INDEX

Units Page No.

 UNIT 1
 LESSON 1-NATURE AND SCOPE OF MANAGEMENT
1 to 17
ACCOUNTING
 UNIT 2
 LESSON 1-INTRODUCTION- BUDGETING &
18 to 32
BUDGETARY CONTROL
 LESSON 2-FUNCTIONAL BUDGETS 33 to 46
 LESSON 3- FIXED AND FLEXIBLE BUDGET 47 to 60
 LESSON 4-RECENT DEVELOPMENTS IN BUDGET 61 to 71
 UNIT 3
 LESSON 1-STANDARD COSTING 72 to 83
 LESSON 2- VARIANCE ANALYSIS – MATERIAL &
84 to 107
LABOUR VARIANCE
 LESSON 3-VARIANCE ANALYSIS - OVERHEAD &
108 to 131
SALES VARIANCE
 UNIT 4
 LESSON 1-ABSORPTION COSTING VS. VARIABLE
132 to 149
COSTING
 LESSON 2-COST-VOLUME-PROFIT ANALYSIS 150 to 170
 UNIT 5
 LESSON 1-DECISION MAKING & VARIABLE
171 to 194
COSTING
 LESSON 2-DECISION MAKING & DIFFERENTIAL
195 to 206
COST ANALYSIS
 UNIT 6
 LESSON 1-RESPONSIBILITY ACCOUNTING &
207 to 220
DIVISIONAL PERFORMANCE MEASUREMENT
 Previous Year Question Papers

Ms. Preeti Singh

Assistant Professor
Daulat Ram College
 LESSON-1 UNIT 1

NATURE AND SCOPE OF MANAGEMENT ACCOUNTING

1. STRUCTURE

1.0 Learning Objectives

1.1 Introduction
1.2 Definitions
1.3 Nature of Management Accounting
1.4 Objectives of Management Accounting
1.5 Tools and Techniques of Management Accounting
1.6 Limitations of Management Accounting
1.7 Comparison between Financial Accounting, Cost Accounting and Management
Accounting
1.7.1 Comparison between Financial Accounting and Management Accounting
1.7.2 Comparison between Cost Accounting and Management Accounting
1.8 Cost Control
1.9 Cost Reduction
1.9.1 Area and Scope of Cost Reduction
1.10 Comparison of Cost Control and Cost Reduction
1.11 Cost Management
1.12 Self-Test Questions

1.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn the meaning, nature and scope of management accounting
(b) Learn to compare financial accounting, cost accounting and management
accounting
(c) Learn the various concept like cost control, cost reduction and cost management
(d) Learn different tools and techniques of management accounting

1.1 INTRODUCTION

Every organization requires accounting information for managing daily operations

and to make variety of decisions in different situations. Management has to work for the
success of the enterprise and it requires only that information which helps them in
planning, organizing, commanding, coordinating and controlling. For these reasons, the

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accounting information is to be analyzed, regrouped and looked into minutely. On the
basis of information provided by accounting data, it is divided into three category
financial accounting, cost accounting and management accounting.

Management Accounting is a new approach to accounting. The term Management

Accounting is composed of two words - Management and Accounting. It refers to
Accounting for the Management. Management Accounting is a modern tool to
management. It includes various methods, tools and techniques necessary for effective
planning for choosing among alternative business actions, and for control through the
evaluation and interpretation of performance and finally for decision making purpose. It
is basically concerned with providing the information to the insiders for decision making
and achieving the objectives of the organization effectively.

Management has to forecast, has to Accounting information needed to be

plan, has to organise, has to analysed for the management to
command, has to co-ordinate and contribute to the success of the
has to control various operations. enterprise.

1.2 DEFINITIONS

CIMA, London “Management accounting is an integral part of management

concerned with identifying, presenting and interpreting
information used for: (a) formulating strategy; (b) planning
and controlling activities; (c) decision taking; (d)
optimizing the use of resources; (e) disclosure to
shareholders and others external to the entity; (f) disclosure
to employees; (g) safeguarding assets”
American Accounting “Management Accounting is the application of appropriate
Association techniques and concepts in processing historical and
projected economic data of an entity to assist management
in establishing plans for reasonable economic objectives in
the making of rational decisions with a view towards these
objectives.”
ICMA, London “The application of professional knowledge and skill in the
preparation and presentation of accounting information in
such a way as to assist management in the formulation of
policies and in the planning and control of the operation of
the undertaking.”

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The management “The presentation of accounting information in such a way
accounting team of Anglo- as to assist management in the creation of policy and in day
American Council on to day operation of an understanding”.
Productivity
Robert Anthony “Management accounting is concerned with accounting
information which is useful to management”
Brown and Howard Management accounting may be defined broadly as that
aspect of accounting, which is concerned with the efficient
management of a business through the presentation to
management of such information as, will facilitate efficient
and opportune planning and control.
J Batty “Management accounting is the term used to describe
accounting methods, systems and techniques which coupled
with special knowledge and ability, assists management in
its task of maximizing profits or minimizing losses.”
The Institute of “Any form of Accounting which enables a business to be
Chartered Accountants conducted more efficiently can be regarded as Management
of England and Wales Accounting.”

From the above definitions, one can have clear view about the management
accounting. It focuses on that accounting information, which is useful to the management
for various reasons. The accounting information is rearranged in such a manner and
provided to the top management for planning, controlling and decision making.

1.3 NATURE OF MANAGEMENT ACCOUNTING

Decision
Making
System

Selective Future
Nature Oriented

Nature of
Management
Accounting
Internal
Not Rigid
Use

Selective
Optional
Nature

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 (1) Decision Making System: Management accounting is useful in decision making.
It uses various techniques and collects and analyzes the information/figure relating
to cost, price, profit and savings for each of the available alternatives in order to
make sound decisions.
(2) Future Oriented: Management Accounting is an accounting system which is
directly related to future course of events. As it is concerned with planning,
decision making and controlling which relate to future period. Hence the primary
nature of management accounting is that it is futuristic.
(3) Internal Use: Financial accounting information is basically intended for outsiders
or externals but management accounting is meant mainly for internal users.
Because the information provided by the management accounting is use by the
management for internal use.
(4) Selective Nature: It is also a potent characteristic of this accounting system. Here
selective means, in management accounting, a management accountant is only
collect those data and information from a variety of alternatives or do comparison
analysis which would be useful in decision making. Hence, it is selective in nature.
(5) Optional: As there is no statutory obligation in management accounting. It is
purely voluntary in nature. There is no obligation related to this accounting. It can
be used according to its utility for the managements.
(6) Not Rigid: In financial accounting, accountants need to follow different norms
and rules for creating ledgers and other books of account. But there is no need to
follow fixed norms in management accounting. Even there is flexibility for
presenting the records and other information. Management accounting tool may be
different from one organization to other organization. Usage of different tools is
fully dependent on the persons who are using it.

1.4 OBJECTIVES OF MANAGEMENT ACCOUNTING

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(1) Planning: Management accounting assists management in planning the activities
of the business. It involves forecasting on the basis of available information,
setting goals, framing policies, determining the alternative courses of action and
deciding on the program of activities. The techniques which are used in the
management accounting are Budgeting, standard costing and variance analysis etc.
(2) Controlling: Management accounting is a useful device of managerial control. It
is an important function of management accounting. Control means measurement
and evaluation of performance. Thus, management accounting helps management
in discharging its control function successfully through budgetary control and
standard costing.
(3) Decision Making: The main objective of management accounting is to help in
decision making. Modified data, analyzed data and interpreted information are
highly useful to management for taking quality decision and policy formulation in
a management accounting system.
(4) Classifying, analyzing and interpretation of data: Under management
accounting, the data is properly classified, analyzed and interpreted to make the
accounting information more relevant for decision making purpose. By doing this
exercise, the data become more understandable and explanatory for the
management.
(5) Increasing Efficiency: By setting norms or standards for the units or centers, the
management accounting evaluates the performance and helps in improving the
efficiency. For example - management accounting lays emphasis on management
audit which means evaluating the efficiency of management policies to improve
efficiency.
(6) Coordinating: Budgeting is one of the techniques that create sink between the
objectives of the organization as a whole with the objectives of all the
departments. For instance - Preparing the functional budgets in the first instance
and then co-coordinating the whole activities of the concern by integrating all
functional budgets into one known as master budget involves coordination.
(7) Increase Profitability: Management accounting can help companies lower their
operational expenses. Business owners often use management accounting
information to review the cost of economic resources and other business
operations. This information allows owners to take better decision related to cost
and ultimately helps in increasing the profitability of an organization.
(8) Performance Evaluation: Setting goals, objectives and standards and planning
the best and economical course of action and then measuring the performance on
the basis of these, helps an organization to increase the effectiveness and thereby
motivate the members of the organization.

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1.5 TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING

Management accounting deals with number of tools and techniques to help the
managers in better planning, controlling and decision making. Some of the important
tools and techniques are as follows:

(1) Financial Planning

(2) Financial Statement Analysis
(3) Decision Making
(4) Standard costing and variance analysis
(5) Marginal costing and cost profit volume analysis
(6) Responsibility Accounting
(7) Discounted Cash flow
(8) Learning Curve
(9) Ratio analysis
(10) Statistical and Graphical Techniques
(11) Funds flow statement
(12) Cash flow statement
(13) Value analysis
(14) Risk analysis

1.6 LIMITATIONS OF MANAGEMENT ACCOUNTING

Management accounting is a very useful tool of management but is subject to the

following limitations:

(1) Evolutionary stage: Management accounting is comparatively a new discipline.

Its rules, principles and conventions are still in the developing stage. A lot of
research needs to be done to increase its scope. This limits the usage of
management accounting in making a perfect tool for planning and decision
making.
(2) Costly: The installation of this system of accounting involves huge cost. It
involves huge investment (in terms of money and man power) and wide area of
network of the management which is not specifically possible for the small
organization.
(3) Based on historical data: As management accounting requires lot information
and data which is retrieve from the books of financial accounts and cost accounts
which in turn based on historical data. The success of management accounting
depends on the accuracy of the information. And the past data is inaccurate and
not reliable for the decision making purpose.

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 (4) Opposition to change: Management accounting demands a break away from
traditional accounting practices. Installation of new techniques demands a change
of attitude and acceptance and support from the employees. It calls for a
rearrangement of the personnel and their activities, which is generally not like by
the people involved.
(5) Wide coverage: The application of management accounting requires wide
knowledge of various disciplines like economics, taxation, statistics, and
management and so on, not only of cost accounting and management accounting.
This all brings inexactness and subjectivity in the conclusions obtained through it.
(6) Not a substitute of management: Management accounting cannot replace the
management. Management accountant is only an adviser to the management and
provides necessary data for decision making. The decision regarding
implementing his advice is to be taken by the management. There is always a
temptation to take an easy course of arriving at decision by intuition rather than
going by the advice of the management accountant.
(7) Subjectivity: There is every possibility of personal bias and manipulation from
the collection of data to the interpretation stage in management accounting. Thus,
it losses objectivity and validity. The outcomes can be influenced and affected by
the quality of the management team.

1.7 COMPARISON BETWEEN FINANCIAL ACCOUNTING, COST

ACCOUNTING AND MANAGEMENT ACCOUNTING

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1.7.1 Comparison between Financial Accounting and Management
Accounting

Basis Financial Accounting Management Accounting

Objective The main objectives of The main objective of managerial
financial accounting are to accounting is to help management
disclose the end results of the by providing information that is
business, and the financial used to plan, set goals and evaluate
condition of the business on a these goals.
particular date.
External and The information provided by The information provided by
internal users financial accounting is in the management accounting is for
form of profit and loss account internal use of the management.
and balance sheet for external Thus, management accounting is
Users like shareholders, primarily an internal reporting
creditors, banks, investors and process.
Government. Thus, financial
accounting is primarily an
external reporting process.
Statutory Financial Accounting is to be Management Accounting is
Requirements done according to the optional. Though it is meant for
provisions of Companies Act insiders, management can frame and
and Income Tax Act. It has adopt its own rules and principles.
obligations to satisfy various
statutory provisions.
Compulsory Financial Accounting is Management accounting is entirely
and optional compulsory and a necessity for optional and its forms and contents
joint stock companies, sole depend upon the outlook of the
proprietorship and partnership management.
firms and so on for various
reasons.
Rigid and Financial Statement must be Management Accounting is not
flexible prepared in accordance for bounded by the accounting
generally accepted accounting standards. It can be done in
principles as they provide accordance with the need of
consistency and comparability. management of a specific business.
Historical and Financial Accounting data is Management Accounting is
Futuristic historical in nature. It recordsfuturistic in nature. It analyses the
and analyses business events events as they take place and also
long after they have taken anticipates such events for the
place. Comparatively it is more future. The data reflects expected
precise and estimated values which has
relevance in future.
Periodicity The reports and accounts are In management accounting, weekly,
reported on year to year basis. fortnightly and even monthly
reporting is used.

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 Basis Financial Accounting
Monetary and Financial statements prepared
Non-Monetary under financial accounting
provide monetary information
only.
Types of The financial statement - profit
Statement and loss account, balance sheet
and cash flow statements reveal
the overall performance and
position of the enterprise.
Publication and These above mentioned
audit statements are required to be
published for general use and
need to be audited by statutory
auditors.
1.7.2 Comparison between Cost Accounting and Management Accounting
Basis Cost Accounting
Objective The objective of Cost
accounting is cost ascertainment,
allocation, distribution, analysis
and cost control.
Scope Cost accounting is concerned
merely with assisting in
management functions and does
not provide for the evaluation of
the performance of management
Evolution Evolution of cost accounting is
based on the limitation of
financial accounting.
Approaches The approach of the cost
accountant is much narrower
than that of a management
accountant as they are more
focused on cost ascertainment
and cost control.
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Management Accounting
Management accounting statements
in addition to monetary information
also provide non-monetary
information, viz., quantities of
materials consumed, labour hours,
machines hour, quantities produced
and sold and so on
Management accounting reports
emphasize on the details of
operational costs, inventories,
products, process and jobs. It traces
the effect and impact of the business
transactions and events on costs,
inventories, processes, jobs and
products.
These reports are completely for
internal use and are not required to
be published as well as need not to
be audited by statutory auditors.
Management Accounting
The objective of Management
accounting is to provide information
related to decision making to
management. It is concerned more
with impact and effect aspect of costs.
Management accounting is concerned,
both, with assisting management in its
functions, as well as evaluating the
performance of the management as an
institution.
Evolution of Management accounting
is based on the limitation of cost
accounting.
The approach of management
accountant is much broader than that
of a cost accountant as they have to
use certain economic and statistical
data along with the costing data to
enable the management to be more
accurate and precise in its functions of
planning, control and decision-making.
 Basis Cost Accounting Management Accounting
Source of Source of information for cost Source of information for management
Information accounting is data provided by accounting data is derived cost
financial accounts. accounts and financial accounts.
Installation Cost accounting system can be Management accounting cannot be
installed without management installed without a proper system cost
accounting. accounting.
Hierarchical Cost accountant generally is Management accountant generally is
Status placed at a lower level of placed at a higher level of hierarchy
hierarchy than the Management than the Cost accountant.
accountant.
Techniques Techniques used in cost Management accounting, in addition to
accounting are variable costing, the tools and techniques used in cost
break-even analysis, standard accounting also makes use of other
costing, marginal costing, techniques like cash flow, ratio
uniform costing etc. analysis, etc., which are not within the
scope of cost accounting.
Historical Cost accounting is mostly Management accounting is futuristic in
and historical in its approach and it nature. Management accounting is
Futuristic projects the past records. more predictive in nature than cost
accounting.
Planning Cost accounting is more Management accounting is concerned
concerned with short-term equally with short-range and long-
planning. range planning and uses techniques
like capital budgeting, ratio analysis,
sensitivity analysis, funds flow
statement statistical analysis etc., in
the planning and forecasting.

1.8 COST CONTROL

Meaning CIMA, London has defined cost control as, “the guidance and regulation
by executive action of the cost of operating an undertaking particularly
where action is guided by cost accounting”. This definition reveals the
following characteristics of cost control:
(1) The word “guidance” reflects a goal or standard to be achieved which
is required to be set for performance evaluation and controlling cost.
(2) The word “regulation” means taking corrective measures to control
deviations which can be found when actual cost is compared with
standard cost.
(3) The word “executive action” indicates that the action to regulate or
control the deviation must be taken by executives.
Hence cost control is an important component of cost accounting. It is
exercised by making comparison between actual cost and pre-determined
cost.

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Aim Its aim is to achieve pre-determined cost targets and standards and
keeping them within the budgeted limits.
Nature Cost Control is preventive in nature and is implemented for the total cost.
Process The process of cost control includes the following steps:
(1) Setting targets: Establishing the targets for different elements of the
cost is the first step of cost controlling which may serve as a base
for measuring the performance. Setting targets or establishing
standards are not easy task. The past data is used and modified
according to the future perspectives for making standards.
(2) Comparison with actual performance: The next step is measuring
the actual performance and compares it with established targets to
know the deviations.
(3) Taking corrective actions: After investigating the reasons for such
deviation, next step will be to take corrective actions and prevent
re-occurrence of deviations in future. Sometimes there is need to
review standards and revising them according to the dynamic
business conditions.
Techniques There are various techniques used for cost controlling are as follows:
(1) Budgetary control
(2) Standard costing and variance analysis
(3) Ratio analysis
(4) Material control
(5) Labour control
(6) Overhead control
(7) ABC analysis
(8) Economic order quantity
(9) Time and Motion Study
Advantages The advantages of cost control are as follows:
(1) It helps in utilizing the resources efficiently.
(2) It helps in reduction of prices which are benefited by customers.
(3) It helps in competing successfully in the market by keeping a close
view on cost structure.
(4) It increases the profit earning capacity of the business.

1.9 COST REDUCTION

Meaning CIMA, London defines cost reduction as “the achievement of real and
permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for use intended.” This
definition reveals the following characteristics of cost reduction:
(1) The reduction in cost should be real which can be achieved by
increasing the productivity, elimination of wastes etc.
(2) The cost reduction should be permanent. Its effectiveness
should not be temporary or short lived like changes in cost due
to change in tax structure, market prices of input etc.
(3) The reduction in cost should be attained without impairing the

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 suitability of product for the intended use i.e. the main utility of
the product should not be sacrificed to have reduction in cost.
Aim The aim of cost reduction is to have real and permanent reduction in
cost and to lower unit cost of production without negatively affecting
the quality.
Nature Cost reduction is corrective measure in nature and is focused on unit
cost.
Techniques There are various techniques used for cost reduction are as follows:
(1) Inventory Control
(2) Production Planning and control
(3) Value analysis
(4) Improvement in Product Design
(5) Standardization and Simplification
(6) Market research
(7) Minimization/ Elimination of wastes
(8) Substitute material utilization
(9) Labour control
(10)Quality control techniques
Advantages The following are the advantages of using cost reduction as technique
in the organization:
(1) It helps in increasing the profit of the organization.
(2) It helps in increasing the capacity of the organization
(3) It enhances the competitive edge of the organization
(4) It also provides scope for more money for labour welfare
schemes and thus improves men- management relationship.
(5) As it results in reduction in cost due to which export price may
be lowered which may increase total exports.

1.9.1 Area and Scope of Cost Reduction

Area of Cost
Application of Cost Reduction
Reduction
Product Design Product design constitutes the most important field where cost
reduction may be attempted. It is the first step in the manufacture of a
product and employing some changes at this stage can bring
economies in cost. Cost reduction in product design has the greatest
scope without impairing the quality of the product.
Efficient designing for a new product and improving the design for an
existing product reduce cost in the following way:
(a) Material Cost: Changing design of the product, using
economical substitutes,, economic quantity, variety of materials
so that storage cost and investment in inventory are reduced.
(b) Labour Cost: Improvement in product design can reduce time
of operation etc.
(c) Standardization and simplification of methods increases
productivity and reduces cost.
(d) Design of tools, equipments and machinery.

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Organization Cost reduction can be attained by bringing changes in the
organizational structure. All efforts should be constantly made to
reduce the costs by the adoption of new methods of organization and
new production methods. By defining clear cut authority and
responsibility, adopting proper channels of purchasing, receiving,
inspection, storage of material etc., well defined channels of
communication can bring permanent and real reduction in cost.
Production The scope of cost reduction in this area is also very wide. As an
efficient system of production control ensures proper production
planning, initiates efficient production procedures and develops
economical production programmes. It avoids wastage of time, money
and non-monetary resources, brings about economy in various types of
costs.
Administration Office should be re-organized if there is scope for improvement in the
efficiency of persons engaged in the office which can lead to reduction
in cost. The followings measures can be adopted:
(1) Avoid the use of unnecessary forms.
(2) Systematic supervision of the use of office machinery.
(3) Possibility of reduction of files and filing space.
(4) Expenditure on printing, postage and telephone.
(5) Computerize the routine office jobs.
Marketing In this area of cost reduction, improvement can be made by revising
the methods of market research, advertising, packing, warehousing,
distribution, after-sale services and so on.
Finance With the increasing difficulty in procuring funds, management should
eliminate useless investment. Wasteful use of capital is as bad as
inadequate capital. The following cost reduction programme can be
used:
(1) Better utilization of fixed assets
(2) Better credit control
(3) Capital budgeting
(4) Avoid under/over capitalization
(5) Procuring capital at minimum cost to get maximum return

1.10 COMPARISON OF COST CONTROL AND COST REDUCTION

Cost control and cost reduction are two effective tools for management. Both concepts
differ from each other in the following aspects:

Basis Cost Control Cost Reduction

Meaning Cost Control is defined as the
“the guidance and regulation by
executive action of the cost of
operating an undertaking
particularly where action is
guided by cost accounting”.
Cost Reduction is defined as “the
achievement of real and permanent
reduction in the unit cost of goods
manufactured or services rendered
without impairing their suitability
for use intended”.

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 Basis Cost Control
Objective Its main objective is to achieve
pre-determined cost targets and
standards and keeping them
within the budgeted limits.
Nature It is temporary in nature.
Approach It has static approach as it limits
its achievement to the targets
established.
Process It involves setting targets,
comparison with actual cost and
finally taking corrective actions.
Dependence on It is a part of cost accounting
cost accounting function.
Function Cost Control is a preventive
function and is implemented for
the total cost.
Standards It follows standards and always
does comparison of actual
performance with standard
performance.
Cost Reduction
Its main objective of is to have
real and permanent reduction in
cost and to lower unit cost of
production without negatively
affecting the quality.
It is real and permanent in nature.
It has dynamic approach as it is
not one time activity and can be
performed in different areas.
It is not based on pre-determined
targets. It concerned with finding
out new product designs, methods
etc.
It can be achieved even when no
cost accounting system is in
operation.
Cost reduction is a corrective
function and is focused on unit
cost.
It does not follow standards. Even
it assumes that there is room for
changes in standards too.

1.11 COST MANAGEMENT

The term „Cost Management‟ is a new terminology of management and has no

uniform definition. But some authors tried to define it. According to Horngren, cost
management is used “to describe the approaches and activities of mangers in the short
term and long term planning and control decisions that increase value for customers and
lower costs of products and services”. According to Hansen and Mowen, “Cost
management identifies, collects, measures, classifies and reports information that is useful
to managers in costing (determining what something costs), planning, controlling and
decision making”. Cost management involves different cost accounting methods that have
the goal of improving business cost efficiency by reducing costs or atleast having
measures in place to restrict the growth of costs.

Effective management of cost makes an organization more strong, more stable and
helps in improving the potential of a business. The organization calls for a system that
would help them in understanding the process and activities of the business. This provides
supplying of information to the top management for improving the business performance
and productivity. Cost management also helps in optimizing resources which will
improve overall efficiency of the organization and help the firm to achieve its objectives.

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1.12 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) The term management accounting was first coined in

(a) 1960
(b) 1950
(c) 1945
(d) 1955

(2) The use of management accounting is

(a) Optional
(b) Compulsory
(c) Legally obligatory
(d) Compulsory to some and optional to others

(3) Management accounting assists the management

(a) Only in control
(b) Only in direction
(c) Only in planning
(d) In planning, direction and control

(4) Who coined the concept of management accounting?

(a) R.N Anthony
(b) James H. Bliss
(c) J. Batty
(d) American Accounting Association

(5) The definition ‘Management Accounting is the presentation of accounting

information in such a way as to assist management in the creation of policy and
the day-to-day operation of an undertaking.’
(a) Ango-American Council on Productivity
(b) AICPA
(c) Robert N. Anthony
(d) All of the above
(6) Management accounting deals with
(a) Quantitative information
(b) Qualitative information
(c) Both (a) and (b)
(d) None of the above

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(7) Management accountancy is a structure for
(a) Costing
(b) Accounting
(c) Decision making
(d) Management

Answers: (1) (b), (2) (a), (3) (d), (4) (b), (5) (a), (6) (c), (7) (c)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) Cost management is the process whereby companies use _____________ to report
or control the various costs of doing business.
(b) Management accounting is the application of ____________ techniques to the
provision of information designed to assist all levels of management in planning
and controlling the activities of the firm.
(c) Management accounting is an integral part of ____________ concerned with
identifying, presenting and interpreting information used for formulating strategy,
planning and controlling and decision making.
(d) Cost control is defined as regulation by executive action of the _________ of
operating an undertaking particularly where action is guided by ___________.
(e) Management accounting is primarily to assist _____________ in performing
various functions.

Answers: (a) cost accounting (b) accounting (c) management (d) cost, cost accounting
(e) management

Q2. True/False Statement:

(a) Management accounting is also called controller.

(b) Main emphasis of management accounting is on cost ascertainment and cost
control for maximization of profit.
(c) Management accounting system cannot be installed without a proper system of
cost accounting.
(d) Management accounting is a branch of financial accounting.
(e) Management accounting is a substitute for management.
(f) Management accounting is a branch of accounting that produces information for
managers within an organization.

Answers: (a) F (b) F (c) T (d) F (e) F (f) T

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EXERCISE 3: LONG ANSWER QUESTIONS

Q1. What is cost reduction? Give examples.

Q2. Distinguish between cost control and cost reduction?

Q3. State objectives and limitations of management accounting?

Q4. What is management accounting? How does management accounting differ from cost
accounting and financial accounting?

Q5. “Management accounting is the best tool for the management to achieve higher
profits and efficient operations”. Elucidate the statement.

Q6. Distinguish between cost accounting and management accounting?

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 LESSON-1 UNIT 2

INTRODUCTION-BUDGETING AND BUDGETARY CONTROL

1. STRUCTURE

1.0 Learning Objectives

1.1 Meaning of Budget
1.2 Meaning of Budgeting
1.3 Meaning of Budgetary Control
1.4 Objectives of Budgetary Control
1.5 Advantages of Budgetary Control
1.6 Limitation of Budgetary Control
1.7 Requisites for Effective Budgetary Control
1.8 Budget Administration
1.9 Types of Budgets
1.9.1 On the basis of Time
1.9.2 On the basis of Coverage
1.9.3 On the basis of Capacity
1.10 Self-Test Questions

“Budgeting in a Company is like navigation in a ship. On the ship, the crew keeps a log
of the happenings on and the position of the ship from hour to hour. The captain learns
valuable lessons by studying the factors that caused misadventures in the past. But, to
pilot his ship safely, he requires his navigation officer to plan the course ahead and to
constantly check the position of the ship against the plan. If the ship is off-course, the
navigation officer must report it immediately, so that the captain can take prompt
corrective action. In addition, the navigation officer should be in a position to foresee
possible obstacles and deviations and to minimize losses by taking early corrective action
in case the ship is off-course.”

Just as a ship that needs to be navigated properly to reach its destination safely, a
Company needs a well-planned budget to help achieve its goals. The ship‟s log is like the
previous budgets of the Company. Just as the Captain refers to the log to learn valuable
lessons and avoid repeating mistakes, managers also use previous budgets to help set
benchmark in light of current business conditions. Planning the ship‟s course in advance
helps the Captain to expect and identify deviations from course and carry out salvage
operations as early as possible. In the same way, preparing a budget helps the Company
to meaningfully identify variances during the year.
(Axzo Press on Budgeting)

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1.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn the meaning of budget and budgetary control
(b) Understand the benefits of budget and budgetary control
(c) Learn the advantages and limitations of budget and budgetary control
(d) Learn the prerequisites for effective budgetary control
(e) Learn the division of budget on different basis

1.1 MEANING OF BUDGET

According to CIMA, London a budget is defined as “a financial and/or

quantitative statement prepared and approved prior to a defined period of time, of the
policy to be pursued during that period for the purpose of attaining a given objective. It
may include income, expenditure and the employment of capital”.

According to Robert Anthony, “Budgeting also called profit planning involves a

projection of the activity of the enterprise in terms of expenses, revenues, assets and
equities over a specific period of time in future, usually one year”.

According to Glenn A. Welsch, “a formal statement of management plans and

policies for a given period to be used as a guide or blueprint in that period. The budget
expresses revenue goals in the sales budget and expense limitations in the expense budget
that must be attained in order to realize the net income objective. In addition, the budget
expresses plans relating to such items as inventory levels, capital additions, cash
requirements, financing, production plans, purchasing plans, labour requirements and so
forth”.

According to Brown and Howard, “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”.

According to Gorden Shillinglaw, a business budget is “a pre-determined detailed

plan of action, developed and distributed as a guide to current operations and as a partial
basis for subsequent evaluation of performance”.

According to Kohler in „A Dictionary for Accountants‟ defines budget as “any

financial plan serving as an estimate of and a control over future operations, any estimate
of future costs and any systematic plan for utilization of manpower, material or other
resources.”

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Distinctive features of a budget are:
 It is prepared in advance.
 It is based on future course of actions.
 It is a guide or blue print for future period.
 It is financial/Quantitative statement.
 It is goal oriented and prepared for attaining a given objective.

Budgeting is a
process not 1 2 3
an event

1.2 MEANING OF BUDGETING

Budgeting is an act of preparing budgets. According to Wildavsky budgeting is the

process of “translating financial resources into human purposes”. In the words of J. Batty,
“the entire process of preparing the budgets is known as budgeting”.

1.3 MEANING OF BUDGETARY CONTROL

Budgetary control is a means to control all aspects of the business operations

through budgeting. Budgetary control is defined by CIMA, London as “the establishment
of budgets relating the responsibilities of executives to the requirements of a policy, and
the continuous comparison of actual with budgeted results, either to secure by individual
action the objective of that policy, or to provide a basis for its revision”. From this
definition, the steps for Budgetary Control can be drawn as follows:

(i) Establishment of Budgets: Budgetary control begins with the objective of

preparation of various budgets such as sales Budget, production budget, overhead
expenses budget, cash budget etc.,
(ii) Responsibilities of executives: The budgetary control system is designed to fix
responsibilities for executives through setting targets in the form of budgets.
(iii) Policy making: The established policies of the organization are designed as
budgets so as to fix responsibility on executives.
(iv) Continuous comparison of actuals with budgets: After establishing the
budgets, the actuals performance is compared with them and deviations are
calculated.

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 (v) Achieving the standards: The desired result of the budgetary control system is
comparison of actuals with the budgeted results and analyzing the causes of
variances, if found any.
(vi) Reporting to Executives: After the causes of Variances are analyzed, the
variances and their causes are reported to top management so that they can take
corrective action.

Rowland and William in their book entitled Budgeting for Management Control has
given the difference between budget, budgeting and budgetary control as follows:

“Budgets are the individual objectives of a department, etc. whereas budgeting may be
said to be the act of building budgets. Budgetary Control embraces all this and in addition
includes the science of planning the budgets themselves and the utilization of such
budgets to affect an overall management tool for the business planning and control”.

DISTINGUISH BETWEEN FORECAST AND BUDGET

Forecast
(1) Forecast is a mere estimate of what
is likely to happen. It is a statement of
probable events which are likely to
happen under anticipated conditions
during a specified period of time.
(2) Forecasts, being statements of future
events, do not connote any sense of
control.
(3) Forecasting is a preliminary step for
budgeting. It ends with the forecast of
likely events.
(4) Forecasts have wider scope, since it
can be made in those spheres also where
budgets cannot interfere.
Budget
(1) Budget shows that policy and
programmes to be followed in a future
period under planned conditions.
(2) A budget is a tool of control since it
represents actions which can be shaped
according to will so that it can be suited to
the conditions which may or may not
happen.
(3) It begins when forecasting ends.
Forecasts are converted into budgets.
(4) Budgets have limited scope. It can
be made of phenomenon non capable of
being expressed quantitatively.

1.4 OBJECTIVES OF BUDGETARY CONTROL

 PLANNING: Budgets are the plans to be pursued to attain objectives for each
department and division in the organization during a specified period of time.
These plans drawn up for material, labour, production, sales, purchase etc.
Budgetary control will force the management at all levels to plan various activities
well in advance in the organization. Planning helps in anticipating future
requirements and expected performance.

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  COORDINATING: Budget helps the management in creating sink between the
objectives of the organization with the objectives of different departments.
Budgeting also bring co-ordination in various activities of the business. For
example, the budget of sales department should be in co-ordination with the
budget of production department. Similarly, the budget of production department
should be in co-ordination with the budget of purchase department.
 COMMUNICATION: Budget is a communication device. Communication of
ideas and plans to each department and division is effected by budgetary control.
In order to make sure that each person is aware of what he is supposed to do, it is
necessary that the approved budget copies need to be shared with all management
personnel. Not only sharing will enhance the communication, but participating in
the preparation of budgets will also contribute in communication of ideas and
plan.
 MOTIVATING: Budgetary control motivates the employees to improve their
performance. Budget acts as a yardstick which will be followed by employees.
When individuals participate in the preparation of budgets, it acts as a strong
motivating force to achieve the targets.
 CONTROLLING: A system of control can be established by preparing budgets
against which comparison can be made with actual results. Budgetary control is an
important instrument of managerial control in any organization. After comparison
of budgeted performance with actual one, it reports the significant variations from
the budgets to the top management in the organization. Since separate budgets are
prepared for each department becomes easier to determine the weak points and
areas of correction.
 PERFORMANCE EVALUATION: Budgetary control helps the management in
evaluating the performance of each department and division and even of
individuals. It provides a useful means of informing managers how well they are
performing in meeting targets they have previously helped to set. Even in some
companies, on the basis of achieving the budget targets individuals are rewarded.

1.5 ADVANTAGES OF BUDGETARY CONTROL

 Budgeting is an all-inclusive management tool. It harmonizes various

organizational activities in the organization from planning to controlling. This
results in smoother functioning of entire organization.
 Budgets provide standards against which actual performance can be measured.
This helps in taking corrective action, which is an important part of controlling.
 Budgeting in the organization helps in reducing unproductive operations by
minimizing waste of resources.
 Budgeting motivates executives to attain the given goals.
 Budgeting promotes coordination and communication.

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  Budgeting acts as a safety signal for the management. It shows when to proceed
cautiously and when manufacturing expansion can be safely undertaken.
 Budgeting in the organization makes financial planning and control easy. The
ultimate effect of budgeting is the thorough examination and scrutinizing the
financial aspect of the business enterprise. This helps in optimum use of financial
resources of the enterprise.
 Budgeting helps in clearly defining responsibilities and authorities for the
management. For which managers will be held responsible for achieving the
budget targets.
 Budgeting in the organization is an important device for fixing the responsibility
of various positions. The persons occupying various positions can be made to
understand their responsibilities with the help of budgets.
 Budgeting ensures team work and thus encourages the spirit of support and mutual
understanding among the staff.

1.6 LIMITATION OF BUDGETARY CONTROL

 Benefits of the budget must exceed the cost: Budgeting is a fairly complex
process and specifically for small businesses which may find that it is too much of
a burden in terms of time and other resources, with only limited benefits. As a
general rule, the benefit of producing the budget must exceed its cost which is
difficult for these businesses.
 Based on estimates: Budgetary control starts with the formulation of budgets
which are mere estimates. Therefore, the adequacy of budgetary control system, to
a very large extent, depends upon the accuracy of the data or basis with which
estimates are formed.
 Rigid: Budgets should be dynamic and can be adjusted according to the changes
in business environment. It tends to bring about rigidity in operation, which is
harmful. In this case, it will not be a correct tool of measuring performance. It is
necessary that budgetary control system should be kept adequately flexible.
 Only a tool of management: Budgetary control cannot replace management. It
can be used as an instrument of management. „The budget should be considered
not as a master, but as a servant.‟ Mostly, it is assumed that that the introduction of
budgeting alone is enough to ensure success and security of future profits.
 No automatic execution: Proper implementation of budget is cumbersome task.
Preparation of budget will not ensure its proper implementation. It is necessary
that the entire organization must participate in meeting the budgeted targets.
 Resistance from staff: It is a part of human nature that all controls are resented to.
Budgetary control which places restrictions on the authority of executive is also
resented by the employees. They may not like to be evaluated on the basis of
budgeted targets.

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  Costly and time consuming: The mechanism of budgeting system is a detailed
process involving too much time and costs. It requires employing the specialized
staff and involves other expenditure which small companies may find difficult to
incur.

1.7 REQUISITES FOR EFFECTIVE BUDGETARY CONTROL

 Support of top management: If the budget system is to be made successful, it

must be ensured that every member of the management is fully supported and also
the impetus and direction should also come from the top management. No control
system can be effective unless the organization is convinced that the management
considers the system to be important.
 Group efforts: This is an essential requirement. From top to bottom, everyone
should be supportive and ready to attain the budgeted targets. The top
management must understand and give enthusiastic support to the members so that
there can be proper co-ordination in achievements of targets.
 Budget Education: Continuous budget education is very much essential requisite
for successful budgetary control system. The best way to ensure that is all those
who are affected by the budgeted targets is provided continuous education about
the objectives, techniques and targets to be achieved.
 Achievable Goals: The budgeted values should be achievable, realistic and
reasonable. Sometimes budgets are set at too high level, which will discourage the
executives. Where the budget is too easy to achieve it will be of no benefit to the
business and may, in fact, lead to lower levels of output and higher costs than
before the budget was established.
 Reporting System: Reports comparing budget and actual results should be
prepared timely and then if any variance is there i.e. actual performance
significantly different from expected one. An effective budgeting system also
requires the presence of a proper feed‐back system. So timely and proper system
of recording should be installed into the organization.
 Cost-Benefit analysis: Cost for installing budgetary control system should not be
more than the benefits. Because it will not be reasonable to have a system which
doesn‟t add to your profitability.
 Sound Organizational structure: For the success of a budgetary control system,
it is essential that there should be a sound organization for budget preparation,
budget maintenance, and budget administration. Responsibilities and authorities
should be clearly specified to avoid any confusion.
 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.

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  Inspirational Approach: All the employees or staff other than executives should
be strongly and properly inspired towards budgeting system. Human beings by
nature do not like any pressure and they dislike or even rebel against anything
forced upon them.

1.8 BUDGET ADMINISTRATION

In organizing and administering a budgetary control system the following characteristics

may apply:

Budget
Administration

Organization Budget
Budget Center Budget Officer Budget Manual Budget Period Key Factor
Chart Committee

(1) Organization Chart: For the purpose of effective budgetary control, it‟s
important to have proper organization chart to clearly define the plan and structure
of the organization. An organizational chart helps in explaining clearly the
position of each executive's authority and responsibility and his relationship to
other members. This chart shows functional responsibility of a particular
executive, Delegation of authority to various levels and relative position of a
functional head with heads of other functions. An organization chart for budgetary
control may be as follows:
Organization Chart
Chief
Executive

Budget
Officer

Budget
Committee

Sales Purchase Production Personnel Finance Accounts

Manager Manager Manager Manager Manager Manager

Sales Budget,
Selling Cost Cost Budget,
Purchase Production Cash Budget,
Budget, Capital Exp.
Advertising Budget, Budget, Plant Labour Cost Income and
Material Utilization Budget,
Budget and Budget Expenditure
Budget Budget Master
Distribution Budget
Budget
Budget
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(2) Budget Center: A Budget Center is defined by the terminology as "a section of
the organization of an undertaking defined for the purpose of budgetary control."
For cost control purpose, budget center need to be established and for each of
which budget will be set with the help of the head of the department concerned.
For example, for the preparation of purchase budget, the purchase manager will be
consulted.
(3) Budget Officer: The functional head of the budget committee is the budget
officer. His main duty is assisting the various departmental heads in preparation of
budgets. He is appointed to administer the budgeting programme. He Budget
officer does not control; he is staff man; he advises but does not issue instructions.
His duties will be to help in preparation of the various budgets and their
coordination and compilation into the master budget; Compiling of information
about actual performance on a continuous basis comparing it against the budget
figures, ascertaining causes of deviation and preparing reports based thereon and
sending them to the appropriate executive; Bringing to the notice of the
management the need for revision of budgets and assisting them in the task; and
Compiling information of all types for the purposes of efficient preparation of
budgets and proper reporting.
(4) Budget Committee: Budget Committee comprising of the Managing Director, the
Production Manager, Sales Manager and Accountant as shown in the
organizational chart. Each member has to prepare his own departmental budgets.
In small concerns, the Budget Officer may co-ordinate the work for preparation
and implementation of budgets. In large-scale concern a budget committee is setup
for preparation of budgets and execution of budgetary control. The budget manual
should specify the responsibilities and duties of the budget committee, which
should include the following:
(a) To provide historical data for preparing budgets to all the department
heads.
(b) To review budget estimates from the respective departments and suggest
recommendations.
(c) To recommend decisions on budget related matters where there may be
conflicts between departments or divisions.
(d) To inform departmental heads of any changes and approval of the revised
budget.
(e) To co-ordinate all budget related activities.
(f) To analyze periodic reports by comparing the budgeted performance with
actual one. Consider policies with respect to follow-up procedures.
(g) To make recommendations for changes in budget policies and procedures.
(h) To provide recommendations for the budget manual.

26
(5) Budget Manual: A Budget Manual has been defined by CIMA, London as "a
document which set out the responsibilities of persons engaged in the routine of
and the forms and records required for budgetary control." It contains all details
regarding the plan and procedures to be followed and the time schedules to be
observed. The following are some important matters dealt with in the budget
manual:
(a) The dates by which preliminary forecasts and plans are to submitted;
(b) The form in which these are to be submitted and the persons to whom these
are to be forwarded;
(c) The important factors that must be considered for each forecast or plan;
(d) The categorization of expenses, e.g., variable and fixed, and the manner in
which each category is to be estimated and dealt with;
(e) The manner of scrutiny and the personnel to carry it out;
(f) The matters which must be settled only with the consent of the managing
director, departmental manager, etc.;
(g) The finalization of the functional budgets and their compilation into the
master budget;
(h) The form in which the various reports are to be made out, their periodicity
and dates, the persons to whom these and their copies are to be sent;
(i) The reporting of the remedial action;
(j) The manner in which budgets, after acceptance and issuance, are to be
revised or amended; and
(k) The matters, included in budgets, on which action may be taken only with
the approval of top management.
(6) Budget Period: CIMA defines budget period as “the period for which a budget is
prepared and used, which may then be sub-divided into control periods”. It refers
to the period of time covered by a budget. The broad classification in this regard
has already been stated as “long-term budget” and “short-term budget”. For
example, industries which are subject to fashion change use short-term budget
whereas industries which involve long term expenditure with relatively little
change in product design use long-term budget. Generally a budget is prepared for
one year which corresponds to the accounting year. It is then sub-divided into
quarters and in turn each quarter is broken down into three separate months.
(7) Key Factor: A budget key factor or principal budget factor is described by the
CIMA London as: “a factor which will limit the activities of an undertaking and
which is taken into account in preparing budgets”. For example, if production
cannot be increased inspite of heavy demand, due to non-availability of raw-
material, then in this case raw-material is called here key factor/limiting factor.
The Key Factors include:
(1) Raw materials may be in short supply.
(2) Non-availability of skilled labours.

