costing only variable costs are considered. Marginal costing is mainly concerned with providing of information to management to assist in decision making and for exercising control. Marginal costing is considered to be a technique with a broader meaning than direct costing. Marginal costing is also known as variable costing or out of pocket costing. 4. Differential cost : It may be defined as the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations. It represents an increase or decrease in total cost resulting out of : (a) producing or distributing a few more or few less of the products; (b) a change in the method of production or of distribution; (c) an addition or deletion of a product or a territory; and (d) selection of an additional sales channel. Differential cost, thus includes fixed and semi-variable expenses. It is the difference between the total costs of two alternatives. It is an adhoc cost determined for the

purpose of choosing between competing alternatives, each with its own combination of income and costs. 5. Incremental cost : It is defined as, the additional costs of a change in the level or nature of activity. As such for all practical purposes there is no difference between incremental cost and differential cost. However, from a conceptual point of view, differential cost refers to both incremental as well as decremental cost. Incremental cost and differential cost calculated from the same data will be the same. In practice, therefore, generally no distinction is made between differential cost and incremental cost. One aspect which is worthy to note is that incremental cost is not the same at all levels. Incremental cost between 50% and 60% level of output may be different from that which is arrived at between 80% and 90% level of output. Differential cost or incremental costanalysis deals with both short-term and long-term problems. This analysis is more useful when various alternatives or various capacity levels are being considered. Differential costs or incremental costs can be easily identified by preparing a flexible budget. Contribution : Contribution or the contributory margin is the difference between sales value and the marginal cost. It is obtained by subtracting marginal cost from sales revenue of a given activity. It can also be defined as excess of sales revenue over the variable cost. The difference between sales revenue and marginal/variable cost is considered to be the contribution towards fixed expenses and profit of the entire business. The contribution concept is based on the theory that the profit and fixed expenses of a business is a joint cost which cannot be equitably apportioned to different segments of the business. In view of this difficulty the contribution serves as a measure of efficiency of operations of various segments of the business. The contribution forms a fund for fixed expenses and profit as illustrated below: Key factor : Key factor or Limiting factor is a factor which at a particular time or over a period limits the activities of an undertaking. It may be the level of demand for the products or services or it may be the shortage of one or more of the productive resources, e.g., labour hours, available plant capacity, raw materials availability etc. Examples of Key Factors or Limiting Factors are: (a) Shortage of raw material. (b) Shortage of labour.

(c) Plant capacity available. (d) Sales capacity available. (e) Cash availability. ASCERTAINMENT OF MARGINAL COST Under marginal costing, fixed expenses are treated as period costs and are therefore, charged to profit and loss account. In order to ascertain the marginal cost, we classify the expenses as under: 1. Variable expenses : Apart from prime costs which are variable, the overhead expensesthat change in proportion to the change in the level of activity are also variable expenses. Thus when expenses go up or come down in proportion to a change in the volume of output, such that, with every increase of 20% in output, expenses also go up by 20% or vice versa, these expenses are known as variable expenses. Variable expenses fluctuate in total with fluctuations in the level of output but tend to remain constant per unit of output. Examples of such expenses are raw material, power, commission paid to salesmen as a percentage of sales, etc. 2. Fixed expenses : Fixed expenses or constant expenses are those which do not vary in total with the change in volume of output for a given period of time. Fixed cost per unit of output will, however, fluctuate with changes in the level of production. Examples of such expenses are managerial remuneration, rent, taxes, etc. There may, however, be different levels of fixed costs at different levels of output, as for example, where after certain level of output extra expenditure may be needed. In the case of introduction of additional shift working, fixed expenses will be incurred, say, for the appointment of additional supervisors. Fixed expenses are treated as period costs and are therefore charged to profit and loss account. 3. Semi-variable expenses : These expenses (also known as semi-fixed expenses) do not change within the limits of a small range of activity but may change when the output reaches a new level in the same direction in which the output changes. Such increases or decreases in expenses are not in proportion to output. An example of such an expense is delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level of activity and may increase in total from 60% to 70% level of activity. These expenses can be segregated into fixed and variable by using any one of the method, as given under next heading. Depreciation of plant and machinery depends partly on efflux of time and partly on wear and tear. The former

is fixed and the latter is variable. The total cost is arrived at by merging these three type of expenses. SEPARATING FIXED AND VARIABLE COSTS Please Refer to Chapter 1 Uses of segregation of cost Segregation of all expenses into fixed and variable elements is the essence of marginal costing. The primary objective of the classification of expenses into fixed and variable elements is to find out the marginal cost for various types of managerial decisions. A number of such decisions will be discussed later in the chapter-3of this book. The other uses of it are as below: (i) Control of expenses : The classification of expenses helps in controlling expenses. Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of production activity and they are regarded as uncontrollable expenses. Since variable expenses vary with the production they are said to be controllable. By this classification, therefore, responsibility for incurring variable expenses is determined in relation to activity and hence the management is able to control these expenses. The departmental heads always try to keep these expenses within limits set by the management. (ii) Preparation of budget estimates: This distinction between fixed and variable cost also helps the management to estimate precisely, the budgeted expenses to gauge the actual efficiency of the business, by comparing the actual with budgets. This can be illustrated by means of the following example. DISTINCTION BETWEEN MARGINAL AND ABSORPTION COSTING The main points of distinction between marginal costing and absorption costing are as

below: Marginal costing 1. Only are

Absorption costing variable considered costs Both fixed and variable for costs are considered inventory valuation. are Fixed costs are Each bears a

product costing and for product costing and inventory valuation. 2. Fixed regarded costs as

period charged to the cost of

costs. The Profitability production. of different products is product ratio.

judged by their P/V reasonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed costs. 3. Cost data presented Cost highlight product. the data are in pattern. of each total presented Net profit

contribution of each conventional

product is determined after subtracting fixed cost along with their variable costs. 4. The difference in the The difference in the magnitude of opening magnitude of opening stock the and unit closing stock cost and closing stock does not affect stock affects the unit of cost of production due to the impact of related fixed cost. production.


