Marginal Costing Formulas

Marginal Costing Equation: We know that profit is difference between sales & total cost. Total can bifurcated in to Fixed & Variable costs. Thus,

Profit = Sales – Total Cost. (Variable + Fixed Cost).

Fixed Cost + Profit = Sales – Variable Cost.

The above equation termed as Marginal Costing equation.

Fixed Cost: F.C ,as the name suggests, remain fixed in amount. The amount spent towards such an expensive remains the same irrespective of the Volume of production. They may have to be incurred even if there is no production. For ex: rent of factory building has to be paid irrespective of whether or not production is taking place. Ex: Salaries, Audit fees, go down rent etc.,

Variable Cost: Variable cost varies in direct proportion to the volume of production. No variable costs are included if production is stopped. As production increases, variable costs increase. However, Variable cost P.U will not change. For Ex: if it is estimated that 2 units are required to produce 1 unit of finished product, then material cost will continue to increase as the number of units finished stock desired increases. All direct costs are Variable cost. Commission to sales persons, Certain taxes., etc.

Semi -Variable Cost: S.V.C change with the changes in out put of production, but the change not proportionate. For the purpose of analysis, S.V.C are split in to Fixed Cost and Variable Cost. S.V.C normally has a fixed cost component, which needs to be incurred irrespective of no. of units produced. Telephone expenses are a example of S.V.C. Telephone exp. Can be split in to a fixed component of a rent, that needs to be paid whether or not the telephone is used. The charge for every call made constitutes the variable component.

Two point Method: Under this method, the out put at two different levels is compared with corresponding amount of semi variable expenses. Since fixed costs, the change in amount of expenses is on account of variable costs, divided by the change in out put, gives the variable costs per unit. If the number of units at a given level of output are multiplied with variable cost per unit, we get the variable proportion in the total amount of expenses at the given level. The difference between the two amounts gives us the ‘Fixed Cost’ component in the semi – variable cost.

Contribution: Contribution is the difference between sales and Variable Costs. Since sales & Variable Cost can be both be expressed in P.U. terms, contribution is usually expressed in P.U. terms.

Contribution = Sales –Variable Cost

Contribution P.U. = Selling Price P.U.= Selling Price P.U. – Variable Cost P.U.

Total contribution = Contribution P.U. X No. of Units.

“ “ Total Sales – Total Variable Cost.

P/v Ratio: P/v Ratio stands for Profit /Volume Ratio. However, it is ratio of contribution to sales. (The term Profit is used as fixed costs are not considered in Marginal Costing technique & profit is same as Contribution).

= P/v Ratio = Contribution / Sales; Sales-Variable Costs/ Sales;

1-V.C/Sales; Change in Profit(Contribution)/Change in Sales;

BEP ( Break – Even Point ):

BEP= Fixed Cost / P/V Ratio;

In Units : Fixed Cost / Contribution P.U;

Fixed costs / Selling Price P.U. – Variable Cost P.U;

BEP (Sales in Volume) BEP in Units X Selling Price P.U

= Fixed Cost X Total Sales / Total Sales – Total Variable Cost.

Units for Desired Profit = Fixed Cost + Desired Profit/ Contribution P.U.

Sales for Desired Profit = Fixed Cost / Desired Profit / P/v Ratio.

Margin of Safety (MOS) = Total Sales – BEP Sales

Example:

Sales Rs.50, 000; Fixed Cost Rs.1, 00,000; Profit Rs.1, 50,000;

Find out the following (i) P/V Ratio (iii) BEP (iv) MOS

Sol: P/V Ratio = Contribution / Sales

Contribution = Sales – Variable Cost; Fixed Cost + Profit / Sales

Sales = Rs.50, 000, Profit = Rs.1, 50, 000

1, 00, 000 + 1, 50, 000 / 5, 00, 000

= 0.5 or 50%.

I.e. P/v Ratio = 0.5 or 50%;

BEP = Fixed Cost / P/V Ratio

Fixed Cost = Rs.1, 00, 000; P/V Ratio = 0.5 or 50%;

BEP = 1, 00, 000 / 50%

= 2, 00, 000

Margin of Safety (MOS) = Total Sales – Break – Even Sales

.5, 00, 000 – 2, 00, 000 = 3, 00, 000.

Balance Sheet Ratios

Balance Sheet Ratios

1. Current or Working Capital Ratio: (Test of Liquidity)

*C.R = Current Assets/ Current Liabilities

Since C.A are expected to be converted in to cash with in the normal period and since C.L are satisfied by use of C.A. The C.A generally considered being an indicator of the ability of the business to pay its current debts promptly.

C.R is also a measure of the liquidity of the business. And also to determine the solvency of the business enterprise, that is the probable ability of the business to meet its debts promptly & with out loss.

Satisfactory Current Ratio

The ultimate results of all factors is that the financial analysts usually accept that an organization have its C.L covered at least twice by C.A. Thus a minimum 2 to 1 (2:1) C.R is often referred as a ‘rule of thumb’. Standard of liquidity of business, especially from the point of view of short term creditors such as bankers.