27
 (3) Government restrictions.
(4) Limited sales due to insufficient sales promotion.
(5) Shortage of power.
(6) Underutilization of plant capacity.
(7) Shortage of efficient executives.
(8) Management policies regarding lack of capital.
(9) Insufficient research into new product development.
(10) Insufficiency due to shortage of space.

1.9 TYPES OF BUDGETS

Long-Term Budget

On the basis of
Short-Term Budget
Time
Types of Budget

Current Budget

Functional Budget
On the basis of
Coverage
Master Budget

Fixed Budget
On the Basis of
Capacity
Flexible Budget

1.9.1 On the Basis of Time

(1) Long-term Budget: Long-term budgets are prepared for a longer period
specifically for more than a year is called long-term budget. These budgets are
prepared by top management team. These budgets are useful in business
forecasting and planning. Capital expenditure budgets and research developments
budgets are just examples of long-term budgets.
(2) Short-term Budget: A budget which is prepared for period upto one year is called
as short-term budget. Sometimes they may be prepared for shorter period as for
quarterly or half yearly. The scope of budgeting activity may vary considerably
among different organization. It is basically use by lower level of management.
(3) Current Budget: A budget which is related to the current conditions and is
prepared for use over a short period of time is called current budget.

28
1.9.2 On the Basis of Coverage

FUNCTIONAL BUDGETS:

A functional budget is the one which is prepared for particular function of the
business. For example, sales budget, production budget, purchase budget etc. These
functional budgets are subsidiary to the master budget and they will vary according to the
size and nature of the business.

MASTER BUDGET:

According to CIMA, London “master budget is a summary budget incorporating

its component functional budgets and which is finally approved, adopted and employed.”
A master budget is also known as comprehensive budget which incorporates all
functional budgets in a capsule form. The Master Budget represents the activities of a
business during a profit plan. This budget is also helpful in coordinating activities of
various functional departments.

A master budget has two components:

 Operating Budget- Budgeted Profit and Loss Account

 Financial Budget- Budgeted Balance Sheet

This budget is prepared by Budget Director and presented to the Budget Committee for
the approval.

MERITS OF THE MASTER BUDGET:

 A review of all the functional budgets in specific form is available in one re

port.
 It presents an overall profit position of the organization for the budget.
 It also contains the information regarding the forecast balance sheet.
 It examines the fitness of all the functional budgets

1.9.3 On the Basis of Capacity

FIXED BUDGET

A fixed budget is one which is prepared keeping in mind one level of output.
According to ICMA London "Fixed budget is a budget which is designed to remain
unchanged irrespective of the level of activity actually attained." This kind of budget is
quite suitable for fixed expenses. Fixed budget is prepared before the beginning of the
financial year. This type of budget is not going to highlight the cost variances due to the
difference in the levels of activity. Fixed Budgets are suitable under static conditions.

29
FLEXIBLE BUDGET

In flexible budgeting, a series of budgets are prepared one for each of a number of
alternative production levels or volumes. According to lCMA, London defined “Flexible
Budget is a budget which, by recognizing the difference between fixed, semi-variable and
variable costs is designed to change in relation to level of activity attained."

A flexible budget shows the budgeted expenses against each item of cost at
different levels of activity. This budget has come into use for solving the problems caused
by the application of the fixed budget.

1.10 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) A budget is a plan of action expressed in…

(a) Financial terms
(b) Non‐financial terms
(c) Both
(d) Subjective matter

(2) Budget is prepared for a…

(a) Indefinite period
(b) Definite period
(c) Period of one year
(d) Six months

(3) A budget is tool which helps the management in planning and control of…
(a) All business activities
(b) Production activities
(c) Purchase activities
(d) Sales activities

(4) Budgetary control helps the management in…

(a) Obtaining bank credit
(b) Issue of shares
(c) Getting grants from government
(d) All of these

(5) Budgetary control helps to introduce a suitable incentive and remuneration

based on…
(a) Changes in government policies
(b) Inflationary conditions
(c) Both
(d) None

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(6) Budgetary control __________ replace management in decision‐making.
(a) Can
(b) Cannot
(c) Sometimes
(d) Inadequate data

(7) Revision of budgets is…

(a) Unnecessary
(b) Can‟t determine
(c) Necessary
(d) Inadequate data

Answers: (1) (c), (2) (b), (3) (a), (4) (a), (5) (b), (6) (b), (7) (c)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) A system by which budgets are used as a means of planning and controlling all
aspects of a business is called ______________.
(b) A document which sets out the responsibilities of the persons engaged in the
routine of and the forms and records required for budgetary control is called
__________.
(c) The entire process of preparing the budgets is known as ____________.
(d) ____________ is defined as the factor the extent of whose influence must first be
assessed in order to ensure that functional budgets are capable of fulfillments.

Answers: (a) budgetary control (b) budget manual (c) budgeting (d) key factor

Q2. True/False Statement:

(a) A system of budgetary control can be used even when standard costing is in use in
a concern.
(b) A budget coordinates the activities of various departments.
(c) A budget centre is a part of the organization for which a separate budget is
prepared.
(d) There is no difference between a forecast and a budget.
(e) A budget manual contains a summary of all functional budgets.
(f) Budgeting may be said to be an act of determining costing standard.
(g) Strategic planning is the same thing as preparing annual budgets.

Answers: (a) T (b) T (c) T (d) F (e) F (f) F (g) F

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Q3. Write short notes on:

(a) Budget Period

(b) Limitations of Budget
(c) Master Budget
(d) Budgeting
(e) Distinguish between budget and forecast
(f) Principal budget factor

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. What are the main objectives of a system of budgetary control? Do you think
budgetary control is subject to certain limitations?

Q2. Briefly explain the essentials of an effective budgetary control system.

Q3. State four limitations of budgetary control system.

Q4. Briefly describe any five objectives of budgetary control.

Q5. State Pre-requisites for Successful Budgeting control systems.

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 LESSON 2

FUNCTIONAL BUDGETS

2. STRUCTURE

2.0 Learning Objectives

2.1 Functional Budgets
2.1.1 Sales Budget
2.1.2 Production Budget
2.1.3 Production Cost Budget
2.1.4 Direct Material Budget
2.1.5 Direct Labour Budget
2.1.6 Overheads Budget
2.1.7 Purchase Budget
2.1.8 Plant Utilization Budget
2.1.9 Capital Expenditure Budget
2.1.10 Research and Development Cost Budget
2.1.11 Cash Budget
2.2 Self-Test Questions

2.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Understand the concept of functional budgets
(b) Learn more about different functional budgets
(c) Learn pre-requisites for various important budgets

2.1 FUNCTIONAL BUDGETS

A functional budget is the one which is prepared for particular function of the
business. For example, sales budget, production budget, purchase budget etc. These
functional budgets are subsidiary to the master budget and they will vary according to the
size and nature of the business. The various commonly used functional budgets are
discussed below:

2.1.1 Sales Budget

The sales budget is a forecast of total sales, expressed in terms of money and quantity.
The first step in the preparation of the sales budget is to forecast as accurately as possible

33
the sales anticipated during the budget period. The sales manager is directly responsible
for the preparation and execution of sales budget. There is difference between sales
forecast and sales budget. Sales forecast provides probable sales figure and relatively
sales budget provides planned sales figure that is to be achieved during the period. While
preparing sales budget the following factors need to be considered:
(i) Market Conditions
(ii) Production Capacity
(iii) Key Factors
(iv) Nature of Business
(v) Order in hand
(vi) Degree of competition
(vii) Past sales
(viii) Financial Aspects
(ix) Government Restrictions
(x) Advertisement, Publicity and Sales Promotion
(xi) Pricing Policy
(xii) Consumer Behaviour
(xiii) Business Conditions
(xiv) Types of Product

2.1.2 Production Budget

The production budget is a forecast of the production for budget period. It is generally
prepared on the basis of sales budget. It is prepared in two parts, firstly production units
of each product to be manufactured and the cost of manufacturing budget detailing the
budgeted costs. The production budget is prepared by the production manager and he/she
will be responsible for the execution of the same. While preparing production budget the
following factors need to be considered:
(a) Sales requirement as per sales budget
(b) Inventory Policy (storage facilities, length of the production period, and so on)
(c) Production Policy
(d) Production Capacity (introduction of additional plant, sub-contracting
components‟ production and so on)
(e) Make or Buy decision
(f) Availability of inputs

2.1.3 Production Cost Budget

This budget shows the cost of products to be manufactured. The quantities of production
are now expressed in terms of cost in production. Cost of Production Budget is grouped in
to Material Cost Budget, Labour Cost Budget and Overhead Cost Budget. Because it
breaks up the cost of each product into three main elements material, labour and
overheads.

34
Illustration 1: The following information has been available from the records of In
charge Precision Tools Limited for the last six months of 2017 (and of only the sales of
January, 2018) in respect of product „X‟:

(i) The units to be sold in different months are:

July 1,100 November 2,500

August 1,100 December, 2017 2,300
September 1,700 January, 2018 2,000
October 1,900
(ii) There will be no work in progress at the end of any month.
(iii) Finished goods equal to half the sales for the next month will be in stock at the end
of every month (including June, 2017).
(iv) Budgeted production and production cost for the year ending 31st December, 2017
are as thus:

Production (units) 22,000 units

Direct materials per unit Rs. 10.00
Direct wages per unit Rs. 4.00
Total factory overheads apportioned to product Rs. 88,000
It is required to prepare –

(a) A production budget for each of the last six months of 2017, and
(b) A summarized production cost budget for the same period.

Solution: Production budget

July Aug. Sept. Oct. Nov. Dec.

Sales (in units) 1,100 1,100 1,700 1,900 2,500 2,300
Add: Closing Stock 550 850 950 1,250 1,150 1,000
1,650 1,950 2,650 3,150 3,650 3,300
Less: Opening Stock 550 550 850 950 1,250 1,150
Production (in units) 1,100 1,400 1,800 2,200 2,400 2,150

Production cost budget

Production for six months (July to Dec) (in units) 11,050 units
Direct material cost @ Rs. 10 per unit 1,10,500
Direct wages @ Rs. 4 per unit 44,200
Factory overheads @ Rs. 4 per unit 44,200
Total production cost 1,98,900

2.1.4 Direct Material Budget

This budget shows the estimated quantities of the all raw material requirements. That is
why materials requirement budget, commonly known as materials budget. This budget

35
assist the purchase department in suitably planning the purchases, helps in preparation of
purchase budget and provides data for raw material control.

2.1.5 Direct Labour Budget

This budget shows the labour hours and cost of total labour force required during the
budget period. This labour cost is classified into direct and indirect cost. Some
organizations include only direct labour cost but some include both direct and indirect
labour cost in this budget. The personnel manager is responsible for the preparation and
execution of this budget. The rates of pay, allowances, bonus, etc., of each category are
then considered and labour cost to be set for each budget centre is calculated by
multiplying the wage rate with the labour hours for the number of units of products
budgeted.

2.1.6 Overheads Budget

Overhead means aggregate of all indirect cost which can be further classified as
production overheads, office and administration overheads and selling and distribution
overheads. That is why overhead budget is classified into three parts namely
factory/production overhead budget, office and administration overhead budget and
selling and distribution overhead budget. Factory Overhead Budget shows all indirect cost
incurred in connection with the manufacture of a product during the budget period. It is
useful for calculating the pre-determined overhead recovery rates. Office and
Administration Overhead Budget shows all the cost related to formulation of policy,
directing the organization and controlling the operations which are not related to
production, selling and distribution, research or development activity or function to be
incurred during the budget period. It is useful for calculating the pre-determined
administrative overhead rates. Selling and Distribution Overhead budget shows the total
cost of selling and Distribution that incurred to stimulate demand and securing orders
during the budget period. It is useful for calculating the pre-determined selling and
distribution overhead rates.

Illustration 2: Prepare a Sales Overhead Budget for January, February and March from
the estimates given below:

Rs.
Advertisement 2,500
Salaries of the sales department 5,000
Expenses of the sales department 1,500
Counter salesmen‟s salaries and dearness allowance 6,000

Commission to counter salesmen at 1% on their sales.

Travelling salesmen‟s commission at 10% on their sales and expenses at 5% on their
sales. The sales during the period were estimated as follows:

36
 Month Counter Sales Travelling Salesmen’s Sales
Rs. Rs.
January 80,000 10,000
February 1,20,000 15,000
March 1,40,000 20,000
[B.Com (Hons), Delhi]

Solution: Sales Overhead Budget (for the period ending January, February and
March) ( in Rs.)

Particulars January February March

Estimated Sales (Counter Sales + Travelling 90,000 1,35,000 1,60,000
Salesmen‟s Sales)
(1) Fixed Overheads:
Advertisement 2,500 2,500 2,500
Salaries of Sales department 5,000 5,000 5,000
Expenses of Sales Department 1,500 1,500 1,500
Counter Salesmen‟s Salaries and DA 6,000 6,000 6,000
15,000 15,000 15,000
(2) Variable Overheads:
Counter salesmen‟s commission @ 1% on sales 800 1,200 1,400
Travelling salesmen‟s commission @ 10% 1,000 1,500 2,000
Expenses 5% 500 750 1,000
2,300 3,450 4,400
Total Sales Overheads (1) + (2) 17,300 18,450 19,400

2.1.7 Purchase Budget

This budget shows the physical quantities and cost of total materials to be purchased
during the period. The purchase director or manager is responsible for the preparation and
execution of the same. This budget includes the quantities of each type of raw material to
be purchased, timing of purchases and estimated cost of material purchases. While
preparing purchase budget the following factors need to be considered:
(a) Estimated sales and production
(b) Requirement of materials during budget period
(c) Expected changes in the prices of raw materials
(d) Quality standards for each item of material
(e) Minimum and maximum stock level
(f) Economic order quantity
(g) Safety stocks
(h) Availability of raw materials, i.e., seasonal or otherwise.
(i) Availability of financial resources.

Illustration 3: The sales director of a manufacturing company reports that next year he
expected to sell 1,08,000 units of a certain product. The production manager consults the
store keeper and costs his figures as follows:

37
The kinds of raw materials X and Y are required for manufacturing the product. Each unit
of the product required 2 units of X and 3 units of Y. The estimated opening balances at
the commencement of the next year are:

Finished product: 20,000 units, X - 24,000 units, Y- 30,000 units.

The desirable closing balances at the end of the next year are:
Finished product: 28,000 units, X - 26,000 units, Y- 32,000 units.
Draw up the material purchase budget for the next year.

Solution: Units to be produced

Sales 1,08,000 units
Add: desired closing stock 28,000 units
1,36,000 units
Less: opening stock 20,000 units
Production 1,16,000 units

MATERIALS PURCHASE BUDGET

Finished Materials
Particulars Product A B
(Units) (Units) (Units)
Production budget 1,16,000 2,32,000 3,48,000
Estimated opening balance (+) 20,000 (-) 24,000 (-) 30,000
1,36,000 2,08,000 3,18,000
Estimated closing balance (-) 28,000 (+) 26,000 (+) 32,000
Estimated sale of product/ estimated
1,08,000 2,34,000 3,50,000
purchase of materials

2.1.8 Plant Utilization Budget

Plant Utilization Budget is prepared for the estimation of plant capacity to meet the
budgeted production during the budgeted period. This budget is expressed in working
hours or other convenient units. Followings are the features of Plant Utilization Budget:
(a) It will indicate the requirement of machine for sale and production department.
(b) It will provide the base of reasonable depreciation so that machine can be replaced
in future.
(c) It may be base for the new inventions in the context of plant and machinery.
(d) It will indicate the budgeted machine load on departments or machines.

2.1.9 Capital Expenditure Budget

This budget represents the expenditure on all fixed assets to be incurred during the budget
period. This budget is prepared after considering the factors such as capital development
plans, expansion plans, renovation plans, replacement plans and expected future earnings.

38
2.1.10 Research And Development Cost Budget
This depends mostly on management decisions regarding the research and development.
This budget shows the cost of researching for new or improved production, methods,
processes, system or services to be incurred during the budget period.

2.1.11 Cash Budget

This budget is one of the most important budgets and one of the last to be prepared. This
budget represents the anticipated receipts and payment of cash during the budget period.
It provides an estimate showing the amount of cash which would be available in a future
period. This budget usually of two parts giving detailed estimates of (i) cash receipts and
(ii) cash disbursements/payments. This budget enables the management to determine
when there is likely to be surplus or shortage of cash. The estimates of cash-receipts are
prepared on a monthly basis and depend upon estimated cash-sales, collections from
debtors and anticipated receipts from other sources such as sale of assets, borrowings etc.
Estimates of cash disbursements are based on estimated cash purchases, payment to
creditors, employees‟ remuneration, bonus, advances to suppliers, budgeted capital
expenditure for expansion etc. Thus this budget plays an important role in the financial
management of a business undertaking.
The main objectives of preparing cash budget are as follows:
(a) To determine the probable cash position. This helps in arranging short term
borrowings in advance to meet the situations of shortage of cash or making
investments in times of cash in excess.
(b) To enable the management to prepare the repayment schedule well in advance.
(c) To establish a sound basis for control of cash position.
(d) To determine the sudden and seasonal requirements, large stocks, delay in
collection of receipts etc. on the cash position of the organization.

A cash budget can be prepared by any of the following methods:

(i) Receipts and payments method
(ii) Adjusted profit and loss account method
(iii) Balance sheet method.

(i) Receipts and Payments Method: It is most popular and is universally used for
preparing cash budget. In this method the cash receipts from various sources and
cash payments to various agencies are estimated. Delay in cash receipts and lag in
payments are taken into account for making estimates. The cash budget begins with
the opening balance of cash of a period and the estimated cash receipts are added
and from this, the total of estimated cash payments is deducted to find out the
closing balance.

39
 (ii) Adjusted Profit and Loss Account Method: In this method the opening balance
is adjusted with the anticipated increases or decreases in current assets and
liabilities, provision for depreciation, special receipts and the net profit for the year
before taxation and appropriations. From the aggregate amount of these, the
estimated taxation and dividends payable, expenditure on fixed assets and special
payments if any are deducted. The resulting balance is the estimated cash in hand at
the end of the budget period. The vital point of difference between receipts and
payments method and adjusted profit and loss method is that the former takes into
account only cash transactions while the latter considers non-cash items as it
reverses all accruals.

(iii) Balance Sheet Method: Under this method of preparing cash budget a forecast
balance sheet is prepared as at the end of the budget period with all items of assets
and liabilities except cash balance which is arrived at as a balancing figure. The
magnitude of the two sides of the balance sheet excluding cash balance would
determine whether the bank account would show a debit or credit balance i.e. cash
balance at bank or bank overdraft.

Illustration 4: Prepare cash budget of a company for April, May and June 2017 in a
columnar form using the following information:

Sales Purchases Wages Expenses

Months 2017
Rs. Rs. Rs. Rs.
January (Actual) 80,000 45,000 20,000 5,000
February (Actual) 80,000 40,000 18,000 6,000
March (Actual) 75,000 42,000 22,000 6,000
April (Budgeted) 90,000 50,000 24,000 7,000
May (Budgeted) 85,000 45,000 20,000 6,000
June (Budgeted) 80,000 35,000 18,000 5,000

You are further informed that:

(a) 10% of the purchases and 20% of the sales are for cash.
(b) The average collection period of the company is 0.5 month and the credit
purchases are paid off regularly after one month.
(c) Wages and expenses are paid half monthly and the rent of Rs. 500 included in
expenses is paid monthly.
(d) Cash and bank balance as on April 1, was Rs. 15,000 and the company wants to
keep it on the end of every month below this figure, the excess cash being put in
fixed deposits. (M.Com, Rajasthan)

Solution: Cash Budget for April to June 2017 ( in Rs.)

Particulars April May June

Cash balance b/d 15,000 11,700 12,700

40
 Particulars April May June
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 purchase 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

Note: It is assumed that wages and expenses are paid on 16th and 1st of the following
months i.e. fortnightly.

Illustration 5: Lakshya Ltd. has seasonal sales; is sales it goods at Rs. 50 per unit sales
are 25% cash and the reminder at 1.5 months‟ credit. The cost of the goods in terms of
percentage the selling price is as follows:

Materials 20%
Wages 25%
Factory expenses 20%
Depreciation 10%
Total 75%

In addition each month a sum of Rs. 1,00,000 has to be paid in respect of fixed factory
and administrative expenses. Income tax Rs. 60,000 is payable in July, October and
December. The company pays dividend on equity shares in August, amounting to Rs.
75,000. The company purchases material a month before the one in which it is required.
Payment is made to suppliers after one month and in respect of expenses fortnightly,
unless otherwise indicated.

The sales in units for various months are as follows:

April 3,000 July 8,000

May 5,000 August 8,000
June 6,000 September 10,000

Sales in each month are spread uniformly over the month.

On 1st July, 2017, the company expected to have an overdraft of Rs. 54,000. Prepare the
cash budget for the three months ending September 30, 2017.

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Solution: CASH BUDGET for the quarter ending 30th September, 2017

July (Rs.) August (Rs.) September (Rs.)

Receipts:
Cash sales 1,00,000 1,00,000 1,25,000
Received from debtors 2,06,250 2,62,500 3,00,000
Total receipts 3,06,250 3,62,500 4,25,000
Payments:
Fixed expenses 1,00,000 1,00,000 1,00,000
Materials 80,000 80,000 1,00,000
Wages 87,500 1,00,000 1,12,500
Factory expenses 70,000 80,000 90,000
Dividends/ income tax 60,000 75,000 -
Total payments 3,97,500 4,35,000 4,02,500
Add: Operating overdraft 54,000 1,45,250 2,17,750
4,51,000 5,80,250 6,20,250
Less: Receipts 3,06,250 3,62,500 4,25,000
Overdrafts at the end of the month 1,45,250 2,17,750 1,95,250

Working notes:
(i) Receipts from debtors (75% of total sales on credit)

July (Rs.) August (Rs.) September (Rs.)

½ of month preceding last month 93,750 1,12,500 1,50,000
½ of last month 1,12,500 1,50,000 1,50,000
2,06,250 2,62,500 3,00,000

(ii) Payments of wages and factory overheads

July (Rs.) August (Rs.) September (Rs.)

Wages FO Wages FO Wages FO
½ month‟s 37,500 30,000 50,000 40,000 50,000 40,000
previous
½ month‟s 50,000 40,000 50,000 40,000 62,500 50,000
current
87,500 70,000 1,00,000 80,000 1,12,500 90,000

2.2 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) R&D budget and Capital expenditure budget are examples of

(a) Short-term budget
(b) Current budget

42
 (c) Long-term budget
(d) None of the above

(2) __________ contains the picture of total plans during the budget period and it
comprises information relating to sales, profit, cost, production etc.
(a) Master budget
(b) Functional budget
(c) Cost budget
(d) None of the above
(3) The budgets are classified on the basis of…
(a) Time
(b) Function
(c) Flexibility
(d) All

(4) Sales budget shows the sales details as…

(a) Month wise
(b) Product wise
(c) Area wise
(d) All of the above

(5) ________ is the first step of budgetary system and all other budgets depends on
it.
(a) Cost budget
(b) Sales budget
(c) Production budget
(d) None of the above

(6) _______also known as subsidiary budgets.

(a) Master budget
(b) Functional budget
(c) Cost budget
(d) None of the above

(7) Production budget is…

(a) Dependent on purchase budget
(b) Dependent on sales budget
(c) Dependent on cash budget
(d) None

Answers: (1) (c), (2) (a), (3) (d), (4) (d), (5) (b), (6) (b), (7) (b)

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EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) _______________ shows the anticipated sources and utilization of cash.

(b) The ___________ budget represents the forecast of labour requirements to meet
the demands of the company during the budget period.
(c) The production budget shows the quantities of production. These quantities of
production are expressed in terms of cost in ____________ budget.
(d) ____________ budget is a summary budget incorporating its component
functional budgets and which is finally approved, adopted and employed.
(e) All other budgets are unreliable if ___________ budget is significantly off target.
(f) ________ also called „Financial Budget‟ or „Ways and Means Budget‟ shows the
estimates of cash receipts and outlays and cash balances by month throughout the
budget period.

Answers: (a) Cash budget (b) labour (c) production cost (d) master budget (e) Sales
(f) Cash budget

Q2. Write short notes on:

(a) Principal Budget Factor

(b) Functional Budget
(c) Cash Budget
(d) Production budget
(e) Sales budget
(f) Purchase budget
(g) Master Budget

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. List the important functional budgets prepared by a business.

Q2. What is a cash budget? What are its uses?

Q3. What is production budget?

Q4. What are the steps involved in the preparation of a production budget?

Q5. A company has to plan to prepare a production budget for the product P, Q and R. the
sales forecasts for these product is 2,08,000 units, 1,82,000 units and 2,21,000 units
respectively. The estimates requirements of inventory both at the beginning and at the end
of the budget period are shown in the following table:

44
 Inventory Table
Product
Month
P Q R
April, 1st (units) 40,000 30,000 50,000
March, 31st (units) 52,000 27,900 69,000

You are required to prepare the production budget for the company.

Answers: Budgeted Production: P: 2,20,000 units; Q: 1,79,000 units; R: 2,40,000 units

Q6. Chennai Engineering Co. Ltd. Manufactures two product X and Y. An estimate of
number of units expected to be sold in the first seven months of 2015 is given below:

Product X Product Y
January 500 1,400
February 600 1,400
March 800 1,200
April 1,000 1,000
May 1,200 800
June 1,200 800
July 1,000 900

It is anticipated that:
(a) There will be no work-in progress at the end of any month
(b) Finished units equal to half the anticipated sales for the next month will be in
stock at the end of each month (including December 2014). The budgeted
production and production costs for the year ending 31st December 2014 are as
follows:

Product X Product Y
Rs. Rs.
Production (units) 11,000 12,000
Direct material per unit 12 19
Direct wages per unit 5 7
Other manufacturing charges apportionable to each
33,000 48,000
type of product

You are required to prepare:

(a) A production budget showing the number of units to be manufactured each month.
(b) A summarized production cost budget for the 6-month period- January to June
2015. (B.Com Adapted)
Answers: Production for Six months: X - 5,550 units, Y - 6,350 units; Total Cost - X Rs.
1,10,000; Y Rs. 1,90,500

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Q7. A company produces two products M and N.

A forecast of units to be sold in the first five months of the year is given below:

Months Product M Product N

January 1,000 units 2,800 units
February 1,200 units 2,800 units
March 1,600 units 2,400 units
April 2,000 units 2,000 units
May 2,400 units 1,600 units

Cost per unit is as follows:

Product M Product N
Rs. Rs.
Direct Material 12.50 19.00
Direct Labour 4.50 7.00
Factory Overhead 3.00 4.00

There will be no opening and closing work-in-progress at the end of any month.

Finished product (in units), equal to half of the budgeted sale of the next month, should be
in stock at the end of each month (including previous year December).

You are required to prepare:

(a) Production Budget for January to April, and
(b) Summarized Production Cost Budget.

Answer:

Jan. Feb. Mar. April

Production Budget of Product M (units) 1,100 1,400 1,800 2,200
Production Budget of Product M (units) 2,800 2,600 2,200 1,800

Production Cost Budget of M is Rs. 1,30,000

Production Cost Budget of N is Rs. 2,82,000

46
 LESSON 3

FIXED AND FLEXIBLE BUDGET

3. STRUCTURE

3.0 Learning Objectives

3.1 Fixed Budget
3.1.1 Features
3.2 Flexible Budget
3.2.1 Features
3.2.2 Need of Flexible Budget
3.3 Distinction Between Fixed and Flexible Budget
3.4 Self-Test Questions

3.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Prepare different types of budget like flexible and fixed budget
(b) Learn the difference between flexible and fixed budget
(c) Understand the key features of fixed budget
(d) Understand the key features of flexible budget

3.1 FIXED BUDGET

A fixed budget is one which is prepared keeping in mind one level of output.
According to ICMA London "Fixed budget is a budget which is designed to remain
unchanged irrespective of the level of activity actually attained." This kind of budget is
quite suitable for fixed expenses. Fixed budget is prepared before the beginning of the
financial year. This type of budget is not going to highlight the cost variances due to the
difference in the levels of activity. Fixed Budgets are suitable under static conditions. For
preparation of this budget, sales forecast will have to be prepared along with the cost
estimates. Cost estimates can be prepared by segregating the costs according to their
behaviour i.e. fixed and variable. Cost predictions should be made element wise and the
projected profit or loss can be worked out by deducting the costs from the sales revenue.
Actually in practice, fixed budgets are prepared very rarely. The main reason is that the
actual output differs from the budgeted output significantly. Thus if the budget is prepared
on the assumption of producing 20,000 units and actually the number of units produced
are 15,000, the comparison of actual results with the budgeted ones will be unfair and
misleading. The budget may reveal the difference between the budgeted costs and actual

47
costs but the reasons for the deviations may not be pointed out. A fixed budget may be
prepared when the budgeted output and actual output are quite close and not much
deviation exists between the two. In such cases, maximum control can be exercised
between the budgeted performance and actual performance.

3.1.1 Features

 It is prepared for one fixed level of activity.

 It does not change with the change in the level of activity.
 Expenses are not classified into fixed, variable and semi-variable.

3.2 FLEXIBLE BUDGET

In flexible budgeting, a series of budgets are prepared one for each of a number of
alternative production levels or volumes. According to lCMA, London defined “Flexible
Budget is a budget which, by recognizing the difference between fixed, semi-variable and
variable costs is designed to change in relation to level of activity attained."

A flexible budget shows the budgeted expenses against each item of cost at
different levels of activity. This budget has come into use for solving the problems caused
by the application of the fixed budget.

For example, a budget can be prepared for capacity utilization levels of 50%, 60%,
70%, 80%, 90% and 100%. The basic principle of flexible budget is that if a budget is
prepared for showing the results at, 20,000 units and the actual production is only 15,000
units, the comparison between the expenditures, budgeted and actual will not be fair as
the budget was prepared for 20,000 units. Therefore a flexible budget is developed for a
relevant range of production from 15,000 units to 20,000 units. Thus even if the actual
production is 15,000 units, the results will be comparable with the budgeted performance
of 20,000 units. Even if the production slips to 12,000 units, the manager has a tool that
can be used to determine budgeted cost at 12,000 units of output. Thus It is more realistic
and practicable because it gives due consideration to cost behavior at different levels of
activity.

3.2.1 Features

 It is prepared for different levels of activity.

 It changes with the change in the level of activity.
 Expenses are classified into fixed, variable and semi-variable. Semi-variable
expenses are further segregated into fixed and variable expenses.

48
3.2.2 Need of Flexible Budget

 In case of industries where there are seasonal fluctuations in sales/production.

 In case of a company which keeps on introducing new products or make changes
in the design of its products frequently
 In case of new business venture due to its typical nature it may be difficult to
forecast the demand of a product accurately.
 In case of labour intensive industry where the production of the concern is
dependent upon the availability of labour.
 Where the business is dependent upon the nature for example wool traders.

3.3 DISTINCTION BETWEEN FIXED AND FLEXIBLE BUDGET

Basis Fixed Budget Flexible Budget

Change with It does not change with actual
volume of activity volume of activity achieved.
Thus it is known as rigid or
inflexible budget.
One or different It operates on one level of
level of activity activity and under one set of
conditions. It assumes that there
will be no change in the
prevailing conditions, which is
unrealistic.
Variance Analysis Since all costs like – fixed,
variable and semi-variable are
related to only one level of
activity so variance analysis
does not give useful information.
Helps in decision If the budgeted and actual
making activity levels differ
significantly, then the aspects
like cost ascertainment and price
fixation do not give a correct
picture.
Basis of Comparison of actual
comparison performance with budgeted
targets will be meaningless
specially when there is a
difference between the two
activity levels.
It can be recreated on the basis
of activity level to be achieved.
Thus, it is not rigid.
It consists of various budgets
for different levels of activity.
Here analysis of variance
provides useful information as
each cost is analyzed according
to its behaviour.
Flexible budgeting at different
levels of activity facilitates the
ascertainment of cost, fixation
of selling price and tendering of
quotations.
It provides a meaningful basis
of comparison of the actual
performance with the budgeted
targets

49
Practical Questions:

Illustration 1: Following information is recorded from WJK Ltd., these expenses

budgeted for production of 10,000 units:

Items Per Unit (Rs.)

Direct materials 120
Direct labour 30
Variable overheads 50
Fixed overheads (Rs. 1,50,000) 15
Variable expenses (direct) 10
Selling expenses (10% fixed) 15
Administrative expenses (Rs. 50,000 rigid for all levels of production) 5
Distribution expenses (20% fixed) 5
Total cost of sale per unit 250

Prepare a budget for production of 6,000 units, 7,000 units and 8,000 units showing
distinctly Marginal cost and Total cost.

Solution: Flexible Budget for WJK Ltd.

Production 6,000 units 7,000 units 8,000 units

Per Per Per
Elements of Total Total Total
unit unit units
cost (Rs.) (Rs.) (Rs.)
(Rs.) (Rs.) (Rs.)
Direct materials 7,20,000 120.00 8,40,000 120.00 9,60,000 120.00
Direct labour 1,80,000 30.00 2,10,000 30.00 2,40,000 30.00
Direct variable
60,000 10.00 70,000 10.00 80,000 10.00
expenses
Variable
Overheads :
Production 3,00,000 50.00 3,50,000 50.00 4,00,000 50.00
Selling 81,000 13.50 94,500 13.50 1,08,000 13.00
Distribution 24,000 4.00 28,000 4.00 32,000 4.00
Marginal cost
13,65,000 227.50 15,92,500 227.50 18,20,000 227.50
(A)
Fixed
Overheads :
Fixed
production 1,50,000 25.00 1,50,000 21.43 1,50,000 18.75
overheads
Administrative
50,000 8.33 50,000 7.14 50,000 6.25
overheads
Selling
15,000 2.50 15,000 2.14 15,000 1.88
overheads
Distribution
10,000 1.67 10,000 1.43 10,000 1.25
overheads

50
 Fixed cost (B) 2,25,000 37.50 2,25,000 32.14 2,25,000 28.13
Total cost
(A+B)
Marginal cost
15,90,000 265.00 18,17,500 259.64 20,45,000 256.63
plus fixed cost

Working Notes:

Selling Expenses Distribution Expenses

Total for 10,000 units (Rs.) 1,50,000 5,00,000
Variable expenses per unit (Rs.) (15-1.5) = 13.50 (5-1) = 4.00
Fixed expenses 10% and 20% of
15,000 10,000
total respectively (Rs.)

Illustration 2: Shyam Manufacturers can produce 4,000 units of a certain product at

100% capacity. The following information is obtained from the books of account:

Aug 2006 Sept 2006

Units produced 2,800 3,600
Rs. Rs.
Repairs and maintenance 500 560
Power 1,800 2,000
Shop labour 700 900
Consumable stores 1,400 1,800
Salaries 1,000 1,000
Inspection 200 240
Depreciation 1,400 1,400

Rate of production per hour is 10 units. Direct material cost per unit is Re. 1 and direct
wages per hour is Rs. 4.
You are required to:
(1) Compute the cost of production at 100%, 80% and 60% capacity showing the
variable, fixed and semi variable items under the flexible budget.
(2) Find out the overhead absorption rate per unit at 80% capacity. (CS Inter)

Solution: (i) Flexible Budget for Shyam Manufacturers

100% 80% 60%

4,000 units 3,200 units 2,400 units
Rs. Rs. Rs.
Variable costs:
Direct materials(@ Re. 1 per unit) 4,000 3,200 2,400
Direst wages (@ Rs. 4 per hour 1,600 1,280 960
for 10 units)
Shop labour 1,000 800 600

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 100% 80% 60%
4,000 units 3,200 units 2,400 units
Rs. Rs. Rs.
Consumable stores 2,000 1,600 1,200
Total „A‟ 8,600 6,800 5,160
Semi variable costs:
Power 2,100 1,900 1,700
Inspection 260 220 180
Repairs and maintenance 590 530 470
Total „B‟ 2,950 2650 2,350
Fixed costs:
Salaries 1,000 1,000 1,000
Depreciation 1,400 1,400 1,400
Total „C‟ 2,400 2,400 2,400
Total cost (A + B + C) 13,950 11,930 9,910
Cost per unit (total cost/units) 3.49 3.73 4.13

(ii) Calculation of overhead absorption rate per unit at 80% capacity

Total cost at 80% Rs. 11,930
Less: Direct material and direct wages (i.e. Rs. 3,200 + 1,280) 4,480
Overhead cost 7,450
Overhead rate per unit = Rs. 7,450 /3,200 units = Rs. 2.33

Working notes:
Calculation of semi variable costs
Variable cost per unit = Difference in cost
Difference in units

Power = Rs. 2,000 - 1,800 = Rs. 200 = Re. 0.25

3,600 - 2,800 units 800 units
At 70%, fixed element in power cost = 1,800 - 700 (i.e. 2800 units @ 0.25 per unit) = Rs.
1,100
Semi variable power cost at 100% = 1,100 + 1,000 (i.e. 4,000 units @ 0.25) = Rs. 2,100
Semi variable power cost at 80% = 1,100 + 800 (i.e. 3,200 units @ 0.25) = Rs. 1,900
Semi variable power cost at 60% = 1,100 + 600 (i.e. 2,400 units @ 0.25) = Rs. 1,700

Similar calculations for inspection and repairs and maintenance.

Illustration 3: The budget manager of Pankaj Cosmetics Limited is preparing a budget

for the accounting year starting from 1st July, 1984.

As part of the budget operations, some items of factory overhead costs have been
estimated by him under specified conditions of volume as follows:

52
Volume of production (in units) : 1,20,000 1,50,000
Rs. Rs.
Expenses:
Indirect materials 2,64,000 3,30,000
Indirect labour 1,50,000 1,87,500
Maintenance 84,000 1,02,000
Supervision 1,98,000 2,34,000
Engineering services 94,000 94,000

Calculate the cost of factory overhead items given above at 1,40,000 units of production.
[B.Com (Hons), Delhi]

Solution: FACTORY OVERHEADS BUDGET (Production 1,40,000 units)

Rs.
Indirect material (variable @ Rs. 2.20 per unit) 3,08,000
Indirect labour (variable @ Rs.1.25 per unit) 1,75,000
Maintenance: Fixed 12,000
variable @ Re. 0.60 per unit 84,000
Supervision: Fixed 54,000
variable @ Rs. 1.20 per unit 1,68,000
Engineering services (fixed) 94,000
Total factory overheads 8,95,000

Working notes:

(i) Indirect material

Cost per unit Rs 2,64,000 Rs. 3,30,000

1,20,000 1,50,000
= Rs. 2.20 = Rs. 2.20

Therefore it is a variable expense.

Similar calculations for Indirect Labour.

(ii) Maintenance

Cost per unit = 84,000 1,02,000

1,20,000 1,50,000
= Rs. 0.70 = Rs. 0.68
Therefore it is not a variable expense. It would be Semi-Variable Expense.

Variable Cost per unit = (1,02,000 - 84,000) = Rs. 0.60 per unit
(1,50,000 - 1,20,000)

Variable Cost (at 1,20,000 units) = 1,20,000 × 0.60 = Rs. 72,000

Fixed Cost = TC - VC = 84,000 - 72,000 = Rs. 12,000

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Variable Cost (at 1,40,000 units) = 1,40,000 × 0.6 = Rs. 84,000

Illustration 4: The following data is available in a manufacturing company for a half

yearly period.

Rs. (Lakhs)
Fixed Expenses:
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 etc. 3.8
Sundry administrative expenses 2.8

Variable expenses: (at 50% of capacity)

Materials 21.7
Labour 20.4
Other expenses 7.9

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 the various levels are:

(Rs. Lakhs)
50% capacity 100.00
60% capacity 120.00
75% capacity 150.00
90% capacity 180.00
100% capacity 200.00

Prepare a flexible budget for the half year and forecast the profits at 60%, 75%, 90% and
100% of capacity. [B.Com (Hons), Delhi]

Solution: Flexible Budget for the period

(Figures in Rs. Lakh)
CAPACITY LEVEL
50% 60% 75% 90% 100%
Rs. Rs. Rs. Rs. Rs.
Sales 100 120 150 180 200
Materials 21.7 26.0 32.5 39.0 43.4

54
Labour 20.4 24.5 30.6 36.7 40.8
Other expenses 7.9 9.5 11.9 14.3 15.8
Total variable expenses 50.0 60.0 75.0 90.0 100.0
Semi-variable expenses:
Maintenance and repairs 3.5 3.5 3.8 4.2 4.2
Indirect labour 7.9 7.9 8.7 9.5 9.5
Sales, deptt. Salaries etc. 3.8 3.8 4.2 4.6 4.6
Sundry administration expenses 2.8 2.8 3.1 3.3 3.3
Total semi variable expenses 18.0 18.0 19.8 21.6 21.6
Fixed expenses:
Wages and salaries 9.5 9.5 9.5 9.5 9.5
Rent, rates and taxes 6.6 6.6 6.6 6.6 6.6
Depreciation 7.4 7.4 7.4 7.4 7.4
Sundry administration expenses 6.5 6.5 6.5 6.5 6.5
Total fixed overheads 30.0 30.0 30.0 30.0 30.0
Total cost 98.0 108.0 124.8 141.6 151.6
Profit (Loss) 2.0 12.0 25.2 38.4 48.4

Illustration 5: A factory is currently working at 50% capacity and produces 10,000 units.
Estimate the profits of the company when it works to 60 percent and 80 percent capacity
and offer your critical comments.
At 60% working, raw material cost increases by 2 percent and selling price falls by 2
percent. At 80%, raw material cost increases by 5 percent and selling price falls by 5 per
cent. At 50% capacity working the product costs Rs. 180 per unit and is sold at Rs. 200
per unit.
The unit cost of Rs. 180 is made up as follows: (in Rs.)
Raw material 100
Labour 30
Factory overheads 30 (40% fixed)
Administration overheads 20 (50% fixed)

Solution: FLEXIBLE BUDGET

50% capacity 60% capacity 80% capacity

Amount Per Amount Per Amount Per
(10,000 unit (12,000 unit (16,000 unit
units) units) units)
Rs. Rs. Rs. Rs. Rs. Rs.
Raw material 10,00,000 100.00 12,24,000 102.00 16,80,000 105.00
Labour 3,00,000 30.00 3,60,000 30.00 4,80,000 30.00
Factory OH:
Fixed 1,20,000 12.00 1,20,000 10.00 1,20,000 7.50
Variable 1,80,000 18.00 2,16,000 18.00 2,88,000 18.00
Administration
overheads

55
 Fixed 1,00,000 10.00 1,00,000 8.33 1,00,000 6.25
Variable 1,00,000 10.00 1,20,000 10.00 1,60,000 10.00
Total cost 18,00,000 180 21,40,000 178.33 28,28,000 176.75
Profit 2,00,000 20.00 2,12,000 17.67 2,12,000 13.25
Sales 20,00,000 200.00 23,52,000 196.00 30,40,000 190.00

3.4 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) _________ is stated as a budget which is made to change as per the levels of
activity attained.
(a) Fixed budget
(b) Flexible budget
(c) Both a and b
(d) None of the above

(2) _______ is prepared for single level of activity and single set of business
conditions.
(a) Fixed budget
(b) Flexible budget
(c) Both a and b
(d) None of the above

(3) Fixed budget is useless for comparison when the level of activity…
(a) Increases
(b) Fluctuates both ways
(c) Decreases
(d) Constant

(4) In order to prepare a flexible budget, items of anticipated expenditures are

classified into _______ classes.
(a) Five
(b) Three
(c) Two
(d) None of the above

(5) Flexible budget is used when

(a) Demand remains static even when there is change in taste and fashion of
customers
(b) When the business unit is new
(c) Whenever there is change of activity due to change in government policies
(d) All of the above

56
(6) Flexible budgeting is used when the supply of material and labor required for
production is _____.
(a) Uncertain
(b) Certain
(c) Either a or b
(d) None of the above

(7) Which of the following statements are true flexible budget?