1. The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision making task difficult. 2. 2. Overheads are recovered in costing on the basis of pre-determined rates. If fixed overheads are included on the basis of pre-determined rates, there will be under- recovery of overheads if production is less or if overheads are more. There will be over- recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over-recovery of overheads. Marginal costing avoids such under or over recovery of overheads. 3. 3. Advocates of marginal costing argues that under the marginal costing technique, the stock of finished goods and work-in-progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit of the period. 4. 4. Marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company. 5. 5. Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances. 6. 6. Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of a particular product, replacement of machines, etc. Limitations of Marginal Costing 1. It is difficult to classify exactly the expenses into fixed and variable category. Most of the expenses are neither totally variable nor wholly fixed. For example, various amenities provided to workers may have no relation either to volume of production or time factor.

2. Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor. 3. Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost. 4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts, while valuing the work-in- progress. In order to show the correct position fixed overheads have to be included in work-in-progress. 5. Some of the assumptions regarding the behaviour of various costs are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct. Fixed cost may change from one period to another. For example salaries bill may go up because of annual increments or due to change in payrate etc. The variable costs do not remain constant per unit of output. There may be changes in the prices of raw materials, wage rates etc. after a certain level of output has been reached due to shortage of material, shortage of skilled labour, concessions of bulk purchases etc. 6. Marginal costing ignores time factor and investment. For example, the marginal cost of two jobs may be the same but the time taken for their completion and the cost of machines used may differ. The true cost of a job which takes longer time and uses costlier machine would be higher. This fact is not disclosed by marginal costing. Absorption Costing : It is a costing technique where all normal costs whether it is variable or fixed costs are charged to cost units produced. Unlike marginal costing which take the fixed cost as period cost.

Advantages It recognizes the importance of fixed costs in production; This method is accepted by Inland Revenue as stock is not undervalued;

This method is always used to prepare financial accounts; When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and

Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.

Disadvantages As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control;

as the managers emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.

Activity Based Costing Origin Activity Based Costing, or ABC for short, has been in use since the early 20 th century. As the manufacturing industry became more complex, managers needed a way to keep a closer watch on manufacturing costs within the company. This in turn allowed them to more appropriately price their products, making them more competitive. (DirectoryM) By the 1980s ABC had been in use for nearly 80 years, though it had yet to be truly identified and defined as a solid business practice. Although in 1987, Robert Kaplan and W. Bruns first defined ABC in their book, Accounting and Management: A Field Study Perspective, it was in 1988 that Robin Cooper and Kaplan worked together on a series of articles for the Harvard Business Review that better defined the practice of ABC. They also recognized the reasons it was more beneficial to business than traditional cost accounting methods. (Wikipedia.org) General Purpose

The purpose of ABC is to more accurately define the overhead and/or indirect costs associated with the manufacturing process and apply those costs to the product. (Answers.com) In the past, cost accountants would add a percentage of expenses into direct costs as an allowance for indirect costs. (Wikipedia.org) With the advent of ABC, expenses are now more accurately defined and added to product lines appropriately. Although the process to define these expenses is sometimes tedious and costly, for some companies it provides an invaluable tool with which to measure the profitability of a product. Organizational Strategy A definite organizational strategy has to be in place before beginning the process of identifying actual costs within the manufacturing process, as well as implementing a plan once those costs are identified. Although a small company or a company with only a product or two may be able to dive right into ABC analysis and implementation, a larger organization must do some careful planning before beginning. Sometimes, a pilot project using only product or department is an ideal place to start. This allows the ABC pilot project team to get some experience as well as hopefully providing some semi-rapid results that can be utilized in the short-term, thereby proving the effectiveness of the method. (Tarr) According to the OSD Comptroller iCenter website, which provides financial services information for the Department of Defense, there are four steps to ABC implementation: 1. Identify activitiesperform an in-depth analysis of the operating processes of each responsibility segment. Each process may consist of one or more activities required by outputs. 2. Assign resource costs to activities this is sometimes called "tracing." Traceability refers to tracing costs to cost objects to determine why costs were incurred. DoD categorizes costs in three ways: a. Directcosts that can be traced directly to one output. Example: the material costs (varnish, wood, paint) to build a chair. b. Indirectcosts that cannot be allocated to an individual output; in other words, they benefit two or more outputs, but not all outputs.

Examples: maintenance costs for the saws that cut the wood, storage costs, other construction materials, and quality assurance.) c. General & Administrativecosts that cannot reasonably be

associated with any particular product or service produced (overhead). These costs would remain the same no matter what output the activity produced. Examples: salaries of personnel in purchasing department, depreciation on equipment, and plant security. 3. Identify outputsidentify all of the outputs for which an activity segment performs activities and consumes resources. Outputs can be products, services, or customers (persons or entities to whom a federal agency is required to provide goods or services). 4. Assign activity costs to outputs assign activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs consumption or demand for activities. For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver). (OSD Comptroller iCenter) While these steps seem simple enough, they can sometimes be difficult to achieve, which is why there are still a great number of companies today that still use traditional costing methods instead of the more accurate ABC method. Investigating or implementing an ABC method requires a commitment from top management, which will filter down to each and every employee. Strengths and Weaknesses While the thought behind ABC makes sense, and the results would be of great benefit for many companies, there are still some inherent problems with the methodology. In some instances, costs can be defined, but where and how to assign them can be extremely difficult. An example would be the salary of the companys CEO. This is difficult to assign because there is no solid method of doing so. (Wikipedia.org) Just because a cost cannot be assigned to a product or products

does not mean that the ABC method is seriously flawed and should be abandoned. According to Robert Kaplan, one of the founding fathers of ABC, small inconsistencies are acceptable. The objective is to be approximately right. (Kaplan and Anderson) A strength of ABC, as has been mentioned throughout this paper, is having a better understanding of what indirect or overhead costs go into the cost of a product. Knowing exactly how much time and materials go into a product from all areas instead of just the ones that are obvious is of great value to any organization. It leads to more efficient processing in the manufacturing process, which in turn leads to greater profits through realization of cost savings. Specific Applications There are too many specific applications of ABC to be listed here, but it will suffice to say that many industries could see benefits from implementing an ABC method, or at the very least identifying actual costs within a process. One interesting example I found through my research was how United States shipyards were being compared to Northern European shipyards in their conversion from mainly military use to commercial shipbuilding. A large part of this study required determining hidden costs within the process that are the result of bloat and financial sloppiness that are inherent in the fulfillment of government contracts. (Kvaerner Masa Marine INC Annapolis MD) Conclusion In conclusion, we can see that the methodology behind Activity-Based Costing is sound, and can result in sometimes great savings to a company willing to take the time, effort and expense to implement a plan. Although there are some pitfalls to the process, with perseverance and a solid commitment from management, ABC can be of great benefit to a manufacturing company.

