Dear Students,
As your exams are near and your preparations are in full swing, i would like to provide you some general instructions to be followed in Exams...
SOME GENERAL INSTRUCTIONS TO BE FOLLOWED IN EXAMS:
· Make sure that you have all the accessories, which you may need in the Exam.
· Do not take hot milk before you go for Exam, it can make you feel sleepy.
· Make sure that you do not have any piece of paper along with you in the examination hall, willingly or by default.
· Take your seat 10 minutes before the paper starts and try to concentrate on what you have studied for the exam.
· Last day before the exam must be kept for revision only.
· Give proper rest to your mind after long hours of studies.
· Exercise proper time management and start preparing with favourite and easy topics.
HOW TO TACKLE MANAGEMENT ACCOUNTING :-)
As somebody has said, “MORE risk - MORE gain, NO risk - NO gain.” The exam of management accounting also possesses same characteristics; this paper is a unique blend of numerical and theoretical questions. Numerical questions can provide you marks’ leverage where as theoretical questions can bring you margin of safety. Only those students, who are confident of formulae and have practiced them at home, are suggested to attempt the numerical portion, while the rest may try their luck if they desire. There are no predictions about the ratio of numerical and theoretical questions so students are suggested to be ready for any situation (Hope for the best but be ready for the worst).
IF you want to attempt numerical questions:
· Try to understand the formulae in spite of just mugging them.
· Start practicing numericals with solved examples in the book and with the easier questions.
· Do not try to solve big and difficult questions from the book prior to the exam.
IF you want to attempt theoretical questions:
· Try to make an overview of the topics in your mind.
· Make short forms of the list of points.
(e.g.: for functions of management POSDCORB – Planning, Oraganising, Staffing, Directing, Controlling, Recruiting and Budgeting)
· If not able to recall the points, try to relate them with suitable examples.
Wish You All The Best….
Tribhuvan Pratap Singh
Lecturer,
Department of Management Studies
Note: ur exam schedule is out and available at WWW.UPTU.ORG and also on this Blog for your convenience.
Sunday, April 15, 2007
Saturday, April 14, 2007
Notes: UNIT - 5
UNIT - 5
Objective:
To make the students aware of various Neo cost concepts developed in the modern era of complex business activities.
UNIT OVERVIEW
Topics covered: Neo concepts for decision making: Concept, distinctive features of Activity Based Costing, Cost drivers, Cost of activities, Cost object such as product, service and customer. Cost management: Concept, Strategies and Applications. Value Chain Analysis, Target Costing and Life cycle costing.
How Activity-Based Costing Works
1. ABC is a management tool that provides better allocation of resources.
2. ABC principles are applicable to both appropriations and revolving funds.
3. ABC relates total cost (resources consumed) to work accomplished (outputs produced).
4. The ABC or unit cost goal is a financial benchmark that represents an expectation of the maximum total cost incurred in the production of an output.
5. ABC aligns costs to outputs thereby increasing cost visibility, and is useful in forecasting financial baselines.
ABC focuses on the activities of a production cycle; it is based on the premise that outputs (products or services) require activities to produce, and that activities consume resources. It recognizes the causal relationship of cost drivers to activities. An output is defined as something "put out" at the end of a production process. It can be a good or service, and it must be measurable or quantifiable.
As a rule, outputs are:
produced to satisfy customer requirements;
distinctly quantifiable, measurable, and auditable;
consistent from fiscal period to fiscal period to allow cost comparisons;
incorporated into existing or modified financial management systems; and
separately identifiable so costs can be more easily allocated.
DoD activities are generally more complex than the example cited above, and often involve the production of more than one output. For example, a distribution depot handles millions of items, some of which require different resources to receive, store, and issue them. In these cases, DoD unit cost methodology uses output measures that are aggregated. To determine an organization's outputs, it must look at its core activities or processes—the things that it does. For example, an output at the Defense Finance Accounting Service (DFAS) might be a paid invoice.
In addition, unit cost activities also often fall into the service category as opposed to the manufacturing category. This can make the identification of outputs more difficult, as there is not always a physical product provided to the customer. For example, a research and development activity may be "employed" by one of the military services to test a specific missile system in addition to its basic research mission. Though it could be argued that a tested missile is a valid output, the diversity of services available to customers requires that a more common output be identified. In this case, direct labor hours expended in accomplishment of a task has been adopted as a surrogate or proxy output measure.
The Unit Cost Formula
The ABC system uses cost drivers to assign the costs of resources to activities. ABC can use unit cost as a way of measuring an output. Unit cost is the "average total cost" of producing one unit of output. It is calculated by dividing the total cost of production by the total number of units of output produced. For example, if an automobile manufacturer produces 50 vehicles for a total cost of $1,250,000, then the cost per unit (vehicle) is $25,000. But unlike a company like General Motors, which calculates the unit cost for an automobile in order to determine an adequate selling price and profit margin, DoD providers normally do not build in a profit margin. Their goal is an accumulated operating result (AOR) of zero.
ABC's Basic Benefits
v Enables determination of total production costs traced to outputs.
v Targets areas needing management attention.
v Encourages the consideration of alternative methods of production.
v Highlights operational efficiency and inefficiency.
v Identifies financial benchmarks for activity performance.
v Generates more information to measure and reward performance, and prioritizes activities for cost reductions.
v Provides a common managerial framework among support activities.
Comparison between Traditional costing and ABC
Traditional
ABC
Salaries $100
Clean door $40
Equipment $80
Paint door $75
Supplies $20
Inspect door $75
Overhead $45
Send door to assembly $55
TOTAL $245
TOTAL $245
Steps for Performing Activity Based Costing
Analyze Activities
Gather Costs
Trace Costs to Activities
Establish Output Measures
Analyze Costs
These steps should be performed by the core BPI team - which the FAA identifies as a small group of people, committed by top management to work on a BPI project full time if available, or part time on the effort with possible support from BPI contractors. This process can take anywhere from a few days to a few months, depending on level of detail, complexity of an organization's processes, and commitment of team resources.
Analyze Activities
First the scope of the activities to be analyzed must be identified. It is suggested that the program include at least a half-dozen organizational units having a common functional orientation, and preferably also a common budget somewhere in the reporting chain. The depth and detail of analysis will be determined by activity decomposition, since activity decomposition is complete when one common or homogeneous primary output per activity is reached. Any prior work captured in IDEF0 models and their related definitions is considered here. This is where the core team can use activity models as a basis for selecting and interviewing key people associated with the business process.
A determination then is made if an activity is value or non-value added; also if the activity is primary or secondary, and required or not needed. Value added is determined if the output of the activity is directly related to customer requirements, service or product, as opposed to an administrative or logistical outcome that services the providing organization. For instance, if the output of an activity were an inventory report or update for products (for which there are customers), the output would be non-value added, but necessary to the organization, i.e., "overhead." A major goal of reengineering is to reduce non-value added activities and eliminate those that are not necessary. Primary activities directly support the organization's mission while secondary activities support primary activities. Required activities are those that must always be performed while discretionary activities are performed only when allowed by the operating management.
Gather Costs
In this step costs are gathered for the activity producing the products or services provided as the outcome. These costs can be salaries, expenditures for research, machinery, office furniture, etc. These costs are used as the baseline activity costs. When documents for the costs incurred are not available, cost assignment formulas may be used.
Trace Costs to Activities
In this step the results of analyzing activities and the gathered organizational inputs and costs are brought together, which produces the total input cost for each activity. A simple formula for costs is provided - outputs consume activities that in turn have consumed costs associated with resources. This leads to a simple method to calculate total costs consumed by an activity - multiply the percent of time expended by an organizational unit, e.g., branch, division, on each activity by the total input cost for that entity. Here we are not calculating costs, just finding where they come from.
Establish Output Measures
In this step the actual activity unit cost is calculated. Even though activities may have multiple outputs, only one is identified as the primary output. Activity unit cost is calculated by dividing the total input cost, including assigned costs from secondary activities, by the primary activity output volume; the primary output must be measurable and its volume or quantity obtainable. From this, a bill of activities can then be calculated which contains or lists a set of activities and the amount of each activity consumed. The amount of each activity consumed is extended by the activity unit cost and is added up as a total cost for the bill of activity.
Analyze Costs
In the final step, the calculated activity unit costs and bills of activity are used to identify candidates for improving the business processes. Managers can use the information by stratifying, for a Pareto analysis, the activity costs and identifying a certain percentage of activities that consume the majority of costs. The thing to keep in mind is that the identification of non-value added activities occurs through this process with a clarity that allows us to eliminate them, and at the same time permits the product or service to be provided to the customer with greater efficiency.
Reference:
v www.isixsigma.com
v www.altavista.com
Total Cost Management for Competitiveness
v What is Total Cost Management or Cost Management?
v Issues addressed by TCM.
v Some Tools and Techniques of TCM.
v The areas of focus for cost reduction also include.
v The areas of focus for cost reduction also include.
v TCM techniques and their overview (e.g. ABC).
Value chain analysis
Introduction
Value Chain Analysis describes the activities that take place in a business and relates them to an analysis of the competitive strength of the business. Influential work by Michael Porter suggested that the activities of a business could be grouped under two headings:
(1) Primary Activities - those that are directly concerned with creating and delivering a product (e.g. component assembly); and
(2) Support Activities, which whilst they are not directly involved in production, may increase effectiveness or efficiency (e.g. human resource management). It is rare for a business to undertake all primary and support activities.
Value Chain Analysis is one way of identifying which activities are best undertaken by a business and which are best provided by others ("out sourced").
Linking Value Chain Analysis to Competitive Advantage
What activities a business undertakes is directly linked to achieving competitive advantage. For example, a business which wishes to outperform its competitors through differentiating itself through higher quality will have to perform its value chain activities better than the opposition. By contrast, a strategy based on seeking cost leadership will require a reduction in the costs associated with the value chain activities, or a reduction in the total amount of resources used.
Primary Activities
Primary value chain activities include:
Primary Activity
Description
Inbound logistics
All those activities concerned with receiving and storing externally sourced materials
Operations
The manufacture of products and services - the way in which resource inputs (e.g. materials) are converted to outputs (e.g. products)
Outbound logistics
All those activities associated with getting finished goods and services to buyers
Marketing and sales
Essentially an information activity - informing buyers and consumers about products and services (benefits, use, price etc.)
Service
All those activities associated with maintaining product performance after the product has been sold
Support activities include:
Secondary Activity
Description
Procurement
This concerns how resources are acquired for a business (e.g. sourcing and negotiating with materials suppliers)
Human Resource Management
Those activities concerned with recruiting, developing, motivating and rewarding the workforce of a business
Technology Development
Activities concerned with managing information processing and the development and protection of "knowledge" in a business
Infrastructure
Concerned with a wide range of support systems and functions such as finance, planning, quality control and general senior management
Steps in Value Chain Analysis:
Value chain analysis can be broken down into a three sequential steps:
(1) Break down a market/organisation into its key activities under each of the major headings in the model;
(2) Assess the potential for adding value via cost advantage or differentiation, or identify current activities where a business appears to be at a competitive disadvantage;
(3) Determine strategies built around focusing on activities where competitive advantage can be sustained
Reference:
v www.tutor2u.net
v www.google.com
v www.indiainfoline.com
Target Costing
THE TARGET COSTING PROCESS
Essentially, companies use target costing to establish concrete and highly visible cost targets for their new products. To maximize cost control and enhance profit improvement, most companies set relatively aggressive targets. The process begins when top management establishes a target cost for a new product, for example, a Chrysler Neon or a Caterpillar Excavator. A cost estimating group will then decompose the target cost for the product as a whole into cost targets for subassemblies and individual component parts--engine, transmission, seats, and so on.
Frequently a "gap" exists between the target cost and cost projections for the new product based on current designs and manufacturing capabilities. Closing the gap through cost reduction is central to the target costing process. This is accomplished through cross-functional target costing teams, which analyze the product's design, raw material requirements, and manufacturing processes to search for cost savings opportunities. The cross-functional teams employ a variety of management tools and initiatives to help them achieve their objectives. The following section describes some of these tools and initiatives and other characteristics of successful target costing companies.
TARGET-COSTING PRINCIPLES
Target costing can best be described as a systematic process of cost management and profit planning. The six key principles of target costing are: (1)
1. Price-led costing. Market prices are used to determine allowable--or target--costs. Target costs are calculated using a formula similar to the following: market price - required profit margin = target cost.
2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in product and process decisions and guide cost analysis. The value (to the customer) of any features and functionality built into the product must be greater than the cost of providing those features and functionality.
3. Focus on design. Cost control is emphasized at the product and process design stage. Therefore, engineering changes must occur before production begins, resulting in lower costs and reduced "time-to-market" for new products.
4. Cross-functional involvement. Cross-functional product and process teams are responsible for the entire product from initial concept through final production.
5. Value-chain involvement. All members of the value chain--e.g., suppliers, distributors, service providers, and customers--are included in the target costing process.
6. A life-cycle orientation. Total life-cycle costs are minimized for both the producer and the customer. Life-cycle costs include purchase price, operating costs, maintenance, and distribution costs.
The following ten steps are required to install a comprehensive target costing approach within an organization.
Re-orient culture and attitudes. The first and most challenging step is re-orient thinking toward market-driven pricing and prioritized customer needs rather than just technical requirements as a basis for product development. This is a fundamental change from the attitude in most organizations where cost is the result of the design rather than the influencer of the design and that pricing is derived from building up a estimate of the cost of manufacturing a product.
Establish a market-driven target price. A target price needs to be established based upon market factors such as the company position in the market place (market share), business and market penetration strategy, competition and competitive price response, targeted market niche or price point, and elasticity of demand. If the company is responding to a request for proposal/quotation, the target price is based on analysis of the price to win considering customer affordability and competitive analysis.
Determine the target cost. Once the target price is established, a worksheet (see example below) is used to calculate the target cost by subtracting the standard profit margin, warranty reserves, and any uncontrollable corporate allocations. If a bid includes non-recurring development costs, these are also subtracted. The target cost is allocated down to lower level assemblies of subsystems in a manner consistent with the structure of teams or individual designer responsibilities.
TARGET COSTING STEPS AT CATERPILLAR
Once companies have the tools and systems in place to support target costing, they often develop a standardized approach for achieving their target costing objectives. Caterpillar offers a good illustration to highlight the target costing process for one of its new products. For this particular vehicle, management set the target cost at 94.6% of a comparable model, creating an initial gap of 5.4%. The cost of the comparable model is based on current manufacturing capabilities. Therefore, to achieve the target, costs must be reduced by 5.4%.Current costs for a comparable model 100.0%Target cost for new product 94.6%Cost gap 5.4%
A cost improvement team is then assembled from product design, manufacturing engineering, production, marketing, and purchasing to determine how to close the gap. Initially, the group evaluates component part substitutions that would reduce costs but still provide the product features and benefits necessary to satisfy customer requirements. The group also considers opportunities to reduce costs through efficiency improvements. Table 1 shows that the cost improvement team identified 4.6% in "known" savings through an initial evaluation of cost savings opportunities.
Having reduced the gap by 4.6%, the team must find an additional 0.8% in savings to achieve the 5.4% cost reduction target. At this stage, the cost improvement team surveys the operational groups to identify potential cost savings opportunities. The responses to the questionnaire do not recommend specific solutions, but they do identify where improvement opportunities are more likely to be successful (see Table 2). Each "yes" response on the questionnaire indicates an opportunity for cost reduction, and the component part category (cab, engine, hydraulics, etc.) that has the largest number of positive responses is viewed as having the greatest potential for saving money. Table 2 highlights a sample questionnaire, and a tally of the responses indicates the extent to which each part category will be targeted for cost reduction. In this case, hydraulics will be responsible for achieving the highest percentage (50%) of the cost savings that are needed. Therefore, the cost of hydraulics must be reduced by .4% (.50 * .08).
Table 3 illustrates the final step in the process. It takes the adjusted costs column from Table 1 and subtracts the additional savings that are required for each component part category. The right-hand column in Table 3 illustrates the target cost for the new vehicle, broken down to the component level. To recap, Caterpillar began with current costs for a comparable product (100%) and, after deducting known savings based on existing technology (Table 1) and potential savings based on an analysis of the questionnaire (Table 2), established cost targets for each component of the new vehicle.
Reference:
v www.findarticles.com
v www.npd-solusions.com
v www.altavista.com
LIFE CYCLE COSTING
In the past, comparisons of asset alternatives, whether at the concept or detailed design level, have been based mainly on initial capital costs. However, with growing pressure to achieve better outcomes from assets, ongoing operating and maintenance costs must be considered as they consume most resources over the asset’s service life.
Life Cycle Costing is a process to determine the sum of all the costs associated with an asset or part thereof, including acquisition, installation, operation, maintenance, and refurbishment and disposal costs. It is therefore pivotal to the asset management process.
Life Cycle Costing incorporates both Life Cost Planning which occurs during development or manufacture and implementation of that plan by Life Cost Analysis as the asset is used or occupied.
Life Cycle Costing forms an input to evaluation processes such as Value Management, Economic Appraisal and Financial Appraisal.
Understanding Life Cycle Costing
An example of stainless steel-
Life Cycle Costing (LCC) has long been used in planning for reliability and maintenance for complex engineering systems in defence, airline, railway, offshore platform, power station, and other applications.