(a) On the basis of fixed budget, marginal analysis can be obtained
(b) Flexible budget is important for cost reduction and cost control
(c) Fixed budgetary system is more flexible than flexible budgetary system
(d) None of the above

(8) In _________ actual performance can easily be compared due to availability of

budgets at different levels of activity.
(a) Fixed budget
(b) Flexible budget
(c) Both (a) and (b)
(d) None of the above

Answers: (1) (b), (2) (a), (3) (b), (4) (b), 5. (d), (6) (a), (7) (b), (8) (b)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) Flexible budget recognizes the difference between ____________ and

___________.
(b) The method of budgeting whereby all the activities are re-valued each time a
budget is formulated is regarded as ________________.
(c) The difference between fixed and variable cost has a special significance in the
preparation of _______________.
(d) The primary difference between a fixed budget and a variable budget is that a
_________ budget is a plan for a single level of sales while a ___________ budget
consists of several plans, one of each of several levels of sales.

Answers: (a) Variable and Fixed Costs (b) flexible budget (c) Flexible budget (d) Fixed
and Variable budget

Q2. True/False Statements:

(i) In a fixed budget, figures are adjusted according to actual level of activity.
(ii) Fixed budgets are most suited for fixed expenses.
(iii) A flexible budget is necessary for a business enterprise whose demand of goods is
stable.

57
(iv) A fixed budget is concerned with budgeting of fixed assets.
(v) A flexible budget is preferable to fixed budget.
(vi) A fixed budget is one which is designed to remain unchanged irrespective of level
of activity actually attained.
(vii) Flexible budgets change with the level of activity.

Answers: (a) F (b) T (c) F (d) F (e) T (f) T (g) T

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Distinguish between fixed budget and flexible budget. Briefly state the circumstances
in which flexible budgets are used.

Q2. State the uses of flexible budget.

Q3. What are the key features of flexible budget?

Q4. What are the key features of fixed budget?

Q5. With the following data for a 60% activity level, prepare a budget at 80% and 100%
activity.

Production at 60% capacity - 600 units

Materials Rs. 100 per unit

Labour Rs. 40 per unit

Expenses Rs. 10 per unit

Factory Expenses Rs. 40,000 (40% fixed)

Administration expenses Rs. 30,000 (60% fixed)

Answers: At 60% Rs. 1,60,000; at 80% Rs. 2,02,000; and at 100% Rs. 2,44,000

Q6. The monthly budgets for factory overhead of a company for two levels of activity
were as follows:
60% 100%
Budgeted Production (units) 600 1,000
Rs. Rs.
Wages 1,200 2,000
Consumable stores 900 1,500
Maintenance 1,100 1,500
Power and fuel 1,600 2,000
Depreciation 4,000 4,000
Insurance 1,000 1,000
Total 9,800 12,000

58
You are required to:

(a) Indicate which of the items are fixed, variable and semi-variable
(b) Prepare a budget for 80% capacity
(c) Find the total cost, both fixed and variable, per unit of output at 80% capacity.

[B.Com (Hons), Delhi]

Answer: Cost per unit at 80% Rs. 13.625

Q7. Gemini Steel Ltd. Manufactures a single product for which market demand exists for
additional quantity. Present sales of Rs. 60,000 per month utilizes 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:

(a) Selling price is Rs. 10 per unit
(b) Variable cost is Rs. 3 per unit
(c) Semi-variable cost is Rs. 6,000 fixed + 50 paise per unit
(d) Fixed cost Rs. 20,000 at present level estimated to be Rs. 24,000 at 80% output.

You are required to prepare the following statements showing:

(i) The operating profit at 60%, 70% and 80% levels at current selling price, and
(ii) The operating profit at proposed selling price at the above levels.

[B.Com (Hons), Delhi]

Answers: Profit at current selling prices Rs. 13,000; 19,500 and 22,000; Profit at
proposed selling price Rs. 7,000; Rs. 12,500 and Rs. 14,000

Q8. From the following data, prepare a flexible budget for production of 40,000 units,
60,000 units and 75,000 units of product X, distinctly showing variable and fixed cost as
well as total cost. Also indicate element wise cost per unit. Budgeted output and costs per
unit are:

Budgeted output 1,00,000 units

Per unit cost Rs.
Direct material 90
Direct labour 45
Direct variable expenses 10
Manufacturing variable overhead 40
Fixed production overhead 5
Administration overhead (fixed) 5
Selling overhead 10 (10% fixed)
Distribution overhead 15 (20% fixed)
[B.com (Hons), Delhi]

59
Answer: Total Cost Rs. 96,40,000 at 40,000 units; Rs. 1,37,60,000 at 60,000 units; and
Rs. 1,68,50,000 at 75,000 units

Q9. A factory is currently running at 50% capacity and produces 5,000 units at a cost of
Rs. 90 per units as per details given below:

Material - Rs. 50

Labour - Rs. 15

Factory overheads - Rs. 15 (Rs. 6 fixed)

Administration overheads - Rs. 10 (Rs. 5 fixed)

The currently selling price is Rs. 100 per unit. At 60% working, material cost per unit
increases by 2% and selling price per unit falls by 2%.

At 80% working, material cost per unit increases by 5% and selling price per unit falls by
2.5%.

Prepare a flexible budget showing profits of the factory at 60% and 80% working and
offer your comments.

[B.Com (Hons), Delhi]

Answers: Profit at 60% Rs. 53,000; at 80% Rs. 73,000

60
 LESSON 4

RECENT DEVELOPMENTS IN BUDGET

4. STRUCTURE

4.0 Learning Objectives

4.1 Zero Base Budgeting (ZBB)
4.1.1 Meaning and Definition
4.1.2 Need for Zero-Based Budgeting
4.1.3 Features of Zero Base Budgeting
4.1.4 Four Steps involved in the process of Zero Base Budgeting
4.1.5 Advantages of Zero Base Budgeting
4.1.6 Disadvantages of Zero Base Budgeting
4.1.7 Distinction between Traditional Budgeting and Zero Base Budgeting
4.2 Programme Budgeting
4.2.1 Objectives
4.2.2 Limitations
4.3 Performance Budgeting
4.3.1 Meaning of Performance Budgeting
4.3.2 Purpose
4.3.3 Pre-Requisites of Performance Budgeting
4.3.4 Features Performance Budgeting
4.3.5 Steps Performance Budgeting
4.3.6 Advantages Performance Budgeting
4.3.7 Limitations Performance Budgeting
4.3.8 Traditional Budgeting and Performance Budgeting
4.4 Self-Test Questions

4.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Understand the meaning of zero base budgeting, its benefits and limitations
(b) Understand the meaning of programme budgeting its objectives and limitations
(c) Understand the meaning of performance budgeting, its purpose, pre-requisites,
advantages and limitations.
(d) Compare traditional budgeting with zero base budgeting, programme budgeting and
performance budgeting.

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4.1 ZERO BASE BUDGETING (ZBB)

4.1.1 Meaning and Definition

Zero base budgeting is a revolutionary concept of planning the future activities

and there is a sharp contradiction from conventional budgeting. Zero base budgeting, may
be better termed budgeting from the beginning without any reference to any base-past
budgets and actual happening. It is designed to meet the needs of the management in
order to ensure the operational efficiency and effective utilization of the allocated
resources of a concern.

This technique was originally developed by Peter A. Phyhrr (who is known as

the father of ZBB), Manager of Taxas Instrument during 1969. This concept is widely
used in USA for controlling their state expenditure when Mr. Jimmy Carter was the
president of the USA. Mr. Pyhrr was subsequently asked by Georgia governor Jimmy
Carter to manage the Georgia budget process. Pyhrr authored "Zero Based Budgeting: A
Practical Management Tool for Evaluating Expenses". At present this technique has for
its global recognition for many countries have implemented in real terms.

Zero Base Budgeting is so called because it requires each budget to be prepared

and justified from zero, instead of simply using last year‟s budget as a base. Incremental
level of expenditure on each activity is evaluated according to the resulting incremental
benefits. Available resources are then allocated where they can be used most effectively.

In real terms, the ZBB is simply an extension of the Cost Benefit Analysis Method
to the area of corporate planning and budgeting.

Peter Phyrr has defined Zero base budgeting as “a planning and budgeting
process which requires each manager to justify his entire budget request in detail from
scratch (hence zero base) and shifts the burden of proof to each manager to justify why he
should spend any money at all. The approach requires that all activities be analyzed in
decision packages which are evaluated by systematic analysis and ranked in order of
importance”.

CIMA defines Zero Base Budgeting as “a method of budgeting whereby all

activities are re-evaluated each time a budget is set. Discrete levels of each activity are
valued and a combination chosen to match funds available.”

David Lieninger has defined ZBB as, “ZBB is a management tool, which
provides a systematic method for evaluating all operations and programmes, current or
new, allows for budget reductions and expansions in a rational manner and allows re‐
allocation of sources from low to high priority programmes."

62
 According to Peter Sarant, former director of management analysis training for
the United States Civil Service Commission, defined as ZBB is "a technique which
complements and links to existing planning, budgeting and review processes. It identifies
alternative and efficient methods of utilizing limited resources. It is a flexible
management approach which provides a credible rationale for reallocating resources by
focusing on a systematic review and justification of the funding and performance levels
of current programs."

4.1.2 Need for Zero-Based Budgeting

 Low priority programs can be eliminated or reduced.
 Effectiveness of programmes can be dramatically improved.
 Programmes of high priority can obtain increased funding by shifting resources
within an agency.
 The government need not increase the tax revenue as ZBB can to do a more
effective job with existing revenues.

4.1.3 Features of Zero Base Budgeting

Zero-base budgeting is based on the premise that every rupee of expenditure requires
justification. These are the following features which makes ZBB unique in comparison to
traditional budgeting:
 Each budget item whether old or new is to be identified and evaluated critically
from the scratch each time a new budget is formulated.
 It is holistic in nature as this technique deals practically with all the elements of
budget proposals.
 A detailed cost benefit analysis of each budget programme is undertaken and each
programme has to compete for scarce resources.
 Choices are made on the basis of what each unit can offer for a specific cost.
 Individual unit‟s objects are linked to corporate targets.
 It defines alternatives and efficient ways of utilizing limited resources.
 Participation of all levels in decision-making.
 Concentration of efforts is not simply on “how much” a unit will spend but “why”
it needs to spend. Each manager has to justify why he should spend any money at
all.

4.1.4 Four Steps Involved in the Process of Zero Base Budgeting

 Developing ‘decision units’: Different departments/responsibility centers are

considered as decision units. These decision units are for which cost-benefit
analysis is proposed have to be developed so as to arrive at decision whether they
should be allowed to continue or be dropped if the cost analysis proves to be
unfavourable for it.

63
  Developing ‘decision package’: The content and format of the decision package
must provide management with the information it needs to evaluate each decision
unit. Describing and analyzing all current or proposed programmes usually called
“decision packages”. This consists of identification, analysis and formulation
assists an evaluation in terms of purposes, consequence, performance measures,
alternatives and cause and benefits.
 Ranking of Decision Packages: Evaluate and rank all decision packages to
develop the appropriations request. The ranking process provides management to
allocate its limited resources by making management concentrate on these
questions. „How much should we spend‟ and „where should we spend it‟?
 Funding: Prepare the detailed operating budgets and allocate the resources in
accordance with the ranking.

4.1.5 Advantages of Zero Base Budgeting

 It provides a systematic approach for the evaluation of different activities and rank
them in order of preference for the allocation of scarce resources.
 It provides an opportunity to the management to allocate resources for various
activities only after having a thorough Cost-Benefit Analysis. The chance of
arbitrary cuts and enhancement are thus avoided.
 It will lead to goal congruence as departmental budgets are linked with overall
corporate objectives
 It helps in identifying and eliminating the areas of wasteful expenditure and if
desired, it can also be used for suggesting alternate course of action.
 This technique can be used for the implementation of the system of „Management
by Objectives‟.
 It promotes operational efficiency because it requires managers to review and
justify their activities or the funds requested.
 Cost behavior pattern are more closely examined.
 This technique is relatively elastic because budgets are prepared every year on a
zero base. This system makes it obligatory to develop financial planning and
management information system
 Since this system requires participation of all managers, preparation of budgets,
responsibility of all levels at management in successful execution of budgetary
system can be ensured.

4.1.6 Disadvantages of Zero Base Budgeting

 It is an expensive method as ZBB incurs a huge cost every in its preparation.

 It also requires high volume of paper work, hence sometimes it becomes a tedious
job.

64
  In ZBB there is a danger of emphasizing short term benefits at the expenses of
long term ones.
 Defining the decision units and decision packages is rather difficult.
 Zero base budgeting requires a lot of training for managers.
 Cost of preparing the various packages may be very high in large firms involving
large number of decision packages.
 It may lay more emphasis on short term benefits to the detriment of long-term
objectives of the organization.
 Where objectives are very difficult to quantify as in research and development,
zero base budgeting does not offer any significant control advantage.

4.1.7 Distinction between Traditional Budgeting and Zero Base Budgeting

Traditional Budgeting Zero Base Budgeting

Traditional budgeting is accounting- Zero base budgeting is a decision-oriented
oriented, with stressed laid on previous approach, in a rational manner, for
level of expenditure. allocation of resources for both old and
new programmes and activities.
In traditional budgeting, first reference is In zero base budgeting a decision unit is
made to past period levels of revenues and broken into understandable decision
costs, and then adjustments are made for packages which are ranked according to
inflation, market demand and new importance to enable top management to
programmes. focus attention on top priority decision
packages.
In traditional budgeting, it is for top In zero base budgeting this responsibility is
management to decide why a particular shifted from top management to the
amount should be spent on a particular manager of decision unit. It is their
decision unit. responsibility to justify why there should
be a budget allocation for his division.
Traditional budgeting is a routine and Zero base budgeting makes a very straight
direct approach, treating each forward approach and immediately
division/decision unit equally. spotlights the decisions packages enjoying
priority over others.
In traditional budgeting, managers In zero base budgeting, managers do not
deliberately inflate their budget request, so have temporary approach for budgets. Top
that after the cuts they may still get what management accords its approval only to a
they require. carefully devised, result-oriented Decision
Package.
It is comparatively rigid, and not clearly This is very flexible and responsive to
responsive to environmental changes. environmental changes.

65
4.2 PROGRAMME BUDGETING

Programme budgeting is a more transparent mechanism for monitoring budget

expenditures and outlays of a specific programme. It allows for more efficient allocation
of funds for the purpose of fulfilling concrete responsibilities, and enables decision-
makers to easily understand the connection between the required, that is approved funds
and strategies, programs and outcomes. Programme budgeting, developed by U.S.
president Lyndon Johnson, is the budgeting system that, contrary to conventional
budgeting which is inherited with serious limitation that it ignores the benefits of an
activity in its evaluation. As budget proposals are evaluated on the basis of costs.
Consequently, conventional budgeting approach does not prove to be much effective.

Hence, Program budgeting is an instrument of policy analysis, means of improving

managerial performance, used for allocating and managing costs and a planning process.

4.2.1 Objectives

 Alternative means of achieving the goals shall be developed and analyzed.

 Long term costs are projected and compared with the benefits of each programme.
 Control over each and every programme.
 Improved analysis of each programme in relation to cost will be strengthened.

4.2.2 Limitations

 It has no relevance in preparation of actual budget.

 It does not serve as operating tool for the line executives who implement the
policy and programme decisions.
 The evaluation of on-going programme activities and operations are not focused
but stresses only on new programme.

4.3 PERFORMANCE BUDGETING

4.3.1 Meaning of Performance Budgeting

The concept of performance budgeting was first time used by the Hoover
Commission in the US in the year 1949 and then it was applied in the defence budget of
the said country in the 1960s. Performance budgeting involves evaluation of performance
of every executive in an organization in the context of both specific as well as overall
objectives of the organization. The concept of performance budgeting relates to greater
management efficiency specially in government work. With a view to introducing a
system‟s approach, the concept of performance budgeting was developed and as such
there was a shift from financial classification to „cost‟ or „objective‟ classification.
Performance budgeting, is therefore, looked upon as a budget based on functions,

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activities and projects and is linked to the budgetary system based on objective
classification of expenditure.

According to National Institute of Bank Management, Bombay performance budgeting

technique is “the process of analyzing identifying, simplifying and crystallizing specific
performance objectives of a job to be achieved over a period in the frame work of the
organizational objectives, the purpose and objectives of the job.” The technique is
characterized by its specific direction towards the business objectives of the organization.
Thus, performance budgeting lays immediate stress on the achievement of specific goals
over a period of time. It requires preparation of periodic performance reports. Such
reports compare budget and actual data and show any existing variances.

Performance budgeting is a method of budgeting that provides the purpose and objectives
for which funds are needed, costs of programs and related activities proposed to
accomplish those objectives and outputs to be produced or services to be rendered under
each program (Shah, 2007).

4.3.2 Purpose

The main purposes of performance budgeting are:

 To review at every stage, and at every level of the organization, so as to measure

progress towards the short-term and long-term objectives.
 To inter-relate physical and financial aspects of every programme, project or
activity.
 To facilitate more effective performance audit.
 To assess the effects of the decision-making of supervisor to the middle and top-
managers.
 To bring annual plans and budgets in line with the short and long-term plan
objectives.
 To present a comprehensive operational document showing the complete planning
of the programmes and prospectus their objectives inter-woven with the financial
and physical aspects.

4.3.3 Pre-Requisites of Performance Budgeting

 Objectives of the firm should be defined clearly

 Objectives should be divided into specific functions, programmes, activities and
tasks, for different levels of management, within the realities of fiscal and physical
constraints.
 Realistic and acceptable norms, yardsticks, standards or performance indicators
should be evolved, and expressed in quantifiable terms.

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  A decentralized responsibility structure and flexible management style should be
adopted.
 A suitable accounting and reporting system should be developed to facilitate
monitoring, analysis and review of actual performance, by comparison with
budgets.

4.3.4 Features of Performance Budgeting

 The budget is prepared for each managerial level. The manager concerned is made
responsible and held accountable for performance at his level over the specified
period of time as given in the budget.
 Performance budget implies that the budget must clearly indicate the actual output
expected by spending a particular amount on a particular activity. Hence, it is an
output oriented budget that focuses more on achievement rather than means of
achievements.
 Cost-Benefit analysis is done for making decisions regarding allocation of funds.
 This system has been designed to plan for long term.
 It tries to answer questions like- what is to be achieved? How is it to be achieved?
When is it to be achieved? And so on.

4.3.5 Steps for Performance Budgeting

 Formulation of objectives
 Establishing a meaningful functional programme and project which will
accomplish these objectives
 Evaluation and selection of programmes and projects on the basis of cost benefit
analysis
 Development of performance criteria for various programmes
 Preparing financial plans for each program and the final annual budget
 Assessing the performance of each programme an comparing the same with
budgeted performance
 Correcting deviation

4.3.6 Advantages of Performance Budgeting

 It clearly indicate the actual output expected by spending a particular amount on a

particular activity
 It helps in improving performance of division/department in a continuous manner
 It brings transparency and clarity in the budget formulation process
 It helps in decision making at all levels of management in the organization.
 It acts as a tool for reviewing efficiency of programs
 It integrates the process of planning, programming and budgeting

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4.3.7 Limitations of Performance Budgeting

 Performance budgeting helps in evaluation of only quantitative and financial

variables of the programme and therefore it lacks qualitative approach in the
evaluation of programme which is very important for proper screening.
 It has limited scope because it can be used for such programmes where evaluation
can be done in a precise manner.
 The application of performance budgeting requires that the departments of an
organization are well organized and the programmes and activities properly
defined which is practically unfeasible, therefore, only a limited number of
organizations can be benefitted by this approach of budgeting.

4.3.8 Traditional Budgeting and Performance Budgeting

Basis Traditional Budgeting Performance Budgeting

Emphasis It gives more emphasis on It gives more emphasis on the physical
financial aspect, than physical aspects or performance than the
aspects or performance. financial aspects. It aims at
establishing between inputs and
outputs, with emphasis on
performance.
Preparation It is prepared with focus on It is prepared with focus on the
expenditure control and function and not the cost of function as
highlighting items of such. The functions, programmes,
expenditure and variances activities and tasks, are reported, along
between budgets and actual with costs thereof.

4.4 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) A budgeting process which demands each manager to justify his entire budget in
detail from beginning is
(a) Functional budget
(b) Master budget
(c) Zero base budgeting
(d) None of the above

(2) What does successful implementation of ZBB rely on?

(a) Implementation of new technologies
(b) Strong leadership
(c) Reduction of silos
(d) Robust management data

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(3) Who is championing zero based budgeting?
(a) Government quangos
(b) Public sector organisations
(c) Small and medium sized companies
(d) Large multinationals like Unilever and Diageo

(4) Why is zero based budgeting making a comeback?

(a) To improve efficiencies
(b) To invest in new technologies
(c) To help reduce costs
(d) To cut costs and generate capital for investment in growth

(5) Zero Based Budgeting (ZBB) lays emphasis on:

1. Unlimited deficit financing.
2. New budget right from the scratch.
3. The budget neglecting the expenditure.
Choose the correct code:
(a) 1, 2 and 3
(b) 2 and 3
(c) Only 2
(d) Only 3

Answers: (1) (c), (2) (d), (3) (d), (4) (d), (5) (c)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. True/False Statement:

(a) Zero-based budgeting questions each activity in the current budget and determines
whether an activity should be supported as is re-engineered of eliminated.
(b) A potential problem with zero-based budgeting is a “spend it or lose it” attitude.
(c) Programme budgeting is output oriented.
(d) Zero base budgeting will be appropriate in areas where output is not related to
production.
(e) Zero base budgeting was first used by Jimmy Carter.
(f) Zero base budgeting forces mangers to identify decision packages.

Answers: (a) T (b) F (c) T (d) T (e) T (f) T

Q2. Fill in the blanks:

(a) _________________________ is a budget which specifies output or results to be

achieved along with the inputs or expenditures to be incurred during the budget
period.
(b) ________________________ is a technique of preparing budget from scratch.

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Answers: (a) Performance Budget (b) Zero Base budgeting

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Write Short note:

(1) Zero Base Budgeting
(2) Performance Budgeting
(3) Programme Budgeting

Q2. State the important features of Zero Base Budgeting.

Q3. Distinguish between zero-base budgeting and conventional budget.

Q4. What is meant by Zero Base Budgeting? What are the essentials of introducing a
system of Zero Base Budgeting? Explain in brief about the drawbacks of this system.

Q5. What is the difference between Performance Budget and Programme Budget? What
are the special areas of application of Programme Budgeting?

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 LESSON 1 UNIT 3

STANDARD COSTING

1. STRUCTURE

1.0 Learning Objectives

1.1 Introduction
1.2 Meaning and Definition of Standard Cost
1.3 Distinction between Standard Cost and Estimated Cost
1.4 Meaning of Standard Costing
1.5 Applicability of Standard Costing
1.6 Comparison between Standard Costing and Budgetary Control
1.7 Advantages of Standard Costing
1.8 Limitations of Standard Costing
1.9 Preliminaries in Establishing a System of Standard Costing
1.10 Setting Standard Cost
1.11 Standard Hour
1.12 Standard Cost Card (Cost Sheet)
1.13 Self-Test Questions

1.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn how the standard costs are set
(b) Explain the concept of standard costing
(c) Understand and describe the purpose of a standard costing system
(d) Explain the applicability of standard costing
(e) Learn the advantages and limitation of standard costing

1.1 INTRODUCTION

Two vital functions of management of any organization are planning and

controlling. While planning helps the management to make systematic efforts to achieve
the well-defined objectives, control enables them to evaluate the actual performance and
determine the difference between the planned performance and actual performance. Thus
for evaluating performance, it is necessary to compare the actual performance with some
pre-determined or pre planned targets. One of the important parameters of performance is
the cost of production. According to M. Porter, for achieving sustainable competitive

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advantage it is necessary to establish cost leadership. For achieving this, it is of
paramount importance that the various costs are monitored closely and there is a constant
comparison of the actual costs with some pre-determined targets. Standard Costing is an
important tool in the hands of management for improving the management control by
providing parameters for comparison of actual with these parameters. In this technique,
all costs are pre-determined, i.e. cost is determined in advance of production.

During the first stages of development of cost accounting, historical costing was
the only method available for ascertaining and presenting costs. Historical costs have,
however, the following limitations:

 Historical cost is valid only for one accounting period, during which the particular
manufacturing operation took place.
 Data is obtained too late for price quotations and production planning.
 Historical cost relating to one batch or lot of production is not a true guide for
fixing price for other batch or lot of production.
 Historical costing is comparatively expensive as it involves the maintenance of a
large volume of records and forms.

The limitations and disadvantages attached to historical costing system led to further
thinking on the subject and resulted in the emergence of standard costing which makes
use of scientifically predetermined standard costs under each element.

1.2 MEANING AND DEFINITION OF STANDARD COST

Brown and Howard define Standard Cost as a Pre-determined Cost which

determines what each product or service should cost under given circumstances. This
definition states that standard costs represent planned cost of a product.

Standard Cost as defined by the Institute of Cost and Management Accountant,

London "is the Predetermined Cost based on technical estimate for materials, labour and
overhead for a selected period of time and for a prescribed set of working conditions."

The following are the features of standard cost can be drawn from the above definition:

 Standard cost is a pre-determined cost. This means that the standard cost is
determined even before the commencement of production.
 Standard cost is not an estimated cost. There is a difference between saying what
would be the cost and what should be the cost. Standard cost is a planned cost and
it is a cost that should be the actual cost of production.
 It is computed for a specific period of time.
 It is calculated after taking into consideration the management‟s standard of
efficient operation.

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  Standard cost can be used as a basis for price fixation as well as for exercising
control over the cost.
 It is attained under a given set of efficient operating conditions.

1.3 DISTINCTION BETWEEN STANDARD COST AND ESTIMATED

COST

Basis Standard Cost Estimated Cost

Determination It is determined on a scientific
basis.
Emphasizes It emphasizes "what the cost
should be."
Usage It is used to evaluate actual
performance and it serves as an
effective tool of cost.
Which firm uses? It is used by a firm having
standard costing system in
operation.
Recording It is a part of accounting system
and standard costing variances
are recorded in the books of
accounts.
It is determined on the basis of
statistical facts and figures.
It emphasizes "what the cost
will be."
It is used to cost ascertainment
for fixing sales price.
It is used by a firm having
historical cost system
It is not a part of accounting
system because it is based on
statistical facts and figures

1.4 MEANING OF STANDARD COSTING

According to CIMA, London, “Standard Costing is defined as - the preparation

and use of standard cost, their comparison with actual costs and the measurement and
analysis of variances to their causes and points of incidence.”

On the basis of above definition, the steps involved in the techniques of standard costing
are as follows:
(1) Pre-determination of technical data related to production. i.e., details of materials and
labour operations required for each product, the quantum of inevitable losses, efficiencies
expected, level of activity, etc.
(2) Pre-determination of standard costs in full details under each element of cost, viz.,
labour, material and overhead.
(3) Comparison of the actual performance and costs with the standards and working out
the variances, i.e., the differences between the actuals and the standards.
(4) Analysis of the variances in order to determine the reasons for deviations of actuals
from the standards.
(5) Presentation of information to the appropriate level of management to enable suitable
action (remedial measures or revision of the standards) being taken.

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1.5 APPLICABILITY OF STANDARD COSTING

The application of standard costing requires certain conditions to be fulfilled. These are:

 A sufficient volume of standard products or components should be produced.

 Methods, operations and processes should be capable of being standardized.
 A sufficient number of costs should be capable of being controlled.

Industries using process costing method like fertilizers, cement, steel, sugar etc. may
use standard costing method because such industries are producing standardized products
which are repetitive in nature.

In job order industries, it is not useful to employ a full system of standard costing
because in such industries each job undertaken may be different from another and setting
standards for each job may prove difficult and expensive.

1.6 COMPARISON BETWEEN STANDARD COSTING AND BUDGETARY

CONTROL

Relationship: The following are certain basic principles common to both Standard
Costing and Budgetary Control:
(1) Determination of standards or pre-determined targets
(2) For both of them measurement of actual performance is done
(3) Comparison of actual costs with standard cost to find out deviations.
(4) Analysis of variances to find out the causes of deviation between actual and standard
performance.
(5) To take corrective measures.

Differences: Although basic principles of standard costing and budgetary control are
same, but still they differ in the following respects:

Basis Standard Costing Budgetary Control

Meaning Standard Cost are the "Norms" or Budgets are estimated costs.
"what cost should be." They are "what the cost will
be."
Scope The scope of standard costing is The scope of budgetary control
relatively narrow as it covers mainly is wide as it relates to different
production costs. functions of business such as
sales, purchase, cash, capital
expenditure etc.
Aim Standard costing aims at economy Budgeting is meant for
and promptness in cost ascertainment determination of policy and
and fixation of selling prices. delegation of responsibilities
Projection Standard Costing is a projection of Budgets are projections of
cost accounts. financial accounts.

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 Basis Standard Costing Budgetary Control
Usefulness Standard cost represents realistic Budgets represent an upper
yardsticks and are therefore more limit on spending without
useful for controlling and reducing considering the effectiveness
costs. of the expenditure in terms of
output.
Intensity It is intensive in application as it calls Budgetary control is extensive
for detailed analysis of variance. in nature and the intensity of
analysis tends to be much less
than in standard costing.
Dependence Standard Costing cannot be used Budget can be operated with
without budgets standards.
Recording of Under standard costing variances are In budgetary control variances
Variance revealed through different accounts. are not revealed through the
accounts.
Preparation Standard cost are planned and Budgets are prepared on the
prepared on the basis of technical basis of historical facts and
estimates figures.

1.7 ADVANTAGES OF STANDARD COSTING

The advantages derived from a system of standard costing are tabulated below:

 Effective cost control: the most important advantage of Standard Costing system
is that it facilitates the control of cost. It establishes yard-sticks against which the
efficiency of actual performances is measured.
 Facilitates Motivation: The standards provide incentive and motivation to work
with greater effort and vigilance for achieving the standard. This increase
efficiency and productivity all round.
 Operational Efficiency: At the very stage of setting the standards, simplification
and standardization of products, methods, and operations are effected and waste of
time and materials is eliminated. This assists in managerial planning for efficient
operation and benefits all the divisions of the concern.
 Less records: Costing procedure is simplified. There is a reduction in paper work
in accounting and less number of forms and records are required.
 Helps in fixing prices and valuation: Cost are available with promptitude for
various purposes like fixation of selling prices, pricing of interdepartmental
transfers, ascertaining the value of costing stocks of work-in-progress and finished
stock and determining idle capacity.
 Helps in planning: Standard Costing is an exercise in planning. It can be very
easily fitted into and used for budgetary planning.

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  Facilitates delegation of authority: Standard Costing system facilities delegation
of authority and fixation of responsibility for each department or individual. This
also tones up the general organization of the concern.
 Management by Exception: Variance analysis and reporting is based on the
principles of management by exception. The top management may not be
interested in details of actual performance but only in the variances form the
standards, so that corrective measures may be taken in time.
 Cost reduction: When constantly reviewed, the standards provide means for
achieving cost reduction.
 Regular Checks: The analysis of variances ensures that regular checks are made
upon expenditure incurred. There is quick recognition of deviations from the pre-
determined standards.
 Aids in policy making: Production and pricing policies may be formulated in
advance before production starts. This helps in prompt decision-making.
 Integration of accounts: Standard costing facilitates the integration of accounts
so that reconciliation between cost accounts and financial accounts may be
eliminated.
 Optimal use of resources: Standard Costing optimizes the use of plant facilities,
current assets and working capital.

1.8 LIMITATIONS OF STANDARD COSTING

 Difficulty in setting standards: The process of setting up standards is a difficult

task as it requires technical skill. Standards may be too strict or too liberal. If
inaccurate standards are set, they can do more harm than good to the business.
 Frequent Revision of Standard: In course of time, sometimes even in a short
period the standards become rigid. They require revision because business
conditions constantly keep on changing. Keeping them up to date can be a major
problem. It may not always be possible to change standards to keep pace with the
frequent changes in the manufacturing conditions.
 Effect on Psychology of Employees: Sometimes, standards create adverse
psychological effects on the morale and motivation of the employees. If the
standard is set at high level, its non-achievement would result in frustration and
build-up of resistance.
 Explanation of variance difficult: Due to the play of random factors, variances
cannot sometimes be properly explained, and it is difficult to distinguish between
controllable and non-controllable expenses.
 Not suitable for small concern: Standard costing may not sometimes be suitable
for some small concerns. Where production cannot be carefully scheduled,
frequent changes in production conditions result in variances. Detailed analysis of
all of which would be meaningless, superfluous and costly.

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  Expensive: Standard costing may not, sometimes, be suitable and costly in the
case of industries dealing with non-standardized products and for repair jobs
which keep on changing in accordance with customer„s specifications.
 Lack of management’s enthusiasm: Lack of interest in standard costing on the
part of the management makes the system practically ineffective. This limitation,
of course, applies equally in the case of any other system which the management
does not accept wholeheartedly.

1.9 PRELIMINARIES IN ESTABLISHING A SYSTEM OF STANDARD

COSTING
These preliminary steps must be taken before determination of standard cost:

(1) Establishment of Cost Centres

(2) Classification and Codification of Accounts.
(3) Types of Standards to be applied.
(a) Ideal Standard
(b) Basic Standard
(c) Current Standard
(d) Expected Standard
(e) Normal Standard
(4) Organization for Standard Costing.
(5) Setting of Standards.

(1) Establishment of Cost Centres: It is the very first step required before setting of
Standards. According to CIMA, London Cost Centre is "a location, person or item of
equipment for which costs may be ascertained and used for the purpose of cost control."
For the determination of standard costs, it is necessary to establish cost centres for each
product and comparison of actual cost with the predetermined standards to ascertain the
deviations to take corrective measures.

(2) Classification and Codification of Accounts: Classification of Accounts and

Codification of different items of expenses and incomes help quick ascertainment and
analysis of cost information.

(3) Types of Standards to be applied: Determination of the type of standard to be used

is one of the important steps before setting up of standard cost. The different types of
standards are given below:

(a) Ideal Standard: The standard which basically develops under the most
favorable/possible conditions. It is based on high degree of efficiency. No
wastages/power failures/labor idle times and etc. it is merely a theoretical standard
which is unrealistic and unattainable.

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 (b) Basic Standard: The standard is fixed in relation to the base year and no
adjustments made based on the changes taken place thereafter. It has no practical
utility from the point of view of cost control.

(c) Current Standard: The standard mainly develops for short period of time and
depicts current situation at any given time.

(d) Expected Standard: The standard which develops for future periods and
depicts what need to be attained. Hence, it is more relevant for business purposes
as the variances from the expected standard indicate real deviations from the
attainable performance.

(e) Normal Standard: It is a standard which is based on average performance in

the past. It is attainable under normal conditions. The main purpose of normal
standard is to eliminate variations in the cost arising out of trade cycles.

(4) Organization for Standard Costing: The accurate standard costing system depends
upon the reliable standards. Hence the organization structure should be like in which
responsibility for setting standard is vested with the Standard Committee which consists
of Purchase Manager, Production Manager, Personnel Manager, Time and Motion Study
Engineers, Marketing Manager and Cost Accountant.

(5) Setting of Standard: The Standard Committee is responsible for setting standards for
each element of costs such as

(a) Direct Material

(1) Direct Material Price
(2) Direct Material Quantity
(b) Direct Labour
(1) Labour Rate Standard
(2) Labour Efficiency Standard
(c) Overheads (Fixed Overheads and Variable Overheads).

1.10 SETTING STANDARD COST

Standards for Material

Two standards are
developed for material Material Price Standard
costs:
(1) Current market Price
(2) Forecasts of Price Trends
Considerable Factors (3) Market Conditions
(4) Discounts, packing and
delivery charges etc.
Material Quantity Standard
(1) Quality of material
(2) Quantity of material
(3) Analysis of material
requirements
(4) Normal material losses

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 Standards for Labour
Two standards are
developed for labour Labour Rate Standard Labour Efficiency Standard
costs:
(1) Current rates of Pay (1) Grade of labour
(2) Method of wage payment (2) Time and motion study
Considerable Factors (3) Forecast of wage trends (3) Normal loss of labour time
(4) Guaranteed minimum (4) Most efficient method of
wages and overtime wages working
Standard for Direct Expenses
Setting standards for direct expenses is quite simple as these may be based on past
records adjusted according to anticipated changes therein.
Standard for Overheads
(1) Standard Indirect Material Costs
(2) Standard Indirect Labour Costs
Considerable Factors (3) Standard Indirect Expenses
(4) Standard level of activity such as standard hours, standard
production (in units)

1.11 STANDARD HOUR

Usually production is expressed in terms of units, dozen. kgs, pound, liters etc. When
productions are of different types, all products cannot be expressed in one unit. Under
such circumstances, it is essential to have a common unit for all the products. Time factor
is common to all the operation. ICMA, London, defines a Standard Time as a
"hypothetical unit pre-established to represent the amount of work which should be
performed in one hour at standard performance."

1.12 STANDARD COST CARD (COST SHEET)

Standard Cost Card is a record of Standards for direct material, direct labour and
overhead cost. This Standard cost is presented for each unit cost of a product. The total
Standard Cost of manufacturing a product can be obtained by aggregating the different
Standard Cost Cards of different processes. These Cost Cards are useful to the firm in
production planning and pricing policies.

1.13 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) The process of standard costing

(a) Can be incorporated in accounting routine
(b) Helps in reaching variances from the accounting procedure

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 (c) Both (a) and (b)
(d) None of the above

(2) As per J. Batty, Standard Cost represents ______under given conditions.

(a) Anticipated costs
(b) Current costs
(c) Historical costs
(d) None of the above

(3) When standard costs are used, the amount of detailed record keeping will
normally
(a) Reduce
(b) Increase
(c) Stay the same
(d) None of the above

(4) Standard costing committee is responsible for

(a) Computation of variances
(b) Linking the deviations with responsibilities
(c) Setting all types of standards
(d) All of the above

(5) Which of the following statements are not true about normal standards?
(a) Normal Standards are meant to smooth out fluctuations caused by cyclical and
seasonal changes
(b) Normal Standards can be applied for absorption of overheads for a long period of
time
(c) In establishing normal standards, allowance is given to normal fatigue and breaks,
and normal waste and scrap
(d) None of the above

(6) Which of the following standards cannot be used for cost control?
(a) Basic Standard
(b) Normal Standard
(c) Both (a) and (b)
(d) None of the above

(7) Basic standard is established for

(a) Short period
(b) Current period
(c) Indefinite period
(d) None of the above

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(8) __________ is based on past averages adjusted to anticipated future changes.
(a) Ideal Standard
(b) Normal Standard
(c) Basic Standard
(d) Perfection Standard

(9) To establish an effective system of standard costing it is essential that

(A) The technical process of operation should be prone to planning
(B) The cost of the products should be given
(C) The process or operating costs of products should be provided
(D) The standard costing should be consistent with the technical procedure of the
production of the specific entity

(a) A, B and C
(b) A, C and D
(c) B, C and D
(d) D, C and A

Answers: (1) (c), (2) (a), (3) (a), (4) (d), (5) (d), (6) (c), (7) (c), (8) (b), (9) (b)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Differentiate:
(a) Standard Costing and Budgetary Control
(b) Actual Cost System and Standard Cost System
(c) Standard Cost and Budgeted Cost

Q2. Write short notes on:

(a) Standard Cost
(b) Standard Costing
(c) Estimated Cost
(d) Historical Costing
(e) Ideal Standard
(f) Current Standard

Q3. Fill in the blanks:

(a) The system of standard costing and budgetary control have the common
objectives, both are ________________
(b) Standard costing works on the principle of _________________

Answers: (a) two different techniques (b) management by exception

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Q4. True/False Statements:
(a) Standards are arrived at based on past performance.
(b) Standard cost is also known as pre-determined cost of production.
(c) Standard costing is a technique of cost control and not of cost reduction.
(d) Standards which allow for normal down time and employees rest periods are
called practical standards.
(e) Standard should be set on a reasonable basis taking into consideration all known
normal factors but without an abnormal loss provision.

Answers: (a) F (b) T (c) F (d) T (e) T

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Discuss the advantages and limitations of standard costing.

Q2. Distinguish between standard costing and budgetary control.

Q3. What are the advantages of having a system of standard cost? Have they any
significance in effective Budgetary Control?

Q4. Standard Costing and Budgetary Control are the two important tools for controlling
costs. Discuss.

Q5. “Standard Costing and Budgetary Control are interrelated but not independent.”
Comment.

