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LESSON 1
1.0 Introduction
1.1 Objectives
1.2 Requirement for Reconciliation
1.3 Reasons for difference in Profit/Loss
1.4 System of Reconciliation
1.5 Memorandum Reconciliation Account
1.6 Summary of the chapter
1.7 Exercise
1.1 Objectives
When cost accounts and financial accounts are maintained separately in two different sets of
books, two profit and loss accounts will be prepared-one for costing books and the other for
financial books. The profit or loss shown by financial books may not agree with that shown by
costing books. So, both sets of books are tallied to know the reasons for disagreement of the two
profits.
It is essential to know that the question of reconciliation of cost and financial accounts arises
only under non-integral system. However, under the integral accounts, the problem of
reconciliation does not arise since cost and financial accounts are integrated into one set of
books and only one Profit and Loss Account is prepared.
1. It discloses the causes for variance in profit or loss between cost and financial
accounts.
2. Reconciliation aids in checking the arithmetic accuracy of both sets of books.
In other words, it enables to test the reliability of cost accounts.
3. It promotes coordination between cost accounting and financial accounting
departments.
1
1.3 Reasons for difference in Profit/Loss
Difference in profit or loss between cost and financial accounts may arise due to the
following reasons:
1. Items shown in cost accounts only- There are a few items which are included in
cost accounts and not in financial accounts. Examples:
2. Items shown only in financial accounts -there are a number of items which does not
appear in cost accounts but shown in financial accounts. At the time of reconciling, any
items under this category must be taken under consideration. Following are the examples
of such items.
(a) financial incomes
▪ Income tax refund
▪ Transfer fees received
▪ Dividend and interest received on investments
▪ Interest received on bank deposits
▪ Rent receivable
(b) financial expenses
• Loss on the sale of capital assets
• Amounts written off, goodwill, discount on debentures, preliminary expenses
• Provision for bad and doubtful debts
• Loss due to theft, pilferage, etc.
• Interest on bank loans and mortgages etc.
The financial and cost accounts are reconciled by preparing a Reconciliation Statement or a
Memorandum Reconciliation Account. The following procedure is suggested for preparing a
Reconciliation Statement:
• Opening Stock-
Deduct: Amount of under-valuation in cost accounts
Add: Amount of over-valuation in cost accounts
• Closing Stock-
Deduct: Amount of over-valuation in cost accounts
Add: Amount of under-valuation in cost accounts
3. Closing stock of finished goods in cost accounts in calculated on the basis of cost
of production. Thus
Value of closing stock = Cost of production X Units Produced
Units of Closing Stock
Here
Units Produced =Units sold+
Units in closing stock - Units in opening stock
4. After making all the above additions and deductions in costing profit, the result will be
the profit as per financial books.
3
5. The above treatment of items will be reversed when the starting point in the
Reconciliation Statement is the profit as per financial accounts or loss as per cost
accounts.
Add:
• Financial incomes not recorded in cost books
• Items charged only in cost accounts (Notional
rent and interest on capital, etc.)
Over-absorption of overheads
Rs.
Rs. Rs.
36,200
5
Illustration 2.
The profits as per cost accounts were Rs. 14,330, whereas the net profit as per
financial accounts of a company amounted to Rs. 9275. On reconciling the figure, the
following were noted:
Rs.
Reconciliation Statement
Particulars Rs. (+) Rs. (-)
Profit as per Cost Accounts 14,330
Less: Directors Fees not charged in Cost Account 525
Less: Provision for bad debts. not shown in Cost Accounts 485
Add: Bank interest credited in Profit & Loss Account 15
Less: Provision for income tax not shown in Cost
Accounts 4,150
Add: Over-recovery of overhead in Cost Accounts 90
14,435 5,160
Profit as per Financial Accounts 9,275
14,435 14,435
6
Illustration 3.
7
Illustration 4.
From the following figures,
prepare a reconciliation statement:
Cost Books Financial Books
Profit 25,000 ?
Marketing overheads 4,000 4,000
Provision for bad debts - 2,500
Factory overheads 4,250 3,500
Director's fees - 1,000
Income Tax paid - 7,500
Rent of owned Premises 3,000 -
Depreciation 5,625 6,000
Share transfer fee (Cr.) - 500
Administrative overheads 2,500 4,000
Solution
Reconciliation Statement
Particulars Rs - (+) Rs. (-)
Profit as per cost books
25,000
Less: Provision for bad debts charged in financial
books 2,500
Add: Factory overheads over-absorbed in cost accounts
750
Less: Director's fees charged in financial books 1,000
Less: Income tax charged in financial books 7,500
Add: Rent of owned premises charged in cost books
3,000
Less: Depreciation overcharged in financial books 375
Add: Share transfer fees credited in financial books
500
Less: Administrative overheads under absorbed in cost
books 1,500
12,875
29,250
Profit as per Financial Books 16,375
29,250 29,250
8
Illustration 5
From the following information, reconcile the profit as per cost accounts with financial
accounts:
Cost A/c Financial A/c
Rs. Rs.
Profit 86,250
Opening Stock:
Material 10,000 10,300
Work-in-progress 8,500 8,000
Closing Stock:
Material 14,200 15,000
Work-In-Progress 6,000 5,600
Dividend and interest received Rs. 600. Loss on sale of investment Rs. 1,000. Interest charged
by the bank not considered in Financial Accounts and Cost Accounts Rs. 1,500. Goodwill
written off during the year Rs. 2,500. Preliminary expenses written off Rs. 3,000. Overhead
incurred Rs. 40,000. Overhead absorbed in Cost Accounts Rs. 38,500. Find out profit as per
financial accounts.
Working Note: Interest charged by the bank not considered in Financial Accounts as well
as Cost Accounts will not be shown in Reconciliation Statement.
9
Illustration 6 (Do it yourself)
A manufacturing company disclosed a net loss of Rs. 3,47,000 as per their cost accounts for the
year ended March 31, 2004. The financial accounts however disclosed a net loss of Rs. 5,10,000
for the same period. The following information was discovered as a result of inspection of the
figures of both the sets of accounts:
Rs.
Factory overheads under-absorbed 40,000
Administration overheads over-absorbed 60,000
Depreciation charged in Financial Accounts 3,25,000
Depreciation recovered in Cost Accounts 2,75,000
Interest on investments not included in Cost Accounts 96,000
Income-tax provided 54,000
Interest on loan funds in Financial Accounts 2,45,000
Transfer fee (credit in financial books) 24,000
Stores adjustment (credit in financial books) 14,000
Dividend received 32,000
Prepare a statement showing reconciliation between the figure of net loss as per cost
accounts and the figure of net loss shown in the financial books.
Solution (Do it yourself)
Memorandum Reconciliation Account
Particulars Rs. Particulars Rs.
7,36,000 7,36,000
10
Illustration 7
M/s shreeram Traders maintains separate cost books which disclosed a profit of Rs.
15057 for the year ending March 31, 2010. The net profits disclosed by financial
accounts amounted to Rs. 9880. Upon enquiry, it is found that:
(i) Overheads charged to production in cost books were Rs. 3,750, whereas actual
overhead expenses amounted to Rs= 3,466.
(ii) The company made a provision of Rs. 300 for bad debts.
(iii) The company received interest on bank deposits amounting to Rs. 14.
(iv) It paid income tax Rs. 4,500.
(v) Installation of a new plant involved an expenditure of Rs. 6,000 but it had not
gone into production as yet. Depreciation @ 5% was provided on the cost of
the plant.
(vi) Directors were paid fee amounting to Rs. 375.
Prepare a reconciliation statement.
Solution
Reconciliation Statement
Particulars + Rs. -Rs.
15,355 5,475
11
Illustration 8
The following is the Trading and Profit & Loss Account of Sumit Industries Ltd. for
the year ended 31st December, 2016
Rs. Rs.
1,16,400 1,16,400
Solution:
Statement of Cost
Particulars Rs.
Materials 45,000
Wages 33,000
Prime Cost 78.000
Add: Works overhead (6,000 x 3) 18,000
Works Cost 96,000
Add: Administrative Overhead (6,000 x 1.50) 9,000
Cost of Production 1,05,000
Less: Closing Stock (1,05,000 x 1,200/6,000) 21,000
Cost of Goods sold 84,000
Profit 12,000
Sales 96,000
12
Working Note:
No. of units Produced = No. of units sold
+ No. of units in closing stock = 4.800 + 1.200 = 6,000
Reconciliation Statement
Particulars Rs. (+) Rs. (-)
15,000 6,600
15,000 15,000
Illustration 9
The following Profit and Loss Account for the year ending 31st March, 2010 has
been extracted from the books of Awadesh Ltd.
13
To Net Profit 3,000
54,000
By Sales 50,000
By Work-in-Progress in hand:
Direct labour 600
Cost Accounts manual states that the factory overheads are to be recovered
at50% of direct wages, administration overheads at 10% of works-cost and selling
and distribution overheads @ Re. 1. per unit sold.
The units of product sold and in-hand were 4,000 and 257 respectively.
Prepare: Statement of cost and profit as per Cost Accounts and Reconciliation
Statement.
Solution
Statement of Cost and Profit as per Cost Accounts
Particulars Rs.
14
Reconciliation Statement
Particulars Rs. (+) Rs. (-)
Rs. Units
15
Solution (Do it yourself)
Cost Sheet
Particulars Rs.
Materials 1,00,000
Wages 50,000
Prime Cost 1,50,000
Factory Overhead ?
Gross Factory Cost 2,00,000
Less: Closing Work-in-Progress 7,000
Factory Cost 1,93,000
Office and Administrative Overheads
(10% of Factory Cost 19,300
Cost of Production 2,12,300
Less: Closing Stock of Finished Goods ?
Cost of Goods Sold 2,00,000
?
Cost of Sales 2,20,000
Sales 2,50,000
16
Working Notes:
(v) Selling and distribution overhead is calculated for number of units sold.
Reconciliation Statement
Particulars Rs. (+) Rs. (-)
Cost Accounts ? -
39,700 28,700
Profit as per Profit and Loss A/c (39,700 -
28,700) - 11,000
39,700 39,700
17
Illustration 11(Do it yourself)
From the following information you are required to prepare:
(i) Cost Sheet for Articles A and B.
(ii) Profit and Loss Account as per financial hooks.
(iii) Reconciliation between profit as per cost books and as per financial books.
There was neither opening stock nor any closing stock. Works overhead are charged
100% on labour and office overhead are charged at 25% on works cost.
Solution:
Profit & Loss Account as per Financials’ Books
Particulars Rs. Particulars Rs.
To Material communed By Sales 6,13,000
? ?
To Labour ?
To Works Overheads 1,42,000
To Office Overheads 95,700
To Net Profit 1,44,300
6,13,000 6,13,000
Cost Sheet
Particulars A B Total
Rs. Rs. Rs.
Material communed 36,000 48,400 84,400
Labour Cost 63,000 83,600 1,46,600
Prime Cost 99,000 1,32,000 2,31,000
Add: Works overheads @ 100% on Labour
Cost ? ? ?
Works Cost 1,62,000 2,15,600 3,77,600
Add: Office overhead @ 25% on works cost ? ? ?
Cost of Goods produced/Sold ? ? ?
Profit 58,500 82 500 1,41,000
Total Sales 2,61,000 3,52,000 6,13,000
18
Reconciliation Statement
Particulars Rs.
Profit as per Cost Accounts 1,41,000
Add: Over-absorption of Works Overheads ?
1,44,300
Illustration 12
M/s Mysore petro Ltd. Showed a net loss of Rs 2,08,000 as per their financial accounts for the
year ended 31st march, 1989. The cost accounts, however, disclosed a net loss of Rs 1,64,00 for
the same period. The following information was revealed as a result of the scrutiny of the
figures of both the sets of books:
Factory overhead under-recovered 3,000
Administration overhead over-recovered 2,000
Depreciation charged in financial accounts 60,000
Interest on investment not included in costs 10,000
Depreciation recovered in costs 65,000
Income-tax provided 60,000
Transfer fees (in financial books) 1,000
Stores adjustment (credit in financial books) 1,000
Prepare a memorandum reconciliation account
Solution
Memorandum Reconciliation Account
================================================================
To Net Loss as per Costing Books 1,64,000 By administration overhead
Over-recovered in costs 2,000
To Factory overhead
Under-recovered in costs 3,000 By Depreciation over-charged
In costs 5,000
To Income-tax not provided in
Costs 60,000 By interest on investment
not included in costs 10,000
By Transfer fees in financial
Books 1,000
By Stores adjustments 1,000
By Net loss as per financial
Books 2,08,000
2,27,000 2,27,000
===============================================================================
Illustration 13
In reconciliation between cost and financial accounts, one of the areas of differences is for
different methods of stock valuation. State, with reasons, in each of the following circumstances
whether costing profit will be higher or lower than the financial profit.
19
Items of Stock Cost Valuation Financial Valuation
Raw material (opening) 50,000 60,000
Work-in-progress(closing) 60,000 50,000
Finished stock (closing) 50,000 60,000
Finished stock (opening) 60,000 50,000
Solution
In the reconciliation, it does not matter in which form the stock is kept, i.e., raw material, work-
in- progress or finished stocks. The basic principle is that if the opening stock is larger, profit is
lower whereas if the closing stock is larger, profit is higher and vice-versa. On the basis of this
principle, the following conclusions on the four propositions can be drawn:
1. Raw material (opening) is lower in cost accounts, the costing profit will be higher by Rs
10,000
2. Work-in-progress (closing) is higher in cost Accounts, costing profit will be higher by
Rs 10,000
3. Finished stock (closing) is lower in cost Accounts, costing profit will be lower by Rs
10,000.
4. Finished stock (opening) is higher by Rs 10,000 in cost Accounts, Costing profit will,
therefore, be lower by Rs 10,000.
Illustration 14
A company maintains separate cost and financial Accounts and the costing profit for 1991
differed to that revealed in the financial account which was shown as Rs 50,000.
The following information is available
Cost Accounts Financial Accounts
Opening stock of raw material 5,000 5,500
Closing stock of Raw Material 4,000 5,300
Opening stock of finished Goods 12,000 15,000
Closing stock of finished goods 14,000 16,000
Dividend of Rs 1,000 were received by the company
A machine with net book value of Rs 10,000 was sold during the year for Rs 8,000.
The company charged 10% interest on its opening capital employed of Rs 80,000 to its process
costs.
You are required to determine the profit figure which was shown in the cost accounts.
Solution:
Reconciliation Statement
20
Loss on sale of machinery excluded from cost accounts 2,000
Interest on capital excluded from cost accounts 8,000
less
Note. It has been presumed that interest on capital has been charged only in financial accounts.