A basic attribute of stainless steel is the ability to provide long-term performance with a minimum of downtime and cost associated with maintenance. As a result LCC is of particular importance to the stainless industry.
Whilst the mathematics of LCC can be quite complex the International Chromium Development Association (ICDA) has developed an IBM or compatible PC program on floppy disk which can be easily applied to most examples.
The Australian Stainless Steel Development Association can make this program available to any interested party on request.
LCC analysis provides a more secure basis for comparing and selecting material options than the traditional method of judgments based on comparing acquisition costs alone. This particularly applies to situations where the initial cost is high and downtime for unplanned maintenance is costly.
In circumstances where stainless is being considered or introduced into new fields of applications, comparisons are often made with materials of a lower initial cost such as coated carbon steel or plastics.
Here the reasoning should progress well beyond the simple initial cost comparison and take account of the long term cost assessments associated with maintenance replacement and operating stoppages.
LCC is the tool to make this assessment and the ICDA program makes it easy.
Calculating LCC
In the LCC calculation, consideration is given only to relevant costs which are directly or indirectly affected by the material options being considered. Besides the cost of material, these include costs of installation, operation, maintenance, stoppages, replacements and possibly the residual value at the end of the service life. The time intervals at which the various costs arise during the selected life cycle period must also be taken into account.
Before the various cost items can be put together, those that arise every year and those that occur at certain time intervals during the service life must be converted into present values.
Again the complexities of the mathematics are catered for by the PC program.
Examples are the best way of demonstrating LCC principles and application and two are offered to illustrate the point.
The first is from Swedish practice and features roofing.
The building industry is one of the most rapidly expanding markets for stainless steel and roofing is a major growth application. A method based on seam welding 0.4 mm strips of cold rolled stainless steel was invented in Sweden in the 60s and has since found favour in Europe and Japan. An LCC calculation was carried out based on these material options:
galvanised and plastic coated carbon steel, double folded edges
0.4 mm stainless steel strip, seam-welded and single folded edges (type 316 for coastal areas or polluted atmospheres, otherwise type 304)
In this example the LCC period is 50 years and a real interest rate of 3% is used (comparative figures are given per sq metre):
The LCC result shows that stainless steels are less costly than galvanised and plastic coated steel. Galvanised carbon steel requires replacement after about 20 years. The calculation does, however, not take into account the risk of damage to building substructures each time the covering is replaced. The stainless steel alternative is the only one which is virtually maintenance free.
Reference:
v www.gamc.nsw.gov.au
v www.indisinfoline.com
v www.khoj.com
Objective:
To make the students aware of various Neo cost concepts developed in the modern era of complex business activities.
UNIT OVERVIEW
Topics covered: Neo concepts for decision making: Concept, distinctive features of Activity Based Costing, Cost drivers, Cost of activities, Cost object such as product, service and customer. Cost management: Concept, Strategies and Applications. Value Chain Analysis, Target Costing and Life cycle costing.
How Activity-Based Costing Works
1. ABC is a management tool that provides better allocation of resources.
2. ABC principles are applicable to both appropriations and revolving funds.
3. ABC relates total cost (resources consumed) to work accomplished (outputs produced).
4. The ABC or unit cost goal is a financial benchmark that represents an expectation of the maximum total cost incurred in the production of an output.
5. ABC aligns costs to outputs thereby increasing cost visibility, and is useful in forecasting financial baselines.
ABC focuses on the activities of a production cycle; it is based on the premise that outputs (products or services) require activities to produce, and that activities consume resources. It recognizes the causal relationship of cost drivers to activities. An output is defined as something "put out" at the end of a production process. It can be a good or service, and it must be measurable or quantifiable.
As a rule, outputs are:
produced to satisfy customer requirements;
distinctly quantifiable, measurable, and auditable;
consistent from fiscal period to fiscal period to allow cost comparisons;
incorporated into existing or modified financial management systems; and
separately identifiable so costs can be more easily allocated.
DoD activities are generally more complex than the example cited above, and often involve the production of more than one output. For example, a distribution depot handles millions of items, some of which require different resources to receive, store, and issue them. In these cases, DoD unit cost methodology uses output measures that are aggregated. To determine an organization's outputs, it must look at its core activities or processes—the things that it does. For example, an output at the Defense Finance Accounting Service (DFAS) might be a paid invoice.
In addition, unit cost activities also often fall into the service category as opposed to the manufacturing category. This can make the identification of outputs more difficult, as there is not always a physical product provided to the customer. For example, a research and development activity may be "employed" by one of the military services to test a specific missile system in addition to its basic research mission. Though it could be argued that a tested missile is a valid output, the diversity of services available to customers requires that a more common output be identified. In this case, direct labor hours expended in accomplishment of a task has been adopted as a surrogate or proxy output measure.
The Unit Cost Formula
The ABC system uses cost drivers to assign the costs of resources to activities. ABC can use unit cost as a way of measuring an output. Unit cost is the "average total cost" of producing one unit of output. It is calculated by dividing the total cost of production by the total number of units of output produced. For example, if an automobile manufacturer produces 50 vehicles for a total cost of $1,250,000, then the cost per unit (vehicle) is $25,000. But unlike a company like General Motors, which calculates the unit cost for an automobile in order to determine an adequate selling price and profit margin, DoD providers normally do not build in a profit margin. Their goal is an accumulated operating result (AOR) of zero.
ABC's Basic Benefits
v Enables determination of total production costs traced to outputs.
v Targets areas needing management attention.
v Encourages the consideration of alternative methods of production.
v Highlights operational efficiency and inefficiency.
v Identifies financial benchmarks for activity performance.
v Generates more information to measure and reward performance, and prioritizes activities for cost reductions.
v Provides a common managerial framework among support activities.
Comparison between Traditional costing and ABC
Traditional
ABC
Salaries $100
Clean door $40
Equipment $80
Paint door $75
Supplies $20
Inspect door $75
Overhead $45
Send door to assembly $55
TOTAL $245
TOTAL $245
Steps for Performing Activity Based Costing
Analyze Activities
Gather Costs
Trace Costs to Activities
Establish Output Measures
Analyze Costs
These steps should be performed by the core BPI team - which the FAA identifies as a small group of people, committed by top management to work on a BPI project full time if available, or part time on the effort with possible support from BPI contractors. This process can take anywhere from a few days to a few months, depending on level of detail, complexity of an organization's processes, and commitment of team resources.
Analyze Activities
First the scope of the activities to be analyzed must be identified. It is suggested that the program include at least a half-dozen organizational units having a common functional orientation, and preferably also a common budget somewhere in the reporting chain. The depth and detail of analysis will be determined by activity decomposition, since activity decomposition is complete when one common or homogeneous primary output per activity is reached. Any prior work captured in IDEF0 models and their related definitions is considered here. This is where the core team can use activity models as a basis for selecting and interviewing key people associated with the business process.
A determination then is made if an activity is value or non-value added; also if the activity is primary or secondary, and required or not needed. Value added is determined if the output of the activity is directly related to customer requirements, service or product, as opposed to an administrative or logistical outcome that services the providing organization. For instance, if the output of an activity were an inventory report or update for products (for which there are customers), the output would be non-value added, but necessary to the organization, i.e., "overhead." A major goal of reengineering is to reduce non-value added activities and eliminate those that are not necessary. Primary activities directly support the organization's mission while secondary activities support primary activities. Required activities are those that must always be performed while discretionary activities are performed only when allowed by the operating management.
Gather Costs
In this step costs are gathered for the activity producing the products or services provided as the outcome. These costs can be salaries, expenditures for research, machinery, office furniture, etc. These costs are used as the baseline activity costs. When documents for the costs incurred are not available, cost assignment formulas may be used.
Trace Costs to Activities
In this step the results of analyzing activities and the gathered organizational inputs and costs are brought together, which produces the total input cost for each activity. A simple formula for costs is provided - outputs consume activities that in turn have consumed costs associated with resources. This leads to a simple method to calculate total costs consumed by an activity - multiply the percent of time expended by an organizational unit, e.g., branch, division, on each activity by the total input cost for that entity. Here we are not calculating costs, just finding where they come from.
Establish Output Measures
In this step the actual activity unit cost is calculated. Even though activities may have multiple outputs, only one is identified as the primary output. Activity unit cost is calculated by dividing the total input cost, including assigned costs from secondary activities, by the primary activity output volume; the primary output must be measurable and its volume or quantity obtainable. From this, a bill of activities can then be calculated which contains or lists a set of activities and the amount of each activity consumed. The amount of each activity consumed is extended by the activity unit cost and is added up as a total cost for the bill of activity.
Analyze Costs
In the final step, the calculated activity unit costs and bills of activity are used to identify candidates for improving the business processes. Managers can use the information by stratifying, for a Pareto analysis, the activity costs and identifying a certain percentage of activities that consume the majority of costs. The thing to keep in mind is that the identification of non-value added activities occurs through this process with a clarity that allows us to eliminate them, and at the same time permits the product or service to be provided to the customer with greater efficiency.
Reference:
v www.isixsigma.com
v www.altavista.com
Total Cost Management for Competitiveness
v What is Total Cost Management or Cost Management?
v Issues addressed by TCM.
v Some Tools and Techniques of TCM.
v The areas of focus for cost reduction also include.
v The areas of focus for cost reduction also include.
v TCM techniques and their overview (e.g. ABC).
Value chain analysis
Introduction
Value Chain Analysis describes the activities that take place in a business and relates them to an analysis of the competitive strength of the business. Influential work by Michael Porter suggested that the activities of a business could be grouped under two headings:
(1) Primary Activities - those that are directly concerned with creating and delivering a product (e.g. component assembly); and
(2) Support Activities, which whilst they are not directly involved in production, may increase effectiveness or efficiency (e.g. human resource management). It is rare for a business to undertake all primary and support activities.
Value Chain Analysis is one way of identifying which activities are best undertaken by a business and which are best provided by others ("out sourced").
Linking Value Chain Analysis to Competitive Advantage
What activities a business undertakes is directly linked to achieving competitive advantage. For example, a business which wishes to outperform its competitors through differentiating itself through higher quality will have to perform its value chain activities better than the opposition. By contrast, a strategy based on seeking cost leadership will require a reduction in the costs associated with the value chain activities, or a reduction in the total amount of resources used.
Primary Activities
Primary value chain activities include:
Primary Activity
Description
Inbound logistics
All those activities concerned with receiving and storing externally sourced materials
Operations
The manufacture of products and services - the way in which resource inputs (e.g. materials) are converted to outputs (e.g. products)
Outbound logistics
All those activities associated with getting finished goods and services to buyers
Marketing and sales
Essentially an information activity - informing buyers and consumers about products and services (benefits, use, price etc.)
Service
All those activities associated with maintaining product performance after the product has been sold
Support activities include:
Secondary Activity
Description
Procurement
This concerns how resources are acquired for a business (e.g. sourcing and negotiating with materials suppliers)
Human Resource Management
Those activities concerned with recruiting, developing, motivating and rewarding the workforce of a business
Technology Development
Activities concerned with managing information processing and the development and protection of "knowledge" in a business
Infrastructure
Concerned with a wide range of support systems and functions such as finance, planning, quality control and general senior management
Steps in Value Chain Analysis:
Value chain analysis can be broken down into a three sequential steps:
(1) Break down a market/organisation into its key activities under each of the major headings in the model;
(2) Assess the potential for adding value via cost advantage or differentiation, or identify current activities where a business appears to be at a competitive disadvantage;
(3) Determine strategies built around focusing on activities where competitive advantage can be sustained
Reference:
v www.tutor2u.net
v www.google.com
v www.indiainfoline.com
Target Costing
THE TARGET COSTING PROCESS
Essentially, companies use target costing to establish concrete and highly visible cost targets for their new products. To maximize cost control and enhance profit improvement, most companies set relatively aggressive targets. The process begins when top management establishes a target cost for a new product, for example, a Chrysler Neon or a Caterpillar Excavator. A cost estimating group will then decompose the target cost for the product as a whole into cost targets for subassemblies and individual component parts--engine, transmission, seats, and so on.
Frequently a "gap" exists between the target cost and cost projections for the new product based on current designs and manufacturing capabilities. Closing the gap through cost reduction is central to the target costing process. This is accomplished through cross-functional target costing teams, which analyze the product's design, raw material requirements, and manufacturing processes to search for cost savings opportunities. The cross-functional teams employ a variety of management tools and initiatives to help them achieve their objectives. The following section describes some of these tools and initiatives and other characteristics of successful target costing companies.
TARGET-COSTING PRINCIPLES
Target costing can best be described as a systematic process of cost management and profit planning. The six key principles of target costing are: (1)
1. Price-led costing. Market prices are used to determine allowable--or target--costs. Target costs are calculated using a formula similar to the following: market price - required profit margin = target cost.
2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in product and process decisions and guide cost analysis. The value (to the customer) of any features and functionality built into the product must be greater than the cost of providing those features and functionality.
3. Focus on design. Cost control is emphasized at the product and process design stage. Therefore, engineering changes must occur before production begins, resulting in lower costs and reduced "time-to-market" for new products.
4. Cross-functional involvement. Cross-functional product and process teams are responsible for the entire product from initial concept through final production.
5. Value-chain involvement. All members of the value chain--e.g., suppliers, distributors, service providers, and customers--are included in the target costing process.
6. A life-cycle orientation. Total life-cycle costs are minimized for both the producer and the customer. Life-cycle costs include purchase price, operating costs, maintenance, and distribution costs.
The following ten steps are required to install a comprehensive target costing approach within an organization.
Re-orient culture and attitudes. The first and most challenging step is re-orient thinking toward market-driven pricing and prioritized customer needs rather than just technical requirements as a basis for product development. This is a fundamental change from the attitude in most organizations where cost is the result of the design rather than the influencer of the design and that pricing is derived from building up a estimate of the cost of manufacturing a product.
Establish a market-driven target price. A target price needs to be established based upon market factors such as the company position in the market place (market share), business and market penetration strategy, competition and competitive price response, targeted market niche or price point, and elasticity of demand. If the company is responding to a request for proposal/quotation, the target price is based on analysis of the price to win considering customer affordability and competitive analysis.
Determine the target cost. Once the target price is established, a worksheet (see example below) is used to calculate the target cost by subtracting the standard profit margin, warranty reserves, and any uncontrollable corporate allocations. If a bid includes non-recurring development costs, these are also subtracted. The target cost is allocated down to lower level assemblies of subsystems in a manner consistent with the structure of teams or individual designer responsibilities.
TARGET COSTING STEPS AT CATERPILLAR
Once companies have the tools and systems in place to support target costing, they often develop a standardized approach for achieving their target costing objectives. Caterpillar offers a good illustration to highlight the target costing process for one of its new products. For this particular vehicle, management set the target cost at 94.6% of a comparable model, creating an initial gap of 5.4%. The cost of the comparable model is based on current manufacturing capabilities. Therefore, to achieve the target, costs must be reduced by 5.4%.Current costs for a comparable model 100.0%Target cost for new product 94.6%Cost gap 5.4%
A cost improvement team is then assembled from product design, manufacturing engineering, production, marketing, and purchasing to determine how to close the gap. Initially, the group evaluates component part substitutions that would reduce costs but still provide the product features and benefits necessary to satisfy customer requirements. The group also considers opportunities to reduce costs through efficiency improvements. Table 1 shows that the cost improvement team identified 4.6% in "known" savings through an initial evaluation of cost savings opportunities.
Having reduced the gap by 4.6%, the team must find an additional 0.8% in savings to achieve the 5.4% cost reduction target. At this stage, the cost improvement team surveys the operational groups to identify potential cost savings opportunities. The responses to the questionnaire do not recommend specific solutions, but they do identify where improvement opportunities are more likely to be successful (see Table 2). Each "yes" response on the questionnaire indicates an opportunity for cost reduction, and the component part category (cab, engine, hydraulics, etc.) that has the largest number of positive responses is viewed as having the greatest potential for saving money. Table 2 highlights a sample questionnaire, and a tally of the responses indicates the extent to which each part category will be targeted for cost reduction. In this case, hydraulics will be responsible for achieving the highest percentage (50%) of the cost savings that are needed. Therefore, the cost of hydraulics must be reduced by .4% (.50 * .08).
Table 3 illustrates the final step in the process. It takes the adjusted costs column from Table 1 and subtracts the additional savings that are required for each component part category. The right-hand column in Table 3 illustrates the target cost for the new vehicle, broken down to the component level. To recap, Caterpillar began with current costs for a comparable product (100%) and, after deducting known savings based on existing technology (Table 1) and potential savings based on an analysis of the questionnaire (Table 2), established cost targets for each component of the new vehicle.
Reference:
v www.findarticles.com
v www.npd-solusions.com
v www.altavista.com
LIFE CYCLE COSTING
In the past, comparisons of asset alternatives, whether at the concept or detailed design level, have been based mainly on initial capital costs. However, with growing pressure to achieve better outcomes from assets, ongoing operating and maintenance costs must be considered as they consume most resources over the asset’s service life.
Life Cycle Costing is a process to determine the sum of all the costs associated with an asset or part thereof, including acquisition, installation, operation, maintenance, and refurbishment and disposal costs. It is therefore pivotal to the asset management process.
Life Cycle Costing incorporates both Life Cost Planning which occurs during development or manufacture and implementation of that plan by Life Cost Analysis as the asset is used or occupied.
Life Cycle Costing forms an input to evaluation processes such as Value Management, Economic Appraisal and Financial Appraisal.
