Unit-1

Introduction to management accounting

Financial accounting:

Every business organization wants to know whether it has made profit or loss
at the end of the given period; for this purpose it has to prepare a statement
containing profit or loss. It also wants to know what it owns (assets) and how
much it owes (liabilities) to its suppliers and others. In order to prepare these
statements the business organization has to maintain a set of accounts.
Accounting as an information system is the process of identifying, measuring
and communicating the economic information of an organization to its users
who need the information for decision making. The following are the various
activities for accounting.

1. Identifying the transactions and events:

Accounting identifies the transactions and events of a specific entity. A

transaction is an exchange in which each participant receives or sacrifices value
(purchase of raw materials). An event (whether external or internal) is a
happening of consequence to an entity (use of raw materials for production). An
entity means an economic unit that performs economic activities.

2. Measuring the identified transactions and events:

Accounting measures the transactions and events in terms of a common

measuring unit that is the currency of the country.

3. Recording:

It is concerned with recording of identified and measured financial transactions

in an orderly manner soon after their occurrence in the proper books of accounts.

4. Classifying:

It is concerned with classification of recorded transactions so as to group the

transactions of similar type at one place. This function is performed by
maintaining the ledger in which different accounts are opened to which related
transactions are brought to one place by posting. For example all purchases of
goods made for cash or on credit on different dates are brought to purchases ac.

5. Summarizing:
 It is concerned with the summarization of the classified transactions in a manner
useful to the users. This function involves preparation of financial statements
such as income statement, balance sheet, statement of changes in financial
position, statement of cash flows etc.,

6. Analyzing:

It is concerned with the establishment of relationship between the various items

or groups of items taken from income statement or balance sheet or both. Its
purpose is to identify the financial strengths and weaknesses of an enterprise. It
provides the basis for interpretation.

7. Interpreting:

It is concerned with explaining the meaning and significance of relationship

between the transactions by analyzing. Now-a-days the above six functions are
performed by electronic data processing devices and accountant has to
concentrate mainly on the interpretation aspects of accounting. The accountants
should interpret the statements in a manner useful to users, so as to enable the
users to make reasonable decisions out of alternative courses of action.

8. Communicating:

It is concerned with the transactions of summarized and analyzed and interpreted

information communicated to the users, to enable them to make reasoned
decisions.

Branches of accounting:

Broadly speaking, there are three main branches of accounting:

1. Financial Accounting
2. Cost Accounting
3. Management Accounting
4. Social responsibility Accounting

Financial accounting:

It is a process of identifying, measuring, recording, classifying, summarizing,

analyzing, interpreting and communicating the financial transaction and events;
the purpose of this branch of accounting is to keep systematic records to
ascertain financial performance and financial position and communicate the
Accounting information to the interested parties.

Cost accounting:
 It is the process of Accounting and controlling the cost of a product, operation or
function. The purpose of this branch of Accounting is to ascertain the cost, to
control the cost and to communicate information for decision making.

Management Accounting:

It is the application of Accounting techniques for providing information

designed to help all levels of management in planning and controlling activities
of business enterprise and in decision making. The purpose of this branch of
Accounting is to provide information that management may need in taking
decisions and to evaluate the impact of its decisions and actions. Management
Accounting is not only confined to the area of cost Accounting but also covers
other areas such as capital structure decisions, capital expenditure decisions,
dividend decisions etc.

Social responsibility Accounting:

It is the process of identifying, measuring and communicating the social effects

of business decisions to permit informed judgement and decisions by the users of
information. It is Accounting for social responsibility aspects of a business.
Management is held responsibility for what it contributes to social well being
and progress. Accounting for environment is the part of social responsibility
Accounting.

Advantages of Financial Accounting:

Facilitates to replace memory:

Accounting facilitates to replace human memory by maintaining complete

record of financial transactions. Human memory is limited and Accounting helps
to overcome this limitation.

Facilitates to comply with legal requirements:

Accounting facilitates to comply with legal requirements which require an

enterprise to maintain books of Accounts.

Example: Section 209 of the company’s act 1956, requires a company to

maintain proper books of accounts, section 44AA of the income tax act, 1961
requires certain persons to maintain specified books of Accounts.

Facilitates to ascertain net results of operations:

Accounting facilitates to ascertain net result of operations by preparing

income statements.
 Facilitates to ascertain financial position:

Accounting facilitates to ascertain financial position by preparing balance

sheet.

Facilitates the users to take decisions:

Accounting facilitates the users (i.e., short-term creditors, long-term

creditors. Present investors, potential investors, employee groups, management,
general public, tax authorities), to take decisions, by communicating accounting
information to them.

Facilitates a comparative study:

Accounting facilitates a comparative study in the following four ways:

o Comparison of actual figures with standard or budgeted figures for

the same period and the same firm.
o Comparison of actual figures of one period with those of another
period for the same firm (intra firm comparison).
o Comparison of actual figures of one firm with those of another
standard firm belonging to the same industry (inter firm comparison).
o Comparison of actual figures of one firm with those of industry to
which the firm belongs (pattern comparison).

Facilitates and assists management:

Accounting assists the management in planning and controlling business

activities and in taking decisions.

e.g., projected cash flow statement facilitates the management to know the
future receipts and payments and to take decisions regarding anticipated surplus
or shortage of funds.

Facilitates control over assets:

Accounting facilitates control over assets by providing information regarding

cash balance, bank balance, debtors, fixed assets, stock etc.,

Facilitates the settlement of tax liability:

Accounting facilitates the settlement of tax liability with the authorities by

maintaining proper books of accounts in the systematic manner.

Facilitates the ascertainment of the value of business:

 Accounting facilitates the ascertainment of the value of the business in case
of transfer of business to another entity.

Facilitates raising loans:

Accounting facilitates raising loans from lenders by providing them

historical and projected financial statements.

Acts as legal evidence:

Proper books of accounts maintained in a systematic manner act as legal

evidences in case of disputes.

Disadvantages of financial accounting:

Ignores the quantitative elements:

Since the Accounting is confined to the monetary matters only. The

quantitative elements like quality of management, quality of labour force, public
relations are ignored.

Not free from bias:

In many situations the accountant has to make a choice out of various

alternatives available. The examples are:

i. choice in method of depreciation (straight line vs. written

down)
ii. choice in method of inventory valuation ( FIFO vs. LIFO)

As a result the analysis of financial statements cannot be said to be free from

bias.

Estimated position and not real position:

Since the financial statements are prepared on a going concern basis as

against liquidation basis, they report only the estimated periodic results and not
the true results can be ascertained only on the liquidation of an enterprise.

Ignores the price level changes in case of financial statements prepared on

historical costs:

In case of financial statements prepared on historical cost, the fixed assets

are shown in balance sheet as historical cost less depreciation and not at the
replacement value which is often higher than the value stated in balance sheet
 the analysis of such financial statements will not yield strictly comparable results
unless the price level changes are taken into account.

Danger of window dressing:

When the management decides to enter wrong figures to artificially inflate or

deflate the figure of profits, assets and liabilities, income statements, fails to
provide true and fair view of the result of operations and balance sheet fails to
provide true and fair view of financial position of the enterprise.

Primary objectives of accounting:

To maintain Accounting records:

Written records are always better than oral records since written records can
be used by different persons for decision making purposes and serve as evidence
of transactions. Now-a-days, the volume of transactions is so large; a human
memory cannot absorb each and every transaction. Accounting is done to keep a
systematic record of:

a. financial transactions
b. assets
c. liabilities

To calculate the results of operations:

To measure the financial performance of an enterprise, the results of

operations are ascertained by preparing an income statement (also known as
profit and loss account) which shows the matching of current costs with current
revenues during a particular accounting period.

A systematic record of incomes and expenses facilitates the preparation of

income statement.

To ascertain the financial position:

To evaluate the financial strengths and weaknesses of an enterprise, the

financial position is ascertained by preparing balance sheet which shows
resources (assets owned by an enterprise on right hand side) and the sources of
financing those resources.

A businessman wants to know whether the business is attaining profits and

losses during a financial period. A systematic record of various assets and
liabilities facilitates the preparation of balance sheet.

To communicate the information to the users:

 Accounting communicates information to internal users and external users.
The internal users include all the organizational participants at all levels of
management (top, middle and lower levels). The top level of management
requires information for planning, middle level management requires
information for controlling the operations and lower level for implementation.
For internal use, the information is usually provided as reports.

e.g., cash budget reports, production reports, idle time reports, feedback reports
whether to retain or replace an equipment decision reports, project appraisal
reports etc.,

External users include government, new investors, creditors etc.,

Role of financial managers:

Raising finance:

This is a very important function performed by the finance manager. He has

to calculate the financial requirements of the firm, a firm’s capital structure, the
various sources from which funds are to be acquired, keeping in view the cost,
benefits, risks characteristics of the firm and the time when the finance is to be
raised.

Allocation of financial resources:

The financial manager is concerned with the efficient allocation of the firm’s
scarce resources to alternate uses. He has to invest money in long-term assets,
inventory, marketable securities, and debtors, paying off dividends, maintaining
sufficient cash to make payments and keep the firm running.

The process of allocating funds is a complex process. It involves an analysis

of opportunities available keeping in mind the opportunity cost of capital, the
firm’s risk bearing capacity and the expectations of the shareholders.

Financial planning:

It involves analysis of financial flows of the firm, forecasting the outcome of

various financing, investment and dividend decisions and evaluation of effects of
various alternatives. This is to determine where the firm has been if positioned in
the market. This leads to a financial plan or strategy which includes a
contingency plan for dealing with unfavorable situations.

Analysis of capital market trends:

 A firm is a product of its environment. It is dependent upon the capital
market for raising finance, for meeting its long term needs. The financial
manager must understand the operations of the capital market and analyze the
trends from time to time in order to ascertain how securities are valued, manner
in which risk is assessed etc., and this would enable him to deal with the
problems arising from investment, financing and dividend decisions.

Foreign exchange risk management:

In recent years, the value of foreign exchange transactions has increased

considerably. They have also been rapid change in international finance. New
markets, currency and institutions have emerged. This has considerably
increased the risk of firms.

Analysis of capital market trends:

A firm is a product of its environment. It is dependent upon the capital

market for raising finance, for meeting its long term needs. The finance manager
must understand the operations of the capital market and analyze the trends from
time to time in order to ascertain how securities are valued, manner in which risk
is assessed etc., this would enable him to deal with the problems arising from
investment, financing and dividend decisions.

Treasury operations:

This is another function which the financial manager has to perform; treasury
operations have the potential to generate considerable profit for the organization.

Foreign exchange risk management:

In recent years, the value of foreign exchange transactions has increased

considerably. They have also been rapid change in international finance. New
markets, currency and institutions have emerged. This has considerably
increased the risk of firms.

Analysis of business, industry and competitor trends:

The financial manager has to analyze and understand the trends in business,
industry and competition in order to ascertain the direction in which business
and industry are moving competitors’ objectives and strategies and their
financial and market positions and capital structure.

Analysis of macroeconomic trends:

The performance of business is affected by the macroeconomic conditions

prevailing in the economy. These are like changes in intrest rates, inflation,
 money supply, incentives etc., and the financial manager must understand and
analyze these trends. This would enable him to make sound investment,
financing and dividend decisions.

Management accounting:

Scope of management accounting:

The main aim of management accounting is to help the management in its function of
planning, directing and controlling. It provides techniques for the interpretation of the
accounting data. The following facts of management accounting speak for the scope of
this subject.

Financial accounting:

It deals with historical data. The recorded facts are useful for planning the
future course of action. The performance appraisal is based on recorded facts
and figures. Thus management accounting is closely related to financial
accounting.

Cost accounting:

It provides various techniques for determining cost of manufacturing

products. The systems of standard costing, marginal costing, differential costing
and opportunity costing are all helpful to management for planning various
business activities. By using cost accounting techniques efficiency of various
departments is judged.

Budgeting and forecasting:

Budgeting explains the plans, policies and goals of an enterprise for a

definite period in future. Targets are set for the different departments &
responsibility is fixed for achieving those targets. Comparison of actual
performance with budgeted figures gives an idea about the performance of
different departments to the management. On the other hand, forecasting is a
prediction of a given set of circumstances. Both budgeting and forecasting are
useful for management accountant in planning various activities.

Inventory control:

Inventory has a special significance in accountingfor determining correct

income for a given period. Since it involves large sums, the management should
determine different levels of stocks i.e., minimum level, maximum level,
reordering level for inventory control. The control of inventory will ultimately
 help in controlling stocks. Management will need effective inventory control to
control stocks.

Management reporting:

Keeping the management informed of various activities of the concern is one

of the important functions of management accountant. The reports are presented
in the form of graphs, diagrams, index numbers or other statistical techniques so
as to make them easily understandable. The management accountant sends
monthly, quarterly, and half-yearly reports to the management. The reports may
cover profit and loss statements, cash flow statements, funds flow statements,
and stock reports etc., the reports are helpful in giving a constant review of the
working of the business.

Interpretation of data:

The management accountant interprets various financial statements

information to the management. These statements give an idea about the
financial and earning position of the concern. If the statements are not properly
interpreted then wrong conclusions may be drawn. So interpretation is also an
important scope of management accounting.

Internal audit:

To judge the performance of every department internal audit system is

necessary. Internal audit helps management in fixing responsibility of different
individuals.

The management compares actual performance with the predetermined standards.

Tax accounting:

Tax planning is an important part of management accounting. Income

statements are prepared and tax liabilities are calculated. The management is
informed about the tax burden from the central government, state government
and local authorities. Various tax returns are to be filed with different
departments and tax payments are to be made in time.

Tools and techniques of management accounting:

A number of tools and techniques are available and are used to supply the information
required by the management. Some of them are discussed below:

Analysis of financial statements:

 In the financial statement analysis the data are classified and presented to the
management in a useful way. The techniques used for financial analysis include
comparative financial statements, ratios, funds flow statements, trend analysis
etc.,

Budgetary control:

Budgetary control technique is used as a tool for planning and control. The
budgets of different departments are prepared in advance based on historical data
and future possibilities. The actual performance is recorded and compared with
the predetermined targets. The management is able to assess the performance of
each and every person in the organization.

Standard costing:

This is one of the important techniques of cost control. It is determined in

advance based on a systematic analysis of prevalent conditions. The actual costs
are recorded and compared with standard costs and the variances if any are
analyzed with their reasons. This standard costing technique helps to enhance the
efficiency of the concern and also “management by exception”.

Marginal costing:

This is a technique of costing which is concerned with changes in cost

resulting from changes in the volume of production. It is helpful in measurement
of profitability of different lines of production, departments and divisions of an
enterprise. The short-term utilization of capacity decisions are also assessed with
the help of marginal costing.

Decision accounting:

Decision taking involves a choice from various alternatives. Management

accounting helps to calculate the financial implications of each alternative and
enables the management in taking important decisions regarding capital
expenditure, make or buy decisions or expansion or diversification etc.,

Revaluation accounting:

This is also known as replacement accounting. The preservation of capital in

the business is the objective of management. Revaluation accountingis used to
denote the methods employed for overcoming the problems connected with fixed
asset replacement in a period of rising prices.

Management Information Systems:

 With the development of electronic devices for recording and classifying
data reporting to management has considerably improved. The data pertaining to
planning, coordination and control is supplied to the management.

Limitations of management accounting:

Although management accounting is helpful in providing guidelines for planning,

directing and controlling functions still its effectiveness is limited a number of reasons.
Some of the limitations of it are as follows:

It is based on accounting information:

Management is based on the data supplied by financial accounting and cost

accounting. The data used for making the future decisions is historical. The
correctness of managerial decisions will depend upon the quality of data. If
financial data collected is incorrect then the management accounting will not
provide correct analysis.

Comprehensive analysis:

Management accounting requires the knowledge of a number of related

subjects. The management should have a thorough knowledge of the accounting
principles, statistics, principles of management, economics etc., to have an
effective management accounting.

It is not an alternative to administration:

Management accounting does not provide an alternative to administration.

Its tools and techniques only provide information and not decisions. These
decisions are to be made by management. Therefore management accounting
does the supplementary service function either in taking decisions or in their
implementation.

Evolutionary process:

Management is only in the evolutionary stage, the techniques and tools used
by this system give varying results. The conclusions taken from analysis and
interpretations are not the same.

Personal judgment:

The interpretation of financial information depends upon the capability of

interpreter and his personal judgment. Thus personal bias may creep in the
analysis and interpretations and affect the objectivity of decisions.

