Standard Costing and Variance Analysis: In this section of the website we study management control and performance measures. Quite often, these terms

carry with them negative connotations - we may have a tendency to think of performance measurement as something to be feared. And indeed, performance measurements can be used in very negative ways - to cast blame and to punish. However, that is not the way they should be used. Performance measurement serves a vital function in

both personal life and in organizations. Performance measurement can provide feedback concerning what works and what does not work, and it can help motivate people to sustain their efforts.

In this section we see how various measures are used to control operations and to evaluate performance. Even though we are starting with the lowest levels in the organization, keep in mind that performance measures should be derived from the organization's overall strategy. For example, a company like Sony that bases its strategy on rapid introduction of

innovative consumer products should use different performance measures than a company like Federal Express where on-time delivery, customer convenience, and low cost are key competitive advantages. Sony may want to keep close track of the percentage of revenues from products introduced within the last year; whereas Federal Express may want to closely monitor the percentage of packages delivered on time.  Later in this section when we discuss the balance scorecard, we will have more to say concerning the role of strategy in the selection of performance measures. But first we will see how standard costs are used by managers to help control costs.

Company in highly competitive industries like Federal Express, Southwest airlines, Dell Computer, Shell Oil, and Toyota must be able to provide high quality goods and services at low cost. If they do not, they will perish. Stated in the starkest terms, managers must obtain inputs such as raw materials and electricity at the lowest possible prices and must use them as effectively as possible - while maintaining or increasing the quality of the output. If inputs are purchased at prices that are too high or more inputs are used than is really necessary, higher costs will result.

How do managers control the prices that are paid for inputs and the quantities that are used? They could examine every transaction in detail, but this obviously would be an inefficient use of management time. For many companies, the answer to this control problem lies at least partially in standard costing system.

Standard Costs-Management by Exception:

Definition and Explanation of Standard Cost and Management by Exception:

A standard cost is the predetermined cost of manufacturing a single unit or a number of product units during a specific period in the immediate future. It is the planned cost of a product under current and / or anticipated operating conditions.

A standard is a "benchmark" or "norm" for measuring performance. Standards are found everywhere your doctor, for

example, evaluates your weight using standards that have been set for individuals of your age, height

and gender. the food we eat in restaurants must be prepared under specified standards of cleanliness.

The buildings we live in must conform to standards set in building codes. Standards are

also widely used in managerial accounting where they relate to the quantity and cost of inputs used in manufacturing goods and producing services. Engineers and accountants assist managers to set quantity and cost

standards for each major input such as raw materials and direct labor time. Quantity standards specify how much of an input should be used to make a product or provide a service. Cost or price

standards specify how much should be paid for each unit of input. Actual quantities and actual costs are

then compared with these standards. In case of significant deviations managers investigate the discrepancies. The purpose is to find the problem and eliminate it so that it does not recur. This process is called management by exception.

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In our daily lives, we operate in a management by exception mode most of the time. Consider what happens when you sit down in the driver's seat of your car. You put the key in the ignition, your turn the key, and your car starts. Your

exception (standard) that the car will start is met; you do not have to open the car hood and check the battery, the connecting cables, the fuel lines, and so on. If you turn the key and the car does not start, then you have a discrepancy (variance). Your exceptions are not met, and you need to investigate why. Note that even if the car is started

after a second try, it would be wise to investigate anyway. The fact that exception was not met should be viewed as an opportunity to uncover the cause of the problem rather than as simply an annoyance. If the underlying cause is not discovered and corrected, the problem may recur and become much worse.

This basic approach to identifying and solving problems is exploited in the variance analysis cycle, The cycle begins with the preparation of standard cost performance reports in the accounting department. These reports highlight the variances, which are the differences between actual results and what should have occurred according to the

standards. The variances raise questions. Why did this variance occur?  Why is this variance larger than it was last period? The significant variances are investigated to discover their root causes. Corrective actions are taken. And then next period's operations are carried out. The cycle then begins again with the preparation of a new standard cost performance for the latest period. The emphasis should be on flagging problems for attention, finding their root causes, and then taking corrective actions. The goal is to improve operations - not to find blame.