Understanding Life Cycle Costing
An example of stainless steel-
Life Cycle Costing (LCC) has long been used in planning for reliability and maintenance for complex engineering systems in defence, airline, railway, offshore platform, power station, and other applications.
A basic attribute of stainless steel is the ability to provide long-term performance with a minimum of downtime and cost associated with maintenance. As a result LCC is of particular importance to the stainless industry.
Whilst the mathematics of LCC can be quite complex the International Chromium Development Association (ICDA) has developed an IBM or compatible PC program on floppy disk which can be easily applied to most examples.
The Australian Stainless Steel Development Association can make this program available to any interested party on request.
LCC analysis provides a more secure basis for comparing and selecting material options than the traditional method of judgments based on comparing acquisition costs alone. This particularly applies to situations where the initial cost is high and downtime for unplanned maintenance is costly.
In circumstances where stainless is being considered or introduced into new fields of applications, comparisons are often made with materials of a lower initial cost such as coated carbon steel or plastics.
Here the reasoning should progress well beyond the simple initial cost comparison and take account of the long term cost assessments associated with maintenance replacement and operating stoppages.
LCC is the tool to make this assessment and the ICDA program makes it easy.
Calculating LCC
In the LCC calculation, consideration is given only to relevant costs which are directly or indirectly affected by the material options being considered. Besides the cost of material, these include costs of installation, operation, maintenance, stoppages, replacements and possibly the residual value at the end of the service life. The time intervals at which the various costs arise during the selected life cycle period must also be taken into account.
Before the various cost items can be put together, those that arise every year and those that occur at certain time intervals during the service life must be converted into present values.
Again the complexities of the mathematics are catered for by the PC program.
Examples are the best way of demonstrating LCC principles and application and two are offered to illustrate the point.
The first is from Swedish practice and features roofing.
The building industry is one of the most rapidly expanding markets for stainless steel and roofing is a major growth application. A method based on seam welding 0.4 mm strips of cold rolled stainless steel was invented in Sweden in the 60s and has since found favour in Europe and Japan. An LCC calculation was carried out based on these material options:
galvanised and plastic coated carbon steel, double folded edges
0.4 mm stainless steel strip, seam-welded and single folded edges (type 316 for coastal areas or polluted atmospheres, otherwise type 304)
In this example the LCC period is 50 years and a real interest rate of 3% is used (comparative figures are given per sq metre):
The LCC result shows that stainless steels are less costly than galvanised and plastic coated steel. Galvanised carbon steel requires replacement after about 20 years. The calculation does, however, not take into account the risk of damage to building substructures each time the covering is replaced. The stainless steel alternative is the only one which is virtually maintenance free.
Reference:
v www.gamc.nsw.gov.au
v www.indisinfoline.com
v www.khoj.com
Notes: UNIT - 4
UNIT - 4
Objective:
To enable the students to understand the role of responsibility accounting and transfer pricing in the growth of modern organisations.
UNIT OVERVIEW
Topics covered: Responsibility Accounting: Concept and various approached to Responsibility Accounting: Concept of Investment Center, Cost Center, Profit Center, Responsibility Center and its managerial implications, Transfer Pricing –Multinational Transfer Pricing, Market Based Transfer Pricing, Cost-Based Transfer Pricing, Cost of Quality and Time.
Responsibility Accounting
Responsibility Accounting collects and reports planned and actual accounting information about the inputs and outputs of the responsibility centers.
Main Features:
1. Input and Output Analysis.
2. Planned and Actual performance evaluation.
3. Creation of responsibility centres to measure the performance.
Objectives:
1. Determination of contribution of a division.
2. Evaluation of quality of performance.
3. Motivation consistent with organisational goals.
Types of Responsibility Centres:
1. Cost Center
2. Profit Center
3. Investment Center
Cost Centers
Decision rights:
1. Labor
2. Supplies
3. Materials
Performance measures:
1. Minimize total cost for a selected level of output.
2. Maximize total output for a given budget.
Problems:
1. Quality for Quantity Tradeoff Average cost crates incentive to overproduce
Profit Centers
Decision Rights;
1. Input Mix (same as Cost Centers)
2. Product Mix
3. Selling Price
Performance Measurements:
1. Accounting profits compared to budgets or some expectations.
Problems:
1. Interdependencies of profit centers
2. Transfer Pricing
3. Cost allocation.
Investment Centers
Decision Rights:
1. Input Mix
2. Product Mix
3. Selling Prices
4. Capital Investment
Performance measures:
1. Net Income
2. Return on Investment
3. Residual Income
TRANSFER PRICING
The determination of an exchange price when different business units within a firm exchange products or services.
Objectives of Transfer Pricing:
ΠTo motivate managers.
To provide an incentive for managers to make decisions consistent with the firm’s goals.
Ž To provide a basis for fairly rewarding the managers.
Transfer-Pricing Methods:
•Variable cost – sets the transfer price equal to the variable cost of the selling unit.
•Full cost – sets the transfer price as the variable cost plus allocated fixed cost for the selling unit.
•Market price – Set the transfer price as the current price for the selling unit’s product in the market.
•Negotiated price – involves a negotiation process and sometimes arbitration between units to determine the transfer price.
Variable cost Method:
Advantage: Causes buyer to act as desired, to buy inside.
Limitation: Unfair to seller if seller is profit or investment SBU.
Full Cost Method
Advantage:
> Easy to implement
> Intuitive and easily understood.
> Preferred by tax authorities over variable cost.
Limitation:
> Irrelevance of fixed cost in decision making; fixed costs should be ignored in the buyer’s choice of whether to buy inside or outside the firm.
> If used, should be standard rather than actual cost.
Market Price Method
Advantage:
Helps to preserve unit autonomy.
Provide for the selling unit to be competitive with outside suppliers.
Has arm’s-length standard desired by taxing authorities.
Limitation:
Often intermediate products have no market price.
Should be adjusted for cost savings such as reduced selling costs, no commissions, etc.
Negotiated Price Method
Advantage: May be most practical approach when there is significant conflict.
Limitation:
Need negotiation rule and/or arbitrations procedure, and this may reduce autonomy.
Potential tax problems; may not be considered arm’s length.
Choosing the Right Transfer Price
If there is no outside supply-
ΠDecision to Transfer: Buy inside.
Transfer Price: Cost or negotiated price.
Choosing the Right Transfer Price
If there is an outside supply-
And if the seller’s variable cost is grater than outside price?
ΠDecision to Transfer: Buy outside (i.e. no transfer)
Transfer Price: No transfer price.
Choosing the Right Transfer Price
If there is an outside supply-
And if the seller’s variable cost is less than outside price? And seller has excess capacity?
ΠDecision to Transfer: Buy inside.
Transfer Price: Low – variable cost. High – market price.
Choosing the Right Transfer Price
If there is an outside supply . . .
And if the seller’s variable cost is less than outside price? And seller has no excess capacity?
If contribution from outside purchase is grater than the contribution from inside purchase-
ΠDecision to Transfer: Buy outside.
Transfer Price: No transfer price.
v In other words, we compare the savings from a transfer purchase (market price – internal variable costs) to the opportunity cost of the external sales (contribution margin of our sales) that we would have to give up in order to transfer.
v When the opportunity cost exceeds the savings, purchase from outside supplier.
Choosing the Right Transfer Price
If there is an outside supply-
And if the seller’s variable costs is less than outside price? And seller does not have excess capacity?
And If contribution from outside purchase is less than the contribution from inside purchase.
ΠDecision to Transfer: Buy inside.
Transfer Price: Market price.
v Again, we compare the savings from a transfer purchase (market price – internal variable costs) to the opportunity cost of the external sales (contribution margin of our sales) that we would have to give up in order to transfer.
v But if the savings is greater than the opportunity cost, we should effect the transfer, at the market price (so transferor is not penalized) General Guideline.
COST OF QUALITY
What is it?
The price of nonconformance (Philip Crosby) or the cost of poor quality (Joseph Juran), the term 'Cost of Quality', refers to the costs associated with providing poor quality product or service.
Why is it important?
Quality processes cannot be justified simply because "everyone else is doing them" - but return on quality (ROQ) has dramatic impacts as companies mature. Research shows that the costs of poor quality can range from 15%-40% of business costs (e.g., rework, returns or complaints, reduced service levels, lost revenue). Most businesses do not know what their quality costs are because they do not keep reliable statistics. Finding and correcting mistakes consumes an inordinately large portion resource. Typically, the cost to eliminate a failure in the customer phase is five times greater than it is at the development or manufacturing phase. Effective quality management decreases production costs because the sooner an error is found and corrected, the less costly it will be. When to use it?
Cost of quality comprises of four parts:
External Failure Cost
cost associated with defects found after the customer receives the product or service. ex: processing customer complaints, customer returns, warranty claims, product recalls.
Internal Failure Cost
Cost associated with defects found before the customer receives the product or service ex: scrap, rework, re-inspection, re-testing, material review, material downgrades.
Inspection (appraisal) Cost
Cost incurred to determine the degree of conformance to quality requirements (measuring, evaluating or auditing) ex: inspection, testing, process or service audits, calibration of measuring and test equipment.
Prevention Cost
Cost incurred to prevent (keep failure and appraisal cost to a minimum) poor quality ex: new product review, quality planning, supplier surveys, process reviews, quality improvement teams, education and training.
How to use it?
1. Gather some basic information about the number of failures in the system,
2. Apply some basic assumptions to that data in order to quantify the data,
3. Chart the data based on the four elements listed above and study it,
4. Allocate resources to combat the weak-spots,
5. Do this study on a regular basis and evaluate your performance
COST OF TIME
REFERENCE:
v www.thequalityportal.com
v www.indiainfoline.com
v www.npd-solutions.com
v www.google.com
v www.altavista.com
Objective:
To enable the students to understand the role of responsibility accounting and transfer pricing in the growth of modern organisations.
UNIT OVERVIEW
Topics covered: Responsibility Accounting: Concept and various approached to Responsibility Accounting: Concept of Investment Center, Cost Center, Profit Center, Responsibility Center and its managerial implications, Transfer Pricing –Multinational Transfer Pricing, Market Based Transfer Pricing, Cost-Based Transfer Pricing, Cost of Quality and Time.
Responsibility Accounting
Responsibility Accounting collects and reports planned and actual accounting information about the inputs and outputs of the responsibility centers.
Main Features:
1. Input and Output Analysis.
2. Planned and Actual performance evaluation.
3. Creation of responsibility centres to measure the performance.
Objectives:
1. Determination of contribution of a division.
2. Evaluation of quality of performance.
3. Motivation consistent with organisational goals.
Types of Responsibility Centres:
1. Cost Center
2. Profit Center
3. Investment Center
Cost Centers
Decision rights:
1. Labor
2. Supplies
3. Materials
Performance measures:
1. Minimize total cost for a selected level of output.
2. Maximize total output for a given budget.
Problems:
1. Quality for Quantity Tradeoff Average cost crates incentive to overproduce
Profit Centers
Decision Rights;
1. Input Mix (same as Cost Centers)
2. Product Mix
3. Selling Price
Performance Measurements:
1. Accounting profits compared to budgets or some expectations.
Problems:
1. Interdependencies of profit centers
2. Transfer Pricing
3. Cost allocation.
Investment Centers
Decision Rights:
1. Input Mix
2. Product Mix
3. Selling Prices
4. Capital Investment
Performance measures:
1. Net Income
2. Return on Investment
3. Residual Income
TRANSFER PRICING
The determination of an exchange price when different business units within a firm exchange products or services.
Objectives of Transfer Pricing:
ΠTo motivate managers.
To provide an incentive for managers to make decisions consistent with the firm’s goals.
Ž To provide a basis for fairly rewarding the managers.
Transfer-Pricing Methods:
•Variable cost – sets the transfer price equal to the variable cost of the selling unit.
•Full cost – sets the transfer price as the variable cost plus allocated fixed cost for the selling unit.
•Market price – Set the transfer price as the current price for the selling unit’s product in the market.
•Negotiated price – involves a negotiation process and sometimes arbitration between units to determine the transfer price.
Variable cost Method:
Advantage: Causes buyer to act as desired, to buy inside.
Limitation: Unfair to seller if seller is profit or investment SBU.
Full Cost Method
Advantage:
> Easy to implement
> Intuitive and easily understood.
> Preferred by tax authorities over variable cost.
Limitation:
> Irrelevance of fixed cost in decision making; fixed costs should be ignored in the buyer’s choice of whether to buy inside or outside the firm.
> If used, should be standard rather than actual cost.
Market Price Method
Advantage:
Helps to preserve unit autonomy.
Provide for the selling unit to be competitive with outside suppliers.
Has arm’s-length standard desired by taxing authorities.
Limitation:
Often intermediate products have no market price.
Should be adjusted for cost savings such as reduced selling costs, no commissions, etc.
Negotiated Price Method
Advantage: May be most practical approach when there is significant conflict.
Limitation:
Need negotiation rule and/or arbitrations procedure, and this may reduce autonomy.
Potential tax problems; may not be considered arm’s length.
Choosing the Right Transfer Price
If there is no outside supply-
ΠDecision to Transfer: Buy inside.
Transfer Price: Cost or negotiated price.
Choosing the Right Transfer Price
If there is an outside supply-
And if the seller’s variable cost is grater than outside price?
ΠDecision to Transfer: Buy outside (i.e. no transfer)
Transfer Price: No transfer price.
Choosing the Right Transfer Price
If there is an outside supply-
And if the seller’s variable cost is less than outside price? And seller has excess capacity?
ΠDecision to Transfer: Buy inside.
Transfer Price: Low – variable cost. High – market price.
Choosing the Right Transfer Price
If there is an outside supply . . .
And if the seller’s variable cost is less than outside price? And seller has no excess capacity?
If contribution from outside purchase is grater than the contribution from inside purchase-
ΠDecision to Transfer: Buy outside.
Transfer Price: No transfer price.
v In other words, we compare the savings from a transfer purchase (market price – internal variable costs) to the opportunity cost of the external sales (contribution margin of our sales) that we would have to give up in order to transfer.
v When the opportunity cost exceeds the savings, purchase from outside supplier.
Choosing the Right Transfer Price
If there is an outside supply-
And if the seller’s variable costs is less than outside price? And seller does not have excess capacity?
And If contribution from outside purchase is less than the contribution from inside purchase.
ΠDecision to Transfer: Buy inside.
Transfer Price: Market price.
v Again, we compare the savings from a transfer purchase (market price – internal variable costs) to the opportunity cost of the external sales (contribution margin of our sales) that we would have to give up in order to transfer.
v But if the savings is greater than the opportunity cost, we should effect the transfer, at the market price (so transferor is not penalized) General Guideline.
COST OF QUALITY
What is it?
The price of nonconformance (Philip Crosby) or the cost of poor quality (Joseph Juran), the term 'Cost of Quality', refers to the costs associated with providing poor quality product or service.
Why is it important?
Quality processes cannot be justified simply because "everyone else is doing them" - but return on quality (ROQ) has dramatic impacts as companies mature. Research shows that the costs of poor quality can range from 15%-40% of business costs (e.g., rework, returns or complaints, reduced service levels, lost revenue). Most businesses do not know what their quality costs are because they do not keep reliable statistics. Finding and correcting mistakes consumes an inordinately large portion resource. Typically, the cost to eliminate a failure in the customer phase is five times greater than it is at the development or manufacturing phase. Effective quality management decreases production costs because the sooner an error is found and corrected, the less costly it will be. When to use it?
Cost of quality comprises of four parts:
External Failure Cost
cost associated with defects found after the customer receives the product or service. ex: processing customer complaints, customer returns, warranty claims, product recalls.
Internal Failure Cost
Cost associated with defects found before the customer receives the product or service ex: scrap, rework, re-inspection, re-testing, material review, material downgrades.
Inspection (appraisal) Cost
Cost incurred to determine the degree of conformance to quality requirements (measuring, evaluating or auditing) ex: inspection, testing, process or service audits, calibration of measuring and test equipment.
Prevention Cost
Cost incurred to prevent (keep failure and appraisal cost to a minimum) poor quality ex: new product review, quality planning, supplier surveys, process reviews, quality improvement teams, education and training.
How to use it?
1. Gather some basic information about the number of failures in the system,
2. Apply some basic assumptions to that data in order to quantify the data,
3. Chart the data based on the four elements listed above and study it,
4. Allocate resources to combat the weak-spots,
5. Do this study on a regular basis and evaluate your performance
COST OF TIME
REFERENCE:
v www.thequalityportal.com
v www.indiainfoline.com
v www.npd-solutions.com
v www.google.com
v www.altavista.com
Notes: UNIT – 3
STANDARD COSTING
One of the most important functions of management accounting is to facilitate managerial control. The major aspect of managerial control is cost control. The efficiency of management, among other things, depends upon the effective control of costs. For controlling costs, management should not only know actual cost- the cost actually incurred but also pre-determined costs – the cost which should have been incurred. Standards costs are the widely used form of pre-determined costs. The system of standard costing is the most efficient way to controlling costs.
Historical costs systems are principally associated with recording of historical, or as they are commonly called, actual cost. Historical costing is the ascertainment of costs after they have been incurred. No doubt, information on actual costs is useful in determining the cost of production per unit; but from the point of view of decision-making and control, actual costs are not useful to management. Actual costs are meaningful only when they are compared with pre-determined costs.