Resistance:
 Installation of management accounting involves basic change in the
organizational setup. New rules and regulations are also required to be framed
which effect a number of personnel; and hence there is a possibility of resistance
for some quarter or other.

Functions of management accountant:

Management accountant is known by different titles such as chief accountant, general

manager of accounting; some of the duties that the management accountant has to
perform are:

 Forecasting
 Planning the financial requirements of business
 Regulating the cash flows
 Managing credit
 Raising funds
 Maintaining proper relationship with financial
institutions and
 Protecting the funds.

The functions of management accountant relate to the management and control of the
firm’s resources. His job involves providing information to design accounting and costing
policies, preparation of financial reports, budgeting and inventory control.

Planning and controlling function:

The management accountant establishes coordinates and maintains an

integrated plan for control of operations. These plans would provide cost
standards, expense budgets, sales forecasts, capital investment programmes,
profit planning etc.,

Reporting and interpreting function:

The management accountant compares the actual performance with

operating plans and standards and to report deviations if any to the owners of the
business.

Tax administration:

The management accountant in order to establish and administer tax policies

and procedures undergoes tax administration.

Preparation of reports to government agencies:

The management accountant prepares the reports to the government agencies

as required under different laws.
 Protect the assets of business:

The management accountant performs the function of protecting the assets of

the business through internal controls, auditing and ensuring proper insurance
coverage.

Appraisal of external influences on the business:

The management accountant makes an appraisal of the influence of

economic, social and governmental influences and their effect on the business.

Differences between management and financial accounting:

Management and financial accounting are two sides or branches of accounting. Financial
accounting collects the financial data which is suitably altered for management
accounting purposes. In a broader perspective, the scope of management accounting
includes financial accounting. The major point of distinction is that they differ in their
emphasis and approach. Some of the major areas of distinction between management
accounting and financial accounting are discussed below:

Focus:

The objective of the preparation of financial accounting is to meet the

informational needs of the external users; Businesses preparation of the profit
and loss account to inform the external users like shareholders, creditors etc.,
about the performance of the firm. The objective of management accounting is
to prepare reports about the use of firm’s resources to meet the use/needs of
internal users.

Information:

Financial accounting reports are prepared on the basis of historical

information. The profit and loss account and balance sheet reveals to the
shareholders how the resources entrusted to them have been utilized.
Management accounting is meant for decision making process and focuses on
the future.

Need:

Financial accounting needs the statutory requirements as per the companies

act, 1956 and submission of the same to the shareholders. Financial accounts are
required to be prepared in formats prescribed by law. No such statutory
requirements are need to management accounting information.

Timing:
 Financial accounting is based on the concept of accounting year in which
annual reports are prepared to be presented to the shareholders and interested
groups. Management accounting reports are prepared for shorter durations,
information is collected for the preparation of long term loans up to five years or
more in case of capital expenditure plans.

Basis of preparation:

The preparation of financial accounts is subjected to GAAP. This makes the

financial accounts consistent and meaningful from the investors’ and
users’ point of view. With the help of financial accounting information one can
make inter firm comparisons and analyze the performance trends over the years.
This is possible because all the firms follow some GAAP.

Management accounting on the other hand is not based on any set of

accepted principles. Every business follows its own procedure and principles for
preparing reports for the internal users. Such information generated should be
relevant and aid management to make decisions.

Scope:

Financial accounting covers the entire organization and shows revenues and
expenses and equity of the firm as a whole. For the purpose of management
accounting, an organization is divided into centers or units headed by
responsible persons. These centers collect cost and other related data.

Reporting:

Financial accounting emphasizes precision and accuracy because it is subject

to statutory audit. Management accounting requires information promptly for
decision making where there is a need for continuous and speedy flow of
information rather than precise information which may delay the process.

Cost accounting:

Cost is the amount of resources given in exchange for some goods or services. The
resources given up are money or money’s equivalent expressed in monetary units.
ICWAI defines cost as, “The amount of expenditure (actual or notional) incurred on or
attributable to a specified thing or activity.”

A cost must always be studied in relation to its purpose and conditions. Different
costs may be ascertained for different purposes and under different conditions. Work in
progress is valued at factory cost while stock of finished goods may be valued at office
cost. Even if the purpose of the study of the cost is the same, different conditions may
lead to variation in cost. The cost per unit of product is sure to vary with an increase in
the volume of output since the amount of fixed expenses to be borne by each unit of
output decreases.

Classification of costs:

The different bases of cost classification are:

• By time- historical and predetermined costs

• By nature or elements –material, labour and overheads costs
• By degree of traceability of the product-direct and indirect costs
• Association with the product-product and period costs
• Changes in activity or volume- fixed, variable and semi-variable costs
• By function- manufacturing, administration, selling, R&D, and
preproduction costs
• Relationships with accounting period-capital, revenue costs
• Controllability-controllable, uncontrollable costs
• Cost for analytical & decision making purposes- opportunity, sunk,
differentials, joint, common, imputed, marginal, uniform replacement out-of
pocket costs
• Others –conversion, traceable, normal, avoidable, unavoidable, total costs

I. Classification on the basis of time:

i. Historical costs: these are ascertained after they are

incurred. Such costs are available only when the production of a
particular thing has already been done. They are objective in
nature and can be verified with reference to actual operations.
ii. Predetermined costs: these costs are calculated before
they are incurred on the basis of a specification of all factors
affecting cost such costs may be:

 Estimated costs—costs are estimated before goods

are produced; these are naturally less accurate than
standards.
 Standard costs—this method involves setting up of
predetermined standards for each element of cost and each
product. These are essential for comparing actual with
standards. These costs are essential for finding out the
reasons of such variances and taking remedial actions.

II. By nature or elements:

 i. Material costs: the substance from which the product is
made is known as material. It can be direct as well as indirect.

 Direct material—it refers to those materials which

can become a major part of finished product and can be
easily traceable to the units.
 Indirect materials—all material which is used for
purposes ancillary to the production and which cannot be
conveniently assigned to specific physical units is termed
as indirect materials. E.g., consumable stores, printing and
stationery etc.,

ii. Labor costs: labor can be classified into direct or indirect,

 Direct labor—it can be defined as the wages paid to

workers who are engaged in the production process whose
time can be conveniently and economically traceable to
units of products.
 Indirect labor—labor employed for the purpose of
carrying the tasks incidental to goods or services provided
is indirect labor.

iii. Overhead / expenses costs: expenses may be direct and

indirect

 Direct expenses—these expenses are incurred on a

specific cost unit and identifiable with the cost unit
 Indirect expenses—these are the expenses which
cannot be directly, conveniently and wholly allocated to
cost centers/units.

III. By degree of traceability to the products:

Costs can be distinguished as direct and indirect. Costs which can be easily
traceable to a product or some specific activity are called direct costs. Indirect
costs are difficult to trace to a single product or it is uneconomic to do so.

IV. Association with the product:

Costs can be classified as product costs and period costs.

i. Product costs: The costs which are traceability to the

products and include in inventory values. In a manufacturing
concern, it comprises the cost of direct materials, direct labor and
manufacturing overheads. Product cost is a full a factory cost.
 These costs are useful for valuing inventories which are shown in
the balance sheets as assets till they are sold.
ii. Period costs: these costs are incurred on the basis of time
such as rent, salaries etc., include many selling and administrative
costs are essential to keep the business running.

V. By changes in activity or volume:

These costs can be classified into fixed, variable, semi variable / mixed
costs.

i. Fixed costs: CIMA (The Chartered Institute of

Management Accountants) defines fixed cost as, “A cost which
tends to be unaffected by variations in volume of output is fixed
cost”. Fixed cost depends mainly on time and do not vary directly
with volume or rate of output. Fixed cost can be classified as

 Committed costs—these costs incurred to

maintain certain facilities and cannot be quickly
eliminated.- rent, insurance.
 Policy and managed costs—policy costs are
incurred for implementing particular management
policies such as executive development, housing
etc., Managed costs are incurred to ensure the
operating existence of the company-staff services.
 Discretionary costs—these are not related to
operations and can be controlled by management.
These costs result from special policy decisions,
new researches and can be eliminated or reduced
to a desired level at the direction of management.
 Step costs—these costs are constant for a
given level of output and then increases by a fixed
amount at a higher level of output.

ii. Variable costs: these are the costs that vary directly and
proportionately with the output- Direct materials and Direct labor.

It should be kept in mind that the variable cost/unit is constant but

the cost changes corresponding to the levels of output.

iii. Semi fixed /semi variable / mixed costs: Such costs

contain fixed and variable element because of the variable
element, they fluctuate with volume and because of fixed
elements they do not change in direct proportion to the output.
Semi variable also known as semi fixed costs change in the same
 direction as that of the output but in the same proportion.-
depreciation.

VI. By function:

A company performs a no. of functions; functional costs are classified as

follows:

i. Manufacturing or production costs: cost of operating

manufacturing division of an undertaking. It includes the cost of
direct materials, direct labor, direct expenses, packing and all
overhead expenses relating to production.
ii. Administrative costs: they are indirect and cover all
expenditure incurred in formulating the policy, directing the
organization and controlling operations of the concern, which is
not related to R&D, production, distribution and selling functions.
iii. Selling and distribution costs: selling cost is the cost of
seeking to create and stimulate demand. E.g., advertisements,
market research etc., distribution cost is expenditure incurred
which begins with making of package produced available for
dispatch and ends with making the reconditioned packages
available for reuse-warehousing, cartage etc.,
iv. R&D Cost: they include the cost of discovering new ideas,
processes, and products by experiment and implementing such
results on a commercial basis.
v. Pre-production costs: when a new factory is started or
when a new product is introduced certain expenses are incurred
such costs are termed as pre-production costs and termed as
deferred revenue expenditure.

VII. Relationship with accounting period:

Costs can be capital and revenue cost capital expenditure provides

benefit to future period and is classified as an asset. Revenue expenditure
benefits only the current period and is treated as an expense.

VIII. Controllability:

The CIMA defines controllable costs as, “A cost which can be influenced by
the action of a specified member of an undertaking” and uncontrollable cost as,
“ a cost which cannot be influenced by the action of a specified member of an
undertaking.”

A controllable cost can be controlled by a person at a given organization

level. Controllable costs are not totally controllable some costs are partly
uncontrollable.
IX. Costs for analytical and decision making purpose:

i. Opportunity costs: these costs are the costs of

selecting one course of action and the losing of other
opportunities to carry out that course of action. It is the
benefits loosed by rejecting the best competing alternative
to the one chosen.

ii. Sunk costs: it is one that has already been incurred

and can’t be avoided by decisions taken in the future. It is
also called as unavoidable cost. It is an expenditure for
equipment or productive resources which has no
economic relevance to the present decision making
process. This cost is not useful for decision making as all
past costs are irrelevant. It is defined as the difference
between the purchase prices of an asset.
iii. Differential costs: these are defined as the
increase / decrease in total cost resulting out of the
selection of an additional sales channel a change in the
method of production and distribution and addition or
deletion of product.
iv. Joint costs: the processing of a single raw material
results in 2 or more different products simultaneously.
The joint products are not identifiable as different types of
products until a certain stage of production known as split
off point is reached. Joint costs are the costs incurred up to
the point of separation. One product may be of major
importance and others have minor importances which are
called byproducts.
v. Common costs: common costs are those costs
which are incurred for more than one product. They are
not easily related with individual products and hence they
are generally apportioned.
vi. Imputed costs: some costs are not incurred and are
useful while taking decisions pertaining to a particular
situation. These costs are known as imputed / notional
costs and they do not enter into traditional accounting
system.
vii. Out of pocket costs: these signify the cash outlay
required for an activity. The management would like to
know that the income from a particular project will at least
cover the expenditure for the project.
viii. Uniform costs: these are not distinct. Uniform
costing signifies the common costing principles and
procedures adopted by a no. of firms. They are useful in
inter firm comparison.
 ix. Marginal cost: it is the aggregate of variable cost
i.e., prime costs +variable over heads. These are classified
as fixed and variable.
x. Replacement costs: these are the costs of
replacing an asset at current market values e.g., when the
cost of replacing an asset is considered it means the cost
of purchasing the asset at the current market price is
important and not the cost at which it was purchased.

X. Others:

i. Conversion costs: it is the cost of a finished

product/work in progress comprising direct labour and
manufacturing overheads. It is the production cost less the
cost of raw materials but including gains and losses in
weight or volume of direct labor arising due to production.
ii. Normal costs: this is the cost which is normally
incurred at a given level of output in the conditions in
which that the level of output is achieved.
iii. Traceable costs: these are those costs which can be
easily associated with the product process and
iv. Avoidable costs: these are those costs which under
the present conditions need not be incurred.
v. Unavoidable costs: unavoidable costs are those
which under the present conditions must be incurred.
vi. Total cost: this is the sum of all costs associated to
a particular unit, or process or department or the entire
concern. It may also mean the sum of the total material,
labor and overheads. The term total cost however is not
precise by using terms that indicate the elements of cost
included.
vii. Value added costs: it means the selling price of the
product/ service less the cost of materials used in the
product/service. Often depreciation is deducted for
ascertaining value added.

Managerial Use of classification of costs

1. Helps in Ascertainment of Cost: Cost Accounting helps in the ascertainment of cost of
each product, process, job, contract, activity etc. by using different methods of costing such
as Job Costing and Process Costing.

2. Helps in Control of Cost: It helps in the control of material costs, labor costs and
overheads by using different techniques of control such as Standard Costing and Budgetary
Control.

3. Helps in Decision making: It helps the management in making various decisions such as
–

(a) Whether to make or buy a component

(b) Whether to retain or replace an existing machine

(c) Whether to process further or not

(d) Whether to shut down or continue operations

(e) Whether to accept orders below cost or not

(f) Whether to expand or not

(g) How much reduction in the selling price should be made in case of depression?

4. Helps in fixing Selling Prices: It helps the management in fixing selling prices of
products or services by providing detailed cost information.

5. Helps in Inventory Control: It helps in inventory by using various techniques such as

ABC analysis, Economic Order Quantity, Stock levels, Perpetual Inventory system and
Continuous Stock Taking, Inventory Turnover Ratio etc.

6. Helps in Cost reduction: It helps in the introduction of cost reduction programme and
finding out new and improved method to reduce costs.

7. Helps in measurements of Efficiency: It helps in measurements of efficiency of

operations through establishment of standards and variance analysis.

8. Helps in preparation of Budgets: It helps in the preparation of various budgets such as

Sales Budget, Production Budget, Purchase Budget, Man-Power Budget, Overheads
budget.
9. Helps in identifying Unprofitable Activities: It helps in identifying unprofitable activities
so that the necessary correction action may be taken.

10. Helps in identifying Material Losses: It helps in identifying material losses such as
wastage, scrap, spoilage and defective through report on material losses so that the
necessary corrective action may be taken.

11. Helps in identifying Idle Time and Labour Turnover: It helps in identifying idle time
and labour turnover through the report on idle time and labour turnover so that the necessary
corrective action may be taken.

12. Helps in identifying Idle Capacity: It helps in identifying idle capacity so that the
necessary corrective action may be taken.

13. Helps in improving Productivity: It helps in improving productivity of materials and

labour.

14. Helps in Cost Comparison: It helps in Cost Comparisons such as –

(a) Comparison with Standard Figures: Comparison of actual figures with standard of
budgeted figures for the same period and the same firm;

(b) Intra-firm Comparison: Comparison of actual figures of one period with those of another
period for the same firm;

(c) Inter-firm Comparison: Comparison of actual figures of one firm with those of another
standard firm belonging to the same industry; and

(d) Pattern Comparison: Comparison of actual figures of one firm with those of industry to
which the firm belongs.

15. Helps in checking the accuracy of financial accounts: It helps in checking the
accuracy of financial accounts with the help of reconciliation statement prepared to reconcile
the profit as per cost accounts with the profit as per financial accounts.
 The Cost Accountant Duties Are Critical To Any Organization And Its Growth

A cost accountant plays a very vital and an informative role in any organization. The
analysis, compare as well as interpretation of facts and figures included in the cost
accountant duties play an important role in the overall operations of the organization. His
sound judgments based on the data collected; his ability to communicate the results of his
work verbally as well as in writing; his interpersonal skills and his ability to work on
various business systems as well as computers along with the most important qualities
like integrity and honesty are some of the qualifications that can separate an excellent
cost accountant from the others. Along with all these the qualification of CPA can really
be the jewel in the crown of a cost accountant.