Factors affecting Current Ratio

1. The ability of the business to convert debtors, Bills Receivables & stock in to cash determines the extent of C.R. 1 to 1 (1:1) C.R is sufficient in business enterprise in which there is quick stock turnover & collection of debtors because in that case the requirement of working capital would be low. On the other hand a business engaged in the prolonged manufacturing process requires more working capital & hence a high C.R.
2. Seasonal fluctuations also have considerable impact on the C.R. A larger amount of working capital is needed in the peak season when there are heavy purchases of raw materials &production is in full swing. The liabilities may be assumed. As goods are sold, the stock of goods is replaced debtors & B. Receivables. While cash is diminished by the expenses of operation. The cycle is completed when the repayment of Liabilities.

Window Dressing:

For keeping C.R. at a satisfactory level the enterprises uses manipulation or malpractice. It is commonly known as Window Dressing. One of the most common devices used to enhance C.R. is to avoid purchase of goods just before the closing of the books of accounts. The Balance sheet also window Dressed by sale of Fixed Assets, Sale of Debentures.

3. Liquid, Quick or Acid Test Ratio:

= *Quick Assets-(stock +prepaid Exp.) / C.L–(Bank over Draft)

Satisfactory Level:

It indicates a satisfactory liquidity position for the simple reason that the ratio is more than the required yardstick of 1 to 1 (1:1). It may be emphasized that sometimes the investors are more liquid than the debtors & B. Receivables, especially under condition of scarcity.

Balance sheet Ratios Regarding Long Term Position:

1. Proprietary Ratio (Equity – Asset Ratio/ Net worth – Total Asset Ratio (Test of Solvency)

= *Total Shareholders Equity / Total Assets

The ratio should probably be expressed in percentage which can never exceed 100% & it would at the most equal to 100 when there are out side liabilities.

The ratio is of particularly importance of the investors because the presence of a high performance of shareholders fund indicates that there is relatively little danger of winding up or forced reorganization in the event of default in payments to outside liabilities.

Satisfactory Level:

A low proprietary ratio indicates that in the event of financial difficulties the sharejolders may receive little if any of their original investment.

Then the higher proprietary ratio des not it self show that the business is sound. An equity ratio of say 80% or 100% would not necessarily good because sometimes funds from outsiders can be used to the long run advantage of the business enterprises.

2. Asset Proprietorship Ratio:

i. Fixed Asset to Proprietors Fund

ii. C.A to Proprietors fund

F.A to P.F : It expresses the relation of the F.A with funds contributed by the owners or shareholders. In this there are no fictitious assets.

F.A/P.F*100

If the ratio is unduly high the enterprise may be handicapped as 100 much capital is not circulating but it is locked up in F.A.

C.A to P.F: This ratio designed to express the percentage of the amount invested in the C.A to the total funds of the Proprietors.

Total C.A / Total P.F *100

Funds Flow Analysis

The Funds flow analysis explains the various sources from which funds are raised and uses to which funds are put. It shows the change in assets and liabilities from the end of one period of time to the end of another period of time (i.e. between two Balance sheet dates). An analysis of statement helps us in answering question such as what is the amount of funds generated from Operations. How were the Fixed Assets of Organisation Financed? Whether the liquidity position of the organization increased? Etc.

Concept of Funds

The term fund has been defined and interpreted differently by different experts. Broadly the term fund refers to all the financial resources of the company. On the other extreme, fund has been understood as Cash only. However, the most acceptable meaning if funds is working capital. Working capital is the excess of current assets over current liabilities.

Concept of Flow

The flow of funds refers to transfer of economic values from one asset or equity to another. When funds mean working capital, flow of funds refers to changes in assets and liabilities, which cause a change in working capital of the organisaton. To identify a flow of funds, we have to understand the difference between current and Non – current Accounts.

Current Accounts and Non – Current Accounts.

Any account which is either current asset or a current liability is a current account. An account which is neither current asset nor current liability is Non – Current Account.

The concept of current accounts is important as fund implies working capital, which is the difference between current assets and current liabilities. If there is a change in a current account, there is a Possibility of Flow of funds If there is no change in any of the current accounts, there is cannot be any flow of funds.

General Rule

1. Transactions that involve only current Accounts do not result in a flow. In other words, if both the accounts getting impacted on account of a transaction are Current accounts there is no change in position of funds.
2. Similarly, transactions that involve only Non – Current Accounts also do not result in a flow.
3. Transactions that involve one current account and one non – current account results in a flow of funds.

Examples:

1. Cash Purchases Rs.10,000/-

In this transactions two current accounts are affected i.e. Cash & Stock. Firstly there is a decrease in cash. Therefore, C. Assets will fall by Rs10,000/-. However there is increase in Stock Therefore, C .Assets will rise by Rs.10,000/-. There is no effect in Current Assets and Working Capital. So, there is no flow of Funds.

2. Bills Payable accepted Rs.5,000/-

In this transaction two Current Liabilities are affected. Creditors are reduced by Rs.5,000/-. However, Bills Payable increase by Rs.5,000/-. No net change in Current Liabilities and Working Capital. So, there is no flow of funds.

3. Cash Paid to Creditors Rs.2,000/-

In this transaction, cash gets reduced by Rs.2,000/-. Thus, C.A decreased by Rs.2,000/-. However, creditors are also reduced by Rs.2,000/-. Consequently, C.L decrease by Rs.2,000/-. Since Working Capital is the difference in C.A and C.L, it remains same as the change in C.A is equal to the change in C.L There is no flow of funds.