Standard costs seeks to establish the cost of a product, operations or process under standard operating conditions. The aim of standard cost is to eliminate the influenced of abnormal changes in prices. It is used a guide for future decision and action over a period of time . Standard coatings as an effective management tool for planning decision making coordination and control of business. The object of standard costs is to ascertain the quotation and determination of price policy. It is a new technique of cost control.
Standard costing is defined by I.C.M.A. Terminology as, “The preparation and use of standard costs, their comparison with actual costs and the analysis of variances to their causes and points of incidence.”
“Standard costing is a method of ascertaining the costs whereby statistics are prepared to show (a) the standard cost (b) the actual cost (c) the difference between these costs, which is termed the variance”. Thus the techniques of standard cost study comprises of :
1. Ascertainment and use of standard costs.
2. Comparison of actual costs with standard costs and measuring the variances.
3. Controlling costs by the variance analysis.
4. Reporting to management for taking proper action to maximize the efficiency.
ADVANTAGES OF STANDARD COSTING
1. It helps the management in formulating price and production policy.
2. It is a yardstick of performance. Standard costs are compared with actual costs, and the differences are analysed and effective cost control is taken. Thus reduction of cost is possible by increasing the profits.
3. It reduces avoidable wastages and losses.
4. It facilitates to reduce clerical and accounting cost and managerial time.
5. It creates cost consciousness among the personnel, because the variance analysis fixes responsibility for favourable or unfavourable performance.
6. Executives become more responsible, as it shows clearly who is responsible for the cost centres.
7. By the variance analysis and reporting, “the principle of management by exception: “the principle of management by exception” is facilitated. Management must concentrate their attention on variations only.
8. It aids in budgetary control and in decision-making.
9. Opening stock and closing stock are valued at the standard price. This helps in the preparation of Profit and Loss Account for a short period-say a week, a month etc.
10. It facilitates timely cost reports to management and a forward looking mentality is encouraged at all levels of the management. It is a basic for the implementation of an incentive system for the employees.
Standard costs form a basis for future planning, preparation of tenders, fixation of price etc. Otherwise, or in the absence of standard cost, decision will be based on actual cost. The prices of material, labour etc, may change from time to time. There must be a fixed cost structure based on normal standard efficiency. Thus it helps the management in formulating price and production policy.
When standards have been fixed, the section-heads safely delegate the responsibility to the workers. The standard of activity can be measured through the costing reports.
Introduction of standard cost facilitates timely reporting. The management gives attention to the variances and takes corrective steps. The costing reports, based on standard cost, reveal the overall result of the manufacturing side.
LIMITATIONS OF STANDARD COSTING
1. It is costly, as the setting of standards needs technical skill.
2. Keeping of up-to-date standard is a problem. Periodic revision of standard is a costly thing.
3. Inefficient staff is incapable of operating this system.
4. Since it is difficult to set correct standards, it is difficult to ascertain correct variance.
5. Industries, which are subject to frequent changes in technological process or the quality of material or the character of labour, need a constant revision of standard. But revision of standard is more expensive.
6. For small concerns, standard costing is expensive.
7. It is difficult to apply this method where production takes more than one accounting period. Standard c may not be effective in industries which deal in non-standardised products or jobs according to customer’s requirements.
SETTING THE STANDARD
While setting standard cost for operations, process or products, the following preliminaries must be gone through :
1. There must be Standard Committee, similar to Budget Committee, in which Purchase Manger, Personnel Manager, and Production Manager are represented. The Cost Accountant coordinates the functions of the Standard Committee.
2. Study the existing costing system, cost records and forms in use. If necessary, review the existing system.
3. A technical survey of the existing methods of production should be undertaken so that accurate and reliable standard can be established.
4. Determine the type of standard to be used.
5. Fix standard for each element of cost.
6. Determine standard costs for each product.
7. Fix the responsibility for setting standards.
8. Classify the accounts properly so that variances may be accounted for in the manner desired.
9. Comparison of actual costs with pre-determined standards to ascertain the deviations.
10. Action to be taken by management to ensure that adverse variances are not repeated.
The most significant contribution of standard costing to the science and art of management is the presentation of ‘variances’. As a matter of act, without determination and analysis of variances, standard costing is meaningless. The term ‘Variance’ has been derived from the verb ‘To vary’ meaning to differ. In cost accounting, variance means deviation of the actual cost from the standard cost. In standard costing, standard costs are pre-determined and refer to the amounts which ought to be incurred. These become the yardsticks against which actual costs can be compared.
That is, variance analysis is a tool to measure performances and based on the principle of management by exception.
After the standard costs have been fixed, the next stage in the operation of standard costing is to ascertain the actual cost of each element and compare them with the standard already set. Computation and analysis of variances is the main objective of standard costing. The deviation of actual from the standard is called ‘variance’.
FAVOURABLE AND UNFAVOURABLE VARIANCES
Variances may be favourable (positive or credit) or unfavourable (or negative or adverse or debit) depending upon whether the actual resulting cost is less or more than the standard cost.
Favourable variance : When the actual cost incurred is less than the standard cost, the deviation is known as favourable variance. The effect of the favourable variance increases the profit. Again, favourable variance would result when the actual cost is lower than the standard cost. It is also known as positive or credit variance and viewed only as savings.
Unfavourable variance : When the actual cost incurred is more than the standard cost, there is a variance, known as unfavourable or adverse variance. Unfavourable variance refers to deviation to the loss of business. It is also known as negative or debit variance and viewed as additional costs or losses.
When the profit is greater than the standard profit, it is known as favourable variance. When the profit is less than the standard profit, it is known as unfavourable variance. This favourable variance is a sign or efficiency of the organization and the unfavourable variance is a sign of inefficiency of the organization.
CALCULATION & ANALYSIS OF VARIANCE
Analysis of variance is a an important and crucial part of standard costing. Calculation of variance indicates a management whether a cost are under control or not. By knowing favourable & unfavourable variances, the management can decide whether a process are under a not and identity those areas where remedial action need to be taken.
VARIANCE CAN BE SUDIVIDED IN THE FOLLOWING CATEGORY:
1. Material cost variance
2. Labour or wage variance
3. Overhead cost variance
4. Sales variance
I. MATERIAL COST VARIANCE
It is a difference between a standard cost of a material and actual cost of the material used. It is important to study this variance in crde to know a difference between a actual & standard cost of material used. It produce a particular product. It may be favourable if a actual cost is less than a standard cost. It will be unfavourable & actual cost is more than the standard cost.
MCV = (SP ´ SQ) - (AQ ´ AP)
Where SQ = Standard Qty.
SP = Standard Price
AQ = Actual Qty.
AP = Actual price
The following are the variance in the case of materials :
Materials Variances (Diagrammatic representation)
MATERIAL COST VARIANCE (OR) MCV
(SQ´SP) - (AQ´AP)
MATERIAL PRICE VARIANCE MATERIAL USAGE VARIANCE
(OR) MPV (OR) MUV
AQ (SR-AR) SR(SQ-AQ)
MATERIAL MIX VARIANCE MATERIAL YIELD VARIANCE
(OR) MMV (OR) MYV
SR(SQ-AQ) OR SR (RSQ-AQ) SR (AY-SY)
MCV = MPV + MUV
MUV = MMV + MYV
MCV = MPV + MMV + MYV
ILLUSTRATION 1: The standard material and standard cost per Kg. of material required for the production of one unit of product A is as follows :
Material : 5 Kg.
The actual production and related material data are as follows :
400 units of product A
Material used 2,200 Kgs.
Price of material Rs. 4.50 per Kg.
Calculate Material cost variance.
Solution :
Material cost variance : (SQ´SP)-(AQ´AP)
SQ refers to standard quantity for action production.
Standard quantity for actual production of 400 units = 400´5 = 2,000 Kgs.
MCV = (2,000 ´ Rs. 5) - (2,200 ´ Rs. 4.50)
= Rs. 10,000 - Rs. 9,900
= Rs. 100 (F)
This is the responsibility of the purchase manager. Material price variance is that portion of the direct material cost variance which is the difference between the standard price specified and the actual price paid for the direct materials used. The formula is :
Direct material price variance =(Actual quantity consumed ´ Standard price)
-(Actual quantity consumed ´ Actual price)
or
Actual quantity consumed (Standard Rate - Actual Rate)
MPV = AQ(SR-AR)
A favourable variance arises if the actual price is less than the standard price and vice versa.
The reasons for direct material price variances are :
1. Fluctuations in market price.
2. Non-availability of standard quality
3. Using cheaper materials or substitute
4. Inefficiency in buying
5. High cost of transportation and carriage of goods
6. Loss of discount and fraud in purchases.
7. Changes in price policies
8. Emergency purchase leading to higher price
9. Government interferences leading to rise in prices
10. Incorrect setting of standard
11. Untimely purchase
12. Loss in transit, in excess of normal loss
13. Unexpected additional cost
14. Failure to enter into forward contract
ILLUSTRATION 2 : The standard cost of a material for manufacturing a unit of particular product is estimated as follows :
20 Kg. of raw materials @ Rs. 2 per kg.
On completion of the unit, it was found that 25 Kg. of raw material costing Rs. 3 per kg. has been consumed.
Solution :
MPV = AQ(SR-AR)
= 25 (Rs. 2 - Rs.3)
= 25 ´ (Re -1)
= - 25 or Rs. 25 (Adverse)
Variance : It is the deviation caused by the standards due to difference in quantity used. It is calculated by multiplying the difference between the standard quantity specified and the actual quantity used by the standard price.
Thus material usage variance is “that portion of the direct materials cost variance which is the difference between the standard quantity specified for the production achieved, whether completed or not, and the actual quantity used, both valued at standard prices.”
Material Usage or Quantity Variance
= Standard Rate (Standard Quantity - Actual Quantity)
(OR)
MUV = SR (SR - AQ)
The reasons for usage variance are :
1. Careless handling of materials;
2. Wastages, scarp, spoilage etc. due to inefficient production method or unskilled employees;
3. Change in design or specifications of product;
4. Use of inferior materials;
5. Defective equipment and tools;
6. Non- standard material used;
7. Accounting errors;
8. Setting of proper standards;
9. Improper inspection;
10. Non-standard substitutes used;
11. Theft of materials;
12. Difference between actual yield from materials and standard yield.
13. Lack of proper tools and machines.
ILLUSTRATION 3 : From the following data calculate material usage variance :
Standard 20 Kg. at Rs. 5.50 per kg.
Actual 25 Kg. at Rs. 6 per kg.
Solution :
MUV = SR(SQ-AQ)
= Rs. 5.50 (20-25)
= Rs. 5.50 (-5)
= Rs. -27.50 or Rs. 27.50 (Adverse)
When two or more materials are used in the manufacture of a product, the difference between the standard composition and the actual composition of material mix is the Material mix variance. The variance arises due to the actual composition of material and the standard ratio. The formula is :
Direct material mix variance = Standard Rate (Standard mix - Actual Mix)
i.) When actual weight of mix and standard weight of mix are the same
DMMV = Standard Rate (Standard quantity - Actual quantity)
or SR (SQ-AQ)
Standard is revised due to the shortage of a particular type of material.
The formula is :
MMV = Standard Rate (Revised standard quantity - Actual quantity)
Revised standard quantity
= ´ Standard quantity
Material Mix Variance :
Here, the actual weight of mix and standard weight of mix differ from each other therefore,
MMV = Standard Rate (Revised Standard Quantity - Actual Quantity)
Here, the revised standard quantity formula :
´ Standard Quantity
RSQ for material A = ´ 40 = 44 units
B = ´ 60 = 66 units
Then,
MMV = Standard Rate (Revised Standard Quantity- Actual Quantity)
= SR (RSQ - AQ)
Material A : 50(44-50) = Rs. 300 (Adverse)
B : 40(60-66) = Rs. 240 (Favourable)
-----------
Rs. 60 (Adverse)
Revised material usage variance
= Standard Rate (Standard Quantity -Revised Standard Quantity)
Material A : Rs. 50 (40-44) = 200 (Adverse)
B : Rs. 40 (60-66) = 240 (Adverse)
-----------
Rs. 440 (A)
Material Cost Variance :
Material : MCV = (SQ´SP) -(AQ´AP)
A = (40´50)-(50´50) = 500 (A)
B = (60´40)-(60´45) =300 (A)
-----------
Rs. 800 (A)
MCV = MPV + MUV
Rs. 800 (A) = Rs. 300 (A) + Rs. 500 (A)
MUV = RUV + NMV
Rs. 500 (a) = Rs. 440 (A) + Rs. 60(A)
Direct Material Yield Variance :
It is that portion of the direct material usage variance which is the due to the difference between the standard yield specified and the actual yield obtained.
i) When actual mix and standard mix are the same the formula is :
MYV = Standard Yield Rate ( Standard Yield - Actual Yield)
(Or) = Standard Revised Rate (Actual Loss - Standard Loss)
Here Standard Yield Rate =
Net Standard Output = Gross Output - Standard Loss
ii.) When the actual mix and the standard mix differ from each other, the formula is :
Standard Rate =
Material Yield Variance
= Standard Rate (Actual Standard Yield - Revised Standard Yield)
ILLUSTRATION : The standard material cost for 100 kg of chemical D is made up of :
Chemical A - 30 kg. @ Rs. 4 per kg.
Chemical B - 40 kg. @ Rs. 5 per kg.
Chemical C - 80 kg. @ Rs. 6 per kg.
In a batch, 500 kg of chemical D where produced from a mix of
Chemical A - 140 kg. at a cost of Rs. 588
Chemical B - 220 kg at a cost of Rs. 1,056
Chemical C - 440 kg. at a cost of Rs. 2,860
How do you yield, mix and the price factor contribute to the variance in the actual per 100 kg of chemical D over the standard cost?
Solution :
MCV Rs.
Rs. 100.80(A)
MPV (Rs. 40.80)(A) MUV (Rs.60)(A)
MMV (Rs. 6.67)(A) MYV (Rs. 53.33)(A)
We have to find out the variance only for 100 kg of output. Therefore, the date required is calculated as follows :
Chemical A : Rate = = Rs. 4.20 per kg
Chemical B : Rate = = Rs. 4.80 per kg.
Chemical C : Rate = = Rs. 6.50 per kg
Chemical D (500 kg) the chemical A is 140 kg.
\ 100 kg of chemical D, the required :
Chemical A is = 28 kg.
Chemical B is = 44 kg.
Chemical C is = 88 kg.
(a) Material Cost Variance :
(SQ ´SP)-(AQ-AP)
Chemical A = (30´Rs.4)-(28´Rs. 4.20)= Rs. 2.40 (F)
Chemical B = (40´Rs.5)-(44´Rs. 4.80)= Rs.11.20 (A)
Chemical B = (80´Rs.6)-(88´Rs. 6.50)= Rs 92.00 (A)
--------------------
Total MCV = Rs. 100.80(A)
--------------------
(b) Material Price Variance :
AQ (SP - AP)
Chemical A = 28 (4-4.20) =Rs. 5.60 (A)
Chemical B = 44 (5-4.80) =Rs. 8.80 (F)
Chemical C = 88 (6-6.50) =Rs. 44.00 (A)
-------------------
Total MPV =Rs. 40.80 (A)
(c) Material Usage Variance :
SP(SQ-AQ)
Chemical A : 4(30-28) = Rs. 8(F)
Chemical B : 5(40-44) = Rs. 20(A)
Chemical C : 6(80-88) = Rs. 48(A)
------------
Total MUV = Rs. 60(A)
(d) Material Mix Variance :
SP (RSQ-AQ)
The actual quantity of 160 kg to be apportioned in the standard proportion, i.e., 30:40:80
Chemical A is = 32 kg.
Chemical B is = 42 kg.
Chemical C is = 85 kg.
MMV = SP(RSQ-AQ)
For Chemical A : 4(32-28) = Rs. 16.00(F)
Chemical B : 5(42-44) = Rs. 6.67(A)
Chemical C : 6(85-88) = Rs. 16.00(A)
-----------------
Total MMV = Rs. 6.67(A)
e) Material Yield Variance
Average standard price = = = Rs. 8
150 kg. mix will produce 100 kg.
\ 160 kg. of mix will produce = = 106 kg.
MYV = Average standard price (Actual Production - Standard Production)
= Rs. 8(100 Kgs-106 Kgs.)
= Rs. 8 (6) = Rs. 53.33(A)
II. LABOUR VARAINCES
Labour variances arise because of (i) difference in actual rates and standard rates of labour and (ii) the variation in action time taken by workers and the standard time allotted to them for performing a job. The various variances can be analysed as follows :
A. Labour Cost Variance
B. Labour Rate Variance
C. Labour Time or Efficiency Variance
D. Labour Idle Time Variance
E. Labour Mix Variance or Gang Composition Variance
The second important element of cost is labour. The management keeps a close watch on the labour cost in order to keep the cost of production low. The various labour variances are :
When one type of labour is employed :
LABOURT COST VARIANCE
(ST ´ SR) - (AT ´ AR)
Rate Variance Either
AT (SR-AR) Total Efficiency Variance
SR (ST - AT)
or
Yield Variance
Total efficiency variance may be sub-divided into two :
TOTAL EFFICIENCY VARIANCE
SR(ST-AT)
Idle time either
(SR ´IT) SR(ST-AT)
AT means less idle time
(or)
Yield variance
when different grades of labour are employed :
LABOUR COST VARIANCE
Rate Variance Total efficiency variance
AT (SR-AR) SR(ST-AT)
Mix Variance (Gang Composition) either
SR (RST AT) (or)
Yield variance
Total efficiency many be sub-divided into three, when idle time variance is also to be calculated :
TOTAL EFFICIECNCY VARIANCE
SR (ST-AT)
Idle time variance Mix variance either
SR ´ IT SR (RST-AT) SR(SR-rst)
LCV = LRV + LEV
LEV = LMV + LYV + LITV
(a) Labour Cost Variance or Labour Wage Variance
This variance represents the difference between the standard labour costs and the actual labour costs. That is, it is the difference between standard direct wages specified for the activity achieved and the actual direct wages paid.