VARIANCE ANALYSIS CYCLE

Identify Questions → Receive

Explanations →Take

Corrective Actions

↑ ↓

Analyze Variances

Conduct Next Period's

Operations

↑ ↓

← ←Prepare Standard Cost

Performance Report ← ←

BEGIN

Who Uses Standard Costs?

Manufacturing, service, food, and not-for-profit organizations all make use of standards

to some extent. Auto service centers like Firestone and Sears, for example, often set specific labor time standards for the completion of certain work tasks, such as installing a carburetor or doing a valve job, and then measure

actual performance against these standards. Fast-food outlets such as McDonald's have exacting

standards for the quantity of meat going a sandwich, as well as standards for the cost of

the meat. Hospitals have standards costs (for food, laundry, and other items) for each occupied bed every day, as well as standard time allowances for certain routine activities, such as laboratory tests. In short, you are likely to run into standard costs in virtually any line of business that you enter.

Manufacturing companies often have highly developed standard costing systems in which

standards relating to direct materials, direct labor and overhead are developed in detail for each separate

product. These standards are listed on a standard cost card that provides the manager with a great deal of information concerning the inputs that are required to produce a unit and their costs.

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Setting Standard Costs:

Setting price and quantity standards requires the combined expertise of all persons who have responsibility over input prices and over effective use of inputs. In a manufacturing firm, this might include accountants, purchasing managers, engineers, production supervisors, line mangers, and production workers. Past records of

purchase prices and input usage can help in setting standards. However, the standards should be designed to encourage efficient future operations, not a repetition of past inefficient operations.

Ideal versus Practical Standards:

Should standards be attainable all of the time, should they be attainable only part of the time, or should

they be so tight that they become, in effect, "the impossible dream"? Opinions among managers vary, but

standards tend to fall into one of two categories. These are ideal standards and Practical standards.

Ideal Standards - Definition and Explanation:

Ideal standards are those that can be attained only under the best circumstances. They allow for no machine breakdowns or other work interruptions and they call for a level of effort that can be attained only by the most

skilled and efficient employees working at peak effort 100% of the time. Some managers feel that such

standards have a motivational value These managers argue that even though employees

know that they will rarely meet the standards, it is a constant reminder of the need for ever increasing

efficiency and effort. Few firms use ideal standards. Most managers feel that ideal

standards tend to discourage even the most diligent workers. Moreover, variances from ideal

standards are difficult to interpret. Large variances from the ideal are normal and it is difficult to manage by exceptions.

Practical Standards - Definition and Explanation:

Practical standards are those standards that are tight but attainable. They allow for normal machine downtime and employee rest period. They can be attained through reasonable, though highly efficient,

efforts by the average worker. Variances from such  standards represent deviations that fall outside of

normal operating conditions and signal a need for management attention. Furthermore, practical standards can serve multiple purposes. In addition to signaling abnormal conditions, they can also be used in forecasting

cash flows and in planning inventory. By contrast, ideal standards cannot be used in forecasting and planning; they do not allow for normal inefficiencies, and therefore they result in unrealistic planning and forecasting figures.

Comparison of Budgets and Standards:The budget is one method of securing reliable and prompt information regarding the operation and control of an

enterprise. When manufacturing budgets are based on standards for materials, labor, and factory overhead a strong team for possible control and reduction of costs is created.

Standards are almost indispensable in establishing a budget. Because both standard and budgets aim at the same objective-managerial control-it is felt that the two are the same and cannot function independently. This opinion is supported by the fact that both use predetermined costs for the coming period. Both budgets and standard costs make it possible to prepare reports which compare actual costs and predetermined costs for management.