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 LESSON 2

VARIANCE ANALYSIS - MATERIAL AND LABOUR VARIANCE

2. STRUCTURE

2.0 Learning Objectives

2.1 Meaning of Variance
2.2 Variance Analysis
2.3 Favourable and Unfavourable Variance
2.4 Controllable and Uncontrollable Variance
2.5 Revision Variance
2.6 Method Variance
2.7 Material Variance
2.7.1 Material Cost Variance (MCV)
2.7.2 Material Price Variance (MPV)
2.7.3 Material Usage Variance (MUV)
2.7.4 Material Mix Variance (MMV)
2.7.5 Material Yield Variance (MYV)
2.8 Labour Variance
2.8.1 Labour Cost Variance (LCV)
2.8.2 Labour Rate Variance (LRV)
2.8.3 Labour Efficiency Variance (LEV)
2.8.4 Idle Time Variance (ITV)
2.8.5 Labour Mix Variance (Gang Composition Variance)
2.8.6 Labour Yield Variance (LYV)
2.8.7 Labour Revised Efficiency Variance (LREV)
2.9 Self-Test Questions

2.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn to compute direct material and direct labour variance
(b) Learn to analyse direct material and direct labour variance
(c) Explain how they are used for control
(d) Calculate mix and yield variances for direct materials and direct labour.

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2.1 MEANING OF VARIANCE

Standard Costing act as a measuring tool for the management for determination of
"Variances" in order to evaluate the production performance. The primary object of
standard costing is to reveal the difference between actual cost and standard cost.
Variance is the difference between the standard cost and the actual cost. In other words it
is the difference between what the cost should have been and what the actual cost is.
Variances of different cost items provide the key to cost control. They indicate whether
and to what extent standards set have been achieved. This enables management to correct
adverse tendencies.

After standard costs have been established, the next step is to ascertain the actual
cost under each element and compare them with the standard cost. The difference
between these two is termed as cost variance. According to the CIMA, London “Cost
variance is the difference between a standard cost and the comparable actual cost
incurred during a given period.”

The Chartered Institute of Management Accountants, London, defines

Variance as “the difference between planned, budgeted, or standard cost and actual cost;
and similarly for revenue.”

2.2 VARIANCE ANALYSIS

Variance analysis can be defined as “the analysis of performance by means of variances”.

According to C.I.M.A., London “It is the process of computing the amount of and
isolating the cause of variances between actual costs and standard costs.”

According to CIMA Official Terminology, 2005 “the evaluation of performance

by means of variances, whose timely reporting should maximize the opportunity for
managerial action.”

Variance analysis helps to fix the responsibility so that management can ascertain:
(a) The amount of the variance
(b) The reasons for the difference between the actual performance and budgeted
performance
(c) The person responsible for its occurrence and
(d) Corrective actions to be taken

2.3 FAVOURABLE AND UNFAVOURABLE VARIANCE

Variance analysis is a quantitative technique that involves identification and

evaluation of causes behind differences between actual costs and standard costs.
Variances are analyzed in terms of being favourable or unfavourable for business and are

85
monetized as a difference is a financial value which is easier for the relevant authorities to
assess its financial impact on business.

Where the actual cost is less than standard cost, the difference is known as
Favourable or Credit or Positive Variance denoted by (F) or Cr. In other words, any
variance which increases the actual profit is Favourable variance.

Where the actual cost is more than standard cost, the difference is known as
Unfavourable or Adverse or Debit Variance denoted by (A) or Dr. In other words, any
variance which decreases the actual profit is Unfavourable variance.

2.4 CONTROLLABLE AND UNCONTROLLABLE VARIANCE

Controllable Variance:
A variance is said to be controllable if it can be identified as the primary
responsibility of a specified person or a department. For example the workers may be
held responsible for use of material in excess of standard quantity. The size of
controllable variance reflects the degree of efficiency of person (or department)
concerned. Actually it is the controllable variance with which the management is
concerned because it is here where corrective action is required.

Uncontrollable Variance:
A Variance is said to be uncontrollable if variance is due to the factors beyond the
control of the concerned person (or department). For example, change in market price of
material or increase in material prices due to increase in import duty are the examples of
adverse uncontrollable variance. No person or department can be held responsible for
uncontrollable variances. Actually revision of standards is required to remove such
variances in future.

When variances are reported, attention of the management is particularly drawn

towards controllable variances. If a variance has been caused by multiple factors, the part
of cost variance relevant to each factor should be determined.

There are certain variances which may arise under material, labour or overhead
due to change in the basic condition on which the standards are established.

2.5 REVISION VARIANCE

Sometimes the standard costs may be affected by changes in prices of various

factors like wages, material, overhead rates and changes in methods. The standard costs
are not disturbed to account for these uncontrollable factors and to avoid the amount of
labour and cost involved in revision, the basic standard costs are allowed to stand. It is
essential to isolate the variance arising out of non-revision in order to analyze the other

86
 variances correctly. Revision variance is the difference between the original standard cost
and the revised standard costs.

Revision variance = Original Standard Cost of Actual Output - Revised Standard Cost of
Actual Output

Creation of revision variance is only an interim adjustment which allows the

standard costing system to operate even when there are changes in standard cost.

2.6 METHOD VARIANCE

Method Variance is that part of Revision Variance which arises due to the use of
methods other than those specified. According to CIMA, London, method variance is “the
difference between the standard cost of a product or operation produced or performed by
the normal method and the standard cost of a product or operation produced or performed
by the alternative method actually employed.”

Variance

Sales
Cost Variance
Variance

Direct
Direct Labour Overhead Sales Price Sales Volume
Material Cost
Cost Variance Cost Variance Variance Variance
Variance

Variable Fixed Sales

Overhead Overhead Sales Mix
Quantity
Material Variance Variance Variance
Material Price Variance
Usage
Variance
Variance

Labour
Labour Rate
Efficiency
Variance
Variance

Figure: Cost Variance Analysis

87
2.7 MATERIAL VARIANCE

Material Cost Variance

(MCV)

Material Price Variance Material Usage Variance

(MPV) (MUV)

Material Mix Variance Material Yield Variance

(MMV) (MYV)

2.7.1 Material Cost Variance (MCV)

It is the difference between the standard cost of material consumed for actual production
and the actual cost of material consumed. It is calculated as:

Standard cost of Actual cost of

Material
standard quantity of actual quantity of
Cost = -
material used for material used for
Variance
actual output actual output
=
MCV [SQAO × SP] - [AQ × AP]
SQAO stands for Standard Quantity for Actual Output. It is
calculated by the below given formula:
SQAO = Standard Qty of Material × Actual Output
Standard Output

Interpretation of Variance:
 If the standard cost is more than actual cost, it will be favourable variance. It
represents positive (+) symbol.
 If the standard cost is less than actual cost, it will be adverse variance. It represents
negative (-) symbol.

Reasons for Material Cost Variance:

 Change in price of material or
 Change in quantity of material or
 Change in price and quantity of material

Division of Material Cost Variance:

 Material Price Variance (MPV), and
 Material Usage Variance (MUV)

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2.7.2 Material Price Variance (MPV)

It is that portion of Material Cost Variance which is due to the difference between the
standard price specified and the actual price paid. It is calculated as:

Material
Price = ( Standard Price - Actual Price) × Actual Quantity
Variance
MPV = (SP - AP) × AQ

Interpretation of Variance:
 If the standard price is more than actual price, it will be favourable variance. It
represents positive (+) symbol.
 If the standard price is less than actual price, it will be adverse variance. It
represents negative (-) symbol.

Reasons for Material Price Variance:

 Change in the market price of material
 Changes in the quantity of material purchased leading to lower/higher quantity
discounts
 Failure to take advantage of off-season price, or failure to purchase when price is
cheaper
 Failure to avail cash and/or trade discounts which were provided while setting
standards
 Incorrect setting of standards
 Change in delivery costs
 Emergency purchase on the request of production/sales manager
 Changes in issue price due to differences in changes related to store-keeping,
materials handling, carriage inward expenses etc.
 Changes in the pattern or amount of taxes and duties

2.7.3 Material Usage Variance (MUV)

It is that portion of Material Cost Variance which is due to the difference between the
standard quantity specified and the actual quantity consumed both valued at standard
prices. It is calculated as:

Material
(Standard Quantity for Actual Output - Actual Quantity) ×
Usage =
Standard Price
Variance
MUV = ( SQAO - AQ ) × SP

89
 SQAO stands for Standard Quantity for Actual Output. It is
calculated by the below given formula:
SQAO = Standard Qty of Material × Actual Output
Standard Output

Interpretation of Variance:
 If the standard quantity is more than actual quantity, it will be favourable variance.
It represents positive (+) symbol.
 If the standard quantity is less than actual quantity, it will be adverse variance. It
represents negative (-) symbol.

Reasons for Material Usage Variance:

 Inefficiency in production resulting in wastages
 Use of non-standard material
 Use of non-standard material mixture
 Change in specification or design of product
 Pilferage
 Defect in plant and machinery
 Use of substitute materials
 Poor inspection of raw materials
 Change in the method of production
 Yield from material in excess of or less than standard yield

Division of Material Usage Variance:

 Material Mix Variance (MMV), and
 Material Yield Variance (MYV)

2.7.4 Material Mix Variance (MMV)

It is that portion of Material Usage Variance which is due to the difference between the
standard and the actual composition of materails. It arises only where more than one type
of material is used for producing the finished product. It is calculated as:

Standard Cost of Revised

Material Standard Cost of Actual Quantity of
= Quantity of Actual -
Mix Material Consumed
Material Consumed
Variance
= (Revised Standard Quantity - Actual Quantity) × Standard Price
MMV = ( RSQ - AQ ) × SP
RSQ is calculated by the below given formula:

= Standard Qty of one material × Total Actual Quantities of all

Total Standard Quantities of material
all material

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Interpretation of Variance:
 If the revised quantity is more than actual quantity, it will be favourable variance.
It represents positive (+) symbol.
 If the revised quantity is less than actual quantity, it will be adverse variance. It
represents negative (-) symbol.

Reasons for Material Mix Variance:

 Non-availability of one or more components of the mix
 Non-purchase of materials at proper time
 Larger proportion of the more expensive material is used than that the laid down in
the standard mix, materials usage will reflect a higher cost than the standard
 Contrarily, the use of cheaper materials in large proportions will indicate a lower
cost of materials usage than the standard

2.7.5 Material Yield Variance (MYV)

It is that portion of Material Usage Variance which is due to the difference between the
actual yield obtained and standard yield specified for actual quantity used. While setting
standards, the normal or standard loss is taken into account. But actual loss may differ
from normal or standard loss. This results in actual yield different from standard yield.
Material Yield Variance is calculated as:

Material
(Actual Yield - Standard Yield for Actual Quantity) × Standard
Yield =
Output Price
Variance
MYV = ( AY - SYAQ ) × SOP
1) Standard Yield for Actual Quantity (SYAQ) is calculated as below:

SYAQ = Standard Output × Total Actual Quantities of

Total Standard Quantities all material
of all material
2) Standard Output Price (SOP) is calculated as below:
SOP = SQ × SP
Standard Output

Interpretation of Variance:
 If the Actual Yield is more than Standard Yield, it will be favourable variance. It
represents positive (+) symbol.
 If the Actual Yield is more than Standard Yield, it will be adverse variance. It
represents negative (-) symbol.

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Reasons for Material Yield Variance:
 It arises only when the actual loss as % of total actual input differs from the
standard loss as % of total standard input.

Illustration 1: Mixers Ltd. is engaged in producing a „standard mix‟ using 60 kgs of

chemical X and 40 kgs of chemical Y. The standard loss of production is 30%. The
standard price of X is Rs. 5 per kg and of Y Rs. 10 per kg.

The actual mix and yield were as follows:

X: 80 kgs @ Rs. 4.50 per kg
Y: 70 kgs @ Rs. 8.00 per kg
Actual Yield: 115 kgs
Calculate Direct Material Cost, Price, Usage, Mix and Yield Variances.
[B.Com (Hons), Delhi]

Solution:

(1) Standard mix for actual input of 150 kgs

Material X = 150 × 60% i.e. 90 kgs
Material Y = 150 × 40% i.e. 60 kgs
(2) Standard output for actual mix
150 × 70% = 105 kgs
(3) Actual output = 115 kgs
(4) Standard cost per unit of output
Rs. (90 × 5 + 60 × 10) = Rs. 10 per kg.
105 kgs
(5) Actual cost comes to Rs. 8 per kg (being Rs. 920/115)

Standard Actual
Material
Qty (kg) Rate (Rs.) Amt (Rs.) Qty (kg) Rate (Rs.) Amt (Rs.)
X 90 5 450 80 4.50 360
Y 60 10 600 70 8.00 560
150 1,050 150 920

Direct material cost variance = Standard Cost of actual output - Actual cost of actual
output = Rs. (115× 10) - Rs. 920
= Rs. 230 (F)

Direct material price variance = AQ (SR - AR)

Material X = 80 × (5 - 4.50) = 40 (F)
Materials Y = 70 × (10 - 8) = 140 (F)
Rs. 180 (F)

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Direct material usage variance = SR (SQ - AQ)
Material X = 5 × (98.57* - 80) = 92.85 (F)
Material Y = 10 × (65.73* - 70) = 42.70 (A)
Rs. 50.15 (F)

Direct material mix variance = SR (SM-AM)

Material X = 5 × (90 - 80) = 50 (F)
Material Y = 10 × (60 - 70) = 100 (A)
Rs. 50 (A)

Direct material yield variance = Standard Cost per unit of output (Actual Output -
Standard output) = 10 × (115 - 105) = Rs. 100 (F)

Verification
DMCV= DMPV + DMUV
= Rs. 180 (F) + Rs. 50 (F) = Rs. 230 (F)
DMUV =DMMV + DMYV
= Rs. 50 (A) + Rs. 100 (F)
= Rs. 50 (F)

* Standard Quantity for Actual Output

90 × (115/105) = 98.57 kg.
60 × (115/105) = 65.73 kg.

Illustration 2: The standard cost of a certain chemical mixture is:

35% Material A at Rs. 25 per kilogram
65% material B at Rs. 36 per kilogram
A standard loss of 5% is expected in production. During a period there is used:
125 kilograms of Material A @ Rs. 27 per kg.
275 kilograms of Material B @ Rs. 34 per kg.
The actual output was 365 kgs. [B.Com (Hons), Delhi]
Calculate:

(a) Material Cost Variance

(b) Material Price Variance
(c) Material Mix Variance
(d) Material Yield Variance

Solution:

(i) Standard Input for actual output

365 × 100/95 = 384.21 kg
Material A: 35% = 134.47 kgs.

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 Material B: 65% = 249.74 kgs.
(ii) Standard mix of actual input
Material A 35% of 400 kgs = 140 kgs.
Material B 65% of 400 kgs = 260 kgs.
(iii) Cost per unit of output (standard)
Rs. (35 × 25) + Rs. (65 × 36) = Rs. 3,215 = Rs. 33.84
95 95

(a) Material Cost Variance = (SP × SQ) - (AP × AQ)

Material A: (25 × 134.47) - (27 × 125) = 13.25 (A)
Material B: (36 × 249.74) - (34 × 275) = 359.35 (A)
Rs. 372.60 (A)
(b) Material Price Variance = AQ × (SP - AP)
Material A: 125 × (25 - 27) = 250 (A)
Material B: 275 × (36 - 34) = 550 (F)
Rs. 300 (F)
(c) Material Mix Variance = SP (SM - AM)
Material A: 25 × (140 - 125) = 375 (F)
Material B: 36 × (260 - 275) = 540 (A)
Rs. 165 (A)
(d) Material Yield Variance
= Standard Output price per unit (SY - AY)
= 33.84 × (380 - 365)
= 33.84 × (15)
= Rs. 507.60 (A)

Verification

MUV = MCV - MPV

= 372.60 (A) - 300 (F) = 672.60 (A)
This will be verified as under-
MUV = SP (SQ - AQ)
Material A: 25 (134.47 - 125) = 236.75 (F)
Material B: 36 (249.74 - 275) = 909.35 (A)
672.60 (A)

Illustration 3: The standard mix of product is given below:

X: 60 units at 15 paise per unit
Y: 80 units at 20 paise per unit
Z: 100 units at 25 paise per unit

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Ten units of the finished products should be obtained from this mix. During the month of
February, ten mixes were completed and the consumption was:
X: 640 units at 20 P per unit
Y: 960 units at 15 P per unit
Z: 840 units at 30 P per unit
Actual output was 90 units.
Calculate the various Material Variances.
Solution:

(i) Calculation of revised quantity (RQ)

X: 60/240 × 2,440 = 610
Y: 80/240 × 2,440 = 813
Z: 100/ 240 × 2,440 = 1,017
(ii) Standard cost of standard materials:
X: 600 × 15 P. = Rs. 90
Y: 800 × 20 P. = Rs. 160
Z: 1,000 × 25 P. = Rs. 250
Rs. 500
(iii) Actual cost of actual material
X: 640 × 20 P. = Rs. 128
Y: 960 × 15 P. = Rs. 144
Z: 840 × 30 P. = Rs. 252
2,440 Rs. 524

ANALYSIS OF MATERIAL VARIANCE

Total Material Variance: Rs. Rs.

(SC - AC) × AY
(5 - 5.822) × 90 74 (A)
This is accounted for:
(a) Material Price Variance:
(SP - AP) × AQ
X = (15 P. - 20 P.) × 640 32 (A)
Y = (20 P.- 15 P.) × 960 48 (F)
Z = (25 P.- 30 P.) × 840 42 (A) 26 (A)
(b) Material Usage Variance:
(SQ - RQ) × SP
X = (600 - 610) × 15 P. 1.50 (A)
Y = (800 - 813) × 20 P. 2.60 (A)
Z = (1,000 - 1,017) × 25 P. 4.25 (A) 8.35 (A)
(c) Material Mix Variance:
(RQ - AQ) × SP

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X = (610 - 640) × 15 P. 4.50 (A)
Y = (813 - 960) × 20 P. 29.40 (A)
Z = (1,017 - 840) × 25 P. 44.25 (F) 10.35 (F)
(d) Material Yield Variance:
(AY - SY) × SC
(90 - 100) × Rs. 5 50.00 (A)
Total Material Variances 74. 00 (A)
SC = 500/100 = Rs. 5 per unit

2.8 LABOUR VARIANCE

Labour Cost Variance

(LCV)

Labour Rate Variance Labour Efficiency

(LRV) Variance (LEV)

Idle Time Variance Labour Mix Variance Labour Yield Variance

(ITV) (LMV) (LYV)

2.8.1 Labour Cost Variance (LCV)

It is the difference between the Standard Cost of Labour Hours specified for the output
achieved and the Actual Cost of Labour Hours expended. It is calculated as:

Standard Cost of Actual Cost of

Labour
Standard Labour Hours Actual Labour Hours
Cost = -
used for used for
Variance
Actual Output Actual Output
LCV = [SHAO × SR] - [AH × AR]
SHAO stands for Standard Labour Hours for Actual Output. It
is calculated by the below given formula:
SHAO = Standard Labour Hours × Actual Output
Standard Output

Interpretation of Variance:
 If the standard cost is more than actual cost, it will be favourable variance. It
represents positive (+) symbol.
 If the standard cost is less than actual cost, it will be adverse variance. It represents
negative (-) symbol.

96
Reasons for Labour Cost Variance:
 Change in Rate of Labour or
 Change in Labour Hours or
 Change in Rate and Labour Hours

Division of Labour Cost Variance:

 Labour Rate Variance (LRV), and
 Labour Efficiency Variance (LEV)

2.8.2 Labour Rate Variance (LRV)

It is that portion of Labour Cost Variance which is due to the difference between the
standard rate specified and the actual rate paid. It is calculated as:

Labour
Rate = (Standard Rate - Actual Rate) × Actual Hours
Variance
LRV = (SR - AR) × AH

Interpretation of Variance:
 If the standard rate is more than actual rate, it will be favourable variance. It
represents positive (+) symbol.
 If the standard rate is less than actual rate, it will be adverse variance. It represents
negative (-) symbol.

Reasons for Labour Rate Variance:

 Change in basic wage structure or change in piece-work rate
 Use of a different method of payment, e.g. payment at day-rates while standards
are based on piece-work method of remuneration
 Higher or lower rates paid to casual and temporary workers
 New workers not being allowed full normal wage rates
 The composition of a gang as regards the skill and rate of wages being different
from that laid down in the standard.
 Overtime and night shift work in excess of or less than the standard.

2.8.3 Labour Efficiency Variance (LEV)

It is that portion of Labour Cost Variance which is due to the difference between the
standard hours specified for actual output and the actual hours expended both valued at
standard rate. It is calculated as:

Labour Efficiency (Standard Hours for Actual Output - Actual Hours) ×

=
Variance Standard Rate

97
 LEV = ( SHAO - AH ) × SR
SHAO stands for Standard Hours for Actual Output. It is
calculated by the below given formula:
SHAO = Standard Hours × Actual Output
Standard Output

Interpretation of Variance:
 If the Standard Hours are more than Actual Hours, it will be favourable variance.
It represents positive (+) symbol.
 If the Standard Hours are less than Actual Hours, it will be adverse variance. It
represents negative (-) symbol.

Reasons for Labour Efficiency Variance:

 Basic inefficiency of workers due to low morale, insufficient training, faulty
instructions, incorrect scheduling of jobs, etc.
 Use of non-standard material requiring more or less operation time.
 Carrying out operations not provided for a booking them as direct wages.
 Incorrect standard
 Lack of proper supervision or strict supervision than specified
 Poor working conditions
 Use of defective machines, tools and other equipments.
 Use of defective methods of operations

Division of Labour Efficiency Variance:

 Idle Time Variance (ILV)
 Labour Mix Variance (LMV)
 Labour Yield Variance (LYV)

2.8.4 Idle Time Variance (ITV)

It is that portion of Labour Efficeincy Variance which is due to abnormal idle time such
as time lost due to power failure, machinery break-down, strike etc. It arises due to the
difference between Actual labour Hours worked and Actual Labour Hours paid. It is
calculated as:

Idle Time
= (Actual Hours worked - Actual Hours paid) × Standard Rate
Variance
Idle Hours × Standard rate
ITV =
[ IT × SR]

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Interpretation of Variance:
As idle time represents a loss and is always an adverse or unfavourable variance. It
represents negative (-) symbol.

2.8.5 Labour Mix Variance (Gang Composition Variance)

It is that portion of Labour Efficiency Variance which is due to the difference between the
standard and the actual composition of labour. It is calculated as:

Labour Standard Cost of Revised Standard Cost of Actual Labour

= -
Mix Labour Hours Hours expended
Variance = (Revised Standard Hours - Actual Hours) × Standard Rate
LMV = ( RSH - AH ) × SR
RSH is calculated as below:

RSH = Standard Hours of the grade × Total Actual Hours of

Total Standard Hours of all grades all grades

Interpretation of Variance:
 If the revised hours are more than actual hours, it will be favourable variance. It
represents positive (+) symbol.
 If the revised hours are less than actual hours, it will be adverse variance. It
represents negative (-) symbol.

Reasons for Material Mix Variance:

It arises only where more than one grade of labour is employed for producing the finished
product. And when the actual two or more grades of labour are mixed in a ratio different
from the standard labour mix ratio. One of the reason of this difference can be due to the
non-avialability of one or more grades of labour mix.

2.8.6 Labour Yield Variance (LYV)

It is that portion of Labour Efficiency Variance which is due to the difference between the
actual yield obtained and standard yield specified for actual hours used. LYV is an output
variance which represents a gain or loss on output in terms of finished production. Labour
Yield Variance is calculated as:

Labour Yield (Actual Yield - Standard Yield for Actual Hours) × Standard
=
Variance Output Rate

LYV = (AY - SYAH ) × SOR

99
 1) Standard Yield for Actual Hours (SYAH) is calculated as:

SYAQ = Standard Output × Total Actual Hours of all

Total Standard Hours grades
of all grades
2) Standard Output Price (SOP) is calculated as below:
SOP = SQ × SP
Standard Output

Interpretation of Variance:
 If the Actual Yield is more than Standard Yield, it will be favourable variance. It
represents positive (+) symbol.
 If the Actual Yield is more than Standard Yield, it will be adverse variance. It
represents negative (-) symbol.

2.8.7 Labour Revised Efficiency Variance (LREV)

It is that portion of Labour Efficiency Variance which arises due to the factors other than
those which give rise to idle time variance and labour mix variance.

Labour
Revised (Standard Hours for Actual Output - Actual Productive
=
Efficiency Hours) × Standard Rate
Variance
LREV = (SHAO - APH) × SR

Where, Actual Productive Hours= Actual Hours - Idle Hours

Interpretation of the Variance:

 If the Standard Hours are more than Actual Productive Hours, it will be favourable
variance. It represents positive (+) symbol.
 If the Standard Hours are less than Actual Productive Hours, it will be adverse
variance. It represents negative (-) symbol.

Illustration 4: The details regarding the composition and the weekly wage rates of labour
force engaged on a job scheduled to be completed in 30 weeks are as follows:

Standard Actual
Category of workers No. of Weekly wage No. of Weekly wage
labourers rate (in Rs.) labourers rate (in Rs.)
Skilled 75 60 70 70
Semi-skilled 45 40 30 50
Unskilled 60 30 80 20

The work is actually completed in 32 weeks. Calculate the various labour variances.

100
 Standard Actual
Weeks Rate Amount Weeks Rate Amount
Skilled 2,250 60 1,35,000 2,240 70 1,56,800
Semi-skilled 1,350 40 54,000 960 50 48,000
Unskilled 1,800 30 54,000 2,500 20 51,200
5,400 2,43,000 5,760 2,56,000

Note: Number of weeks is calculated above by multiplying number of workers with

number of weeks.

Solution:
Labour Cost Variance = (Standard Cost - Actual Cost)
= 2,43,000 - 2,56,000 = Rs. 13,000 (A)

Labour Rate Variance = (SR - AR) × AT

Skilled (60 - 70) × 2,240 = Rs. 22,400 (A)
Semi-skilled (40 - 50) × 960 = Rs. 9,600 (A)
Unskilled (30 - 20) × 2560 = Rs. 25,600 (F)
Total = Rs. 6,400 (A)

Labour Time Variance = (ST - AT) × SR

Skilled (2250 - 2240) × 60 = Rs. 600 (F)
Semi-skilled (1350 - 960) × 40 = Rs. 15,600 (F)
Unskilled (1800 - 2500) × 30 = Rs. 22,800 (A)
Total Rs. 6,600 (A)

Labour Mix Variance

(Revised Standard time - AT ) × SR
Skilled (2250/5400 × 5760 - 2240) × 60 = Rs. 9,600 (F)
Semi-skilled (1350/5400 × 5760 - 960) × 40 = Rs. 19,200 (F)
Unskilled (1800/5400 × 5760 - 2560) × 30 = Rs. 19,200 (A)
Total Rs. 9,600 (F)

Illustration 5: A gang of workers usually consists of 10 men, 5 women and 5 boys in a

factory. They are paid at standard hourly rate of Rs. 1.25, Re. 0.80 and Re. 0.70
respectively. In a normal working week of 40 hours the gang is expected to produce 1,000
units of output. In a certain week, the gang consisted of 13 men, 4 women and 3 boys.
Actual wages were paid at the rates of Rs. 1.20, Re. 0.85 and Re. 0.65 respectively. Two
hours were lost due to abnormal idle to abnormal idle time and 960 units of output were
produced. Calculate various labour variances.
(ICWA Inter)

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Solution:
Standard Actual
Category
Hrs Rate Amount Hrs Rate Amount
of workers
Rs. Rs.
Men 400 1.25 500 520 1.20 624
Women 200 0.80 160 160 0.85 136
Boys 200 0.70 140 120 0.65 78
800 800 800 838

DLCV = Standard cost for actual output - Actual Cost

= 960 × Re. 0.80 - Rs. 838
= Rs. 768 - Rs. 838
= Rs. 70 (Adverse)

DLRV = Actual hrs. Paid for × (Standard Rate - Actual Rate)

Men = 520 × (Rs. 1.25 - Rs. 1.20) = Rs. 26 (F)
Women = 160 × (Re. 0.80 - Re. 0.85) = Rs. 8 (A)
Boys = 120 × (Re. 0.70 - Re. 0.65) = Rs. 6 (F)
Total Rs. 24 (Favourable)

Total Direct labour efficiency variance (TDLEV) = Standard Rate × (Standard Time
for actual output * - Actual Time paid for)
Men = Rs. 1.25 × (384 - 520) = 170 (A)
Women = Re. 0.80 × (192 - 160) = 25.60 (F)
Boys = Re. 0.70 × (192 - 120) = 50.40 (F)
Rs. 94 (Adverse)
* (Standard hrs./Standard Output) × Actual Output
Total Direct labour efficiency variance may be segregated into:

Direct labour efficiency variance (DLEV) = Standard Rate × (Standard Time for actual
output * - actual time worked)
Men = Rs. 1.25 × (384 - 494) = 137.50 (A)
Women = Re. 0.80 × (192 - 152) = 32.00 (F)
Boys = Re. 0.70 × (192 - 114) = 50.40 (F)
Rs. 50.90 (Adverse)

Idle time variance (ITV) = Idle hrs. × Standard Rate

Men = 26 × 1.25 = Rs. 32.50 (A)
Women = 8 × 0.80 = Rs. 6.40 (A)
Boys = 6 × 0.70 = Rs. 4.20 (A)
Total 43.10 (Adverse)

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DLMV = Standard Rate × (Revised Standard Time - Actual Time Taken)
Revised Standard Time = (Total Actual Time/ Total Standard Time) × Standard Time
Men = (760/800) × 400 = 380
Women = (760 /800) × 200 = 190
Boys = (760/800) × 200 = 190

Men = Rs. 1.25 × (380 - 494) = 142.50 (A)

Women = Re. 0.80 × (190 - 152) = 30.40 (F)
Boys = Re. 0.70 × (190 - 114) = 53.20 (F)
Total Rs. 58.90 (Adverse)

Direct Labour Yield Variance (DLYV) = Standard Cost per unit× (Standard Output for
actual time - actual output)
= Re. 0.80 (950 - 960)
= Rs. 8 (F)
Verification

DLCV = DLRV + DLEV

= 24 (F) + 94 (A)
= Rs. 70 (A)
TDLEV = DLEV + ITV
= 50.90 (A) + 43.10 (A)
= Rs. 94 (A)
Or
= DLMV + ITV + DLYN
= Rs. 58.90 (A) + 43.10 (A) + 8 (F)
= Rs. 94 (A)

2.9 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) If labour time is based on the maximum efficiency, the unit cost will be
(b) Higher
(b) Lower
(c) Equal
(d) None of the above

(2) Which of the following statements are true about standard labour time?
(b) Standard labour time indicates the time in hours needed for a specified process
(b) It is standardized on the basis of past experience with no adjustments made for
time and motion study

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 (c) In fixing standard time due allowance should not be given to fatigue and tool
setting
(d) The Production manager does not provide any input in setting the labour time
standard

(3) The labour engaged in the making of a product is known as _______

(b) Direct labour
(b) Indirect labour
(c) Temporary labour
(d) None of the above

(4) ______ is responsible for setting up of materials price standard

(a) Production department
(b) Engineering department
(c) Purchase department
(d) None of the above

(5) While determining material quantity standards, a proper consideration should

be assigned to
(a) Normal material wastage
(b) Abnormal material wastage
(c) Both (a) and (b)
(d) None of the above

(6) The sub-variance of material usage variance, known as Material mix variance is
measured as
(a) Total standard cost - Total actual cost
(b) Standard cost of revised standard mix - Standard cost of actual mix
(c) (Standard unit price - Actual unit price) * Actual quantity used
(d) (Standard quantity - Actual quantity) * Unit standard price

(7) Volume variance arises when

(a) There is rise in overhead rate per hour
(b) There is decline in overhead rate per hour
(c) There is decrease or increase in actual output compared to the budgeted output
(d) None of the above

(8) Which variance is also known as Gang composition variance?

(a) Labour mix variance
(b) Labour cost variance
(c) Labour efficiency variance
(d) None of the above

Answers: (1) (c), (2) (a), (3) (a), (4) (c), (5) (a), (6) (b), (7) (c), (8) (a)

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EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. State the meaning, method of computation and causes of:

(a) Material Cost Variance

(b) Material Price Variance
(c) Material Usage Variance
(d) Material Mix Variance
(e) Material Yield Variance

Q2. State the meaning, method of computation and causes of:

(a) Labour Cost Variance

(b) Labour Rate Variance
(c) Labour Efficiency Variance
(d) Labour Mix Variance
(e) Labour Yield Variance

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Standard material cost for manufacturing 1000 units of output is 400 kg. of material
at Rs. 2.50 per kg. When 2000 units are produced it is found that actual cost is 825 Kg of
material at Rs. 2.70 per kg. Calculate material cost variance, material price variance and
material usage variance.

[B.Com (Hons), Delhi 2008]

Answers: Material Cost Variance Rs. 227.50 (A), Material Price Variance Rs. 165 (A),
Material Usage Variance Rs. 62.50 (A)

Q2. From the following particulars find out the following variances:

(a) Material Price Variance (b) Material Usage Variance

Standard quantities of material per unit 5 Kg

Standard price per kg. Rs. 5
Actual number of units produced 400
Actual quantity of material used 2,200 kg
Price of material Rs. 4.80 per kg
(B.Com, Madurai)
Answers: (a) Rs. 440 (F) (b) Rs. 1,000 (A)

Q3. Philips Co. manufactures Product „P‟ by mixing three raw materials. For every 100
kg of P, 125 Kg of raw materials are used. In April there was an output of 5,600 Kg of P.
the standard and actual particulars for April are as follows:

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Raw Material Standard Actual
Mix Price Mix Price
Rs. Per Kg. Rs. Per Kg.
I 50% 40 60% 42
II 30% 20 20% 16
III 20% 10 20% 12

Calculate all material variances assuming actual quantity of material consumed was 7,000
Kg. [B.Com (Hons), Delhi]

Answers: MCV Rs. 19,600 (A), MPV Rs. 5,600 (A), MUV Rs. 14,000 (A), MMV Rs.
14,000 (A), MYV Nil

Q4. The standard cost of a product is: 10 hours per unit at Rs. 5 per hour

The actual data is:

Production 1,000 units

Hours taken:
Production 10,400 hours
Idle time 400 hours
Total time 10,800 hours

Payments made Rs. 56,160 at Rs. 5.20 per hour. Calculate:

(a) Labour Cost Variance

(b) Labour Efficiency Variance
(c) Labour Rate Variance
(d) Idle time Variance

Answers: (a) Rs. 6,160 (A) (b) Rs. 4,000 (A) (c) Rs. 2,160 (A) (d) Rs. 2,000 (A)

Q5. A job is schedule to be completed in 30 weeks with a labour employment of 100

skilled operatives, 40 semi-skilled operatives and 60 unskilled operatives. The standard
weekly wages of each type of operatives are - skilled Rs. 60, Semi-skilled Rs. 36 and
unskilled Rs. 24. The work is actually completed in 32 weeks with a labour force of 80
skilled, 50 semi-skilled and 70 unskilled operatives and the actual weekly wage rates
average Rs. 65 for skilled, Rs. 40 for semi-skilled and Rs. 20 for unskilled labour.
Analyse the variance in the labour cost due to various reasons. (ICWA)

Answers: LCV Rs. 8,800 (A), LRV Rs. 10,240 (A), LEV Rs. 1,440 (F), LMV Rs. 19,200
(F), LREV Rs. 17,760 (A)

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Q6. The standard labour composition and the actual labour composition engaged during
the month are given below:

Skilled Semi-Skilled Unskilled

Standard number of workers in a group 30 10 10
Standard wage rate (Rs. per hour) 5 3 2
Actual number of workers employed during 24 15 12
the month in the group
Actual wage rate per hour (Rs.) 6 2.5 2

During the month of 200 working hours, the group produced 9,600 standard hours of
work.

Calculate wage rate variance, labour efficiency (revised) variance, labour mix variance,
Total labour cost variance. (ICWA)

Answers: Wage rate variance Rs. 3,300 (A), Labour efficiency (revised) variance Rs.
2,400 (A), Labour mix variance Rs. 3,000 (F), Total labour cost variance Rs. 2,700 (A)

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 LESSON 3

VARIANCE ANALYSIS OVERHEAD AND SALES VARIANCE

3. STRUCTURE

3.0 Learning Objectives

3.1 Overhead Variance
3.2 Variable Overhead Cost Variance
3.2.1 Variable Overhead Expenditure Variance
3.2.2 Variable Overhead Efficiency Variance
3.3 Fixed Overhead Cost Variance
3.3.1 Fixed Overhead Expenditure Variance
3.3.2 Fixed Overhead Volume Variance
3.3.2.1 Fixed Overhead Efficiency Variance
3.3.2.2 Fixed Overhead Capacity Variance
3.3.2.3 Fixed Overhead Calender Variance
3.3.2.4 Revised Fixed Overhead Capacity Variance
3.4 Sales Variance
3.4.1 Turnover Method or Value Method
3.4.2 Margin Method Or Profit Method
3.5 Accounting Treatment of Variances
3.6 Control Ratios
3.7 Self-Test Question

3.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn to compute overhead and sales variance
(b) Learn to analyse overhead and sales variance
(c) Explain how they are used for control
(d) Calculate control ratios and understand its use.

3.1 OVERHEAD VARIANCE

Overhead is the aggregate of indirect material, indirect labour and indirect

expenses. Variance analysis of overhead is different from that of direct material and direct
labour variance. The overhead cost variance can be described as the difference between
total standard Cost of overhead allowed for the actual output achieved and the actual

108
overhead cost incurred. In other words, overhead cost variance indicates under or over
absorption of overheads. Favourable Overhead Variances indicate over absorption of
overheads and Adverse Overhead Variances indicate under absorption of overheads. In
case of direct material and direct labour variances, there is no question of dividing them
into fixed and variable as the direct material and direct labour costs are variable.
However, in case of overheads, it is necessary to divide them into fixed and variable for
computation of variances.

The absorbed overheads are the overheads which are charged to each unit of
production on the basis of a pre-determined overhead rate. Since actual overheads can be
known only at the time of finalization of expense accounts at the end of accounting
period, the overheads are charged to each unit of production on the basis of Pre-
determined Overhead rates.

Overhead Cost
Variance (OCV)

Variable Overhead Fixed Overhead

Variance (VOV) Variance (FOV)

Basic Terms used in connection with overhead variance are explained below:

When overhead rate per hour When overhead rate per unit is
Terms
is used used
Standard Fixed = Budgeted Fixed Overhead = Budgeted Fixed Overhead
Overhead Rate Budgeted Hours Budgeted Output
Standard = Budgeted Variable Overhead = Budgeted Variable Overhead
Variable Budgeted Hours Budgeted Output
Overhead Rate
Absorbed (or = Standard Hours for Actual = Actual Output × Standard
Recovered Output × Standard Overhead Rate Overhead Rate
Overhead)
Standard = Actual Hours × Standard = Standard Output for Actual
Overhead Overhead Rate Hours × Standard Overhead Rate

Budgeted = Budgeted Hours × Standard = Budgeted Output × Standard

Overhead Overhead Rate Overhead Rate

Actual = Actual Hours × Actual = Actual Output × Actual

Overhead Overhead Rate Overhead Rate
SHAO= Budgeted Hours × AO SOAH= Budgeted Output × AH
SHAO/SOAH Budgeted Output Budgeted Hours

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Overhead Cost Variance:

It is the difference between total standard overhead cost absorbed in the output achieved
and the actual overhead cost. It is calculated as:

Overhead
Cost = Absorbed Overhead - Actual Overhead
Variance
Standard Hours × Standard Overhead
OCV = - Actual Overhead
for Actual Output Absorption Rate

Division of Overhead Cost Variance:

 Variable Overhead Variance
 Fixed Overhead Variance

Variable Overhead Cost

Variance (VOCV)

Variable Overhead Variable Overhead

Expenditure Variance Efficiency Variance
(VOEV) (VOEV)

3.2 VARIABLE OVERHEAD COST VARIANCE

It is the difference between Absorbed Variable Overhead and Actual Variable Overhead.
It is calculated as:

Variable
Overhead
= (Absorbed Variable Overhead - Actual Variable Overhead )
Cost
Variance
(Standard Hours for Actual Output × Standard Variable Overhead Rate) -
=
Actual Variable Overhead
Or (SHAO × SVOR) - (AH × AVOR)

Division of Overhead Cost Variance:

 Variable Expenditure Overhead Variance
 Variable Efficiency Overhead Variance

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3.2.1 Variable Overhead Expenditure Variance

It is that portion of Variable Overhead Cost Variance which arises due to the difference
between Standard Variable Overhead allowed and Actual Variable Overhead incurred. It
is calculated as:

Variable
Overhead
= (Standard Variable Overhead - Actual Variable Overhead )
Expenditure
Variance
(Actual Hours × Standard Variable Overhead Rate) - (Actual Hours ×
=
Actual Variable Overhead Rate)
or (AH × SVOR) - (AH × AVOR)

3.2.2 Variable Overhead Efficiency Variance

It is that portion of Variable Overhead Cost Variance which arises due to the difference
between Standard Hours for Actual Output and Actual Hours. It is calculated as:

Variable
Overhead
= (Absorbed Variable Overhead - Standard Variable Overhead)
Efficiency
Variance
(Standard Hours for Actual Output × Standard Variable Overhead Rate) -
=
(Actual Hours × Standard Variable Overhead Rate)
or (SHAO × SVOR) - (AH × SVOR)

Fixed Overhead
Cost Variance
(FOCV)

Fixed Overhead Fixed Overhead

Expenditure Volume
Variance (FOEV) Variance (FOVV)

Fixed Overhead Fixed Overhead Fixed Overhead

Efficiency Capacity Calender
Variance (FOEV) Variance (FOCV) Variance (FOCV)

3.3 FIXED OVERHEAD COST VARIANCE

It is the difference between Total Standard Fixed Overhead Absorbed and Total Actual
Fixed Overhead incurred. It is calculated as:

111
Fixed
Overhead
= (Absorbed Fixed Overhead - Actual Fixed Overhead )
Cost
Variance
(Standard Hours for Actual Output × Standard Fixed Overhead Rate) -
=
(Actual Hours × Actual Fixed Overhead Rate)
Or (SHAO × SFOR) - (AH × AFOR)

Division of Fixed Overhead Cost Variance:

 Fixed Overhead Expenditure Variance
 Fixed Overhead Volume Variance

3.3.1 Fixed Overhead Expenditure Variance

It is that portion of Fixed Overhead Cost Variance which arises due to the difference
between Budgeted Fixed Overhead and Actual Fixed Overhead incurred. It is also known
as Spending or Budget Variance. It is calculated as:

Fixed
Overhead
= (Budgeted Fixed Overhead - Actual Fixed Overhead )
Expenditure
Variance
(Budgeted Hours × Standard Fixed Overhead Rate) - (Actual Hours ×
=
Actual Fixed Overhead Rate)
or (BH × SFOR) - (AH × AFOR)

Reasons for Fixed Overhead Expenditure Variance:

 Rise in general price level
 Changes in production methods
 Ineffective control

3.3.2 Fixed Overhead Volume Variance

It is that portion of Fixed Overhead Cost Variance which arises due to the difference
between Standard Hours for Actual Output and Budgeted Hours. It is calculated as:

Fixed
Overhead
= (Absorbed Fixed Overhead - Budgeted Fixed Overhead )
Volume
Variance
(Standard Hours for Actual Output × Standard Fixed Overhead Rate) -
=
(Budgeted Hours × Standard Fixed Overhead Rate)
Or (SHAO - BH) × SFOR

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Reasons for Fixed Overhead Volume Variance:
 Poor efficiency of workers
 Poor efficiency of machinery
 Lack of orders
 Shortage of power
 Ineffective supervision
 More or less working days.