Chapter 5

COST-VOLUME-PROFIT ANALYSIS As the name suggests, cost volume profit (CVP) analysis is the analysis of three variables cost, volume and profit. Such an analysis explores the relationship between costs, revenue, activity levels and the resulting profit. It aims at measuring variations in cost and volume. CVP analysis is based on the following assumptions: 1. Changes in the levels of revenues and costs arise only because of changes in the number of product (or service) units produced and old for example, the number of television sets produced and sold by Sony Corporation or the number of packages delivered by Overnight Express. The number of output units is the only revenue driverdriver is a variable, such as volume, that causally affects revenues. 2. Total costs can be separated into two components; a fixed component that does not vary with output level and a variable component that changes with respect to output level. Furthermore, variable costs include both direct variable costs and indirect variable costs of a product. Similarly, fixed costs include both direct fixed costs and indirect fixed costs of a product 3. When represented graphically, the behaviours of total revenues and total costs are linear (meaning they can be represented as a straight line) in relation to output level within a relevant range (and time period). 4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period) are known and constant. 5. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes 6. All revenues and costs can be added, subtracted, and compared without taking into account the time value of money. (Refer to the FM study material for a clear understanding of time value of money). 9.91 THE BREAKEVEN POINT The word contribution has been given its name because of the fact that it literally contributes towards the recovery of fixed costs and the making of

profits. The contribution grows along with the sales revenue till the time it just covers the fixed cost. This point where neither profits nor losses have been made is known as a break-even point. This implies that in order to break even the amount of contribution generated should be exactly equal to the fixed costs incurred. Hence, if we know how much contribution is generated from each unit sold we shall have sufficient information for computing the number of units to be sold in order to break even. Mathematically, Break even point in units = Fixed cost/ Contribution per unit Let us consider an example of a company (ABC Ltd) manufacturing a single product, incurring variable costs of Rs 300 per unit and fixed costs of Rs 2, 00,000 per month. If the product sells for Rs 500 per unit, the breakeven point shall be calculated as follows;

MARGIN OF SAFETY The margin of safety can be defined as the difference between the expected level of sale and the breakeven sales. The larger the margin of safety , the higher are the chances of making profits. In the above example if the forecast sale is 1,700 units per month, the margin of safety can be calculated as follows, Margin of safety = Projected sales Breakeven sales

MARGIN OF SAFETY The margin of safety can be defined as the difference between the expected level of sale and the breakeven sales. The larger the margin of safety , the higher are the chances of making profits. In the above example if the forecast sale is 1,700 units per month, the margin of safety can be calculated as follows, Margin of safety = Projected sales Breakeven sales The Margin of Safety can also be calculated by identifying the difference between the projected sales and breakeven sales in units multiplied by the contribution per unit. This is possible because, at the breakeven point all the fixed costs are recovered and any further contribution goes into the making of profits.

Chapter 6
Budgets and Budgetary Control

Learning objectives When you have finished studying this chapter, you should be able to Understand the objectives and importance of budgeting and budgetary control Understand the Advantages and disadvantages of budgetary control Differentiate between various types of budgets. Understand the process of preparation of budgets

INTRODUCTION Budgetary control and Standard costing systems are two essential tools frequently used by business executives for the purpose of planning and control. In the case of budgetary control, the entire exercise starts with the setting up of budgets or targets and ends with the taking of an action, in case the actual figures differed with the budgetary ones. The Chartered Institute of Management Accountants of England and Wales has defined the terms budget and budgetary control as follows : Budget: A financial and/or quantitative statement, prepared and approved prior to a defined period of time of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and employment of capital. Budgets are usually, set up in the light of past experience after taking into account the changes that are expected to occur in the future. It is, therefore, to be expected that actual figures will correspond to the budget unless there is some important change in the conditions. In fact, it must be the constant endeavour of the management to see that actual performance does correspond with the budget concerned. Since budgets assume the optimum efficiency attainable, the system of budgetary control helps to increase efficiency and enables the concern to achieve the targets which are considered attainable.


The process of budgeting is initiated with the establishment of specific targets of performance and is followed by executing plans to achieve such desired goals and from time to time comparing actual results with the targets of performances/goals. These targets include both the overall business targets as well as the specific targets for the individual units within the business. Establishing specific targets for future operations is part of the planning function of management, while executing actions to meet the goals is the directing function of management. Planning : A set of targets/goals is often necessary to guide and focus individual and group actions. For example, students set academic goals, batsmen runs, employees set career goals, and business set financial goals. In the same way, budgeting supports the planning process by requiring all organisational units to establish their targets for the upcoming period. The targets, in turn, motivate individuals and groups to perform at high levels. Using the budget to communicate these expectations throughout the organization has helped many a companies to reduce expenses during a severe business recession. Planning not only motivates employees to attain goals but also improves overall decision making. During the planning phase of the budget process, all viewpoints are considered, options identified, and cost reduction opportunities assessed. This process may reveal opportunities or threats that were not known prior to the budget planning process. Directing: Once the budget plans are in place, they can be used to direct and coordinate operations in order to achieve the stated targets. For example, your target to receive 90% in an exam would result in certain activities, such as reading books, completing assignments, participating in class, and studying for exams. Such actions are fairly easy to direct and coordinate. A business, however, is much more complex and requires more formal direction and coordination. The budget is one way to direct and coordinate business activities and units to achieve stated targets of performance. The budgetary units of an organisation are called responsibility centers. Each responsibility center is led by a manager who has the authority over and responsibility for the units performance. Controlling: As time passes, the actual performance of an operation can be compared against the planned targets. This provides prompt feedback to employees