Building budgets without the use of standard cost figures can never lead to a real budgetary control system. The principle difference between budgets and standard costs lies in their scope. The budget, as a statement of expected costs, acts as

a guidepost which keeps the business on a charted course. Standards, on other hand, do not tell what

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costs are expected to be, but rather what they will be if certain performances are achieved. A budget emphasizes the volume of business and the cost level which should be maintained if the firm is to operate as desired. Standard stress the level to which costs should be reduced. If costs reach this level, profit will be increased.

Purpose of Standard Costing:

Standard cost systems aid in planning operations and gaining insights into the probable impact of managerial decisions on cost levels and profits. Standard costs are used for:

1. Establishing budgets. 2. Controlling costs, directing and motivating employees and measuring efficiencies. 3. Promoting possible cost reduction. 4. Simplifying costing procedures and expediting cost reports. 5. Assigning costs to materials, work in process, and finished goods inventories.

6. Forming the basis for establishing bids and contracts and for setting sales prices

Direct Materials Standards and Variance Analysis:

Direct Materials Price and Quantity Standards:

1. Direct Materials Price Standards 2. Direct Materials Quantity Standards 3. Example of standard cost card

Direct Materials Price Standards:

Definition and Explanation:

Standard price per unit of direct materials is the price that should be

paid for a single unit of materials, including allowances for quality, quantity purchased, shipping, receiving, and other such costs, net of any discounts allowed.

Price standards for direct materials permit checking the performance of the purchasing

department and the influence of various internal and external factors and measuring the effect of

price increase or decrease on the company's profits. Determining the price or cost to be used as the standard cost often difficult, because the prices used are controlled more by external factors than by company's management. Prices selected should reflect current market prices and are generally used throughout the

forthcoming fiscal period. If the actual price paid is more or less than the standard

price, a price variance occurs. This is usually called direct materials price variance.

Price increases or decreases occurring during the fiscal period are recorded in the materials price

variance account(s). Price standards are revised at inventory dates or whenever there is

a major change in the market price of any of the principle materials or parts

Standard price per unit for direct materials should reflect the final delivered cost of materials, net of any discounts taken. Allowances for freights and handling should also be taken into account.

Example:

Calculation of standard price per unit of direct materials or raw materials:

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Purchase price, top-grade pewter ingots, in 40-pounds ingotsFreight, by truck, from suppliers warehouseReceiving and handlingLess purchase discount

Standard price per pound

$ 3.60+0.44+0.05-0.09--------$4.00====

Notice that the standard price reflects a particular grade of materials (top grade), purchased in particular lot size (40 pound ingots), and delivered by a particular type of carrier (truck). Allowances have also been made for handling and discounts. If every thing proceeds according to these expectations, the net cost of a pound of pewter (direct material in the example above) should therefore be $4.00.

Direct Materials Quantity Standards:

Definition and Explanation:

Standard quantity per unit of direct materials is the amount of direct materials or raw materials that should be required to complete a single unit of product, including allowances for normal waste, spoilage, rejects, and similar inefficiencies.

Quantity of usage standards are generally developed from materials specifications prepared by the department of engineering (mechanical, electrical, or chemical) or product design. In a small or medium sized company, the superintendent or even the foremen will state basic specifications regarding type, quantity, and quality of raw materials need and operations to be performed.

Quantity standards should be set after the most economical size, shape, and quality of the product and the results expected from the use of various kinds and grades of materials have been analyzed

The standard quantity should be increased to include allowances for acceptable levels of waste, spoilage, shrinkage, seepage, evaporation, and leakage. The determination of spoilage or waste should be based on figures that prevail after the experimental and developmental stages of the product have been passed.

The standard quantity per unit for direct materials should reflect the

amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies.

Example:

Calculation of standard quantity per unit of  direct materials or raw materials:

Materials requirement (in pounds) per unit as specified in the bill of materials*Allowance for wastage and spoilageAllowance for rejects

Standard of materials requirements (in pounds)

2.7 0.20.1

------3.0

====

*A bill of materials is a list that shows the quantity of each type of material in a unit of

finished product. It is a handy source of determining the basic material input per unit, but it should be

adjusted for waste and other factors as shown above, when determining the standard

quantity per unit of product. "waste and spoilage" in the table above refers to materials that are wasted as a normal part of the production process or that spoil before they are used. "Rejects" refers to the direct material contained in units that are defective and must be scrapped.