The cost accountant duties need specialization as it concerns with some of the most
crucial aspects of the entire financial operations that the organization is involved with.

Some of the primary cost accountant duties can be summarized as:

• Keep a close eye on the company’s various financial operations

• Maintain a strict vigil on all the employees during the audits

• Access as well as evaluate the management’s response to the audits

• He might also be required to conduct internal audits of the company in order to

check the efficiency as well as effectiveness of the various controls, operations as
well as the accuracy of the financial records of the company

• The cost accountant duties might also include the uncovering of the weaknesses
that might be inherent in the company’s bidding process

• He has to report any discrepancy that he might have interpreted, to the

management

• He also has to provide the management with the information regarding the factors
that might have a bearing on the prices as well as profitability of the products and
explain if there are any variances in the same to the senior management

Concerning the seriousness and importance of the cost accountant duties, it is really
imperative that the selection of the cost accountant is done carefully.

Cost Accountant Responsibilities

Wanting to have a career in something, and enjoying what you do every day in this role; can often be two different
things. If you are considering a career as an Cost Accountant, you may know the basic role or function of this
position; but do you know what responsibilities you will have? Here is a list of the most standard responsibilities
in the daily position of Cost Accountant.

Collect operational data and make analyses reports to forecast expenses and budgets.

Collect production data, maintenance and inventory control data.

Manage and coordinate annual physical counts and cycle counts in a plant.

Evaluate production costs, gains & losses and month-end closing data.

Forecast, prepare and implement a plant's budget.

Collect and analyze past years data to forecast budget for the ensuing year.

Study, review and reconcile variances in reports and data.

Identify solutions and create resources to control gaps.

Design, create and implement strategies, best practices and process improvements.

Identify operational opportunities and implement best processes and practices.

Design and implement advanced solutions based on collected data.

Accounting information system

An accounting information system (AIS) is the system of records a business keeps
maintaining its accounting system. This includes the purchase, sales, and other financial
processes of the business. The purpose of AIS is to accumulate data and provide decision
makers (investors, creditors, and managers) with information.

While this was previously a paper-based process, most businesses now use accounting
software. In an electronic financial accounting system, the steps in the accounting cycle
are dependent upon the system itself. For example, some systems allow direct journal
posting to the various ledgers and others do not. Not All AISs are computerized.
 Key characteristics of accounting information

There is general agreement that, before it can be regarded as useful in satisfying the needs
of various user groups, accounting information should satisfy the following criteria:

Understandability

This implies the expression, with clarity, of accounting information in such a way that it
will be understandable to users - who are generally assumed to have a reasonable
knowledge of business and economic activities

Relevance

This implies that, to be useful, accounting information must assist a user to form, confirm
or maybe revise a view - usually in the context of making a decision (e.g. should I invest,
should I lend money to this business? Should I work for this business?)

Consistency

This implies consistent treatment of similar items and application of accounting policies

Comparability

This implies the ability for users to be able to compare similar companies in the same
industry group and to make comparisons of performance over time. Much of the work
that goes into setting accounting standards is based around the need for comparability.

Reliability

This implies that the accounting information that is presented is truthful, accurate,
complete (nothing significant missed out) and capable of being verified (e.g. by a
potential investor).

Objectivity

This implies that accounting information is prepared and reported in a "neutral" way. In
other words, it is not biased towards a particular user group or vested interest

Budgeting and Internal Controls - Accounting Information for

Planning
In most operations, the manager is responsible for preparing and maintaining a budget.
The budget, or financial plan, simply details the expectations of an operation’s owners
and managers for a specific period of time. In this article you will learn about the variety
of ways hospitality managers utilize budgets and the budgeting process to better operate
their businesses. In fact, as you will discover, managers most often prepare not one, but
several types of budgets. You will learn about the various types of budgets most
hospitality operators prepare and why they develop them. Of all the many budgets that
can be produced, the operations budget is the one that is often foremost in the minds of
those who actually manage hospitality businesses. This is so because these budgets
contain important information about the controllable costs that are frequently used to
determine a manager’s actual skill and effectiveness. When managers meet budget
expectations, they are often rewarded. When their operational budgets are not met,
financial and other incentives may be reduced or even eliminated. As experienced
managers know, one important result of creating a budget is the potential to later make
comparisons between budgeted and actual financial performance. A second type of
budget that is of critical importance to many hospitality managers is the cash budget. It is
this budget that allows managers to ensure that the operation’s cash on hand, which is
used to pay the normal operating costs of the business, is sufficient to cover those
expenses. Finally, you will learn about some of the pitfalls and solutions to controlling
the actual outcomes of careful budgeting. An effective control system will have five
fundamental characteristics, which are management’s concern for assets, accurate data
collection and comparison to written standards, separation of responsibilities, cost
effectiveness, and regular external review.
- The Importance of Budgets

- Types of Budgets

- Operations Budget Essentials

- Developing an Operations Budget

- Monitoring an Operations Budget

- Cash Budgeting

- Managing Budgets through Internal Controls

The Importance of Budgets
Just as the income statement tells a managerial accountant about past performance, the

budget, or financial plan, is developed to help you achieve your future goals. In effect,

the budget tells you what must be done if predetermined profit and cost objectives are to

be met. To prepare the budget and stay within it assures your predetermined profit levels.

Without such a plan, you must guess about how much to spend and how much sales you

should anticipate. Effective managers build their budgets, monitor them closely, modify

them when necessary, and achieve their desired results. Budgeting can also cause conflicts.

This is true, for example, when a hotel’s food and beverage department and housekeeping

department both seek dollars budgeted for new equipment. The top needs are for either

a new kitchen range or a new commercial washing machine. Obviously, the food and

beverage manager and the housekeeping manager may hold different points of view on

where these funds can best be spent!

Accounting Information for Planning - Forecasting in the Hospitality

Industry

Hospitality managers working in restaurants and hotels simply must be able to accurately

predict the number of guests they will serve as well as when those guests will arrive. If they

cannot, guest service levels or profits will surely suffer. In this article you will learn how

hospitality managers forecast business revenues so they can carefully plan to maximize

guest satisfaction.

It has been said that average managers know what has happened in their operations

in the past and good managers know what is currently happening in their operations.

However, the very best managers also know what will happen in the future. While it may

not be possible for managerial accountants to predict their future business volume with

100% accuracy, it is possible to create and utilize management tools that will become very

accurate in estimating future revenues, expense requirements, and staffing needs.

The advantages of maintaining accurate sales forecasts are many but include greater
efficiency in scheduling the employees needed to service anticipated guests, greater accuracy

in estimating food production requirements, improved levels of inventory maintained

(because demand for products will be better known), and greater effectiveness in developing

and maintaining purchasing systems.

In the restaurant business, an understanding of anticipated sales, in terms of either

revenue dollars, guest counts, or both, will help you have the right number of workers,

with the right amounts of product available, at the right time. For hoteliers, knowing the

anticipated demand for guest rooms and other hotel services also allows for the proper

scheduling of employees; however, it does even more. Because hotel room rates (unlike

a restaurant’s menu prices) are often adjusted monthly, weekly, or daily to reflect the

immediate demand for rooms, a good understanding of how to forecast room occupancy

rates allows hoteliers the ability tomaximize RevPAR through the effective pricing of rooms

and the elimination of room discounts during periods of high room demand.

In this article, you will learn how managerial accountants can accurately forecast

revenues as well as how they utilize this information to maximize profit and increase

operational efficiency.

- The Importance of Accurate Forecasts

- Forecast Methodology

- Utilizing Trend Lines in Forecasting

The Importance of Accurate Forecasts

One of the first questions restaurateurs and hoteliers must ask themselves is very simple:

‘‘How many guests will we serve today? This week? This year?’’ The correct answers to

questions such as these are critical, since these guests will provide the revenue from which

basic operating expenses will be paid. Clearly, if too fewguests are served, total revenuemay

be insufficient to cover expenses, even if costs are well managed. In addition, purchasing

decisions regarding the kind and quantity of food or beverage to buy, the number of rooms

to clean, or the supplies to have on hand are dependent on knowing the number of guests

who will be coming to consume those products.

Labor required to serve the guests is also determined based on the manager’s ‘‘best
guess’’ of the projected number of customers to be served and what these guests will buy.

Forecasts of future revenues are normally based on a careful recording of previous sales,

since what has happened in the past in an operation is usually the best predictor of what will

happen in that same operation in the future. Finally, operating, cash, and capital budgets

cannot be prepared unless an operator knows the amount of revenue

upon which these bugets should be based.

In the hospitality industry, there are a variety of ways of counting or defining sales. In its

simplest case, sales are the dollar amount of revenue collected during some predetermined

time period. The time period may be an hour, shift, day, week, month, or year. When used

in this manner, sales and revenue are interchangeable terms. It is important, however, to

remember that a distinction ismade in the hospitality industry between sales (revenue) and

sales volume, which is the number of units sold. In many areas of the hospitality industry,

for example, in college and university dormitory food service, it is customary that no cash

actually changes hands during a particular meal period. Of course, the manager of such a

facility still created sales and would be interested in sales volume, that is, how much food

was actually consumed by the students on that day. This is critical information because, as

we have seen, a managermust be prepared to answer the question, ‘‘Howmany individuals

did I serve today, and how many should I expect tomorrow?’’

Need for Managerial Accounting Information:

Every organization-large and small-has managers. Someone must be responsible for making plans,
organizing resources, directing personnel, and controlling operations. Every where mangers carry out three
major activities-planning, directing and motivating, and controlling.

Planning:
Planning involves selecting a course of action and specifying how the action will be implemented. The first
step in planning is to identify the alternatives and then to select from among the alternatives the one that
does the best job of furthering the organization's objectives. While making choices management must
balance the opportunity against the demands made on the companies resources.
The plans of management are often expressed formally in budgets, and the term budgeting is applied to
generally describe the planning process. Budgets are usually prepared under the direction of controller, who
is the manager in charge of the accounting department. Typically, budgets are prepared annually and
represent management's plans in specific, quantitative terms.

Directing and Motivating:

In addition to planning for the future, managers must oversee day-to-day activities and keep the
organization functioning smoothly. This requires the ability to motivate and affectively direct people.
Managers assign tasks to employees, arbitrate disputes, answer questions, solve on-the-spot problems, and
make many small decisions that affect customers and employees. In effect, directing is that part of the
manager's work that deals with the routine and the here and now. Managerial accounting data, such as daily
sales reports are often used in this type of day-to-day decision making.

Controlling:
In carrying out the control function, managers seek to ensure that the plan is being followed. Feedback,
which signals operations are on track, is the key to effective control. In sophisticated organizations, this
feedback is provided by detailed reports of various types. One of these reports, which compares budgeted
to actual results, is called a performance report. Performance report suggest where operations are not
proceeding as planned and where some parts of the organization may require additional attention.

The Planning and Control Cycle:

The work of management can be summarized in a model. The model, which depicts the planning and
control cycle, illustrates the smooth flow of management activities from planning through directing and
motivating, controlling, and then back to planning again. all of these activities involve decision making. So
it is depicted as the hub around which the activities revolve.

Business Planning and Control: Integrating Accounting, Strategy and People starts
with an introduction to core areas of management accounting and business planning. It
then explores relationships between strategy, management accounting information, and
the design of control systems, taking into account the needs of both people and
organizations.

Business Planning and Control is an indispensable text for both undergraduate and
postgraduate students taking modules related to management accounting and business
planning and control.
Management process

Management process is a process of planning and controlling the performance or

execution of any type of activity, such as:

• a project (project management process) or

• a process (process management process, sometimes referred to as the process
performance measurement and management system).

The organization's senior management is responsible for carrying out its management
process. However, this is not always the case for all management processes, for example,
it is the responsibility of the project manager to carry out a project management
process[1].

[edit] See also

The Role of Accounting Information

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Accounting is "an information and measurement system that identifies, records,

and communicates relevant, reliable, and comparable information about
organizations business activities," as defined in "Fundamental Accounting
Principles" by Wild, Larson, and Chiappetta. Generally accepted accounting
principles (GAAP) are place that help us interpret and apply this information
effectively.

What is Accounting Used For?

1. Accounting informs users of two main points about a company--what

it owes and what it owns. The basic accounting equation is as follows:
Assets equal liabilities plus equity. Assets are resources that will
provide benefit in the future to the company. Liabilities are what the
company owes to creditors or non-owners in future services goods or
payments. Equity is explained as owner capital. By using the
accounting process and GAAP principles to identify, document and
balance these items, we can determine a net income for a business
and prepare financial statements for internal and external users who
will rely on this information.

Who Uses Accounting information?

2. Accounting keeps track of not only current financial information but

also a history, which will aid not only employees but outside interested
parties as well. Two types of users rely upon financial accounting--
external and internal. External users are not directly involved with
running the organization. These types of users will typically have limited
access to the information but will base their business decisions on
these reports. Examples of external users are customers, shareholders,
lawyers and brokers. Internal users are directly involved in managing
and operating an organization. They use accounting information to
help improve the effectiveness of the business. Managers, payroll
directors, and sales staff are examples of internal users of accounting.

Applying Accounting

3. In every business as well as in personal finance, there is a need for

a knowledgeable and ethical accounting; it is a key to success and a
solid financial future. Proper documenting, balancing, and reporting of
financial information is used by consumers, investors, employees, and
management.

Employment Opportunities

4. Opportunities for employment in this field are in demand and usually

paid well. Certification is usually required and helps maintain a standard
of knowledge in this field. There are four categories--financial,
managerial, taxation, and accounting-related work. Examples of these
various jobs are external and internal auditors, certified professional
accountants, chief financial auditors, payroll specialists, and appraisers.

Personal Accounting

5. Keeping track of income, expenses and assets is also a key element

of personal accounting. Individuals invest their money into various
 stocks and bonds or savings accounts based on the financial reporting
of those companies. Maintaining accurate accounting of income versus
monthly expenses and planning for the future are important. Some
people hire CPAs to help them understand where and how to invest as
well as to assist them in understanding tax filing and responsibilities.

Read more: The Role of Accounting Information | eHow.com

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Accounting Information Systems (Accounting information systems s) combine the study and practice of

accounting with the design, implementation, and monitoring of information systems. Such systems use modern

information technology resources together with traditional accounting controls and methods to provide users

the financial information necessary to manage their organizations.

Accounting information systems TECHNOLOGY

Input The input devices commonly associated with Accounting information systems include: standard personal

computers or workstations running applications; scanning devices for standardized data entry; electronic

communication devices for electronic data interchange (EDI) and e-commerce. In addition, many financial

systems come ‘‘Web-enabled’’ to allow devices to connect to the World Wide Web.

Process Basic processing is achieved through computer systems ranging from individual personal computers to

large-scale enterprise servers. However, conceptually, the underlying processing model is still the ‘‘double-

entry’’ accounting system initially introduced in the fifteenth century.

Output Output devices used include computer displays, impact and nonimpact printers, and electronic

communication devices for EDI and e-commerce. The output content may encompass almost any type of

financial reports from budgets and tax reports to multinational financial statements.

MANAGEMENT INFORMATION SYSTEMS (MIS)

MISs are interactive human/machine systems that support decision making for users both in and out of

traditional organizational boundaries. These systems are used to support an organization’s daily operational
activities; current and future tactical decisions; and overall strategic direction. MISs are made up of several

major applications including, but not limited to, the financial and human resources systems.

Financial applications make up the heart of an Accounting information systems in practice. Modules commonly

implemented include: general ledger, payables, procurement/ purchasing, receivables, billing, inventory,

assets, projects, and budgeting. Human resource applications make up another major part of modern

information systems. Modules commonly integrated with the Accounting information systems include: human

resources, benefits administration, pension administration, payroll, and time and labor reporting.

Accounting information systems — INFORMATION SYSTEMS IN CONTEXT

Accounting information systems s cover all business functions from backbone accounting transaction processing

systems to sophisticated financial management planning and processing systems. Financial reporting starts at

the operational levels of the organization, where the transaction processing systems capture important business

events such as normal production, purchasing, and selling activities. These events (transactions) are classified

and summarized for internal decision making and for external financial reporting. Cost accounting systems are

used in manufacturing and service environments. These allow organizations to track the costs associated with

the production of goods and/or performance of services. In addition, the Accounting information systems can

provide advanced analyses for improved resource allocation and performance tracking. Management accounting

systems are used to allow organizational planning, monitoring, and control for a variety of activities. This allows

managerial-level employees to have access to advanced reporting and statistical analysis. The systems can be

used to gather information, to develop various scenarios, and to choose an optimal answer among alternative

scenarios.