about their performance. If necessary. employees can use such feedback to adjust their activities in the future. For example, a salesperson may he given a quota to achieve Rs10,00,000 in sales for a particular period. If the actual sales are only Rs 8,75,000, theimprove future sales. Feedback is not only helpful to individuals, but it can also redirect a complete organisation, For example. McDonalds" Corporation recently decided to reverse its growth plans by closing stores and pulling out of a few countries as a result of reporting its first quarterly loss since becoming a public company in 1965. Comparing actual results to the plan also helps prevent unplanned expenditures. The budget encourages employees to establish their spending priorities. For example, committees in professional Institutes have budgets to support faculty travel to conferences and meetings. The travel budget communicates to the officer the upper limit on travel. Often, desired travel exceeds the budget. Thus, the budget requires the officer to prioritise travel-related opportunities. BUDGETARY CONTROL It can be defined as the establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results either to secure by individual action the objective of that policy or to provide a base for its revision. The salient features of such a system are the following : (i) Determining the objectives to be achieved, over the budget period, and the policy or policies that might be adopted for the achievement of these ends. (ii) Determining the variety of activities that should be undertaken for the achievement of the objectives. (iii) Drawing up a plan or a scheme of operation in respect of each class of activity, in physical as well as monetary terms for the full budget period and its parts. (iv) Laying out a system of comparison of actual performance by each person, section or department with the relevant budget and determination of causes for the discrepancies, if any. (v) Ensuring that corrective action will be taken where the plan is not being achieved and, if that be not possible, for the revision of the plan.

In brief, it is a system to assist management in the allocation of responsibility and authority, to provide it with aid for making, estimating and planning for the future and to facilitate the analysis of the variation between estimated and actual performance. In orderdevelop proper basis of measurement or standards with which to evaluate the efficiency of operations, i.e., it should have in operation a system of standard costing. Beside this, the organisation of the concern should be so integrated that all lines of authority and responsibility are laid, allocated and defined. This is essential since the system of budgetary control postulates separation of functions and division of responsibilities and thus requires that the organisation shall be planned in such a manner that every one, from the Managing Director down to the Shop Foreman, will have his duties properly defined. Objectives of Budgetary Control System : The objectives of a system of budgetary control are given below : (i) Portraying with precision the overall aims of the business and determining targets of performance for each section or department of the business. (ii) Laying down the responsibilities of each of the executives and other personnel so that every one knows what is expected of him and how he will be judged. Budgetary control is one of the few ways in which an objective assessment of executives or department is possible. (iii) Providing a basis for the comparison of actual performance with the predetermined targets and investigation of deviation, if any, of actual performance and expenses from the budgeted figures. This naturally helps in adopting corrective measures. (iv) Ensuring the best use of all available resources to maximise profit or production, subject to the limiting factors. Since budgets cannot be properly drawn up without considering all aspects usually there is good co-ordination when a system of budgetary control operates. (v) Co-ordinating the various activities of the business, and centralising control and yet enabling management to decentralise responsibility and delegate authority in the overall interest of the business.

(vi) Engendering a spirit of careful forethought, assessment of what is possible and an attempt at it. It leads to dynamism without recklessness. Of course, much depends on the objectives of the firm and the vigour of its management. (vii) Providing a basis for revision of current and future policies. (viii) Drawing up long range plans with a fair measure of accuracy. (ix) Providing a yardstick against which actual results can be compared. Working of a Budgetary Control System : The responsibility for successfully introducing and implementing a Budgetary Control System rests with the Budget Committee acting through the Budget Officer. The Budget Committee would be composed of all functional heads and a member from the Board to preside over and guide the deliberations. The main responsibilities of the Budget Officer are : (i) to assist in the preparation of the various budgets by coordinating the work of the accounts department which is normally responsible to compile the budgetswith the relevant functional departments like Sales, Production, Plant maintenance etc.; (ii) to forward the budget to the individuals who are responsible to adhere to them, and to guide them in overcoming any practical difficulties in its working; (iii) to prepare the periodical budget reports for circulation to the individuals concerned; (iv) to follow-up action to be taken on the budget reports; (v) to prepare an overall budget working report for discussion at the Budget Committee meetings and to ensure follow-up on the lines of action suggested by the Committee; (vi) to prepare periodical reports for the Board meeting. Comparing the budgeted Profit and Loss Account and the Balance Sheet with the actual results attained. It is necessary that every budget should be thoroughly discussed with the functional head before it is finalised. It is the duty of the Budget Officer to see that the periodical budget reports are supplied to the recipients at frequent intervals as far as possible. The efficiency of the Budget Officer, and through him of the Budget Committee, will be judged more by the smooth working of the system and the agreement between the actual figures and the budgeted figures. Budgets are

primarily an incentive and a challenge for better performance; it is up to the Budget Officer to see that attention of the different functional heads is drawn to it to face the challenge in a successful manner. Advantages of Budgetary Control System 1. The use of budgetary control system enables the management of a business concern to conduct its business activities in the efficient manner. 2. It is a powerful instrument used by business houses for the control of their expenditure. It infact provides a yardstick for measuring and evaluating the performance of individuals and their departments. 3. It reveals the deviations to management, from the budgeted figures after making a comparison with actual figures. 4. Effective utilisation of various resources likemen, material, machinery and moneyis made possible, as the production is planned after taking them into account. 5. It helps in the review of current trends and framing of future policies. 6. It creates suitable conditions for the implementation of standard costing system in a business organisation. 7. It inculcates the feeling of cost consciousness among workers. Limitations of Budgetary Control System : The limitations of budgetary control system are as follows : 1. Budgets may or may not be true, as they are based on estimates. 2. Budgets are considered as rigid document. 3. Budgets cannot be executed automatically. 4. Staff co-operation is usually not available during budgetary control exercise. 5. Its implementation is quite expensive. 10.3.5 Components of Budgetary Control System : The policy of a business for a defined period is represented by the master budget the details of which are given in