4. Issue of Bonus shares to equity share holders out of General Reserve in the ratio 1:1

The effect of this transaction is the Equity share capital of the company gets doubled. However, the reserves of the company come down. Both accounts are non-current accounts. The current accounts are not affected. There is no flow of funds.

5. Land Purchased for Rs.3,00,000/-, payment made by cheque.

In this account cash at Bank, a current account gets reduced. Consequently, there is a fall in working capital to the extent of Rs.3,00,000/-. A new asset, land is acquired. However, it being a non-current account, it does not affect the working capital. Therefore the net affect is a fall in working capital to the extent of Rs.3,00,000/-. There is an outflow of funds.

6. Sale of Building for Rs.10,00,000/-

In this transaction, the amount received on sale is current asset. The current asset increased by Rs.10,00,000/-. Consequently, working capital increased by Rs.10,00,000/-. The business has to part with an asset worth Rs.10,00,000/-, but building being a non-current account, it does not affect working capital. There is an inflow of funds.

Preparation of Funds Flow Statement

The funds flow statement is prepared to reflect the changes in the financial position of an organization during a particular period. As such, Balance sheets of the organization at the beginning and end of the particular period are the basic documents that are needed for preparation of funds flow statement

The fund flow statement can also be presented in a vertical form. In such a case, all sources are listed down, totaled and then all Applications are listed at one place and totaled. The totals should be the Increase and decrease in Working capital.

Statement of changes in Working Capital

This statement follows the statement of Sources and Application of Funds. The primary purpose of the statement is to explain the net change in Working Capital, as arrived in the Funds Flow Statement. In this statement, all current Assets and Current Liabilities are individually listed. Against each account, the figure pertaining to that account at the beginning and at the end of accounting period shown. The net change in its position also shown. The changes taking place with respect to each account should and up to equal the net change in working capital, as shown by the Funds Flow statement.

While entering the effect of change in a current account on working capital, the following rules must be followed.

1. An increase in Current Assets means an increase in Working Capital;
2. An decrease in Current Assets means an decrease in Working Capital;
3. An increase in Current Liabilities means an decrease in Working Capital;
4. An decrease in Current Liabilities means an increase in Working Capital;

Time Value of Money

The time value of money is the basis of the mathematics of finance determination of the time value of money in financial decision making is extremely important. The objective of wealth maximization much of the subject matter of financial management is future oriented. The financial decision taken day has implications for a number of years i.e. if spreads into the future

Ex Firms have to acquire fixed assets for which they have to pay a certain sum of money to the vendors (cash outflows). The benefits arising out of the acquisition of such assets will be spread over a number of years. In the future till the waking life of the assets.

On the other hand funds have to be procured from different sources such as rising of capital through new issues. Bank borrowings, term loams from financial institutions, sale of debentures & so on. These as well as an obligation to pay interest/Dividend & return the principle in future.

It is on the basis of comparison pf the cash out flows & the benefits (cash inflows) that financial decisions are made for a meaningful comparison. One basic requirement of compatibility is the incorporation of time element in the calculations.

In other words in order to have a logical and meaningful comparison between cash flows and that accrue in different time period. It is necessary to convert the sums of money to a common point of time.

Definition: “Time value of money means that the value of a unit of money of different in different time periods”.

The value of sum of money receive today is more than its value received after some time. The sum of money received in future is valuable than it is today. The present worth of rupee receive after sometime will be less than a rupee receive today.

The main reason for the time preference for money is to be found in the reinvestment opportunities for funds which are received early. The funds so invested will earn a rate of return. This would not be possible if the funds are received at a later time.

The capital budgeting decision s generally involves the current cash outflows in terns of the amount required for purchasing a new machine or lunching a new project and the execution of the scheme generates future cash inflows during its useful life.

Ex: Assume that the project cost (current cash outflows) as Rs.10lakhs. Assume it has a life of only one year in which it is estimated to have cash inflows Rs.10.80lakhs (at the end of first year). This project is acceptable as it adds Rs.80,000 as profit. However when we take into account a rate of interest. Say 10% the earlier conclusion has to be realized as without the project the sum could have amounted to Rs.11lakhs.

If the decision us made to raise at loan of Rs.10lakhs from a financial institution or by issuing debentures for a period of 10 years. The firm is not only under obligation to make interest payment as and when it becomes due on debt of fixed intervals, but also must make a provisions. So that it can we pay Rs.10lakhs when the loan or debenture becomes due. Thus time value of money is of critical significance. This requires the development of processors and techniques for evaluating future incomes in terms of the present.

Financial Management

Introduction:

Financial Management is that managerial activity which is concerned with the planning & controlling of firms financial recovers.

Firms creating manufacturing capacities for production of goods and services to their customers and sell it to earn Profit. Funds are acquiring manufacturing and other facilities.

A firm secure whatever capital it needs and employs it in activities (Finance activity) which generate returns a invested capital. (Production & marketing Service)

The function of raising fund interesting them in asset and distributing returns earned from asset to share holders are respectively known as financing investment and dividend decisions.

Real Assets:

1.Tangible Assets:

Plant & Machinery

Building

Furniture

2. In Tangible Assets:

Goodwill

Patents & Copy Rights

3. Financial Assets:

Shares

Debentures

Lease obligation

Borrowings

Finance may be defined as the Art and Science of managing money. The major areas of financing are

(i) Financial Services:

It is concerned with the designed and delivery of advice and financial products to the individuals, business and Govt. with the areas of banking and related institutions, personals financial planning, investments, real estate, insurance and so on.