3.3.2.1 Fixed Overhead Efficiency Variance: It is that portion of Fixed Overhead

Volume Variance which arises due to the difference between Standard Hours for Actual
Output and Actual Hours. It is calculated as:

Fixed
Overhead
= (Absorbed Fixed Overhead - Standard Fixed Overhead )
Efficiency
Variance
(Standard Hours for Actual Output × Standard Fixed Overhead Rate) -
=
(Actual Hours × Standard Fixed Overhead Rate)
or (SHAO - AH) × SFOR

3.3.2.2 Fixed Overhead Capacity Variance: It is that portion of Fixed Overhead

Volume Variance which arises due to the difference between Actual Hours and Budgeted
Hours. This variance arises when plant capacity actually utilized is more or less than the
capacity planned to be utilized due to factors like idle time, under or over customer
demand, strikes, power failure etc. It is calculated as:

Fixed
Overhead
= (Standard Fixed Overhead - Budgeted Fixed Overhead )
Capacity
Variance
(Actual Hours × Standard Fixed Overhead Rate) - (Budgeted Hours ×
=
Standard Fixed Overhead Rate)
Or (AH - BH) × SFOR

Reasons for Fixed Overhead Expenditure Variance:

 Shortage of Material
 Shortage of Labour
 Shortage of Power
 Machine Break Down

113
3.3.2.3 Fixed Overhead Calender Variance: It is that portion of Fixed Overhead
Volume Variance which arises due to the difference between Actual Number of Working
Days and Budgeted Number of Working Days. It is calculated as:

= (Revised Budgeted Fixed Overhead - Budgeted Fixed Overhead )

Fixed = (Revised Budgeted Hours - Budgeted Hours) × Standard Rate per hour
Overhead
Calender Where Revised Budgeted Hours
Variance = Budgeted Hours × Actual Number of Working Days
Budgeted Number of Working Days

(Actual Number of Working Days - Standard Number of Working Days) ×

OR
Standard Rate per day

3.3.2.4 Revised Fixed Overhead Capacity Variance: When Calender Variance is

to be calculated, the method of calculating capacity variance has to be modified. It is
calculated as follows:

Revised
Fixed = (Standard Fixed Overhead - Revised Budgeted Fixed Overhead )
Overhead
Capacity = (Actual Hours - Revised Budgeted Hours) × Standard Fixed Overhead Rate
Variance
Or (AH - RBH) × SFOR

Illustration 1: A factory supplies figures of production and overheads for a month:

Budget Actual
Production (units) 50,000 52,000
Variable overheads(Rs.) 4,00,000 4,10,000
Fixed overheads (Rs.) 6,00,000 6,20,000
Number of hours 2,00,000 2,20,000

Work out variances that are involved. (CS Final)

Solution: VARIABLE OVERHEADS VARIANCE

(i) Variable Overhead Expenditure Variance
= Recovered Variable Overheads - Actual Variable Overheads
Or (Standard Variable overheads on actual production - actual variable overheads)
[(52,000 × 4,00,000) / 50,000 - 4,10,000]
= Rs. 6,000 (F)
(ii) Fixed Overhead Expenditure Variance
(Budgeted Overheads - Actual Overheads)

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 = (Rs. 6,00,000 - 6,20,000)
= Rs. 20,000 (A)
(iii) Volume Variance
= Recovered Overheads - Budgeted Overheads
= Rs. (6,00,000/50,000) × 52,000 - Rs. 6,00,000
= Rs. 24,000 (F)
(iv) Capacity Variance
= Standard Overheads - Budgeted Overhead
= [(Budgeted Output/Budgeted Hours) × Actual Hours - 6,00,000]
= (12 × (50,000/2,00,000) × 2,20,000 - 6,00,000]
= Rs. 60,000 (F)
(v) Efficiency Variance
= Recovered Overheads - Standard Overheads
= Rs. 6,24,000 - 6,60,000*
= Rs. 36,000 (F)
*reverse signs are applied

Illustration 2: Ridham Ltd. has furnished you the following data:

Budget Actual (July, 1991)

No. of working days 25 27
Production in units 20,000 22,000
Fixed overheads Rs. 30,000 Rs. 31,000

(i) Budgeted fixed overhead rate Re. 1 per hour.

(ii) In July, 1991, actual hours worked 31,500.
Calculate the following variances:
(i) Efficiency variance
(ii) Capacity variance
(iii) Calendar variance
(iv) Volume variance
(v) Expenditure variance
(vi) Total overhead variance [CA Inter]

Solution: BASIC CALCULATIONS

(a) Budgeted hours = Rs. 30,000 / Re. 1 i.e. 30,000 hours
(b) Actual hours = 31,500 hours
(c) Standard hours = (30,000/20,000) × 22,000 = 33,000 hours
(d) Possible hours = (27/25) × 30,000 = 32,400 hours
(e) Budgeted fixed overheads = Rs. 30,000
(f) Actual fixed overheads = Rs. 31,000
(g) Standard fixed overhead = Rs. (30,000 × 22,000) / 20,000 = Rs. 33,000
(h) Standard rate per hour = Re. 1

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(1) Efficiency Variance = SR × (SH - AH)
= 1.00 × (33,000 - 31,500)
= Rs. 1,500 (F)
(2) Capacity Variance = SR × (BH - AH)
= 1.00 (30,000 - 31,500)
= Rs. 1,500 (F)
(3) Revised Capacity Variance = SR × (PH - AH)
= Re. 1 (32,400 - 31,500)
= Rs. 900 (A)
(4) Calendar Variance = SR × (BH - PH)
= 1.00 × (30,000 - 32,400)
= Rs. 2,400 (F)
(5) Volume Variance = SR × (BH - SH)
= 1.00 × (30,000 - 33,000)
= Rs. 3,000 (F)
(6) Expenditure Variance = BFO - AFO
= Rs. 30,000 - 31,000
= Rs. 1,000 (A)
(7) Total Overhead Variance = SFO - AFO
= Rs. 33,000 - 31,000
= Rs. 2,000 (F)
Reconciliation I
Total overhead variance = Expenditure Variance + volume variance
Rs. 2,000 (F) = Rs. 1,000 (A) + Rs. 3,000 (F)
Reconciliation II
Volume Variance = Efficiency Variance + Capacity Variance
Rs. 3,000 (F) = Rs. 1,500 (F) + Rs. 1,500 (F)
Reconciliation III
Capacity Variance = Revised Capacity Variance + Calendar Variance
Rs. 1,500 (F) = Rs. 900 (A) + Rs. 2,400 (F)
Final reconciliation
Total Overhead Variance = Expenditure Variance + Efficiency Variance + Revised
Capacity Variance + Calendar Variance
Rs. 2,000 (F) = Rs. 1,000(A) + 1,500 (F) + 900 (A) + 2,400 (F)

Illustration 3: Find out variable overheads variances from the following:

Budgeted variable overheads for January Rs. 8,000
Budgeted production for the month 500 units
Standard time for one unit of production 10 hours
Actual variable overheads Rs. 6,600
Actual production for the month 400 units

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Actual hours worked Rs. 3,800 hours

Solution: Standard variable overhead rate per unit = Rs. 16

Standard Variable overhead rate per hour = Rs. 8,000 = Rs. 1.60
500 × 10
Computation of variable overhead variances
Rs.
(a) Actual variable overheads during the period 6,600
(b) Actual hours worked × Standard Variable overhead Rate per hour 6,080
(3,800 hrs. × Rs. 1.60)
(c) Actual production × Standard Variable overhead Rate per unit 6,400
(400 units × Rs. 16)

Variable overhead variances:

(i) Expenditure Variances (a - b) Rs. 520 (A)
(ii) Efficiency Variance (b - c) Rs. 320 (F)
(iii) Total Variable Overheads Variance (a - c) Rs. 200 (A)

By application of formula:
(i) Variable Overheads Variance = (SVO - AVO)
= Rs. 6,400 - Rs. 6,600 = Rs. 200 (A)
(ii) Expenditure Variance = (AT × SR ) - AVO
= (3,800 Hrs. × Rs. 1.60) - Rs. 6,600
= Rs. 6,080 - Rs. 6,600 = Rs. 520 (A)
(iii) Efficiency Variance = Standard Overhead Rate (Actual Hours - Standard Hours
for Actual Production)
= Rs. 1.60 (3,800 Hrs. - 4,000 Hrs.)
= Rs. 320 (F)

3.4 SALES VARIANCE

Sales Variances

Turnover
Margin Method
Method

Price Volume Price Volume

Variance Variance Variance Variance

Mix Quantity Mix Quantity

Variance Variance Variance Variance

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 The analysis of variances will be complete only when the difference between the
actual profit and standard profit is fully analyzed. As profit is difference between sales
and cost. While cost variances are concerned with cost and their effect on budgeted profit
due to favourable or adverse variances, the sales variances affect the budgeted profit due
to changes in sales revenue i.e. changes caused by either a change in selling prices or
sales quantities.

Sales variance can be calculated by two methods:

(1) Turnover (or Value) Method
(2) Margin (or profit) Method

3.4.1 Turnover Method or Value Method

The following variances are calculated under this method:

3.4.1.1 Sales Value Variance: This Variance refers to the difference between
budgeted sales and actual sales. It may be calculated as follows:

= Actual Value of Sales - Budgeted Value of Sales

Sales Value = (Actual Sales Quantity × Actual Selling Price) - (Budgeted Sales
Variance Quantity × Budgeted Selling Price)
= (AQ × AP) - (SQ × SP)

Interpretation of Sales Value Variance:

 If the Actual Sales is more than Budgeted Sales, it will be favourable variance. It
represents positive (+) symbol.
 If the Actual Sales is more than Budgeted Sales, it will be adverse variance. It
represents negative (-) symbol.

Reason for Sales Value Variance:

 Change in selling price of the product or
 Change in quantity of the product or
 Change in selling price and quantity of the product

Division of Sales Value Variance:

 Sales Price Variance
 Sales Volume Variance

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3.4.1.2 Sales Price Variance: This Variance is that portion of Sales Value Variance
which occurs due to the difference between Actual selling Price and Budgeted Selling
Price. It may be calculated as follows:

= Actual Sales - Standard Sales

Sales Price = (Actual Quantity × Actual Price) - (Actual Quantity × Standard
Variance Price)
= (AQ × AP) - (AQ × SP) = (AP - SP) × AQ

Interpretation of Sales Price Variance:

 If the Actual Price is more than Budgeted Price, it will be favourable variance. It
represents positive (+) symbol.
 If the Actual Price is more than Budgeted Price, it will be adverse variance. It
represents negative (-) symbol.

Reason for Sales Price Variance:

 Change in the market price
 Not giving cash discounts
 Change in the delivery cost

3.4.1.3 Sales Volume Variance: This Variance is that portion of Sales Value
Variance which occurs due to the difference between Actual Sales Quantity sold and
Budgeted Sales Quantity specified. It may be calculated as follows:

= Standard Sales - Budgeted Sales

Sales Volume = (Actual Quantity × Standard Price) - (Standard Quantity ×
Variance Standard Price)
= (AQ × SP) - (SQ × SP) = (AQ - SQ) × SP

Interpretation of Sales Volume Variance:

 If the Actual Quantity is more than Budgeted Quantity, it will be favourable
variance. It represents positive (+) symbol.
 If the Actual Quantity is more than Budgeted Quantity, it will be adverse variance.
It represents negative (-) symbol.

Reason for Sales Volume Variance:

 Use of non-standard products
 Use of non-standard sales mixture
 Pilferage

119
  Change in the quality of the product
 Use of substitute products

Division of Sales Value Variance:

 Sales Mix Variance
 Sales Quantity Variance

3.4.1.4 Sales Mix Variance: This Variance is that portion of Sales Volume Variance
which occurs due to the difference between standard value of revised mix and standard
value of actual mix. It occurs due to changes in sales mix of different product. It may be
calculated as follows:

= Standard Sales - Revised Standard Sales

Sales = (Actual Quantity × Standard Price) - (Revised Standard Quantity × Standard
Mix Price)
Variance
= (AQ × SP) - (RSQ × SP) = (AQ - RSQ) × SP
Where, Revised Standard Quantity

= Standard Quantity of one product × Total of actual quantities of all product

Total of Standard quantities of all product

Interpretation of Sales Mix Variance:

 If the Actual Quantity is more than Revised Standard Quantity, it will be

favourable variance. It represents positive (+) symbol.
 If the Actual Quantity is more than Revised Standard Quantity, it will be adverse
variance. It represents negative (-) symbol.

3.4.1.5 Sales Quantity Variance: This Variance is that portion of Sales Volume
Variance which occurs due to the difference between Budgeted Sales and Revised
Standard Sales. It may be calculated as follows:

= Revised Standard Sales - Budgeted Sales

Sales = (Revised Standard Quantity × Standard Price) - (Standard Quantity ×
Mix Standard Price)
Variance
= (RSQ × SP) - (SQ × SP) = (RSQ - SQ) × SP
Where, Revised Standard Quantity

= Standard Quantity of one product × Total of actual quantities of all product

Total of Standard quantities of all product

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3.4.2 Margin Method or Profit Method

This method studies the effect of changes in sale quantities and selling prices on the
profits of the company. The sales management is interested in knowing sales margin
variance. Under this method, the following variances are calculated:

3.4.2.1 Total Sales Margin Variance: This is the difference between the actual
value of sales margin and budgeted value of sales margin. It is calculated as follows:

Total Sales
Margin = Actual Profit - Budgeted Profit
Variance
= (Actual Quantity × Actual Profit per unit) - (Standard Quantity ×
Standard Profit per unit)

Division of Sales Margin Variance:

 Sales Margin Price Variance
 Sales Margin Volume Variance

3.4.2.2 Sales Margin Price Variance: This is that portion of the total Sales Margin
Variance that arises due to the difference between the actual profit and standard profit. It
is calculated as follows:

Sales = Actual Profit - Standard Profit

Margin Price
Variance = (Actual Profit per unit - Standard Profit per unit) × Actual Quantity Sold

3.4.2.3 Sales Margin Volume Variance: This is that portion of the total Sales
Margin Variance that arises due to the difference between standard profit and Budgeted
profit. It is calculated as follows:

Sales
= Standard Profit - Budgeted Profit
Margin
Volume
= (Actual Quantity - Standard Quantity) × Standard Profit per unit
Variance

Division of Sales Margin Volume Variance:

 Sales Margin Mix Variance
 Sales Margin Quantity Variance

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3.4.2.4 Sales Margin Mix Variance: This is that portion of the Sales Margin
Volume Variance that arises due to the difference between Standard Profit and Revised
Standard profit. It is calculated as follows:

= Standard Profit - Revised Standard Profit

Sales
Margin = (Actual Quantity × Standard Profit Per Unit) - (Revised Standard Quantity ×
Mix Standard Profit Per Unit)
Variance
= (AQ × SP) - (RSQ × SP) = (AQ - RSQ) × SP

Where, Revised Standard Quantity

= Standard Quantity of one product × Total of actual quantities of all product

Total of Standard quantities of all product

3.4.2.5 Sales Margin Quantity Variance: This Variance is that portion of Sales
Margin Volume Variance which occurs due to the difference between Budgeted Profit
and Revised Standard Profit. It may be calculated as follows:

= Revised Standard Profit - Budgeted Profit

Sales
Margin = (Revised Standard Quantity × Standard Profit per unit) - (Standard Quantity ×
Quantity Standard Profit per unit)
Variance
= (RSQ × SP) - (SQ × SP) = (RSQ - SQ) × SP
Where, Revised Standard Quantity

= Standard Quantity of one product × Total of actual quantities of all product

Total of Standard quantities of all product

Illustration 4: From the following figures calculate different sales variances:

Budget Actual
Product
Quantity Price Value Quantity Price Value
Rs. Rs. Rs. Rs.
X 360 60 21,600 364 59 21,476
Y 320 40 12,800 316 41 12,956
Total 34,400 34,432

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Solution: The standard value of the actual mix of sales and the standard value of the
standard mix of sales must be calculated.

Standard sales Revised Standard Sales

Product
Quantity Price Value Ratio Value
Rs. Rs. Rs.
X 364 60 21,840 216.128 21,650
Y 316 40 12,640 128.216 12,830
Total 34,480 34,480

Product X
(a) Sales Volume Variance: (SS - BS) Rs.
= Rs. 21,840 - 21,600 = 240 (F)
(b) Sales Price Variance: (AS - SS)
= Rs. 21,476 - 21,840 = 364 (A)
(c) Sales Volume Variance: (AS - BS)
= Rs. 21,476 - 21,600 = 124 (A)
(d) Sales Quantity Variance: (RSS - BS)
= Rs. 21,650 - 21,600 = 50 (F)
(e) Sales Mix Variance: (SS - RSS)
= Rs. 21,840 - 21,650 = 190 (F)
Check:
(i) Value Variance = Price Variance + Volume Variance
Rs. 124 (A) = Rs. 364 (A) + Rs. 240 (F)
(ii) Volume Variance = Quantity Variance + Mix Variance
Rs. 240 (F) = Rs. 50 (F) + Rs. 190 (F)

Product Y
(a) Sales Volume Variance = (SS - BS) Rs.
= Rs. 12,640 - 12,800 =160 (A)
(b) Sales Price Variance = (BS - AS)
= Rs. 12,956 - 12,640 = 316 (F)
(c) Sales value variance = (AS - BS)
= Rs. 12,956 - 12,800 = 156 (F)
(d) Sales Quantity Variance = (RSS - BS)
= Rs. 12,830 - 12,800 = 30 (F)
(e) Sales Mix Variance = (SS - RSS)
= Rs. 12,640 - 12,830 = 190 (A)

Check:
(i) Value Variance = Price Variance + Volume Variance
Rs. 156 (F) = Rs. 316 (F) + Rs. 160 (A)

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(ii) Value Variance = Quantity Variance + Mix Variance
Rs. 160 (A) = Rs. 30 (F) + Rs. 190 (A)

3.5 ACCOUNTING TREATMENT OF VARIANCES

The cost records maintained and entries made under a system of standard costing
vary from company to company depending upon the information that is desired from cost
records, and the intended use of standard cost and variance analysis. Variances which
emerge in standard costing and recorded in the cost books may be disposed of in any of
the following ways:

(i) Transfer to costing profit and loss account: In this method, the stock of work-in-
progress, finished goods and cost of sales are maintained at standard cost and all
variances are charged to costing profit and loss account at the end of the accounting
period. This method is favoured because standard costs facilities prompt inventory
valuation and also variances are separated out so as to attract the attention of the
management.

(ii) Allocation of variances to finished stock, work-in-progress and cost of sales

account: Under this method the variances are distributed over stocks of finished goods,
work-in-progress and to cost of sales account in proportion to the closing balances (value)
of each account depending upon the type of variance.

(iii) Transfer to reserve account: In this method favourable variances are carried
forward as deferred credits until they are set-off by adverse variances. It is considered that
controllable variances according to method (ii).

3.6 CONTROL RATIOS

In addition to variances, Control Ratios are also used by management for the purpose
of controlling. It is expressed in %. If the ratio is 100% or more, it indicates a favourable
position and versa, if the ratio is less than 100%. It indicates unfavorable position. Three
important control ratios are as follows:

(1) Efficiency Ratio: It is defined as “the standard hours equivalent to the work
produced expressed as a percentage of actual hours spent in production”. It is
calculated as:
Efficiency Ratio = Standard hours for actual output × 100
Actual Hours worked

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 (2) Activity Ratio: It is defined as “the standard hours equivalent to the work
produced, expressed as percentage of budgeted standard hours”. It is calculated as:
Activity Ratio = Standard hours for actual output × 100
Budgetary Hours

(3) Capacity Ratio: It shows the relationship between actual hours worked and the
budgeted hours. It is calculated as:
Capacity Ratio = Actual hours worked × 100
Budgetary Hours

(4) Calender Ratio: Calender Ratio indicates the extent of actual working days
availed during the budget period. It is calculated as:
Calender Ratio = Actual number of working days in the budget period × 100
Budgeted number of working days in the budget period

Illustration 5: (A) Calculate -

(a) Efficiency ratio
(b) Activity ratio
(c) Capacity ratio

From the following figures:

Budgeted production 88 units

Standard hours per unit 10
Actual production 75 units
Actual working hours 600
[B.Com (Hons), Delhi]
Solution:
(a) Efficiency ratio = Standard Hours for Actual Production × 10
Actual Hours Worked
= (75 units @ 10 hours) × 100 = 750 ×100
600 600
= 125%

(b) Activity Ratio = Standard Hours for Actual Production ×100

Budgeted hours
= 750 ×100
880
= 85.23%
(c) Capacity Ratio = Actual Hours Worked ×100
Budgeted hours

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 = 600 × 100
880
= 68.18%

Illustration 5: (B) In M/s Pandavs, 3,000 jars of mixed pickles can be filled in one hour,
5,000 jars, of pickled onion can be filled in one hour and 10,000 bottles of sauce can be
filled in one hour. The budgeted and actual production for December, 1989 was as
follows:
Budget Actual
Mixed pickles 1,92,000 jars 2,02,500 jars
Pickled onions 3,00,000 jars 3,20,000 jars
Sauce 3,60,000 bottles 4,00,000 bottles

The clock hours for the month were 160. Express the budgeted and actual production in
standard hours and calculate the efficiency.

Answers: STATEMENT OF STANDARD HOURS AND EFFICIENCY

Particulars Budgeted standard hours Actual standard hours

Mixed pickles 1,92,000/3,000 = 64 hr 2,02,500/3,000 = 67.5 hr
Pickled onions 3,00,000/5,000 = 60 hr 3,20,000/5,000 = 64 hr
Sauce 3,60,000/10,000 = 36 hr 4,00,000/10,000 = 40 hr
Total 160 hours 171.5 hours

Efficiency ratio = Actual Production in Terms of Standard Hours × 100

Actual hours worked

= 171.5 × 100 = 107.1875%

160

Illustration 6: Nagaro Ltd. produces two commodities. Good and Better, in one of its
departments. Each unit takes 5 hours and 10 hours as production time, respectively. 1,000
units of Good and 600 units of Better were produced during March 1991. Actual man
hours spent in this production were 10,000. Yearly budgeted hours are 96,000. Compute
the various control ratios.

Solution: BASIC CALCULATION

(i) Budgeted hours = 96,000/ 12 hours i.e. 8,000 hours
(ii) Actual hours worked: 10,000 hours
(iii) Standard hours: (a) Good 1,000 × 5 = 5,000
(b) Better 600 ×10 = 6,000
11,000 hours
CONTROL RATIOS
(a) Activity Ratio = Standard Hours For Actual Production × 100
Budgeted Hours

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 = (11,000/ 8,000) × 100 i.e. 137.5%

(b) Capacity Ratio = Actual Hours Worked × 100

Budgeted Hours
= (10,000/ 8,000) × 100 = 125%

(c) Efficiency Ratio = Standard Hours For Actual Production × 100

Actual Hours Worked
= (11,000/ 10,000) × 100 = 110%

3.8 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) Sales margin variance due to sales quantities is measured as

(a) Standard profit - Revised standard profit
(b) Revised standard profit - Budgeted profit
(c) Standard profit + Revised standard profit
(d) Revised standard profit + Budgeted profit

(2) The formula to estimate the sales margin variance due to sales mixture is
(a) Standard profit - Revised standard profit
(b) Revised standard profit - Budgeted profit
(c) Standard profit + Revised standard profit
(d) Revised standard profit + Budgeted profit

(3) Sales margin variance due to volume can be classified into ___ parts.
(a) 3
(b) 2
(c) 4
(d) 5

(4) Analysis of overhead variances can be done by

(a) Two variance method
(b) Three variance method
(c) Four variance method
(d) All of the above

Answers: (1) (b), (2) (a), (3) (b), (4) (d)

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EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. State the meaning, method of computation and causes of:

(a) Variable Overhead Cost Variance
(b) Variable Overhead Efficiency Variance
(c) Variable Overhead Expenditure Variance
(d) Fixed Overhead Cost Variance
(e) Fixed Overhead Expenditure Variance
(f) Fixed Overhead Volume Variance
(g) Fixed Overhead Efficiency Variance
(h) Fixed Overhead Capacity Variance
(i) Fixed Overhead Calender Variance
(j) Overhead Cost Variance

Q2. State the meaning, method of computation and causes of:

(a) Sales Value Variance
(b) Sales Price Variance
(c) Sales Volume Variance
(d) Sales Mix Variance
(e) Sales Quantity Variance

Q3. What do you understand by the following:

(a) Efficiency Ratio
(b) Activity Ratio
(c) Capacity Ratio

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. From the following calculate fixed overhead expenditure and volume variances:

Budgeted fixed overhead for the month of November Rs. 1,00,000

Budgeted production for the month: 50,000 units
Actual production for the month: 54,000 units
Actual fixed overhead for the month: Rs. 1,20,000
(M.Com, Madras)

Answers: Expenditure variance Rs. 20,000 (A), Volume Variance Rs. 8,000 (F)

Q2. The following information is available from the records of a company:

Budgeted Actual
Fixed overhead for January Rs. 10,000 12,000
Production in January 2,000 2,100

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Standard time per unit (hrs.) 10 -
Actual hours worked in January (hrs.) - 22,000

Compute:
(1) Fixed overhead cost variance
(2) Expenditure variance
(3) Volume variance
(4) Capacity Variance
(5) Efficiency variance

Answers: (1) Rs. 1500 (A), (2) Rs. 2,000 (A), (3) Rs. 500 (F) (4) Rs. 1,000 (F), (5) Rs.
500 (A)

Q3. Budgeted and actual sales for the month of March, 2016 of two products X and Y of
ABC Ltd. were as follows:

Sales Price p.u. Actual Price p.u.

Product Budgeted Units Actual Units
(in Rs.) (in Rs.)
5,000 5
X 6,000 5
1,500 4.75
7,500 2
Y 10,000 2
1,750 1.9

Budgeted Costs for the product X and Y were Rs. 4 and Rs. 1.50 per unit respectively.
Work out from the above data the following variances:

(1) Sales value variance

(2) Sales volume variance
(3) Sales price variance
(4) Sales mixture variance
(5) Sales quantity variance

Answers: (1) Rs. 450 (F) (2) Rs. 550 (A) (3) Rs. 1,000 (F) (4) 1,782 (F), (5) Rs. 782
(A)

Q4. ABC Ltd. Manufactures two products A and B. Product A takes 6 hours to make
while Product B takes 12 hours. In a month of 25 days of 8 hours each, 1200 units of A
and 750 units of B were produced. The firm employs 75 men in the department
responsible for producing these two products. The budgeted hours are 1,86,000 per
annum. You are required to calculate activity ratio, capacity ration and efficiency ratio.
(ICWA, Inter June, 1990)

Answers: Activity ratio 104.5%, Capacity ratio 96.8%, Efficiency ratio 108%

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Q5. Calculate:
(1) Efficiency ratio
(2) Capacity ratio from the following figures:

Budgeted production 80 units

Actual production 60 units
Standard time per unit 8 hours
Actual hours worked 500 [B.Com (Hons), Delhi]
Answers: (1) Efficiency ratio 96%; (2) Capacity ratio 78.12%

Q6. Argon Ltd. furnishes the following information relating to budgeted sales and actual
sales for the month of March, 2017:

Product Sales Quantity units Sales Price Per unit

Budgeted Sales: A 1,200 15
B 800 20
C 2,000 40
Actual Sales: A 880 18
B 880 20
C 2,640 38

You are required to calculate:

(1) Sales price variance
(2) Sales volume variance
(3) Sales mix variance
(4) Total sales value variance
(5) Assume products to be homogeneous [B.Com (Hons), Delhi]

Answers: (1) Sales price variance Rs. 2,640 (A), (2) Sales volume variance Rs. 22,400
(F), (3) Sales mix variance Rs. 11,000 (F), (4) Total sales value variance Rs. 19,760 (F)

Q7. A factory supplies figures of production and overheads for a month:

Budgeted Actual
Production (Units) 50,000 52,000
Variable Overheads (Rs.) 4,00,000 4,10,000
Fixed Overhead (Rs.) 6,00,000 6,20,000
Number of hours 2,00,000 2,20,000

Work out all variance that are involved. (CS Final)

Answers: (1) Variable Overhead expenditure variance Rs. 6,000 (F) (2) Fixed Overhead
expenditure Rs. 20,000 (F) (3) Volume Variance Rs. 24,000 (F) (4) Capacity Variance
Rs. 60,000 (F) (5) Efficiency Variance Rs. 36,000 (F)

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Q8. Calculate the following:
(i) Efficiency Ratio
(ii) Activity Ratio
(iii) Capacity Ratio
Details Units per hour
Budget production (units) 880
Standard hours per unit 10
Actual production 750
Actual working hours 6,000
[B.com (Hons), Delhi]

Ans: (i) ER = 125%, (ii) AR = 85.23%, (iii) CR = 68.18%

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 LESSON 1 UNIT 4

ABSORPTION COSTING VERSUS VARIABLE COSTING

1. STRUCTURE

1.0 Learning Objectives

1.1 Introduction
1.2 Prior Knowledge Required
1.2.1 Variable Costs Vs Fixed Costs
1.2.2 Product Costs and Period Costs
1.2.3 Manufacturing Costs and Non-Manufacturing Costs
1.3 Absorption Costing
1.3.1 Characteristics of Absorption Costing
1.3.2 Income Determination under Absorption Costing
1.4 Marginal Costing
1.4.1 Characteristics of Variable/Marginal Costing
1.4.2 Advantages of Marginal Costing
1.4.3 Disadvantages of Marginal Costing
1.4.4 Income Determination under Marginal Costing
1.5 Statement of Reconciliation
1.6 Difference between Absorption Costing and Marginal Costing
1.7 Difference in Profit under Absorption Costing and Marginal Costing
1.8 Self-Test Questions

1.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn the Concepts of marginal costing and absorption costing
(b) Differentiate between absorption and marginal costing
(c) Explain advantages and limitations of marginal costing
(d) Explain the difference in profit under marginal costing and absorption costing

1.1 INTRODUCTION

Marginal Costing and Absorption Costing are not a method of costing like job, batch
or contract costing but are the two main techniques of Management Accounting for
ascertaining cost and determining income of an organization. These two techniques are
often used in management accounting, for different purposes:

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 (1) Marginal Costing helps with short-term decision-making
(2) Absorption Costing is used to calculate inventory valuations and profit
calculations in financial statements

The use of each system is dependent on the information needs of the business or
organization:
 Can we afford to sell 2,000 units of our product each month to ABC Limited at a
discount of 5 per cent? (use marginal costing for decision making)
 „What profit have we made this year?‟ (use absorption costing for calculating
profit)
These costing systems use the same costs, but they are treated differently according to
their behaviour.

1.2 PRIOR KNOWLEDGE REQUIRED

Product Costs vs
Period Costs

Manufacturing
Costs vs Non- Variable Costs
Manufacturing vs Fixed Costs
Costs

1.2.1 Variable Costs Vs Fixed Costs

Variable Cost is that portion of cost which tends to vary in direct proportion to the
volume of output. When volume of output increases, total variable cost also increases,
and vice versa but the variable cost per unit remains fixed.

Fixed Cost is that portion of cost which tends to remain constant in total amount
over a specific range of activity for a specified period of time, but it does not increase or
decrease with the change in the volume of production.

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 Variable Costs Fixed Costs

Variable Cost= Direct Material+ Direct

Fixed Cost= Fixed Production OH+ Fixed
Labour+ Direct Expenses+ Variable
Administration OH+ Fixed S & D OH
Production OH+ Variable S & D OH

Fixed Cost per unit of output will vary

Variable Cost per unit is assumed to inversely with changes in the level of
remain constant at all levels of output. output. As output increases, Fixed Cost
per unit decreases and vice versa

Variable costs are incurred only when

Fixed Costs are incurred even at zero level
production takes place. Hence, no
of output.
production means no variable costs.

Variable Costs are considered as product- Fixed Costs are treated as period-related
related costs. costs.

1.2.2 Product Costs and Period Costs

Product Costs are those costs which are necessary for production and which will
not be incurred if there is no production. These costs are assigned to the product and are
included in inventory valuation. These are also called as Inventoriable Costs. These are
included in inventory valuation. They are treated as assets till the goods to which they are
assigned are actually sold. Examples: Direct Material, Direct Wages, Production OH, etc.

Period Costs are those costs which are not necessary for production and incurred
even if there is no production. These costs are not assigned to the products but are
charged as expenses against the revenue of the period in which they are incurred. As these
are not included in the value of inventory, it is also called as Non-Inventoriable Costs.
They are written off as expense in the period in which they are incurred. Examples:
General Administration Costs, Salesmen Salary, Selling Expenses, etc.

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 Recorded as an asset in the
Product Cost form of inventory in the
Balance Sheet

Recorded as an expenses in
Period Cost the Profit and Loss Account
of the current period

Figure: Product and Period Cost

In the above figure, it is showing accounting treatment of product and period

costs. Classification into product and period cost is important from the point of view of
profit determination. This is so because product cost is carried forward to the next
accounting period as part of the unsold finished stock whereas period cost is written off in
the accounting period in which it is incurred.

1.2.3 Manufacturing Costs and Non-Manufacturing Costs

These costs are apportioned on the basis of traceability of cost into direct versus
indirect costs associated with producing a product. There are three major categories of
manufacturing costs consisting of direct labor, direct material, and manufacturing
overhead. There can be Variable Manufacturing Costs and Fixed Manufacturing Costs.
Non-manufacturing Costs are fixed costs which are not associated with production. It is
also known as "period" costs, consists of selling and administrative expenses.

1.3 ABSORPTION COSTING

Absorption Costing is a conventional technique of cost ascertainment. CIMA,

London, defines the Absorption Costing as “the practice of charging all costs, both
variable and fixed to operations, processes or products”.

It is also known as 'Full Costing Technique'. It is a procedure of cost recognition

wherein costs are classified on the basis of functions as Production Costs, Administration
Costs, Selling Costs and Distribution Costs. In this type of costing system, fixed factory
overheads are absorbed on actual cost basis or on the basis of a pre-determined overhead
rate based on normal capacity. Under/Over absorbed overhead are adjusted before
computing profit for a particular period. Closing stock is valued at total cost which
includes fixed factory overhead. The figure below explains absorption costing system:

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 Direct Materials
Charged to cost Charged as
Direct Labour
Variable Factory OH of goods expenses when
Fixed Factory OH produced goods are sold

All Selling and Charged as

Administration expenses when
Overhead incurred

Figure: Absorption Costing Approach

1.3.1 Characteristics of Absorption Costing

 All costs are classified on functional basis as Production Costs, Administration

Costs, Selling Costs, and Distribution Costs.
 All variable manufacturing costs and fixed production overheads are treated as
product costs and hence are charged to operations or product.
 All Administration Costs, Selling Costs, and Distribution Costs are treated as
period costs and hence are not charged to operations or product but written off
against the profits in the period in which they arise. These are Non-Inventoriable
Costs.
 All cost of production, both Fixed and Variable, are included in inventory
valuation.
 There may be under or over absorption of factory overhead.
 Fixed cost can be charged on actual basis or at pre-determined overhead rates
based on normal capacity.

1.3.2 Income Determination under Absorption Costing

The income statement is prepared as shown below:

Income Statement under Absorption Costing

Particulars Rs. Rs.
Sales XXXX
Less: Variable Manufacturing Costs
Direct Material Consumed XXXX
Direct Labour XXXX
Variable Manufacturing Overhead XXXX
Fixed Manufacturing Overhead XXXX
Cost of goods produced XXXX
Add: Opening stock of finished goods (valued at XXXX

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 cost of previous period)
Less: Closing stock of finished goods (valued at (XXXX)
production cost of Current period)
Cost of goods sold XXXX
Add: Under absorption of Fixed Manufacturing XXXX
Overhead
Less: Over absorption of Fixed Manufacturing
Overhead
Add: Variable Office and Administration XXXX
Overhead XXXX
Variable Selling and Distribution Overhead
Total Variable Cost XXXX
Contribution (Sales-Total Variable Cost) XXXX
Less: Fixed Production Overhead XXXX
Fixed Administration Overhead XXXX
Fixed Selling and Distribution Overhead XXXX XXXX
Net Profit XXXX

1.4 MARGINAL COSTING

Marginal Cost: The CIMA London has defined the term Marginal Cost “as the amount
at any given volume of output by which the aggregate costs are charged if the volume of
output is changed by one unit.” Accordingly, it means that the added or additional cost of
an extra unit of output. For example, if the total number of units produced are 1,800 and
the total cost of production is Rs. 1,12,000, if one unit is additionally produced the total
cost of production may become Rs. 1,12,010 and if the production quantity is decreased
by one unit, the total cost may come down to Rs. 1,11,990. Thus the change in the total
cost is by Rs. 10 and hence the marginal cost is Rs. 10. The increase or decrease in the
total cost is by the same amount because the variable cost always remains constant on per
unit basis.

Marginal Costing: This technique of costing is also known as “Variable Costing”,

“Differential Costing” or “Out-of-pocket” costing.

According to CIMA Terminology Marginal Costing is the ascertainment of

marginal costs and of the effect on profit of changes in volume or type of output by
differentiating between fixed costs and variable costs in this technique of costing only
variable costs are charged to operations, processes or products leaving all indirect costs to
be written off against profits in the period in which they arise.

According to J. Batty, Marginal costing is "a technique of cost accounting pays

special attention to the behaviour of costs with changes in the volume of output." This

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definition lays emphasis on the ascertainment of marginal costs and also the effect of
changes in volume or type of output on the company's profit.

To clarify the point, let us take a simple example, suppose company X is

manufacturing three products A, B and C at present and the number of units produced are
45,000, 50,000 and 30,000 respectively p.a. If it decides to change the product mix and
decides that the production of B is to be reduced by 5,000 units and that of A should be
increased by 5,000 units, there will be impact on profits and it will be essential to measure
the same before the final decision is taken. This decision is regarding the change in the
volume of output. Now suppose if the company has to take a decision that product B
should not be produced at all and the capacity, which will be available, should be utilized
for A and B this will be change in the type of output and again the impact on profit will
have to be measured. This can be done with the help of marginal costing by preparing
comparative statement showing profits before the decision and after the decision. This is
subject to one assumption and that is the fixed cost remains constant irrespective of the
changes in the production. Thus marginal costing is a useful technique for decision-
making.

Under this technique, only variable costs are charged as product costs and
included in inventory valuation. Fixed manufacturing costs are not allotted to products
but are considered as period costs and thus charged directly to Profit and Loss Account of
that year. Fixed costs also do not enter in stock valuation.

Direct Materials Charged as

Charged to cost
Direct Labour
of goods expenses when
Variable Factory
produced goods are sold
Overhead

Fixed Factory OH
Charged as
and all Selling
expenses when
and
incurred
Administration
Overhead

Figure: Variable Costing Approach

1.4.1 Characteristics of Variable/Marginal Costing

 Division of Cost into Fixed and Variable Cost: In marginal costing, costs are
segregated into fixed and variable. Only variable costs are charged to the
production, i.e. included in the cost of production. Fixed costs are not included in
the cost of production, which means that they are not absorbed in the production.

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  Valuation of Inventory: Another important feature of marginal costing is the
valuation of inventory is done at variable cost only. This means, that variable costs
only are taken into consideration while valuing the inventory. Fixed costs are
eliminated from the inventory valuation because they are largely period costs and
relate to a particular period or year.
 Fixed costs as period costs: The fixed costs are written off soon after they are
incurred and do not find place in product cost or inventories.
 Variable costs as product costs: Only marginal or variable costs are charged to
products produced during the period.
 Contribution: Contribution is the difference between sales value and variable cost
of sales. Profitability of each department or product is determined with reference
to their contribution margin.

1.4.2 Advantages of Marginal Costing

 Simple Technique: Marginal costing system is comparatively simple to operate

because it avoids the complications involved in apportionment and recovery of
fixed overheads which is arbitrary division of indivisible fixed costs.
 Useful technique for cost control: Marginal costing is essentially useful to
management as a technique in cost analysis and cost presentation. It enables the
presentation of data in a useful manner to different levels of management for the
purpose of controlling costs. Therefore, it is an important technique in cost
control.
 Profit Planning: Future profit planning of the business enterprises can well be
carried out by marginal costing. The contribution ratio and marginal cost ratios are
very useful to ascertain the changes in selling price, variable cost etc. Thus,
marginal costing is greatly helpful in profit planning.
 No over or under absorption of overheads: It avoids the complications of over
or under absorption of fixed cost by excluding it from cost of production.
 Clear Relationships: It establishes a clear relationship between cost, sales and
volume of put and break even analysis which shows the effect of increasing or
decreasing production activity on the profitability of the company.
 Apart from the above, numerous managerial decisions can be taken with the help
of marginal costing, some of which, may be as follows:-
o Make or buy decisions,
o Exploring foreign markets,
o Accept an order or not,
o Determination of selling price in different conditions,
o Replace one product with some other product,
o Optimum utilization of labour or machine hours,
o Evaluation of alternative choices,

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 o Subcontract some of the production processes or not,
o Expand the business or not,
o Diversification,
o Shutdown or continue.

1.4.3 Disadvantages of Marginal Costing

 Difficult Analysis of Cost: The separation of costs into fixed and variable
present„s technical difficulties and no variable cost is completely variable nor is a
fixed cost completely fixed.
 Under Valuation of Stock: Under the marginal cost system, stock of finished
goods and work-in-progress are understated. After all, fixed costs are incurred in
order to manufacture products and as such, these should form a part of the cost of
the products. It is, therefore, not correct to eliminate fixed costs from finished
stock and work-in-progress.
 Affect the profit: The exclusion of fixed manufacturing overhead from the
valuation of inventories affects the Profit and Loss Account. Unless adjustments
are made in the financial accounts at the end of the period, this way it can
produces an unrealistic and conservative Balance Sheet.
 Misleading: During the earlier stages of a period of recession, the low profits or
increase in losses, as revealed in a magnified way in the marginal costs statements,
may unduly create panic and compel the management to take action that may lead
to further depression of the market.
 Useful for short term: Though for short-term assessment of profitability marginal
costs may be useful, long term profit is correctly determined on full costs basis
only.
 Ignore cost of developments: With increased automation and technological
developments, the impact on fixed costs on products is much more than that of
variable costs. A costing system which ignores fixed costs of these developments
is therefore, less effective because a major portion of the cost, such as not taken
care of.
 No evaluation of performance: Marginal Costing does not provide any standard
for the evaluation of performance. A system of budgetary control and standard
costing provides more effective control than that obtained by marginal costing.