Labour Cost Variance = Standard Cost of Labour - Actual Cost of Labour
= (Standard Time´ Standard Rate)-(Actual Time´Actual Rate)
= (ST´SR)-(AT´AR)
(b) Labour or Wage Rate Variance
This variance is the direct result of the wages paid at a rate different from the standard rated. That is, it is the different between the standard rate of pay specified and the actual rate paid.
Labour Rate
=Actual Time (Standard Wage Rage´Actual Wage Rate Variance )
= AT (SR-AR)
The reasons for wage rate variance :
1. Changes in basic wage rates.
2. Overtime work at higher or lower than standard rate.
3. Faulty recruitment.
4. Overtime work at higher or lower than specified hours.
5. Change in composition of gang at a different rate from standard.
6. Higher or lower rate paid to causal labourers.
7. Improper planning of overtime or bonus.
8. General rise in wages.
9. Wrong setting of standard rates of labour.
10. Higher wages paid because of urgent work.
(c) Labour Time or Labour Efficiency Variance
The terminology defines Labour Efficiency V as “the difference between the standard hours for the actual production achieved and the hours actually worked, valued at the standard labour rate.
Labour Efficiency Variance = Standard Rate (Standard Time -Actual Time)
= SR (SR-AT)
Favourable Factors
1. Strict supervision
2. Use of good quality materials.
3. Low labour turnover rate
4. High morale of workers
5. Proper working condition
6. Improved tools and machines
7. Good incentives
8. Worker’s co-operation
9. Right man at right work
10. Employment of skilled workers.
Unfavourable Factors
1. Improper training to employees
2. Inadequate supervision
3. Low employee morale
4. More idle time than normal
5. Incorrect instruction
6. Engaging new or unskilled workers
7. Workers’ dissatisfaction
8. Defective machinery
9. High labour turnover rate
10. Bad working condition
11. Failure of power supply
12. Use of sub-standard materials
13. Delay due to waiting for materials
14. Fixation of incorrect standard
15. Lack of co-operation
(d) Idle Time Variance
This type of variance arises because of the time during which the labour remains idle due to abnormal reasons, i.e., power failure, strikes, machine breakdown, shortage of materials etc.
Labour Idle Time Variance = Abnormal Idle Time ´ Standard Hourly Rate
(e) Labour Mix Variance or Gang Composition Variance
It results from employing different grades of labour from the standard fixed in advance. It is the difference between the standard composition of workers and the actual gang of workers.
i. When the total hours i.e. time of the standard composition and actual composition of workers do not differ, the formula is :
Mix = (Standard Cost of Standard Mix)-(Standard Cost of Actual Mix)
Variance
ii. When the total hours i.e. time of the standard composition and actual composition of workers differ, the formula is :
Labour Mix Variance
= -(Std.Costof ActualMix)
(f) Labour Yield Variance
It is the difference between the standard labour output and actual output or yield. It is calculated as below :
Labour Yield Variance
= Std. Cost per unit (Std. Production of Actual Mix - Actual Production)
If the actual production is more than standard production, it would result in a favourable variance and vice versa.
Relationship
a. Labour cost variance = Labour rate variance + Labour efficiency variance
b. Labour efficiency variance = Labour mix variance + Idle time variance
c. Labour efficiency variance = Labour yield variance +Idle time variance
d. Efficiency variance = Labour mix variance + yield variance + Idle time variance
ILLUSTRATIION : With the help of following information calculate
a. Labour cost variance
b. Labour rate variance
c. Labour efficiency variance
Standard hours : 40 @ Rs. 3 per hour
Actual hours : 50 @ Rs. 4 per hour
Solution :
a. Labour cost variance = (Std. time´ Std. rate)-(Actual time ´Actual rate)
= (40´ Rs.3)- (50´Rs. 4)
= Rs. 120-200 = Rs. -80
= Rs.80 (Adverse)
b. Labour rate variance = Actual Time (Std. rate -Actual rate)
= 50 (Rs. 3- Rs. 4) = Rs. -50
= Rs. 50 (Adverse)
c. Labour efficiency variance = Std. Rate (Std. time - Actual time)
= Rs. 3(40-50) = Rs. -30
= Rs. 30 (Adverse)
ILLUSTRATION : Using the following information, calculate the labour variance :
Direct wages : Rs. 3,000
Standard hours produced : 1,600
Standard rate per hour : 1.50
Actual hours paid 1,500 hours, out of which hours not worked (abnormal idle time) are 50.
Solution :
a) Labour Cost Variance
= (Std. time ´ Std. rate) -(Actual time ´Actual rate)
= (1,600´Rs. 1.50) -(1,500´Rs.2)
= Rs. 2,400 - Rs. 3,000
= Rs. 600 (Adverse)
b) Labour Rate Variance
= Actual time (Std. rate -Actual rate)
= 1,500 (Rs. 1.50 -2.00)
= 1500 (-Rs. .50) = - Rs. 750
= Rs. 750 (Adverse)
c) Labour Efficiency Variance
= Std. rate (Std. time - Actual time)
Actual time = Actual hour paid - Abnormal idle time
= 1,500 - 50 = 1,450
LEV = Rs. 1.50 (1,600-1,450)
= Rs. 1.50´150
= Rs. 225 (Favourable)
d) Idle time variance
= Idle time ´ Standard hourly rate
= 50 ´ Rs. 1.50
= Rs. 75(A)
III. OVERHEAD VARIANCE
Overhead variance is “the difference between the standard cost of overhead absorbed in the actual output achieved and the actual overhead cost”. The term overhead includes indirect material, indirect labour and indirect expenses and the variances relate to factory, office or selling and distribution overheads. Overhead variance are divided into two broad categories : (i) Variable overhead variance and (iii) Fixed overhead variances.
a) Standard overheads rate per unit =
b) Standard overheads rate per hour =
c) Standard hours for actual output = ´Actual output
d) Standard output for actual time = ´ Actual hours
e) Recovered or Absorbed overheads = Standard rate per unit´Actual output
or
Standard rte per hour ´ Budgeted hours
f) Budgeted overheads = Standard rate per unit´ Budgeted output
or
Standard rate per hour ´ Budgeted hours
g) Standard overheads = Std. rate per unit ´ Std. output for actual time
or
Standard rate per hour ´ Actual hours
h) Actual overheads = Actual rate per unit ´ Actual output
or
Actual rate per hour ´ Actual hours
OVER HEAD COST VARIANCE
Fixed Variable
Expenditure Volume Expenditure Efficiency
Efficiency Capacity Calendar
(A) VARIABLE SOVERHEAD VARIANCE
Variable cost varies in proportion to the level of output, while the cost is fixed per unit. As such the standard cost per unit of these overheads remains the same irrespective of the level of output attained. As the volume does not affect the variable cost per unit or per hour, the only factor leading to difference is price. The variance will result because of the change in the expenditure incurred.
i) Variance Overhead expenditure Variance
Variable Overhead Expenditure Variance
= (Actual hours worked - Std. Variable Overhead rate per hour)
- Actual Variable Overheads.
ii) Variable Overhead Efficiency Variance :
It shows the effect of change in labour efficiency on variable overheads recovery.
Formula :
Variable Overhead Efficiency Varia = Std. Rate (Std. Qnty - Actual Qnty)
Standard Overhead Ra = (Std. Time for Actual - Actual Time)
iii.) Variable Overhead Variance
It is divided into two : Overhead Expenditure Variance and Overhead Efficiency Variance.
That is,
Formula :
= Variable Overhead Expenditure Variance + Variable Overhead Efficiency
Variance
OR
= (Std. variable overhea) - (Actual Variable Overhea)
(B) FIXED OVERHEAD VARIANCE
Fixed overhead variance depends on (a) fixed expenses incurred and (b) the volume of production obtained. The volume of production depends upon (i) efficiency (ii) the days for which the factory runs in a week (calendar variance) (iii) capacity of plant for production.
FOV = Actual Output (Fixed Overhead Rate - Actual Fixed Overheads)
(a) Fixed Overhead Expenditure Variance (Budgeted or cost variance): It is the portion of the fixed overhead which is incurred during a particular period due tot eh difference between the budgeted fixed overheads and the actual fixed overheads.
Fixed overhead expenditure variance
= Budgeted fixed overhead - actual fixed overhead.
(b) Fixed Overhead volume : This variance is the difference between the standard cost of overhead absorbed in actual output and the standard allowance for that output. This variance measures the over or under recovery of fixed overheads due to deviation of actual output from the budgeted output level.
i) On the basis of units of output :
Fixed overhead Volume Variance
= Standard Rate (Budgeted Output - Actual Output)
OR
= (Budgeted Cost - Standard Cost)
OR
= (Actual Output times Std. Rate) - Budgeted fixed overheads
ii.) On the basis of standard hours :
Fixed Overhead Volume Variance = Standard Rate per hour
(Budgeted Hours - Std. Hours)
Standard Hours = Actual Output + Standard Output per hour
CLASSIFICATION OF VOLUME VARIANCES
(i) Fixed Overhead Efficiency Variance :
This variance is closely related to labour efficiency variance. If the workers have been efficient, the production will be above standard as such overheads will be over-recovered. The portion of the overhead variation, which is due to the differences between the budgeted efficiency of production and the actual efficiency attained, is the efficiency variance.
Efficiency variance = Standard rate (Actual Production - Std. Production)
(or)
= Std. rate (Actual quantity - Std. quantity)
(ii) Fixed Overhead Calendar Variance :
It is the difference between the number of working days anticipated in the budget period and actual working days in the budget period. This may be the result of unexpected public holiday being declared, as such the work in the unit is stopped.
Fixed Overhead Calendar Variance
= Std. Rate per hours (day) ´ Excess of Deficit Hours of days worked
(iii) Fixed Overhead Capacity Variance
The variance which is related to the over and under-utilisation of plant or equipment is known as capacity variance. This variance arises because of the working above or below standard capacity. Strikes, idle time, lock-out etc. leads to under-utilisation, and extra shifts, overtime etc. lead to over-utilisation.
Capacity Variance = Std. Rate (Revised Budgeted Units - Budgeted Units)
(OR) = Std. Rate (Revised Budgeted Hours - Budgeted Hours)
ILLUSTRATION : From the following data, calculate overhead variances.
Budgeted
Actual
Output
15,000 units
16,000 units
Number of working days
25
28
Fixed overheads
Rs. 30,000
Rs. 30,500
Variable overhead
Rs. 45,000
Rs. 47,000
There was an increase of 5% in capacity.
Solution :
Std. Rate =
Fixed Variable
30,000 45,000
15,000 15,000
= Rs. 2.00 = Rs. 3.00
a) Variable overhead expenditure variance :
= Actual units ´ Std. rate - Actual variable Overhead cost
= (16,000´ Rs. 3) - 47,000 = Rs. 1,000(F)
b) Fixed overhead expenditure variance :
= Actual units ´ Std. rate - Actual fixed overhead cost
= 16,000 ´ Rs. 2 - 30,500
= Rs. 1,500 (F)
c) Total overhead cost variance = VOEV + FOV
= Rs. 1,000 (F) + 1,500 (F)
= Rs. 2,500 (F)
d) Volume variance= Actual units ´ Std rate -Budgeted fixed overheads
= 16,000 ´ 2 - 30,000
= Rs. 2,000 (F)
e) Expenditure variance=Budgeted fixed overheads-Actual fixed overheads
= Rs. 30,000 - Rs. 30,500
= Rs. 500 (A)
f) Capacity variance = Std. rate (revised budgeted units-budgeted units)
Revised budgeted units = budgeted units + increase in capacity
= 15,000 +
= Rs. 15,750
Capacity variance = Rs. 2 (15,750 - 15,000)
= Rs. 1,500 (F)
g) Calendar variance = Increase or decrease in production due to more or less working days ´ std rate per unit with the increase in capacity.
The std. production = 15,750
\ For 3 days (28-25) production
= ´3 = 1890 units
C.V. = 1890 ´ Rs. 2 = Rs. 3780 (F)
h) Efficiency variance = Std. rate (Actual production - Std. production)
Std. Production = 15000 units (Budgeted)
= 750 units (Capacity increased)
= units (3 days increased)
\ E.V. = Rs. 2(16,000-17,640)
= Rs. 3,280 (A)
One of the most important functions of management accounting is to facilitate managerial control. The major aspect of managerial control is cost control. The efficiency of management, among other things, depends upon the effective control of costs. For controlling costs, management should not only know actual cost- the cost actually incurred but also pre-determined costs – the cost which should have been incurred. Standards costs are the widely used form of pre-determined costs. The system of standard costing is the most efficient way to controlling costs.
Historical costs systems are principally associated with recording of historical, or as they are commonly called, actual cost. Historical costing is the ascertainment of costs after they have been incurred. No doubt, information on actual costs is useful in determining the cost of production per unit; but from the point of view of decision-making and control, actual costs are not useful to management. Actual costs are meaningful only when they are compared with pre-determined costs.
Standard costs seeks to establish the cost of a product, operations or process under standard operating conditions. The aim of standard cost is to eliminate the influenced of abnormal changes in prices. It is used a guide for future decision and action over a period of time . Standard coatings as an effective management tool for planning decision making coordination and control of business. The object of standard costs is to ascertain the quotation and determination of price policy. It is a new technique of cost control.
Standard costing is defined by I.C.M.A. Terminology as, “The preparation and use of standard costs, their comparison with actual costs and the analysis of variances to their causes and points of incidence.”
“Standard costing is a method of ascertaining the costs whereby statistics are prepared to show (a) the standard cost (b) the actual cost (c) the difference between these costs, which is termed the variance”. Thus the techniques of standard cost study comprises of :
1. Ascertainment and use of standard costs.
2. Comparison of actual costs with standard costs and measuring the variances.
3. Controlling costs by the variance analysis.
4. Reporting to management for taking proper action to maximize the efficiency.
ADVANTAGES OF STANDARD COSTING
1. It helps the management in formulating price and production policy.
2. It is a yardstick of performance. Standard costs are compared with actual costs, and the differences are analysed and effective cost control is taken. Thus reduction of cost is possible by increasing the profits.
3. It reduces avoidable wastages and losses.
4. It facilitates to reduce clerical and accounting cost and managerial time.
5. It creates cost consciousness among the personnel, because the variance analysis fixes responsibility for favourable or unfavourable performance.
6. Executives become more responsible, as it shows clearly who is responsible for the cost centres.
7. By the variance analysis and reporting, “the principle of management by exception: “the principle of management by exception” is facilitated. Management must concentrate their attention on variations only.
8. It aids in budgetary control and in decision-making.
9. Opening stock and closing stock are valued at the standard price. This helps in the preparation of Profit and Loss Account for a short period-say a week, a month etc.
10. It facilitates timely cost reports to management and a forward looking mentality is encouraged at all levels of the management. It is a basic for the implementation of an incentive system for the employees.
Standard costs form a basis for future planning, preparation of tenders, fixation of price etc. Otherwise, or in the absence of standard cost, decision will be based on actual cost. The prices of material, labour etc, may change from time to time. There must be a fixed cost structure based on normal standard efficiency. Thus it helps the management in formulating price and production policy.
When standards have been fixed, the section-heads safely delegate the responsibility to the workers. The standard of activity can be measured through the costing reports.
Introduction of standard cost facilitates timely reporting. The management gives attention to the variances and takes corrective steps. The costing reports, based on standard cost, reveal the overall result of the manufacturing side.
LIMITATIONS OF STANDARD COSTING
1. It is costly, as the setting of standards needs technical skill.
2. Keeping of up-to-date standard is a problem. Periodic revision of standard is a costly thing.
3. Inefficient staff is incapable of operating this system.
4. Since it is difficult to set correct standards, it is difficult to ascertain correct variance.
5. Industries, which are subject to frequent changes in technological process or the quality of material or the character of labour, need a constant revision of standard. But revision of standard is more expensive.
6. For small concerns, standard costing is expensive.
7. It is difficult to apply this method where production takes more than one accounting period. Standard c may not be effective in industries which deal in non-standardised products or jobs according to customer’s requirements.
SETTING THE STANDARD
While setting standard cost for operations, process or products, the following preliminaries must be gone through :
1. There must be Standard Committee, similar to Budget Committee, in which Purchase Manger, Personnel Manager, and Production Manager are represented. The Cost Accountant coordinates the functions of the Standard Committee.
2. Study the existing costing system, cost records and forms in use. If necessary, review the existing system.
3. A technical survey of the existing methods of production should be undertaken so that accurate and reliable standard can be established.