1.6 Summary
The profit or loss shown by financial books may not agree with that shown by costing books. So
both sets of books are tallied to know the reasons for disagreement of the two profits. It is
essential to know that the question of reconciliation of cost and financial accounts arises only
under non-integral system. Reasons for difference in Profit/Loss may arise due to the following
reasons:
1. Items shown in cost accounts only.
2. Items shown only in financial accounts.
3. Under-absorption or over-absorption of overheads.
4. Bases of stock valuation.
5. Different charges for depreciation.
1.7 Exercise
Answer
1. The requirement for reconciliation of costing profits and financial profits arises if cost
accounts are maintained independent of financial accounts.
2. Income tax is provided only in financial accounts and not in cost accounts.
3. Different methods of charging depreciation are adopted in cost and financial books.
4. Rent on owned building is included in cost: accounts.
5. Purely financial incomes are included in Profit and Loss Account but are excluded from
the cost sheet.
6. Under-absorption of overheads decreases profit in costing books.
Answer
a) True
b) True.
c) True
d) True
e) True.
f) False. Under-absorption of overheads results in more profits.
Descriptive Questions
2.0 Introduction
2.1 Objectives
2.2 Reconciliation Statement
2.3 Profit and Loss Account as per financial books
2.4 Summary of the chapter
2.5 Exercise
2.1 Objectives
Illustration 1.The net profit of a Manufacturing Co. Ltd. appeared at Rs. 64,377 as
per financial records for the year ended 31st December, 1990. The cost books,
however, showed a net profit of Rs. 86,200 for the same per iod. A scrutiny of the
figures from both the sets of accounts revealed the following facts:
Rs.
Works overhead under-recovered in costs 1,560
Administration overhead over-recovered in costs 850
Depreciation charged in financial accounts 5,600
Depreciation recovered in costs 6,250
Interest on investments not included in costs 4,000
Loss due to obsolescence charged in financial accounts 2,850
Income tax provided in financial accounts 20,150
Bank interest and transfer fees in financial books 375
Stores adjustments (credit in financial books) 237
Loss due to depreciation in stock values (charged in financial 3,375
Prepare a statement showing the reconciliation between the figures of net profit as
per cost accounts and the figure of net profit shown in the financial books.
Illustration 2
A transistor manufacturer, who commenced his business on 1st January,1999
supplies you with the following information and asks you to prepare a statement
showing the profit per transistor sold. Wages and materials ar e to be charged at actual
cost, works overhead at 75% of wages and office overhead at 30% of works cost.
Number of transistors manufactured and sold during the year was 540.Other
particulars are:
Materials per set Rs. 240 Wages per set Rs. 80
Selling price per set Rs. 600
If the actual works expenses wer e Rs. 32,160 and office expenses were Rs. 61,800.
Prepare a Reconciliation Statement.
Solution :
STATEMENT OF PROFIT AS PER COST ACCOUNTS
========================================================== ===
Materials (Rs 240x540) Rs 1,29,600
Wages (Rs 80*540) 43,200
Prime cost 1,72,800
Works overhead (75% of wages) 32,400
Works cost 2,05,200
Office overhead (30% of works cost) 61,560
Total cost 2,66,760
Profit 57,240
Sales 3,24,000
========================================================= ====
Illustration 3
In a factory two types of radios are manufactured namely 'Model A' and `Model
B'. From the following particulars prepare a statement showing cost and profit per
radio sold.
Model A Model B
Labour Rs. 15,600 Rs. 69,920
Materials 27,300 1,08,680
Works expenses are charged at 80% on labour and office expenses at 15% on
works cost. The selling price of both radios is Rs. 1,000 each. 75 'Model A' radios and
300 'Model B' radios were sold.
Find out profit as per financial books assuming the actual works expenses as Rs.
64,020 and office expenses as Rs. 46,800. Reconcile the profits shown by cost and
financial books.
Solution :
Statement of cost and profit as per cost Accounts
Model A Model B
Radios manufactured 75 300
and sold
Total Per unit Total Per unit
Cost of materials 27,300 364 1,08,680 362.27
Cost of labour 15,600 208 69,920 233.07
Prime cost 42,900 572 1,78,600 595.34
Add: works 12,480 166.40 55,936 186.45
expenses(80% on labour)
41,597
25
Profit and Loss Account (As per financial Books)
=============================================================
To materials By sales
Model A 27,300 Model A 75,000
Model B 1,08,680 Model B 3,00,000
To Labour
Model A 15,600
Model 69,920
To work expenses 64,020
To office expenses 46,800
To Net Profit 42,680
3,75,000 3,75,000
=============================================================
RECONCILIATION STATEMENT
(+)
43,993 4,396
Working Notes :
Model A 8,307
26
Illustration 4
Mrs Piano co. which commenced business on 1 st January,1990, puts before you the
following information, and asks you to prepare a statement showing the profit per
piano sold (charge labour and material at actual cost, works overhead at 100% on
labour, and office overheads at 25% on works cost), and a statement showing a
reconciliation between the profits, as shown by the cost accounts and the profit as
shown by the profit and loss account for the year ended 31 st December, 1990.
Two grades of pianos are manufactured and are known as ‘Fi nis’ and ‘omega’. There
were no pianos in stock or in course of manufacture on 31 st December, 1990.
Average cost of materials per piano ‘Finis’ 8.00
Average cost of materials per piano ‘Omega’ 6.625
Average cost of Labour per Piano ‘Finis’ 14.625
Average cost of Labour per Piano ‘Omega’ 12.00
Finished Piano sold ‘finis’ 95.00
Finished Piano sold ‘Omega’ 160
Sale price per piano ‘Finis’ 60.00
Sale price per piano ‘Omega’ 45.00
Work expenses 4,200.00
Office expenses 1,555.00
You are required to prepare the necessary reconciliation statement
2,351.562
Illustration 5
Prepare a statement reconciling the profit as per cost records with the profit as per
financial records of the company.
28
Solution :
=============================================================
STATEMENT OF PROFIT AS PER COST ACCOUNTS
=============================================================
Materials 16,00,000
Wages 8,00,000
Prime Cost 24,00,000
Factory Overheads (100% of Wages) 8,00,000
32,00,000
Less :Closing Stock of Work-in-progress 1,12,000
Works Cost 30,88,000
Add: Administration overheads(10% on works cost) 3,08,800
Cost of production(21,230 units) 33,96,800
Less: closing stock (1,230 units) 1,96,800
Cost of production of goods sold 32,00,000
Add: selling and distribution over heads @Rs 16per unit sold 3,20,000
Cost of sales 35,20,000
Profit 4,80,000
Sales 40,00,000
=============================================================
Profit and loss Account (financial Books)
=============================================================
29
Problems (unsolved)
Problem 1. The following figures are available from financial accounts for the year
ended 31st March, 1996 :
Rs. Rs.
Direct material consumption 2,50,000 Legal charges 5,000
Direct wages 1,00,000 Dividend received 50,000
Factory overheads 3,80,000 Interest on deposit received 10,000
Administration overheads 2,50,000 Sales1,20,000 uni ts 7,00,000
Selling and distribution
overheads 4,80,000 Closing sto ck :
Bad debts 20,000 Finished stock 40,000 units 1,20,000
Preliminary expenses (written off) 10,000 Work-in-progress 80,000
The cost accounts reveal:
Direct material consumption: Rs. 2 ,80,000.
Factory overheads recovered at 20% on prime cost.
Administration overhead at Rs. 3 per unit of production.
Selling and distribution overheads at Rs. 4 per unit sold.
Prepare
1 . C osti ng pr ofi t and l oss account .
2 . Fi nan ci al profit and l oss acco unt .
3 . Statement reconciling the profits disclosed by the costing profit and loss
account and financial profit and loss account.
Problem 2
The following figures have been extracted from the financial accounts of a
Manufacturing Firm for the first year of its operatio n :
Rs. Rs.
Direct Material 50,00,000 Legal Charges 10,000
Consumption.
Direct Wages 30,00,000 Dividends 1,00,000
Received
Factory Overheads 16,00,000 Interest received 20,000
on Deposits
Administrative 7,00,000 Sales (1,20,000 1,20,00,000
Overheads units)
Selling and 9,60,000 Closing Stocks :
Distribution
Overheads
Bad Debts 80,000 Finished Goods 3,20,000
(4,000 units)
Preliminary Expenses 40,000 Work-in-progress 2,40,000
written off
The cost accounts for the same period reveal that the direc t material consumption was
Rs. 36,00,000. Factory overhead is recovered at 20% on prime cost. Adminis tration
overhead is recovered at Rs. 6 per unit of production. Selling and distribution
overheads are recovered at Rs. 8 per unit sold.
30
Prepare the Profit and Loss Accounts both as per Financial Records and as per Cost
Records. Reconcile the profits as per the two records.
Problem 3
The net profit of a company amounted to Rs. 60,412 for the year ending 31st
December, 1996, as per its financial records. The cost records, however, revealed a
different figure. A scrutiny of the two sets of accounts disclosed the following facts:
(a) Works overhead recovered in Cost Accounts during the period amounted to Rs.
28,450 while the actual amount of these expenses was Rs. 2 1,390 only.
(b) Actual office expenses for the period were Rs. 19,850, whereas the office
overhead recovered in Cost Accounts amounted to Rs. 14,500.
(c) The annual rental value of premises owned by the company, amounting to Rs:
10,800 was charged in Cost Accounts but not in Financial Accounts.
(d) Selling and Distribution expenses for the period amounting to Rs. 16,490 were
excluded from costing records.
(e) Excess depreciation charged in Cost Accounts -Rs. 2,400.
(f) Expenses not included in Cost Accounts and shown in Financi al Accounts :
Interest of Bank Loan Rs. 1,600
Bank charges 160
Director's fees 750
Penalty due to late completion on contract 2,500
(g) Gains during the year not included in Cost Accounts
Transfer fees R s. 4 5
Profit on sale of investment 4,250
Interest on investments 9,450
(h) The following appropriation had been made before arriving at the profit figure
of Rs. 60,412, shown above :
Transfer to Dividend Equalization Fund Rs. 10,500
Transfer to Income Tax Reserve 6,400
Transfer to Debenture Redemption Fund 9,000
(i) A sum of Rs. 10,000 given as donation to the Prime Minister's Relief Fund had
been charged to - Profit and Loss Account as business expense.
Problem 4
The following information is available from the financial books of a company having a
normal production capacity of 60,000 units for the year ended 31st March 1995 :
(i) Sales Rs. 10,00,000 (50,000 units).
(ii) There was no opening and closing stocks of finished units.
(iii) Direct material and direct wages cost were Rs.5,00,000 and Rs.2,50,000
respectively.
(iv) Actual factory expenses were Rs. 1,50,000 of which 60% are fixed.
(v) Actual administrative expenses were Rs. 45,000 which are completely fixed.
(vi) Actual selling and distribution expenses were Rs. 30,000 of which 40% are
fixed.
(vii) Interest and dividends received Rs. 15,000.
31
You are required to :
(a ) Find out profit as per financial books for the year ended 31st March, 1995;
(b ) Prepare the cost sheet and ascertain the profit as per cost account for the year
ended 31st March, 1995 assuming that the indirect expenses are absorbed on the
basis of normal production capacity; and Prepare a statement reconciling profits
shown by financial and c ost books.
Problem 5
The following transactions have been extracted from the financial books of M/s
Maheshwari Bros:
Rs. Units
Sales 2,50,000 20,000
Materials ' 1,00,000
Wages 50,000
Factory overheads 45,000
Office and administration overheads 26,000
Selling and distribution overheads 18,000
Closing Stock :
Finished goods 15,000 1,230
Work-in-progress:
Materials Rs. 3,000
Wages 2,000
Factory overheads 2,000 7,000
Goodwill written off 20,000
Interest on capital 2,000
In costing books factory overhead is charged at 100% on wages, administration
overhead at 10% of factory cost and selling and distribution at the rate of R s. 1
per unit sold. Prepare a statement reconciling the profit as per cost and financial
accounts.
Problem 6
From the following information
(i) determine the profit as it would be shown by cost accounts, and
(ii) prepare a statement reconciling it with profit shown by financial accounts
======================================================================
TRADING AND PROFIT AND LOSS ACCOUNT
(for the year ended 31st December, 1990)
======================================================================
32
The normal output of the factory is 1,50,000 units. Works expenses of a fixed nature are
Rs. 36,000. Office expenses are for all practical purposes constant. Selling and
distribution expenses are constant to the extent of Rs. 6,000, and the balance varies
directly with sales.
Problem 8
A transistor manufacturer who commenced his business on 1st January, 1999
supplies you with the following information and asks you to prepare a statement
showing the profit per transistor sold. Wages and materials are to be charged at actual
cost, works overhead at 75% of wages and office overhead at 30% of works cost.
Number of transistors manufactured and sold during the year was 540.
Other particulars are:
Materials per set Rs. 240
Wages per set Rs. 80
Selling price per set Rs. 600
If the actual works expenses were Rs. 32,160 and office expenses were Rs. 61,800 ,
prepare a Reconciliation Statement.
Problem 9
The following information is available from the financial books of a company
having a normal production capacity of 60,000 units for the year ended 31st March
1995 :
(i)Sales Rs. 10,00,000 (50,000 units).
(ii)There was no opening and closing stocks of finished units.
33
(iii)Direct material and direct wages cost were Rs. 5,00,000 and Rs. 2,50,000
respectively.
(iv)Actual factory expenses were Rs. 1,50,000 of which 60% are fixed.
(v)Actual administrative expenses were Rs. 45,000 which are completely
fixed.
(vi) Actual selling and distribution expenses were Rs. 30,000 of which 40% are
fixed.
(vii) Interest and dividends received Rs. 15,000.
Problem 10
M/s Alpha Ltd. made a profit of Rs. 23,000 during the year 1990 as per
costing records, whereas their financial accounts disclosed a profit of Rs. 15,000.
From the following profit and 16"ss account for the year ended 31.12.1990, as per the
financial books you are required to prepare a reconciliation statement :
Rs. Rs.
To Opening Stock 1,00,000 By Sales 1,75,000
To Purchases 80,000 By Closing Stock 80,000
To Direct Wages 20,000
To Factory Expenses 15,000
To Administration 10,000
Expenses
To Selling Expenses 15,000
To Net Profit 15,000
2,55,000 2,55,000
Problem 11
During the year a company's profits have been estimated from the costing system to
be Rs. 46,126, whereas the financial accounts audited by the auditors disclose a
profit of Rs. 33,248. Given the following information, you are required to prepare a
reconciliation statement showing clearly the reasons for the difference:
34
To Opening Stock Rs. 4,94,358 By Sales Rs. 6,93,000
To Purchases 1,64,308
6,58,666
Less :Closing Stock1,50,242 5,08,424
To Direct Wages 46,266
To Factory Overhead 41,652
To Gross Profit c/d 96,658
6,93,000 6,93,000
To Administration Expenses 19,690 By Gross Profit b/d 96,658
To Selling Expenses 44,352 By Sundry Income 632
To Net Profit 33,248
97,290 97,290
(a) Stock ledger closing balance is Rs. 1,56,394;
(b) Credit balance in wages control account is Rs. 49,734;
(c) Credit balance in factory overhead control account is Rs. 39,428;
(d) Administration expenses are charged to sales at 3% of selling price in cost
accounts, Selling price includes 5% (on sales) provision for selling expenses.