a number of individual budgets called functional budgets. These functional budgets are broadly grouped under the following heads : (i) Physical budgets - Those budgets which contains information in terms of physical units about sales, production etc. for example, quantity of sales, quantity of production, inventories, and manpower budgets are physical budgets. (ii) Cost budgets - Budgets which provides cost information in respect of manufacturing, selling, administration etc. for example, manufacturing costs, selling costs, administration cost, and research and development cost budgets are cost budgets. (iii) Profit budgets - A budget which enables in the ascertainment of profit, for example, sales budget, profit and loss budget, etc. (iv) Financial budgets - A budget which facilitates in ascertaining the financial position ofa concern, for example, cash budgets, capital expenditure budget, budgeted balance sheet etc. DIFFERENT TYPES OF BUDGETS Budgets may be classified by : Capacity, coverage they encompass, periods which they cover and conditions on which they are based. BUDGET Capacity Coverage Period Conditions Fixed Flexible Functional Master Long Short Basic Current Budgets Budgets Budgets term Budgets term Budgets Budgets Budgets Budgets Fixed budget - According to Chartered Institute of Management Accountants of England, a fixed budget, is a budget designed to remain unchanged irrespective of the level of activity actually attained. A fixed budget shows the expected results of a responsibility center for only one activity level. Once the budget has been determined, it is not changed, even if the activity changes. Fixed budgeting is used by many service companies and for some administrative functions of manufacturing companies, such as purchasing, engi-neering, and accounting. Fixed Budget is used as an effective tool of cost control. In case, the level of activity attained is different from the level of activity for budgeting purposes, the fixed budget becomes

ineffective. Such a budget is quite suitable for fixed expenses. It is also known as a static budget. Flexible budget - Unlike static budgets, flexible budgets show the expected results of a responsibility center for several activity levels. You can think of a flexible budget as a series of static budgets for different levels of activity. Such budgets are especially useful in estimating and controlling factory costs and operating expenses. It is more realistic and practicable because it gives due consideration to cost behaviour at different levels of activity. While preparing a flexible budget the expenses are classified into three categories viz. (i) Fixed, (ii) Variable, and (iii) Semi-variable. Flexible budgeting may be resorted to under following situations: (i) In the case of new business venture due to its typical nature it may be difficult to forecast the demand of a product accurately. (ii) Where the business is dependent upon the mercy of nature e.g., a person dealing in wool trade may have enough market if temperature goes below the freezing point. (iii) In the case of labour intensive industry where the production of the concern is dependent upon the availability of labour. Functional budgets - Budgets which relate to the individual functions in an organisation are known as Functional Budgets. For example, purchase budget; sales budget; production budget; plant-utilisation budget and cash budget. Master budget - It is a consolidated summary of the various functional budgets. It serves as the basis upon which budgeted P & L A/c and forecasted Balance Sheet are built up. Long-term budgets - The budgets which are prepared for periods longer than a year are called long-term budgets. Such budgets are helpful in business forecasting and forward planning. Capital expenditure budget and Research and Development budget are exam-ples of long-term budgets.

Short-term budgets - Budgets which are prepared for periods less than a year are known as short-term budgets. Cash budget is an example of short-term budget. Such types of budgets are prepared in cases where a specific action has to be immediately taken to bring any variation under control, as in cash budgets. Basic budgets - A budget which remains unaltered over a long period of time is called basic budget. Current budgets - A budget which is established for use over a short period of time and is related to the current conditions is called current budget. PREPARATION OF BUDGETS (a) Definition of objectives - A budget being a plan for the achievement of certain operational objectives, it is desirable that the same are defined precisely. The objectives should be written out; the areas of control demarcated; and items of revenue and expenditure to be covered by the budget stated. This will give a clear understanding of theplan and its scope to all those who must cooperate to make it a success. (b) Location of the key (or budget) factor - There is usually one factor (sometimes there may be more than one) which sets a limit to the total activity. For instance, in India today sometimes non-availability of power does not allow production to increase inspite of heavy demand. Similarly, lack of demand may limit production. Such a factor is known as key factor. For proper budgeting, it must be located and estimated properly. (c) Appointment of controller - Formulation of a budget usually required whole time services of a senior executive; he must be assisted in this work by a Budget Committee, consisting of all the heads of department along with the Managing Director as the Chairman. The Controller is responsible for co-ordinating and development of budget programmes and preparing the manual of instruction, known as Budget manual. The Budget manual is a schedule, document or booklet which shows, in written forms the budgeting organisation and procedures. The manual should be well written and indexed so that a copy thereof may be given to each departmental head for guidance.

(d) Budget period - The period covered by a budget is known as budget period. There is no general rule governing the selection of the budget period. In practice the Budget Committee determines the length of the budget period suitable for the business. Normally, a calendar year or a period coterminous with the financial year is adopted. The budget period is then sub-divided into shorter periodsit may be months or quarters or such periods as coincide with period of trading activity. (e) Standard of activity or output - For preparing budgets for the future, past statistics cannot be completely relied upon, for the past usually represents a combination of good and bad factors. Therefore, though results of the past should be studied but these should only be applied when there is a likelihood of similar conditions repeating in the future. Also, while setting the targets for the future, it must be remembered that in a progressive business, the achievement of a year must exceed those of earlier years. Therefore what was good in the past is only fair for the current year. In budgeting, fixing the budget of sales and of capital expenditure are most important since these budgets determine the extent of development activity. For budgeting sales, one must consider the trend of economic activity of the country, reactions of salesmen, customers and employees, effect of price changes on sales, the provision for advertisement campaign plan capacity etc. 10.5.1 Functional budget - A functional budget is one which is related to function of the business as for example, production budget relating to the manufacturing function. Functional budgets are prepared for each function and they are subsidiary to the master budget of the business. The various types of functional budgets to be prepared will vary according to the size and nature of the business. The various commonly used functional budgets are : (i) Sales budget (ii) Production budget (iii) Plant utilisation budget (iv) Direct-material usage budget (v) Direct-material purchase budget

(vi) Direct-labour (personnel) budget (vii) Factory overhead budget (viii) Production cost budget (ix) Ending-inventory budget (x) Cost-of-goods-sold budget (xi) Selling and distribution cost budget (xii) Administration expenses budget (xiii) Research and development cost budget (xiv) Capital expenditure budget (xv) Cash budget (xvi) Budget summaries/Master budget - Budgeted income statement and Budgeted balance sheet. The important functional budgets (also known as schedules to master budget) and the master budget are discussed and illustrated below : Sales budget - Sales forecast is the commencement of budgeting and hence sales budget assumes primary importance. The quantity which can be sold may be the principal budget factor in many business undertakings. In any case in order to chalk out a realisticbudget programme, there must be an accurate sales forecast. The sales budget indicates for each product (1) the quantity of estimated sales and (2) the expected unit selling price. These data are often reported by regions or by sales representatives. In estimating the quantity of sales for each product, past sales volumes are often used as a starting point. These amounts are revised for factors that are expected to affect future sales, such as the factors listed below. backlog of unfilled sales orders planned advertising and promotion expected industry and general economic conditions productive capacity projected pricing

findings of market research studies relative product profitability. competition.