4. Determine the type of standard to be used.
5. Fix standard for each element of cost.
6. Determine standard costs for each product.
7. Fix the responsibility for setting standards.
8. Classify the accounts properly so that variances may be accounted for in the manner desired.
9. Comparison of actual costs with pre-determined standards to ascertain the deviations.
10. Action to be taken by management to ensure that adverse variances are not repeated.
The most significant contribution of standard costing to the science and art of management is the presentation of ‘variances’. As a matter of act, without determination and analysis of variances, standard costing is meaningless. The term ‘Variance’ has been derived from the verb ‘To vary’ meaning to differ. In cost accounting, variance means deviation of the actual cost from the standard cost. In standard costing, standard costs are pre-determined and refer to the amounts which ought to be incurred. These become the yardsticks against which actual costs can be compared.
That is, variance analysis is a tool to measure performances and based on the principle of management by exception.
After the standard costs have been fixed, the next stage in the operation of standard costing is to ascertain the actual cost of each element and compare them with the standard already set. Computation and analysis of variances is the main objective of standard costing. The deviation of actual from the standard is called ‘variance’.
FAVOURABLE AND UNFAVOURABLE VARIANCES
Variances may be favourable (positive or credit) or unfavourable (or negative or adverse or debit) depending upon whether the actual resulting cost is less or more than the standard cost.
Favourable variance : When the actual cost incurred is less than the standard cost, the deviation is known as favourable variance. The effect of the favourable variance increases the profit. Again, favourable variance would result when the actual cost is lower than the standard cost. It is also known as positive or credit variance and viewed only as savings.
Unfavourable variance : When the actual cost incurred is more than the standard cost, there is a variance, known as unfavourable or adverse variance. Unfavourable variance refers to deviation to the loss of business. It is also known as negative or debit variance and viewed as additional costs or losses.
When the profit is greater than the standard profit, it is known as favourable variance. When the profit is less than the standard profit, it is known as unfavourable variance. This favourable variance is a sign or efficiency of the organization and the unfavourable variance is a sign of inefficiency of the organization.
CALCULATION & ANALYSIS OF VARIANCE
Analysis of variance is a an important and crucial part of standard costing. Calculation of variance indicates a management whether a cost are under control or not. By knowing favourable & unfavourable variances, the management can decide whether a process are under a not and identity those areas where remedial action need to be taken.
VARIANCE CAN BE SUDIVIDED IN THE FOLLOWING CATEGORY:
1. Material cost variance
2. Labour or wage variance
3. Overhead cost variance
4. Sales variance
I. MATERIAL COST VARIANCE
It is a difference between a standard cost of a material and actual cost of the material used. It is important to study this variance in crde to know a difference between a actual & standard cost of material used. It produce a particular product. It may be favourable if a actual cost is less than a standard cost. It will be unfavourable & actual cost is more than the standard cost.
MCV = (SP ´ SQ) - (AQ ´ AP)
Where SQ = Standard Qty.
SP = Standard Price
AQ = Actual Qty.
AP = Actual price
The following are the variance in the case of materials :
Materials Variances (Diagrammatic representation)
MATERIAL COST VARIANCE (OR) MCV
(SQ´SP) - (AQ´AP)
MATERIAL PRICE VARIANCE MATERIAL USAGE VARIANCE
(OR) MPV (OR) MUV
AQ (SR-AR) SR(SQ-AQ)
MATERIAL MIX VARIANCE MATERIAL YIELD VARIANCE
(OR) MMV (OR) MYV
SR(SQ-AQ) OR SR (RSQ-AQ) SR (AY-SY)
MCV = MPV + MUV
MUV = MMV + MYV
MCV = MPV + MMV + MYV
ILLUSTRATION 1: The standard material and standard cost per Kg. of material required for the production of one unit of product A is as follows :
Material : 5 Kg.
The actual production and related material data are as follows :
400 units of product A
Material used 2,200 Kgs.
Price of material Rs. 4.50 per Kg.
Calculate Material cost variance.
Solution :
Material cost variance : (SQ´SP)-(AQ´AP)
SQ refers to standard quantity for action production.
Standard quantity for actual production of 400 units = 400´5 = 2,000 Kgs.
MCV = (2,000 ´ Rs. 5) - (2,200 ´ Rs. 4.50)
= Rs. 10,000 - Rs. 9,900
= Rs. 100 (F)
This is the responsibility of the purchase manager. Material price variance is that portion of the direct material cost variance which is the difference between the standard price specified and the actual price paid for the direct materials used. The formula is :
Direct material price variance =(Actual quantity consumed ´ Standard price)
-(Actual quantity consumed ´ Actual price)
or
Actual quantity consumed (Standard Rate - Actual Rate)
MPV = AQ(SR-AR)
A favourable variance arises if the actual price is less than the standard price and vice versa.
The reasons for direct material price variances are :
1. Fluctuations in market price.
2. Non-availability of standard quality
3. Using cheaper materials or substitute
4. Inefficiency in buying
5. High cost of transportation and carriage of goods
6. Loss of discount and fraud in purchases.
7. Changes in price policies
8. Emergency purchase leading to higher price
9. Government interferences leading to rise in prices
10. Incorrect setting of standard
11. Untimely purchase
12. Loss in transit, in excess of normal loss
13. Unexpected additional cost
14. Failure to enter into forward contract
ILLUSTRATION 2 : The standard cost of a material for manufacturing a unit of particular product is estimated as follows :
20 Kg. of raw materials @ Rs. 2 per kg.
On completion of the unit, it was found that 25 Kg. of raw material costing Rs. 3 per kg. has been consumed.
Solution :
MPV = AQ(SR-AR)
= 25 (Rs. 2 - Rs.3)
= 25 ´ (Re -1)
= - 25 or Rs. 25 (Adverse)
Variance : It is the deviation caused by the standards due to difference in quantity used. It is calculated by multiplying the difference between the standard quantity specified and the actual quantity used by the standard price.
Thus material usage variance is “that portion of the direct materials cost variance which is the difference between the standard quantity specified for the production achieved, whether completed or not, and the actual quantity used, both valued at standard prices.”
Material Usage or Quantity Variance
= Standard Rate (Standard Quantity - Actual Quantity)
(OR)
MUV = SR (SR - AQ)
The reasons for usage variance are :
1. Careless handling of materials;
2. Wastages, scarp, spoilage etc. due to inefficient production method or unskilled employees;
3. Change in design or specifications of product;
4. Use of inferior materials;
5. Defective equipment and tools;
6. Non- standard material used;
7. Accounting errors;
8. Setting of proper standards;
9. Improper inspection;
10. Non-standard substitutes used;
11. Theft of materials;
12. Difference between actual yield from materials and standard yield.
13. Lack of proper tools and machines.
ILLUSTRATION 3 : From the following data calculate material usage variance :
Standard 20 Kg. at Rs. 5.50 per kg.
Actual 25 Kg. at Rs. 6 per kg.
Solution :
MUV = SR(SQ-AQ)
= Rs. 5.50 (20-25)
= Rs. 5.50 (-5)
= Rs. -27.50 or Rs. 27.50 (Adverse)
When two or more materials are used in the manufacture of a product, the difference between the standard composition and the actual composition of material mix is the Material mix variance. The variance arises due to the actual composition of material and the standard ratio. The formula is :
Direct material mix variance = Standard Rate (Standard mix - Actual Mix)
i.) When actual weight of mix and standard weight of mix are the same
DMMV = Standard Rate (Standard quantity - Actual quantity)
or SR (SQ-AQ)
Standard is revised due to the shortage of a particular type of material.
The formula is :
MMV = Standard Rate (Revised standard quantity - Actual quantity)
Revised standard quantity
= ´ Standard quantity
Material Mix Variance :
Here, the actual weight of mix and standard weight of mix differ from each other therefore,
MMV = Standard Rate (Revised Standard Quantity - Actual Quantity)
Here, the revised standard quantity formula :
´ Standard Quantity
RSQ for material A = ´ 40 = 44 units
B = ´ 60 = 66 units
Then,
MMV = Standard Rate (Revised Standard Quantity- Actual Quantity)
= SR (RSQ - AQ)
Material A : 50(44-50) = Rs. 300 (Adverse)
B : 40(60-66) = Rs. 240 (Favourable)
-----------
Rs. 60 (Adverse)
Revised material usage variance
= Standard Rate (Standard Quantity -Revised Standard Quantity)
Material A : Rs. 50 (40-44) = 200 (Adverse)
B : Rs. 40 (60-66) = 240 (Adverse)
-----------
Rs. 440 (A)
Material Cost Variance :
Material : MCV = (SQ´SP) -(AQ´AP)
A = (40´50)-(50´50) = 500 (A)
B = (60´40)-(60´45) =300 (A)
-----------
Rs. 800 (A)
MCV = MPV + MUV
Rs. 800 (A) = Rs. 300 (A) + Rs. 500 (A)
MUV = RUV + NMV
Rs. 500 (a) = Rs. 440 (A) + Rs. 60(A)
Direct Material Yield Variance :
It is that portion of the direct material usage variance which is the due to the difference between the standard yield specified and the actual yield obtained.
i) When actual mix and standard mix are the same the formula is :
MYV = Standard Yield Rate ( Standard Yield - Actual Yield)
(Or) = Standard Revised Rate (Actual Loss - Standard Loss)
Here Standard Yield Rate =
Net Standard Output = Gross Output - Standard Loss
ii.) When the actual mix and the standard mix differ from each other, the formula is :
Standard Rate =
Material Yield Variance
= Standard Rate (Actual Standard Yield - Revised Standard Yield)
ILLUSTRATION : The standard material cost for 100 kg of chemical D is made up of :
Chemical A - 30 kg. @ Rs. 4 per kg.
Chemical B - 40 kg. @ Rs. 5 per kg.
Chemical C - 80 kg. @ Rs. 6 per kg.
In a batch, 500 kg of chemical D where produced from a mix of
Chemical A - 140 kg. at a cost of Rs. 588
Chemical B - 220 kg at a cost of Rs. 1,056
Chemical C - 440 kg. at a cost of Rs. 2,860
How do you yield, mix and the price factor contribute to the variance in the actual per 100 kg of chemical D over the standard cost?
Solution :
MCV Rs.
Rs. 100.80(A)
MPV (Rs. 40.80)(A) MUV (Rs.60)(A)
MMV (Rs. 6.67)(A) MYV (Rs. 53.33)(A)
We have to find out the variance only for 100 kg of output. Therefore, the date required is calculated as follows :
Chemical A : Rate = = Rs. 4.20 per kg
Chemical B : Rate = = Rs. 4.80 per kg.
Chemical C : Rate = = Rs. 6.50 per kg
Chemical D (500 kg) the chemical A is 140 kg.
\ 100 kg of chemical D, the required :
Chemical A is = 28 kg.
Chemical B is = 44 kg.
Chemical C is = 88 kg.
(a) Material Cost Variance :
(SQ ´SP)-(AQ-AP)
Chemical A = (30´Rs.4)-(28´Rs. 4.20)= Rs. 2.40 (F)
Chemical B = (40´Rs.5)-(44´Rs. 4.80)= Rs.11.20 (A)
Chemical B = (80´Rs.6)-(88´Rs. 6.50)= Rs 92.00 (A)
--------------------
Total MCV = Rs. 100.80(A)
--------------------
(b) Material Price Variance :
AQ (SP - AP)
Chemical A = 28 (4-4.20) =Rs. 5.60 (A)
Chemical B = 44 (5-4.80) =Rs. 8.80 (F)
Chemical C = 88 (6-6.50) =Rs. 44.00 (A)
-------------------
Total MPV =Rs. 40.80 (A)
(c) Material Usage Variance :
SP(SQ-AQ)
Chemical A : 4(30-28) = Rs. 8(F)
Chemical B : 5(40-44) = Rs. 20(A)
Chemical C : 6(80-88) = Rs. 48(A)
------------
Total MUV = Rs. 60(A)
(d) Material Mix Variance :
SP (RSQ-AQ)
The actual quantity of 160 kg to be apportioned in the standard proportion, i.e., 30:40:80
Chemical A is = 32 kg.
Chemical B is = 42 kg.
Chemical C is = 85 kg.
MMV = SP(RSQ-AQ)
For Chemical A : 4(32-28) = Rs. 16.00(F)
Chemical B : 5(42-44) = Rs. 6.67(A)
Chemical C : 6(85-88) = Rs. 16.00(A)
-----------------
Total MMV = Rs. 6.67(A)
e) Material Yield Variance
Average standard price = = = Rs. 8
150 kg. mix will produce 100 kg.
\ 160 kg. of mix will produce = = 106 kg.
MYV = Average standard price (Actual Production - Standard Production)
= Rs. 8(100 Kgs-106 Kgs.)
= Rs. 8 (6) = Rs. 53.33(A)
II. LABOUR VARAINCES
Labour variances arise because of (i) difference in actual rates and standard rates of labour and (ii) the variation in action time taken by workers and the standard time allotted to them for performing a job. The various variances can be analysed as follows :
A. Labour Cost Variance
B. Labour Rate Variance
C. Labour Time or Efficiency Variance
D. Labour Idle Time Variance
E. Labour Mix Variance or Gang Composition Variance
The second important element of cost is labour. The management keeps a close watch on the labour cost in order to keep the cost of production low. The various labour variances are :
When one type of labour is employed :
LABOURT COST VARIANCE
(ST ´ SR) - (AT ´ AR)
Rate Variance Either
AT (SR-AR) Total Efficiency Variance
SR (ST - AT)
or
Yield Variance
Total efficiency variance may be sub-divided into two :
TOTAL EFFICIENCY VARIANCE
SR(ST-AT)
Idle time either
(SR ´IT) SR(ST-AT)
AT means less idle time
(or)
Yield variance
when different grades of labour are employed :
LABOUR COST VARIANCE
Rate Variance Total efficiency variance
AT (SR-AR) SR(ST-AT)
Mix Variance (Gang Composition) either
SR (RST AT) (or)
Yield variance
Total efficiency many be sub-divided into three, when idle time variance is also to be calculated :
TOTAL EFFICIECNCY VARIANCE
SR (ST-AT)
Idle time variance Mix variance either
SR ´ IT SR (RST-AT) SR(SR-rst)
LCV = LRV + LEV
LEV = LMV + LYV + LITV
(a) Labour Cost Variance or Labour Wage Variance
This variance represents the difference between the standard labour costs and the actual labour costs. That is, it is the difference between standard direct wages specified for the activity achieved and the actual direct wages paid.
Labour Cost Variance = Standard Cost of Labour - Actual Cost of Labour
= (Standard Time´ Standard Rate)-(Actual Time´Actual Rate)
= (ST´SR)-(AT´AR)
(b) Labour or Wage Rate Variance
This variance is the direct result of the wages paid at a rate different from the standard rated. That is, it is the different between the standard rate of pay specified and the actual rate paid.
Labour Rate
=Actual Time (Standard Wage Rage´Actual Wage Rate Variance )
= AT (SR-AR)
The reasons for wage rate variance :
1. Changes in basic wage rates.
2. Overtime work at higher or lower than standard rate.
3. Faulty recruitment.
4. Overtime work at higher or lower than specified hours.
5. Change in composition of gang at a different rate from standard.
6. Higher or lower rate paid to causal labourers.
7. Improper planning of overtime or bonus.
8. General rise in wages.
9. Wrong setting of standard rates of labour.
10. Higher wages paid because of urgent work.
(c) Labour Time or Labour Efficiency Variance
The terminology defines Labour Efficiency V as “the difference between the standard hours for the actual production achieved and the hours actually worked, valued at the standard labour rate.
Labour Efficiency Variance = Standard Rate (Standard Time -Actual Time)
= SR (SR-AT)
Favourable Factors
1. Strict supervision
2. Use of good quality materials.
3. Low labour turnover rate
4. High morale of workers
5. Proper working condition
6. Improved tools and machines
7. Good incentives
8. Worker’s co-operation
9. Right man at right work
10. Employment of skilled workers.
Unfavourable Factors
1. Improper training to employees
2. Inadequate supervision
3. Low employee morale
4. More idle time than normal
5. Incorrect instruction
6. Engaging new or unskilled workers
7. Workers’ dissatisfaction
8. Defective machinery
9. High labour turnover rate
10. Bad working condition
11. Failure of power supply
12. Use of sub-standard materials
13. Delay due to waiting for materials
14. Fixation of incorrect standard
15. Lack of co-operation
(d) Idle Time Variance
This type of variance arises because of the time during which the labour remains idle due to abnormal reasons, i.e., power failure, strikes, machine breakdown, shortage of materials etc.
Labour Idle Time Variance = Abnormal Idle Time ´ Standard Hourly Rate
(e) Labour Mix Variance or Gang Composition Variance
It results from employing different grades of labour from the standard fixed in advance. It is the difference between the standard composition of workers and the actual gang of workers.
i. When the total hours i.e. time of the standard composition and actual composition of workers do not differ, the formula is :
Mix = (Standard Cost of Standard Mix)-(Standard Cost of Actual Mix)
Variance
ii. When the total hours i.e. time of the standard composition and actual composition of workers differ, the formula is :
Labour Mix Variance
= -(Std.Costof ActualMix)
(f) Labour Yield Variance
It is the difference between the standard labour output and actual output or yield. It is calculated as below :
Labour Yield Variance
= Std. Cost per unit (Std. Production of Actual Mix - Actual Production)
If the actual production is more than standard production, it would result in a favourable variance and vice versa.