Sundry income is not considered in cost accounts.
Problem 12
From the following information (i) determine the profit as it would be shown by cost
accounts, and (a) prepare a statement reconciling it with profit shown by financial accounts
TRADING AND PROFIT AND LOSS ACCOUNT
(for the year ended 31st December, 1990)
Materials consumed Rs. Sales (1,00,000 Rs. 4,00,000
2,00,000 units)
Direct wages 1,00,000
Indirect expenses (works) 60,000
Office expenses 18,000
Selling and distribution 12,000
expenses
Net profit 10,000
Total 4,00,000 4,00,000
The normal output of the factory is 1,50,000 units. Works expenses of a fixed
nature are Rs. 36,000. Office expenses are for all practical purpose s constant.
Selling and distribution expenses are constant to the extent of Rs. 6,000, and the
balance varies directly with sales.
Problem 13
M/s B.K Piano Co., which commenced business on 1st January, 1990, puts
before you the following information, and asks you to prepare a statement showing
the profit per piano sold (charge labour and material at actual cos t, works overhead
at 100% on labour, and office overheads at 25% on works cost), and a statement
showing a reconciliation between the profits, as sho wn by the cost accounts and the
35
profit as shown by the profit and loss account for the year ended 31st December,
1990.
Two grades of pianos are manufactured and are known as 'Finis' and 'Omega'.
There were no pianos in stock or in course of manufacture on 31st December, 1990.
Average cost of materials per piano 'Finis' Rs. 8.000
Average cost of materials per piano 'Omega' 6.625
Average cost of labour per piano 'Finis' 14.625
Average cost of labour per piano `Omega' 12.000
Finished piano sold `Finis' 95
Finished piano sold 'Omega' 160
Sale price per piano 'Finis' 60.000
Sale price per piano 'Omega' 45.000
Works expenses 4,200.000
Office expenses 1,555.000
You are required to prepare the necessary reconciliation statement.
Problem 14
The net profit of a company amounted to Rs. 60,412 for the year ending 31st
December, 1996, as per its financial records. The cost records, however, revealed a
different figure. A scrutiny of the two sets of accounts disclosed the following facts:
(a) Works overhead recovered in Cost Accounts during the period amounted to Rs.
28,450 while the actual amount of these expenses was Rs. 21,390 only.
(b) Actual office expenses for the period were Rs. 19,850, whereas the office
overhead recovered in Cost Accounts amounted to Rs. 14 ,500.
(c) The annual rental value of premises owned by the company, amounting to Rs:
10,800 was charged in Cost Accounts but not in Financial Accounts.
(d) Selling and Distribution expenses for the period amounting to Rs. 16,490 were
excluded from costing records.
(e) Excess depreciation charged in Cost Accounts-Rs. 2,400.
(f) Expenses not included in Cost Accounts and shown i n Financial Accounts :
Interest of Bank Loan Rs. 1,600
Bank charges 160
Director's fees 750
Penalty due to late completion on contract 2,500
(g)Gains during the year not included in Cost Accounts
Transfer fees R s. 4 5
Profit on sale of investment 4,250
Interest on investments 9,450
(h)The following appropriation had been made before arriving at the profit
figure of Rs. 60,412, shown above :
Transfer to Dividend Equalization Fund Rs. 10,500
Transfer to Income Tax Reserve 6,400
Transfer to Debenture Redemption Fund 9,000
(i) A sum of Rs. 10,000 given as donation to the Prime Minister's Relief Fund
had been charged to - Profit and Loss Account as business expense.
36
2.4 Summary
2.5 Exercise
Theory Questions with answers
Q1. Why is it necessary to reconcile the Profits between the Cost Accounts & Financial
Accounts?
Ans: There is need for reconciliation because of maintenance of two sets of accounts. It finds
out reasons for the difference between the Net Profit & Loss in Cost accounts & those in
Financial accounts. It ensures the mathematical accuracy & reliability of Cost accounts in order
to have cost ascertainment, cost control & cost reduction.
Because of maintenance of two sets of accounts & different approach in cost accounts, profit or
loss revealed in Financial accounts may not agree with the profit or loss as per Cost accounts.
Every month or at least every six months, the two sets of records-cost and financial accounts
must be reconciled.
One may start with profit as per Cost accounts and arrive at the financial profit and vice-versa
by adding and subtracting the items of variation between both sets of accounts as shown in the
following Performa. I. Profit or loss as per cost accounts:
Add:
1. Income and profits taken in Financial accounts and not in Cost accounts
2.. Notional expenses taken in Cost accounts and not in Financial accounts
3. Over-absorption of overheads in Cost accounts
4. Excess valuation of opening inventory in Cost accounts as compared to valuation in
Financial accounts
5. Lower valuation of closing inventory in Cost accounts as compared to valuation in
Financial accounts
6. Excess depreciation accounted for in Cost accounts
37
Less:
7. Expenses and Losses accounted for in Financial accounts sand not in Cost accounts
8. Appropriations in Financial accounts only
9. Notional income taken in Cost accounts and not in Financial accounts
10. Under-absorption of overheads in Cost accounts
11. Lower valuation of opening inventory in Cost accounts as compared to valuation in
Financial accounts
12. Higher valuation of closing inventory in Cost accounts as compared to valuation in
Financial accounts
13. Lower depreciation accounted for in Cost accounts
Profit or loss as per Financial accounts
Note-Inventory includes raw materials, stores, spares, work-in-progress, stock of finished goods
etc. U. Profit as per Financial Accounts Add-Items 7 to 13 as mentioned above Less- Items 1 to
6 as mentioned above Prof it or loss as per Cost accounts
Q3. What are the reasons for disagreement of Profits as per financial accounts & cost Accounts?
Discuss.
or
List the Financial expenses which are not included in cost
Ans. Reasons for difference between Profits shown in Cost accounts & those shown in
Financial accounts.
2. Items included in cost accounts only: These are notional charges called as imputed
costs/opportunity costs.
(a) Interest on capital at notional figure though not incurred. -
(b) Salary of owner manager at notional figure though not incurred.
(c) Notional rent of own building.
(d) Notional Depreciation on the asset fully depreciated for which book value is
nil.
4. Different basis of stock valuation: In Financial accounts, stock may be valued at the
FIFO, Weighted Average or specific identification method whereas in Cost accounts, the
value of stock in hand may differ depending on the method followed for pricing of
material issues i.e., Simple Average, Specific identification, LIFO, HIFO, FIFO,
Weighted Average etc, resulting in different values of inventories in both these sets of
accounts:-
Valuation of work-in-progress (WTP) may be at prime cost or at prime cost + Factory
overhead & different basis may be used in valuing inventory of WIP in Cost &
Financial accounts. Similarly finished goods may be valued at prime cost ? Factory
overhead + Administration overhead i.e.. Cost of Production in Cost accounts and at
prime cost + Factory overhead in Financial accounts.
Q4. "Is reconciliation of cost accounts and financial accounts necessary in case of integrated
accounting system?'
39
Ans. Integrated Accounting is the-name given to a system of accounting whereby cost and
financial accounts are kept in the same set of books. Such a system will have to afford full
information required for Costing as well as for Financial Accounts. In other words", information
and data Should be recorded in such a way so as to enable the firm to ascertain the cost together
with the necessary analysis of each product, job, process, operation or any other identifiable
activity.
The integrated accounts give full information in such a manner so that the profit and loss
account and the balance sheet can be prepared according to the requirements of law and the
management maintains full control over the liabilities, and assets of its business.
While non-integrated system of accounting necessitates reconciliation between financial and
cost accounts, no reconciliation between two sets of accounts is required under integrated
accounting.
Q5. "Reconciliation of cost & financial accounts in the modern computer age is redundant."
Ans. In the modern computer age the use of computer knowledge and accounting software has
helped the field of Financial and Cost Accounting in a big way. In fact, computers work at a
very high speed and can process voluminous data for generating desired output in no time.
Output produced is precise and accurate. Computers can work for hours without any fatigue.
They can bring out different Financial Accounting Statements A reports accurately in a
presentable form. Financial accounts and Cost accounts show their results accurately and
precisely, when maintained on a computer system, but the profit shown by one set of books may
not agree with that of the other set.
Hence, the above statement is not correct & still reconciliation of financial & cost records is
impatient as both of records may differ.
40
LESSON 3
BUDGETARY CONTROL
3.0 Introduction
3.1 Objectives
3.2 Budget
3.2.1 Meaning
3.2.2 Definition of Budget
3.2.3 Characteristics
3.3 Budgeting
3.3.1 Meaning
3.3.2 Definition of Budgeting
3.3.3 Characteristics
3.3.4 Necessities of Budgeting
3.4 Budgetary Control
3.4.1 Definitions
3.4.2 Steps in the process of Budgetary Control System
3.4.3 Features
3.4.4 Objectives of Budgetary control
3.4.5 Advantages of Budgetary Control
3.4.6 Limitations of Budgetary Control
3.5 Fixed Budget and Flexible budget
3.6 Limitations of Fixed Budget and Flexible budget
3.7 Flexible Budget
3.7.1 Steps in preparing a flexible budget
3.7.2 Features
3.7.3 Benefits
3.8 Distinction between Distinction between Fixed & flexible budget
3.9 Summary of the chapter
3.10 Exercise
3.1 Objectives
After studying this chapter, students would be able to:
• Understand Budgeting- Meaning, Definition of Budgeting, characteristics &
Necessities of Budgeting
• Understand Budgetary Control-Definitions
• Understand Steps in the process of Budgetary Control System
• Understand Features and Objectives of Budgetary control
• Understand Advantages of Budgetary Control and Limitations of Budgetary Control
• Understand fixed Budget and Flexible budget and Limitations
• Understand Flexible Budget
--Steps in preparing a flexible budget
--Features
--Benefits
• Distinction between Fixed & flexible budget
41
3.2 Budgetary Control
Planning is the basic step for good management because it involves observing systematically at
the future. Monetary planning plays an important role in all the spheres of activities. Whether it
is household or business or government, planning is the first basic exercise to carry out before
venturing out for any activity. Financial budgets help managers in developing financial plan to
guide them in allocating their resources over a specific future period.
Budgeting is the most commonly management used tool of planning and controlling cost.
Control is the process of measuring and correcting actual performance to ensure that plans for
implementing the chosen course of action are carried out.
3.2.1 Meaning
The word ‘budget’ is derived from a French term “bougette” denoting a leather pouch in which
money is put in order to meet expected expenses.
Budget is a plan relating which is expressed in monetary and/ or quantitative terms for a
definite future period of time in relative to commercial aspect; a budget is a formal expression
of the expected incomes and expenditures for a definite future period.
3.2.2 Definition of Budget
"A budget is a pre-determined statement of management policy during a given period which
provides a standard for comparison with the results actually achieved." Brown and Howard
“Budget is an estimate of future needs arranged according to an orderly basis covering some
or all the activities of an enterprise for definite period of time.” George R. Terry
The Chartered Institute of Management Accountants (C.I.M.A.) London, has defined a budget
as "a financial and/or quantitative statement, prepared 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.
3.2.3 Characteristics
3.3 Budgeting
3.3.2 Definitions
“Budgeting may be said to be the act of building budget.” Rowland & Hary
“The entire process of preparing the budget is known as budgeting.” Batty
Thus budgeting involves studying the business situations, understanding the management
objectives and also the capacity of the enterprise. Budgeting is a planning function while its
implementation is a control function.
3.3.3 Characteristics
It is a method of planning keeping future aspects in mind. b. It tries to solve various problems
that may arise in future. c. It is the process of allocation of resources within different activities,
processes, departments and levels etc. d. Its main objective is fixation and achievement of goals
for different parts of the organization and the organization as a whole.
3.3.4 Necessities of Budgeting
1. Realistic goals. The budget goals should be realistic and almost attainable. The responsible
executives should do a lot of effort before preparing budget.
3. Involvement of executives. Those entrusted with the performance of the budgets should
contribute in the process of setting the budget. This will make sure proper implementation
of budget programmes.
5. Integration with standard costing system. Where standard costing system is also used,
it should be completely integrated with the budget programme, in respect of both
budget preparation and variance analysis.
6. Cost of the system. The cost of budget system should not be more than the benefit of
it. Since, it is not practicable to calculate exactly what a budget system is worth, it only
implies a caution against adding expensive refinements unless their value clearly
justifies them.
43
7. Support of top Management. Support of the top management required to implement
the budget system is successfully. No control system can be effective unless the
organisation is convinced that the top management considers the system to be
important. Since the top management must be committed to the budget idea as well as to
the principles, policies and philosophy underlying the system.
1. Establishment of budgets - Budgets are prepared for each department and then
they are presented to the management for approval.
4. Revision – The budgets are revised in the light of changes in the conditions and
Circumstances.
3.4.3 Features
1. The efficiency of budgetary control depends on how correctly estimates have been made
about future.
2. Budgetary control involves comparison of actual results with budgetary standards.
3. Budgetary control is a persistent activity. Managers at all levels need to participate in the
budgetary control.
4. Budgetary control focuses on specific and time-bound goals.
5. Budgetary control is a continuous exercise. A budgeted plan is framed, it is implemented, it is
compared with actual results, it is revised and followed by another plan.
1. Since budgets are based on the estimates of future and future is uncertain, so the budgets
may or may not be true.
2. Budgets cannot be executed automatically. Thus it may provide a false sense of security.
3. When the staff co-operation is not available, the whole budgetary control exercise will be
waste.
4. Introducing and implementing the budgetary control system is an expensive exercise.
Sometimes it may happen that the cost of introducing and operating a budgetary control
system exceeds the benefits derived there from.
5. Budgets are considered to be rigid documents. Therefore budgets should be thoroughly
revised with the change in the circumstances.
On the basis of level of activity or capacity, budgets are classified into fixed budget and flexible
budget.
45
A fixed budget means a budget which is prepared for fixed level of activity. It is defined as a
fixed budget is a budget designed to remain unchanged irrespective of the level of activity
attained. A fixed budget has following characteristics:
• A fixed budget is a rigid budget.
• It is suitable for the conditions when output and sales can be estimated with a fair degree
of accuracy. It means where sales and output cannot be accurately estimated, fixed
budget does not suit.
• A fixed budget is geared towards a single level of activity,
Fixed budget is also known as "Static" or "Rigid' budget. A fixed budget does not take into
consideration any change in the level of activity,
3.6 Limitations
1. Preparation of fixed budget does not involve detailed analysis of costs into fixed,
variable and semi-variable costs.