Once an estimate of the sales volume is obtained, the expected sales revenue can be determined by multiplying the volume by the expected unit sales price,The sales budget represents the total sales in physical quantities and values for a future budget period. Sales managers are constantly faced with problem like anticipation of customer requirements, new product needs, competitor strategies and various changes in distribution methods or promotional techniques. The purposes of sales budget is not to attempt to estimate or guess what the actual sales will be, but rather to develop a plan with clearly defined objectives towards which the operational effort is directed in order to attain or exceed the objective. Hence, sales budget is not merely a sales forecast. A budget is a planning and control document which shows what the management intends to accomplish. Thus, the sales budget is active rather than passive. A sales forecast, however, is a projection or estimate of the available customer demand. A forecast reflects the environmental or competitive situation facing the company whereas the sales budget shows how the management intends to react to this environmental and competitive situation. A good budget hinges on aggressive management control rather than on passive acceptance of what the market appears to offer. If the company fails to make this distinction, the budget will remain more a figure-work exercise than a working tool of dynamic management control. The sales budget may be prepared under the following classification or combination of classifications : (a) Products or groups of products. (b) Areas, towns, salesmen and agents. (c) Types of customers as for example: (i) Government, (ii) Export, (iii) Home sales, (iv) Retail depots. (d) Periodmonths, weeks, etc.

Production budget - Production budget shows the production for the budget period based upon : (a) Sales budget, (b) Production capacity of the factory, (c) Planned increase or decrease in finished stocks, and (d) Policy governing outside purchase. Production budget is normally stated in units of output. Production should be carefully coordinated with the sales budget to ensure that production and sales are kept in balance during the period. The number of units to be manufactured to meet budgeted sales and inventory needs for each product is set forth in the production budget The production facility available and the sales budget will be compared and coordinated to determine the production budget. If production facilities are not sufficient, consideration may be given to such factors as working overtime, introducing shift working, sub-contracting or purchasing of additional plant and machinery. If, however, the production facilities are surplus, consideration should be given to promote advertising, reduction of prices to increase the sales, subcontracting of surplus capacity, etc. One of the conditions to be considered in all the compilation of production budget is the level of stock to be maintained. The level of stocks will depend upon three factors viz. : (a) seasonal industries in which stocks have to be built up during off season to cater to the peak season, (b) a steady and uniform level of production to utilise the plant fully and to avoid retrenchment or lay-off of the workers, and (c) to produce in such a way that minimum stocks are maintained at any time to avoid locking up of funds in inventory. Production budget can, therefore, show : ( a) stabilised production every month, say, the maximum possible production or (b) stabilised minimum quantity of stocks which will reduce inventory costs.

In the case of stabilised production, the production facility will be fully utilised but the inventory carrying costs will vary according to stocks held. In the case of stabilised stocks method, however, the inventory carrying will be the lowest but there may be under-utilisation of capacity. weight or other convenient units of plant facilities required to carry out the programme laid down in the production budget. The main purposes of this budget are : (a) To determine the load on each process, cost or groups of machines for the budget period. (b) To indicate the processes or cost centres which are overloaded so that corrective action may be taken such as : (i) working overtime (ii) sub-contracting (iii) expansion of production facility, etc. (c) To dovetail the sales production budgets where it is not possible to increase the capacity of any of the overloaded processes. (d) Where surplus capacity is available in any of the processes, to make effort to boost sales to utilise the surplus capacity. Direct material usage budget - The steps involved in the compilation of direct materials usage budget are as under : (i) The quality standards for each item of material have to be specified. In this connection, standardisation of size, quality, colour, etc., may be considered. (ii) Standard requirement of each item of materials required should also be set. While setting the standard quality consideration should be given to normal loss in process. The standard allowance for normal loss may be given on the basis of past performance, test runs, technical estimates etc. (iii) Standard prices for each item of materials should be set after giving consideration to stock and contracts entered into. After setting standards for quality, quantity and prices, the direct materials budget can be prepared by multiplying each item of material required for the production by the standard price. Purchase budget - The production budget is the starting point for determining the estimated quantities of direct materials to be purchased. Multiplying these quantities

by the expected unit purchase price determines the total cost of direct materials to be purchased. Two important considerations that govern purchase budgets are as follows: (a) Economic order quantity. (b) Re-order point with safety stocks to cover fluctuations in demand. The direct material purchases budget helps management maintain inventory levels within reasonable limits, For this purpose, the timing of the direct materials purchases should he coordinated between the purchasing and production departments. Personnel (or Labour cost) budget - Once sales budget and Production budget are compiled and thereafter plant utilisation budget is settled, detailed amount of the various machine operations involved and services required can be arrived at. This will facilitate preparation of an estimate of different grades of labour required. From this the standard hours required to be worked can be prepared. The total labour complement thus budgeted can be divided into direct and indirect. Standard rates of wages for each grade of labour can be introduced and then the direct and indirect labour cost budget can be prepared. The advantages of labour budget are the following: (a) It defines the direct and indirect labour force required. (b) It enables the personnel department to plan ahead in recruitment and training of workers so that labour turnover can be reduced to the minimum. (c) It reveals the labour cost to be incurred in the manufacture, to facilitate preparation of manufacturing cost budgets and cash budgets for financing the wage bill. Production or Factory overhead budget - Production overheads consists of all items such as indirect materials, indirect labour and indirect expenses. Indirect expenses include power, fuel, fringe benefits, depreciation etc. These estimated factory overhead costs necessary for production make up the factory overhead cost budget. This budget usually includes the total estimated cost for each item of factory overhead. The production overhead budget is useful for working out the predetermined overhead recovery rates. A business may prepare supporting