DEVELOPMENT

The development of an Accounting information systems includes five basic phases: planning, analysis, design,

implementation, and support. The time period associated with each of these phases can be as short as a few

weeks or as long as several years.

Planning—project management objectives and techniques The first phase of systems development is the

planning of the project. This entails determination of the scope and objectives of the project, the definition of

project responsibilities, control requirements, project phases, project budgets, and project deliverables.

Analysis The analysis phase is used to both determine and document the accounting and business processes used

by the organization. Such processes are redesigned to take advantage of best practices or of the operating

characteristics of modern system solutions.

Data analysis is a thorough review of the accounting information that is currently being collected by an

organization. Current data are then compared to the data that the organization should be using for managerial

purposes. This method is used primarily when designing accounting transaction processing systems.

Decision analysis is a thorough review of the decisions a manager is responsible for making. The primary

decisions that managers are responsible for are identified on an individual basis. Then models are created to

support the manager in gathering financial and related information to develop and design alternatives, and to

make actionable choices. This method is valuable when decision support is the system’s primary objective.

Process analysis is a thorough review of the organization’s business processes. Organizational processes are

identified and segmented into a series of events that either add or change data. These processes can then be

modified or reengineered to improve the organization’s operations in terms of lowering cost, improving service,

improving quality, or improving management information. This method is appropriate when automation or

reengineering is the system’s primary objective.

Design The design phase takes the conceptual results of the analysis phase and develops detailed, specific

designs that can be implemented in subsequent phases. It involves the detailed design of all inputs, processing,

storage, and outputs of the proposed accounting system. Inputs may be defined using screen layout tools and

application generators. Processing can be shown through the use of flowcharts or business process maps that

define the system logic, operations, and work flow. Logical data storage designs are identified by modeling the

relationships among the organization’s resources, events, and agents through diagrams. Also, entity relationship

diagram (ERD) modeling is used to document largescale database relationships. Output designs are documented

through the use of a variety of reporting tools such as report writers, data extraction tools, query tools, and on-

line analytical processing tools. In addition, all aspects of the design phase can be performed with software tool

sets provided by specific software manufacturers.

Reporting is the driving force behind an Accounting information systems development. If the system analysis and

design are successful, the reporting process provides the information that helps drive management decision

making. Accounting systems make use of a variety of scheduled and on-demand reports. The reports can be

tabular, showing data in a table or tables; graphic, using images to convey information in a picture format; or

matrices, to show complex relationships in multiple dimensions. There are numerous characteristics to consider

when defining reporting requirements. The reports must be accessible through the system’s interface. They

should convey information in a proactive manner. They must be relevant. Accuracy must be maintained. Lastly,

reports must meet the information processing (cognitive) style of the audience they are to inform.

Reports are of three basic types: A filter report that separates select data from a database, such as a monthly

check register; a responsibility report to meet the needs of a specific user, such as a weekly sales report for a

regional sales manager; a comparative report to show period differences, percentage breakdowns and variances
between actual and budgeted expenditures. An example would be the financial statement analytics showing the

expenses from the current year and prior year as a percentage of sales.

Screen designs and system interfaces are the primary data capture devices of Accounting information systems s

and are developed through a variety of tools. Storage is achieved through the use of normalized databases that

assure functionality and flexibility.

Business process maps and flowcharts are used to document the operations of the systems. Modern Accounting

information systems s use specialized databases and processing designed specifically for accounting operations.

This means that much of the base processing capabilities come delivered with the accounting or enterprise

software.

Implementation The implementation phase consists of two primary parts: construction and delivery.

Construction includes the selection of hardware, software and vendors for the implementation; building and

testing the network communication systems; building and testing the databases; writing and testing the new

program modifications; and installing and testing the total system from a technical standpoint. Delivery is the

process of conducting final system and user acceptance testing; preparing the conversion plan; installing the

production database; training the users; and converting all operations to the new system.

Tool sets are a variety of application development aids that are vendor-specific and used for customization of

delivered systems. They allow the addition of fields and tables to the database, along with ability to create

screen and other interfaces for data capture. In addition, they help set accessibility and security levels for

adequate internal control within the accounting applications.

Security exists in several forms. Physical security of the system must be addressed. In typical Accounting

information systems s the equipment is located in a locked room with access granted only to technicians.

Software access controls are set at several levels, depending on the size of the Accounting information systems .

The first level of security occurs at the network level, which protects the organization’s communication

systems. Next is the operating system level security, which protects the computing environment. Then,

database security is enabled to protect organizational data from theft, corruption, or other forms of damage.

Lastly, application security is used to keep unauthorized persons from performing operations within the

Accounting information systems .

Testing is performed at four levels. Stub or unit testing is used to insure the proper operation of individual

modifications. Program testing involves the interaction between the individual modification and the program it

enhances. System testing is used to determine that the program modifications work within the Accounting

information systems as a whole. Acceptance testing ensures that the modifications meet user expectations and

that the entire Accounting information systems performs as designed.

Conversion entails the method used to change from an old Accounting information systems to a new Accounting

information systems . There are several methods for achieving this goal. One is to run the new and old systems

in parallel for a specified period. A second method is to directly cut over to the new system at a specified point.

A third is to phase in the system, either by location or system function. A fourth is to pilot the new system at a

specific site before converting the rest of the organization.

Support The support phase has two objectives. The first is to update and maintain the Accounting information

systems . This includes fixing problems and updating the system for business and environmental changes. For

example, changes in generally accepted accounting principles (GAAP) or tax laws might necessitate changes to

conversion or reference tables used for financial reporting. The second objective of support is to continue

development by continuously improving the business through adjustments to the Accounting information systems

caused by business and environmental changes. These changes might result in future problems, new

opportunities, or management or governmental directives requiring additional system modifications.

ATTESTATION

Accounting information systems s change the way internal controls are implemented and the type of audit trails

that exist within a modern organization. The lack of traditional forensic evidence, such as paper, necessitates

the involvement of accounting professionals in the design of such systems. Periodic involvement of public

auditing firms can be used to make sure the Accounting information systems is in compliance with current

internal control and financial reporting standards. After implementation, the focus of attestation is the review

and verification of system operation. This requires adherence to standards such as ISO 9000-3 for software

design and development as well as standards for control of information technology.

Periodic functional business reviews should be conducted to be sure the Accounting information systems remains

in compliance with the intended business functions. Quality standards dictate that this review should be done

according to a periodic schedule.

ENTERPRISE RESOURCE PLANNING (ERP)

ERP systems are large-scale information systems that impact an organization’s Accounting information systems .

These systems permeate all aspects of the organization and require technologies such as client/server and

relational databases. Other system types that currently impact Accounting information systems s are supply

chain management (SCM) and customer relationship management (CRM).

Traditional Accounting information systems s recorded financial information and produced financial statements

on a periodic basis according to GAAP pronouncements. Modern ERP systems provide a broader view of

organizational information, enabling the use of advanced accounting techniques, such as activity- based costing

(ABC) and improved managerial reporting using a variety of analytical techniques.

General principles of cost Accounting
The followings may be considered as the general principles of cost
accounting:

1. A cost should be related to its causes: Costs should be related as closely as

possible to their causes so that cost can be shared only among the cost units
passing through that department of which expenses are being considered.

2. A cost should be charged only after it has been incurred:

While determining the cost of individual units those costs which have actually been incurred
should be considered. For example, a cost unit should not be charged to the selling costs, while it is
still in the factory. Selling costs can be charged with the products which are sold.

3. The convention of prudence should be ignored: Usually accountants believe in historical

costs and while determining cost, they always attach importance to the historical cost. In cost
accounting this convention must be ignored, otherwise, the management appraisal of the
profitability of projects may be VI tilted. According to W.M.harper,"a cost statement should, as far
as possible, give the facts with no known bias. If a contingency needs to taken into consideration it
should be shown separately and distinctly".

4. Abnormal costs should be excluded from cost accounts:

Costs which are of abnormal nature (e.g. accident, negligence etc.)Should be ignored while
computing the cost, otherwise, it will distort cost figures and mislead management as to the
working results of their undertaking under normal conditions.

5. Past costs not to be charged to future period:

Costs which could not be recovered or charged in full during the concerned period should not be
taken to a future period ,they are likely to influence the future period and future results are likely
to be distorted.

6. Principles of double entry should be applied wherever necessary:

Costing requires a greater use of cost sheets and cost statements for the purpose of cost
ascertainment and cost control, but cost ledger and cost control accounts should be kept on double
principle as far as possible.

Objectives of Cost Accounting

Cost accounting aims at systematic recording of expenses and analysis of the same so as to
ascertain the cost of each product manufactured or service rendered by an organisation.information
regarding cost of each product or service would enable the management to know where to
economize on costs, how to fix prices, how to maximize profits and so on. Thus, the main objects
of cost accounting are the following:
1. To analyze and classify all expenditure with reference to the cost of products and operations.

2. To arrive at the cost of production of every unit, job, operation, process, department or service
and to develop cost standard.
3. To indicate to the management any inefficiencies and the extent of various forms of waste,
whether of materials, time, expenses or in the use of machinery, equipment and tools. Analysis of
the causes of unsatisfactory results may indicate remedial measures.
4. To provide data for periodical profit &loss accounts and balance sheets at such intervals, e.g.,
weekly, monthly or quarterly, as may be desired by the management during the financial year, not
only for the whole business but also by departments or individual products. Also, to explain in
detail the exact reasons for profit or loss revealed in total, in the profit &loss Account.
5. To reveal source of economies in production having regard to methods, types of equipment,
design, output and layout. Daily, weekly, monthly or quarterly information may be necessary to
ensure prompt constructive action.
6. To provide actual figures of cost for comparison with estimates and to serve as a guide for future
estimates or quotations and to assist the management in their price-fixing policy.
7. To show, where standard costs are prepared, what the cost of production ought to be and with
which the actual costs which are eventually recorded may be compared.
8. To present comparative cost data for different periods and various volumes of output and to
provide guidance in the development of business. This is also helpful in budgetary control.
9. To record the relative production results of each unit of plant and machinery in use as a basis for
examining its efficiency. A comparison with the performance of other types of machines may
suggest the necessity for replacement.
10. To provide a perpetual inventory of stores and other materials so that interim profit and loss
account and balance sheet can be prepared without stock taking and checks on stores and
adjustments are made at frequent intervals. Also to provide the basis for production planning and
for avoiding unnecessary wastage or losses of materials and stores.
11. To provide information to enable management to make short term decisions of
various types, such as quotation of price to special customers or during a slump,
make or buy decision, assigning priorities to various products, etc.
 Unit-2

Budget, Budgeting and Budgetary Control

Budget: A budget is a plan and blueprint for future management

action. It is expressed in monetary terms. The statement shows the planned level
of income which the firm is expected to generate and the expenditure that is
expected to be incurred. It also lays down the capital that is to be employed for the
purpose.
The Terminology of CIMA defines a budget as under:

“A plan quantified in monetary terms prepared and approved prior

to a defined period of time usually showing planned income to be generated
expenditure to be incurred during that period and the capital to be employed to
attain a given objective

A budget is a plan which helps an organization to answer such questions are:

1. What to achieve?
2. How to achieve it?

In the process of answering such questions, management systematically

analyses the likely changes in the internal as well as the external environment and
their probabilities.it is also used for control.

Budgeting: the process of preparation, implementation and the operation of

budgets is knows as budgeting. Budgeting is the formulation of plans for a given
future of period in numerical terms. It is a method of looking ahead and attempting
to solve problems before they arise. it requires that a business study and evaluate
its role in the economic environment with the object of establishing and achieving
stated goals for all levels of the organization.bussiness transactions essential for
the attainment of these goals are forecast and summarized in the form of projected
financial statements.

Budgetary Control: Budgetary control is a systematic and formalized approach for

accomplishing the planning, coordination and control responsibilities of
management. As defined by the terminology of CIMA “budgetary control is 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.”

(1) Establishment of budgets

(2) Comparison on a continuous basis of actual results with budgets
(3) Ascertainment of variances by responsibility centers
(4) Investigation of variances to highlight causes
(5) Corrective action to remedy the causes in order to ensure the defined
objectives are attained

Features of a Budget

A budget is a blueprint for management action. It is a vital tool for carrying

out effective short-term planning and control in firma.the following are the
features of a budget:

(i)One Year Duration-generally, budgets are prepared for one year. however in the
case of seasonal business like fruit canning,ice-cream,apparels etc, here may be
two budgets for each year-a slack season budget and a peak season budget.

(ii)Estimation of Business Units Profit Potential-it shows how much profit or loss
a business unit is expected to make and thereby reveals its profit potential.

(iii)Appraisal of Performance-At the end of a specified period, actual performance

is compared with the budget and deviations are as certained. These deviations
which are known as variances are analyzed by causes and responsibility centers.

(iv)Monetary Terms-the figures in the budget are expressed in monetary terms.

However the monetary figures are supported by non-monetary information namely
units purchased, units purchased, units manufactured, units sold etc.

(v)Alteration of Approved budget under Specified conditions-After the budget has

been approved by the top management, the same cannot be altered except under
specified conditions.

(vi)Review and Approval by a Higher Authority-the budget proposal which is

prepared by the budgetee is reviewed and approved by an authority higher than the
budgetee.
(vii)Managerial Commitment-the budget is essentially a commitment made by the
managers of responsibility centres.They agree to shoulder responsibility for the
purpose of achieving the budgeted objectives.

Difference between Budget and Forecast

A budget is a plan for management action. It is prepared based on the

implied assumption that the budgetee will take positive steps to make actual events
conform to plans. A prediction of what is most likely to happen is known as a
forecast.

A budget happens to be a tool for planning and control whereas a

forecast is a planning device. Elements of forecasting are included in all budgets.
The budge tees cannot be made to bear responsibility for certain outcomes that
have an affect on their ability to meet budgeted objectives.

A budget is prepared for a defined period of time while a forecast can be for
any time period. A budget is usually expressed in monetary terms whereas a
forecast may not be stated in monetary terms.

An updating of a forecast is carried out as soon as new information gives the

indication that there is a change in conditions, this is not the case with a budget.

Prerequisites of a budgetary control system:

A Budgetary control system must posses the under noted

features in order to be successful:

1. Top management support: The top management of the firm must be

convinced about the benefits of budgeting, participate in its implementation,
issue guidelines as and when necessary and devote time and resources for
the preparation. It should also shoulder the responsibility for coordination of
budgets of various departments and their final approval. Last but not least, it
has to resolve conflicts of different departments regarding resources
allocation and take follow up procedure in order to secure that budgets are
effectively implemented.

2. Proper organizational structure: A sound organizational structure should

be there in the firm and the authorities and responsibilities of each system
should be established. In the absence of this demarcation of authorities and
responsibilities, managers can not be held responsible. This is because they
 would be unaware of their responsibilities and at the same time held
responsible for activities over which they have responsibility.

3. Clear and realistic nature of goals: Every organization has its own goals
and objectives and budgeting is a tool for achieving them. The goals must be
clear and should preferably be in writing. This would provide proper
direction to the employees and save management’s time.
The goals should also be reasonable, appear realistic and
capable of being attained. Goals should not be set at a very low level as the
same can be easily attained with out providing any motivation. On the other
hand, goals set at an extremely high level appear unrealistic and unattainable
to the employees, creates a sense of demoralization and as a result they do
not make serious efforts to attain them.

4. Flexibility: One of the essential requirements of an effective budgetary

control system is flexibility, whenever the situation so requires, a manager
should be take action which is considered prudent. A part from this, the
system should have a built-in flexibility so that the impact of changes in
activity levels on costs, revenues and profits are easily known.

5. Participative process: People at all levels should participate in the

preparation of budgets. A combination of top down and bottom up process is
desirable. It has been proved that if employees participate in developing
budgets, they will make efforts to ensure the success of the budgeting
system.

Budgets are prepared by line managers with the assistance and

under the supervision of the controller’s/ financial controller’s department.
This provides them motivation during the implementation process.

6. Conductive Environment: In order to enable the budgetary control system

to function effectively, a conductive environment should be created. This
can only be done by educating employees so that they regard the system as a
positive tool for achieving performance rather than a negative device for
pressuring, finding fault and punishment. Similarly, the dysfunctional
aspects of budgeting must be clear to the management. They must take due
care to avoid or at least minimize them (e.g.: overreaction to adverse
variances or reporting only adverse variances.)