2. It cannot be used for price fixation and cost ascertainment.
3. As a tool of cost control, it is ineffective if the level of activity attained is different from
the level of budgeted activity. Generally actual level of activity is different from
budgeted level of activity.
4. Fixed budget does not suit in the situations where sales and output cannot be accurately
estimated.
A flexible budget is designed to change in relation to the change in the level of activity. In this
budget, a series of budgets are prepared at different levels of activity. It can be prepared for
different levels of activity, like 60%, 70%, 80% etc. It is useful for cost control, cost
ascertainment and performance appraisal for the tenders and quotations.
CIMA London defines a flexible budget as a budget which is designed to change in relation
to the level of activity attained:"
3.7.1 Steps
Following are the basic steps in preparing a flexible budget:
(i) The first step is to determine the relevant range over which activity is expected to
fluctuate during the budget period.
(ii.) Next step is to analyse the costs that will be incurred over the relevant range in terms of
determining cost behaviour.
(iii) Now all the costs are classified into fixed, variable and semi-variable costs.
(iv) Semi-variable costs are segregated into fixed component and variable component.
Variable component of semi-variable cost is calculated by using following
formula:
46
Variable Component of Semi-Variable Cost per unit
Change in Semi-variable Cost
Change in Output
On the basis of variable component per unit, variable component of semi-variable
cost is calculated as under:
Variable Component = Variable Component per unit
x No. of units at a production level
Now fixed component of semi-variable cost is calculated as under: Fixed Component
--Semi-variable Cost
--Variable Component
(v) Finally various elements of cost are ascertained for various levels of activity.
3.7.2 Features
Flexible budget has following features:
(i) A flexible budget does not confine itself to a single level of activity but is geared
towards a range of activity. A flexible budget can complied for any level of activity
say 50%, 60%, 70% or 100% capacity utilisation.
(ii) A flexible budget is dynamic in nature rather than static.
(iii) A flexible budget is prepared after making an intelligent classification of all expenses
between fixed, semi-variable and variable expenses.
3.7.3 Benefits
Flexible budget is prepared in such a way so as to present the budgeted cost for different levels of
activity. Flexible budget is more realistic and practical because changes expected at different
levels of activity are given due consideration. Following are the main, advantages of a flexible
budget:
(i) A flexible budget makes it possible to establish budgeted cost for any level of activity
within the relevant range even after the period. 's activity is over.
(ii) A flexible budget is helpful in assessing the performance of departmental heads
because their performance can be judged in relation to the level of activity
attained. Flexible budget is a readymade comparison for cost control,
(iii) Flexible budget makes it possible to ascertain the cost at various levels of activity.
Flexible budget is helpful in price fixation and sending quotations.
(iv) Flexible budget assists in evaluating the effects of varying volumes of activities on profits
and on cash position. Flexible budget facilitates production planning as well as profit
planning.
(v) Flexible budget helps in controlling overheads.
Following are the situations where flexible budget proves its worth in decision-making:
47
(i) Where the industry is subject to sudden changes in fashion, designs, tastes and consumer
preferences.
(ii) Where overall business is highly dynamic and fast changing.
(iii) Where consumer profile, product profile and technology are fast changing.
(iv) Where the company frequently introduces new products.
(v) Where large part of output is meant for export.
Following table shows the distinction between fixed budget and flexible budget:
Illustration 1
ABC Ltd. prepares a flexible budget which revealed that the cost of production is of ' 79000 at
an anticipated 10000 unit's activity level. Variable production costs were
How much is the total production cost for an activity level of 10,800 units
48
Solution:
Activity Levels
Cost per Unit (') 10,000 10,800
Direct Material 1.50 15,000 16,200
Direct Labour 3.50 35,000 37,800
Variable Factory Overheads 0.75 7,500 8,100
Fixed Cost 21,500 21,500
Total Cost 79,000 83,600
Illustration 2
The following data are available in a manufacturing company for a yearly period:
Fixed expenses: Rs. lakhs
Wages and salaries 9.5
Rent, rates and taxes 6.6
Depreciation 7.4
Sundry administration expenses 6.5
Semi--variable expenses (At ,50% of capacity):
Maintenance and repairs 3.5
Indirect labour 7.9
Sales department salaries 3.8
Sundry administration expenses 2.8
Variable expenses (at 50% of capacity)
Materials 21.7
Labour 204
Other expenses 7.9
98
Assume that the fixed expenses remain constant for all levels of production, semi-variable
expenses remain constant between 45% and 65% of capacity, increasing by 10% between 65%
and 80% capacity and by 20% between 80% and 100% capacity.
Sales at various levels are:
Rs. (lakhs )
50% capacity 100
60% capacity 120
75% capacity 150
90% capacity 180
100% capacity 200
Prepare flexible budget for the year and forecast the profits at 60%, 75%. 90% and 100% of
capacity.
49
Solution
I. Sales 600
II. Direct Material 125
Direct Labour 125
Direct Expenses 50
III. Semi-Variable Expenses
Repairs & Maintenance 50
Indirect Labour 25
Supervision 25
Heating & Lighting 10
IV. Fixed Expenses
Salaries–Managers 15
Rents, Rates &Taxes 15
50
Depreciation 20
Audit Fees 10
V. Total Cost of Sales 470
VI. Budget Profit 130
Construct a Flexible Budget for 30%, 50% and 70% capacity utilization, showing Variable
and Semi-Variable Cost, Cost of Sales and Profit with the help of following assumptions:
Fixed Expenses will remain constant at all the levels of the activity.
Semi Variable Expenses remains constant between 25% and 45% capacity, increases by
10% between 45% and 60% capacity and by 20% above 60% capacity.
Solution3:
Flexible Budget for the year ended 31-3-2013 (in Lacs)
Activity Level 40% 30% 50% 70%
I Sales 600 450 750 1050
II Direct Cost
Material 125 93.75 156.25 218.75
Labour 125 93.75 156.25 218.75
Expenses 50 37.50 62.50 87.50
Total 300 225.00 375.00 525.00
III Semi-Variable Cost
Repairs& 50 50 55 60
Maintenance
Indirect Labour 25 25 27.5 30
Supervision 25 25 27.5 30
Heating & Lighting 10 10 11 12
110 110 121 132
IV Total of II and III 410 335 496 657
V Fixed Expenses 15 15 15 15
Salaries–Managers
Rents, Rates & 15 15 15 15
Taxes
Depreciation 20 20 20 20
Audit Fees 10 10 10 10
60 60 60 60
VI Total Cost of 470 395 556 717
Sales IV&V
VII Profit(I–VI) 130 55 194 333
Illustration 4
Prepare Flexible Budget. for production at 80 per cent and 100 per cent activity on the basis of
the following information:
Production at 50% capacity 5,000 units
Raw materials Rs. 80 per unit.
Direct labour Rs. 50 per unit.
Direct Expenses Rs. 15 per unit.
Factory Expenses Rs. 80,000 (50% fixed)
Administration Expenses Rs. 1,60,000 (60% variable)
51
Solution
Illustration 5
Production costs of Oriental Enterprises Limited are as follows:
Level of Activity
60% 70% 80%
Output (units) 1,200 1,400 1,600
Costs (Rs.):
Direct materials 24,000 28,000 32,000
Direct labour 7,200 8,400 9,600
Factory overheads 12,800 13,600 14,400
Works cost 44,000 50,000 56,000
A proposal to increase production to 90% level of activity is under the consideration of
management. The proposal is not expected to involve any increase in fixed factory overheads.
Prepare a statement showing the prime cost, total marginal cost and total factory cost at
60%, 70%, 80% and 90% activity levels.
52
Solution (try to find yourself)
Statement -Showing Costs at Various Levels of Activities
Level of Activity
Output (in units)
Direct material
Direct labour
Prime Cost
Variable factory overhead
Marginal Cost
Fixed factory overhead
Factory Cost
Working note:
Change in Cost
Variable Component per unit = Change in Output
13,600-12,800
1,400-1,200
Rs. 4
53
Solution
Flexible budget for the period…………
Particulars , Ri
At 70% At 80% At 90%
Capacity Capacity Capacity .
Variable overheads: Rs. Rs. Rs.
Indirect labour 10,500 12,000 13,500
Stores including spares 3,500 4,000 4,500
Semi-variable overheads:
Power—Fixed 6,000 6,000 6,000
Variable 12,250 14,000 15,750
Repairs and maintenance—Fixed 1200 1200 1200
Variable 700 800 900
Fixed overheads:
Depreciation 11000 11,000 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000
Total overheads 58,150 62,000 62,850
Illustration 7
The budget manager of Jupiter Electricals Limited is preparing a flexible budget for the
accounting year starting from 1 July, 2008.
The company produces one product-DETX II. Direct material costs Rs. 7 per unit. Direct
labour averages Rs. 2.50 per hour and requires 1.6 hours to produce one unit of DETX II.
Salesmen are paid a commission of Re. I per unit sold. Fixed selling and administrative expenses
amount to Rs. 85,000 per year..
Manufacturing overhead is estimated in the following amounts under specified conditions
of volume:
Volume of production (m units):1,20,0001,50,000
Rs.. Rs.
Expenses:
Indirect material 2,64,000 3,30,000
Indirect labour 1,50,000 1,87,500
Inspection 90,000 1,12,500
Maintenance 84,000 1,02,000
Supervision 1,98,000 2,34,000
Depreciation-plant and equipment 90,000 90,000
Engineering Services 94,000 94,000
Total manufacturing overhead 9,70,000 11,50,000
Working Notes.
(i) Depreciation and engineering services are same at two levels of production and, therefore,
are of fixed nature.
(ii) Supervision and maintenance are semi-variable costs. Variable components of these two
items will be calculated as under:
(iii) Variable cost per unit =
Change in Cost
Change in Output
Variable component of supervision per unit= 2,34,000-1,98,000
1,50,000–1,20,000
36,000
30,000
= Rs. 1.20 per unit
3.9 Summary
Financial budgets help managers in developing financial plan to guide them in allocating their
resources over a specific future period.
55
Budgeting is the most commonly management used tool of planning and controlling cost.
Control is the process of measuring and correcting actual performance to ensure that plans for
implementing the chosen course of action are carried out.
Budgeting is a process undertaken by organizations to manage money in the most effective way
that facilitates the organizations to meet their financial goals and dreams. On the basis of level
of activity or capacity, budgets are classified into fixed budget and flexible budget. A fixed
budget means a budget which is prepared for fixed level of activity. A flexible budget is
designed to change in relation to the change in the level of activity. Flexible budget is more
realistic and practical because changes expected at different levels of activity are given due
consideration.
3.10 Exercise
Answer
1. True, 2. True, 3. False, 4. False, 5. False
Exercise 2: Short Answer Type Questions:
58
LESSON 4
CASH BUDGET
4.0 Introduction
4.1 Objectives
4.2 Cash Budget
4.3 Advantages of Cash Budget
4.4 Zero–Based Budgeting
4.4.1 –Advantages
4.4.2 -Limitations
4.5 Master Budget
4.6 Summary of the chapter
4.7 Exercise
4.1 Objectives
The cash budget is one of the most important and one of the last to be prepared. It is a detailed
estimate of cash receipts from all sources and cash payments for all purposes and the resultant cash
balances during the budget period. It makes certain that the business has sufficient cash available -
to- meet its needs as and when these arise. It is a device for coordinating and controlling the
financial side of the business to ensure solvency and provide a basis for planning and financing
required to cover up any deficiency in cash. Cash budget thus plays an important role in the
financial management of a business undertaking.
Purposes: The main purposes of cash budget are outlined below:
a) It ensures that sufficient cash is available when required.
b) It indicates cash excesses and shortages so that action may be taken in time to invest any excess
cash or to borrow funds to meet any shortages.
c) It establishes a sound basis for credit.
d)It shows whether capital expenditure may be financed internally.
e) It establishes a sound basis for control of cash position.
Cash budget is prepared on the basis of anticipated cash receipts and anticipated cash payments
during the budget period. One part of the budget shows anticipated cash receipts while other
part shows estimated cash payments. The excess of opening cash balance and estimated cash
receipts over estimated cash payments results in budgeted closing balance of cash. Budgeted
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closing balance of cash may be positive or negative. The equation of cash budget may be
expressed as under:
Budgeted Closing Cash Balance = Opening Cash Balance + Anticipated Cash Receipts
- Anticipated Cash Payments
Cash budget is an important financial tool for the management. Following are the main
advantages of cash budget:
Efficient Cash Management: Cash is the basis for all operations. Cash budget helps in
evaluating financial policies and cash position. Cash budget enables the management to plan
and coordinate the financial operations properly. The management can know how much cash is
needed and from which source it will be generated.
Internal Financial Management: Cash budget provides information about cash which
will be available. This will help the management in determining policies regarding internal
financial management e.g. possibility of payment of long-term debt, dividend policy,
replacement of machinery etc.
Movement of Cash: Cash budget discloses the complete story of cash movement. Cash
budget enables a company to meet all its commitments in time and at the same time prevent
accumulations of unnecessary large balance with it.
Cash Planning: Cash budget determines the future cash needs of the firm. The extent of
success or failure of cash planning can be known by the cash budget. Cash budget ensures that
sufficient cash is available when required. If shortage of cash is expected, action may be taken
to raise the funds internally or externally. If surplus of cash is expected management may invest
or lend this surplus.
This is a method of budgeting which is based on the objective of resetting the clock
each year. In this method of budgeting, during the process of review, no reference is made to
the previous level of expenditure and budgets are re-evaluated thoroughly, starting from the
zero-base level. In this method of budgeting, each cost element is justified specifically as if
the activities which are related to the budget are undertaken for the first time, as this is based
on the promise that even the expenditure of a rupee requires justification. No reference is
made to the previous level of expenditure during the process of review of this method. This
method of budgeting is based on the premises that even the expenditure of a rupee requires
justification. Therefore, the activities related to the budget which are undertaken for the first
time are required to be justified for each cost element. Thus, in this method of budgeting the
concentration is put on, “why this unit requires a particular amount and not simply on how
much” this unit requires. With the use of this method of budgeting there is an effective
utilization of limited resources, so that organization objectives can be achieved.
4.4.1 Advantages
Illustration 1
From the following data, prepare a cash budget for the three months commencing from 1st
June, 2008 when the bank balance was Rs. 1,00,000:
Solution
Preparation of Cash Budget from June to August, 2008
Particulars June July August
Opening Balance
1,00,000 1,15,400 1,25,900
Add: Receipts:
Collection from Debtors 80,000 76,500 78,500
Cash Budget
April May June
Receipts:
Opening Balance of Cash Receipts 40,000 32,000 20,750
Cash Sales (25% of current month's sales) 23,750 32,500 25,000
Collection from Debtors (75% of previous 60,000 71,250 97,500
month's sale)
Total Receipts 1,23,750 1,35,750 1,43,250
Payments:
Creditors 45,000 65,000 60,000
Wages 9,000 8,500 11,000
Factory Expenses 7,250 7,500 6,270
Office Expenses 7,000 6,000 5,000
Selling Expenses 3,500 3,000 5,500
Dividend to Shareholder 20,000
Bonus to Workers 25,000
Purchase of Plant 2,00,000
Payment of Income Tax 60,000
Total Payments 91,750 1,15,000 3,47,770
Closing Balance (Receipts - Payments) 32,000 20,750 2,04,520
Notes: The company is required to make overdraft facility to the extent of 204520 in
the month of June.