1.4.4 Income Determination under Marginal Costing

The income statement is prepared as shown below:

Income Statement under Marginal Costing

Particulars Rs. Rs.
Sales XXXX

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Less: Variable Manufacturing Costs
Direct Material Consumed XXXX
Direct Labour XXXX
Variable Manufacturing Overhead XXXX
Cost of goods produced XXXX
Add: Opening stock of finished goods (valued at XXXX
variable cost of previous period)
Less: Closing stock of finished goods (valued at (XXXX)
variable cost of Current period)
Cost of goods sold XXXX
Add: Variable Office and Administration XXXX
Overhead XXXX
Variable Selling and Distribution Overhead
Total Variable Cost XXXX
Contribution (Sales-Total Variable Cost) XXXX
Less: Fixed Production Overhead XXXX
Fixed Administration Overhead XXXX
Fixed Selling and Distribution Overhead XXXX XXXX
Net Profit XXXX

1.5 STATEMENT OF RECONCILIATION

Reconciliation of Profit under Marginal Costing with the Profit under Absorption Costing

Particulars Rs.
(a) Profit under Marginal Costing XXXX
(b) Add: Fixed Manufacturing Overhead included in Closing Stock XXXX
(c) Less: Fixed Manufacturing Overhead included in Opening Stock XXXX
(d) Profit under Absorption Costing XXXX

1.6 DIFFERENCE BETWEEN ABSORPTION COSTING AND

MARGINAL COSTING

Basis Absorption Costing Marginal Costing

Classification Costs are classified according to
of costs functional basis such
production cost, administration
cost, selling and distribution cost.
Product Costs All variable manufacturing and
fixed production overheads are
treated as product cost and
charged to product, processes or
operations.
Period Costs Only administration, selling and
distribution overheads are treated
Costs are classified according to
as variability i.e. Fixed and Variable.
Only variable manufacturing costs are
treated as product costs and hence,
are charged to products, processes or
operations.
All fixed costs i.e. Production/
Administration/ Selling/ Distribution

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 Basis Absorption Costing
as period costs and are written off
against the profits in the period in
which they arise.
Valuation of Stock of work-in-progress and
Stock finished goods are valued at full
or total cost. Fixed cost is carried
over from one period to another
period which distorts cost
comparison.
Profit The difference between sales and
Calculation total cost constitute profit.
Over/ Under The fixed overhead absorption
Absorption may create some problems like
over/ under absorption. This
happens because of the overhead
absorption rate which is pre-
determined. Suitable corrective
entries are to be made to rectify
the over/under absorption of
overheads; otherwise the cost of
production will be distorted.
Basis of Managerial Decisions are based Managerial Decisions are based on
Managerial on total profit i.e. excess of total contribution i.e. excess of sales
Decisions sales revenue over total costs.
Marginal Costing
Overheads are treated as period costs
and are written off against profits in
the period in which they arise.
Stock of work-in-progress and
finished goods are valued at marginal
cost. This facilitates cost comparison.
The excess of sales revenue over
variable cost is known as contribution
when fixed cost is deducted from
contribution, it results in profit.
The fixed overheads are charged
directly to the Costing Profit and Loss
Account and not absorbed in the
product units. Therefore there is no
question of under/ over absorption of
overheads.
revenue over variable costs.

1.7 DIFFERENCE IN PROFIT UNDER ABSORPTION COSTING AND

MARGINAL COSTING
Profit under these two systems may be different because of difference in valuation
method of stock. The impact on profits can be summarized as under:

When Production Quantity is

Equal to Sales Quantity More than Sales Quantity Less than Sales Quantity
 When there is no opening When production is more When production is less
and closing stock. So, than sales, it is a situation than sales, it is a situation
there will be no when closing stock will be when closing stock will be
difference between more than opening stock. less than opening stock.
profits under Absorption Then the profit as per Then the profit as per
Costing and Marginal absorption costing will be absorption costing will be
Costing. more than that shown by less than that shown by
 When opening stock is variable costing. This is due variable costing. This is due
equal to closing stock, to the reason that in to the reason that in
then also there will be no absorption costing a part of absorption costing a part of

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 difference between fixed overhead included in fixed overhead from the
profits under Absorption closing stock value is preceding period is added to
Costing and Marginal carried forward to next the current year‟s cost of
Costing. period in the form of goods sold in the form of
opening stock. opening stock.

Practical Questions:

Illustration 1: Prepare income statements under marginal costing from the following
information for the year 2003-04:

Opening stock 500 units valued at Rs. 35,000 including variable cost of Rs. 50 per
unit
Fixed cost Rs. 1,00,000
Output 5,000 units, variable cost: Rs. 60 per unit
Sales 3,000 units @ Rs. 100 per unit

Closing stock is valued on the basis of FIFO. Also explain the reason for difference in
profits in both the cases. [B.Com (Hons), Delhi]

Solution: INCOME STATEMENT UNDER ABSORPTION COSTING

Particulars Rs. Rs.

Sales (3,000 units @ Rs. 100) 3,00,000
Less: cost of sales: 35,000
Opening stock (500 units @ Rs. 70 p.u.)
Add: Cost of output
Fixed cost 1,00,000
Variable cost 3,00,000
4,35,000
Less: closing stock (FIFO) 2,500 units @ 80 per unit 2,00,000 2,35,000
Profit 65,000

INCOME STATEMENT UNDER MARGINAL COSTING

Particulars Rs. Rs.

Sales (3,000 units @ Rs. 100) 3,00,000
Less: Variable cost of sales : 25,000
Opening stock (500 units @ Rs. 50 each)
Add: cost of output (5,000 units @ Rs. 60 per unit) 3,00,000
3,25,000
Less: closing stock (2,500 units@ Rs. 60 each) 1,50,000 1,75,000
Contribution (S - V) 1,25,000
Less: Total fixed cost 1,00,000
Profit 25,000

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Reasons for difference in profit: the reason for difference in two profits is due to
valuation of opening and closing stock i.e. (35,000 - 25,000) and (2,00,000 - 1,50,000).

Illustration 2: Onkar Ltd. has a production capacity of 12,500 units and normal capacity
utilization is 80%. Opening inventory of finished goods on 1-1-1999 was 1,000 units.
During the year ending 31-12-1999, it produced 11,000 units while it sold only 10,000
units.
Standard variable cost per unit is Rs. 6.50 and standard fixed factory cost per unit is Rs.
1.50. Total fixed selling and administration overhead amounted to Rs. 10,000. The
company sells its product at Rs. 10 per unit.
Prepare Income Statements under Absorption Costing and Marginal Costing. Explain the
reasons for difference in profit, if any. [B.Com (Hons), Delhi]

Solution: INCOME STATEMENT (ABSORPTION COSTING)

Particulars Rs.
Sales (10,000 units @ Rs. 10) 1,00,000
Variable factory cost (11,000 units @ Rs. 6.50) 71,500
Fixed factory cost (11,000 units @ Rs. 1.50) 16,500
88,000
Add: opening stock (1,000 units @ Rs. 8) 8,000
96,000
Less: closing stock (2,000 units @ Rs. 8) 16,000
80,000
Less: over absorption of fixed factory overheads (1,000 units @ Rs. 1.50) 1,500
78,500
Add: fixed selling and administration overhead 10,000
Cost of sales 88,500
Profit (Sales - cost of sales) 11,500

INCOME STATEMENT (MARGINAL COSTING)

Particulars Rs.
Sales (10,000 units @ 10 ) 1,00,000
Variable cost (11,000 units @ Rs. 6.50) 71,500
Add: opening stock (1,000 units @ Rs. 6.50) 6,500
78,000
Less: closing stock (2,000 units @ Rs. 6.50) 13,000
Variable cost of goods manufactured 65,000
Contribution (1,00,000 - 65,000) 35,000
Less: Fixed cost
Factory 15,000
Selling and administration 10,000 25,000
Profit 10,000

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Reasons for difference in profits:
The difference in two profit figures arises due to differences in the basis of stock
valuation. Under absorption costing, stock is valued at total production cost per unit
inclusive of the fixed manufacturing overheads per unit whereas in marginal costing stock
is valued at variable production cost per unit. The difference is explained by the following
statement:
Reconciliation statement

Rs.
Profit as per absorption costing 11,500
Add: under valuation of opening cost in marginal costing 1,500
13,000
Less: under valuation of closing stock in marginal costing 3,000
Profit as per marginal costing 10,000

1.8 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) Marginal costing technique helps the management in deciding…

(a) Pricing
(b) To accept fresh orders at low price
(c) To make or buy
(d) All of the above

(2) The term contribution refers to…

(a) The difference between selling price and fixed cost
(b) The difference between selling price and variable cost
(c) Profit
(d) None of these

(3) The term gross margin refers to…

(a) Total profit
(b) Contribution
(c) Profit before tax
(d) Profit before interest and tax

(4) Sales Rs. 1,00,000, variable cost Rs. 60,000 and net profit ratio is 10% on sales,
find out fixed cost.
(a) 40,000
(b) 60,000
(c) 50,000
(d) The data inadequate

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(5) Under absorption costing, profit is ascertained
(a) On the basis of difference between sales and total cost.
(b) By computation as per desired rate of profit on sales or cost
(c) Both (a) and (b)
(d) None of the above.

(6) Under absorption costing among fixed expenses

(a) Fixed manufacturing expenses are included in unit cost
(b) Fixed non-manufacturing expenses are included in unit cost
(c) Both (a) and (b)
(d) None of the above

(7) Absorption costs helps in

(a) Difference between product cost and period cost
(b) Charged of fixed factory overheads on inventory
(c) Both (a) and (b)
(d) None of the above

(8) Marginal costs is taken as equal to

(a) Prime Cost plus all variable overheads
(b) Prime Cost minus all variable overheads
(c) Variable overheads
(d) None of the above

(9) Marginal cost is computed as

(a) Prime cost + All Variable overheads
(b) Direct material + Direct labor + Direct Expenses + All variable overheads
(c) Total costs - All fixed overheads
(d) All of the above

Answers: (1) (d), (2) (b), (3) (b), (4) (c), (5) (c), (6) (a), (7) (c), (8) (a), (9) (a)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) The technique of marginal costing is based on classification of cost into

____________ costs.
(b) ___________ cost not related to manufacture of a product.
(c) ______________ cost is production costs incurred in the manufacture of a
product.
(d) In marginal costing stock of finished goods is valued at ____________
(e) Both fixed and variable costs are charged to products in _____________
(f) Contribution is the difference between sales and _________________

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Answers: (a) Fixed and Variable; (b) period; (c) product; (d) marginal cost; (e)
absorption cost; (f) Variable cost

Q2. True/False Statement:

(a) Profit under marginal costing and absorption costing may differ even if there are
no opening and closing stocks.
(b) Variable costing is used mainly for internal reporting
(c) Absorption costing is not as suitable for decision-making as marginal costing.
(d) Absorption costing is a total cost technique.
(e) Variable costing is more widely used than absorption costing for external
reporting.
(f) When opening stock is more than closing stock, variable costing shows higher
profit than absorption costing.
(g) All variable cost is included in marginal cost.

Answers: (a) F, (b) T, (c) T, (d) T, (e) F, (f) F, (g) T

Q3. Write short notes on:

(a) Absorption costing

(b) Variable costing
(c) Period cost
(d) Product cost
(e) Contribution
(f) Differential cost

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Distinguish between marginal costing and absorption costing.

Q2. “Marginal costing rewards sales whereas absorption costing rewards production.”
Comment.

Q3. Which costs are to be inventorised in absorption costing for external reporting. Give
reason for your answers.

Q4. “Absorption costing income exceeds variable costing when the number of units sold
exceeds the number of units produced.” Do you agree.

Q5. Nagarro Ltd. released the figures given ahead from its record for Year 1 and Year 2:

Year 1 Year 2
Sales (units) 2,40,000 2,40,000
Production (Units) 2,40,000 4,00,000
Selling price per unit (Rs.) 20 20

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 Year 1 Year 2
Variable manufacturing cost per unit (Rs.) 12 12
Actual fixed manufacturing cost (Rs.) 12,00,000 12,00,000
Variable marketing and administration cost per unit (Rs.) 1.25 1.25
Fixed marketing and administration cost (Rs.) 4,20,000 4,20,000

(a) Prepare income statements for both years, using full-absorption costing.
(b) Prepare income statement for both years, using variable costing
(c) Comment on the different operating profit figures. [B.Com (Hons), Delhi]

Answers: (1) Profit under absorption costing

Year 1 Nil; Year 2 Rs. 4,80,000
(2) Profit under Variable Costing
Year 1 Nil; Year 2 Rs. Nil

Q6. The following is the cost information of a product:

Variable manufacturing costs: Rs. 4 per unit

Fixed manufacturing costs: Rs. 2,00,000 per year
The normal capacity is set at 2,00,000 units. There are no work-in-progress inventories.
Last year the firm produced 2,10,000 units and sold 90% at a price of Rs. 7 per unit. In
the current year, the firm produced 2,10,000 units and sold 2,15,000 units at the same
price. Prepare income statements for both the years based on

(a) Absorption Costing (b) Variable Costing [B.Com (Hons), Delhi, 2013]

Answers: Absorption Costing:

Operating Income: Previous year Rs. 3,60,000, Current year Rs. 4,40,000

Variable Costing:

Operating Income: Previous year Rs. 3,40,000, Current year Rs. 4,45,000

Q7. You are given the following information relating to the year 2005-06 and 2006-07:

2005-06 2006-07
Opening stock (units) - 300
Production (units) 1,200 1,400
Fixed cost Rs. 2,00,000 Rs. 2,10,000
Variable cost Rs. 1,50,000 Rs. 2,80,000
Sales (units) 900 1,100
Selling price (in Rs. per unit) 400 500
Closing stock (units) 300 600

Prepare Profit and Loss Account using FIFO under marginal costing and under absorption
costing. [B.Com (Hons), Delhi 2007]

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Answers: (1) Profit under Marginal Costing

2005-06 Rs. 47,500; 2006-07 Rs. 1,42,500

(2) Profit under Absorption Costing

2005-06 Rs. 97,500; 2006-07 Rs. 1,82,500

Q8. Your company has a production capacity of 2,00,000 units per year. Normal capacity
utilization is reckoned as 90%. Standard variable production costs are Rs. 11 per unit. The
fixed costs are Rs. 3,60,000 per year. Variable selling costs are Rs. 3 per unit and fixed
selling costs are Rs. 2,70,000 per year. The unit selling price is Rs. 20. In the year just
ended on 30th June, 2017, the production was 1,60,000 units and sales were 1,50,000
units. The closing inventory on 30.06.09 was 20,000 units. The actual variable production
costs for the year were Rs. 35,000 higher than the standard.

(a) Calculate the profit for the year:

(1) By the absorption costing method
(2) By the marginal costing method
(b) Explain the difference in the profit.

Answers: (a) (1) Rs. 2,64,375, (2) Rs. 2,39,375

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 LESSON 2

COST-VOLUME-PROFIT ANALYSIS

2. STRUCTURE

2.0 Learning Objectives

2.1 Meaning of Cost-Volume-Profit Analysis
2.1.1 Assumptions
2.2 Formula of Marginal Cost and Contribution
2.3 P/V Ratio or Contribution/Sales Ratio
2.4 Break Even Point
2.4.1 Break-Even Chart
2.4.2 Assumptions of Break Even Point
2.4.3 Limitations of Break-Even Analysis
2.4.4 Cash Break-Even Point
2.5 Margin of Safety
2.6 Angle of Incidence
2.7 Cost Indifference Point
2.8 Key Factor
2.9 Self-Test Questions

2.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn the meaning of CVP Analysis
(b) Understand the Practical applications of marginal costing
(c) Learn the utilizes of P/V ratio, BEP, margin of safety, angle of incidence and cost
indifference point
(d) Explain the concept of key factor

2.1 MEANING OF COST-VOLUME-PROFIT ANALYSIS

Managers are concerned about the impact of their decisions on profit. The
decisions they make are about volume, pricing, or incurring a cost. Therefore, managers
require an understanding of the relations among revenues, costs, volume, and profit. The
cost accounting department supplies the data and analysis, called cost-volume-profit
(CVP) analysis, which support these managers.

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 Cost-volume-profit (CVP) analysis is a model which studies the inter relationship of
these three factors namely cost of production, volume of production/sales and profit. In
other words, it analyzes the behaviour of net income in response to changes in total
revenue, total costs, or both. Businesses operate in a complex environment, so in this
situation, it is a powerful tool in making managerial decisions including marketing,
production, investment, and financing decisions. It is a model that reduces the complexity
by using simplifying assumptions to focus on only the relevant relationships. Managers
often perform CVP analysis to make various plans to increase company profitability and
provide information about:
 How many units of products must a firm sell to reach break-even point?
 How many units of products must a firm sell to earn desired amount of profit?
 Which products or services to emphasize?
 Should a firm invest in highly automated machinery and reduce its labor force?
 Whether to increase fixed costs?

CIMA London has defined CVP analysis as, “the study of the effects on future profit
of changes in fixed cost, variable cost, sales price, quantity and mix”.

2.1.1 Assumptions

 Changes in the sales volume and production volume are same. The closing
balances in all inventories are zero. Everything purchased is used in production;
everything produced is sold.
 Total costs can be classified into fixed (that does not vary with output level) or
variable (that changes with respect to output level). All mixed costs are broken
into their respective fixed and variable components. The fixed costs include both
direct fixed costs and indirect fixed costs. The total variable costs include both
direct variable costs and indirect variable costs.
 When represented graphically, All cost behaviour is linear (that represents a
straight line) in relation to output within a relevant volume range.
 The selling price per unit, variable costs per unit, and total fixed costs and sales (or
production) volume are known and constant.
 This analysis either covers a single product or assumes that the proportion of
different products when multiple products are sold will remain constant, although
the volume changes.
 Time value of money is not considered.

To know the cost, volume and profit relationship, a study of the following is essential:
 Marginal Cost Formula and Contribution
 Profit Volume Ratio (or) PV Ratio
 Break-Even Analysis
 Margin of Safety

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  Angle of Incidence
 Key Factors and
 Sales Mix

2.2 FORMULA OF MARGINAL COST AND CONTRIBUTION

Marginal Cost equation explains that the difference between sales and variable cost is the
contribution towards fixed costs and profit. The Following are the important equations of
Marginal Cost:

Sales = Variable Cost + Fixed Expenses ± Profit or Loss

(Or)
Sales - Variable Cost = Fixed Cost ± Profit or Loss
(Or)
Sales - Variable Cost = Contribution
Contribution = Fixed Cost + Profit

Contribution is the excess of sales revenue over variable costs. A product whose selling
price exceeds its variable cost is said to have:
(a) Covering its variable cost and
(b) Making a contribution,
(i) Towards the firm‟s fixed cost and after these have been covered;
(ii) Towards the firm‟s profit.

By equation, the concept of contribution can be stated as follows:

Contribution = Sales - Variable Cost

Contribution = Fixed Expenses + Profit
Contribution = Fixed Cost - Loss
Sales - Variable Cost = Fixed Cost + Profit
Sales - Variable Cost = Fixed Cost - Loss

2.3 P/V RATIO OR CONTRIBUTION/SALES RATIO

P/V Ratio is also known as Contribution Sales Ratio or Marginal Income Ratio or
Variable Profit Ratio. It is important for decision-making purpose. As this ratio involves
two elements i.e. Contribution and Sales, it is used to measure the relationship between
contribution and sales value. The following formula for calculating the P/V ratio is given
below:

Contribution × 100
=
P/V Ratio Sales
(in %) Sales - Variable Cost × 100
=
Sales

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 Fixed Cost + Profit × 100
=
Sales
Change in Contribution × 100
=
Change in Sales
Change in Profit × 100
=
Change in Sales
100 - Variable Cost× 100
=
Sales

Significance of PV Ratio:
 P/V Ratio indicates the effect on profit for a change in the sales
 The higher the P/V Ratio, the better it is for the business. If the business
conditions are steady over a period of years, the P/V Ratio will also remain steady.
 If P/V Ratio will be improved, it will result in higher profits.

Improvement of PV Ratio:
 By reducing variable cost or
 By increasing the selling price or
 By reducing variable cost and increasing the selling price or
 By increasing the share of products with higher P/V Ratio in the overall sales mix

Uses of PV Ratio:
 To determine of variable costs for any volume of sales
 To determine of Break-Even point
 To determine of contribution for any volume of sales
 To determine of the level of output required to earn a desired profit
 Identification of minimum volume of activity that the enterprise must achieve to
avoid incurring losses.
 To decide the most profitable mix
 To measure the efficiency of each product, operation, process etc.

Illustration 1: A company has fixed expenses of Rs. 90,000 with sales at Rs. 3,00,000
and a profit of Rs. 60,000. Calculate the profit/ volume ratio. If in the next period, the
company suffered a loss of Rs. 30,000. Calculate the sales volume.[B.Com (Hons), Delhi]
Solution:
Given: (i) Fixed expenses = Rs. 90,000, Sales = Rs. 3,00,000, Profit = Rs. 60,000
Variables = Sales - (fixed cost and profit)
= Rs. 3,00,000 - 1,50,000 = Rs. 1,50,000
Profit / volume ratio = S - V × 100
S
P/ V ratio = 3,00,000 - 1,50,000 × 100 = 50 %
3,00,000

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(ii) In the next year, the company suffered a loss of Rs. 30,000. In other words, it would
recover the fixed costs of Rs. 90,000 to the extent of only Rs. 60,000.

Sales volume at Rs. 30,000 loss level = Rs. 60,000 = Rs. 1,20,000
P/V ratio or 50%

2.4 BREAK EVEN POINT

The concept of „Break Even Point‟ is very important for the decision making
purpose in various areas. This concept is based on the behaviour of costs, i.e. fixed cost
and variable costs. Fixed costs are those costs that remain constant irrespective of the
changes in the volume of production. On the other hand, variable costs are the costs that
vary with the change in the level of production. While fixed cost per unit is always
variable, variable cost per units is always fixed. In addition to these two types of costs,
there are semi variable costs that are partially fixed and partially variable. Semi variable
costs thus have the features of both types of costs. They remain fixed up to a certain level
of production and after crossing that level, they become variable.

The Break Even Point is a level of production where the total costs (TC) are equal
to the total revenue (TR), i.e. sales. Thus at the break-even level, there is neither profit nor
loss situation. This is a point where contribution is equal to fixed cost. If Production level
is below the break-even-point, it will result into loss while if production level is above
break-even point, it will result in profits. This concept can be analyzed with the help of
the following table.

Suppose, the selling price of a product is Rs. 12 per unit, variable cost Rs. 7 per unit and
fixed cost Rs. 10,000, the break-even level can be found out with the help of the
following table.

Variable
Sales Value Total Cost Profit/Loss
Cost Fixed Cost
Number (Rs. 12 per (Variable + (Sales value -
(Rs. 7 per (Rs. 10,000)
of Units unit) Fixed) total cost)
unit) (Rs.)
(Rs.) (Rs.) (Rs.)
(Rs.)
800 9,600 5,600 10,000 15,600 -6,000
1,000 12,000 7,000 10,000 17,000 -5,000
1,500 18,000 10,500 10,000 20,500 -2,500
1,800 21,600 12,600 10,000 22,600 -1,000
2,000 24,000 14,000 10,000 24,000 0
2,500 30,000 17,500 10,000 27,500 2,500
3,000 36,000 21,000 10,000 31,000 5,000

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 The above table shows that at the production level of 2,000 units, the total costs
are equal to the total revenue and hence it is the break-even level. Production level and
sales level below the break-even level results into loss as shown in the table while above
the break-even level will result in profits.

If the above table is analyzed, it will be seen that, when the production level was
800, the revenue from sales was not sufficient to cover the total cost i.e. sum of variable
and fixed Cost. When the production level starts rising, the sales level starts rising but the
total cost does not rise in the proportion as the fixed cost remains the same. Consequently
the amount of loss starts decreasing and the trend continues till the break-even level is
reached. After the break-even level is crossed, (at 2,500 units and 3,000 units of
production) the sales revenue exceeds the total costs and hence it results in profits. Break-
even level can also be worked out with the help of the following formulae.

Break-even Fixed Cost Fixed Cost

=
point [in units] Contribution per Unit Selling Price per Unit- Variable Cost Per Unit
Break-even Fixed Cost Fixed Cost × Contribution
=
point [in Rs.] P/V Ratio Sales

2.4.1 Break-Even Chart

A break-even chart is a graphical representation of Cost-Volume-Profit

relationship. The chart depicts fixed costs, variable cost, break-even point, profit or loss,
margin of safety and the angle of incidence. Break-even point is an important stage in the
break-even chart which represents no profit no loss. From the break-even chart, we can
understand the following points:

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  Cost and sales revenue are represented on vertical axis, i.e., Y-axis.
 Volume of production or output in units is plotted on horizontal axis, i.e., X-axis.
 Fixed cost line is drawn parallel to X-axis.
 The sales line is plotted from the zero level, it represents sales revenue.
 The point of intersection of total cost line and sales line is called the break-even
point which means no profit no loss.
 The margin of safety is the distance between the break-even point and total output
produced.
 The area below the break-even point represents the loss area as the total sales are
less than the total cost.
 The area above the break-even point represents the profit area as the total sales
more than the cost.
 The sales line intersects the total cost line represents the angle of incidence
represented by Theta (θ). The large angle of incidence indicates a high rate of
profit and vice versa.

2.4.2 Assumptions of Break Even Point

Break-even point is based on the following assumptions:

(1) Production and sales are the same, which means that as much as is produced is sold
out. Thus there is no inventory remaining at the end of the period.
(2) Fixed cost remains same irrespective of the level of production volume. Fixed Cost
per unit varies with the level of production.
(3) Variable cost varies with the production volume. It varies directly with the level of
production. Hence it has a linear relationship with the production. Variable cost per unit
remains the same irrespective of change in the level of production.
(4) Selling price per unit remains same.

2.4.3 Limitations of Break-Even Analysis

Though break-even analysis is decision making tool for management, but there are some
limitations against the utility of break-even analysis:

 Fixed costs do not always remain constant.

 Variable costs need not always vary proportionately
 Selling price may not be a constant factor.
 Break-even analysis is of doubtful validity when a number of products are
produced. Different break-even charts need to be prepared, which involve a
problem of apportionment of fixed expenses to each product.

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  This analysis ignores the capital employed in business, which is one of the
important guiding factors in the determination of returns for decision making
purpose.
 Break-even analysis is based on the assumption that income is influenced by
changes in sales so that changes in inventory would not directly affect income. If
marginal costing is used, this assumption would hold good but in other cases,
changes in inventory will affect income because the absorption of fixed costs will
depend on production rather than sales.
 Conditions of growth or expansion in an organization are not assumed under
break-even analysis. In actual life of any business organization, the operation
undergoes a continuous process of growth and expansion.

2.4.4 Cash Break-Even Point

In cash break-even chart, only cash fixed costs are considered. Non-cash items like
depreciation etc. are excluded from the fixed costs. Cash Break-Even Chart depicts the
level of output or sales at which the sales revenue will be equal to total cash outflow. It is
computed as under:

Cash Break-Even Point = Cash Fixed Costs

Contribution per unit

Illustration 2: Following information is given for the manufacture of a product:

Fixed expenses Rs. 4,00,000

Material Rs. 10 per unit
Labour Rs. 5 per unit
Direct expenses:
Fuel Rs. 3 per unit
Carriage inwards Rs. 2 per unit
Selling price Rs. 40 per unit

Calculate Break-Even point in terms of units. Also find out new B.E.P. if selling price is
reduced by 10% per unit. (B.Com, Delhi)
Solution:
(1) Contribution Margin per unit = Selling price - Variable cost*
= Rs. 40 - Rs. 20
= Rs. 20
 Variable cost per unit Rs.
Material 10
Labour 5
Fuel 3
Carriage Inwards 2
Total VC 20

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Break Even point = fixed expenses
(in terms of unit) Contribution Margin Per unit

= Rs. 4,00,000
Rs. 20
= 20,000 units

(2) If selling price is reduced by 10% i.e. Rs. 40 - Rs. 4 = Rs. 36

The new B.E.P will be:
= fixed expenses i.e. Rs. 4,00,000
(Rs. 36 - Rs. 20) =Rs. 16
= 25,000 units

2.5 MARGIN OF SAFETY

Margin of safety is the difference between the Actual Sales and Break Even Point Sales.
Sales beyond break-even volume brings in profits and that represents margin of safety. It
is that level of sales which incurred after Break-Even Point and already covered Fixed
Cost.

Margin of safety is calculated as follows:

= Total sales (units) - Break even sales (units)

Margin of Safety
= Profit
(in units)
Contribution per unit
= Total sales (in value) - Break even sales (in value)
= Profit
Margin of Safety P/V Ratio
(in Rs.) = Profit × Contribution
Sales
= Margin of Safety × Selling Price
= 100 - Break Even Sales (in %)
Margin of Safety
= Profit × 100
(in % of sales)
Total Contribution

Other equations that can be made from above relations to calculate Profit:

When Margin of Safety is given,

Profit = Margin of Safety × P/V Ratio

When Actual sales are given,

Profit = M/S Ratio × P/V Ratio × Actual Sales

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Significance of Margin of Safety:

 Till BEP, the contribution is sufficient to recover fixed costs. After BEP, the
contribution is called Profit ( since fixed costs are fully recovered at BEP)
 Profit is the contribution earned out of Margin of Safety Sales.
 The soundness of a business is gauged by the size of the margin of safety.
 A low margin of safety indicates that the firm has high fixed overheads and is
more vulnerable to changes in sales.
 A high margin of safety indicates that a slight fall in sales may not affect the
business very much.

Improvement in Margin of Safety:

 Reduction in fixed costs.

 Reduction in variable costs so as to improve marginal contribution.
 Increasing the sales volume, provided there is unused capacity.
 Increasing the selling price, provided market conditions permit, and
 Substituting or introduction of a product mix as to improve contribution and to
have more profitable lines.

Illustration 3: From the following data, Compute Break Even Sales and Margin of
Safety:
Rs.
Sales 10,00,000
Fixed cost 3,00,000
Profit 2,00,000
[B.Com (Pass), Delhi]

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Solution: Rs.
Sales 10,00,000
Fixed cost 3,00,000
Profit 2,00,000

Solving the following equation we find:

Sales = (FC + VC) + Profit
10,00,000 = 3,00,000 + VC + 2,00,000
VC = 5,00,000

Profit Volume Ratio = S - V × 100

S
= 10,00,000 - 5,00,000 ×100
10,00,000
= 50 %

Breakeven Point = Fixed costs = Rs. 3,00,000 i.e. 6,00,000

P/V ratio 50 %

2.6 ANGLE OF INCIDENCE

The angle formed by the sales line and the total cost line at the break-even point is
known as Angle of Incidence. The angle of incidence shows the rate at which profits are
being earned once the break-even point has been reached. A large angle of incidence
indicates a high rate of profit and on the other hand a small angle of incidence means that
a low rate of profit. Therefore the objective of management will be to have as large as
possible.

2.7 COST INDIFFERENCE POINT

Cost Indifference Point refers to that level of output where the total costs or the
profits of the two alternatives are equal. The decision makers are indifferent as to which
alternative needed to be opted, since both options will result in the same amount of profit.
It is also known as Cost Break-Even Point.

Profit of Option A
Indifference Point
Profit of Option B

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The formula for calculating is as follows:

Cost Indifference Point (in units) = Difference in Fixed Cost

Difference in contribution per unit
Or
= Difference in Fixed Cost
Difference in Variable per unit

Cost Indifference Point (in Rs.) = Difference in Fixed Cost

Difference in P/V ratio
Or
= Difference in Fixed Cost
Difference in Variable to Sales ratio

Indifference point is calculated in respect of two options. Where more than two options
are considered, Indifference Point can be calculated on a comparative basis for two
combinations.

Significance of Indifference Point

 When level of sales is below Indifference point, most profitable option will be that
having lower fixed costs.
 When level of sales is at Indifference point, both options will be equally profitable
options.
 When level of sales is above Indifference point, most profitable option will be that
having higher P/V ratio.

2.8 KEY FACTOR

Key Factor represents a resource whose availability is less than its requirement. It
denotes the resources constraint situation. It is a factor, which at a particular time or over
a period limits the activities of a firm.

It is also called Critical Factor (since it is vital or critical to the firm‟s success) and
Budget Factor (since budgets are formulated by reference to such limitations)

Some examples of key factor are Shortage of Raw Material, Labour Shortage,
Restrictions in Plant Capacity, Demand or Sales Expectancy, Cash Availability etc.

The following steps are taken in case of Key Factor situation:

(1) Identify the Key Factor

(2) Compute Total Contribution or Contribution per unit of the product

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 (3) Compute Contribution Per Unit of the Key Factor, i.e. Contribution per Direct
Labour Hour, Contribution per kg of raw material
(4) Rank the products on the basis of Contribution per unit of the key factor
(5) Allocate the key resources based on Ranks given above and other conditions
specified in the question.

MISCELLANEOUS QUESTIONS

Illustration 4: From the following information relating to Alpha Ltd. you are required to
find out:
(a) Contribution
(b) Breakeven point
(c) Margin of society
(d) Profit
Rs.
Total Fixed Cost 4,500
Total Variable Cost 7,500
Total Sales 15,000
Units Sold 5,000 (units)
(e) Also calculate the volume of sales to earn profit of Rs. 6,000

Solution:
(a) Contribution = Sales - Variable cost
= Rs. 15,000 - Rs. 7,500

(b) Breakeven point (in units) = Fixed cost = Rs. 4,500

Contribution Margin* Rs. 1.50
= 3,000 units

*Total Contribution = Rs. 7,500 i.e. Rs. 1.50

No. of units sold 5,000

(c) Margin of safety = Total Sales - BEP Sales

= Rs. 15,000 - 3,000 ×(Rs. 15,000)
(5,000)
= Rs. 6,000

(d) Profit = Sales - Total cost

Rs. 15,000 - (7,500 + 4,500)
= Rs. 3,000.

(e) Volume of Sales to earn a profit of Rs. 6,000

=F+P = Rs. 4,500 + Rs. 6,000 = Rs. 21,000
P/V Ratio [ 15,000 - 7,500 ]
15,000

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Illustration 5: The following figures are available for the records of Venus Enterprises as
at 31st March -

1988 1989
Rs. Lakhs Rs. Lakhs
Sales 150 200
Profit 30 50

Calculate-
(a) the P/V ratio and total fixed expenses
(b) the breakeven level of sales
(c) sales required to earn a profit of Rs. 90 Lakhs
(d) profit or loss that would arise if the sales were Rs. 280 Lakhs. (CA Inter)

Solution:
(a) P/V ratio = Change in profit × 100
Change in sales

= Rs. 50 Lakhs - Rs. 30 Lakhs × 100

Rs. 200 Lakhs - Rs. 150 Lakhs

= Rs. 20 Lakhs × 100

Rs. 50 Lakhs

= 40 %

Fixed expenses = Contribution - Profit

= P/V Ratio × Sales - Profit

Fixed expenses (in the year 1988)

= 40 % × Rs. 150 Lakhs - Rs. 30 Lakhs
= Rs. 60 Lakhs - Rs. 30 Lakhs
= Rs. 30 Lakhs

Fixed expenses (in the year 1989)

= 40 % × Rs. 200 Lakhs - Rs. 50 Lakhs
= Rs. 80 Lakhs - Rs. 50 Lakhs
= Rs. 30 Lakhs.

(b) Breakeven level of sales = Fixed Expenses = Rs. 30 Lakhs

P/V Ratio 40%
= Rs. 75 Lakhs

(c) Sales required to earn a profit of Rs. 90 Lakhs

(or sales when contribution is Rs. 120 Lakhs)
When contribution is Rs. 60 Lakhs then sale is Rs. 150 Lakhs
When contribution is Rs. 1 Lakh then sale is Rs. 150 Lakhs
Rs. 60 Lakhs

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When contribution is Rs. 120 Lakhs then sale is Rs. 150 Lakhs × 120 lakhs
Rs. 60 Lakhs
= 300 Lakhs

Or Fixed cost + Required Profit = Rs. 30 Lakhs + Rs. 90 Lakhs

P/V Ratio 40 %
= 300 Lakhs

(d) Profit or Loss that would arise if the sales were Rs. 280 Lakhs
Profit = Contribution - Fixed Expenses
= P/V Ratio × Sales - Fixed Expenses
= 40 % × Rs. 280 Lakhs - Rs. 30 Lakhs
= Rs. 82 Lakhs

Illustration 6: X, Y and Z are three similar plants under the same management who want
them to be merged for better operation. The details are as under:

Plant X Y Z
Capacity operated 100% 70% 50%
Rs. Lakhs Rs. Lakhs Rs. lakhs
Turnover 300 280 150
Variable cost 200 210 75
Fixed cost 70 50 62

Find out:
(i) the capacity of the merged plant for break-even
(ii) the profit at 75% capacity of the merged plant
(iii) the turnover from the merged plant to give a profit of Rs. 30,00,000. (CS Inter)

Solution: At 100% capacity the position of merged plant will be as follows:

X Y Z Total
Capacity
100% 100% 100% 100%
utilisation
Rs. Rs. Rs. Rs.
(%)
(in lakhs) (in lakhs) (in lakhs) (in lakhs)
Turnover 300 400 300 1,000
Variable cost 200 300 150 650
Contribution 100 100 150 350
Fixed costs 70 50 62 182
Profit 30 50 88 168

P/V Ratio = Contribution × 100 = 350 × 100 = 35 %

Sales 1,000

(i) BEP of the merged plant = Fixed costs = 182 × 100 = Rs. 520 lakhs.
P/V Ratio 35

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% of capacity = 520 ×100 = 52%
1,000
(ii) if the merged plant works to 75% capacity:
Capacity 75%
Rs. (in Lakhs)
Sales 750.00
Variable costs 487.50
Contribution 262.50
Fixed costs 182.00
Profit 80.50

(iii) Turnover required from the merged plant to give a profit of Rs. 30 lakhs:
Contribution required = 182 + 30 = Rs. 212 lakhs
P/V ratio = 35%
Hence, Sales required = 212 × 100 = Rs. 605.71
35

2.9 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) Profit volume ratio establishes the relationship between…

(a) Contribution and profit
(b) Fixed cost and contribution
(c) Profit and sales
(d) Contribution and sales value

(2) Contribution/sales is equal to…

(a) P/V ratio
(b) Net profit ratio
(c) BEP
(d) EPS

(3) The P/V ratio can be increased by…

(a) Reducing the variable cost
(b) Increasing the selling price
(c) Both
(d) None

(4) The factor which limits the volume of output of different products of an
understanding at a particular point of time is known as…
(a) Key factor
(b) BEP
(c) Contribution
(d) None

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(5) The profit of an undertaking is affected by…
(a) Selling price of the products
(b) Volume of sales
(c) Variable cost per unit and total fixed cost
(d) All of the above

(6) The break even chart helps the management in…

(a) Forecasting costs and profits
(b) Cost control
(c) Long term planning and growth
(d) All of the above

(7)________ is the excess of sales over the break even sales.

(a) Actual sales
(b) Total sales
(c) Margin of safety
(d) Net sales

(8)__________ indicates the extent of which the sales can be reduced without
resulting in loss.
(a) BEP
(b) Key factor
(c) Contribution
(d) Margin of safety

(9) Margin of safety can be improved by…

(a) Increasing production
(b) Increasing selling price
(c) Reducing the costs
(d) All of the above

(10) The angle formed by the sales line and total cost line at the break-even point is
known as…
(a) Profit variable
(b) Margin of safety
(c) Angle of incidence
(d) None

Answers: (1) (d), (2) (a), (3) (d), (4) (a), (5) (d), (6) (a), (7) (c), (8) (d), (9) (d), (10) (c)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) P/V ratio shows the relationship between ______________and _____________.

(b) Contribution is the difference between sales and _______________.
(c) The break-even point is ________________ when selling price increases.

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 (d) The difference between actual sales and Break even sales is called
______________.
(e) At break-even point, contribution will be equal to ________________.
(f) In a profit volume graph, Break-even Point takes place where ___________
intersect each other.
(g) When sales increase from Rs. 40,000 to Rs. 60,000 and profit increases by Rs.
5,000, the P/V ratio is ______________.

Answers: (a) contribution and sales, (b) variable, (c) Decreased, (d) Margin of safety, (e)
Fixed costs, (f) profit and sales line, (g) 25%

Q2. True/False Statement:

(a) Margin of safety can be improved by lowering the volume of sales.

(b) Contribution is always equal to fixed costs.
(c) P/V ration is the ratio of profit and the volume of output.
(d) At break-even-point contribution margin equals variable cost.
(e) Margin of safety is the excess of actual sales over break even sales
(f) All direct costs are marginal costs.

Answers: (a) F, (b) F, (c) F, (d) F, (e) T, (f) T

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. What is break-even point? What are the limitations of break-even analysis?

Q2. Explain the following:

(a) Key Factor
(b) P/V Ratio
(c) Margin of Safety
(d) Angle of Incidence
(e) Break-even Point
(f) Contribution
(g) Marginal Costing

Q3. What is P/V Ratio? Explain its uses.

Q4. What is meant by angle of incidence and margin of safety and show these in a break-
even chart. Explain.

Q5. Explain the ways by which P/V Ratio can be improved.

Q6. From the following data, calculate:

(a) P/V ratio

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 (b) Profit when sales are Rs. 20,000
(c) New break-even point if selling price is reduced by 20%

Fixed Expenses Rs. 4,000

Break-even Point 10,000 [B.com (Hons), Delhi]

Answers: (a) 40%, (b) Rs. 4,000, (c) Rs. 16,000

Q7. XYZ Ltd. manufacturers pressure cookers the selling price of which is Rs. 300 per
unit. Currently the capacity utilization is 60% with a sales turnover of Rs. 18 Lakhs. The
company proposes to reduce the selling price by 20% but desires to maintain the same
profit position by increasing the output. Assuming that the increased output could be
made and sold, determine the level at which the company should operate to achieve the
desired objective.

The following further data are available:

(i) Variable cost per unit Rs. 60.

(ii) Semi variable cost (including a variable element of Rs. 10 per unit) Rs. 1,80,000

(iii) Fixed cost Rs. 3,00,000 will remain constant up to 80% level. Beyond this an
additional amount of Rs. 60,000 will be incurred.