ADVANTAGES OF BUDGETING
1. Budgeting helps in solving problems in a disciplined manner.
2. It helps the organization to plan well in advance for mobilizing resources
needed for achieving its goals.
3. The nature of evaluation criteria is more objective. Apart from this, the
performance in each aspect of a manager’s operation can be measured by
using this yardstick.
4. Forward planning gets encouragement where there is a system of
budgeting. Cost consciousness and profit mindedness are created
throughout the organization.
5. As the performance of managers is measured against budgets, they are
motivated to accomplish high performance.
6. One of the advantages of budgeting is that there is an improvement in
communication. More over, it also leads to proper coordination.
7. Another advantage is that if facilitates management by exception. This is
done through variance analysis.
8. Budgeting enables the organization to review and restate its fundamental
goals, policies and procedures.

LIMITATIONS OF BUDGETING:

1. Conflict of goals: The goals of budgeting must match with the objectives of
the enterprise. How ever, it does happen that budget goals are set with out
considering the aims and objectives of the enterprise. This gives rise to
confusion and defeats the purpose of budgeting.

2. Judgment of management: Budgeting is both an art as well as a science.

As a result, managerial judgment plays an equally important role. There is an
element of bias and subjectivity in managerial judgment. This can create
problems while preparing estimates for budgets.

A revision or modification of estimates should be made

when variations from the estimates require a change of plans.

3. Establishment of Unattainable targets: One must be careful in setting

targets for budgeting. Unrealistic or unattainable targets will lead to lower
morale and as a result productivity would fall.

4. Improper Implementation: The success of budgeting depends upon its

implementation. If the same is not properly implemented, the system would not
be understood by all the people in the organization. Consequently, the
subordinates and the managers would not put in the desired effort for achieving
the goals laid down in the budget.
 5. Undesirable Complications: A budget should not have more details than is
necessary as it leads to complications. It is, however, found that many a time it
is too detailed and rigid.

6. Failure to continuously Adapt: Budgeting is an exercise in dynamics.

Business conditions change continuously and the organization must adapt the
budgeting system to it. However, it happens that management loses its patience
and as a result it may lead to the failure of the budgeting system.

7. High cost of Operating System: The cost of operating the system is quite
high. It is possible that the benefits arising from it may not be commensurate
with the cost. Hence before installing a budgeting system the size of the firm
and its information needs must be studied so that a power system which can
be utilized fully and effectively can be implemented.

Types of budgets

The end results of the budgetary process are a master budget. The master
budget summarizes the objectives of all sub-units of an organization-marketing,
production, finance and distribution. It quantifies the expectations regarding future
income, financial position, cash flows and supporting plans. The master consists of
two parts-operating budgets and financial budgets.

(1) Operating budgets:

Operating decisions are included in the operating budgets of an
organization. Operating budgets are nothing but plans relating to the operations of
the firm. The operations that are functions relating to and for the next year are laid
down. Apart from this, it includes budgets which specifically lay down plans for
different individuals. The operating budgets generally are sales budget, production
budget, inventory budget, direct materials budget, direct labor budget, production
over head budget, cost of goods sold budget, administration over head budget,
selling and distribution over head budget, man power budget etc.
(2)Financial budget:
Financial budgets are those which incorporate financial decisions of
organizations. The financial budgets are cash budget, working capital budget,
projected statement of changes in working capital and its sources and applications,
projected profit and loss a/c, projected balance sheet and capital budget.
Process of budgeting
The preparation of budget is both an accounting exercise as well as a
management process. From the accounting standpoint the procedures are
essentially the same as those involved in the preparation of final accounts and the
end products of the recording and summarizing operations is a set of financial
statements –a Balance sheet and profit and loss account.
From the managerial standpoint, the budgeting process is very closely
associated with the operation of the business. The general considerations involved
in the process of budgeting are as follows:

(1)Strategy Analysis:
In the case of companies which do not prepare strategic plans or
multi-business companies having business unit form of organization (i.e. strategic
business unit or division), the budget preparation process starts with strategy
analysis. Strategy analysis essentially consists of the following:
(a)A study of political, social, economic and regulatory environment.
(b)A study of technological environment.
(c)A study of the industry in which the firm or business unit as the case may be
is engaged in.
(d)A study of existing and potential competitors.
The analysis helps in the identification of changes that have taken place after the
last budget was finalized and also the changes expected during the budget period.

(2)Definition of budget objectives:

The budget objectives must be clearly and precisely defined and
should be in writing as the budget is a plan for management action .Thereafter;
plans are prepared to accomplish the objectives.

(3)Determination of principal budget factor (key factor):

In practice, the sequence of budget preparation is determined by the
principal budget factor or key factor. This factor imposes a constraint or sets a
limit to the level of activity during the budget period .In the real world, one may
cone across the under noted key factor:
(a)plant capacity(b)restrictions imposed by the government(c)customer
demand(d)supply of lab our(e)corporate policy(f)supply of raw
materials(g)finance(h)power (I)availability of space.
Many key factors may operate at the same time in a firm (a firm engaged in
many types of businesses); different products may have different key factors.
During the process of budget preparation, it is essential that the key factors should
be identified and the maximum volume that the can be manufactured or sold
ascertained.
(4)Developing plans:
 Having identified the principal budget factors or key factors, steos
are taken to develop alternate plans which would lead to the attainment of budget
objectives .Use should be made of proper forecasting tools and judgment exercised
so that reasonably accurate and realistic forecasts can be made which are so
essential for the development of goods plans .detailed discussions of these plans
are made and the most suitable one chosen.
(5)Initial budget proposal:

The budget being planning and control tool creates special

problems in terms of balancing of efficiency and effectiveness, control and
creativity ,risk –taking and caution .The impact of the budget and the budgetary
process on managerial behavior can be most significant.
Three particularly significant elements of the budget affect
managerial behavior .they are the degree of difficulty or reach implicit in the
targets set, the extent of managerial participation in the preparation of the budget
and the nature of the review of actual performance in the relation to the budget.
Proper communication must be made to all levels of
managemaent.Indiviuals that have the responsibility for the preparation of
subsidiary budgets namely managers of various responsibility centers must be duly
provided with broad policy guidelines, skeleton plans and information about key
factors. This process is known as ‘top down principle’ because policy guidelines,
skeleton plan and information about key move down.
On the basis of the guidelines etc., responsibility centre
managers with the assistance of their staff and the budget department of proposed
budget.

(6)Submission of subsidiary budget:

On the basis of communication received, each person responsible

for the preparation of subsidiary budgets relating to his area of responsibility
prepares the said budget. These are submitted to their superiors for scrutiny. The
superior scrutinizes them to ascertain whether the same conforms to the guidelines
etc.issued and is duly discussing the same with his subordinates. The manager of
each department consolidates the subsidiary budgets .Also known as the ‘bottom
up principle’s subsidiary budgets move up.

(7)Negotiation
The department manager discusses the proposal budget with his
superior .This is said to be the heart of the process. The superior critically analyses
the budget, suggests modifications and discusses the same with the process. The
superior critically analysis the budget, suggest modifications and discusses the
same with the budgetee. He tries to judge how valid each of the adjustments are.
Generally, a consideration relating to budgeting is that performance in the budget
year should be improvement over current year’s performance. At this stage it is
finally decided whether a budget should be accepted without modifications or with
modifications. The superior realizes that at the next level of the budget process he
will become the budge tee and therefore must be prepared to defend the budget
that is finally agreed.

(8)Review and Approval

The proposal budget move up through various organizational levels

in the firm .Ultimately, they reach the head of the business unit (In the case of
strategic business unit or functionally organizations) or the chief executive officer
(In the case of single single product, single unit or functionally organized
firms).At this level they are assembled i.e., the pieces are put together and the
proposed budget is examined in totality. While analyzing the same it is ensured
that they are compatible with the overall goals and consistency is checked.
The budget committee makes recommendation for final approval to
the chief executive officer (i.e., managing director). The chief executive officer
after approving it sends it to the Board of Directors for ratification. This happens
in January or February prior to the beginning of beginning of budget year. Once
the budget is ratified, the budget committee returns the approved subsidiary
budgets to the respective departments etc.
In order to be effective, a budgetary control system must be operated
with standard costing.

PREPARATION OF MASTER BUDGET

We have already seen that the master budget consists of two parts:
A. Operating budgets
B. Financial budgets.
Initially we would discuss the method of preparation of operating budgets.

A. Operating Budgets:

Generally, the sales budget is prepared first. However, the principal

budget factor may play a major role in the sequencing of budgets. The implies,
that, for instance, if production capacity of the firm is limited, the production
budget would be prepared first followed by other budgets. The budgets which
an organization usually prepares and their method of preparation are given
below:
1. Sales budget:

The sales budget shows the projected sales of various products, their
average sale price and the total sales realization. The revenue budget also
called as the sales budget, is not only the most critical but is also subject to the
greatest uncertainty varies from time to time. Firms having large backlog of
orders or whose volume of sales are subject to production constraints will be
making sales projections with more certainty compared to firms whose sales
volumes are subject to the uncertainties of the market place.

The sales forecast is the starting point of sales budgeting. It

could be prepared by products, class of customers, regions/geographical areas
or any other manner suitable to the organization .A sales forecast is essentially
an estimate, a prediction of costumer’s demand and a reflection of market
situation. Management reacts to the sales forecast by making a decision
relating to where it wants to position to position the firm in the market place
relation to its competitors. This decision is reflected in the sales budget .A
numbers of factors are considered in forecasting sales which may grouped
under two broad heads (1) internal (2) external.

When sales are influenced by factors which are with in the firm, they are
known as internal factors .Internal factors are given below
(A) Pricing policies
(B) Grading sales
(c) Advertisement and publicity
(D) New products
(e) Relative profitability of products
(f) Size, composition of sales force
(g) Capacity of plant
(H) Expansion proposal

When sales are influenced by forces which are outside the firm
and over which it has no control such factors are known as external factors.
External factors are given below:
(A) Population shift
(b) Purchasing power of population
(c) Consumer tastes and habits
(d) Substitutes available in the market and their prices
(e) Nature and extent of competition
(f) General economic conditions
(g) Changes in the exchange rates
(h) Change in direct taxes
 (I) changes in indirect taxes namely sales tax, octroi, excise duty
and customs duty
(j) Other government regulations and controls
(k) Seasonal and cyclic fluctuations.
While preparing the sales budget, the following factors should be considered

(A) Orders in hand

(b) Past sales in each geographical area
(C) Past sales by competitors in each geographical area
(D) Resource availability i.e., the amount and of resources made available
to it e.g. sales personnel, products etc.
(e) Competitors sales in geographical areas which are not served by the
firm
(f) For industrial products, sales trend of industries to which the customers
belong
(g) Movements in aggregate customer demand and in market share of the
firm
(H) Movements in aggregate customer demand and in the market share of
competitors
(I) action plan and programs of management.

Sales forecast may be prepared by areas sales managers or

market research bureaus. They are duly compiled by departmental heads and
adjustments made for external factors which may not have been considered by
them and internal factors. The use of statistical techniques like multiple co
relation, cycle projection and trend analysis are also made to test the results.

2. PRODUCTION BUDGET

This budget contains an estimate of the various products that a firm intends
to manufacture during the budget period and their quantity. The volume of
goods to be produced depends upon the sales budget, the closing stock to be
maintained as per the firm’s policy and the opening stock of the goods.
The production budget is geared to the sales budget. In order to
develop an optimum production budget, an optimal balance must be struck
between sales, production and stock levels.
Before preparing this budget, a work flow chart should be prepared
showing the movements of the materials through the factory. It should start
from the point if issue of the material and end with the point of dispatch to
the finished goods store. This chart highlights shortcomings in the plant and
factory layout, bottlenecks in each machine or process and surplus machine
capacity.
 Available standard hours form the basis of calculation of plant
capacity which is dependant upon absenteeism, idle time and productivity.
In respect of each product centre i.e., production centre, the available hours
should be calculated. This would enable one to determine the imbalances
between standard hours available at various cost centers and highlight the
shortfall in standard hours which is required to meet the sales budget and
the company’s stock policy.

There are a number of key factors which limit the volume of

output and the usual one’s are plant capacity, power supply, supply of lab
our and availability of raw materials. Generally the management of the
business enterprise decides to take a number of steps in order to minimize
the impact of key factor. They are shift working, new scheduling practices,
methods improvement, overtime time working, retraining of workmen, use
of alternate raw material, improvement in plant layout, introduction of
incentive schemes, installation of balancing equipment, subcontracting,
sourcing(purchasing) from outside the firm components, sub-assemblies
and finished products, product redesign to simplify manufacture and reduce
the number of components in order to ease production bottleneck, opting
for plant with improved technology and diesel generators for power supply.
The production budget must be integrated with the sales
budget. In respect of seasonal business, management should weigh the costs
and benefits of stabilized production throughout the year Vis a Vis
stabilized inventory with production fluctuating on the basis of the seasonal
sales. The former results in stable utilization of facilities and man power
while the later yields a lower inventory carrying cost.
The production budget must be flexible so as to recognize the
impact on performance of varying levels of activity.

3. DIRECT LABOUR BUDGET

This budget shows the number of direct workers required.

Direct lab our is the first classified product center wise i.e., by production cost
centers. They then broken down in to three broad categories such as skilled,
semi-skilled and unskilled.

Direct labor budget must be in agreement with the standard hours of

production as given in the production budget. Consideration should be given to
probable effects of product redesign, productivity trends, probable effects of
methods improvement, training of workers and improved layout.
 The labor cost is then estimated by multiplying the number of
workers in each grade by the standard wage rate and totaling the labor cost of
all the grades.

The direct labor budget is used for the preparation of cash budget and
cost of sales budget. It proves useful to personnel department in drawing up
recruitment, training and allied programs.

4. DIRECT MATERIALS PURCHASE BUDGET

This budget shows the opening stock of each raw material,

indirect materials, purchased services etc., their closing stock and the purchases
to be made during the budget period. It also contains the budgeted quantities of
each raw material required for manufacturing the budgeted volume of goods.

While preparing the direct materials purchase budget, the

following factors should be considered:
(a)production budget(b)inventory policy(c)negotiated landed cost of raw
materials, indirect materials and purchased services(d) stocks available
(e)recorder level (f)economic order quantity (g) standard usage (h) action plans
and programs of management e.g. material substitution, subcontracting, value
analysis and value engineering.

The direct materials purchase budget enables the purchase

department to prepare a purchase schedule and also enter in to long-term
contracts where ever necessary or possible. It used for the preparation of cash
budget.

5. DIRECT MATRERIALS USAGE BUDGET

This budget shows the usage of each raw material required in

the manufacture of various products. The direct materials usage budget is
prepared on the basis of units of production, given in the production budget.
Standards have to be set for each type of material required for each unit of
production. While establishing standard quantities, due consideration should be
given to normal loss. The budget quantities are converted into values using
standard prices for each type of material. This budget is used for the
preparation of direct material purchased budget.

6. INVENTORY BUDGET

The inventory budget shows the closing stock of raw

materials, work in progress and finished goods. It shows the quantity, price and
value of each of the above. The inventory budget is used for the preparation of
direct materials purchase budget, production budget, budgeted profit and loss
account and budgeted balance sheet.

7. FACTORY OVER HEAD BUDGET

Production over head displays two distinct characteristics-one

part of is fixed while the other part is variable. Hence, while budgeting for
factory overhead one has to be careful.

The direct labor budget and the production budget are used for
calculating indirect labor cost. The number of indirect workers required or first
worked out and then translated in to monitory amount by multiplying by
standard wage rate.

The use of the chart of accounts is made to work out the

remaining parts of factory overhead budget i.e., indirect wages and indirect
expenses. Expenses are first divided in to fixed and variable categories. The
fixed overhead being more or less constant, as it does not generally change
with in the volume of production, is some what easy to estimate. Estimation of
expenses which fall under various account heads namely power, fuel, indirect
materials and supplies, light, freight, gas, oxygen, oxyacetylene etc., are made.

The total expenses under various accounts heads are allotted to

respective cost centers. Since responsibility centre managers are responsible
for activities in cost centers which fall under their charge and accountable for
cost variances, the total expenses of each cost centre must be divided in to
controllable and non controllable groups. Controllable expenses are those
which can be controlled by actions or decisions of the manager who is
responsible for the particular cost centre. On the contrary, non-controllable
expenses are those which are appointed to the cost centre and controlled by the
manager in charge of the particular cost centre.