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Illustration 3
Prepare a cash budget from the following data for three months from 1.4.2008
(Rs.)
Month Credit sales Purchases Wages
February 2008 1,80,000 1,24,800 12,000
March 2008 1,92,000 1,44,000 14,000
April 2008 1,08,000 2,43,000 11,000
May 2008 1,74,000 2,46,000 10,000
June 2008 1,26,000 2,68,000 15,000
Fifty per cent to credit sales are realized in the month following the sales and the remaining
fifty per cent in the second month following.
Creditors are paid in the month following the month of purchase. Wages paid in the
month itself. Cash at bank on 1.4.2008 (estimated) Rs. 25,000.
Solution
Cash Budget for 3 Months Ending
Particulars April May June
Illustration 4
A company making for stocks in the first quarter of the year is assisted by its bankers with
overdraft accommodation.
The following are the relevant figures (budgeted):
Budgeted cash at the bank 1 st January is Rs. 8,600. Credit terms of sales are payment by the
end of the month following the month of supply. On average, one half of the sales are paid on
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the due date while the other half are paid during the next month. Creditors are paid during the
month following the month of supply.
You are required to prepare a Cash Budget for the quarter 1st January to 31st March, 2008
showing the budgeted amount of bank facilities required at each month end.
Solution
Cash Budget for the quarter ending 31st March, 2008
Particulars January February March
Rs. Rs. Rs.
Opening Cash balance as on 8,600 18,600 (-
Receipts: )16,200
Sales proceeds 62,000 50,000
47,000
Total Receipts
70,600 68,600 30,800
Payments:
Purchases 48,000 81,000 82,000
Wages 4,000 3,800 5,200
Total Payments Closing Balance 52,000 84,800 87,200
18,600 (-) 16,200 (-)
56,400
Note: Bank overdraft required for February is Rs. 16,200 and for March is
Rs. 40,200 (56,400- 16,200).
Illustration 4
A company is expecting to have Rs. 35,000 cash in hand on 1st April, 2008 and it requires you
to prepare a budget for three months April to June 2008.
The following information is supplied to you:
Other information:
1. Period of credit allowed by suppliers: two months.
2. 25% of the sales are for cash and period of credit allowed to customers for credit
sales one month.
3. Delay in payment of wages and expenses: one month.
4. Income Tax of Rs. 20,000 is to be paid in June 2008.
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Solution
Cash Budget for the three months April-June 2008
Illustration 5
Prepare cash budget of a company for April, May and June 2008 in a columnar
form using the following information:
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Solution
CASH BUDGET for April-June 2008
Particulars April May June
Cash Balance b/d 15,000 11,700 12,700
Add: Cash inflows:
Cash sales-20% 18,000 17,000 16,000
Cash Collection from debtors 66,000 70,000 66,000
99,000 98,700 94,700
Less: Cash out flows:
Cash purchases 10% 5,000 4,500 3,500
Payment to Creditors 37,800 45,000 40,500
Wages 23,000 22,000 19,000
Rent 500 500 500
Expenses 6,000 6,000 5,000
Fixed Deposits 15,000 8,000 13,000
Balance c/d 11,700 12,700 13,200
99,000 98,700 94,700
Note: It is assumed that wages and expenses are paid on 16th and 1st of the following
month i.e. fortnightly.
Illustration 6
Prepare a Cash Budget for the three months ending 30th June, 2008 from the information
given below:
( a ) Months Sales Purchase Wages Expense
s s
Rs. Rs. Rs. Rs.
February 14,000 9,600 3,000 1,700
March 15,000 9,000 3,000 1,900
April 16,000 9,200 3,200 2,000
May ' 17,000 10,000 3,600 2,200
June 18,000 10,400 4,000 2,300
(b) Credit terms are:
Sales and debtors - 10% sales are on cash, 50% of the credit sales are collected next
month and the balance in the following month:
Creditors— Materials 2 months
Wages 1/4 month
Overheads 1/2 month
Cash and bank balance of 1st April, 2008 is expected to be Rs. 6,000.
Other relevant information is:
(i) Plant and machinery will be installed in February 2008 at a cost of Rs. 96,000. The
monthly installments of Rs. 2,000 is payable from April onwards .
(ii)Dividend @ 5% on Preference Share Capital of Rs. 2,00,000 will be paid on 1st June.
(iii)Advance to be received for sale of vehicles Rs. 9,000 in June.
(iv) Dividends from investments amounting to Rs. 1,000 are expected to be received in
June.
(v) Income tax (advance) to be paid in June is Rs. 2,000.
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Solution
Cash Budget For three months ending 30th June, 2008
Particulars April May June
Rs. Rs. Rs.
Opening Balance 6,000 3,950 3,000
Receipts:
Cash Sales 1,600 1,700 1,800
Collection from Debtors 13,050 13,950 14,850
Dividend — — 1,000
Advance against vehicle — — 9,000
Total 20,650 19,600 29,650
Payments:
Creditors (materials) 9,600 9,000 9,200
Wages 3,150 3,500 3,900
Overheads 1,950 2,100 2,250
Instalment for plant 2,000 2,000 2,000
Preference dividend — — 10,000
Income-tax advance — —. 2,000
Total 16,700 16,600 29,350
Closing balance 3,950 3,000 300
Working Notes:
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Payment to creditors for materials will be as under:
Purchases of February will be paid in April
Purchases of March will be paid in May
Purchases of April will be paid in June
Payment of Wages in April = (3,000x1/4)+(3,200x3/4)= Rs. 3,150 Payment
of Wages in May = (3,200x ¼)+(3,600x3/4) = Rs. 3,500
Payment of Wages in June = (3,600x1/4)+(4,000x3/4) = Rs. 3,900
Payment of Overhead in April = (900x1/2)+(2,000x1/2) = Rs 1,950
Payment of Overhead in May = (2,000x1/2)+(2,200x1/2) =Rs 2,100
Payment of Overhead in June = (2,200x1/2)+( 2,300x1/2) =Rs 2,250.
Each manager who is responsible for meeting the budgeted performance has to prepare a
budget. When all the budgets are prepared by respective managers, these are coordinated with
each, other and summarized into a budget which is known as Master Budget. Thus, a master
budget is a consolidated summary of all the functional budgets. According to CIMA London
"Master budget is a summary budget incorporating its component functional budgets.
Accordingly, master budget comprises the functional budget summaries. Master budget
projects the activities of a business during the budget period and is, thus, a profit plan. Master
budget gives a projected overall profit position of the organisation. Master budget serves as a
set of goals to be achieved by the organisation during the budget period. This budget consists of
three parts. budgeted income statement, budgeted balance sheet, and budget ratios.
4.6 Summary
The cash budget is one of the most important and one of the last to be prepared. It is a detailed
estimate of cash receipts from all sources and cash payments for all purposes and the resultant cash
balances during the budget period. Zero–Based Budgeting this is a method of budgeting which is
based on the objective of resetting the c lock each year. In this method of budgeting, during the
process of review, no reference is made to the previous level of expenditure and budgets are re–
evaluated thoroughly, starting from the zero base level. Each manager who is responsible for
meeting the budgeted performance has to prepare a budget. When all the budgets are prepared
by respective managers, these are coordinated with each, other and summarized into a budget
which is known as Master Budget. Thus, a master budget is a consolidated summary of all the
functional budgets.
4.7 Exercise
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(v) A fixed budget is useful only when the actual level of activity corresponds to the
budgeted level of activity.
(vi) A flexible budget is one which changes from year to year.
(vii) A budget discloses area of potential improvement in the company's operations.
(viii) A budget is nothing but an estimate.
(ix) Budgetary control is exercised through the establishment of budgets.
(x) Forecasting is concerned with planned events.
(xi) A budget usually covers a long period while forecasting is planned for short period.
(xii) Budgetary control is based on the principle of management by exception.
(xiii) A budget is a means and the budgetary control is the end.
(xiv) Flexible budget is one which is designed to change with the level of activity.
Ans.
Ans.
(i) Master budget
(ii) Functional
(iii) Flexible
(iv) Fixed
(v) Defined
(vi) Making
(vii) Anticipated
(viii) Forecasting
(ix) Budgets, forecasts
(x) Means, end.
Exercise 3: Long Answer Type Questions:
1. Define budgetary control and state its advantages.
2. Discuss briefly the objectives and limitations of budgetary control.
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3. "A budget is a means and budgetary control is the end result." Explain.
4. What is a budget? How does it serve as an instrument of control.
5. Distinguish between a forecast and a budget!
6. What are functional budgets? Describe any one functional budget.
7. What is a cash budget? What are its objectives.
8. What is a flexible budget? What advantages has a flexible budget over a fixed budget?
9. Define flexible budget and explain its importance.
10. Distinguish between fixed budget and flexible budget.
Exercise 4: Problems
1: Summarised below are the income and expenditure forecasts for the months March to
August 2008.
Sales and purchases all are on credit. You are given the following further information:
Plant costing Rs. 16,000 is due for delivery in July, payable 10% on delivery and the balance
after three months.
Advance Tax installments of Rs. 8,000 each are payable in March and June.
The period of credit allowed by suppliers is 2 months and that allowed to customers is one
months.
Time-lag in payment of manufacturing expenses is 1/2 month, while the lag in payment of all
other expenses is one month.
You are required to prepare a Cash Budget for three months starting on 1st May, 2008 when
cash balance was Rs. 8,000.
Ans. Cash balance May Rs. 13,750, June Rs. 12,250 and July Rs. 16,900.
2. From the following forecasts of income and expenditure, you are required to prepare a cash
budget for three months ending 30th November. The bank balance on 1st September was Rs.
10,000.
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Months Sales Purchases Wages Factory Office
expenses expenses
Rs. Rs. Rs. Rs. Rs.
July 80,000 40,000 5,600 3,900 10,000
August 76,500 42,000 5,800 4,100 12,000
September 78,000 38,500 5,800 4,200 14,000
October 90,000 37,500 5,900 5,100 16,000
November, 95,000 43,000 5,900 6,000 13,000
A sales commission of 4% on sales, due in the month following the month in which the sales
dues are collected, is payable in addition to office expenses. Fixed assets worth Rs. 65,000
will be purchased in September to be paid for in the following month. Rs. 20,000 in respect
of debenture interest will be paid in October. The period of credit allowed to customers is
two months and one month credit is obtained from suppliers of goods. Wages are paid on an
average fortnightly on 1 and 16 of each month in respect of dues for period ending on the
date preceding such days. Expenses are paid in the month in which they are due.
Ans. Cash balance - 30 Sept. Rs. 24,000, 31 Oct. Rs. (-) 53,150, 30 Nov. (-) Rs. 40,610.
3.Vani Ltd. a newly started company wishes to prepare cash budget from January. Prepare a
cash budget for the first six months from the following estimated revenue and expenses:
Overheads
Months Total Sales Material Wages Production Selling and
s
distribution
Rs. Rs. Rs. Rs. Rs.
Jan. 20,000 20,000 4,000 3,200 800
Feb. 22,000 14,000 4,400 3,300 900
Mar. 28,000 14,000 4,600 3,400 900
April 36,000 22,000 4,600 3,500 1,000
May 30,000 20,000 4,000 3,200 900
June 40,000 25,000 5,000 3,600 1,200
Cash balances on 1st January was Rs. 10,000. A new machinery is to be installed at Rs.
20,000 on credit, to be repaid by two equal installments in March and April.
Sales Commission @ 5% on total sales is to be paid within a month following actual sales.
Rs. 10,000 being the amount of 2nd call may be received in March. Share premium
amounting to Rs. 2,000 is also obtainable with the 2nd call.
Ans. Closing Balances: Jan. Rs. 18,000; Feb. Rs. 29,800; March Rs. 27,000; April Rs.
24,700, May Rs. 33,100; June Rs. 36,000.
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4: Make out a Cash Budget for April, May and June 2008 from the following
information:
Actual
Wages Expenses
Rs. Rs.
January 20,000 5,000
February 18,000 6,000
March 22,000 6,000
Budgeted
wages Expenses
Rs. Rs.
April 24,000 7,000
May 20,000 6,000
June 18,000 5,000
1. Special: The advance income tax for May, Rs. 4,000 plant in April, Rs. 10,000.
2. Rent of Rs. 300 payable each month, not included in expenses.
3. 10% of purchases and sales are on cash terms.
4. Credit purchases are paid after one month and credit sales are collected
5. after two months. The time lag in wages and expenses 1/2 month.
6. Cash and bank balances in April, Rs. 13,000.
5: The cost of an article at capacity level of 5,000 units is given under a below. For a variation
of 20% in capacity above or below this level, the individual expenses vary as indicated
under B below:
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A(Rs) B
Material cost 25,000 (100%varying)
Labour cost 15,000 (100% varying)
Power 1,250 (80% varying)
Repairs and maintenance 2,000 (75% varying)
Stores 1,000 (100% varying)
Inspection 500 (20% varying)
Depreciation 10,000 (100% fixed)
Administration overheads 5,000 (25% varying)
Selling overheads 3,000 (50% varying)
62,750
Cost per unit 12.55
Find the unit cost of the product under each individual expense at production levels of
4,000 units and 6,000 units.
Ans. 4,000 units Total cost 53,480 Per unit 13.37
6,000 units Total cost 72,020 Per unit 12.00.
6: The monthly budgets for manufacturing overhead of a concern for two levels of activity
were as follows:
Capacity 60% 100%
Budgets production (units) 600 1,000
Rs. Rs.
Wages 1,200 2,000
Consumable stores 900 1,500
Maintenance 1,100 1,500
Power & fuel 1,600 2,000
Depreciation 4,000 4,000
Insurance 1,000 1,000
9,800 12,000
You are required to: (i) Indicate which of the items are fixed, variable and semi- variable,
(ii) Prepare a budget for 80% capacity; and (iii) Find the total cost, both fixed and variable, per
unit of output at 60%, 80% and 100% capacity.
7: Gemini Steel Ltd. manufactures a single product for which market demand exists for
additional quantity. Present sales of Rs. 60,000 per month utilises only 60% capacity of
the plant. Marketing Manager assures that with the reduction of 10% in the price he
would be in a position to increase the sale by about 25% to 30%.
The following data are available:
Selling price Rs. 10 per unit
Variable cost Rs. 3 per unit
Semi-variable cost Rs 6,000 fixed + 50 paise per unit
Fixed cost Rs. 20,000, at present level estimated to be
Rs. 24,000 at 80% output.