Relationship
a. Labour cost variance = Labour rate variance + Labour efficiency variance
b. Labour efficiency variance = Labour mix variance + Idle time variance
c. Labour efficiency variance = Labour yield variance +Idle time variance
d. Efficiency variance = Labour mix variance + yield variance + Idle time variance
ILLUSTRATIION : With the help of following information calculate
a. Labour cost variance
b. Labour rate variance
c. Labour efficiency variance
Standard hours : 40 @ Rs. 3 per hour
Actual hours : 50 @ Rs. 4 per hour
Solution :
a. Labour cost variance = (Std. time´ Std. rate)-(Actual time ´Actual rate)
= (40´ Rs.3)- (50´Rs. 4)
= Rs. 120-200 = Rs. -80
= Rs.80 (Adverse)
b. Labour rate variance = Actual Time (Std. rate -Actual rate)
= 50 (Rs. 3- Rs. 4) = Rs. -50
= Rs. 50 (Adverse)
c. Labour efficiency variance = Std. Rate (Std. time - Actual time)
= Rs. 3(40-50) = Rs. -30
= Rs. 30 (Adverse)
ILLUSTRATION : Using the following information, calculate the labour variance :
Direct wages : Rs. 3,000
Standard hours produced : 1,600
Standard rate per hour : 1.50
Actual hours paid 1,500 hours, out of which hours not worked (abnormal idle time) are 50.
Solution :
a) Labour Cost Variance
= (Std. time ´ Std. rate) -(Actual time ´Actual rate)
= (1,600´Rs. 1.50) -(1,500´Rs.2)
= Rs. 2,400 - Rs. 3,000
= Rs. 600 (Adverse)
b) Labour Rate Variance
= Actual time (Std. rate -Actual rate)
= 1,500 (Rs. 1.50 -2.00)
= 1500 (-Rs. .50) = - Rs. 750
= Rs. 750 (Adverse)
c) Labour Efficiency Variance
= Std. rate (Std. time - Actual time)
Actual time = Actual hour paid - Abnormal idle time
= 1,500 - 50 = 1,450
LEV = Rs. 1.50 (1,600-1,450)
= Rs. 1.50´150
= Rs. 225 (Favourable)
d) Idle time variance
= Idle time ´ Standard hourly rate
= 50 ´ Rs. 1.50
= Rs. 75(A)
III. OVERHEAD VARIANCE
Overhead variance is “the difference between the standard cost of overhead absorbed in the actual output achieved and the actual overhead cost”. The term overhead includes indirect material, indirect labour and indirect expenses and the variances relate to factory, office or selling and distribution overheads. Overhead variance are divided into two broad categories : (i) Variable overhead variance and (iii) Fixed overhead variances.
a) Standard overheads rate per unit =
b) Standard overheads rate per hour =
c) Standard hours for actual output = ´Actual output
d) Standard output for actual time = ´ Actual hours
e) Recovered or Absorbed overheads = Standard rate per unit´Actual output
or
Standard rte per hour ´ Budgeted hours
f) Budgeted overheads = Standard rate per unit´ Budgeted output
or
Standard rate per hour ´ Budgeted hours
g) Standard overheads = Std. rate per unit ´ Std. output for actual time
or
Standard rate per hour ´ Actual hours
h) Actual overheads = Actual rate per unit ´ Actual output
or
Actual rate per hour ´ Actual hours
OVER HEAD COST VARIANCE
Fixed Variable
Expenditure Volume Expenditure Efficiency
Efficiency Capacity Calendar
(A) VARIABLE SOVERHEAD VARIANCE
Variable cost varies in proportion to the level of output, while the cost is fixed per unit. As such the standard cost per unit of these overheads remains the same irrespective of the level of output attained. As the volume does not affect the variable cost per unit or per hour, the only factor leading to difference is price. The variance will result because of the change in the expenditure incurred.
i) Variance Overhead expenditure Variance
Variable Overhead Expenditure Variance
= (Actual hours worked - Std. Variable Overhead rate per hour)
- Actual Variable Overheads.
ii) Variable Overhead Efficiency Variance :
It shows the effect of change in labour efficiency on variable overheads recovery.
Formula :
Variable Overhead Efficiency Varia = Std. Rate (Std. Qnty - Actual Qnty)
Standard Overhead Ra = (Std. Time for Actual - Actual Time)
iii.) Variable Overhead Variance
It is divided into two : Overhead Expenditure Variance and Overhead Efficiency Variance.
That is,
Formula :
= Variable Overhead Expenditure Variance + Variable Overhead Efficiency
Variance
OR
= (Std. variable overhea) - (Actual Variable Overhea)
(B) FIXED OVERHEAD VARIANCE
Fixed overhead variance depends on (a) fixed expenses incurred and (b) the volume of production obtained. The volume of production depends upon (i) efficiency (ii) the days for which the factory runs in a week (calendar variance) (iii) capacity of plant for production.
FOV = Actual Output (Fixed Overhead Rate - Actual Fixed Overheads)
(a) Fixed Overhead Expenditure Variance (Budgeted or cost variance): It is the portion of the fixed overhead which is incurred during a particular period due tot eh difference between the budgeted fixed overheads and the actual fixed overheads.
Fixed overhead expenditure variance
= Budgeted fixed overhead - actual fixed overhead.
(b) Fixed Overhead volume : This variance is the difference between the standard cost of overhead absorbed in actual output and the standard allowance for that output. This variance measures the over or under recovery of fixed overheads due to deviation of actual output from the budgeted output level.
i) On the basis of units of output :
Fixed overhead Volume Variance
= Standard Rate (Budgeted Output - Actual Output)
OR
= (Budgeted Cost - Standard Cost)
OR
= (Actual Output times Std. Rate) - Budgeted fixed overheads
ii.) On the basis of standard hours :
Fixed Overhead Volume Variance = Standard Rate per hour
(Budgeted Hours - Std. Hours)
Standard Hours = Actual Output + Standard Output per hour
CLASSIFICATION OF VOLUME VARIANCES
(i) Fixed Overhead Efficiency Variance :
This variance is closely related to labour efficiency variance. If the workers have been efficient, the production will be above standard as such overheads will be over-recovered. The portion of the overhead variation, which is due to the differences between the budgeted efficiency of production and the actual efficiency attained, is the efficiency variance.
Efficiency variance = Standard rate (Actual Production - Std. Production)
(or)
= Std. rate (Actual quantity - Std. quantity)
(ii) Fixed Overhead Calendar Variance :
It is the difference between the number of working days anticipated in the budget period and actual working days in the budget period. This may be the result of unexpected public holiday being declared, as such the work in the unit is stopped.
Fixed Overhead Calendar Variance
= Std. Rate per hours (day) ´ Excess of Deficit Hours of days worked
(iii) Fixed Overhead Capacity Variance
The variance which is related to the over and under-utilisation of plant or equipment is known as capacity variance. This variance arises because of the working above or below standard capacity. Strikes, idle time, lock-out etc. leads to under-utilisation, and extra shifts, overtime etc. lead to over-utilisation.
Capacity Variance = Std. Rate (Revised Budgeted Units - Budgeted Units)
(OR) = Std. Rate (Revised Budgeted Hours - Budgeted Hours)
ILLUSTRATION : From the following data, calculate overhead variances.
Budgeted
Actual
Output
15,000 units
16,000 units
Number of working days
25
28
Fixed overheads
Rs. 30,000
Rs. 30,500
Variable overhead
Rs. 45,000
Rs. 47,000
There was an increase of 5% in capacity.
Solution :
Std. Rate =
Fixed Variable
30,000 45,000
15,000 15,000
= Rs. 2.00 = Rs. 3.00
a) Variable overhead expenditure variance :
= Actual units ´ Std. rate - Actual variable Overhead cost
= (16,000´ Rs. 3) - 47,000 = Rs. 1,000(F)
b) Fixed overhead expenditure variance :
= Actual units ´ Std. rate - Actual fixed overhead cost
= 16,000 ´ Rs. 2 - 30,500
= Rs. 1,500 (F)
c) Total overhead cost variance = VOEV + FOV
= Rs. 1,000 (F) + 1,500 (F)
= Rs. 2,500 (F)
d) Volume variance= Actual units ´ Std rate -Budgeted fixed overheads
= 16,000 ´ 2 - 30,000
= Rs. 2,000 (F)
e) Expenditure variance=Budgeted fixed overheads-Actual fixed overheads
= Rs. 30,000 - Rs. 30,500
= Rs. 500 (A)
f) Capacity variance = Std. rate (revised budgeted units-budgeted units)
Revised budgeted units = budgeted units + increase in capacity
= 15,000 +
= Rs. 15,750
Capacity variance = Rs. 2 (15,750 - 15,000)
= Rs. 1,500 (F)
g) Calendar variance = Increase or decrease in production due to more or less working days ´ std rate per unit with the increase in capacity.
The std. production = 15,750
\ For 3 days (28-25) production
= ´3 = 1890 units
C.V. = 1890 ´ Rs. 2 = Rs. 3780 (F)
h) Efficiency variance = Std. rate (Actual production - Std. production)
Std. Production = 15000 units (Budgeted)
= 750 units (Capacity increased)
= units (3 days increased)
\ E.V. = Rs. 2(16,000-17,640)
= Rs. 3,280 (A)
Notes: UNIT – 2
UNIT - 2
Objective:
To enable the students to analyze and understand cost dynamics with the help of various cost analyses and their implementation in future decision making.
UNIT OVERVIEW
Topics covered: Marginal Costing: Cost, Volume analysis Profit analysis, P/v ratio: analysis and implications, Concept and uses of Contribution, Break-even point and its analysis for the various types of decision-making, Single Product Pricing, Multi Product Pricing, Replacement, sales analysis. Differential costing and Incremental costing: (concepts), Uses and applications of differential costing. Method of calculation of above cost concept and its role in management decision making.
MARGINAL COSTING
INTRODUCTION
Marginal cost means same things as variable cost. Economists define marginal cost as the additional cost of producing one additional unit. This shall include fixed cost and variable cost while for the purpose of accounting Marginal Costing does not include fixed cost. The education of marginal cost is as follows.
Marginal Cost = Prime cost + Total Variable over heads
Marginal Cost = Total cost – Fixed cost
ICWA has defined Marginal Costing as – “The ascertainment by differentiating between fixed cost and variable cost of Marginal Costing and of the effect of the change in the volume type of output.”
According to Batty.
“A technique of cost accounting, Which pays special attention to the behaviour of the cost with the changes in the volume of output.”
COMPARISON BETWEEN MARGINAL COSTING AND
ABSORPTION COSTING / FULL COSTING
Absorption cost is a practice of charging all costs both fixed and variable to the operations process and products while Marginal Costing, only variable cost are charged to the production.
Absorption Costing also known as full costing and includes all type of cost, overheads, setting & distribution charges and other factory burden.
The major difference between Marginal Costing & absorption costing is that absorption costing does not reveal the cost volume profit relationship.
While Marginal Costing shows cost volume profit relationship. which is an important tool for decision – making by managers.
ADVANTAGES OF MARGINAL COSTING
1. To decide how much to produce
With the help of marginal costing we can decide the optimum output for a running concern the organisation can calculate the local of production at which it will achieve its break even and above that output level it will earn profits. The organisation can also decide the level of output for a particular amount of profits. Thus marginal costing can help the organisation to maximize the profits and also to plan the profit for future.
2. To decide what to produce
With the help of marginal costing a company can decide the optimum makes of the product. Any company which is dealing in more than one product can divide the quantity of different products to be manufactured by existing facilities. The relative profitability will be a guiding factor for the organisation to decide what to produce.
3. To decide whether to produce
There decisions are concerned with make or buy decisions by company marginal cost of producing of a product with the out sourcing cost the organisation can take such decision effectively.
4. To decide how to produce
When a product can be manufactured by more than one method, with the help of marginal cost of each method the most effective and efficient method can be decided by the organisation. Such decisions can also be taken for those products which can be manufactured manually or by the help of machines.
5. To decide when to produce
By examining the marginal cost structure at different periods of time the organisation can decide when a product can be manufactured most effectively and efficiently.
6. To decide at what cost to produce
With the help or marginal costing the organisation can decide at what cost the product must be manufactured. This decision is important for those organizations which are dealing in many products with different profitability and manufacturing in more than one plant having different levels of efficiency. The organisation can decide which product should be manufactured in which plant so as to achieve desired level of cost. Other decisions of such nature can be-
(a) How to control the cost against set standards.
(b) How to inventory should be valued.
(c) The plant should be owned by the company or it must be taking on lease.
DISADVANTAGES OF MARGINAL COSTING
1. No Consideration for fixed cost
The Quality decisions can only be taken when all types of cost are considered for valuation of production cost as Marginal costing does not take fixed cost separately for the purpose of analysis. The Quality decision can not be taken with out taken the fixed cost.
2. Classification in to fixed and variable cost is a difficult take
In case of semi-variable and semi-fixed cost it is difficult to deride whether there cost should be taken fixed or variable cost because such cost are partly fixed and partly variable.
COST VOLUME PROFIT ANALYSIS (CVP)
CVP analysis includes three variables namely-
1- Cost, 2- Volume 3- Profit
In this analysis, an attempt is made is to measure the variations of the cost and profit with volume. It helps the management in profit planning. How to maximize the profit is the general concern for the organisation. By defining the relationship between the cost and volume the profit planning for future can be possible and can guide the organisation to achieve its profit maximization objective.
In the profit planning, CVP analysis provides information about the following matters.
1- Behaviour of cost in relation to volume.
2- The volume of production or sales where the business will achieve its break-
even point.
3- Sensitivity of profit due to variations of output.
4- Amount of profit for the projected sales volume.
5- Quantity of production & sales for a target profit level.
To know the CVP relationship the study of the following concepts is necessary-
1. Contribution – Contribution is the difference between sales and marginal cost of sales. It is necessary to know the contribution for the ascertainment or break-even point, PV ratio and margin of safety.
C = Sales – Marginal Cost
C= S –VC
This equation is also known as marginal cost equation and can be used for further analysis.
C= F.C + Profit. (л)
2. Break – Even Analysis – It is a tool of financial analysis where by the impact on profit of the changes in the volume, price, cost and mix can be estimated with accuracy. Break even point is a balancing point of no profit loss. In other words, it is the point where total sales are equal to total cost.
BEP à Sales = F.C + V.C
BEP = Sales x Quantity sold = F.C + V.C x Q
Sales x Q – VC x Q = FC
Q (Sales – VC) = FC
Q x C = FC
BEP =FC
Q x C or contribution per unit
- If the price of the product is reduced in the market then in order to achieve the same BEP? Have to produce more.
- If the market of product is increase in the market then in order to achieve the same BEP. We can reduce our production.
3. Profit volume ratio – PV ration is also knows as contribution sales ratio and expresses the relationship of the contribution to the sales. It is generally expressed as the percentage and indicates the relative profitability of different products.
The management can emphasize upon maximization of profits by the help of PV ratio, which can indicate. What should be done-
1- Whether to increase Sales price.
2- Whether to decrease variable cost.
3- or to produce those products which are having higher PV. ratio.
Margin of safety
Margin of safety is the excess of normal or actual sales over Break even point. The margin of safety refers to the amount by which the sales or revenues can fall before a loss is incurred. High margin of safety indicates the soundness of the business because even with Substantial fall in the sales. Some profit shall be made while small margin of safety is the indicator of weak position of the business and even a small reduction in the sale or production adversely affect the profit position of the business.
APPLICATIONS OF MARGINAL COSTING TECHNIQUES
1-Cost Control
2-Fixation of selling price.
3-Closure of department or discontinuing the product.
4-Selection of a profitable product mix.
5- Profit planning.
6-Decision to make or buy.
7-Decision to accept a bulk order.
8-Introduction of a new product.
9-Choice of a technique.
10-Evaluation of performance.
11-Decision – making.
12-Maintaining a desired level of profit.
13-Level of activity planning.
14-Alternative methods of production.
15-Introduction of product line.
1. Cost Control
It is one of the major concerned for the organisation in this era of competition. There are 2 types of cost variable cost and fixed cost. Fixed cost being the non controllable cost are not considered by marginal costing while variable cost are controllable in nature and controlled by operational level management the main emphasis of cost control in on controlling variable cost because these can be of the organisations.
Here the marginal costing provides a frame work to the operational managers to control the cost by the help of various analysis and controlling techniques.
2. Fixation of selling price
The selling price must be fixed above the total cost of a particulars product any organisation knowin its fixed cost and profits (expected profit) can deside the selling price of its products. (the organisation needs to consider both internal and external factors before desiding the sales price.
3. Closure of Department
Marginal costing techniques can be used to decide about discontinuing of product or closure of a department the above example shows that to deride about discontinuing a product the organisation should evaluate the contribution of each product and total contribution before and after discontinuing a specific product. Fixed cost being uncontrollable in nature will not change even after discontinuing a product. If the organisation discontinue product c. as it is giving 5000 Rs net loss the organisation total profit will decline from 1,000 Rs. Profit to 4,000 Rs loss. If the organisation discontinues product A. its net profit are increasing from Rs. 1,000 to profit to Rs. 2000 profit.
In other words, we can say if the organisation discontinues product c. it earns Rs. 11,000 as total contribution for covering its fixed cost while If organisation discontinues product A. it has 17,000 total contribution to cover its fixed cost and earning reasonable amount of profit (fixed cost is Rs. 15,000 and will not change with discontinuing any product.