The estimate of expenses for each cost centre is made on the basis
of projected activity level. These are then submitted. The estimates are
reviewed, discussed and changes made if considered necessary, before being
included in the overall budget.

While preparing the factory overhead budget, the following factors

should be considered:

(a) Past year’s expenses.

 (b) The amount and kind of resources being made available to it e.g.,
production personnel, in directs.
(c) Making comparisons with similar firms in the industry.
(d) Action plans and programs of management e.g., sourcing (i.e.,
purchasing) of products after completely shutting down departments.

8. ADMINISTRATION OVERHEAD BUDGET

Most of it is fixed in nature and not difficult to estimate.

While some items of administration overhead are committed, others belong to
the discretionary or managed category. Expenses belonging to the committed
group are rent, rates and taxes of administrative building, insurance and
depreciation of administrative building and equipments in it, etc. that arise as a
result of commitments previously made by the management. Discretionary
expenses are those which arise from periodic appropriation decisions (usually
annual) which reflect top management policies. Such expenses may have no
particular relation to the volume of activity. They can be what ever
management wants them to be within wide limits. Donations, public relation
expenses, accounts department expenses, internal audit department expenses
etc. are examples of discretionary administration expenses. A detailed break up
of total administration cost is shown in the budget.

9. SELLING AND DISTRIBUTION OVERHEAD BUDGET:

Selling expenses are incurred in order to stimulate demand,

securing orders and executing them. Selling expenses may be
(a) Direct selling expenses e.g. salary, wages and commission of sales
personnel.
(b) Advertisement and publicity expenses
(c) Sales office establishment expenses.

Many factors influence the amount of direct selling expenses and they are
(a) Basis of remuneration to sales personnel e.g., salary vs. commission.
(b) Expansion of regions of areas to be served.
(c) Sales volume.
(d) Incentive scheme for agents and sales personnel.
(e) Withdrawal from existing geographical areas which are being
served.
(f) Appointment of selling agents.

In order to budget accurately, selling expenses must be

broken down in to fixed and variable categories. Advertisement and publicity
expenses belong to the discretionary group of fixed cost. The amount to be
budgeted depends on top management policy and has no relation with the volume
of sales. While budgeting for such expenses, one must however consider the
impact of these on the expenses.
(a) Entry in to a new market.
(b) Launching of a new product
(c) Publicity of new features in a modified product
(d) Re-entry in to a market which has previously been lost.

Establishment expenses relating to sales offices are discretionary

fixed expenses. The budgetee should consider management’s policy decision, if
any, relating to relocation of sales offices to a cheaper location, entertain
prospective customers; provide improved communication facilities like Fax, E-
Mail, Video- conferencing etc.

Distribution expenses refer to those expenses which relate to

making the products of the firm available to customers in saleable condition.
Examples of such expenses are cost of secondary packing, warehousing expenses,
insurance for finished goods and warehouse etc.

A proper analysis must be made of past expenses and same must be

segregated in to fixed and variable categories. Although distribution expenses are
influenced by the volume of sales, the fact remains that they do not vary directly in
proportion to the sales volume. The mode of secondary packing, partial risk taking
vs. insurance of distribution vehicles, finished goods and warehouse, service level,
handling of finished goods and mode of transport e.g., railways vs. road transport
determine the distribution expenses.

B. FINANCIAL BUDGETS

1. CAPITAL BUDGET

This is also known as the capital expenditure budget. The capital

budget contains the capital projects that have been approved as well as a lump sum
amount for small projects that do not require approval at high level. It is
essentially a plan for incurring expenditure on the acquisition of fixed assets.

Proposals for capital expenditure are considered at various levels of

the organization during the year. Some of them are finally approved. This forms a
part of the strategic planning process.

The proposals that have been given approval are totaled into an over
all package at budget time and examined in totality. It is possible that the total
amount is in excess of the amount that the firm is willing to spend. In this case,
some are deleted, others are deferred and the size of others reduced. In respect of
remaining project, an estimate is made of the cash that is expected to be spent in
each month or quarter as the case may be. The capital expenditure which is to be
included in the capital budget should be shown under the following heads:

(A) statutory/mandatory projects- this contains proposals which are

compulsory and have to be compiled with in order to meet legal requirements e.g.,
canteen, hospital, safety items and pollution control equipment.

(B)Replacement projects- this involves the replacement of existing

fixed assets by new ones.

(C)Modernization projects- this leads to the installation of new

machines for improving productivity and reducing cost e.g., manual work stopped
and machines installed to do the at lower cost.

(D)Expansion projects- expansion leads to an increase in the

production of an item or a number of items. This involves the installation of
additional plant and machinery for increased production of an item or a number of
items.

(E)Strategic projects- this category contains investment proposals

which involve production and marketing of new products, purchase of an existing
company, construction of a new plant etc.

(F)Continuing projects- generally expansion and strategic projects

take more then one year to complete. Resources are earmarked for the projects on
the basis of approved programs so that such projects are not delayed. Since these
projects involve large layout of capital, delay in completion may affect the firm’s
over all economic performance significantly.

(G)Balancing projects- this class contains projects which involve

installation of facilities for the removal of imbalances at various work stations.

A capital budget must be carefully prepared as large sums

of money are generally involved and the decision is irreversible and may take firm
to the brink of liquidation. This budget shows the amount of original
appropriation, expenditure to date, new appropriation made, amount of
appropriation not utilized and balance amount carried forward to next year.

Before a capital expenditure can be incurred, an

authorization for capital expenditure must be raised and duly sanctioned at
appropriate level. The budget manual should be lain down the various levels of
authority for capital expenditure.

2. CASH BUDGET

The cash budget shows how much of the cash needs during the year will
be met by retained earnings and how much, if any, must be obtained by borrowing
or other outside sources. It is essentially a statement of planned and receipts and
disbursements.

The cash budget a tool for financial planning. It shows the inflows,
outflows, opening balance and closing balance of cash. This is one of the most
important financial budgets. It enables a firm to plan its cash requirements in such
a manner that an adequate liquidity is always available to meets its needs and to
use cash which is lying idle in the most profitable manner.
The budget is phased into shorter periods/intervals such as weekly,
monthly and quarterly planning lines of credit and short term borrowing and for
control depending on organizational needs it can be prepared by using any one of
the three methods:

(a) adjusted income method

(b) receipts and payment method
(c) adjusted balance sheet method

The receipts and payments method is usually used. While preparing the cash
budget, the following factors are considered:

(a) estimated opening balance

(b) monthly sales valve in the sales budget
(c) Sales policy and credit policy – cash and credit sales ratio. In respect of
credit sales, consider credit policy, type of customer, incentive schemes for
promote payment etc.
(d) Monthly purchases, closing stock in the direct materials purchase budget
and inventory budget
(e) Supplier’s payment policy, credit terms and agreement if any with them.
Out standing payments should also be considered
(f) Miscellaneous sales such as sale of discarded assets, scrap, waste, surplus
and obsolete inventory items.
(g) Amount of salaries, wages and similar payments for the month
(h) Capital budget
(i) Estimated amount of operating expenses on the basis of credit terms,
agreement and timing(actual) of disbursement
(j) Dividend policy
 (k) Hire purchase and installment sale agreement relating to installment
payments for purchase
(l) Minimum cash balance desired depending up on business needs and market
conditions.

As the environment is uncertain, it is desirable to prepare cash

budget under three different sets of assumptions namely optimistic, most likely
and pessimistic.

2. BUDGETED BALANCE SHEET:

We find that the balance sheet contains what is known as the

balance sheet implications of decisions included in the capital budget and the
operating budget. Although on the whole it is not a device for management
control, some parts of it are useful in control. The level of receivables, inventories
and creditors can be influenced by operating managers and held responsible for the
level of these items.
Projection of each item of liability and asset is made in order to
reflect business plan. The business plan is expressed in the cash budget, operating
budgets and the capital budget. The operating balances of assets and liabilities are
adjusted for the under noted items:

(a) credit sales

(b) credit purchases
(c) non cash items in the budgeted profit and loss a/c
(d) cash receipts
(e) cash payments
(f) prepaid expenses
(g) outstanding expenses
(h) Accrued income

STEPS INVOLVED IN THE PREPARATION OF OPERATING BUDGETS

The preparation of an operating budget involves a number of

systematic steps. They are given below:

1. Sales budget:

Generally, the sales budget is prepared on the basis of the forecast. The reason is
that the levels of production and stock are usually dependent up on the rate of
sales. If it is found that sufficient production capacity is not available in order to
produce the quantity given in the sale forecast, the budget prepared based on the
production capacity (e.g., labor hours, machine hours, skilled labor etc.)
2. PRODUCTION BUDGET

The budgeted sales volume and expected changes in finished stock

determine the total number of units to be produced. However, in the case of
seasonal industries, management can either follow a policy of stabilized
production or stabilized inventory. Incidentally, management usually prefers to
build up inventory of finished goods in order to maintain stable production
throughout the year. The production budget is expressed in terms of physical units
of finished goods.

3. DIRECT LABOUR BUDGET

The number of units to be produced, labor hours needed to produce

each unit of finished product and the direct wage rates determine the direct labor
budget.

4. DIRECT MATERIALS USAGE BUDGET

The direct materials usage budget is dependant upon the units to be

produced. This budget gives the quantity and the value of each type of material
that is expected to be consumed for producing the budgeted volume of goods.

5. DIRECT MATERIALS PURCHASE BUDGET

The direct materials purchase budget is prepared on the basis of

expected opening stock of materials, budgeted usage and expected closing stock of
materials.

6. FACTORY OVERHEAD BUDGET

The production budget is the main item which is used for the
preparation of the factory overhead budget. The manner in which the item of
indirect material, indirect labor and indirect expense change with variations with
variations in the production volume determines the amount of factory overhead.

7. INVENTORY BUDGET

The inventory budget shows the closing stock of a raw material,

stores and spares, loose tools, work in progress and finished goods. The
production budget, the sales budget and the inventory norms adopted by the
management determine the level of closing inventory. The production budget,
materials purchase budget, the budgeted profit and loss statement and the budgeted
balance sheet uses information from this budget.

8. COST OF GOODS SOLD BUDGET

The cost goods sold budget is prepared on the basis of

information compiled in steps 3 to 6.

9. ADMINISTRATION OVERHEAD BUDGET AND SELLING

&DISTRIBUTION OVERHEAD BUDGET

Some of these expenses are determined by planned sales and

production. However, most of them are discretionary in nature and depend upon
management’s policy.

10. BUDGETED PROFIT AND LOSS STATEMENT

This budget is prepared on the basis of sales budget; cost of

goods sold budget, administration overhead budget and the selling and distribution
overhead budget.

FIXED AND FELIXIBLE BUDGET

The classification of budget in to fixed and flexible kinds is

important from the control stand point. The fixed budget is “A budget which is
designed to remain unchanged irrespective of the volume of output or turnover
attained” (CIMA Terminology). In other words, this budget is prepared for one
level of activity for a definite time period. It is also known as a static budget.

The main feature of a fixed budget is that it is not adjusted to

actual levels of activity, when comparisons are made with actual results of
operations. A fixed budget may be satisfactory when the firm’s activities can be
estimated reasonably accurately. But at best it has limited usefulness as a control
tool. For instance, a master budget has been prepared by the firm for an output and
sales of only 20,000 units. In case actual performance is above or below this,
comparison of actual outcome fails.

A flexible budget may be defined as “a budget which, by

recognizing the difference in behavior between fixed and variable cost in relation
to fluctuation in output, turnover or other variable factors such as number of
employees, is designed to change appropriately with such fluctuations” (CIMA
terminology). In other words, this budget is constructed in other manner that it will
be possible to determine budgeted cost for any level of activity. It is thus a series
of fixed budgets at different levels of activity.

During the preparation of this budgets, it is not possible to fore

accurately the level of activity (i.e., volume of production) at which a firm unit is
expected to operate through out the year. Reporting of variances is one of the
essential elements of a budgetary control system. As a result, if a fixed budget
were to be prepared for the whole year and incase actual performance is at a level
which is above or below the budget level, comparison of actual cost and revenue
with the budget would be misleading. More over, it would not serve the intended
purpose namely control of costs. The reason is that the cause of variance may not
be easy to explain. It could arise out of managerial failure or change in activity
level. A fixed budget fails to consider the fact that all items of revenue and cost do
not change in proportion with the change in the level of activity. In to overcome
this problem, the flexible budget was devised.

A flexible budget recognizes the difference between variable and fixed

expenses. It is prepared for a range of expected activity levels. For instance, from
past data and fore cast a firm finds that the range of expected output and sales
during the budget period are 1000 units, 2000 units, 3000 units and 4000 units. It
should prepare a flexible budget for these activity levels showing the expected
activity and budgeted cost against each. The range of possible output and sales is
known as relevant range.

PROGRAM BUDGETING IN GOVERNMENT

Programming budgeting address it self to the selection of a program

and is concerned with planning. It was introduced in the U.S. department of
defence in the sixties. Thereafter, it had been extended to other departments.

Program budgeting aims to make the operations of the government

more effective and efficient. It tries to ensure optimal utilization of available
resources in order to get maximum benefit. The achievement of a specified goal
which had been predetermined is known as effectiveness. We measure efficiency
by using input – out put ratio and if the same increases, it can be said that
efficiency has increased.

Program budgeting is used in planning, programming and budgeting

(PPBS). The classification of the budget is done in terms of programs. When we
subdivide functions broadly, we get what is known as a program. Functions are the
broad classification of operations essential for achieving well defined goals. The
segments i.e., a group of work which is homogenous is represented by activities.
For instance, animal husbandry is a government function, high milk yielding
variety of cattle is a program and construction of cattle sheds is an activity.

In the case of program budgeting, a long time horizon is selected in

order to extend over the life of the program. The following gives the steps
involved in the process of program budgeting:

1. Definition of goals to be achieved: The goals which are to be defined e.g., flood
control.
2. Definitions of functions-the functions which are necessary for accomplishing
the goals have to be defined at this stage e.g., carry out dredging operations in
rivers.
3. Development of alternate programmes- Now alternate programmes to be
prepared for achieving goals. The costs, benefits and output of programmes have
to be defined. This is necessary for program evaluation. Cost- benefit analysis is
then in order to evaluate each program e.g., building dams, constructing cannels,
etc.
4. Selection of appropriate program: The program which is expected to yield the
highest net benefit is selected. This is done so that the finance available is
allocated to the best program.

Program budgeting is oriented towards achieving social objectives

and involves out put analysis.

DISTINCTION BETWEEN “ZBB” AND TRADITIONAL BUDGETING:

1. Basis of budgeting: In the case of traditional budgeting, the exercise starts with
previous year expense as base and additions and deletions are made to it. On the
other hand, proper justification and careful analysis is made of decision packages.

2. Degree of frequency: The budget is prepared annually under the additions

system. On the other hand in ZBB it is done once in 5 years.

3. Activities and their priorities: In the case of traditional budget in allocation

Is not made according to priority of activities while the case of ZBB
available resources are allocated to various activities of importance in
optimizing results.
4. Alternatives available: In the case of traditional budgeting no attention is
paid to alternatives while in the case of ZBB all alter navies available are
properly considered.
5. Amount of budget: In the case of traditional budgeting a single amount is
usually involved. On the other hand, every thing is dependent on the
analysis of benefits arising from increments in spending.
 6. Suitable: Traditional budgeting is suitable for activities which are of
general nature while ZBB is suitable for support type activities.
7. Effort in preparation: In the case of traditional budgeting not much of an
effort is required in its preparation while in ZBB a great deal of effort is
required.
8. Involvement of people: In traditional budgeting, generally the sub ordinate
and superior are involved while in ZBB a team consisting of people
belonging to different functions are involved.

PRINCIPLE BUDGET FACTOR

During the process of preparation of budgets, it’s found that there are
some factors which play a limit on the volume of the production or sales. These
are known as principle budget factors. For instance, raw materials, skilled labor,
working capital, space, power, market etc are vital for the smooth running of an
organization and etc. And any storage may restrict the volume of production and
sales.

The principle budget factor is a dynamic concept. Changes in internal

conditions and the external environments may lead to a shift in principle budget
factor.