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You are required to prepare the following statements:
(i) The operating profits at 60%, 70% and 80% levels at current
Selling price, and
(ii) The operating profits at proposed selling price at the above levels
Ans. Profit at 60% Rs. 13,000; at 70% Rs. 19,500 at 80% Rs. 22,000.
Profit at proposed selling prices in above levels Rs. 7,000, Rs. 12,500, Rs, 14,000.
8: For production of 10,000 articles, the following are budgeted expenses per unit:
11: A manufacturing company has the production capacity of 20,000 units per annum. The
expenses budgeted for 12,000 units for a period are as follows:
Per unit
Rs.
Materials 100
Wages (40% Fixed) 20
Manufacturing Expenses (40% Fixed) 20
Administration Expenses (Fixed) 10
Selling & Distribution Expenses (60% Fixed) 10
160
Profit 40
Selling Price 200
Prepare a Flexible Budget showing 70% and 100% level of capacity. It is expected that
the per unit selling price will remain constant upto 60% capacity, there after a 5%
reduction is expected upto 90% capacity level. Above 90% a2 * 1 / 2 .
2 % reduction-in original price is expected for every 5% increase in volume.
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LESSON 5
MARGINAL COSTING-I
5.0 Introduction
5.1 Objectives
5.2 Marginal cost- Definition and Concept
5.3 Methods of segregation of semi-variable costs
5.4 Two popular methods are described-Level of Activity Method
and Range of High and Low Method
5.5 Definition of marginal costing
5.6 Features of marginal costing
5.7 Ascertainment of Net Profit under Marginal Costing
5.8 Distinction between Absorption/full/ convention Costing and Marginal Costing
5.9 Assumptions underlying Marginal Costing
5.10 Advantages of Marginal Costing
5.11 Limitations of Marginal Costing
5.12 Applications of Marginal Costing
5.13 Cost-Volume-Profit (c-v-p) Analysis- Definition, meaning,
Impact of the factors on the profit.
5.14 Break-even Analysis-Assumptions Underlying Break-Even Analysis
5.15 Methods of Break-Even Analysis-
1) Algebraic Method (following terms explained with numerical problems)
(i) Contribution
(ii) PV Ratio
(iii) Break-even point (BEP)
(iv) Margin of Safety. (explained in next chapter)
2 Graphic method (explained in next chapter)
5.16 Summary of the chapter
5.17 Exercise
5.1 Objectives
Marginal costing provides the cost information to management for decision making. The cost of
the product, service, department etc, can be determined by different methods like single Output
costing, job costing, process costing etc. In addition to these methods, there are several
techniques of costing used for managerial decision making. These techniques can be combined
with any of the methods of costing. Marginal costing is one of the techniques of costing used for
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the purpose of assessing the profitability or otherwise of the products, processes, departments or
cost centres.
The technique of marginal costing includes the term marginal cost.
Marginal Cost
According to C.I.M.A. London, "Marginal cost means 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."
Therefore, marginal cost is the cost through which total cost changes when there is a change in
output by one unit. An important point is that marginal cost per unit remains unchanged
irrespective of the level of activity or output.
For example,
If the total cost of producing 10 units of a product is Rs. 100 and the cost for 11 units is Rs.
105, the marginal cost of producing one additional unit will be Rs. 5.
Marginal cost is also called as variable cost because an increase of one unit in production will
cause an increase invariable costs only. Hence,
Marginal Cost = Direct Materials cost + Direct Labour cost + Direct Expenses +
Variable Factory Overheads + Variable Office and Administration
Overhead + Variable Selling and Distribution Overheads.
Example
A plant produces =10 units of product per annum.
Variable cost = Rs. 10(per unit)
The fixed costs = Rs. 2,00 per annum.
Calculate the total cost of 10units of product.
Rs.
Variable Cost (10 x Rs. 10) 100
Fixed Cost 200
Total Cost 300
Suppose production is increased by one unit then it will become 11 units of product per annum;
Rs.
Variable Cost (11 x RS. 10) 110
Fixed Cost 200
Total Cost 310
marginal cost of producing one additional unit is Rs. 10 and it is same as variable cost.
Question 1
Following is the cost sheet of producing 500units of product against a capacity of 750units:
Cost per unit {in Rs.)
Direct materials 72
Direct wages 60
Works overheads (50% of this is variable) 20
Selling overheads (25% of this is variable) 8
The manufacturer decides to increase his output to 600 units. You are required to calculate
marginal cost of 100 units and total cost of 600 units.
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Solution
Statement Showing Marginal Cost and Total Cost
Particulars 500 units 100 600 units
(Rs.) units (Rs.) (Rs.)
Direct Materials 36,000 7,200 43,200
Direct Wages 30,000 6,000 36,000
Variable Works Overhead 5,000 1,000 6,000
Variable Selling Overhead 1,000 200 1,200
Marginal or Variable Costs 72,000 14,400 86,400
Fixed Works Overhead 500 ------ 6,000
Fixed Selling Overhead 30,000 ------ 3,600
Total Cost 75,500 14,400 96,000
Semi-variable cost can be separated into fixed and variable costs by the following methods.
Under this method, output and overheads are compared at two levels of output.
The variable overhead per unit can be obtained by dividing the change in overheads by the
change in output or activity and fixed overheads remain fixed.
Question 2
March April
Output (in units) 2000 2,400
Factory Overheads ( in Rs.) 25,600 27,200
Calculate the fixed factory overhead of the company.
Solution:
Variable overhead per unit = Change in Factory Overheads /change in Output
=1600/400
= Rs. 4 per unit
To calculate fixed OH apply Rs 4 per unit rate for the month of March,
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Fixed Factory Overheads = Total Factory Overheads- Variable Factory Overheads
= 25,600 - (2000 x 4)
= Rs. 17,600.
For the month of April
Fixed Factory Overheads = Total Factory Overheads- Variable Factory Overheads
= 27,200 - (2400 x 4)
= Rs. 17,600.
Highest and lowest points of output are taken into consideration, under this method. Change in
overhead is divided by the change in output to obtain the variable cost per unit.
Question 3
Solution
Output (Units) Factory Overhead (Rs.)
Highest 1,000 8,000
Lowest 500 6,000
Change 1,500 14000
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5.6 Features of Marginal Costing
2. Only variable costs are taken into consideration for computing cost of production and value
of stocks.
4. Marginal contribution is calculated by sales value less variable costs, to ascertain the
profitability of a product or department.
5. Fixed costs are charged to Profit and Loss Account of the period for which costs are incurred.
6. Marginal costing is not a method of costing just as job costing, process costing etc.
Net Profit is ascertained by deducting fixed costs from marginal contribution. For this purpose
marginal cost sheet is prepared. Proforma of marginal cost sheet is shown as under:
Under absorption costing, all manufacturing costs whether fixed or variable are ‘absorbed’ in
the cost of the products produced.
According to C.I.M.A, London, "Absorption costing as the practice of charging all costs, both
variable and fixed, to operations, process or products ".
(i) product costing All costs are allocated Only variable costs are treated
to products. All costs are treated as product costs.
as product costs.
(ii) Cost element Fixed overheads are added to the Fixed overheads are not included
cost of production. in the cost of production.
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line, make or buy, selecting the most profitable product or product mix, accepting
orders, at low price, reduction of price in times of competition or depression, etc.
2. Easy to apply: Marginal costing is simple to use as it avoids the complications
involved in allocation, apportionment and absorption of fixed overheads on estimated
basis.
3. Cost Control: control over cost can be possible by classifying costs into fixed and
variable costs. Management can concentrate more on the control of variable costs which
are usually controllable and pay less attention to fixed costs which may be controlled
only by the top management.
4. No under and over- absorption of overheads: In Marginal costing, there is no
problem of under or over-absorption of overheads.
5. Tool of Profit Planning: cost- volume-profit analysis is one of the important tools used
by the management for profit planning. The use of break even analysis and chart allows
the management to understand the implications of change in different variables on the
profitability of the enterprise.
1. Difficulties in cost division: marginal cost assumes that all costs can be divided into
fixed and variable cost precisely. However, in practice, there are certain items of semi-
variable cost which cannot be precisely divided into fixed and variable. These items of
costs are segregated on the basis of some estimation and may differ from person to
person.
2. Inventories Valuation: Finished goods and work-in-progress are evaluated at marginal
cost, under marginal costing. It would not show the true and fair view of the financial
position, from the point of view of Balance Sheet.
3. Suitable for labour intensive industries: In capital intensive industries, the proportion
of fixed costs is more. The marginal costing technique, which ignores fixed cost, thus
proves less effective in such industries.
4. Difficulty in application: Marginal costing may not be applied by the concerns which
have to carry large stocks by way of work-in- progress. Further, marginal costing is not
suitable to industries working on contract basis.
5. Time Factor: By ignoring fixed costs, time factor is also ignored. For example,
marginal cost of two jobs may be identical but if one job takes twice as long to complete as
the other, the true cost of the job taking longer time is higher than that of the other. It is not
disclosed by marginal costing. It creates an illusion that fixed costs have nothing to do with
production.
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4. Valuation of Profitability of various Departments: it helps the management of the
company to decide whether a department should continue or be closed.
5. Optimum Sales Mix: A firm needs to decide the best product mix which yields the
maximum contribution. It can be ascertained with the help of marginal costing.
6. Different Techniques to Manufacture: Marginal costing is helpful in deciding best
method of production which can give the greater contribution. For example hand work or
machine work.
7. Make or Buy Decision: When management has to decide whether to make product or
buy it from outside then management compares the marginal cost of manufacturing the
product with its purchase price. Marginal costing techniques are used to make such
decisions.
8. Plant Shut-down Decision: this decision totally depends on revenue generated from
the sales activity. If the sales of the product are inadequate to cover fixed costs, the
management may decide whether to shut down the production of the product
temporarily or continue. Marginal costing assists the management in taking such
decision.
9. Launching of a New Product: Marginal costing technique is used, when a firm intends
to introduce a new product in the market to make use of the available facilities or to
capture a new market.
10. Acceptance of special Price: In the course of normal circumstances, price is fixed on the
basis of the total cost. But under abnormal conditions, the prices may be fixed below the
total cost. If selling price is equal to or more than marginal cost, the firm may accept a
price less than the total cost.
Following circumstances necessitate the fixation of price below total cost:
(i)To eliminate weak competitors.
(ii)To make a new product popular in the market.
(iii) To explore a foreign market.
(iv) To keep plant and machinery in running condition.
(v)When a product can be sold with profit in combination with other products.
Algebraic Method
(i) Contribution
(ii) PV Ratio
(iii) Break-even point (BEP)
(iv) Margin of Safety.
Contribution
Contribution is the difference between sales and marginal cost of sales. Contribution is also
known as "Gross Margin" or contribution margin.
It is one of the important concepts in marginal costing. It helps to find out the profitability of a
product or the department. It also helps the management to decide a better product mix and
maximize the profits.
It is affected by the change in any or both of the following factors:
(i) Variable cost per unit.
(ii) Selling price per unit
Illustration 1
Selling price per unit Rs. 20
Variable cost per unit Rs. 15
Fixed cost Rs. 1,00,000
Output 1,00,000 units.
Find out the contribution and profit earned during the year:
Solution
Contribution per unit = Selling price per unit - Variable cost per unit
= 20-15
= Rs. 5
Total Contribution = Contribution x Number of units sold
= Rs. 5 x 1, 00,000
= Rs. 5, 00,000.
Contribution (total) may also be calculated as under:
Contribution = Sales - Variable cost
= 1, 00,000 x 20-1, 00,000 x 15
= 20, 00,000- 15, 00,000
= Rs. 5, 00,000.
Profit= Contribution - Fixed cost
= 5,00,000-1, 00,000
= Rs. 4,00,000
Profit-volume ratio (P/V Ratio) is also called as contribution-sales ratio (C/S Ratio). P/V ratio
expresses the relation of contribution to sales. A higher P/V ratio shows higher proportion of
contribution in the given sales. As the fixed cost remains same, higher is the profit. Hence, P/V
Ratio is affected by the change in any or both of the following two factors:
(i) Selling price per unit
(ii) Variable cost per unit.
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• When the information is given in amount
P/V Ratio = Contribution x l00
Sales
• When the information is given per unit
Illustration 3
Solution
P/V Ratio= Change in Profit x 100
Change in Sales
= 4 Lakhs - 2 Lakhs x 100 =20%.
30 Lakhs - 20 Lakhs
Illustration 4
86
Calculate the present and future P/V Ratio (if there is a reduction of 10% in selling price)
Solution
Illustration 5
Solution
i) P/v Ratio = Contribution per unit x 100
Selling Price per unit
= 200-120x100
200
= 40%
It is the level of sales where the total revenue is equal to the total costs. Break-even point is the
point of "no profit, no loss." Any level of sales above the break-even point gives profit and if
the sale decreases from this level gives loss. Lower the break-even point, higher will be the
chances of higher profitability.
87
Break-even point may be expressed in terms of units of production (or sales) or in terms of sales
volume. It may be calculated as under:
Break-even point (in units) = Fixed Cost /contribution per unit
Illustration 6
Rs.
Selling Price per unit 10
Variable Cost per unit 2
Fixed Cost 40,000
Estimated Sales 1,00,000
Solution
The level of sales required to earn the desired amount of profit is called desired sales.
Sales for Desired Profit (in units) =Fixed Cost + Desired Profit
Contribution per unit
Sales for Desired Profit (in Rs.) = Fixed Cost + Desired Profit
P/V Ratio
88
Illustration 7
(i) Compute break-even point in terms of units and sales
(ii) Compute how many units must be produced and sold to earn a profit of Rs. 30,000.
Solution:
Contribution per unit = Selling price unit- Variable cost per unit
= 17.5-10 = 7.5
P/V Ratio = (Contribution per unit /Selling Price per unit) xl00
= 7.5/17.5 x 100
=42.86%
Illustration 8
Solution
Method-I
Working notes
90
= 5, 00,000 x 25 =RS. 1,25,000
100
Illustration 9
The following figures are available at 31 March of 2007 and 2008:
2007 2008
Rs. (Lacs) Rs. (Lacs)
Sales 200 150
Profit 50 30
Calculate:
1. P/V ratio and total fixed expenses.
2. Break-even level of sales.
3. Sales required to earn a profit of Rs. 90 lakhs.
4. Profit or loss that would arise if the sales were Rs. 280 lakhs.
Solution
Applying P/V Ratio to the sales for the year ending 31st March, 2007
Contribution = 40% of 200 Lakhs
= Rs. 80 Lakhs
Fixed Cost = Contribution - Profit
= 80 Lakhs - 50 Lakhs
= Rs. 30 Lakhs.