(ii) Financial Management:

It is concerned with the duties of financial managers in the business firm. Financial managers actively manage the financial affairs of any type of business. Namely financial and non-financial, private & public, large & small, Profit Seeking & not for profit. They performs varied tasks as budgeting, financial forecasting. cash management, credit administration, investment analysis find management and so on.

Managing financial management:

The term F.M has been defined differently by different authors. According to Solomon “Financial management is concerned with the efficient use of an important economic resource, namely Capital funds”

There are two basic aspects of F.M

(i) Procurement of Funds

(ii) Effective use of these funds.

(i) Procurement of Funds: Since funds can be obtained from different sources therefore their procurement always considered as a complex problem by business concerns. Funds procured from different sources have different characteristics in terms of risk control & cost.

The funds raised by the issue of equity shares are the best from the risk point of view for the company. Since these are no question of repayment of equity capital except when the company is under liquidation from the cost point of view. However, equity capital is usually the most expensive source of funds. This is because the dividend expectations of share holders are normally higher than prevalent interest rate and also because dividend is an appropriation of profits not allowed as an expense under the income tax act. Also the issue of new shares to public may dilate the control of the existing share holders.

(ii) Effective of Utilisation of funds:

The financial manager is also responsible for effective utilization of funds he has to point out situation where the funds are being kept idle or where proper use of funds is not being made.

All the funds are procured at a certain cost and after entailing a certain amount of risk. If these funds are not utilized in the manner so that they generate an income higher than the cost of procure them. There is no point in running the business. This is also an important consideration on dividend decision.

Analysis of Variance - Sales Variance

Sales variance.

The analysis of variances will be complete only when the difference between the actual profit and standard profit is fully analyzed.

Profit method of calculating sales variances:

The sales variances according to this method can be analyzed as:

1. Total sales margin variance (TSMV).

Actual Profit – Budgeted Profit Or Actual Quantity Of Sales X Actual Profit Per Unit – Budgeted Quantity Of Sales X Budgeted Profit Per Unit.

2. Sales margin variance (SMV) due to volume:

It is that portion of total sales margin variance which arises due to the number of articles sold being more or less than the budgeted quantity of sales.

Standard Profit Per Unit (Actual Quantity Of Sales – Budget Quantity Of Sales)

3. Sales Margin variance (SMV) due to selling price:

It is that portion of total sales margin variance which is due to the difference between the actual price of quantity of sales affected and the standard price of those sales. It is calculated as:

(actual selling price per unit – standard selling price per unit)

Value method of calculating sales variance:

Sales variances calculated according to value method show the effect on sales value and enable the sales manager to know the effect of the various sales efforts on his overall sales value figures. Sales variances according to this method may be as follows:

1. Sales value variance (SVV):

It is the difference between the standard value and the actual value of sales affected during a period.

It is calculated as:

Sales value variance = actual value of sales – budgeted value of sales.

2. Sales price variance:

It is that portion of sales value variance which arises due to the difference between actual price and standard price specified.

The formula is:

SPV = actual quantity sold (actual price – standard price)

3. Sales volume variance (S.Vol.V):

It is that portion of the sales value variance which arises due to the difference between actual quantity of sales and standard quantity of sales.

Formula:

Sales volume variance = standard price (actual quantity of sales – budgeted quantity of sales.

Analysis of Variance - Labour Variance

Labour variance

Labour variances can be analyzed as follows:

a) Labour cost variance:

It is the difference between the standard cost of labour allowed (as per standard laid down) for the actual output achieved and the actual cost of labour employed. It is also known as wages variance.

Labour cost variance= standard cost of labour – actual cost of labour.

b) Labour rate variance:

It is that portion of the labour cost variance which arises due to the difference between the standard rate specified and the actual rate paid.

It is calculated as follows:

Rate of pay variance = actual time taken (standard rate – actual rate)

c) Total labour efficiency variance:

It is that part of labour cost variance which arises due to the difference between standard labour cost of standard time for actual output and standard cost of actual time paid for.

It is calculated as follows:

Total labour efficiency variance = standard rate (standard time for actual output – actual time paid for)

d) Labour efficiency variance:

It is that portion of labour cost variance which arises due to the difference between standard labour hours specified for the output achieved and the actual labour hours spent.

Labour efficiency variance = standard rate (standard time for actual output – actual time worked)

e) Labour idle time variance:

It is calculated only when there is abnormal idle time. It is the portion of labour cost variance which is due to the abnormal idle time of workers. While calculating labour efficiency variance abnormal idle time is deducted from actual time expended to ascertain the real efficiency of the workers.

Labour idle time variance is expressed as:

Idle time variance = abnormal idle time x standard rate.

Total labour cost variance = labour rate of pay variance + total labour efficiency variance

f) Labour Mix variance or Gang composition variance:

It is like materials mix variance and is a part of labour efficiency variance. This variance shows to the management as to how much of the labour cost variance is due to the change in the composition of labour force.