Answers: Profit at 60% capacity = Rs. 9,60,000; Required sales to maintain the same
profit = 8,471 units.

Q8. (a) When sales of a company decline from 9,00,000 to Rs. 7,00,000, its profit of Rs.
50,000 is converted into a loss of Rs. 50,000. Determine contribution margin ratio.

(b) Sales at breakeven point in a company is Rs. 25,000 and its fixed cost is Rs. 10,000.
What is its total contribution?

Answers: (a) 50% (b) Rs. 10,000

Q9. The following information is supplied to you:

Rs.
Fixed cost (total) 4,500
Variable cost (total) 7,500
Sales (total) 15,000
Units sold 5,000

Calculate :

(a) Contribution
(b) B.E. point in units

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 (c) Margin of safety
(d) Profit
(e) Volume of sales to earn a profit of Rs. 6,000

Answers: (a) Rs. 7,500 (b) 3,000 units (c) Rs. 6,000 (d) Rs. 3,000 (e) Rs. 21,000

Q10. Taurus Ltd. produces three products: A, B and C from the same manufacturing
facilities. The cost and other details of the three products are as follows:

A B C
Selling price/ unit (Rs.) 200 160 100
Variable cost/unit (Rs.) 120 120 40
Fixed expenses/ month (Rs.) 2,76,000
Maximum production per month (units) 5,000 8,000 6,000
Total hours available for the month 200
Maximum demand per month (units) 2,000 4,000 2,400

The processing hours cannot be increased beyond 200 hours per month.

You are required to:

(a) Compute the most profitable product mix and

(b) Compute the overall breakeven sales of the company for the month based on the
mix calculated in (a) above. (C.A. Inter)

Answers: (i) A - 2,000 units, B - 1,600 units, C - 2,400 units (ii) Rs. 6,72,000

Q11. After a study of cost-volume-profit relationship, the Flemingo Ltd. concluded that
its cost for any given venue of sales could be expressed as Rs. 1,00,000 of fixed costs plus
variable costs equal to 60% of sales. The company‟s range of volume was from zero to
Rs. 8,00,000 of sales.

Prepare a graph which will illustrate this cost volume relationship. Also draw a proper
sales line to the graph form a breakeven point. Determine the breakeven point.

A competitor operating a plant of the same size as that of Flemingo Ltd. also has fixed
costs of approximately Rs. 1,00,000 but this breakeven point is Rs. 3,00,000 sales. What
are probable causes of the difference between this breakeven point and that of the
Flemingo Ltd.

Answer: BEP Rs. 2,50,000

Q12. (a) Draw a breakeven chart form the following data:

Fixed cost Rs. 5,000

Selling price Rs. 20 per unit
Variable cost Rs. 10 per unit

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Show profit and margin of safety when sales are Rs. 20,000.

(b) Draw another break even chart to show the effect of 20% decrease in fixed cost.

Answers: (a) BEP Rs. 10,000; (b) Rs. 8,000

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 LESSON 1 UNIT 5

DECISION MAKING AND VARIABLE COSTING

1. STRUCTURE

1.0 Learning Objectives

1.1 Introduction
1.2 Steps Involved in Decision‐Making
1.3 Short Term Decision and Long Term Decision
1.4 Relevant and Irrelevant Costs for Decision Making
1.5 Classification of Cost for Decision Making
1.6 Decision Making and Variable Costing
1.6.1 Fixation of Selling Price
1.6.2 Exploring New Markets
1.6.3 Make or Buy Decisions
1.6.4 Product Mix Decisions
1.6.5 Operate Or Shut Down
1.7 Self-Test Questions

1.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn different types of cost for decision-making
(b) Learn the concept of relevant and irrelevant costs for decision-making
(c) Learn practical applications of marginal costing in fixation of selling price, Key
or limiting factor, make or buy decisions, selection of a suitable product mix,
effect of change in price, closing down activities and exploring new markets.

1.1 INTRODUCTION

Understanding the behavior of costs is of vital importance to managers.

Understanding how costs behave, whether costs are relevant to specific decisions, and
how costs are affected by different factors allows managers to determine the impact of
changing costs on a variety of decisions. Decision-making is the process of choosing the
best course of action from among available alternative courses of action. Choice between
alternative courses is an all pervading managerial function. Managers of business concern
discharge their functions only by making decisions. Every manager regardless of level in
which he operates is a decision maker.

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 "Managerial Decision Making is the process by which managers‟ responds to
opportunities and threats by analyzing options and making decision about goals and
courses of action.” ‐ Warren Weber

1.2 STEPS INVOLVED IN DECISION‐MAKING

Following steps are helpful in logical decision making:

(1) Defining and Clarifying the Problem: The first step is to define problems clearly
and precisely for decision making so that quantitative data that are relevant to its
solution can be determined. The possible alternative solutions to the problem should
be identified. At times, consideration of more alternative solutions may make the
matters more complex. After that, proper scanning device will help to remove
unattractive alternatives.
(2) Collecting and Analyzing Data: In this regard, if the decision‐taker feels necessary,
they may ask for further collection of information for better decision making process.
In fact, a number of decisions improvised by acquiring further information and it is
normally possible to obtain such information.
(3) Analyzing the Problem: As earlier said, the problem of decision-making is that of
choosing among alternatives. All alternatives have their own advantages and
disadvantages. The decision taker has to take decisions on the basis of the problem
intensity. Problem must be observed from different vantage points.
(4) Ascertaining Alternatives: The decision maker needs to identify various alternatives
by computing various cost structure and revenues under each of the options. So that
later evaluation can be done of each available alternative.
(5) Evaluating each Alternative: There are two types of aspects, viz. quantitative
aspects and qualitative aspects. A decision maker observes all benefits and limitations
of the various aspects to get a best option for enhancement of the company.
(6) Selection of an Alternative: After defining, collecting, analyzing, determining
various alternatives and evaluating them, the decision‐maker can select the best
alternative on the basis of evaluation criteria. Different alternative may be ranked in
order of priorities and may be chosen as per the requirements.
(7) Appraisal of the Result: After executing the decisions, the decision maker should
regularly seek an appraisal of the results. This will help him in correcting his mistake,
modifying his target and making a better forecast in the times to come.

1.3 SHORT TERM DECISION AND LONG TERM DECISION

Decision making involves two types of decisions i.e. long term decisions and short
term decisions. Short‐term decisions are particular in nature. This chapter focuses on
short term decisions. The information relevant for the decision making relies on the given
situation calling for a decision. Here, such information is called the 'relevant data'. The

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short term decisions are mostly affected within a year. Such short‐run decisions may
involve decisions such as make or buy; domestic market or export; sell or process; accept
or reject an order and other decisions. The long‐term decisions force the management to
look beyond the current year. Time value of money and return on investment are major
considerations in long term decisions. Uncertainty is an integral part of the decision‐
making. Hence, the task of decision‐making is quite difficult, crucial and critical.

1.4 RELEVANT AND IRRELEVANT COSTS FOR DECISION MAKING

CIMA Official Terminology defines it as, “Costs and revenues appropriate to a

specific management decision. These are represented by future cash flows whose
magnitude will vary depending upon the outcome of the management decision made. If
stock is used, the relevant cost, used in the determination of the profitability of the
transaction, would be the cost of replacing the stock, not its original purchase price,
which is a sunk cost. Abandonment analysis, based on relevant cost and revenues, is the
process of determining whether or not it is more profitable to discontinue a product or
service than to continue it.”

The cost can be classified in a variety of ways according to their nature and
information needs of the management. But when it comes to the managerial decision
making, the managers are only concerned with relevant costs and relevant revenues. As
not all the costs and revenues are relevant. Relevant means pertinent to the decision at
hand. Relevant costs are those expected future costs that assist the decision makers in
choosing a particular course of action, out of several alternatives.

1.5 CLASSIFICATION OF COST FOR DECISION MAKING

Costs are important feature of many business decisions. For the purpose of decision
making costs can be classified as follows:

(1) Sunk Cost: CIMA Official Terminology defines Sunk cost as, “Cost that has been
irreversibly incurred or committed and cannot therefore be considered relevant to a
decision. Sunk costs may also be termed irrecoverable costs.” It is a cost which has
already been incurred or sunk in the past. It is not relevant for decision-making.
Thus, if a firm has obsolete stock of materials originally purchased for Rs. 40,000
which can be sold as scrap now for Rs. 8,000 or can be utilized in a special job, the
value of stock already available Rs. 40,000 is a sunk cost and is not relevant for
decision-making. Historical costs are sunk costs. They play no role in decision
making in the current period. Sunk Cost do not affect future costs and cannot be
changed by any current or future action, hence these costs are irrelevant in decision
making. Eg. Spending on advertising during product launching is sunk for taking a
decision on continuance of product.

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(2) Shut Down Cost: Sometimes it becomes necessary for a company to temporarily
close down the factory or unit because of trade downturn with view to reopening it in
the future. In this situation decisions are based on the variable cost analysis. If selling
price is above the variable cost then it better to continue because the losses are
minimized. By closing the manufacturing activity, some extra fixed expenses (e.g.
Security) may be incurred and certain fixed expenses can be avoided (e.g.
maintenance cost of plant). Such costs are also relevant.
(3) Fixed Costs: The cost which always remains fixed irrespective of production volume
is known as fixed costs. This cost remains constant whether production activity is
increased or decrease. It is subject to change over a period of time. For short term
managerial decision making, fixed cost may be relevant or irrelevant. When a
particular decision is made that results in occurrence of fixed cost, it is relevant but if
it occurs irrespective of any decision taken in a certain situation then it is irrelevant
cost.
(4) Committed Cost: CIMA Official Terminology defines committed cost as, “Cost
arising from prior decisions, which cannot, in the short run, be changed. Committed
cost incurrence often stems from strategic decisions concerning capacity with
resulting expenditure on plant and facilities. Initial control of committed costs at the
decision point is through investment appraisal techniques.” For example entering into
irrevocable agreements for Rent, Technical Collaboration, etc. Committed Costs are
not relevant for decision-making.
(5) Discretionary Cost: CIMA Official Terminology defines discretionary cost as,
“Cost whose amount within a time period is determined by a decision taken by the
appropriate budget holder. Marketing, research and training are generally regarded as
discretionary costs. Also known as managed or policy costs.” It is also known as
“Avoidable” fixed costs.
(6) Opportunity cost: CIMA Official Terminology defines opportunity cost as, “The
value of the benefit sacrificed when one course of action is chosen in preference to an
alternative. The opportunity cost is represented by the foregone potential benefit
from the best rejected course of action.” In other words, it is the opportunity cost lost
by diversion of input factor from one use to another. It is the measure of the benefit
of opportunity foregone. Opportunity cost is a pure decision‐making cost. It is an
imputed cost, which does not require cash payout. The opportunity cost is helpful to
managers in evaluating various alternatives available when multiple inputs can be
employed for multiple uses. These inputs may nevertheless have a cost and this is
measured by the sacrifice made by the alternative action in course of choosing
another alternatives.
(7) Marginal Cost: CIMA Official Terminology defines marginal cost as, “Assigns
only variable costs to cost units while fixed costs are written off as period costs.”

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 Marginal costing is based on variable cost so that the management can take decisions
on the basis of variable costs. Marginal costing is extremely useful for decision
making. In fact, it is a major tool for decisions making.
(8) Differential Cost: CIMA Official Terminology defines differential cost as,
“Difference in total cost between alternatives. This is calculated to assist decision
making.” In other words, it is the change in costs due to change in the level of
activity or pattern or method of production. When the difference in cost of two
alternatives results in increase in cost, it is called Incremental Cost, whereas the
difference in cost of two alternatives results in decrease in cost, the difference is
called Decremental costs.
(9) Replacement Cost: CIMA Official Terminology defines replacement cost as, “Cost
of replacing an asset. This is important in relevant costing because if, for example,
material that is in constant use is needed for a product or service, the relevant cost of
that material will be its replacement cost. Replacement cost has also been proposed
as an alternate to historic cost accounting and it can, therefore, be an important
concept with relevance to accounting for inflation or measuring performance where
the value of assets is important.”

(10) Imputed Cost: This is similar cost to the opportunity cost in that they are not
recorded in the accounting books. However, they are hypothetical costs that must be
taken into consideration if a correct decision is to be arrived at. In auditing it requires
special treatment. Imputed cost comes from what one could have made from an asset
if you had used it differently. These are Notional Costs appearing in the Cost
Accounts only e.g. notional rent charges, interest on capital for which no interest has
actually been paid. These are relevant costs for decision-making.
(11) Out-of-Pocket Cost: Out‐of‐Pocket costs are those expenses which are current cash
payments to the outsiders. All the explicit costs like payment of rent, wages, salaries,
interest, transport charges etc. fall in category of out‐ of‐pocket costs. This cost is
useful while taking decision like make or buy and price fixation during depression.
This cost concept is a short-run concept and is used in various managerial decisions.
(12) Future Cost: The past cost is historic and sunk cost which has already incurred and
cannot be changed. So the only relevant cost for decision making is pre-determined
or future costs.
(13) Conversion Cost: CIMA Official Terminology defines conversion cost as, “Cost of
converting material into finished product, typically including direct labour, direct
expense and production overhead.” Appropriate use of this cost can be made in
certain managerial decisions.

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(14) Variable Costs: The cost which varies with the production volume is known as
variable cost. It suggests that this cost varies with the increase or decrease in
production. It is so because the input of raw material is used in the exact quantities
needed for production process. From the viewpoint of their behavior, variable costs
are also known as 'Engineered Cost'. Though it is believed that all variable costs are
relevant, it is actually not so because if variable costs vary depending on different
alternatives for decision making process.

1.6 DECISION MAKING AND VARIABLE COSTING

The technique of marginal costing is largely use in the managerial decision making
process. Marginal costing technique 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 application of marginal costing in the day
to day decision making process is as follows:

1.6.1 Fixation of Selling Price

Prices are more controlled by market conditions and other economic factors than by
decisions of management team, but while fixing of selling prices the management should
keep in mind all the factors that affect the area of selling price fixation specially the
desired level of profit. Selling price need to be fixed differently under the different
conditions:

(a) Selling Price under normal circumstances:

In the long run (to have reasonable amount of Profit), Selling Price > Total Cost
(VC+FC)
In the short run (temporarily in adverse conditions), Selling Price < Total Cost, but
Selling Price > Variable Cost.
(b) Selling Price in competition:
In case of acute competition to avoid shut-down situation, Selling Price < Total
Cost, but Selling Price > Variable Cost
If Selling Price is equal to Variable cost, Loss = Fixed Cost
(c) Selling Price under depression or recession:
In case of depression or recession to avoid shut-down situation, Selling Price <
Total Cost, but Selling Price > Variable Cost.

Illustration 1: An umbrella manufactures makes an average profit of Rs. 2.50 per unit on
a selling of Rs. 14.30 by producing and selling 60,000 units at 60% of potential capacity.
His cost of sales per unit is as follows:
Direct Material Rs. 3.50
Direct Wages Rs. 1.25

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Factory Overhead Rs. 6.25 (50% fixed)
Sales Overhead Rs. 0.80 (25% variable)
During the current year, he intends to produce the same number but estimates that his
fixed cost would go up by 10% while the rates of direct wages and direct material will
increase by 8% and 6% respectively. However the selling price cannot be changed. Under
this 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
manufacture and overall profit of Rs. 1,67,300?

Solution: Statement of Marginal Cost and Profit

Per Unit 60,000 units

Rs. Rs.
Sales 14.30 8,58,000
Direct Material (3.50 + 6%) 3.710 2,22,600
Direct Wages (1.25+8%) 1.350 81,000
Variable Overhead
- Fixed 3.125 1,87,500
- Variable 0.200 12,000
Variable Cost 8.385 5,03,100
Contribution (Sales-Variable Cost) 3,54,900
Fixed Cost* 2,45,850
Profit 1,09,050

*Calculation of fixed overhead

Factory Overhead - 60,000 units @ Rs. 3.125 = Rs. 1,87,500
Sales Overhead - 60,000 units @ Rs. 0.60 = Rs. 36,000
2,23,500
Add: 10% increase 22,350
Fixed Cost Rs. 2,45,850

Statement of Price Recommendation (for 20,000 units)

Rs.
Marginal Cost (Rs. 8.385 × 20,000 units) 1,67,700
Additional profit required (1,67,300 - 1,09,050) 58,250
Total sales value 2,25,950
Selling price per unit (2,25,950/20,000) = Rs. 11.30 (approx.)

Selling Price at or below marginal cost:

Some time it may become necessary to sell the goods at a price below the marginal cost
some such situations are as follows:

 Where materials are of perishable nature

 To eliminate competitors from the market

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  To export so as to earn foreign exchange
 Where large quantities of stock are accumulated and whose market prices have
fallen. This will save the carrying cost of stocks.
 In order to popularize a new product.
 In order to increase sales of those products having higher margin or profits.

If the selling price is below the total cost but above the marginal cost, the contribution
will leave on under recovering of fixed cost. If the selling price fixed is equal to marginal
cost, there will be a loss which is equal to fixed cost. However, where the selling price is
fixed is lesser than the marginal cost, the loss will be greater than fixed cost.

1.6.2 Exploring New Markets

 Additional Order for utilizing unused plant capacity:

As the fixed cost has already recovered from current sales at total cost plus profit and
to utilize unused plant capacity, Selling Price > Variable Cost, but Selling Price <
Total Cost. (it will earn additional profit for the company)

 Export Sales:
Additional order from a foreign market at below total cost but above marginal cost
can be accepted (Selling Price > Variable Cost).
While determining acceptance or rejection of Export Order, the following points need
to be considered:
(1) If Export sales result in additional costs, then that is relevant cost for the final
decision. This additional cost should be deducted from the contribution to
determine profit.
(2) If Export Sales results in additional benefit, then that is relevant revenue for the
final decision. This additional benefit should be added into the contribution to
determine profit.
Non-Cost Factors:
 Foreign exchange earnings
 Employment opportunities
 Export status

Illustration 2: Indo-British Company has a capacity to produce 5,000 articles but actually
produce only 2,000 articles for home market at the following costs.

Rs.
Material 40,000
Wages 36,000
Factory Overheads
- Fixed 12,000
- Variable 20,000

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 Administration Overhead - Fixed 18,000
Selling and Distribution overheads
- Fixed 10,000
- Variable 16,000
Total Cost 1,52,000

Solution: Statement of Marginal Cost and Contribution (of 3,000 articles for export)

Rs.
Material @ Rs. 20 per article 60,000
Wages @ Rs. 18 per article 54,000
Variable Overhead
- Factory @ Rs. 10 per article 30,000
- Selling and Dist. @ Rs. 8 per article 24,000
Marginal cost of sales 1,68,000
Sales (3,000 articles @ Rs. 65) 1,95,000
Contribution 27,000
Less: Additional Packing Cost 3,000
Additional Profit 24,000

Acceptance of this export order results in additional profit of Rs. 24,000 and thus the
order should be accepted.

1.6.3 Make or Buy Decisions

Very often management is confronted with the problem of deciding whether to

buy a component or product from an outside source or to manufacture the same if it is
economical as compared to the price quoted by a supplier. In deciding the absorption
costing would mislead. If the decision is to buy from an external source the price quoted
by the supplier should be less than marginal cost. If the decision is to make within the
organization, the cost of production should include all additional cost such as depreciation
on new plant interest on capita, etc. If this cost of production is less than the quotation
price, it should be decided making the product rather than procure it from an external
source.

The following are the cost factors:

 Availability of plant facility.
 Quality and type of item which affects the production schedule
 The space required for the production of item.
 Any special machinery or equipment required.
 Any transportation involved due to the location of production
 Cost of acquiring special know how required for the item.
 Cost of labour redundancies, if any
 Technical obsolescence associated with the components

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COST COMPARISON
COST OF MAKE COST OF BUY
Variable Cost Direct Purchase Cost
+ Specific Fixed Cost, if any + Purchase related cost
+ Opportunity Cost (in case of full capacity +Opportunity Cost if any
operations)

Decisions will be made as under:

 If Cost of Make < Cost of Buy, then MAKE
 If Cost of Make > Cost of Buy, then BUY
 If Cost of Make = Cost of Buy, the company is indifferent
The following are the non-cost factors:
 In favour of making, the factors like Secrecy of company production, Ideal facility
available, Tax considerations, Quality and stability of market supply etc.
 In favour of buying factors like Assurance of quality of the product, Lack of capital
required, Wide selection, Passing know how to suppliers or not, Uneven production of
end product.

Illustration 3: Vinayak manufacturers three components. These components pass through

two of the company‟s departments P and Q. The machine hour capacity of each
department is limited to 6,000 hours in a month. The monthly demand for components
and cost data are as under.

Components A B C
Demand in units 900 900 1,350
Direct materials per unit Rs. 45 Rs. 56 Rs. 14
Direct labour per unit Rs. 36 Rs. 38 Rs. 24
Variable OH per unit Rs. 18 Rs. 20 Rs. 12
Fixed OH:
P at Rs. 8 per hour Rs. 16 Rs. 16 Rs. 12
Q at Rs. 10 per hour Rs. 30 Rs. 30 Rs. 10
Total Rs. 145 Rs. 160 Rs. 72
Components A and C can be purchased from market at Rs. 129 each and Rs. 70 each
respectively. Prepare a statement to show which of the components in what quantities
should be purchased to minimize the cost. (CA Final)

Solution: Computation of Hours required to monthly demand of components

Components A B C D
(a) Demand (units) 900 units 900 units 1,350 units
(b) Hours per unit in Department P 2 hrs 2 hrs 1.5 hrs
(given FOH/ Rs. 8)
(c) Hours per unit in Department Q 3 hrs 3 hrs 1 hrs

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(given FOH/ Rs. 10)
(d) Total hrs required in Dept. P for 1,800 hrs 1,800 hrs 2,025 hrs 5,625 hrs
production (a*b)
(e) Total hrs required in Dept. Q for 2,700 hrs 2,700 hrs 1,350 hrs 6,750 hrs
production (a*c)

 Available Hours = 6,000 each in Department P and Q. So, shortage in Department

Q = 750 machine hours to produce the components as per demand specified above.
 Department P has sufficient spare capacity of 375 hours, while time in department
Q is the key factory.

Particulars A B C Total
(a) Cost of buy (given) Rs. 129 NA Rs. 70
(b) Variable cost of make Rs. 99 Rs. 114 Rs. 50
(Material + Lab + VOH)
(c) Savings per unit, if made (a-b) Rs. 30 NA Rs. 20
(d) Hours required in Dept Q 3 hrs 3 hrs 1 hr
(WN 1c)
(e) Savings per hour, if made Rs. 10 NA Rs. 20
(c/d)
(f) Rank (preference for III I (no choice) II
production)
(g) Time required for production 2,700 hrs 2,700 hours 1,350 hours 6,750 hrs
in Dept Q
(h) Time allocated 1,950 hrs 2,700 hours 1,350 hours 6,000 hrs
(bal. fig)
(i) Production Quantity 650 units 900 units 1,350 units
(j) Purchase Quantity (900- 650 250 units Nil Nil
units)

Note: Since B cannot be bought outside, I Rank for production should be given for that
component.

Illustration 4: AB Ltd. has got a Machine No. 201. It manufactures product X with its
selling price Rs. 100 and marginal cost Rs. 60. The machine takes 20 hours to produce it.
The company uses a component „Y‟, that can be manufactured on Machine No. 201 in 3
hours at a marginal cost of Rs. 5. However, the component „Y‟ can be bought from the
market at a price of Rs. 10. Should the component „Y‟ be made on Machine No. 201?
[B.Com (Hons), Delhi]
Solution: Contribution from Product X
Selling Price Rs. 100
Less: Variable Cost 60
Contribution 40
Contribution per hour = 40/20 = Rs. 2

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 Cost of Producing Component Y
Marginal Cost Rs. 5
Cost due to loss of contribution from Product X (3 hrs.× 2) 6
Total Cost 11
Supplier‟s Price Rs. 10

The above computation shows that purchasing of component Y from the suppliers will
result in a net gain of Re. 1 per component as compared to manufacturing it. Hence, it is
better for the company to buy the component from outside supplier as compared to
manufacturing it.

1.6.4 Product Mix Decisions

Product mix decisions involve deciding upon the priority of products to be

produced and sold so as to maximize the profit. That product‐mix which gives maximum
contribution is to be considered the ideal product‐mix. Therefore, in order to determine
the best product mix, the contribution of each product must be calculated. The product
mix decision should be taken on the basis of contribution per unit of key factor. Assign
the ranking on the basis of contribution per unit. The best product‐mix would be that
which increase P/V. Ratio or which reduces break‐even point.
In addition to relevancy of costs, the other factors that should be considered in deciding
the product mix:
 Volume of output
 Available production capacity and limiting factors
 Market demand of the products
 Opportunity costs, if any.

Illustration 5: Taurus Ltd. produces three products: A, B and C, from the same
manufacturing facilities. The cost and other details of the three products are as follows:

A B C
Selling price/ unit (Rs.) 200 160 100
Variable cost / unit (Rs.) 120 120 40
Fixed expenses / month (Rs.) 2,76,000
Maximum production per month(units) 5,000 8,000 6,000
Total hours available for the month 200 hours
Maximum demand per month (units) 2,000 4,000 2,400

The processing hours cannot be increased beyond 200 hours per month. You are required
to:
(a) Compute the most profitable product mix
(b) Compute the overall break even sales of the company for the month based on the
mix calculated in (a) above (CA Inter)

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Solution: Working Notes:
1. Products A B C
Selling price / unit Rs. (I) 200 160 100
Variable cost / unit Rs. (II) 120 120 40
Contribution / unit Rs. (I - II) 80 40 60
Maximum production per hour (units) 25 40 30
(5,000/ 200) (8,000 / 200) (6,000/200)
Contribution per hour (Rs.) 2,000 1,600 1,800
(Maximum production per hour ×
Contribution per unit)
Ranking 1 3 2
Units to be produced 2,000 1,600 2,400
Time required for the units
to be produced (hrs.) 80 40 80

2. STATEMENT OF CONTRIBUTION

Products Units Selling price V.C Sales Variable Contribution

Per unit per unit Revenue cost
(i) (ii) (iii)
Rs. Rs. Rs. Rs. Rs.
A 2,000 200 120 4,00,000 2,40,000 1,60,000
B 1,600 160 120 2,56,000 1,92,000 64,000
C 2,400 100 40 2,40,000 96,000 1,44,000
Total 8,96,000 5,28,000 3,68,000

(a) M/ S Taurus Limited

MOST PROFITABLE PRODUCT MIX

Products *No. of units to Contribution per Total contribution

produced be unit
Rs. Rs.
A 2,000 80 1,60,000
B 1,600 40 64,000
C 2,400 60 1,44,000
Total 3,68,000
Less: fixed expenses 2,76,000
Profit 92,000
(*refer to working note 1)

(b) OVERALL BREAKEVEN SALES [based on the mix calculated in (a) part]

Breakeven sales = fixed costs × sales

Contribution

= Rs. 2,76,000 × Rs. 8,96,000* = Rs. 6,72,000

Rs. 3,68,000* (*refer to working note 2)

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Illustration 6: A limited manufacturers three different products and the following
information have been collected from the books of accounts:

PRODUCT
S T Y
Sales mix 35% 35% 30%
Selling price (Rs.) 30 40 20
Variable cost (Rs.) 15 20 12
Total fixed cost (Rs.) 1,80,000
Total sales (Rs.) 6,00,000

The company has currently under discussion, a proposal to discontinue the manufacture
of product Y and replace it with product M, when the following results are anticipated:

PRODUCT
S T Y
Sales mix 50% 25% 25%
Selling price (Rs.) 30 40 30
Variable cost (Rs.) 15 20 15
Total fixed cost (Rs.) 1,80,000
Total sales (Rs.) 6,40,000

Will you advise the company to change over to production of M? Give reasons for your
answers. (CS Inter)

Solution: EXISTING PRODUCTION

Products
S T Y
Rs. Rs. Rs.
Selling price 30 40 20
Variable cost 15 20 12
Contribution per unit 15 20 8
P/V ratio (contribution/sales × 100) 50% 50% 40%
Sales mix 35% 35% 30%
Contribution per rupee of sales 17 ½ % 17 ½ % 12%
(P/V ratio × sales mix)
Total contribution 47%
Total sales Rs. 6,00,000
Total contribution
Rs. 2,82,000
(47% of Rs. 6,00,000)
Fixed costs Rs. 1,80,000
Profit at present production Rs. 1,02,000

Breakeven point = Fixed cost = Rs. 1,80,000 = Rs. 3,83,000 (approx)

P/V ratio 47%

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 Proposed Production:

Products
S T M
Rs. Rs. Rs.
Selling price 30 40 30
Variable cost 15 20 15
Contribution per unit 15 20 15
P/V ratio (contribution/sales × 100) 50% 50% 50%
Sales mix 50% 25% 25%
Contribution per rupee of sales (P/V ratio × sales mix) 25% 12 ½ % 12½ %

Total Contribution (6,40,000 × 50) Rs. 3,20,000

Less: Fixed costs Rs. 1,80,000
Profit Rs. 1,40,000

Breakeven point = Fixed cost = 1,80,000 = Rs. 3,60,000

P/V ratio 0.50

The proposal can be accepted because after replacement with product M:

(i) Breakeven point is reached at a lower level of total sales and
(ii) There is an increase of profit by Rs. 38,000.

Illustration 7: A company running an orchard with an adequate supply of labour presents

the following requests your advice about the area to be allotted for the cultivation of
various types of fruits, which would result in the maximization of the profits. The
company contemplates growing Apples, Lemons, Oranges and Peaches.

Apples Lemons Oranges Peaches

Selling price per box (Rs.) 15 15 30 45
Season‟s yield in boxed per acre 500 150 100 200
Cost: Rs. Rs. Rs. Rs.
Material per acre 270 105 90 150
Labour: Growing per acre 300 225 150 195
Packing per acre 1.50 1.50 3 4.50
Transport per box 3 3 1.50 4.50

The fixed costs in each season would be:

Cultivation and growing 56,000

Picking 42,000
Transport 10,000
Administration 84,000
Land revenue 18,000

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The following limitations are also placed before you:
(a) The area available is 450 acres, but out of this, 300 acres are suitable for growing only
oranges and lemons the balance of 150 acres is suitable for growing any of the four fruits.
(b) As the produce may be hypothecated to banks, area allocated for any fruit should be
demarcated in complete acres and not in fraction of an acre.
(c) The marketing strategy of the company requires the compulsory production of all the
four types of fruits in a season and the minimum quantity of any one type to be 18,000
boxes.

Calculate the total profit that would accrue if your advice is accepted.
[B.Com (Hons), Delhi]

Solution: STATEMENT OF COMPARATIVE PROFITABILITY

Particulars Apples Lemons Oranges Peaches

Rs. Rs. Rs. Rs.
Selling price per box 15 15 30 45
Season‟s yield (in boxes) per acre 500 150 100 200
Average sales per acre 7,500 2,250 3,000 9,000
Material per acre 270 105 90 150
Labour cost per acre:
Growing 300 225 150 195
Picking and packing
(500 × 1.50) 750
(150 × 1.50) 225
(100 × 3.00) 300
(200 × 4.50) 900
Transport
(500 × 3.00) 1,500
(150 × 3.00) 450
(100 × 1.50) 150
(200 × 4.50) 900
Total marginal cost per acre 2,820 1,005 690 2,145
Contribution per acre 4,680 1,245 2,310 6,855
Priority as per contribution II IV III I

Land Position

Total area of Orchard 450 acres

Suitable for oranges and lemons 300 acres
Suitable for any fruit 150 acres

Marketing policy

(a) all four types of fruits are to be produced in each season.

(b) Minimum quantity of any one type = 18,000 boxes

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Fruit Boxes Acres Contribution priority revenue
Lemons 18,000 120 IV minority Qty.
Oranges 18,000 180 III minority Qty.
300

Balance 150 acres:

Apples 18,000 boxes 36 acres II minimum Qty.

Peaches 22,800 boxes 114 acres I balance available for maximum
contribution
Grand total 450 acres

STATEMENT SHOWING THE TOTAL PROFIT (MAXIMUM)

Particulars Total Apples Lemons Oranges Peaches

Land in acres 450 36 120 180 114
Season‟s yield (boxes) 76,800 18,000 18,000 18,000 22,800
Contribution (Rs.) 15,15,150 1,68,480 1,49,400 4,15,800 7,81,470
Less: fixed costs 2,10,000
Total profit 13,05,150

i.e. Maximum Profit: Rs. 13,05,150

1.6.5 Operate or Shut Down

The management under certain circumstances might feel that plant shut down. That
means operating or continuing is not a better alternative in comparison to shut down. This
point generally comes in the operation of business where a firm is indifferent to
continuing operations and shutting down temporarily.
Shutdown cost is that cost which the firm incurs when it temporarily stops its
operations. These costs could be saved if the operations are allowed to continue. In
addition to Fixed Costs, shutdown costs include the cost of sheltering plant and
equipment, lay‐of‐expenses, employment and training of workers when the plant is
restarted and above all loss of market. Temporary Shut Down is a short term measure. It
occurs because of strikes, trade depression etc. Permanent Shut Down is taken only in
worst situations when business is not in situation to earn sufficient return to cover the risk
involved. While calculating shutdown costs, only that cost will be considered which
would not occur if the firm continues its operations.
As cost is not the only criterion for deciding in favour of shut down. The other non-
factors to be considered are:
(a) In case of shutting down the business, other companies may get a chance to establish
their product and business
(b) If the production is suspended, the product would be lost from public memory and
when the business restarts, it would take a heavy expenditure on marketing.

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 (c) Once the skilled workers are discharged it might be difficult to get experienced and
skilled workers when the business resumes.
(d) Risk of obsolescence of Plant and Machinery.
(e) Closing down business for limited period or specific activity may leave and adverse
impact on the company or sully its reputation.
(f) Arrangement of finance for compensation payable on retrenchment of unskilled
workers, if any.

Illustration 8: The selling price per unit of a product is Rs. 14. For the forthcoming
period, the demand will be only 5,000 units. The fixed expenses at 50% activity (5,000
units) will be Rs. 30,000. The company is thinking of shutting down operations, in which
case an additional amount of Rs. 2,000 will have to be incurred for shutting down and
only Rs. 20,000 of the above fixed costs can be avoided. What should be the variable cost
per unit to be recommended a shut down? (CA Final)

Solution: Let variable cost per unit be Rs. X

Particulars Continue operations Shutdown

(1) Revenue 5,000 units× Rs. 14 = Rs. 70,000 Nil
(2) Variable cost 5,000 X Nil
(3) Contribution (1-2) 70,000- 5,000 X Nil
(4) Fixed costs 30,000 30,000 - 20,000 + 2,000 =
12,000
(5) Profit (3-4) 40,000 - 5,000 X (12,000)

For indifference between continue and close down options, the profits of the two options
should be equal.
So, 40,000 - 5,000 X = - 12,000,
- 5,000 X = - 52,000
On solving,
X = 10.40 = Desired variable cost p.u.
Conclusion: if variable cost per unit is greater than Rs. 10.40, Shut Down Option is
preferable.

Illustration 9: Plant 3 Budgeted Income and cost estimates are follows:

Sales (annual) Rs. 10,00,000
Costs- Fixed Rs. 4,00,000
Variable Rs. 3,00,000
Head Office allocated Rs. 3,50,000 Rs. 10,50,000
Loss Rs. 50,000
Sales of plant 3 is under consideration. What is your recommendation based on the data
given? Justify your recommendation. [B.Com (Hons), Delhi]

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Solution: Plant 3: Statement of Profit

Rs.
Sales 10,00,000
Less: Variable Cost 3,00,000
Contribution 7,00,000
Own Fixed Cost 4,00,000
Profit 3,00,000
Head Office Allocated Fixed Cost 3,50,000
Loss 50,000

The above statement shows that profit by itself is giving a profit of Rs. 3,00,000. The loss
is because of head office allocated expenses of Rs. 3,50,000. The head office has to
justify charging of such heavy fixed expenses to the branch. It seems they are either on
the higher side or not properly allocated. Hence, the branch should not be closed down
but should continue its operations.

1.7 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) In make or buy decision, marginal costs as well as additional fixed costs are the
factors to be considered.
(a) True
(b) False

(2) If the marginal cost is _________ buying price, additional requirement of the
component should be met by making rather than buying.
(a) Equal to
(b) More than
(c) Less than
(d) None of the above.

(3) If the management decides to manufacture a product it in own factory, the focus
should be on
(a) Cost factors
(b) All Non-cost factors
(c) Both (a) and (b)
(d) None of the above

(4) If there are large fluctuations in demand, the component should be

(a) Purchased from outside
(b) Made in factory
(c) Should be made in factory in peak season
(d) Should be made in factory in off season

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(5) In marginal costing profitability of each product is measured on the basis of its
(a) Cost
(b) Profit
(c) Contribution
(d) None of the above

(6) While making key factor decision, if raw material is key factor then such product
should be preferred which offer:
(a) Highest contribution per hour
(b) Highest contribution per unit
(c) Highest contribution per unit of material
(d) None of the above

(7) Change in product mix decision should be merely based on contribution.

(a) True
(b) False

(8) While selecting optimum product mix ___________ is the real index of
profitability.
(a) Contribution per unit
(b) Contribution per unit of key factor
(c) Profit and sales
(d) None of the above

(9) In a competitive market, the price is determined by the

(a) Individual concern
(b) Market forces
(c) Both (a) and (b)
(d) None of the above

(10) While taking shut-down decisions, the amount of contribution should be

compared with
(a) Escapable fixed costs
(b) Special costs
(c) Net escapable fixed costs
(d) None of the above

(11) A decision regarding temporary closure should be made on

(a) Cost data
(b) Economic factors
(c) Social factors
(d) All of the above

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Answers: (1) (b), (2) (c), (3) (a), (4) (a), (5) (c), (6) (c), (7) (b), (8) (b), (9) (b), (10) (c),
(11) (d)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) Costs which are pertinent to decision-making are termed as _______________.

(b) ___________ costs are those costs that require a definite outlays of funds.
(c) ______________are those costs which are irrelevant for further decisions because
the expenditure has already been made and cannot be changed regardless of the
alternative that is selected.
(d) Special decisions are defined as those decisions which are not _______________
(e) The cost which will be eliminated, if a segment of the business with which it is
directly related, is discontinue is known as __________
(f) The process of choosing among alternatives is regarded as _______________

Answers: (a) Relevant cost, (b) out-of-pocket, (c) sunk cost, (d) routine or recurring, (e)
avoidable cost, (f) decision making

Q2. True/False Statement:

(a) Marginal costing is useful for long term planning

(b) Opportunity cost is the value of benefit sacrificed in favour of an alternative
course of action.
(c) Relevant information is the information that differs between alternatives.
(d) All fixed costs are sunk costs but all sunk costs are not fixed costs.
(e) An opportunity cost is implied in making any decision.

Answers: (a) F (b) T (c) T (d) F (e) T

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Write short notes on:

(a) Relevant Cost
(b) Differential Costing vs Marginal Costing
(c) Out-of-Pocket Cost
(d) Sunk Cost

Q2. What are the cost and non-cost factors in accepting export orders?

Q3. Write note on make or buy decision.

Q4. What do you mean by relevant costs and irrelevant cost in decision making? Give
example.

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Q5. “The technique of variable costing is more used to provide a reasonable and sound
basis for managerial decision decisions than to arrive at product cost.” Explain this
statement with reference to the various types of decisions in which variable costing is
useful.

Q6. A mechanical toy factory presents the following information for the year 2012:

Material cost (Rs.) 1,20,000

Labour cost (Rs.) 2,40,000
Fixed overheads (Rs.) 1,20,000
Variable overheads (Rs.) 60,000
Units produced 12,000
Selling price per unit (Rs.) 50

The available capacity is a production of 20,000 units per year. The firm has an offer for
the purchase of 5,000 additional units at a price of Rs. 40 per unit. It is expected that by
accepting this offer there will be a saving of rupee on per unit in material cost on all units
manufactured. The fixed overhead will increase by 35,000 and the overall efficiency will
drop by 22% on all production. State whether offer is acceptable or not.

Answers: Yes, the new offer is acceptable.

Q7. Y Ltd. wants to merge three similar plants P, Q and R. The details are as under:

Plant P Q R
Capacity operated 100% 70% 50%
(Rs. in Lakhs) (Rs. in Lakhs) (Rs. in Lakhs)
Turnover 300 280 150
Variable cost 200 210 75
Fixed cost 70 50 62

Find out:

(i) The capacity of the merged plant for break even.

(ii) The profit @ 75% capacity of the merged plant.
(iii) The turnover from the merged plant to give a profit or Rs. 28 Lakhs.
[B.com (Hons), Delhi]
Answers: (i) B.E.P. = 52% (ii) Profit = Rs. 80.5 Lakh (iii) Turnover = Rs. 600 Lakh

Q8. Present the following information to show to management:

(i) The marginal product cost and the contribution per unit.
(ii) The total contribution and profit resulting from of the each of the following sales
mixtures.

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Particulars Product Rs. per unit
Direct material A 10
Direct materials B 9
Direct wages A 3
Direct wages B 2
Fixed expenses Rs. 800
(Variable expenses are allotted to products as 100% of
direct wages)
Sales price A Rs. 20
Sales price B Rs. 15

Sales mixture:
(a) 100 units of product A and 200 of B
(b) 150 units of product A and 150 of B
(c) 200 units of product A and 100 of B [B.Com (Hons), Delhi]

Answers: Total contribution

(a) 800 (b) 900 (c) 1000. Sales mix (c) is the best.

Q9. The Vinayak Ltd. Company manufactures a range of products and has just received a
proposal from Shankar Ltd, Company that one of its products T, could be supplied to
them advantageously at a price of Rs. 28 per unit. The cost of manufacturing in the
Vinayak Ltd. Company is as under:

Details Costs per unit (Rs.)

Material 15
Process 1 15
Process 2 5
TOTAL 35

From further enquiries the following facts emerge:

(i) Process 1 cost included an element of fixed overhead of approximately 40%
(ii) Process 2 is a joint process producing three products in addition to T. The process
costs would still be incurred if T were not produced by the company.
Advise the management of the Vinayak Ltd. Company whether the proposal to purchase
should be accepted or to continue manufacturing. [B.Com (Hons), Delhi]
Answers: Proposal should not be accepted as variable cost of Rs. 24 is less than the
purchase price of Rs. 28.