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Although it is common to recognize allowances for waste, spoilage, and rejects when setting standard costs, this practice is now coming into question. Those involved in total quality management (TQM) and similar other business improvement programs argue that no amount of waste or defects should be tolerated. If allowances for waste, spoilage, and rejects are

built into the standard cost, the levels of those allowances should be periodically reviewed and reduced over time to reflect improvement process, better training, and better equipment.

Once the direct materials price and quantity

standards have been set, the standard cost of a material per unit of finished product can be computed as follows.

3 pounds per unit × $ 4.00 per pond = $ 12 per unit

This $12 cost figure will appear as one item on the product's standard cost card as shown by the following example.

Example of standard cost card:(1) (2) (3)

Inputs

Standard

Quantity or Hours

Standard

Price orRate

Standard Cost

(1) × (2)

Direct materials 3.0 pounds $ 4.00 $ 12.00

Direct labor 2.5 hours $ 14.00 $ 35.00

Variable manufacturing overhead 2.5 hours $ 3.00 $ 7.50

----------

Total standard cost per unit $54.50

=====

An important reason for separating standards into two categories - price and

quantity - is that different managers are usually responsible for buying and for using inputs and these two activities occur at different points in time. In the case of raw materials the purchasing manager is responsible for the

price, and this responsibility is exercised at the time of purchase. In contrast, the production manager is responsible for the amount of raw materials used, and this responsibility is exercised when the materials are used in production, which may be many weeks or months after the purchase date. It is important, therefore, that we cleanly

separate discrepancies due to deviations from price standards from those due to

deviations from quantity standards. Differences between standard prices and actual prices and standard quantities and actual quantities are called variances. The act of calculating and interpreting variances is called variance analysis.

Direct Materials Price Variance:

1. Definition and explanation of direct materials price variance 2. Formula 3. Example 4. Isolation of variance

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5. Who is responsible for direct materials price variance? 6. Exercises

Definition and Explanation of Direct Materials Price Variance:

Direct materials price variance is the difference between the actual purchase price and

standard purchase price of materials. Direct materials

price variance is calculated either at the time of purchase of direct materials or at the

time when the direct materials are used. When this variance is computed at the time of purchase of

materials it is called direct materials purchase price variance. When

this variance is computed at the time of usage this is typically called direct materials price usage variance.

Direct materials price variance formula:

Following formula is used to calculate materials price variance:

[ Materials Price Variance = (Actual quantity purchased × Actual price) − (Actual quantity

purchased × Standard price)]

This formula is usually preferred and used by managers because it permits calculation of materials

purchase price variance very quickly.

Example:

Colonial Pewter Company provides the following information:

Standard price of material is $4.00 per pond and 6,500 pounds of materials have bee purchased at a cost of $3.80 per pound. This cost figure includes freight and handling and is net of quantity discount. All

the materials purchased has been used and an output of 2000 units is produced during the period.

Required: Calculate materials price variance.

Calculation of direct materials price variance:

= (6,500 pounds × $3.80) − (6,500 pounds × $4.00)

= $24,700  − $26,000

= $1,300 Favorable

A favorable material price variance of $1,300 exists because the actual price of

materials purchased is less than the standard price of materials

purchased. A material price variance is called unfavorable materials price variance if

the actual price of materials purchased is more than the standard price of

materials purchased.

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Variance analysis reports are often issued in a tabular format. An example of such a variance report

follows along with an explanation for the materials price variance that has been calculated above for

Colonial Pewter Company.