departmental schedules, in which the factory overhead costs are separated into their fixed and variable cost elements. Such schedules enable department managers to direct their attention to those costs for which they are responsible and to evaluate performance A careful study and determination of the behaviour of different types of costs will be essential in preparation of overhead budget. A few examples are given below to show how the expenses are estimated. (a) Fixed expenses are policy cost and hence they are based on policy matters. (b) For estimating indirect labour, work study is resorted to and a flexible estimate of number of indirect workers required for each level of direct workers employed is madefor example, one supervisor for every twenty direct workers. (c) In regard to the estimate of consumption of indirect materials, the age and condition of the plant and machinery are taken into consideration. Production cost budget - Production cost budget covers direct material cost, direct labour cost and manufacturing expenses. After preparing direct material, direct labour and production overhead cost budget, one can prepare production cost budget. Ending Inventory budget - This budget shows the cost of closing stock of raw materials and finished goods, etc. This information is required to prepare cost-ofgoods-sold budget and budgeted financial statements i.e., budgeted income statement and budgeted balance sheet. Cost of goods sold budget - This budget covers direct material cost, direct labour cost, manufacturing expenses and cost of ending inventory of finished products. We present below the cost-of-goods-sold budget on the basis of the data taken from the various budgets already illustrated: of the profit earning function. At the same time, the pre-determination of these costs is also very difficult. Selling cost is defined as the cost of seeking to create and stimulate demand and of securing orders. These costs are, therefore, incurred to maintain and increase the level of sales. All expenses connected with advertising, sales promotion, sales office, salesmen, credit collection, market research, after sales service, etc. are generally

grouped together to form part of the responsibility of the sales manager. While making a budget, selling costs are divided into fixed and variable. Semi-variable costs should also be separated into variable and fixed elements. The problems faced in the preparation of selling cost budgets are : (i) heavy expenditure on selling and sales promotion may have to be incurred when the volume of sales is falling off. This will increase the percentage of such costs to total sales, and (ii) sometimes intensive sales and promotion efforts are called for in one year and the benefit of such efforts accrue in the subsequent years. This makes it difficult to establish a proportion of selling cost to sales. In spite of these problems, some relationship between selling cost and volume of sales has to be established and it is the duty of the Budget Controller to determine the amount of selling costs to be incurred to achieve the desired level of sales volume. Using the past experience as a guide, consideration should be given to the future trend of sales, possible changes in competition etc., in pre-determination of selling costs. Distribution cost has been defined as the cost of the sequence of operations which begins with making the packet of product available for despatch and ends with making the re-conditioned return of empty package, if any available for re-use. It includes transport cost, storage and warehousing costs, etc. Preparation of the advertising cost budget is the responsibility of the sales manager or advertisement manager. When preparing the advertisement cost budget consideration should be given to the following factors : (a) The best method of advertisement must be selected; costs will vary according to the method selected. (b) The maximum amount to be spent in a period, say one year, has to be decided. (c) Advertising and sales should be co-ordinated. It means that money should be spent on advertisement only when sufficient quantities of the product advertised are ready for sale.

(d) An effective control over advertisement expenditure should be exercised and the effectiveness of the advertisement should be measured. The choice of the method of advertising a product is based on the effectiveness of the money spent on advertisement in increasing or maintaining sales. If the output sold increases, the production cost will come down because of the economies of large scale production. The amount to be spent on advertisement appropriation may be settled on the basis of the following factors: (i) A percentage on the total sales value of the budget period or on the expected profit may be fixed on the basis of past experience. (ii) A sum which is expected to be incurred by the competitors may be fixed to be spent during the budget period. (iii) A fixed sum per unit of output can be fixed and added to cost. (iv) An amount is fixed on the basis of the ability of the company to spend on advertising. (v) An advertisement plan is decided upon and the amount to be spent is determined. Depending upon the nature of the product and the effectiveness of the media of the advertising the company prepares a schedule of various methods of advertisement, to be used for effective sales promotion. The number of advertisements (insertions) are determined and the cost calculated as per the rates applicable to each of the media selected. This is a sound method. Administrative expenses budget - The administrative expenses are mostly policy costs and are, therefore, fixed in nature. The most practical method to follow in preparing estimate of these expenses is to follow the past experience with due regard to anticipated changes either in general policy or the volume of business. To bring such expenses under control, it is necessary to review them frequently and to determine at regular intervals whether or not these expenses continue to be adjusted. Examples of such expenses are : audit fees, depreciation of office

equipment, insurance, subscriptions, postage, stationery, telephone, telegrams, office supplies, etc. and/or improve products and methods. When research results in definite benefit to the company, development function begins. After development, formal production can commence on commercial scale and then production function starts. Since the areas of research and development cannot be precisely defined, the costs incurred under both the functions are clubbed together as research and development costs. Research and Development (R & D) plays a vital role in maintaining the business. For example, automobile manufacturers, and those who produce drugs, spend considerable sums on R & D to improve the products. Research may be either pure research or applied research. Pure research increasesmethods of production, etc. Research and development expenses should be controlled carefully and hence a limit on the spending is placed, i.e., the amount to be spent is carefully determined or allocated. The following are the methods of allocation of R & D expenses. (1) A percentage based on total sales value. This method is good if sales value is steady from year to year. (2) A percentage based on net profit. (3) A total sum is estimated on the basis of past experience and future R & D plans and policies. (4) A sum is fixed on the basis of cash resources available with the company. (5) All factors which affect the importance of R & D are considered. For example, factors like demand for existing products, competition, economic conditions, etc., are considered carefully and a sum is set as R & D budget. Capital expenditure budget - The capital expenditure budget represents the planned outlay on fixed assets like land, building, plant and machinery, etc. during the budget period. This budget is subject to strict management control because it entails large amount of expenditure. The budget is prepared to cover a long period of years and it projects the capital costs over the period in which the expenditure is to be incurred and the expected earnings. The preparation of this budget is based on the following considerations :