Fixed cost of Rs. 30 lakhs would be obtained even if P/V Ratio is applied to the sales for the
year ending 31st March, 2008:
(b) Break-even level of Sales = Fixed Expenses/ P/V Ratio
=Rs. 30 lakhs/40%
= Rs. 75 Lakhs
(c) Sales to earn a profit of Rs. 90 lakhs =Fixed Cost + Required Profit
P/V Ratio
= Rs. 30 lakhs + Rs. 90 lakhs
40%
= Rs. 300 Lakhs
(d) Profit or loss that would arise if the sales were Rs. 280 Lakhs
Profit = Contribution - Fixed Expenses
= (P/V Ratio x Sales) - Fixed Expenses
= (40% x Rs. 280 lakhs) - Rs. 30 lakhs
= Rs. 82 lakhs.
5.17 Exercise
1. When fixed cost is Rs 5 lakhs, P/V ratio is 40%, then the break-even point is Rs………..
2. When sales increase from Rs 20,000 to 40,000 while profit increase from Rs 1,000 to Rs
2,000, P/V ratio is …………..
3. Break-even sales are 1000 units, fixed cost Rs 2000, contribution per unit is Rs…………
4. Fixed cost is Rs 2000 and variable cost is 60% of sales, the break-even point is
Rs…………
5. When contribution is Rs 15000, P/V ratio 40%, the sales is Rs………..
Answer
(1) 12,50,000 (2) 5%, (3) Rs 2, (4) 5000, (5) Rs 37,500
Answer
1) b, 2) c, 3) a, 4) a, 5) a
Exercise 4:
Consider the each of the following as independent situations, indicate whether P/V ratio
will increase, decrease or not change
93
LESSON 6
MARGINAL COSTING-II
6.0 Introduction
6.1 Objectives
6.2 Meaning of Margin of Safety
6.3 Introduction of Break-even Chart
6.4 Uses of break-even chart
6.5 Assumptions Regarding Break-even Chart
6.6 Steps in Preparing Break-even Chart
6.7 Angle of incidence
6.8 Types of Break-Even Charts
6.9 Advantages of Break-Even Analysis and Chart
6.10 Specific Applications Break-Even Chart and Analysis
6.11 Limitations of Break-Even Chart
6.12 Cost Break-Even Point
6.13 Composite Break-Even Point
6.14 Cash Break-Even Point
6.15 Summary of the chapter
6.16 Exercise
6.1 Objectives
Margin of safety is the difference between total sales and the sales at breakeven, point. Margin
of safety may be calculated as under:
Margin of Safety = Total Sales - Sales at B.E.P.
or
Margin of Safety = Profit/ PV Ratio
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Margin of Safety (as a percentage) = Margin of Safety xl00
Total Sales
Margin of safety indicates the soundness of the business. A high margin of safety indicates an
extremely favorable position of the firm in the market since even with a substantial decline in
sales, the firm will continue to earn profit. If the margin of safety is small, any decline in sales
may touch BEP and finally results into a loss. Since higher margin of safety implies higher
strength of the business, the management of the concern would like to improve its margin of
safety by :
(a) Increasing the selling price if the market permits.
(b) Increasing the volume of sales if capacity is available for increasing the production.
(c) Reducing the variable costs.
(d) Reducing the fixed costs.
(e) Switching the production to more profitable products.
Illustration 1
Rs.
Sales 5,00,000
Fixed Costs 1,50,000
Profit 1,00,000
Compute break-even sales and margin of safety:
Solution
Contribution = Fixed Costs + Profit
= 1,50,000 + 1, 00,000
= 2,50,000
Alternatively,
Margin of Safety =Profit/ P/V Ratio
=1,00,000x100
50
= Rs. 2,00,000.
95
Illustration 2
Profit =Rs. 30,000
Marginal cost = Rs. 4 per unit
Selling price = Rs. 5 per unit
Find out the amount of 'Margin of Safety'.
Solution
Selling Price per unit = Rs. 5
Marginal Cost per unit = Rs. 4
Contribution per unit (5-4) = Rs. 1
=(30,000/20)x100
= Rs. 150000
Illustration 3
The profit volume ratio = 25%
and the margin of safety = 20%.
Solution
P/V Ratio = 25%
Margin of Safety = 20%
% Break - even Sales = 100 %- Margin of Safety
= 80% of Present Sales
= 80 % Rs. 50,000 = 40,000
Solution
Sales =10,000
Variable Cost = 6,000
Contribution = 4,000
Fixed Cost = Total Cost - Variable Cost
=8,000- 6,000 = Rs. 2,000
Profit =Contribution - Fixed Cost
=4,000 - 2,000 = Rs. 2,000
Alternatively,
Solution
Sale Price per cycle 115
Less: Marginal Cost per motor
Material 25
Labour 40
Variable overhead (50% of Rs. 40) 20 = Rs. 85
Contribution per unit =115- 85
= Rs. 30
Fixed overheads per year = Rs. 1, 20,000
(a) B.E.P. (units) =Fixed Cost
Contribution per unit
= 1,20,000/30
= 40,000 cycles
98
Illustration 6
Two Companies ABC Ltd. and XYZ Ltd. sell the same type of product in the same market. The
forecasted Profit and Loss Accounts for the year 2011-12 are as follows:
You need to determine which company is likely to earn greater profits in conditions of:
(a) Low demand, and
(b) High demand.
Solution
99
(b) In the conditions of high demand, a company having high P/V Ratio is more profitable.
So, XYZ Ltd. is more profitable as its P/V Ratio is higher (40%) as compared to ABC Ltd.
(20%). XYZ Ltd. will earn 40% of the additional sales as profit while ABC Ltd will earn only
20% of the increased sales.
Illustration 7
A company budgets for a production of 1,50,000 units. The variable cost per unit is Rs. 14 and
fixed cost is Rs. 2 per unit. The company fixes its selling price to fetch a profit of 15% on cost.
(i) What is the break-even point?
(ii) What is the profit-volume ratio?
(iii) If it reduces its selling price by 5%, how does the revised selling price affect the break-
even point and the profit-volume ratio?
(iv) If a profit increase of 10% is desired more than the budget, what should be the sales at
the reduced price?
Solution
Variable Cost per unit = Rs. 14.00
Fixed Cost per unit = Rs. 2.00
Total Cost per unit = Rs. 16.00
Profit (15% of Rs. 16) = Rs. 2.40
Selling price per unit = Rs. 18.40
Contribution per unit (18.40-14) = Rs. 4.40
Illustration 8
A retail dealer in garments is currently selling 24,000 shirts annually. He supplies the following
details for the year ended 31st March, 2008:
Rs.
Selling price per shirt 40
Variable cost per shirt 25
Staff salaries for the year 1,20,000
General office costs for the year 80,000
Advertising costs for the year 40,000
As a cost accountant of the firm, you are required to answer the following each part
independently:
(i) Calculate the break-even point and margin of safety in sales revenue and number of shirts
sold.
(ii) Assume that 20,000 shirts were sold in year, find out the net profit of the firm.
(iii) If it is decided to introduce selling commission of Rs. 3 per shirt, how many shirts would
require to be sold in a year to earn a net income of Rs. 15,000?
(iv) Assuming that for the year 2008-09 an additional staff salary of Rs. 33,000 is anticipated,
and price of a shirt is likely to be increased by 15%, what should be the break-even point in
number of shirts and sales revenue?
Solution
Selling Price per shirt = Rs. 40
Variable Cost per shirt = Rs. 25
Contribution per unit = Rs. 15
P/V Ratio = Contribution per unit x 100
Selling price per unit
(iii) Revised Variable Cost per shirt = Previous variable cost per shirt + Commission
= 25 + 3 = Rs. 28
New contribution per shirt = 40-28 = Rs. 12
Sales (in units) for a profit of Rs. 15,000 = New Fixed cost
New Contribution Per unit
= 1,40,000+ 15,000
12
= 21,250 shirts
Break-even chart is the graphic of break-even analysis. This chart takes its name from the fact
that the point at which the total cost line and the sales line intersect is the break-even point. It is
the presentation of the relationship between cost, volume and profit. It depicts the point of
production at which there is no profit and no loss i.e. break-even point. It not only shows the
break-even point but also shows profit and loss at various levels of activity. According to CIMA
(chartered institute of management accountant), “a chart which shows profit or loss at various
levels of activity, the level at which neither profit nor loss is shown being termed as break-even
point”.
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6.4 Uses of break-even chart
A break-even chart is used to get the following information
• Break-even point- the point where there is no profit or loss.
• To know the profit or loss at different levels of output.
• The relationship between variable cost, fixed cost and total cost.
• To know the margin of safety.
• The angle of incidence, indicating the rate at which profit is being made.
• The amount of contribution at various levels of sales.
Following are the assumptions on which break-even graph (chart) are drawn:
1. Costs can be categorized into fixed and variable costs.
2. Fixed costs will be fixed i.e. static during the relevant range of graph.
3. During the relevant range of graph variable cost per unit will remain constant.
4. Change in the volume of sales will not affect selling price per unit. In other words,
selling price per unit will be constant
5. Sales mix will be constant.
6. Production and sales volume are equal.
7 The relationship between costs and revenue will be linear i.e. all are indicated by way
of straight lines.
Angle of incidence is formed by the intersection of sales line and the total cost line at break-
even point. It shows the rate at which profits are being earned once break-even point has been
103
reached. The wider the angle, the greater is the rate of earning profits and a smaller angle of
incidence indicates that the profits are being made at a lower rate. It is formed to the right of
break-even point and graphical representation of profitability.
Illustration 9
Prepare the break-even chart from the following information:
Fixed Cost Rs. 2,000
Variable Cost per unit Rs. 0.50
Selling Price per unit Rs. 1
Solution
Break-even Chart Table
Output Fixed cost Variable cost Total Cost Sales Profit
(Units) (.Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Zero 2,000 Zero 2,000 Zero -2,000
2,000 2,000 1,000 3,000 2,000 -1,000
4,000 2,000 2,000 4,000 4,000 Zero
6,000 2,000 3,000 5,000 6,000 1 000
8,000 2,000 4,000 6,000 8,000 2,000
10,000 2,000 5,000 7,000 10,000 3,000
The main advantages of break-even analysis and break-even chart are given below
1. It shows the relationship between the cost, volume and profit.
2. Break-even chart is act as a management guide for decision-making as it shows
relationship between cost, volume and profit.
3. It shows the profit for different sales volumes and the sales volume to produce desired
profit.
4. It stresses the importance of optimum capacity utilization for achieving cost reduction.
5. It is used for forecasting plans and profit.
6. It provides detailed and clear information about the elements of cost, sales and profit.
7. It may be used for controlling costs and achieving better efficiency.
105
6.11 Limitations of Break-Even Chart
Cost break-even point is a point where the costs of operating two alternatives is equal. Cost
break-even point helps the management in identifying which alternative is better to operate at or
a given level of output. Cost break-even point may be calculated as under:
It is the level of sales required to recover the entire cash costs. At this level of sales, the total
sales revenue is equal to total cash costs so that there is neither any cash profit nor cash loss. In
other words, it is the level of output where a cash break even i.e. there is "no cash profit and no
cash loss". The fixed costs are divided into cash fixed cost and non-cash fixed cost. Cash break-
even point is used to know the liquidity position of the firm i.e. firm's ability to meet cash
obligations. The management ascertains the level of activity below which there are chances of
insolvency.
Algebraically
Cash Break-Even Point (in units) = Cash Fixed Cost / Contribution per unit
106
Cash Break-Even Point (sales volume) = Cash Fixed Cost / P/V Ratio
Graphically, the cash break-even point is determined at the point of meeting of total cash
cost line and total sales line. The area to the left of point signifies cash losses and area on
the right side indicates cash profits.
Illustration 10
Fixed expenses = 2,25,000
Sales = 7,50,000 and
Earned a profit = 1,50,000 (during the first half year)
loss = 1,25,000(during second half, it suffered a loss)
Solution
(i) In the first half year
Illustration 11
A company has annual fixed costs of Rs. 14,00,000. In 2007-08 sales amounted to Rs.
60,00,000 as compared with Rs. 45,00,000 in 2006-07 and profit in 2007-08 was Rs. 4,20,000
higher than in 2006-07:
(i) At what level of sales does the company breakeven?
(ii) Determine profit or loss on a precast sales volume of Rs. 80,00,000.
(iii) If there is a reduction in selling price in 2007-08 by 10% and the company desires to
earn the same profit as in 2006-07 what would be the required sales volume?
Solution
108
Profit earned in 2007-08 = Sales x PV/ Ratio-Fixed Cost
=60,00,000 x 28-14,00,000
100
= 16,80,000- 14,00,000
= Rs. 2,80,000
In 2007-08 reduction in sales price = 10%
Therefore sales at reduced prices = 60,00,000-6,00,000
= Rs. 54,00,000
Contribution at reduced prices = Contribution at original prices - Decline in
sales)
= 16,80,000-6,00,000
= Rs. 10,80,000
New P/V Ratio = Contributionx100
Sales
= 10,80,000 x100
54,00,000
=20%
=16,80,000x100
20
= Rs. 84,00,000.
109
6.16 Exercise
Exercise 1: True or False
True or False
Answer
1. True 2. False 3. False 4. True 5. True
Answer
1. 30%, 2. 20%, 3. 25%, 4. 25000, 5. Rs 37,500
Answer
1. c, 2. a, 3. a, 4. a, 5. a
111
LESSON 7
MARGINAL COSTING-III
7.0 Introduction
7.1 Objectives
7.2 Meaning of decision-making
7.2.1 pricing decision
7.2.2 Make or buy decision
7.2.3 Product mix decision
7.3 Key Factor
7.4 Summary of the chapter
7.5 Exercise
7.1 Objectives
7.2 Decision-Making
Decision making is one of the important aspects which decides the success or failure of any
enterprise. A business has to take the decisions in the different complex situations.
Decision making is the process of selecting the best alternative among the different choices
available in order to attain the desired objectives. According to CIMA, "its special value is in
recognizing cost behavior and, hence, in assisting in decision-making."
Marginal costing is a decision-making technique especially for short-run or tactical decisions.
Following are some of the specific areas where marginal costing is extensively used as a
decision-making technique:
Pricing of a product is the most crucial decision. Price affects sales volume which, in turn,
determines the revenue and profit of the company. There are a quite number of prices which a
company can fix. Pricing decision is influenced by a number of factors, some of them are given
as under:
112
(i) Cost
(ii) Competition
(iii) Objective of the company
(iv) Nature of the product
(v) Nature of the demand for the product
(vi) Government regulations.
Every company will like to maximize its profit. Hence, price of a product has to be more than its
total cost i.e. variable costs plus fixed costs. This is known as "cost plus pricing." Thus
Price = Variable costs + Fixed costs + Profit.
The underlying theory of marginal costing is that the revenue of a product should be more than
its variable cost so that it may contribute towards recovering fixed costs and providing profits.