At the time of budget preparation, the profitability of a product must be

considered in relation to principle factors and budgets prepared accordingly.
Suppose the contribution for unit of products ‘A’ and ‘B’ are Rs 10/- and Rs 15/-
respectively and both use a particular raw material which is in short supply. ‘A’
uses 2 kgs per unit and ‘B’ uses 5 kgs per unit. In this case, the contribution, per
kg of this raw material is to calculated as under.

Contribution per kg of raw material product ‘A’ product ‘B’

Rs 10/2kgs Rs 15/5kgs
=Rs 5 per kg =Rs 3 per kg

Management should plan for maximum production and sale

of product ‘A’ and the remaining capacity should be used for the production of
product ‘B’. What is known as principle budget factor in budgeting is called key
factor or limiting factor in marginal costing.

BUDGET REPORT

One of the functions of the budget controller is the analysis of actual

performance against budget, interpretation of results and preparation of
summarized results for presentation to management. These reports are known as
budget reports.

The budgets are prepared periodically and send to the departmental

managers of all the departments. They show the actual event against the budget
along with variances from the budget duly broken down in to adverse and
favorable. The variances are analyzed by causes. The costs are broken in to
controllable and uncontrollable elements.

A good budget report must be unambiguous, contain relevant

information, promptly presented, should be accurate and must show the period
covered. It serves as a useful tool in the hands of the management. The
departmental manager knows that his performance is being observed and so he
will do his level best to make his actions conform to budgeted targets. Apart from
this, departmental managers are compelled to take prompt remedial action in order
to overcome problems highlighted in the budget report and prevent their
recurrence.

PROBLEMS ON BUDGETING
1) Prepare a cash budget of M/S Novan Television &Co. on the basis of the
following information for the first six months of 1989:
A) Cost and price remains unchanged.
B) Cash sales are 25%of the total sales and 75% credit sales.
C) 60% of credit sales are collected in the month after sales, 30% in the second
month and 10% in the third. No bad debts are anticipated.
D) Sales forecasts are as follows:

October 88 12,00,000 March 89 8,00,000

November 88 14,00,000 April 89 12,00,000
December 89 16,00,000 May 89 10,00,000
January 89 6,00,000 June 89 8,00,000
February 89 8,00,000 July 89 12,00,000
E) Gross profit margin 20%.
F) Anticipated purchases:
 January 89 6,40,000 April 89 8,00,000
February 89 6,40,000 May 89 6,40,000
March 89 9,60,000 June 89 9,60,000
G) Wages and salaries to be paid:

January 89 1,20,000 April 89 2,00,000

February 89 1,60,000 May 89 1,60,000
March 89 2,00,000 June 89 1,40,000

H) Interest on Rs. 20,00,000 @6% on debentures is due by the end of March and
June.
I) Excise deposit due in April Rs. 2,00,000.
J) Capital expenditure on plant and machinery planned for June Rs. 1,20,000.
K) Company has a cash balance of Rs. 4,00,000 @31.12.1988.
L) Company can borrow on monthly basis.
M) Rent is Rs. 8,000 per month.

2) Following are the balance sheets of metal engineering ltd, one actual as on 31st
December, 1988 and other forecast as on 31st December, 1989:

1988(actual) 1989(forecast)
Cash 18,400 1,36,800
Debtors 49,000 83,200
Stock 61,900 92,500
Investment 1,00,000 90,000
Plant (at cost) 2,20,000 2,40,000
4,49,300 642,500
Accounts payable 67,300 1,00,000
Debentures 73,500 50,000
Accumulated Depreciation 50,000 30,000
Equity share capital 1,25,000 1,75,000
Profit and Loss Account 1,33,5000 2,87,500
4,49300 6,42,500

The forecast profit and loss account in a summarized form for the budget year
ended 31st December, 1989 is as follows:
To accumulated 22,000 By gross profit 2,00,000
Depreciation
 To administration 10,000 By profit on sale 2,000
and selling of investment
expenses
To income tax 5,000 By interest 10,000
To interest charged 3,000
To loss on sale of 8,000
plant
To net profit 1,64,000
2,12,000 2,12,000
To dividend 10,000 By net profit 1,64,000
To balance c/d 1,54,000
1,64,000 1,64,000

Additional Information:
i) New plant costing Rs. 80,000 was purchased during the year.
ii) An old plant, costingRs.60,000 and with accumulated depreciation of Rs.
42,000 was sold for Rs. 10,000.
iii) Investments costing Rs. 10,000 were sold for Rs. 12,000.
Prepare cash forecast for the management of the company by adjusted
profit and loss method.
3) Following are available from the records of Jay Ltd, for the year end 31st
December 1988.
Fixed Expenses: Rs. (lakhs)
Wages and salaries 9.5
Rent, Rates and Taxes 6.6
Depreciation 7.4
Sundry administrative expenses 6.5
Semi-variable Expenses50% of capacity)
Maintenance and repairs 3.5
Indirect labour 7.9
Sales department salaries 3.8
Sundry administrative expenses 2.8

Variable expenses (@ 50% of capacity)

Materials 21.7
 Labour 20.4
Other expenses 7.9
----------
98.0
-----------
Assuming that the fixed expenses remain constant for all levels of
production, semi variable expenses remains constant between 45% and
65% of capacity increasing by 10% between 65% and 80% and by 20%
between 80% and 100%.
Sales at various levels are:
50% capacity Rs. (lakhs)
60% ,, 100
,,
75% 120
,,
90% 180
,,
100% 200
Prepare a flexible budget for the year and forecast the profits @
60%,75%,90% and 100% of capacity.
4) A firm at present operates at cost 60% of its capacity. At this level and at the level
of 50% utilization of capacity the figures relating to its operations could be
summarized as statement below:

Rs. 50% Rs. 60%

Materials 10,00,000 12,00,000
Labour 8,00,000 9,00,000
Manufacturing overheads 6,00,000 6,60,000
Administrative overheads 3,50,000 3,50,000
Selling and distribution 4,50,000 5,00,000
Research and development 1,50,000 2,00,000
Total 33,50,000 38,10,000
Profit 1,50,000 3,90,000
Sales 35,00,00 42,00,000

Draw up the budget at 80% utilization of capacity assuming that

i) Sales at this level can be maintained only by a flat 5% reduction in the selling
price;
ii) Economy in purchase of materials will equal to 2-1/2% of the current
amounts;
iii) The R&D expenditure will be pegged at Rs. 2,50,000 per annum; and
iv) Administrative overheads will require 10% increase.
5) ABC Ltd a newly started company wishes to prepare cash budget from January.
Prepare a cash budget for the first six months from the following estimated
revenue and expenses.
Overheads
Month Rs. Total sales Rs. Materials Rs. Wages Rs. Production S&D
Rs.
Jan. 20,000 20,000 4,000 3,200 800
Feb. 22,000 14,000 4,400 3,300 900
March. 28,000 14,000 4,600 3,400 900
April. 36,000 22,000 4,600 3,500 1,000
May. 30,000 20,000 4,000 3,200 900
June. 40,000 25,000 5,000 3,600 1,200
st
Cash balance on 1 January was Rs. 10,000. A new machinery is to be installed at
Rs. 20,000 on credit. To be repaid by two equal installments in March and April.
Sales commission @ 5% on total sales is to be paid with in a month following
actual sales. Rs. 10,000 being the amount of 2nd call may be received in march.
Share premium amounting to Rs. 2,000 is also obtainable with the 2nd call.
Period of credit allowed by suppliers --- 2 months
Period of credit allowed to customers --- 1 month.
Delay in payment of overheads --- 1 month
Delay in payment of wage --- 1/2 month
Assume cash sales to be 50% of total sales.
6) The cost of an article at capacity level of Rs. 5,000 units is given under a below.
For a variation of 25% in capacity above or below this level, the individual
expenses vary as indicated under B below:
A (Rs) B
Materials cost 25,000 (100% varying)
Labor cost 15,000 (100% varying)
Power 1,250 (80% varying)
Repairs and maintenance 2,000 (75% varying)
Stores 1,000 (100% varying)
Inspection 500 (20% varying)
Depreciation 10,000 (100% fixed)
Administration overheads 5,000 (25% varying)
Selling overheads 3,000 (50% varying)
Cost per unit 62,750
 12.55
Find the unit cost of the product under each individual expenses at production
levels of 4,000 units and 6,000 units.

Unit -6
Zero base budgeting:
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 as “DE Nova Budgeting” or budgeting from the beginning without any
reference to any base past budgets and actual happenings. Zero base budgeting may be
defined as “a planning in 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.”
It is a technique which compliments and links the existing planning, budgeting
and review processes. It identifies alternatives and efficient methods of utilizing
resources in effective attainment of selected benefits. It is a flexible management
approach which provides a credible rationale for reallocating resources by focusing one
systematic review and justification of the funding and performance levels of current
programs of activities.
The concept of zero based budgeting was developed in U.S.A. under zero-base
budgeting each programmes and each of its constituent part is challenged for this very
inclusion for each year budget. Programmes objectives are also reexamined with a view
to start things afresh. It requires review analysis and evaluation of each programme in
order to justify its inclusions or exclusions from final budget. The following steps are
usually involved:
a) 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. Decision units are the lowest level
programmes or organizational entity for budget is prepared.
b) Ranking of decision-packages along with documents in support of these packages.
c) The sources are allocated in accordance with the ranking.
Zero based budgeting is based on the premise that every rupee of expenditure requires
justifications. The traditional budgeting approach includes expenditure of previous year
which are automatically incorporated into new budget proposals and only increments are
subjected to debate. Zero based budgeting assumes that a responsibility centre manager
has had no previous expenditure. Important features of Zero based budgeting are:
i) Concentration of efforts is not simply on “how much” a unit will spend but “why”
it needs to spend.
ii) Choices are made on the basis of what each unit can offer for a specific cost.

iii) Individual unit objects are linked to corporate targets.

iv) Quick budget adjustments can be made if, during the operating year costs are
required to maintain expenditure level.
v) Alternative ways are considered.

vi) Participation of all levels in decision making.

Advantages of Zero based budgeting:
1) Zero based budgeting is not based on incremental approach, so it promote
operational efficiency because it require managers to review and justify their
activities or the funds requested.
2) Since this system requires participation of all managers. In preparation of budgets,
responsibility of all levels of management in successful execution of budgetary
system can be ensured.
3) This technique is relatively elastic because budgets are prepares every year on a
Zero base. This system makes it obligatory to develop financial planning and
management information system.
4) This system weeds out inefficiency and reduce the cost of production because
every budget proposal is evaluated on the basis of cost benefit analysis.
5) It provides the organization with a systematic way to evaluate different operations
and programmes undertaken by the management. It enables management to
allocate resources according to priority of the programmes.
6) It is helpful to the management in making optimum allocation of scarce resources
because a unique aspect of Zero based budgeting is the evaluation of both current
and proposed expenditure and placing it some order of priority.

Criticisms against Zero based Budgeting:

1) Defining the decision units and decision packages is rather difficult.

2) Zero based budgeting has been referred to as very threaten process in which
managers have to justify their budget request in complete detail taking nothing for
granted.
 3) Zero based budgeting requires a lot of training for managers. It has to be
impresses upon managers that Zero based budgeting gives them an opportunity to
be heard by top management and therefore, they should use their innovation and
efforts to maximum limits.
Unit II
Cost Analysis and Control

DIRECT EXPENSES

Expense that can be traced directly to (or identified with) a specific cost center or cost
object such as a department, process, or product. Direct costs (such as for labor, material,
fuel or power) vary with the rate of output but are uniform for each unit of production,
and are usually under the control and responsibility of the department manager. As a
general rule, most costs are fixed in the short run and variable in the long run. Also called
direct expense, on cost, operating cost, prime cost, variable cost, or variable expense,
they are grouped under variable costs.

INDIRECT EXPENSES

Indirect expenses are those expenses which are incurred after the manufacturing of
goods. To understand indirect expenses we should first understand direct expenses.
Direct expenses are those which are incurred in relation to the manufacturing of a product
directly.
FOR EX. LABOUR, FACTORY EXPENSES, MACHINERY REPAIRS ETC.

So, indirect expenses will be like, selling and distribution expenses, all the administrative
expenses, carriage outwards,advertisment expenses because they are related indirectly
with the product manufacturing and sales.

Overheads – Meaning:
Overhead may be defined as the cost of indirect material, indirect labour and such other
expenses, including services, as cannot be conveniently charged direct to specific cost
centers or cost units. It should be noted that direct costs (materials, labour, etc,) are
associated with individual jobs or products. Indirect expenses or overheads are not
associated with individual jobs or products. They represent the cost of the facilities
required for carrying on the operations. CIMA London defines overhead as “total cost of
indirect materials, wages and expenses.”
In modern industrial undertakings, overheads are a very large proportion of the total
cost and therefore good deal of attention has to be paid to them. It will be a big mistake to
pay attention to direct cost. The problem in respect of overheads arises from the facts that
the amount of overheads has to be estimated and that too before the concerned period
begins (since it is only continuous costing that is found useful) and that, the amount has
to be distributed over the various cost units, again on an estimated basis.
Classification of Overheads:
The process of classification of overheads involves:
a) The determination of the classes or groups in which the costs are sub-divided: and
b) The actual process of classification of the various items of expenses into one or
another group.
The classification of overheads expenditure depends upon the type and size of a business
and the nature of the product or services rendered.
Generally overheads are classified on the following basis:
a) Function-wise classification
b) Behavior-wise classification
c) Element-wise classification.

a) Function-wise classification
Overheads can be divided into the following categories on functional basis:
i) Manufacturing or Product Overheads:
Manufacturing overheads head includes all indirect costs (indirect material,
indirect labour and indirect expenses) incurred for operations of manufacturing
or production division in a factory. It is also known as factory overheads, work
overheads, factory on cost or work on cost etc.
ii) Administrative Overheads:
It is the sum of those costs of general management, secretarial,
accounting and administrative services, which cannot be directly related to the
production, marketing, research or development functions of the enterprise.
ICMA London defines it as the cost of formulating the policy, directing the
organization and controlling the operations of an undertaking which is not
related directly to production, selling, distribution, research or development
activity or function.
iii) Selling and Distribution:
Selling overheads of the cost of seeking to create and stimulate demand
and of securing orders. It comprises the cost to products of distributors for
soliciting and recurring orders for the articles or commodities dealt in and of
efforts to find and retain customers. Distribution overhead is the expenditure
incurred in the process which begins with making the packed product available
for dispatch and ends with the making the reconditioned returned empty
package, if any available for reuse. It includes expenditure incurred in
transporting articles to central or local storage. It also comprises expenditure
incurred in moving articles to and from prospective customers as in the case of
goods on sale or return basis. In case of gas, electricity and water industries
distribution means pipes, mains and services which may be regarded as
equivalent to packing and transportation.
b) Behavior-wise classification
Based on the behavior patterns, overheads can be classified into the following
categories:
i) Fixed overheads.
ii) Variable overheads.
iii) Semi-variable overheads.
i) Fixed Overheads:
Fixed overheads expenses are those which remains fixed in total amount
with increases or decreases in volume of output or productive activities for a
particular period of time.
E.g. managerial remuneration, rent of building, insurance of building, plant
etc.
Fixed overheads cost remains the same from one period to another except
when incidence of fixed overheads on unit cost decreases as production
increases and vice versa.
Fixed overheads are stated to b uncontrollable in the sense that they are
not influenced by managerial action. However, it should be noted that
expenditure is fixed within specified limit relating to time or activity. In a
hypothetical organization no expenditure remains unchanged for all time.
Therefore, it is true to state that fixed overhead is fixed within specified limit
relating to time and activity.”
ii) Variable Overheads:
Variable overheads costs are those costs which vary in total direct
proportion to the volume of output. For instance, if the output of increased by
5%, the variable expenses are also increased by 5%. Correspondingly, on a
decline of the output it will also decline proportionately. Examples are direct
material and direct labour. Variable overheads changes in total but its
incidences on unit will remains constant.
iii) Semi-Variable Overheads:
These overheads costs are partly fixed and partly variables. they are
known as semi- variable overheads because they contain both fixed and
variable element. Semi variable overheads do not fluctuate in direct
proportion to volume. It may remain fixed within a certain activity level, but
once that level is exceeded, they vary without having direct relationship with
volume changes. Examples are depreciation, telephone charges, repair and
maintenance of buildings, machines and equipments etc.
Semi-variable expenses usually have to parts - one fixed and other
variable. For instance, depreciation usually depends on two factors, - one,
 time (fixed) and other wear and tear (variable). The two together make
depreciation (as a whole) semi variable. An analytical study thus can make it
possible for all semi-variable expenses to be split up into two parts.
Fundamentally, therefore, there are only two types of expenses – fixed and
variable.