It is calculated as follows:

i) If there is no change in the standard composition labour force and total time expended is equal to the total standard time, the formula is:

Labour mix variance = standard cost of standard composition (for actual time taken) – standard cost of actual composition (for actual time worked).

ii) If the standard composition of labour force is revised due to shortage of a particular type of labour and total time expended is equal to the total standard time, the formula is:

Labour Mix variance = standard cost of revised standard composition (for actual time taken) – standard cost of actual composition (for actual time worked).

iii) If the total actual time of labour differs from the total standard time of labour, the formula is:

Total time of actual labour composition (standard cost of standard

-------------------------------------------------- x composition) – (standard cost of

Total time of standard labour composition actual composition)

iv) If the standard is revised and the total actual time of labour differs from the total standard time of labour, the formula for the calculation of labour mix is:

Labour mix variance =

Total time of actual labour composition (standard cost of revised standard ------------------------------------------------- x composition) – (standard cost of

Total time of revised standard labour actual composition)

composition

g) Labour yield variance:

It is like material yield variance and arises due to the difference between yield that should have been obtained by actual time utilized on production and actual yield obtained. It can be calculated as follows:

Standard labour cost per unit (actual yield in units – standard yield in units expected from the actual time worked on production)

h) Substitution variance:

This is a variance in labour cost which arises due to the substitution of labour when one grade of labour is substituted by another. This is denoted by difference between the actual hours at standard rate of standard worker and the actual hours at standard rate of actual worker.

Substitution variance = (actual hours x standard rate for standard worker) – (actual hours x standard rate for actual worker)

Analysis of Variance - Material variance

Analysis of Variance:-

Control is a very important function of management analysis of variances is helpful in controlling the performance and achieving the profits that have been planned.

The deviation of the actual cost or profit or sales from the standard cost or profit or sales is known as “variance”.

1. Material variance:

In case of Materials, the following may be the variances:-

Material cost variance

i. Material price variance
ii. Material usage or quantity variance
a) Material Mix variance
b) Material yield variance

Material cost variance (MCV)

It is the difference between the standard cost of materials allowed (as per standards laid down) for the output achieved and the actual cost of materials used.

Material cost variance :

standard cost of materials for actual output.- Actual cost of materials used.

Material price variance (MPV)

It is that portion of the material cost variance which is due to the difference between the standard cost of materials used for the output achieved and the actual cost of materials used.

Material price variance = actual usage (standard unit price – actual unit price)

Here, actual usage = actual quantity of materials (in units) used

Standard unit priced = standard price of material per unit

Actual unit price = actual price of material per unit.

c) Material usage (or quantity) variance (MQV)

It is that portion of the material cost variance which is due to the difference between the standard quantity of materials specified for the actual output and the actual quantity of materials used.

Material usage variance = standard price per unit (standard quantity – actual quantity)

d) Material Mix variance (MMV):

It is that portion of the material usage variance which is due to the difference between standard and the actual composition of a mixture. It is calculated as the difference between the standard price of standard mix and standard price of actual mix.

i. Actual weight of mix and the standard weight of mix do not differ:-

Material mix variance is calculated with the help of the following formula:

Standard unit cost (standard quantity – actual quantity)

(Or)

Standard cost of standard mix – standard cost of actual mix.

If the standard is revised due to shortage of a particular type of material, the MMV is calculated as follows:

Standard unit cost (revised standard quantity – actual quantity)

(Or)

Standard cost of revised standard mix – standard cost of actual mix.

e) Material yield variance (MYV):

It is that portion of the material usage variance which is due to the difference between the standard yield specified and the actual yield obtained.

(i) When standard and actual mix does not differ:-

In such a case, yield variance is calculated with the help of the following formula:-

Yield variance = standard rate (actual yield – standard yield)

Standard cost of standard mix

Where standard rate = ----------------------------------------

Net stand output (i.e., Gross output – standard loss)

(ii) When actual mix differs from standard mix:-

In such a case, formula for the calculation of yield variance is almost the same.

Standard rate = standard cost of revised standard mix

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

Net standard output

Formula for yield variance in such a case is:-

Yield variance = standard rate (actual yield – revised standard yield).

Standard Costing

Standard cost and standard costing

Standard cost:

Standard cost is a predetermined cost. It is a determination in advance of production of what should be the cost. When Standard costs are used for the purpose of cost-control, the technique is known as Standard Costing.

Eric L. Kohler has defined Standard cost as follows:

“Standard cost is a forecast or predetermination of what actual cost should be under projected conditions, serving as a cost control and as a measure of production efficiency or standard of comparison when ultimately aligned against

Actual cost. It furnishes a medium by which the effectiveness of current results can be measured and the responsibility for deviations can be placed.

Standard costing:

It is the preparation of standard costs and applying them to measure the variations from actual costs and analyzing the causes of variations with a view to

maintain maximum efficiency in production. It is a technique, which use standards for costs and revenue for the purpose of control through variance analysis.

Standard costing is a technique which is complimentary to the actual costing or historical costing system. The system of standard costing can be useful in all types of industries, but it is more commonly used in industries producing standardized products.

(ii) Standard costing Vs. Budgetary control:

Both Standard costing and Budgetary control achieve the same objective of maximum efficiency and cost reduction by establishing predetermined standards, comparing actual performance with the predetermined standards and taking corrective measures, where necessary.

Though both are useful tools to the management in controlling costs, they defer in following respects:

1. To be able to establish standard costs, some form of budgeting is essential as there is the need to forecast the level of output and prescribed set of working conditions in the periods in which the standard costs are to be used.