Q10. Samson and Co. Annually manufacturers 10,000 units of a product at a cost of Rs. 4
per unit. There is home market for consuming the entire volume of production at the sale
price of Rs. 4.25 per unit. In the next year, there is a fall in the demand for home market
which can consume 10,000 units only at a sale price of Rs. 3.72 per unit. The analysis of
the cost per 10,000 units is:

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 Material Rs. 15,000
Fixed overheads 8,000
Wages 11,000
Variable overheads 6,000

The foreign market is explored and it is found that this market can consume 20,000 units
of the product if offered at a sale of Rs. 3.55 per unit. It is also discovered that for
additional 10,000 units of the product (over initial 10,000 units) the fixed overheads will
increase by 10%. Is it worthwhile to try to capture the foreign market?
(C.S. Inter)

Answers: Order should be accepted because it will add Rs. 5,400 to profit. Total variable
cost Rs. 64,000; Additional fixed cost Rs. 1,600

Q11. X Ltd. markets a single product and provides you the following data:

Per unit (Rs.)

Materials 16
Conversion costs (variable) 12
Dealer‟s margin 4
Selling price 40
Fixed cost Rs. 5 Lakhs
Present sales 90,000 units
Capacity utilization 60 percent

There is acute competition, extra efforts are necessary to sell. Suggestions have been
made for increasing sales:
(a) By reducing sales price by 5 percent.
(b) By increasing dealer‟s margin by 25 percent over the existing rate.
Which of these two suggestions you would recommend, if the company desires to
maintain the present profit? Give reasons. (C.S. Inter)

Answers: Contribution per unit (a) Rs. 6.20 (b) Rs. 7. Present profit Rs. 2, 20,000;
Suggestion (b) is recommended, sale 1,02,857 units

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 LESSON 2

DECISION MAKING AND DIFFERENTIAL COST ANALYSIS

2. STRUCTURE

2.0 Learning Objectives

2.1 Decision Making and Differential Cost
2.2 Concept of Differential Revenue
2.3 Characteristics of Differential Costs
2.4 Difference between Marginal Costing and Differential Costing
2.5 Applications of Differential Cost Analysis
2.5.1 Determining Optimum Level of Production
2.5.2 Accepting a Special Order
2.5.3 Adding or Dropping a Product Line
2.5.4 Make or Buy Alternative
2.5.5 Further Processing of Joint Products
2.6 Qualitative or Non-Financial Considerations
2.7 Self-Test Questions

2.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn the uses of differential cost analyses
(b) Differentiate between marginal costing and differential costing
(c) Learn the practical applications of differential cost analyses for accepting a special
order, make or buy decisions, adding or dropping a product line etc.

2.1 DECISION MAKING AND DIFFERENTIAL COST

Decisions involve choosing between alternatives. Every alternative have their own
certain costs and benefits that must be compared to the costs and benefits of the other
available alternatives. A difference in cost between any two alternatives is known as
differential cost. A difference in revenue between any two alternatives is known as
differential revenues.

In Differential cost analysis, it is necessary to know both incremental cost and

decremental cost. Those items that are the same under all alternatives can be ignored. The

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accountant's differential cost concept can be compared to the economist's marginal cost
concept.

Differential cost analysis is a special technique to help management in decision-

making which shows how costs and revenues would be different under different
alternative courses of action. In other words, Differential cost is the difference in cost
between one alternative and another. This difference in cost may occur due to difference
in fixed costs and variable costs, so differential cost is the aggregate of changes in fixed
costs and variable costs which take place due to the adoption of an alternate course of
action or change in the level of output.

2.2 CONCEPT OF DIFFERENTIAL REVENUE

- This is regarded as future revenues which differ between the alternatives being
considered.

- When comparing different alternatives, three distinct situations may exist; these three
basic situations are:

(1) Operating at less than full capacity and the decision will have no effect on other
product sales or revenue generating activities.
- Simply compare the incremental revenues and cost of the different alternatives; no
consideration of lost contribution which is presently being generated need be considered.

(2) Operating at less than full capacity but the decision will effect on other product sales
or revenue-generating activities.
- must consider the revenues and costs of present products and activities which will be
effected by the decision made as well as the estimated results directly generated from the
decision.

(3) Operating at full capacity as well as the decision will effect on other product sales or
revenue-generating activities.
- must consider the revenues and costs of present products or activities which will be
effected by the decision made as well as the estimated results directly generated from the
decision.

2.3 CHARACTERISTICS OF DIFFERENTIAL COSTS

Following are the essential characteristics of differential costs:

 Differential cost analysis is for internal purpose. That is why it is not prepared
within the accounting records rather it is made outside the accounting records.
 Total differential costs are considered in differential cost analysis. Cost per unit is
not taken into consideration. It differs from action to action.

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  Total differential revenues are compared with total differential costs before taking
an alternate course of action. A change is recommended only if the outcome of the
analysis shows that differential revenues exceed differential costs.
 Those items which do not change with change in alternatives under consideration
are ignored, only those items of costs are considered which shows change because
differential costs analysis is concerned with changes in costs.
 The changes in costs are measured from adopting a common base point which can
be a present level of production.
 Differential cost analysis is not related to past or historic cost rather it is related to
the future course of action or future level of output, so it deals with future costs.
 For decision making a choice is made from the various alternatives available, the
alternative which gives the maximum difference between the incremental revenue
and incremental cost is recommended to be adopted.

2.4 DIFFERENCE BETWEEN MARGINAL COSTING AND

DIFFERENTIAL COSTING

Marginal Costing Differential Costing

It is the change (increase or decrease) in
It represents the increase or decrease in
the total cost due to the change in level of
total cost which occurs with a small
activity, technology, production process or
change in output.
methods of production.

In this only variable cost changes due to a Here, variable as well as fixed cost change
change in the level of activity. due to a change in the level of activity.

Marginal costing wholly excludes fixed

Differential costing can be made in the
cost; some of the fixed cost may be
case of both absorption costing as well as
taken into account as being relevant for
marginal costing.
the purpose of differential cost analysis.

Marginal costing may be embodied in the Differential costs are separately noted as
accounting system. analysis statements.

In Marginal Costing, margin of

In differential cost analysis, different costs
contribution and contribution ratios are
are compared with the incremental or
the main yardsticks for the performance
decremental revenues as the case may be.
evaluation and for decision making.

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2.5 APPLICATIONS OF DIFFERENTIAL COST ANALYSIS
2.5.1 Determining optimum level of production
The optimum level is that level of production where profit is the maximum. In order to
arrive at a decision of this type, the differential costs are compared with incremental
revenue at various levels of output. So long as the incremental revenue exceeds
differential costs, it is profitable to increase the output. But as soon as the differential cost
equals or exceeds increments revenue, it is no more profitable to increase the volume of
output.

2.5.2 Accepting a special order

Special orders are onetime orders that do not affect a company‟s normal sales. The profit
from a special order equals the incremental revenue less the incremental costs. As long as
the incremental revenue exceeds the incremental cost and present sales are unaffected, the
special order should be accepted.

- be sure to consider if the special order will have any effect on regular sales or
revenues.
- be sure you are not estimating the incremental costs from per unit cost data that
includes allocated, indirect fixed costs which actually will not be increased by the
taking of this order.

2.5.3 Adding or dropping a product line

In multi-product company, a product line can be added only if the increase in Total
Contribution Margin is greater than the increase in fixed cost. A segment should be
dropped only if the decrease in Total Contribution Margin is less than the decrease in
fixed cost. Some other points to be considered for decision making are follows:

(a) Highly competitive nature of the product

(b) Value of resources released on discontinuation
(c) Contribution margin earned from that product

2.5.4 Make or Buy alternative

Make or Buy alternatives can be analyzed on the basis of the comparison of differential
cost and incremental revenues. Compare the incremental, out-of-pocket type costs of
making the product internally with the definite out-of-pocket costs (price) of purchasing
the product externally.

Essentially in this analysis, costs which will be eliminated if the product is no longer
produced internally (i.e., the benefits of not producing internally) must be compared with
the costs (purchase price, freight charges, insurance, sales taxes, import duties, etc.) of an
outside purchase.

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2.5.5 Further processing of joint products
In some manufacturing processes, several intermediate products are produced from a
single input. Such products are known as joint products. Management has to decide
whether to further process Joint Product or sell By-Product.

Sooner or later a decision often has made about selling a joint product as it is or after
processing it further. Such decisions are taken on the basis of comparison of differential
cost and incremental revenue.

2.6 QUALITATIVE OR NON-FINANCIAL CONSIDERATIONS

In all decision making analysis, after the relevant monetary or financial measures
of the different alternatives has been examined, then it is also required that necessary non-
quantitative issues must be considered.

Such factors as employee‟s morale, customer long-term response, governmental

intervention, quality of the product that will be produced, the acceptable or appropriate
amount of risk, dependency on particular vendors, legal violations, ethical considerations
and meeting corporate social responsibilities must all be considered.

In the final analysis, these qualitative or non-monetary considerations must be

reviewed by the managers along with the economic or quantitative impact of any decision
in arriving at a final decision. Always attempt to identify the qualitative or non-financial
issues which need to be considered. Such non-monetary issues can sometimes outweigh
or give more clarification which can be realized under the decision circumstances.

Illustration 1: A company at present working at 90% capacity and producing 13,500

units per year. It operates a flexible budgetary control system. The following figures are
obtained from its budget.

90% 100%
Rs. Rs.
Sales 15,00,000 16,00,000
Fixed expenses 3,00,500 3,00,600
Variable expenses 1,45,000 1,49,500
Semi fixed expenses 97,500 1,00,400
Units manufactured 13,500 15,000
Labour and material cost per unit is constant under present conditions. Profit margin is
10% of sales at 90% capacity.
(a) You are required to determine the differential cost of producing 1,500 units by
increasing capacity to 100%.
(b) What price would you recommend for export of these 1,500 units, taking into
account that overseas prices are lower than indigenous prices? [B.Com (H), Delhi]

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Solution: The problem does not give the material and labour cost which is needed for
computing differential cost. It is computed by working backward from sales as follows.

At 90% capacity
Rs.
Sales (13,500 units) 15,00,000
Less: profit (10% of sales) 1,50,000
Cost of goods sold 13,50,000
Less: variable expenses 1,45,000
Semi fixed expenses 97,500
Fixed expenses 3,00,500 5,43,000
Cost of labour and material(prime cost) 8,07,000

Labour and material costs are variable in nature and thus at 100% capacity these will be
calculated as under:
8,07,000 ×100/90 = Rs. 8,96,667(approx)

STATEMENT OF DIFFERENTIAL COST ANALYSIS

90% 100% DIFFERENTIAL

Production (units) 13,500 15,000 1,500
Labour and material cost Rs. 8,07,000 8,96, 667 89,667
Variable expenses Rs. 1,45,000 1,49,500 4,500
Semi fixed expenses Rs. 97,500 1,00,400 2,900
Fixed expenses Rs. 3,00,500 3,00,600 100
Total 13,50,000 14,47,167 97,167

Differential cost per unit = Differential cost = Rs. 97,167 = Rs. 64.78
Differential units 1,500 units

At a price of Rs. 64.78, there will be no additional profit. Therefore, any price above Rs.
64.78 which gives atleast reasonable profit should be acceptable for export, assuming that
export will not affect the internal sales.

Illustration 2: X Ltd. has been offered an order from A Ltd. For 10,000 units of output @
Rs. 100 each, which has a variable cost of Rs. 60 and will involve an outlay of Rs. 60,000
for set up, jigs and dies. At the same time there is another offer of an order from B Ltd.
For 8,000 units of output at Rs. 110 each. Variable costs are estimated at Rs. 68 each and
involve an outlay of Rs. 50,000 for set up, jigs and dies. Which order should the company
accept? (Adatpted)

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Solution: STATEMENT OF INCREMENTAL REVENUE AND COST

A Ltd. B Ltd.
(a) Size of order (units) 10,000 8,000
Rs. Rs.
(b) Price per unit 100 110
(c) Variable cost per unit 60 68
(d) Incremental revenue (a×b) 10,00,000 8,80,000
(e) Incremental variable cost (a×c) 6,00,000 5,44,000
(f) Contribution (d-e) 4,00,000 3,36,000
(g) Outlay for set up, jigs etc. 60,000 50,000
(h) Total incremental cost (e+ g) 6,60,000 5,94,000
(i) Net incremental revenue(d-h) 3,40,000 2,86,000
(j) P/V ratio (f/d) × 100 40% 38%

Conclusion: it may be concluded from the above analysis that order from A Ltd. is more
profitable because it gives a higher incremental revenue of Rs. 54,000 (Rs. 3,40,000 -
2,86,000). Order from A Ltd. Should it be accepted. P/V ratio from A Ltd. is also higher.

Illustration 3: The following extracts are taken from sales budget of a company for a
current year:

Rupee in ‘000
Sales: 40,000 units @ Rs. Per unit 1,000
Selling costs:
Advertising 100
Salesman‟s salaries 80
Travelling expenses 50
Rent of sales office 10
Others 10 250

The management is considering a proposal to establish a new market in the eastern region
in the next year. It is proposed to increase the advertising expenditure by 25% and appoint
an additional sales supervisor at a salary of Rs. 30,000 per year to establish a market. This
will involve additional travelling and travelling expense shall increase by 10%. Target
annual sales volume at the existing selling price for the new market is 10,000 units. The
estimated variable cost of production is Rs. 12 per unit.

Should the company try to establish the new market? (ICWA Inter)

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Solution:

Present Proposed Incremental Cost

Position Position and Revenue
Sales units 40,000 50,000 10,000
(A) Sales Rs. „000 1,000 1,250 250
Costs: Advertising 100 125 25
Sales Salaries 80 110 30
Travelling Expenses 50 55 5
Rent 10 10 -
Others 10 10 -
250 310 60
Variable costs of Production @ Rs. 12 480 600 120
per unit
(B) Total Cost 730 910 180
Profit (A-B) 270 340 70

Conclusion: There is incremental cost of Rs. 1,80,000 against incremental revenue of Rs.
2,50,000 resulting in net additional income of Rs. 70,000 (i.e. Rs. 2,50,000 - 1,80,000).
Therefore the proposal should be accepted.

2.7 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) __________ refers to changes in total costs that occur due to changes in volume
of production or sales, product system, product mix or from the adoption of an
alternative course of action.
(a) Differential costs
(b) Marginal costs
(c) Absorption costs
(d) None of the above

(2) As per J.M. Clark, when a decision has to be made involving ___________, the
difference in cost between two policies may be considered to be the cost really
incurred on account of these n-units of business.
(a) An increase of n-units of output
(b) A decrease of n-units of output
(c) An increase or decrease of n-units of output
(d) None of the above

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(3) Pertaining to the differential cost systems, which of the following statements are
true?
(A) Differential cost plus differential income shows net loss or net income
(B) Differential cost is ascertained by comparing total costs of each alternative
(C) Differential cost related to differential investments is calculated every time.
(a) Only A
(b) Only B
(c) Only C
(d) A, B, C

(4) Which of the following statements are true?

(a) Differential cost is also known as relevant cost.
(b) Differential costs are estimated future costs.
(c) Differential costs include only those costs which change as a result of the decision
making being considered.
(d) All of the above

(5) If direct labor is not affected by the change in the type of material, it will form a
part of differential cost.
(a) True
(b) False

(6) The basic data used for differential cost analysis are
(a) Cost
(b) Revenue
(c) Investment data
(d) All of the above

(7) The alternative which shows ____ difference between the incremental revenue
and the differential cost is the one considered to be the best choice for selection.
(a) Maximum
(b) Minimum
(c) No
(d) None of the above

(8) Differential cost is a part of routine accounting records.

(a) True
(b) False

(9) If there is no change in fixed cost at different levels of output,

(a) Marginal costs > Differential cost
(b) Marginal costs < Differential cost
(c) Marginal cost and Differential cost are same
(d) None of the above

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(10) Differential costs are obtained on the basis of
(a) Absorption costing
(b) Marginal costing
(c) Both (a) and (b)
(d) None of the above

(11) In the case of differential costing, ________ is the main criteria for decision
making.
(a) Contribution
(b) Ratios
(c) Incremental/decremental revenue
(d) None of the above

Answers: (1) (a), (2) (c), (3) (b), (4) (d), (5) (b), (6) (d), (7) (a), (8) (b), (9) (c), (10)
(c), (11) (c)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

a) An _______________ cost is the difference between the total cost of available

alternatives.
b) Two general formats used to present relevant information for decision-making
purpose are the ________ or ____________ approach and the __________
approach.
c) ________________ cost is the difference in total cost that results from two
alternative courses of action.

Answers: (a) Incremental, (b) incremental cost or revenue; contribution margin, (c)
differential

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. What is differential costing? Explain its importance in decision-making.

Q2. What is meant by Differential Cost Analysis? Explain the essential features and
points of similarity and difference between Differential Cost Analysis and Marginal
Costing.

Q3. What do you understand by Differential Cost Analysis? Explain

(a) the essential features of differential costing, and
(b) its practical applications.

Q4. Distinguish between marginal costing and differential costing.

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Q5. A company is at present working at 90% capacity and producing 13,500 units per
year. It operates a flexible budgetary control system. The following figures are obtained
from its budget:

90% 100%
Rs. Rs.
Sales 15,00,000 16,00,000
Fixed expenses 3,00,500 3,00,500
Variable expenses 1,45,000 1,49,000
Semi fixed expenses 97,500 1,00,500
Units manufactured 13,500 15,000

Labour and material cost per unit are constant under present conditions. Profit margin is
10 percent.

(a) You are required to determine the differential cost of producing 1,500 units by
increasing capacity to 100 percent.
(b) What would you recommend for an export price for these 1,500 units taking into
account that overseas prices are much lower than indigenous prices?

Answers:
(i) Differential cost of producing 1,500 units = Rs. 97,167
(ii) Minimum price for exports = Rs. 64.78

Q6. Lahore Ltd. is at present operating at 80% capacity level, the production being 15,000
units per annum. It operates a flexible budgetary control system. The following relevant
cost data are obtained from the company‟s budget at different capacity utilization levels:

Capacity utilization level

80% 100%
Sales Rs. 20,00,000 Rs. 25,00,000
Variable overheads Rs. 2,25,000 Rs. 2,50,000
Semi variable overhead Rs. 1,05,000 Rs. 1,11,000
Fixed overheads Rs. 4,00,000 Rs. 4,70,000
Output (in units) 15,000 18,750

Material and labour cost per unit are constant under the present conditioned. The
management expects a profit margin of 10% on sales.
You are required to compute the differential cost of producing the additional 3,750 units
by increasing the capacity utilization level to 100 percent.

Answer: Differential cost Rs. 3,68,500.

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Q7. In a factory the rated capacity is 30,000 units. The following data is supplied:

Output upto From 15,001 - From 25,001 –

15,000 units 25,000 units 30,000 units
Rs. Rs. Rs.
Fixed cost 15,000 16,000 19,500
Variable cost per unit 3 3 3.25
Sales revenue per unit 4 3.80 3.80

What is the most profitable level of output? Use differential cost analysis.

Answer: 25,000 units

Q8. A company has a capacity of producing 50,000 units of a certain product in a month.
The sales department reports that the following schedule of selling prices is possible:

Volume of sales Unit selling price

(% capacity) Rs.
50% 2.00
60% 1.90
70% 1.85
80% 1.80
90% 1.70
100% 1.60

The variable cost of manufacture between the above levels is Re. 1 per unit and the total
amount of fixed cost is Rs. 20,000 p.m. at 100% capacity level.
Prepare a statement showing incremental revenue and differential cost at each of the
above levels of production and sales. At which level the profit will be maximum?

Answer: 80%

Q9. Walia machines Co. Manufacturers had operated sewing machines. Prepare a
schedule showing the total differential costs and increments in revenue from the
following data. At what volume the company should set its level of production?

Output ( in Setting price Total semi Total variable Total fixed

Lakhs) per machine fixed cost (Rs. cost (Rs. in (Rs. in Lakhs)
(Rs.) in Lakhs) Lakhs)
0.60 240 30 83.5 28.40
1.20 220 30 163.6 28.40
1.80 200 34 255.6 28.40
2.40 180 34 315.6 28.40
3.00 160 40 355.6 28.40
3.60 140 40 380.4 28.40

Answer: 3 Lakh unit

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 LESSON 1 UNIT 6

RESPONSIBILITY ACCOUNTING AND DIVISIONAL

PERFORMANCE MEASUREMENT

1. STRUCTURE

1.0 Learning Objectives

1.1 Introduction
1.2 Meaning and Definition of Responsibility Accounting
1.3 Pre-Requisites of Responsibility Accounting
1.4 Features of Responsibility Accounting
1.5 Steps Involved in Responsibility Accounting
1.6 Advantages of Responsibility Accounting
1.7 Limitations of Responsibility Accounting
1.8 Responsibility Centre
1.9 Types of Responsibility Centre
1.10 Divisional Performance Measurement
1.10.1 Introduction
1.10.2 Financial Methods for Evaluation of Divisional Performance
1.10.3 Non-Financial Methods for Evaluation of Divisional Performance
1.11 Self-Test Questions

1.0 LEARNING OBJECTIVES

After reading this lesson, the students will be able to:

(a) Learn the meaning, features and pre-requisites for responsibility accounting
(b) Learn the concept of responsibility centre and types of responsibility centre
(c) Learn to measure performance of divisions
(d) Learn different methods to evaluate divisional performance

1.1 INTRODUCTION

Responsibility Accounting is not a new branch of accounting like financial

accounting or cost accounting. It is a controlling device by which costs are traced to
individual managers and relevant for measurement of performance of an organization. In
this sense, responsibility accounting is a supplementary cost control device.
Responsibility accounting involves a company's internal accounting and budgeting.
Responsibility accounting is a system of control under which managers are given decision

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 making authority and are made responsible for their area assigned activity occurring
within a specific department/division of the company.

1.2 MEANING AND DEFINITION OF RESPONSIBILITY ACCOUNTING

Responsibility Accounting is a system of dividing a large diversified organization

into small manageable units, each of which is to be assigned particular responsibilities.
These units may be in the form of divisions, segments, departments, branches, product
lines and so on. Each department is comprised of a manager who is held responsible for
particular tasks or managerial functions. The managers of various departments should
ensure that all the employees in their department are doing their best to achieve the goal.
It also refers to the various tools and techniques used by managers to measure the
performance of individual unit/division/departments in order to ensure that the
achievement of the goals set by the top management.

According to “Responsibility Accounting is a system of management Accounting

CIMA, under which accountability is established according to the responsibility
London delegated to various levels of management and management information
and reporting system instituted to give adequate feedback in terms of
delegated responsibility. Under this system divisions or units of an
organization under specified authority in a person are developed as
responsibility centers and evaluated individually for their performance.
A good system of transfer pricing is essential to establish at the
performance and result of each responsibility center. Responsibility
accounting is thus used as control technique."
Eric. L. He defines Responsibility accounting as “method of accounting in which
Kohler costs are identified with persons assigned to their control rather than
with product or function."
Schaltke, “Responsibility accounting system is a system of accounting in which
R.W and costs and revenue are accumulated and reported to managers on the
Jonson H.G basis of manager‟s control over these costs and revenues. The
managerial accounting system that ties budgeting and performance
reporting to a decentralized organization is called responsibility
accounting.”
Landouceur “Responsibility Accounting for most part is a change in emphasis from
AG conventional product accounting to the cost control aspects of
accounting and management control, wherein the statement flowing
throughout the management hierarchy on a vertical basis or throughout
the various components of the organization emphasize measurement of
performance based on decision variable identified with the particular
level of the segment. In this respect RA has provided a tool which did

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 not exist on a systematized basis prior to 1950.”
Charles T “Responsibility accounting is a system of accounting that recognizes
Horngren various responsibility centres throughout the organization and reflects
the plans and actions of each of these centres by assigning particular
revenues and cost to the one having the pertinent responsibility. It is also
called profitability accounting and activity accounting.”
Robert N “Responsibility accounting as that type of management accounting that
Antony collects and reports both planned and actual accounting information in
terms of responsibility centre”.

Hence, responsibility accounting focuses on responsibility centres. The managers

of different activity centres are responsible for controlling the costs of their respective
centres. Information about costs incurred for different activities are supplied to the head
that is accountable for his/her centre. The performance is measured by comparing the
actual performance to the standard one and this process is very useful in exercising cost
control. Responsibility accounting is different from cost accounting in the sense that the
former lays emphasis on cost control whereas the latter lays emphasis on cost
ascertainment.

1.3 PRE-REQUISITES OF RESPONSIBILITY ACCOUNTING

 To implement a responsibility accounting system, the business must have a sound

and well organization structure so that responsibility is assignable to individual
managers.
 The various managers and their lines of responsibility and authority should be
fully defined.
 The organization should be divided into various defined responsibility centers.
 The organization chart is usually used as a basis for responsibility reporting.
 The managers are held responsible only for those activities over which they
exercise significant degree of control.
 While decision-making power may be delegated for many items, some decisions
(related to particular revenues, expenses, costs or actions) may remain exclusively
under the control of top management.
 The responsibility accounting system so adopted should have full support from the
higher authorities of the organization.
 Goals for each area of responsibility should be attainable with efficient
performance.
 A conducive organizational environment and progressive management attitude
should exist.

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1.4 FEATURES OF RESPONSIBILITY ACCOUNTING

 Positional Accounting: Responsibility Accounting is different from functional or

product accounting. It is a positional accounting system in which responsibilities
are delegated in favour of individual for execution of plans. Under this system, the
individual responsibility can be measured only when his/her authority to influence
the cost and/ or revenue can be identified and assigned to with reasonable clarity
which is not possible in conventional accounting system.
 Focus on controllable and non-controllable cost differentiation: Responsibility
Accounting system is based on delegation of authority at the discretion of the
individual responsible for execution of a plan. More the delegation, more the
controllability of cost at the discretion of the individual and more the scope of
accounting the responsibility of the individuals.
 Control rather than mere accounting: Responsibility accounting is a concept
that aims at helping achieve a fit between planning and control system and
managerial responsibility. Through this conventional system of cost accounting an
individual in charge of cost center is burdened with a large number of overheads
over which he may have little control. Hence, the system of responsibility
accounting is recommended whereby, the person controlling or initiating a
particular cost should be held responsible for it.
 Not an accounting by Itself: Responsibility accounting as a concept of cost
control uses various accounting and cost control techniques like budgeting,
standard costing, financial trend line analysis, operating leverage and pricing
techniques with only difference that it has a bias towards fixation of responsibility
of individual as against a product or function. It just makes use of different
financial accounting and costing tools to assess the performance of the person who
can best influence the cost and revenue of a business unit he is responsible for.
 Transfer Pricing: Responsibility accounting divides the organization in different
autonomous responsibility centres or subunits. In such circumstances, product or
service of one division or unit can be transferred to another division or unit within
the same organization charging a transfer price. This creates an inter-competitive
environment to make each subunit of the organization more profitable and
efficient.
 Performance Evaluation: Responsibility accounting establishes a sound and fair
system of performance evaluation of each manager and personnel. The
performance of each responsibility center is measured and presented periodically
on performance report.
 Drop or Continue Decision: If the organization is divided into subunits, it
becomes possible to measure division wise or product wise profitability of the
organization. If saving in costs exceeds the foregone revenues, the center can be
discontinued.

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1.5 STEPS INVOLVED IN RESPONSIBILITY ACCOUNTING

Responsibility accounting encompasses the following steps:

(1) Identifying the Responsibility Centres: The basis of responsibility accounting

system is the designation of each sub-unit in the organization as a particular type of
responsibility center. A responsibility center is a sub-unit in an organization whose
manager is held accountable for specific financial results of sub-unit's activities. The
important criteria for creating a responsibility center is that the unit of the organization
should be separable and identifiable for operating purposes and its performance
measurement should be possible. An organization can be broadly subdivided into four
main responsibility centres as cost center, revenue center, profit center and investment
center.

(2) Delegation of Authority and Responsibility or Decentralization: To increase

managerial and operational efficiency, the manager of each subunit should be assigned
specific authority and responsibility for the activity of that division. No one can be held
accountable without having any prior responsibility and responsibility always
accompanies corresponding authority. Responsibility centers are the decision centers also,
and the decision requires the power or authority.

(3) Controllable of the Object: The manager of a cost center can be held accountable
only for the costs, which are controllable by him. Therefore, it is an essential part of
responsibility accounting to identify the controllable and non-controllable costs. The
same thing applies in the case of revenues, profits and investment.

(4) Establishing Performance Evaluation Criteria: Main purpose of responsibility

accounting is to measure the divisional or subunit performance. Performance evaluation is
a yardstick measurement of whether the results are obtained as ought to be or not. Most
often the following criteria are applied for divisional performance evaluation:
 Standard Costing
 Budgetary control
 Profitability ratios
 Valuation measures

(5) Electing Cost Allocation Bases: Divisional profitability heavily depends on the bases
of allocation of joint overheads and corporate overheads. Switching from one method to
another of cost allocation over the products or divisions, product wise profitability change
to a great deal. Remember that for decision-making purpose, such allocated overheads
should be carefully treated and well understood.

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1.6 ADVANTAGES OF RESPONSIBILITY ACCOUNTING

 Provides a way to manage a large diversified organization. Better decisions can be

made at the local level.
 Provides incentives to department managers and individuals to optimize their
individual performances.
 Provides managers with the freedom to make local decisions
 Provides top management with more time to make policy decisions and engage in
strategic planning.
 Allows management to avoid understanding the system by using top down remote
control based on accounting measurements
 Supports management and individual specialization based on comparative
advantage

1.7 LIMITATIONS OF RESPONSIBILITY ACCOUNTING

The basic idea of responsibility accounting concept is that dividing an organization
into small units provides an adequate way to manage a large diversified organization.
However, responsibility accounting causes some problems as indicated below. As
Responsibility Accounting can never be a substitute of good management. It is simply a
tool of management. Responsibility accounting suffers from the following limitations
which are listed below:

(1) The pre-requisites for a successful responsibility accounting system are follows:
(a) A sound organizational structure where organization can be divided into
small units which can be regarded as responsibility centres.
(b) Proper delegation of work and responsibility.
(c) A proper system of reporting.
If these conditions are absent it is difficult to have a responsibility accounting
system.
(2) The traditional way of classification of expenses needs to be subjected to a further
analysis which becomes difficult.
(3) In introducing the system certain managers may require additional classification
particularly if the responsibility reports are different from routine reports.

1.8 RESPONSIBILITY CENTRE

Responsibility accounting is an underlying concept of accounting performance

measurement systems. It traces costs, revenues, or profits to the individual managers who
are primarily responsible for making decisions about the costs, revenues, or profits in
question and taking action about them. Responsibility accounting is suitable where top
management has delegated authority to make decisions. The idea behind responsibility

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accounting is that each manager's performance should be judge by how well he or she
manages those items under his or her control. A responsibility center is an organizational
unit headed by a manager, who is responsible for its activities and results. In
responsibility accounting, revenues and cost information are collected and reported on by
responsibility centers.
A Responsibility Centre “is a division of the organization for which a manager is
held responsible”. CIMA London defined Responsibility Centre as “a segment of the
organization, where an individual manager is held responsible for its segment‟s
performance.”
In the words of Horngren, “a responsibility centre is a part, segment or sub-unit of
an organization whose manager is accountable for a specified set of activities.”

1.9 TYPES OF RESPONSIBILITY CENTRE

Responsibility Centres are of four types: cost centre, revenue centre, profit centre
and investment centre. Together they form basis of Responsibility Accounting.

COST CENTER

A cost center in the CIMA’s official terminology is defined as “a product, services,

functions or items of equipment of which cost may be attributed to cost unit." Cost center
denotes a location, function or items of equipment in respect of which cost may be
ascertained and related to cost units for the purpose of control. It is the smallest of
organizational sub-unit for which separate cost allocation is attempted. It may be a
personal or impersonal cost center. Whether it is personal or impersonal, cost center
represented organizational span for which separate cost determination is aimed at for
deciding the needs of the management. Managers of functional departments like
production, personnel and marketing are treated as heads of the respective cost center and
made responsible for their cost. If the responsibility is measured in financial terms, the
performance statement should analyze the cost

(a) which are directly attributable/controllable by the concerned cost center and
(b) which may not be the result of significance influence by the cost center manager,
but the management wants him to be concerned with such cost.

REVENUE CENTER

It emanates from the act of divisionalisation of earning. Thus, a revenue center

may be defined as an operational responsibility that is devoted to raising revenue with no
direct accountability for the cost of goods or services sold by this operation. Marketing
and sales center can therefore be rightly categorized as revenue centers with the
expectation that the concerned manager‟s effort will proportionately increase or decrease
the revenue.

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 The committee employed by the Indian Railway for identification of cost/profit
centers and the related financial issues, have introduced and described the concept of
revenue center. According to the committee the majority of responsibility centers of
Indian Railway (IR) i.e. the functional units of all service departments performs activities
that eventually contribute to the production of transport services and related activities. For
example a permanent way inspector (PWI) of the civil engineering department is
responsible for the upkeep of the permanent way and so on. In the absence the concept of
transfer pricing, the services provided by the functional units of various department incurs
only cost and no revenue of their own. Hence, they have been termed as cost centers.
Similarly, the functional units that are responsible for booking and handling the traffic for
carriage such as goods sheds, passenger and parcel booking office etc. are the units that
are responsible for the booking all traffic and collecting the revenue. The costs incurred
by these units are for those functions are very small as compared to the revenue
generated. In other words, in the case of such centers, revenue predominates cost. The
revenue thus generated at those functional units adds up to the total revenue of the IR or
at least the bulk of it. Hence, they have been termed as revenue centers. The revenue
generated by each sub-activity center is accounted for through various returns prepared by
it.

PROFIT CENTER

According to CIMA, London, a profit centre is “A part of a business accountable

for costs and revenues. It may be called a business centre, business unit, or strategic
business unit.” A profit center may be construed as the smallest possible functional unit
for which both revenue and expenditure can be worked out in actual terms. This would
enable determination of accountability right from the grass root level, especially when the
organization is vast, multi-location and multi-product in nature. For a profit center
organization to be established, it is necessary to have units of an organization to which
both revenue and cost can be separately attributed. Managers of profit centers should be
responsible both for the revenue as well as cost, which implies that there should be
sufficient decentralization of authority within the organization to permit the profit center
managers to make decisions about the selling prices and the output level at those prices. A
profit center performance report measured in absolute terms would show profit as the
bottom line. A profit center may have sub-profit centers within it. How a responsibility
center may take the form of Profit Center has been explained by Anthony Robert N when
he says “A given responsibility center is a profit center only if the top management
decides to measure its output in monetary terms and believes it to be a good idea to do so.
No accounting principle requires that revenue be measured for individual responsibility
centers within the company. With some ingenuity, practically, any cost (or expenses)
center could be turned into a profit centers can be found. The question is whether there
are sufficient positive benefits in doing so.”

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INVESTMENT CENTER

According to CIMA, London, Investment centre is defined as “A profit centre

whose performance is measured by its return on capital employed.” As noted by Manohar
Bhatia, "Another concept related to profit center concept is the “Investment Center”. An
investment center is a unit or division of the company, which is responsible to the top
management for its profitability in relation to its investment base. As in profit centers,
revenue and expenses are measured but in addition the assets employed in the division are
also measured with a view to determining its investment base. Thus, an investment center
is an extension of profit center idea. Profit is measured in both, but only in investment
center is this profit related to the size of the investment involved." Thus, a factory or an
erection function as Business Units can be considered as investment center to measure the
return on investment. In fact, even Profit Centers, where there is no significant amount of
tangible investment, still can be measured in terms of Investment center because, all the
Business Units need some value of investment as input resources and working capital
requirement is one of them.

1.10 DIVISIONAL PERFORMANCE MEASUREMENT

1.10.1 Introduction

Many companies have business activities in more than one country. In fact, the
operations of some large corporations involve so many different countries that they are
called multinational businesses. The problems of managing and accounting for a company
that has international operations can be very complex, and detailed study of these issues
should be required. Because of the complexity of companies operations, it is difficult for
top management to directly control operations. Therefore a company is divided into
divisions and is allowed divisional managers to operate with a great deal of independence.
When autonomous divisions are created there can be risk that divisional managers might
not able to achieve the objectives that are in the best interests of the company as a whole.

At the strategic business unit level operating profit, return on investment, residual
income and economic value added were examined, and these measures should be used for
measuring divisional performance.

1.10.2 Financial Methods for Evaluation of Divisional Performance

Following are some of the important financial measures applied for performance
evaluation:

(1) Divisional Profit

(2) Return on Investment (ROI)
(3) Residual Income (RI)

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(4) Variance Analysis

(1) Profit:

Profit is the absolute measure of performance. It is easy to calculate, understand and

evaluate the performance of division on the basis of profit. However, it is not considered
to be a very reliable measure of performance because the profit is arrived at after
deducting the apportioned head office expenses, which at times are arbitrarily charged to
the division.

(2) Return on Investment (ROI):

Instead of focusing on the absolute measure, division‟s profits, most companies focus on
the return on investment (ROI) of a division (that is, profit as a percentage of the
investment in a division). ROI expresses divisional profit as a percentage of firm‟s capital
employed in the division.

ROI = Divisional Profit × 100

Capital Employed

ROI = Turnover × Profit × 100

Capital Employed Turnover

Advantages:
 ROI is relative measure of performance as it is expressed in %
 Measuring returns on invested capital focuses managers‟ attention on the impact of
levels of working capital on the ROI.
 ROI is easy to understand and interpret.
 ROI denominator for comparing the returns of dissimilar businesses, such as other
divisions within the group or outside competitors.
 ROI has been most widely used financial measure for many years in all types of
companies.

Disadvantages:

 Divisional ROI can be increased by actions that will make the company as a whole
worse off.
 Evaluating divisional managers on the basis on ROI may not encourage goal
congruence.

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(3) Residual Income (RI):
To overcome some of the dysfunctional consequences of ROI, the residual income (RI)
approach can be used. RI is defined as the profit of a division less a cost of capital charge
on the investment controllable by the divisional manager.

Residual Income = Divisional Profit - (Divisional Investment × Rate of Charge)

A reason cited in favour of RI over the ROI measure is that RI is more flexible, because
different cost of capital percentage rates can be applied to investments that have different
levels of risk. Not only will the cost of capital of divisions that have different levels of
risk differ - so may the risk and cost of capital of assets within the same division.
RI suffers from the disadvantages of being difficult to determine the rate for calculating
the cost of capital.

Illustration 1: Compute Residual Income:

Rs.
Sales 10,00,000
Variable Costs 6,00,000
Fixed Costs 2,00,000
Imputed Interest on Investment 1,00,000

Solution: Rs.
Sales 10,00,000
Less: Variable Cost 6,00,000
Contribution 4,00,000
Less: Fixed Cost 2,00,000
Profit 2,00,000
Less: Imputed Interest 1,00,000
Residual Income 1,00,000

Illustration 2: Wagon Ltd. has three division X, Y and Z. the operating results of the
three divisions are as follows:
Divisions
X Y Z
Rs. Rs. Rs.
Sales 10,00,000 10,00,000 20,00,000
Less: Cost 8,00,000 6,00,000 12,00,000
Profit 2,00,000 4,00,000 8,00,000
Investment 6,00,000 10,00,000 30,00,000

(1) You are required to determine ROI of the three divisions and rank these divisions on
the basis of their performance.

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(2) Determine residual income (RI) of the three divisions and rank them assuming cost of
capital is 15%

Solution:
(1) Return on Investment Method

Division
X Y Z
ROI= Profit × 100 = 2,00,000 × 100 = 4,00,000 × 100 = 8,00,000 × 100
Investment 6,00,000 10,00,000 30,00,000
= 33.33% = 40% = 26.67%
II I III

(2) Residual Income Method

DIVISION
X Y Z
Rs. Rs. Rs.
Investment 6,00,000 10,00,000 30,00,000

Profit 2,00,000 4,00,000 8,00,000

Less: Cost of Capital 90,000 1,50,000 4,50,000
@ 15% on Investment
Residual Income 1,10,000 2,50,000 3,50,000
Ranking III II I

(4) Variance Analysis:

In this technique, actual performance is compared standard performance. This has
been discussed in details in the chapter of standard costing. Variance analysis should
be undertaken for each cost centre and revenue centre to measure the performance of
each such centres.

1.10.3 Non-Financial Methods for Evaluation of Divisional Performance

 Development of Human Resources

 Leadership Qualities
 Marketability of Divisional Product
 Attitudes of the Employees and Colleagues

1.11 SELF-TEST QUESTIONS

EXERCISE 1: MULTIPLE CHOICE QUESTIONS

(1) The responsibility accounting stresses on _________

(a) Decentralization
(b) Centralization
(c) Both (a) and (b)

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 (d) None of these

(2) In responsibility accounting system…

(a) Budgets are prepared
(b) Actual performance is recorded
(c) The performance is reported
(d) All of the above

(3) The responsibility accounting emphasizes the performance of ____

(a) System
(b) Men
(c) Both
(d) None of these

(4) The responsibility accounting is a controlling tool for…

(a) Top‐level management
(b) Lower level management
(c) Middle level management
(d) None of these

(5) The subdivision of responsibility centre is…

(a) Expense centre
(b) Profit centre
(c) Investment centre
(d) All of the above

Answers: (1) (a), (2) (d), (3) (b), (4) (a), (5) (d)

EXERCISE 2: SHORT ANSWER QUESTIONS

Q1. Fill in the blanks:

(a) Market based transfer price is useful in evaluating the performance of

______________
(b) A system of accounting that aggregates revenue and costs into areas of personal
responsibility in order to assess the performance attained by persons to whom
authority has been assigned in known as _________
(c) A centre in which both inputs and outputs/costs and revenues are measured in
monetary terms is termed as ________________.

Answers: (a) different division (b) responsibility accounting (c) profit centre

Q2. True/False statement:

(a) Responsibility accounting is more suitable in diversified companies.

(b) Some indirect costs are controllable costs in a specific responsibility centre.

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 (c) When output cannot be measured but costs are incurred, the segment of the
organization is usually called a cost centre.
(d) Return on investment is a function of function of income earned and the assets
used in order to earn that income.

Answers: (a) T, (b) F, (c) F, (d) T

EXERCISE 3: LONG ANSWER QUESTIONS

Q1. Discuss responsibility accounting in brief.

Q2. What is responsibility centre? Discuss briefly the nature and various types of
responsibility centres.

Q3. Write explanatory note on Responsibility Accounting.

Q4. Write short notes on responsibility centres - cost centre and profit centre.

Q5. What are the different methods of measurement of divisional performance?

Q6. Explain the following methods of measuring performance of responsibility centres

and evaluate them:
(a) Return in Investment
(b) Residual Income

Q7. Compute return on investment in respect of Division “A” of a company on the basis
of the following information:

Rs.
Fixed assets 15,000
Current assets 70,000
Current liabilities 20,000
Equity share capital 1,50,000
Sales 2,00,000
Cost goods sold 1,20,000
Administration expenses 20,000
Interest on Long term loan 5,000

Answer: 36.67% [B.Com (Hons), Delhi 2015]

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