Advantages of classification of Overheads into Fixed and Variable:

1. Effective Cost Control:
The classification of expenses into fixed and variable helps in controlling
expenses. Fixed expenses are incurred by management decisions and are incurred
irrespective of the output; hence it is more or less uncontrollable. Variable
expenses vary with the volume of activity and the responsibility for incurring this
expenditure is determined in relation to output.
2. Preparation of Budget Estimates:
Unless a distinction between a fixed and variable is made, it would not be
possible to prepare a flexible budget in a given period o the basis of different
levels of activity.
3. Ascertaining marginal cost – decision making:
A number of decisions of management depend upon a comparison of
a) The extra amount that would have to be spent if an additional activity is
undertaken or an alternative course is adopted, and
b) Measurement of resulting there from. The extra amount that would have to be
spent will only be the variable costs (including material, labour and variable
expenses) and not fixed expenses. Therefore, a distinction between fixed and
variable expenses is necessary. Marginal cost afford a number of advantages,
in fixing a price in a specific market, for a special customer during a slump or
during a depression, decision on make or buy, shut down or continue etc.
The main principle is that the price available is above the variable or
marginal cost, profits would increase or losses would decrease because of
additional units sold. This is because the fixed expenses would not increase.
Allocation and Apportionment of Overheads (Departmentalization of
Overheads):
Most of the manufacturing process functionally are different and performed by
different departments in a factory. Where such a division of functions has been made,
some of the departments would be engaged in actual production of goods while others n
providing services ancillary there to.
For the efficient working, a factory is divided into a number of sub-divisions.
Such sub-divisions are referred to a department. In other words, departmentation of
overhead means dividing the factory into several segments called departments or cost
centers to which expenses are charged. This sub-division is done in such a manner so that
each department represents a divisions of activity of the organization such as repairs
department, power department, tools department stores department, cost department, cash
department, etc. the following factors are taken care of while dividing an organization
into a number of departments:
i) Every manufacturing process is divided into its natural divisions in order to
maintain natural flows of raw materials from the time of its purchase till its
conversion into finished goods and sale.
ii) The sequences of operations are taken into consideration while determining the
location of various departments.
iii) Division of responsibility as far as possible should be clear, without ambiguity
and dual - control.
The departments in a factory can be broadly categorized into the following types:
1) Producing or manufacturing departments:
A manufacturing or producing department is one in which manual or machine
operations and other process of production of articles or commodities take place.
The number of such departments will depend upon the nature of industry, type of
work performed and the size of the factory.
2) Service Department:
These departments are not directly engaged in production but they render special
type of services for benefit of other departments.
3) Partly Producing Departments:
In every organization a few departments such that it is not possible to place these
departments into a particular category, since they fall within the purview of both
categories, i.e., producing and service departments. For example, if a tool room
manufactures some special tools for utilization in the main hob orders, it is acting
as a productive department though it is a service department.

Advantages of departmentalization:
i) It segregates factory overheads costs and computes the total cost of each service
departments.
ii) It makes possible the establishment of control to keep costs at a minimum.
iii) Ascertainment of cost of different departments helps in computing the cost of
different jobs or products which pass through these departments.

Allocation of Overheads:
 After having collected the overheads under proper standing order numbers the
next step is to arrive at the amount for each department or cost center. This may be
through allocation or absorption. According to the institute of cost and management
accountants, London, “cost allocation is the allotment of whole items of cost to cost
centers or cost units.” Thus, the wages paid to maintenance workers as obtained from
wages analysis book can be allocated directly to maintenance services cost center.
Similarly indirect material cost can also be allocated to different cost centres according to
use by pricing stores requisitions.
Apportion of Overheads:
Apportionment refers to the distribution of overheads among departments or cost
centres on an equitable basis. In other words, apportionment involves charging a share of
the overheads to a cost centre; ICMA London has defined it as “the allotment to two or
more cost centres of productions of common items of cost on an estimated basis of
benefit received.” Apportionment is done in case of these overheads items which cannot
be wholly allocated to a particular department. For example, the salary paid to the works
manner of the factory, factory rent, general manger’s salary etc. cannot be charged
wholly to a particular department or cost center, but will have to be charged to all
departments or cost centres on an equitable basis.
Primary Distribution of Overheads:
Primary distribution of overheads involves allocation or apportionment of different
items of overheads to all departments of a factory. This is also known as
departmentalization of overheads. While making primary distribution the distinction
between production departments and service departments disregarded since it is of little
use. The distribution of different items of overheads in different departments is attempted
on some logical and reasonable basis.
Basis of Apportionment of Overhead Expenses:
It is stated that the total overheads expenses of a department comprises direct
overhead expenses incurred in the departments itself as well as the apportioned overhead
expenses of other service departments. Expenses directly incurred in the departments
which are jointly incurred for several departments have also to be apportioned e.g.
expenses on rent, power, lighting, insurance etc. in otherwords, common expenses have
to be apportioned or distributed over the departments on some equitable basis. The
following bases are most commonly used for apportioning items of overhead expenses
among production and service department.

Bases Items of Overheads

1. Floor area Rent, rates and taxes paid for the building, air
conditioning, etc.
2. No. of employees or wages Group insurance, canteen expenses, E.S.I.
of each department contribution, general welfare expenses,
compensation and other fringe benefits,
supervisions etc.
 3. Capital values Insurance and depreciation of plants, machinery
and equipments.
4. Direct labour hours. Works managers remuneration, general overtime
expenses, cost of inter-department transfers etc.
5. No. of light points. Electric light.
6. Horse power of machines or Electric power.
machine hour.
7. Audit fee Sales or total cost
8. Value or weight of direct Stores overheads
materials
9. Weight, volume, tone, mile. Delivery expenses

Re-appointment of service department overheads (secondary

Distribution):
Normally products do not pass through service departments but service
departments do benefit the manufacture of products. Therefore, it is logical that product
cost should bear an equitable share of the cost of service departments. The process of
redistribution of the cost of service departments among the production departments is
known as secondary distribution.

Criteria for secondary distribution:

1. Service or use method:
Under this method overheads are distributed over various production
departments on the basis of services actually rendered. The greater is the amount
of service received by a production departments, the greater should be the share to
be apportioned to that department. This criterion has greatest applicability in cases
where overhead costs can be easily and directly traced to departments receiving
the benefits. Since this method is based upon the extent of the benefit received by
a department, the expenses are equitably apportioned. This method is considered
to be fair ass it takes into account the time element and consistent results.
2. Analysis or survey:
In certain cases it may not be possible to measure exactly the extent of
benefit which the various departments receive as this may vary from period to
period. Therefore, overheads are apportioned on the basis of analysis and survey
of existing conditions. This basis of apportionment includes arbitrary elements.
3. Ability to Pay:
This method presumes that higher the revenue of a production department,
higher should be the proportionate charge for services. This method is simple to
 apply but it is generally considered inequitable because it penalizes the efficient
and profitable units of a business to the advantage of the inefficient ones.
4. Efficiency or incentive method:
This basis facilitates scientific distribution of service department cost
to production departments. Under this method the apportionment of expenses is
made on the basis of production targets. If the target is exceeded the unit cost
reduces indicating a more than average efficiency. Opposite is the effect if the
assumed levels are not reached. Thus, the department whose sales are increasing
is able to show a greater profit and there by is able to earn greater goodwill and
appreciation of the management.
5. General use of Indices:
If data relating to actual services rendered can not be obtained in some
situations this method assumed flow of service department cost to production
departments. For instance, the service of cost accounting department can be
apportioned to production departments on the basis of number of employees in
each department.
Following is a list of bases, which are frequently used for apportionment of cost of
service departments among production departments.

Service department costs Basis of apportionment

1. Maintenance department Hours worked for each department.
2. Employment /personnel department Rate of labor turnover or number of employees in
each department.
3. Payroll or time departments Direct labor hours, machine hours number of
employees.
4. Stores keeping department No. of requisitions, quantity or value of materials.
5. Welfare department No. of employees in each department.
6. Internal transport service Truck hours, truck mileage or tonnage.
7. Building service department Relative area of each department.
8. Power house. Floor area, cubic contents.
Methods of re-apportionment or Re-distribution:
At first expenses of all departments are complied without making a distinction
between production and service departments but, then, the expenses of the service
departments are apportioned among the production departments on a suitable basis. It is
also possible that expenses of one service department to arrive at the total expenses
incurred on the latter department, which will then be distributed among production
department.
 Following are the method of re-distribution of service department costs to
production departments.
1. Direct distribution method:
Under this method, the costs of service department are directly apportioned to
production departments, without taking into consideration any service from one
service departments to another service department.
2. Step method:
In this method the cost of most serviceable department is first, apportioned to
other serviceable departments and production departments. The next service
department is taken up and its cost is apportioned and this process is going on till
the cost of last service department is apportioned among production departments
only.
3. Reciprocal service method:
This method gives cognizance to the fact that where there are two or more
service departments, they may render service to each other and therefore these
inter- departmental services are to be given due weight in distributing the
expenses of service departments. There are methods available for dealing with
inter service department transfer.
a) Simultaneous equation method:
Under this method, the true cost of service departments are ascertained
first with the help of simultaneous equations. These are then distributed
among the production departments on the basis of given percentages.
b) Repeated distributed method:
According to this method, service departments cost are apportioned
over other departments , production as well as service according to the agreed
percentages and this process is repeated until he total costs f the service
departments are exhausted or the figures become to small to be considered for
further apportionment.
c) Trial and error method:
In this method the cost of one service departments is apportioned to
other service departments. The cost of another service departments plus the
share received from the first service departments is again apportioned to first
service departments and this process is continued until the balancing figure
becomes nil. For instance, suppose there are two services departments x and y.
these service departments render service to each other. Cost of service
departments x will be distributed to service department y. again cost of service
departments y plus he share from service departments will be apportioned to
 x. the amount so apportioned to x will be again apportioned to y and this
process will continue to be repeated till amount involved negligible.

Methods of Absorbing Production Overheads:

Before we described the various methods, it would be better to know how to judge
whether a method will give good results or not. The method selected for charging
overheads to jobs or products should be such as will ensure:
a) That the total amount charged (or recovered) in a period does not differ materially
from actual expenses incurred in that period. In other words, there should not be any
material ovr or under recovery of overheads; and
b) That the amount charged to individual jobs or products equitable. In case of factory
overheads, this means-
i) That the time spent on completion of each job should be taken into consideration;
ii) That a distribution should be made between jobs done by skilled workers and
those done by unskilled workers. Usually, the latter class of workers needs more
supervision, as they cause greater wear and tear of machine and tools and waste
a larger quantity of materials. Hence jobs done by such workers should bear a
correspondingly higher burden for overheads; and
iii) Those jobs done by manual labor and those done by machines should be
distinguished. It stands to reasons that no machine expenses should be charged
to jobs done by manual labour.
In addition, the method should:
i) Be capable of being used conveniently; and
ii) Yield uniform results from period to period a far as possible any change that is
apparent should reflect a change in the underlying situation, such as substitution
of human labour by machines.
Several methods are commonly employed for computing the appropriate overheads rate
to be employed. The more common of these are;
1) Percentage of direct materials cost.
2) Percentage of prime cost.
3) Percentage of direct labour cost.
4) Direct labour hour rate.
5) Machine hour rate.
6) Combined machine hour and labour hour rate.
7) Rate per unit of production.

Direct Labour Hour Rate:

This method is a distinct improvement on the percentage of direct wages basis, as it fully
recognizes the significance of the element of time in the incurring and application of
manufacturing overhead expenses. This method is admirably suited to operations which
do not involve any large use of machinery. A direct labour hour rate is calculated for each
category of workers. The expenses are incurred, other than wages paid to workers, on
each category of workers are listed and totaled for a period. The figure is divided by the
number of hours to be put in by that category of workers. Thus, full attention will be paid
to the skill of the workers for charging overheads. Productive labour hour rate is a
variation of this method. It is computed by dividing the total all the direct workers during
that period. Thus, this method, though making no allowance for the skill of workers,
gives full recognition to the time factor.
Machine hour rate:
By the machine hour rate method, manufacturing overheads expenses are
charged to production on the basis of a number of hours a machine or machines are used
on jobs or work orders. There is a basis similarity between the machine hour rate and the
direct labour hour rate methods, in so far as both are based on the time factor. The choice
of one or the other method is conditioned by the actual circumstances of the individual
case. In respect of department or operations, in which machine predominates and the
operators perform relatively a passive part, the machine hour rate is more appropriate.
This is generally the case for operations or processes performed by costly machines,
which are automatic or semi-automatic and where operators are needed nearly for feeding
and tending them rather for regulating the quality or quantity of their output. In such
cases, the machine hour rate method alone can be depended on to correctly apportion the
manufacturing overhead expenses to different items of production. What is needed for
computing the machine or group of machines for a period by the operating hours of the
machine or the group of machines for the period. It is calculated as follows.

Machine hour rate = Amount of overheads

Machine hour during a given period

Usually, the computation is made on the basis of the estimated expense or the normal
expense for the coming period. Thus, the machine hour rate usually is a predetermined
rate.. rate for each individual machine may be worked out or, where a machine of similar
machines are working in a group, there may be a single rate for the whole group.
The following steps are required to be taken for the calculation of machine hour rate:
i) Each machine or group of machine should be treated as a cost center.
ii) The estimated overheads expenses for the period should be determined for each
machine or group of machines.
iii) Overheads relating to a machine are divided into two parts i.e., fixed or standing
charges and variable or machine expenses.
iv) Standing charges are estimated for a period for every machine and the amount so
estimated is divided by the total number of normal working hours of the machine
 during that period in order to calculate an hourly rate for fixed charges. For
machine expenses, an hourly rate is calculated for each item of expenses
separately by dividing the expenses by the normal working hours.
v) Total of standing charges and machines expenses rate will give the ordinary
machine hour rate.
There is two of computing the machine hour rate. According to the first
method, only indirect expenses directly or immediately connected with the operations of
the machine are taken into account. E.g., power, depreciation, repairs and maintenance,
insurance etc. the rate is calculated by dividing the estimated total of these expenses for a
period by the estimated total of these the machines during the period.
It will be obvious however that in addition to the expenses stated above there
may still be other manufacturing expenses such as supervision charges, shop cleaning and
lighting, consumable stores and shop supplies, shop general labour, rent and rates etc.,
incurred for the departments as a whole and, hence not charged to any particular machine
or group of machines. In order to see that such expenses are not left out of production
costs, one should include a proportionate amount of such expenses, in the expenses of
machines, before proceeding to compute the machine hour rate. Some people even prefer
to add the wages paid to the machine operator in order to get a comprehensive rate for
working a machine for one hour. But it is preferable to include the machine operator’s
wage in direct wages.
Generally, all expenses are not allocated to machines; it will be, therefore,
necessary to calculate another rate for charging the general departmental expenses to
production. This second rate will be calculated on the basis of direct labour hour or
wages. In effect, therefore, both the machine hour rate and the labor rate will be applied,
though separately.
As regards the superiority of one method over the other, it may be considered
hat the recovery of the direct machine expenses without the proportion of the
departmental expenses is likely to be more accurate than when these are made a part
therefore, because the general departmental expenses are not connected with the actual
operation or the machines except remotely. Therefore, when merged with the direct
machine expenses for the purpose of computing the machine hour rate, the resultant rate
may not be as accurate or as it would be otherwise. But the second method has the
advantage of simplifying the routine and procedure of applying manufacturing overheads
in as much as only the machine hour rate has to be applied for charging the general
departmental overhead.

Advantages:
i) Where machinery is the main factor in production, it is usually the best method of
charging machine operating expenses to production.
ii) The under absorption of machine overheads would indicate the extent the
machines have been idle.
 iii) It is particularly advantageous where one operator uses several machines (e.g.,
automatic screw manufacturing machines) or where several operations are
engaged in one machine (e.g., the belt press used in making conveyor belts).
iv) It is a logical method and takes into consideration the time factor completely.

Disadvantages:
i) Additional data concerning the operating time of machines, not otherwise
necessary, must be recorded and maintained.
ii) As general data concerning rates for all the machines in a department may be
suitable, the computation of a separate machine hour rate for each machine or
group of machines would mean additional work-rate for each machine or group
of machines would mean additional work.
iii) If gives inaccurate results if hand labour is equally important.