2. Standards are based on technical assessments whereas budgets are leased on past actual adjusted to future trends.

3. Budgetary control deals with the operations of a department of business as a whole while standard costing is applied to manufacturing of a product, process or processes or providing a service.

4. Standards are set mainly for production and production expenses where as budgets are compiled for all items of income and expenditure.

5. Budgets set up maximum limits of expenses above which the actual expenditure should not normally exceed.

6. Budgets are projection of financial accounts, standard costs are projection of cost accounts because budgetary control adopts a more general approach of giving service to the management than does standard costing.

7. Budgets are anticipated or expected costs meant to be used for forecasting requirements of material, labour, cash, etc.

8. In budgetary control, variances are not revealed through the accounts but are revealed in total.

Both standard costing and budgetary control are complimentary to each other and for maximum efficiency both should be used simultaneously.

Standard costing Vs. Estimated cost

Standard costs and estimated costs are predetermined costs, but their objectives are different.

1. The object of estimated cost is to have a reasonable assessment of what a cost ‘will be’ whereas standard cost aims at what a cost ‘should be’.

2. Estimated costs are calculated on the basis of past performance adjusted in the light of anticipated changes in the future standard costs, on the other hand, are determined on a scientific basis keeping in view certain factors and conditions of efficiency.

3. Estimated costs are used by the concerns for fixing selling prices of products, for taking a decision to manufacture or to buy, for quoting the selling price of a job, etc.

4. Estimated costs are used by the concerns which adopt historical costing system of ascertaining cost where as standard costs are used by the concern, which follow standard costing system.

5. Standard costs are used as a regular system of accounts from which variances are found out. Whereas use of estimated cost as a statistical data only.

6. Standard costs are to be fixed for each element of cost where as estimated cost can be for a part of the business and also for a particular purpose.

(iv) Standard costing and Marginal costing.

Standard costing is a system of accounting in which all expenses (fixed and variable) are considered for the determination of standard cost for a prescribed set of working conditions on the other hand, Marginal costing is a technique in which only variable expenses are taken to ascertain the marginal cost. Both standard costing and marginal costing are completely independent of each other and may be installed jointly. This system of joint installation may be named as marginal standard costing or standard marginal costing system.

Break - Even Analysis

Break even analysis is a vital tool for the management accountant. In a very narrow interpretation of the term, break even analysis is understood as a system of determination of that level of activity where total cost is equal to total sales. However, break even analysis also involves determination of probable profit at any given level of activity.

Break even point:

A business is said to ‘break even’ when its total sales are equal to its total costs. It is a point of ‘no profit no losses. Break even point can be calculated ‘in units’ or ‘in value’. (i.e.) it can be expressed as the number of units to be produced and sold to ‘break-even’, or the sales required to be attained in rupees, so that there is a situation of “no profit – no loss”.

Cost- volume profit analysis (relation ship):

Cost volume profit (CVP) analysis is often misunderstood to be same as break- even analysis. Break even analysis, however, is only a part of CVP analysis studies the relationship between cost, number of units produced and sold, selling price and profit individually and collectively taken.

The scope of CVP analysis covers the study of behavior of cost in relation to volume, sensitivity of profits to variation in output, break even analysis, price formulation, etc. and provides valuable insight into effects of profit on account of various management decisions.

The scope of CVP analysis covers the study of behavior of cost in relation to volume, sensitivity of profits to variation in output, break even analysis, price formulation, etc. and provides valuable insight into effects on profit on account of various management decisions.

The main objectives of cost volume- profit analysis are given below:

i) The analysis helps to forecast profit fairly and accurately as it is essential to know the relationship between profits and costs on the one hand and volume on the other.

ii) This analysis is useful in setting up flexible budget which indicates costs at various levels of activity.

iii) This analysis assists in evaluation of performance for the purpose of control.

iv) This analysis also assists on formulating price policies by showing the effect of different price structures on cost and profits.

Analysis of break even chart:

A break even chart explains about the break even point, angle of incidence and margin of safety for a particular product of a business.

i) The lower the break even point, the better it is:

A low break even point implies that the organization can survive even if it is operating at lower level of activity.

ii) The larger the angle of incidence, the greater is the benefit:

Angle of incidence represents the difference between total sales and total cost. The larger the angle, the greater is the spread. The profits increase in a greater proportion with the increase in production. However, a fall in number of units produced will also have an adverse

iii) The larger the margin of safety the better it is:

Margin of safety reflects the cushion the organization has against a possible fall in sales. The greater the margin of safety, the more comfortable the organization will be. It has a greater capacity to with stand recessionary phases.

Break even chart:

The break even chart is a graphic representation of cost and revenue data which brings out their inter relationship, at different levels of activity.

Steps to construct break even graph:

i) Let the X-axis represent the volume or level of activity and the Y-axis represents the costs and revenue in rupees.

ii) Draw the fixed cost line parallel to X-axis, from the point in Y-axis which represents the amount of fixed cost.

iii) With the help of the data given, construct the total cost line. The total cost is the total of variable costs at any given level of activity and the fixed cost. The total cost line will intersect the Y- axis at the point of fixed cost, as total cost is equal to fixed cost at ‘zero’ level of activity.

iv) With the help of data given construct the ‘total revenue’ chart. The total revenue cost will pass through the origin as the revenues at ‘zero’ level of activity is nil.

v) The break even point is the point of intersection of the total cost line and the total revenue line.

vi) The angle between the two lines of total cost and total revenue is called ‘angle of incidence’.