Once the fixed costs are recovered at a particular level of production, the additional units of
production would contribute towards profit. The marginal cost sets the lower limit to price
fixation. The minimum selling price should not be below marginal cost. Under this situation, the
figure of loss will be equal to the amount of fixed cost. Fixed cost will have to be incurred
irrespective of production or no production.
A company would not like to follow the alternative of suspending the production of the product.
When a company decides to suspend the production of the product, the company will suffer a
loss equal to fixed cost because fixed cost cannot be avoided. Hence, the primary interest of the
company is fix the price equal to or more than the marginal cost.
Thus
Price > Marginal cost
or
Price = Marginal cost.
Sometimes, selling price falls below the marginal cost. In such a case, the company will suffer a
loss more than the amount of fixed cost. Under this situation, a company has an alternative to
stop production so as to reduce the amount of loss upto fixed cost. However, under following
special circumstances, a company may decide to continue production even if the price is less
than marginal cost:
I. When the product is of perishable nature and company wants to avoid total loss by
disposing the product.
II. When the company introduces a new product in the market (because a new product
can be sold at a very low price)
III. When there is a cut-throat competition in the market and company wants to drive out
its competitors.
IV. When the company wants to export the product.
V. When the employees cannot be retrenched.
VI. When the sale of this product at a price below the marginal cost will push up the sale
of other profitable products. (The loss of this product will be made up by profits
other products)
VII. When suspension of production and re-opening of production requires a heavy
expenditure.
113
Students should note that reduction in price leads to reduction in contribution per unit.
Illustration 1
ABC Ltd. manufactures a document reproducing machine which has a variable cost structure as
follows:
Material Rs. 20
Labour Rs. 5
Overhead Rs. 2
Selling price Rs. 45
Sales Rs. 6,75,000
(during the current year are expected to be)
and fixed cost Rs. 70,000.
Under a wage agreement, an increase of 5% is payable to all direct workers from the
beginning of the forthcoming year, whilst material costs are expected to increase by 4% ,
variable overhead costs by 2.5% and fixed overhead costs by 1.5%.
You are required to calculate the new selling price if the current Profit/ Volume Ratio is to be
maintained.
Solution
Computations of New Selling Price
Selling price 45
Contribution (45 - 27) 18
Current year's P/V Ratio = Contribution per unit x 100
selling price per unit
= (Rs 18/ Rs 45)x100
= 40%
Thus, the current year's marginal cost is 60% of the selling price of Rs. 45. In order to maintain
the current Profit/Volume ratio of 40% in the forthcoming year, the new selling price should be:
Rs. 28.10 x 100
60 = Rs. 46.833
114
Illustration 2
In a purely competitive market, 5,000 small motors can be manufactured and a certain profit is
generated. It is estimated that 1,000 small motors need be manufactured and sold in a monopoly
market to earn the same profit.
Profit under both the conditions is targeted at Rs. 1,00,000. The variable cost per motors
is Rs. 50 and the total fixed cost is Rs. 18,500.
You are required to find out the unit selling prices both under monopoly and competitive
conditions
Solution
Under monopolistic conditions
Suppose X is the selling price per unit
Therefore Sales = 1,000 X
Variable cost = 1,000 x Rs. 50 or Rs. 50,000
Fixed Cost = Rs. 18,500
Desired Profit = Rs. 1,00,000
Sales - Variable Cost = Fixed cost + Profit
1,000x - 50,000 = 18500 + 1,00,000
1,68,500
X = 1 000 =168.50 per unit
Thus selling price = Rs. 168.50 per unit
Illustration 3
A manufacturer makes an average profit of Rs. 2.50 per unit on a selling price of Rs. 14.30 by
producing and selling 60,000 units at 60 per cent of potential capacity. His cost of sales per unit
is as follows:
Direct materials Rs. 3.50
Direct wages Rs. 1.25
Factory overhead Rs. 6.25 (50% fixed)
Sales overhead Re. 0.80 (25% variable)
During the current year, he intends to produce the same number but estimates that his fixed
costs would go up by 10 per cent while the rates of direct wages and direct materials will
increase by 8% and 6% respectively. However, the selling price cannot be changed. Under this
115
situation, he obtains an offer for a further 20% of his potential capacity. What minimum price
would you recommend for acceptance of the offer to ensure the manufacturer an overall profit
of Rs. 1,67,300?
Solution
Statement of Marginal Cost and Profit
Per unit 60,000
Rs. units Rs.
Sales (A) 14.300 8,58,000
Direct materials
Direct wages 3.500 2,10,000
Variable overhead -
factory 1.250 75,000
sales
3.125 1,87,500
0.200 12,000
Marginal cost (B) 8.075 4,84,500
Contribution (C = A - B) 6.225 3,73,500
Fixed overhead -
factory 3.125 1,87,500
sales 0.600 36,000
Total fixed cost (D) 3.725 2,23,500
Profit (C - D) 2.500 1,50,000
Variable overhead -
Factory 3.125 1,87,500
Sales 0.200 12,000
Marginal cost (B) 8.385 5,03,100
3,54,900
Contribution (C = A - B)
Fixed cost (D) (Rs. 22,3,500 + 10%) 2,45,850
Profit (C - D) 1,09,050
116
Statement of Price (For 20,000 units)
Rs.
Marginal cost (Rs. 8.385 x 20,000 units) 1,67,700
The above-mentioned treatment is based on the assumption that the company has idle
capacity that can be used to manufacture the component. Thus, there will be no opportunity
cost. However, if there is no idle capacity and manufacturing of the component in the factory
involves the loss of other work, opportunity cost should be added to marginal cost (variable
cost) of production. Here the opportunity cost will be the contribution foregone from the
displacement of work. The concept of opportunity cost will be relevant only when company is
running at its full capacity.
(i) The company should be assured of uninterrupted supply of the component so as not to
suffer the production of main product.
(ii) The supplier should assure the company about the quality of the component.
(iii) The component of be bought should be available at the same price at which we
are considering to buy it at present.
(iv) If the production of the component is not carried out, labour problems should not crop
up.
(v) When component is bought from the outside, secrecy cannot be maintained, and
manufacturing know-how is to be passed on to the supplier of the component. Secrecy
can be maintained only when component is manufactured internally.
The company should have the facility of wider choice in case of buy-decision.
Illustration 4
Suman Ltd. uses a component "Z651" in its manufacturing process that can be purchased
from a supplier for Rs. 90 per unit. The same component is manufactured by Suman Ltd. at
the following cost per unit:
117
Rs.
Direct Material 30
Direct Labour. 25
Variable Overheads 28
Fixed Overheads (75% of Direct Material) 23
106
Suggest whether to make or buy this component.
What would be your suggestion if the offer offers the component at Rs. 80.
Solution
Total 5.90
118
Average inventory level 500 units.
The Purchase Manager investigated outside suppliers and found one that would sign a one year
contract to deliver "12,000 top quality units as needed during the year at Rs. 5.20 per unit".
Serious consideration is being given to this alternative. Should the company make or buy
component 3? Explain the relevant factors influencing your decision.,
Solution
Rs.
Material (direct) 1.40
Labour (direct) 2.20
Annual machine rental (special machine used only
for Component 3) 0.50
Variable factory overhead 1.00
Variable cost of manufacturing 5.10
Purchase price 5.20
Since the variable cost of manufacturing the Component 3 is lesser than the purchase price, it is
advisable to make the component. However, there is a very negligible difference of Rs. 0.10 per
unit. Suman company may think of purchasing the component from outside if the manufacturing
facilities released by the non-manufacture of the component are put to some alternative use.
Illustration 6
A machine manufactures 5,000 units of a part at a total cost of Rs. 11 of which Rs. 8 is variable.
This part is readily available in the market at Rs. 9 per unit.
If the part is purchased from the market then the machine can either be utilised to manufacture a
component in same quantity contributing Rs. 1 per component or it can be hired out at Rs.
11500. Recommend which of the alternatives is profitable?
Solution
Statement Showing Comparative Costs of Make or Buy
Cost of manufacturing the part and buying cost is same. i.e. Rs 40,000 . if alternative II will be
opted then buying from outside will be considered. Further, existing machine should be hired
out.
119
Illustration 7
Sukanya Ltd. produces a variety of products each having a number of component parts. Product
B takes 5 hours to produce on a particular machine which is working at full capacity. B has a
selling price of Rs. 100 and variable cost of Rs. 60 per unit. A component part X-100 could be
made on the same machine in two hours at a variable cost of Rs. 10 per unit. The supplier's price
for the component is Rs. 25 per unit. Advise whether the company should buy the component
X-100. (If necessary make suitable assumptions.)
Solution
Here, cost of buying the component from outside should be compared with relevant cost of
manufacturing which will include opportunity cost i.e. loss of contribution due to non-
manufacturing of product B.
Illustration 8
A company wants to manufacture automobile accessories and parts. The following are the total
costs of processing 50,000 units:
Direct material cost Rs.2.5 lakhs
Direct labour cost 4 lakhs
Variable factory overhead 3 lakhs
Fixed factory overhead 2.5 lakhs
The purchase price of the component is Rs. 11. The fixed overhead would continue to be
incurred even when the component is bought from outside, although there would have been
reduction to the extent of Rs. 1,00,000.
Required:
(i) Should the part be made or bought considering that the present facility when released
following a buying decision would remain idle?
(ii) In case the released capacity can be rented out to another manufacturer for
Rs. 75,000 having good demand, what should be the decision?
120
Solution
Statement Showing Costs of Make of Buy
Particulars Make cost Buy cost
per unit per unit
(Rs. in (Rs. in
lakhs) lakhs)
Materials 2.5
Labour 4
Variable overheads 3
Total variable cost 9.5
Case 1
Cost of Purchase 11
Less: Reduction in fixed overhead
(1,00,000/50,000) -2
Effective Cost of Purchase 9
Case II
Cost of Purchase (Calculated as above) 9
Less: Income from renting the - 1.5
released(75000/50000)
Capacity 7.5
Solution:
Particulars A B C D E
Sales (in 25 20 40 15 22
lakhs)
Variable 30% 25% 33% 40% 38%
cost as % of
Sales
PA/ Ratio 100-30 100-25 100-33 100-40 100-38
=70% = 75% = 67% = 60% =62%
P/V ratio of product D is the minimum. Hence, product D should be dropped. P/V ratio of
product B is the maximum. Hence, the sales of product B should be increased. New product mix
will consist products A, B, C and E.
Illustration 11
Anamika Tools Factory has a plant capacity adequate to provide 15,800 hours of machine use.
The plant can produce all "A" type tools or all "B" type tools or a mixture of the two types. The
following information is relevant:
"A" Type "B" Type
Selling Price per unit Rs. 10 Rs. 15
Variable Cost per unit Rs. 8 Rs. 12
Hours required to produce per unit 3 4
Market conditions are such that not more than 4,000 A type tools and 3,000 B Type tools can be
sold in a year. Annual fixed costs are Rs. 9,900.
Compute the product-mix that will maximise the net income to the company and find that
maximum net income.
123
Solution:
Statement Showing Comparative Profitability
Particulars Type A Type B
Selling Price per unit Rs. 10 Rs. 15
Variable Cost per unit Rs. 8 Rs. 12
Contribution per unit Rs. 2 Rs. 3
PA/ Ratio = Contribution per unit x 100 (2/10)x 100 (3/15)x100
Selling Price per unit = 20% = 20%
Contribution per machine hour 2/3=.67 =3/4=.75
Rankings II I
Since "B" type tools give higher contribution per machine hour (key factor), they should be
produced to the maximum extent. Remaining machine hours should be utilised for production of
"A" type tools.
Statement of Production
Total machine hours available 19,800
Less: Machine hours for producing 3,000 B type tools (300 x 4) 12,000
Remaining machine hours available to produce A type tools 7,800
Number of A type tools to be produced 7,800
= 2,600
Most profitable product mix = A type tools 2,600 + B type tools 3,000
Illustration 12
ABC LTD company can produce three different materials using same production facilities. The
requisite labour is available in plenty at Rs. 8 per hour for all products. The supply of raw
material, which is imported at Rs. 8 per kg., is limited to 10,400 kg. for the budget period. The
variable overheads are Rs. 5.60 per hour. The fixed overheads are Rs. 50,000. The selling
commission is 10% on sales. From the following information, you are required to suggest the
most suitable sales mix which will maximise the company's profit.
Also, determine the profit that will be earned at that level.
Product Market Selling Labour Raw material
demand per unit per unit required per
units. Rs. unit
X 8,000 30 1 0.7
Y 6,000 40 2 0.4
Z 5,000 50 1.5 1.5
124
Solution
(a) Statement of Marginal Cost and Contribution : Statement of marginal cost and
contribution is shown on the next page
Statement of Profit
X Y Z Total
Rs.
No. of units 8,000 6,000 1,600
Contribution per unit 7.80 5.60 12.60
Total contribution 62,384 33,600 20,160 1,16,144
Less: Fixed cost 50,000
Profit 66,144
7.5 Exercise
Answers
1. True, 2. False, 3. False, 4. True, 5. False
126
Answer
1. Key factor, 2. Variable cost, 3. Explore new markets, 4. Marginal cost, 5.
Profit position
Exercise 3: Multiple choice Questions
Q2. One of the following is not a relevant cost in replacement decision regarding a machine
which can increase production capacity if replaced.
a) Direct Material
b) Variable Manufacturing Overheads
c) Rent of Office Building
Q3. A cost which has no role or doesn’t affect manager’s decision is called
a) Opportunity cost
b) Sunk cost
c) Irrelevant cost
Q4 Which of the following is not limiting factor examples which may include limit
production or sales volume?
a) Shortage of material
b) Shortage of labour
c) Sufficient market demand
Q5 Pricing decision is influenced by a number of factors, some of them are given as under:
(a) Objective of the company
(b) Competition
(c) a and b
Answer
1. C, 2. C, 3. C, 4. C, 5. C
Long Questions
Q1 What do you mean by make or buy decisions? State the quantitative as well as
qualitative considerations influencing a ‘make’ or ‘buy’ decision.
Q2 “The technique of marginal costing can be valuable aid to management”. Discuss.
Q3. Explain briefly the circumstances under which selling below marginal cost may be
Justified.
Q4. Do you think a producer can sell his output even below variable cost? If so, mention
these circumstances.
Q5. Indicate any five circumstances under which you will allow to fix a price which is less
than the marginal cost.
127
Short Questions
Q2. State the factors that the managers must consider in selecting the product mix.
……………..………………………………………………………………………………………
……………………………………………………………………………………………..………
…………………………………………………………………………………………..…
Q3. Identify the major factors that should be considered for determining the selling price of a
Product.
……………..………………………………………………………………………………………
……………………………………………………………………………………………..………
…………………………………………………………………………………………..…
Q4. what factors have to be taken into account in a make or buy decision?
……………..………………………………………………………………………………………
……………………………………………………………………………………………..………
…………………………………………………………………………………………..…
128
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