4. Selection of a profitable product mix
Sometimes an organisation is involved in manufacturing and distributing more than one product, the management has to deride about the product mix or sales mix which can maximize the profits for the organisation marginal cost can provide a strong basis for such decision by calculating total contribution of each alternative product mix.
The above example shows the organisation should choose 3rd product mix of 2000 of product A and 1000 units of product B. The decision is taking on the basis of total contribution of all available alternatives, which are 15,000 for alternative First Rs. 16500 for alternative Second and Rs. 18000 for alternative three. Thus the alternative with maximum contribution which will result in maximum profit should be chosen as must profitable product mix.
5. Profit Planning
Profit planning is one of the most important decision and should be done Keeping in mind the cost structure of different products of the organisation. If an organisation is knowing the contribution of its product it can planned for the profits from a particular level of sales and similarly it can plan for sales for a particular level of profits.
6. Decision to make or Buy
It may be happened that the organisation is producing a product which is a combination of many parts or sub parts. The organisation can produce all sub components or if possible it can purchase there sub components from other organizations. If it finds cost saving. When it buy the finished sub components Sub decisions are called make or buy component.
Eg. – A radio manufacturing company finds that a component cost Rs. 6.25 when it manufactures it inside the plant where as the same component is available at Rs. 5.50 from outside the company suggest the organisation buy or manufacture the product. If the cost structure of manufacture that product is as follows-
7. Decision to accept a bulk order
Large Scale purchasers may demand the product at lower cost than the market price – a decision has to be taken by the organisation whether to accept lower cost order or not. Such decisions can be taken by compairing the profit situation before and after accepting the large scale order.
Eg. – A company is running at 50% of its capacity and manufacturing 20,000 units of products A the cost structure of the product is as follows –
S.P. -Rs. 7
Material cost -Rs. 2/ unit
Labour -Rs. 1/ unit
Variable over heads -Rs. 3/ unit
F.C. - Rs. 40,000
Suggest the organisation whether it should accept a bulk order of 5000 units at Rs. 6.50/unit
8. Introduction of a new product
It is a crucial decision and must be taken keeping in mind both internal and external factors. As for as internal factors are concerned it includes market demand taste? Preferences of customers and customer response to the product while among the external factor the cost of product is major contributor for deciding which product should be produced.
Among the internal factors the cost of resources manufacturing a particular product is taken in to account for making & effective relation to be launched in the market.
In other words the organisation should choose those products, which gives the maximum contribution towards the fixed cost and Profits to the organisation.
9-Choice of a technique
The main concern of manufacturing organisation is to achieve efficiency in operations and every management wishes to manufactures the product in the most economical way for this marginal costing is a good technique to decide about the most effective and efficient technique to manufacture a particular product for this purpose cost statements are paired for each technique which can be used for production by comparing different techniques, Cost and the contribution in all cases the technique giving the maximum contribution can be selected to maximize the profits of the organisation.
10. Evaluation of performance
Marginal costing help the management in measuring the performance efficiencies of a department or a product. The department or a product which gives highest PV ratio will be most profitable department or product for the organisation.
11. Decision–making
Marginal costing acts as a prize-fixed and high margins will contribute to the fixed cost and profit. Prices can be fixed above the total variable cost keeping in mind the contribution necessary to off-set fixed cost and to earn reasonable amount of profit. If the organisation set its prices according to its variable cost and desired level of profit, there is a loss of fixed cost. Some times the business has to face such problems due to high compitition, perishable nature of the goods, fear or future market. Strategies of competitors the change in the taste & preferences of the customer.
12. Maintaining a desired level of profit
By fluctuating the sales price of its product on account of competition, Government regulation and other compailling reasons the organisation can maintain a particular level of profits. The profits can be maintain either by decreasing the price for increase in sales or by increasing the sales prices to restrict to a particular segment.
13. Level of activity planning
It is concerned with optimum utilization of available resources. Sometime in many organisation some resources are left idle or in other words the organisation is not using its fall capacity it is always important to achieve optimum level of activities in order to maximize the profit of organisation different levels of activities have different rate of return.
Thus an organisation should utilize its capacity up to the point where it gets the positive rate of return.
14. Alternative method of production
Also used in comparing the alternative methods use for manufacturing e.g. Machine work V/S Hand work, which machine should be used instead of other etc. The cost structure may vary from one alternative to another thus the organsation keeping in mind the demand of the market should adopt those alternative which are most efficient in terms of cost.
v Other Numerical Problems.
Reference:
v Management Accounting by M Y Khan and P K Jain.
v Management Accounting by R S N Pillai and Bagavathi.
v Accounting for Managers by O S Gupta and Pankaj Kothari.
Objective:
To enable the students to analyze and understand cost dynamics with the help of various cost analyses and their implementation in future decision making.
UNIT OVERVIEW
Topics covered: Marginal Costing: Cost, Volume analysis Profit analysis, P/v ratio: analysis and implications, Concept and uses of Contribution, Break-even point and its analysis for the various types of decision-making, Single Product Pricing, Multi Product Pricing, Replacement, sales analysis. Differential costing and Incremental costing: (concepts), Uses and applications of differential costing. Method of calculation of above cost concept and its role in management decision making.
MARGINAL COSTING
INTRODUCTION
Marginal cost means same things as variable cost. Economists define marginal cost as the additional cost of producing one additional unit. This shall include fixed cost and variable cost while for the purpose of accounting Marginal Costing does not include fixed cost. The education of marginal cost is as follows.
Marginal Cost = Prime cost + Total Variable over heads
Marginal Cost = Total cost – Fixed cost
ICWA has defined Marginal Costing as – “The ascertainment by differentiating between fixed cost and variable cost of Marginal Costing and of the effect of the change in the volume type of output.”
According to Batty.
“A technique of cost accounting, Which pays special attention to the behaviour of the cost with the changes in the volume of output.”
COMPARISON BETWEEN MARGINAL COSTING AND
ABSORPTION COSTING / FULL COSTING
Absorption cost is a practice of charging all costs both fixed and variable to the operations process and products while Marginal Costing, only variable cost are charged to the production.
Absorption Costing also known as full costing and includes all type of cost, overheads, setting & distribution charges and other factory burden.
The major difference between Marginal Costing & absorption costing is that absorption costing does not reveal the cost volume profit relationship.
While Marginal Costing shows cost volume profit relationship. which is an important tool for decision – making by managers.
ADVANTAGES OF MARGINAL COSTING
1. To decide how much to produce
With the help of marginal costing we can decide the optimum output for a running concern the organisation can calculate the local of production at which it will achieve its break even and above that output level it will earn profits. The organisation can also decide the level of output for a particular amount of profits. Thus marginal costing can help the organisation to maximize the profits and also to plan the profit for future.
2. To decide what to produce
With the help of marginal costing a company can decide the optimum makes of the product. Any company which is dealing in more than one product can divide the quantity of different products to be manufactured by existing facilities. The relative profitability will be a guiding factor for the organisation to decide what to produce.
3. To decide whether to produce
There decisions are concerned with make or buy decisions by company marginal cost of producing of a product with the out sourcing cost the organisation can take such decision effectively.
4. To decide how to produce
When a product can be manufactured by more than one method, with the help of marginal cost of each method the most effective and efficient method can be decided by the organisation. Such decisions can also be taken for those products which can be manufactured manually or by the help of machines.
5. To decide when to produce
By examining the marginal cost structure at different periods of time the organisation can decide when a product can be manufactured most effectively and efficiently.
6. To decide at what cost to produce
With the help or marginal costing the organisation can decide at what cost the product must be manufactured. This decision is important for those organizations which are dealing in many products with different profitability and manufacturing in more than one plant having different levels of efficiency. The organisation can decide which product should be manufactured in which plant so as to achieve desired level of cost. Other decisions of such nature can be-
(a) How to control the cost against set standards.
(b) How to inventory should be valued.
(c) The plant should be owned by the company or it must be taking on lease.
DISADVANTAGES OF MARGINAL COSTING
1. No Consideration for fixed cost
The Quality decisions can only be taken when all types of cost are considered for valuation of production cost as Marginal costing does not take fixed cost separately for the purpose of analysis. The Quality decision can not be taken with out taken the fixed cost.
2. Classification in to fixed and variable cost is a difficult take
In case of semi-variable and semi-fixed cost it is difficult to deride whether there cost should be taken fixed or variable cost because such cost are partly fixed and partly variable.
COST VOLUME PROFIT ANALYSIS (CVP)
CVP analysis includes three variables namely-
1- Cost, 2- Volume 3- Profit
In this analysis, an attempt is made is to measure the variations of the cost and profit with volume. It helps the management in profit planning. How to maximize the profit is the general concern for the organisation. By defining the relationship between the cost and volume the profit planning for future can be possible and can guide the organisation to achieve its profit maximization objective.
In the profit planning, CVP analysis provides information about the following matters.
1- Behaviour of cost in relation to volume.
2- The volume of production or sales where the business will achieve its break-
even point.
3- Sensitivity of profit due to variations of output.
4- Amount of profit for the projected sales volume.
5- Quantity of production & sales for a target profit level.
To know the CVP relationship the study of the following concepts is necessary-
1. Contribution – Contribution is the difference between sales and marginal cost of sales. It is necessary to know the contribution for the ascertainment or break-even point, PV ratio and margin of safety.
C = Sales – Marginal Cost
C= S –VC
This equation is also known as marginal cost equation and can be used for further analysis.
C= F.C + Profit. (л)
2. Break – Even Analysis – It is a tool of financial analysis where by the impact on profit of the changes in the volume, price, cost and mix can be estimated with accuracy. Break even point is a balancing point of no profit loss. In other words, it is the point where total sales are equal to total cost.
BEP à Sales = F.C + V.C
BEP = Sales x Quantity sold = F.C + V.C x Q
Sales x Q – VC x Q = FC
Q (Sales – VC) = FC
Q x C = FC
BEP =FC
Q x C or contribution per unit
- If the price of the product is reduced in the market then in order to achieve the same BEP? Have to produce more.
- If the market of product is increase in the market then in order to achieve the same BEP. We can reduce our production.
3. Profit volume ratio – PV ration is also knows as contribution sales ratio and expresses the relationship of the contribution to the sales. It is generally expressed as the percentage and indicates the relative profitability of different products.
The management can emphasize upon maximization of profits by the help of PV ratio, which can indicate. What should be done-
1- Whether to increase Sales price.
2- Whether to decrease variable cost.
3- or to produce those products which are having higher PV. ratio.
Margin of safety
Margin of safety is the excess of normal or actual sales over Break even point. The margin of safety refers to the amount by which the sales or revenues can fall before a loss is incurred. High margin of safety indicates the soundness of the business because even with Substantial fall in the sales. Some profit shall be made while small margin of safety is the indicator of weak position of the business and even a small reduction in the sale or production adversely affect the profit position of the business.
APPLICATIONS OF MARGINAL COSTING TECHNIQUES
1-Cost Control
2-Fixation of selling price.
3-Closure of department or discontinuing the product.
4-Selection of a profitable product mix.
5- Profit planning.
6-Decision to make or buy.
7-Decision to accept a bulk order.
8-Introduction of a new product.
9-Choice of a technique.
10-Evaluation of performance.
11-Decision – making.
12-Maintaining a desired level of profit.
13-Level of activity planning.
14-Alternative methods of production.
15-Introduction of product line.
1. Cost Control
It is one of the major concerned for the organisation in this era of competition. There are 2 types of cost variable cost and fixed cost. Fixed cost being the non controllable cost are not considered by marginal costing while variable cost are controllable in nature and controlled by operational level management the main emphasis of cost control in on controlling variable cost because these can be of the organisations.
Here the marginal costing provides a frame work to the operational managers to control the cost by the help of various analysis and controlling techniques.
2. Fixation of selling price
The selling price must be fixed above the total cost of a particulars product any organisation knowin its fixed cost and profits (expected profit) can deside the selling price of its products. (the organisation needs to consider both internal and external factors before desiding the sales price.
3. Closure of Department
Marginal costing techniques can be used to decide about discontinuing of product or closure of a department the above example shows that to deride about discontinuing a product the organisation should evaluate the contribution of each product and total contribution before and after discontinuing a specific product. Fixed cost being uncontrollable in nature will not change even after discontinuing a product. If the organisation discontinue product c. as it is giving 5000 Rs net loss the organisation total profit will decline from 1,000 Rs. Profit to 4,000 Rs loss. If the organisation discontinues product A. its net profit are increasing from Rs. 1,000 to profit to Rs. 2000 profit.
In other words, we can say if the organisation discontinues product c. it earns Rs. 11,000 as total contribution for covering its fixed cost while If organisation discontinues product A. it has 17,000 total contribution to cover its fixed cost and earning reasonable amount of profit (fixed cost is Rs. 15,000 and will not change with discontinuing any product.
4. Selection of a profitable product mix
Sometimes an organisation is involved in manufacturing and distributing more than one product, the management has to deride about the product mix or sales mix which can maximize the profits for the organisation marginal cost can provide a strong basis for such decision by calculating total contribution of each alternative product mix.
The above example shows the organisation should choose 3rd product mix of 2000 of product A and 1000 units of product B. The decision is taking on the basis of total contribution of all available alternatives, which are 15,000 for alternative First Rs. 16500 for alternative Second and Rs. 18000 for alternative three. Thus the alternative with maximum contribution which will result in maximum profit should be chosen as must profitable product mix.
5. Profit Planning
Profit planning is one of the most important decision and should be done Keeping in mind the cost structure of different products of the organisation. If an organisation is knowing the contribution of its product it can planned for the profits from a particular level of sales and similarly it can plan for sales for a particular level of profits.
6. Decision to make or Buy
It may be happened that the organisation is producing a product which is a combination of many parts or sub parts. The organisation can produce all sub components or if possible it can purchase there sub components from other organizations. If it finds cost saving. When it buy the finished sub components Sub decisions are called make or buy component.
Eg. – A radio manufacturing company finds that a component cost Rs. 6.25 when it manufactures it inside the plant where as the same component is available at Rs. 5.50 from outside the company suggest the organisation buy or manufacture the product. If the cost structure of manufacture that product is as follows-
7. Decision to accept a bulk order
Large Scale purchasers may demand the product at lower cost than the market price – a decision has to be taken by the organisation whether to accept lower cost order or not. Such decisions can be taken by compairing the profit situation before and after accepting the large scale order.
Eg. – A company is running at 50% of its capacity and manufacturing 20,000 units of products A the cost structure of the product is as follows –
S.P. -Rs. 7
Material cost -Rs. 2/ unit
Labour -Rs. 1/ unit
Variable over heads -Rs. 3/ unit
F.C. - Rs. 40,000
Suggest the organisation whether it should accept a bulk order of 5000 units at Rs. 6.50/unit
8. Introduction of a new product
It is a crucial decision and must be taken keeping in mind both internal and external factors. As for as internal factors are concerned it includes market demand taste? Preferences of customers and customer response to the product while among the external factor the cost of product is major contributor for deciding which product should be produced.
Among the internal factors the cost of resources manufacturing a particular product is taken in to account for making & effective relation to be launched in the market.
In other words the organisation should choose those products, which gives the maximum contribution towards the fixed cost and Profits to the organisation.
9-Choice of a technique
The main concern of manufacturing organisation is to achieve efficiency in operations and every management wishes to manufactures the product in the most economical way for this marginal costing is a good technique to decide about the most effective and efficient technique to manufacture a particular product for this purpose cost statements are paired for each technique which can be used for production by comparing different techniques, Cost and the contribution in all cases the technique giving the maximum contribution can be selected to maximize the profits of the organisation.
10. Evaluation of performance
Marginal costing help the management in measuring the performance efficiencies of a department or a product. The department or a product which gives highest PV ratio will be most profitable department or product for the organisation.
11. Decision–making
Marginal costing acts as a prize-fixed and high margins will contribute to the fixed cost and profit. Prices can be fixed above the total variable cost keeping in mind the contribution necessary to off-set fixed cost and to earn reasonable amount of profit. If the organisation set its prices according to its variable cost and desired level of profit, there is a loss of fixed cost. Some times the business has to face such problems due to high compitition, perishable nature of the goods, fear or future market. Strategies of competitors the change in the taste & preferences of the customer.
12. Maintaining a desired level of profit
By fluctuating the sales price of its product on account of competition, Government regulation and other compailling reasons the organisation can maintain a particular level of profits. The profits can be maintain either by decreasing the price for increase in sales or by increasing the sales prices to restrict to a particular segment.
13. Level of activity planning
It is concerned with optimum utilization of available resources. Sometime in many organisation some resources are left idle or in other words the organisation is not using its fall capacity it is always important to achieve optimum level of activities in order to maximize the profit of organisation different levels of activities have different rate of return.
Thus an organisation should utilize its capacity up to the point where it gets the positive rate of return.
14. Alternative method of production
Also used in comparing the alternative methods use for manufacturing e.g. Machine work V/S Hand work, which machine should be used instead of other etc. The cost structure may vary from one alternative to another thus the organsation keeping in mind the demand of the market should adopt those alternative which are most efficient in terms of cost.
v Other Numerical Problems.
Reference:
v Management Accounting by M Y Khan and P K Jain.
v Management Accounting by R S N Pillai and Bagavathi.
v Accounting for Managers by O S Gupta and Pankaj Kothari.
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