Assumptions underlying break even chart:

i) All costs can be separated into fixed and variable costs.

ii) Fixed costs will remain constant and will not change with the change in level of output.

iii) Variable costs will fluctuate in the same proportion in which the volume of output varies. In other words, prices of variable cost factors i.e., wage rates; price of material, etc. will remain unchanged.

iv) Selling price will remain constant even though there may be competition or change in volume if production.

v) The number of units produced and sold will be the same so that there is no opening or closing stock.

vi) There will be no change in operating efficiency.

vii) There is only one product or in the case of many products, product mix will remain unchanged.

viii) Product specifications and methods of manufacturing and selling will not change.

Marginal Costing

Marginal costing definition:

According to ICMA London “marginal cost is the amount for any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”. Marginal costing is the technique of applying the concept of marginal cost in decision making process. Marginal costing is a technique that distinguishes between fixed and variable costs. The “marginal” cost of a product is its variable cost.

Applications of marginal costing: marginal costing is a very useful tool for management because of its following applications and merits:

A. Cost control:

Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled by the top management and that to a limited extent. Variable costs can be controlled by the lower level of management. Marginal cost by concentrating all efforts on the variable costs can control and thus provides a tool to the management for control of total cost.

In marginal costing fixed costs are not eliminated at all. These are shown separately as a deduction from the contribution instead of merging with cost of sales and inventories. This helps the management to have a control on fixed costs.

B. Profit planning:

Marginal costing helps the profit planning, i.e., planning for future operations in such a way as to maximize the profits to maintain a specified level of profit. Absorption costing fails to bring out the correct effect of change in sale price, variable cost are product mix on the profits of the concern but that is possible with the help of marginal costing.

Profits are increased or decreased as a consequence of fluctuations in selling prices, variable costs and sales quantities in case there is fixed capacity to produce and sell.

C. evaluation of performance:

The different products, departments, markets and sales divisions have different profit earning potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector of a concern.

Performance evaluation is better done if distinction is made between fixed and variable expenses

D. Decision making:

The information provided by the total cost method is not sufficient in solving the management problems. Material costing techniques is used in providing assistance to the management in vital decision making, especially in dealing with the problems requiring short-term. Decisions where fixed costs are excluded.

The following are the important areas, where managerial problems are simplified by use of the marginal costing:

i. Fixation of selling price.

Ii. Key or limiting factor

iii. Make or by decisions

iv. Selection of a suitable product mix.

v. Effect of change in price.

vi. Maintaining a desired level of profit

vii. Alternative methods of production

viii. Diversification of products.

ix. Closing down or suspending activities.

x. Alternative course of action

The important areas where managerial problems are simplified by use of the marginal costing are:

1. Fixation of selling Price:

Although the prices are more controlled by market conditions and other economic factors than by decisions of management yet fixation of selling prices is one of the most important functions of management. This function is to be performed:

(a) Under normal circumstances

(b) In times of competition

(c) In times of trade depression

(d) In accepting additional orders for utilizing idle capacity

(e) In exporting and exploring new markets.

2. Key (or limiting) factor:

A key factor that factor which puts a limit on production and profit of a business. Usually the limiting factor is sales. A concern may not be able to sell as much as it can produce. But sometimes a concern can sell all it produces but production is limited due to the storage of materials, labour and plant capacity or capital.

3. Make or buy decision:

A concern can utilize its idle capacity by making component parts instead of buying them from market.

Factors that influence make or buy decision:

In a make or buy decision, the following cost and non-cost factors must be considered specifically.

Cost factors:

a) Available of plant facility

b) Quality and type of item which effects the production schedule.

c) The space required for production of item

d) Any special machinery or equipment required.

e) Any transportation involved due to the location of the product, i.e., the “feeder point”.

f) Cost of acquiring special know-how required for the item.

4. Selection of a suitable product mix:

When a factory manufacturers more than one product, a problem is faced by the management as to which product mix will give the maximum profits. The best product mix is that which yields the maximum contribution.

5. Effect of change in sales price:

Management is confronted with the problem of cut in prices of products from time to time on account of competition, expansion programmed or government regulations. It is therefore, necessary to know the effect of a cutting price of the products. The effect of cutting selling price per unit will be that contribution per unit will reduce.

6. Maintaining a desired level of profits:

Management may be interested in maintaining a desired level of profits. The volume of sales needed to have a desired level of profits can be ascertained by the marginal costing technique.

7. Alternative methods of production:

Marginal costing is helpful in comparing the alternative methods of production (i.e.,) machine work or hand work. The method which gives the greatest contribution is to be adopted keeping of course, the limiting factor in view. Where fixed expenses change, the decision will be taken on the basis of profit contributed by each.

8. Diversification of products:

Sometimes it becomes necessary for a concern to introduce a new product to the existing product or products in order to utilize the idle capacity or to capture a new market or for other purposes. General fixed costs will however, be charged to the old product/products.

9. Closing down all suspecting activities:

Sometimes it becomes necessary for a firm to temporary suspends or closes the activities of a particular product, department or factory as a whole due to trade recessions. The decision to close down or suspend its activities will depend on whether products are making a contribution towards fixed costs or not.