(i) Overhead on production facilities of certain departments as indicated by the plant utilisation budget. (ii) Future development plans to increase output by expansion of plant facilities. (iii) Replacement requests from the concerned departments. While preparing the capital expenditure budget, consideration should also be given to factors like sales potential to absorb the increased output, possibility of price reductions, increased costs of advertising and sales promotion to absorb increased output, etc. The advantages of capital expenditure budget are the following : (1) It outlines the capital development programme and estimated capital expenditure during the budget period. (2) It enables the company to establish a system of priorities. When there is a shortage of funds, capital rationing becomes necessary. (3) It serves as a tool for controlling expenditure. (4) It provides the amount of expenditure to be incorporated in the future budget summaries for calculation of estimated return on capital employed. (5) This enables the cash budget to be completed. With other cash commitments capital expenditure commitment should also be considered for the completion of the budget. (6) It facilitates cost reduction programme, particularly when modernisation and renovation is covered by this budget. Cash budget - Cash budget represents the cash requirements of the business during the budget period. It is the plan of receipts and payments 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. The cash budget is one of the most important elements of the budgeted balance sheet. Information from the various operating budgets, such as the sales budget, the direct materials purchases budget, and the selling and administrative expenses budget, affects the cash budget. In addition, the capital expenditures budget, dividend policies, and plans for equity or long-term debt financing also affect the cash budget.

Master budget - When all the necessary functional budgets have been prepared, the budget officer will prepare the master budget which may consist of budgeted profit and loss account and budgeted balance sheet. These are in fact the budget summaries. When the master budget is approved by the board of directors, it represents a standard for the achievement of which all the departments will work. On the basis of the various budgets (schedules) prepared earlier in this study, we prepare below budgeted income statement and budgeted balance sheet. Flexible budget : Definition - A flexible budget is defined as a budget which, by recognising the difference between fixed, semi-variable and variable costs is designed to change in relation to the level of activity attained. A fixed budget, on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. In a fixed budgetary control, budgets are prepared for one level of activity whereas in a flexible budgetary control system, a series of budgets are prepared one for each of a number of alternative production levels or volumes. Flexible budgets represent the amount of expenses that is reasonably necessary to achieve each level of output specified. In other words, the allowances given under flexible budgetary control system serve as standards of what costs should be at each level of output. Need : The need for the preparation of the flexible budgets arises in the following circumstances : (i) seasonal fluctuations in sales and/or production, for example in soft drinks industry; (ii) a company which keeps on introducing new products or makes changes in the design of its products frequently; (iii) industries engaged in make-to-order business like ship building; (iv) an industry which is influenced by changes in fashion; and (v) general changes in sales. Distinction between Fixed and Flexible Budget Fixed Budget 1. It does not change with actual volume of activity achieved. Thus it Flexible Budget It can be recasted on the basis of activity level to be achieved. Thus

is known as rigid or inflexible budget. 2. It operates on one level of activity and under one set of conditions. It assumes that there will be no change in the prevailing

it is not rigid. It consists of various budgets for different levels of activity

conditions, which is unrealistic. 3. Here as all costs like - fixed, Here analysis of variance provide variable and semi-variable so are useful information as each cost is related to only one level of activity analysed variance according to its behaviour.

analysis does not give useful information. 4. If the budgeted and actual Flexible then the aspects like budgeting at different

activity levels differ significantly, levels of activity, facilitates the cost ascertainment of cost, fixation of quotations. actual It provides a meaningful basis of of the actual ascertainment and price fixation do selling price and tendering of not give a correct picture. 5. Comparison of

performance with budgeted targets comparison there is a difference between the targets. two activity levels.

will be meaningless specially when performance with the budgeted

Chapter 7 PRICING

Pricing includes price, discounts, payment terms (installments), credit and mode of payment (cash or demand draft or cheque). Objectives in Pricing Profit maximization in the short term Profit optimization in the long run A minimum return on investment A minimum return on sales turnover Achieving a particular sales volume Achieving a particular market share Deeper penetration of the market Entering new markets Target profit on the entire product line, irrespective of profit level in individual products Keeping competition out, or keeping it under check Keeping parity with competition Fast turnaround and early cash delivery Stabilizing prices and margins in the market Providing the commodities at prices affordable by weaker sections Providing the commodities / services at prices that will stimulate economic development

Broad categories of Pricing Methods Cost-based pricing Demand-based pricing Competition-oriented pricing Value-pricing Product line-oriented pricing Tender pricing Affordability pricing Differentiated pricing

COST-BASED PRICING Types of Costs in this workshop / course conducted by TTTI: Fixed Costs (not related to number of participants) salaries & perks, rent, office expenses, payment to visiting faculty, travelling expenses, Variable costs (related to number of participants) food & snacks, photocopying expenses, folders In most educational institutes, programmes and services, fixed costs are predominant. Types of Cost-based Pricing: For cost-based pricing, first estimate variable costs per unit. Methods differ for allocation of fixed costs. a) Standard Cost Pricing i. Mark-up pricing Add a fixed mark-up say 10% or 20 % to variable costs. ii. Absorption cost pricing Estimate the total number of units likely to be sold and allocate complete fixed costs to the estimated number of units likely to be sold. iii. Target Rate of Return Pricing Similar to absorption cost pricing; add the expected rate of return on investments to fixed costs. b) Marginal Cost Pricing Contribution = Sales revenue per unit Variable cost per unit As long as a product generates positive contribution, it may be continued. Contribution accounting looks at the contribution generated. OTHER RELATED DIMENSIONS Price plays a communicative role index of quality or luxury or status or technical excellence or exclusiveness (It is said that Napoleon used to eat his food in aluminum utensils) Ex-factory price versus price to consumer Psychological pricing Customer has a mental price band for the product. To remain within the band, BPL priced its 21 inch color TV model at Rs.10,900- instead of Rs. 11,000-Similarly BATA price of Rs.499.99

Payment System cash / DD At one time Bajaj used to ask its customers to give a DD for purchase of any scooter. Many companies now use Roaming current account where a customer can deposit the payment. IIT JEE fee is payable at the local bank at the time of purchasing the form compare this with old system of postal order at the time of writing to IIT for form followed by more postal orders / DD with application form. Financing Options Even educational institutes may soon be offering package of loan with admission, in a manner similar to automobile companies.

References: Cost accounting by Maheshwari mittal, 4th addition Cost