10. Alternative course of action:

When deciding between alternative courses of action, it shall be kept in mind that whatever course of action is adopted, certain fixed expenses will remain unaffected. The criterion, therefore, which weighs is the effect of alternative course of action upon the marginal costs in relation to the revenue obtained. The course of action which yields the greatest contribution is the most profitable to be followed by the management.

Process Costing

Definition of process costing:

Process costing is that form of operation costing which is used to ascertain the cost of the product at each process or stage of manufacture.

Application of process costing

The industries in which process costs may be used are many. In fact a process costing system can usually be devised in all industries except where job, batch or unit operation costing is necessary.

Examples of industries, where process costing is applied are:-

1. Chemical works – Textile, weaving, spinning, etc.

2. Paper mills – Paint, Ink and varnishing, etc.

Advantages of process costing

The following are the main advantages of process costing:

1. It is possible to determine process costs periodically at short intervals. Unit cost can be computed weekly or even daily if overhead rates are used on predetermined basis.

2. It is simple and less expensive to find out the process cost.

3. It is possible to have managerial control by evaluating the performance of each process.

4. It is easy to allocate the expenses to processes in order to have accurate cost.

5. It is easy to quote the prices with standardization of process. Standard costing can be established easily in process type of manufacture

Fundamental principles of process costing:

The following are the fundamental principles of process costing:-

1. Cost of materials, wages and overhead expenses are collected for each process or operation in a period.

2. Adequate records in respect of output and scrap of each processor operation during the period are kept.

3. The cost per finished output of each process is obtained by deviating the total cost incurred during a period by the number of units produced during the period after taking into consideration the losses and amount realized from sale of scrap.

4. The finished product along with its cost is transferred from one process to the next process just like raw materials of that process.

Elements of production costing

The following are the main elements of production cost in process costing:-

1. Materials:

Generally in process costing, all the material required for production is issued to the first process, where after processing it is passed to the next process and soon. Some operation on the material is performed in each process which has been passed from the first process.

2. Labour:

Generally, the cost of direct labour is very small part of the cost of production in industries adopting process costing. The direct labour element becomes smaller and smaller while the overhead element increases with the introduction of more and more automatic machinery.

3. Production overhead:

The overhead element of total cost is generally very high in process costing great care is required to ensure that each process is charged with a reasonable share of production overhead. The actual overheads are debited to each process account.

In process costing, the four main aspects which are to be discussed are;

1. Process losses

2. Inter process profits

3. work-in-progress and effective or equivalent production.

4. Joint and by-products.

Normal process loss:-

If the loss is unavoidable on account of inherent nature of production processes. Such loss can be estimated in advance on the basis of past experience or data. The normal process loss is recorded only in items of quantity and the cost per unit of usable production is increased accordingly, where scrap possesses some value as a waste product or a raw material for an earlier process, the value thereof is credited to the process account. This reduces the cost of normal output; process loss is shared by usable units.

Abnormal process loss:-

Any loss caused by unexpected or abnormal conditions such as plant break down, sub-standard materials, careless, accident etc. or loss in excess of the margin anticipated for normal process loss should be regarded as abnormal process loss. The unit of abnormal loss is calculated as under.

Abnormal loss = actual loss – normal loss.

The valuation of abnormal process loss should be done with the help of the following formula.

Value of abnormal loss

Normal cost of normal output

= ------------------------------------ x units of abnormal loss

Normal output

All cases of abnormal process loss should be thoroughly investigated and steps taken to prevent these recurrence in future. Abnormal process loss should not be allowed to affect the cost of production as it is caused by abnormal or unexpected conditions. Such loss representing the cost of materials, labour and overhead incurred on the wastage should be transferred to an abnormal loss account. If this abnormal loss has got any scrap value, it should be credited to abnormal loss account and the balance is ultimately written off to costing profit and loss account.

COST CONCEPTS

Cost:

The Institute of Cost and Management Accountants (ICMA) has defined cost as “the amount of expenditure, actual or notional, incurred on or attributable to a specified thing or activity”. It is the amount of resources sacrificed to achieve a specific objective. A cost must be with reference to the purpose for which it is used and the conditions under which it is computed. To take decisions, managers wish to know the cost of something. This something is called a “cost unit”.

2. Cost unit:

A cost unit is any thing for which a separate measurement of costs if desired. A product, service, department, project or an educational course can all be cost units. Cost units are chosen not for their own sake but to aid decision making. Thus a cost unit is a “quantitative unit or product or service in relation to which costs are ascertained”. The cost unit to be used at any given situation is that which is most relevant to the purpose of cost ascertainment.

3. Cost centre:

According to ICMA London, cost center is “a location, person or items of equipment in respect of which costs may be ascertained and related to cost units for cooses”. It is simply a method by which costs are gathered together, according to their incidence, usually by means of cost center codes. It is the smallest element of an organization in respect of which costs are charged and ascertained.

Maintenance department, a public relation office, a printing machine are all examples of cost centers.

The establishment of cost centers serves two important purposes. Firstly cost ascertainment is made possible by collecting and charging cost to each cost center. Secondly, cost control is ensured as costs can be more closely looked at and more easily monitored by a responsible official. The setting up of a cost centers depends on numerous factors such as organization of factory, requirement of the costing system and management policy.