Colonial Pewter Company

Performance Report - Purchasing Department

Item PurchasedQuantity

PurchasedActual Price Standard

Price

Difference in Price

Total Price Variance

Explanation

1 2 3 4 5

Bargained for an especially

good price

(2) – (3) (1) × (4)

Pewter6,500

pounds$3.80 $4.00 $0.20

$1,300Favorable

Most companies compute materials price variance when the materials are purchased than they are used in production. There are two reasons for this practice. First, delaying the computation of the price

variance until the materials used would result in less timely variance report. Second, by computing the

price variance when the materials are purchased, the materials are carried in the

inventory accounts at their standard costs. This greatly simplifies book keeping. When the

materials price variance is computed at the time of purchase of materials it is typically

called materials purchase price variance.

Isolation of Variances:

At what point should variances be isolated and brought to the attention of management? the answer is, the earlier the better. The sooner deviations from standard are brought to the attention of management, the sooner problems can be evaluated and corrected. Once the performance report has been prepared, what does management do with the price variance data? The most significant variances should be viewed as "red flags," calling attention to the fact that an exception has occurred that will require some explanation and perhaps follow-up effort. Normally, the performance report itself will contain some explanation of the reason for the variance, as shown above, In the case of Colonial Pewter Company, the purchasing department explained that favorable price variance resulted from bargaining for an especially good price.

Who is Responsible for Material Price Variance?Generally speaking, the purchase manager has control over the price paid for goods and is therefore responsible for any price variation. Many factors influence the price paid for the goods, including number of units ordered in a lot, how the

order is delivered, and the quality of materials purchased. A deviation in any of these factors from what was assumed when the standards were set can result in price variance. For example purchase of second grade

materials rather than top-grade materials may be a reason of favorable price variance, since the lower grade material will generally be less costly but perhaps less suitable for production and can be a reason of unfavorable materials quantity variance.

However, someone other than purchasing manager could be responsible for materials price variance. For example, production is scheduled in such a way that the purchasing manager must request express delivery. In this situation the production manager should be held responsible for the resulting price variance.

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Exercises:

Exercise 1: Materials Variance Analysis

The Schlosser Lawn Furniture Company uses 12 meters of aluminum pipe at $0.80 per meter as

standard for the production of its Type A lawn chair. During one month's operations, 100,000 meters of the pipe were purchased at $0.78 a meter, and 7,200 chairs were produced using 87,300 meters of pipe. The

materials price variance is recognized when materials are purchased. Calculate

materials price variance.

Solution:

Meters of pipe

Unit Cost Amount

Actual quantity purchased 100,000 $0.78 actual $78,000

actual quantity purchased 100,000

$0.80

standard

$80,000

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

Materials purchase price variance

100,000 $(0.02) $(2,000) fav.

======= ======= =======

Exercise 2: Materials Variance Analysis

The standard price for material 3-291 is $3.65 per liter. During November, 2,000 liters were purchased at $3.60 per liter. The quantity of material 3-291 issued during the month was 1775 liters and the quantity allowed for

November production was 1,825 liters. Calculate materials price variance, assuming that:

1. It is recorded at the time of purchase ( Materials purchase price variance).

2. It is recorded at the time of issue ( Materials price usage variance).

Solution:

Liters Unit cost Amount

Actual quantity purchased 2,000 3.60 actual $7,200

Actual quantity purchased 2,000

3.65

standard

7,300

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

Materials 2,000 $ (0.05) $(100) fav.

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purchase price variance

====== ====== ======

Actual quantity used 1775 3.60 actual $6390.00

Actual quantity used 1775

3.65

standard

$6478.75

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

Materials price usage variance 1775 $(0.05) (88.75)

====== ====== =======

Direct Materials Quantity Variance:

1. Definition and Explanation of direct materials quantity variance 2. Formula 3. Example 4. Isolation of variance 5. Who is responsible for unfavorable materials quantity variance 6. Exercises

Definition and Explanation of Direct Material Quantity Variance:

Direct materials quantity variance is also known as

Direct materials efficiency variance and Direct

materials usage variance. It measures the difference between the

quantity of materials used in production and the quantity that should have been used

according to the standard that has been set. Although the variance is concerned with the

physical usage of materials, it is generally stated in dollar terms to help gauge its importance.

Materials quantity | Usage variance Formula:

Following formula is used to calculate materials quantity variance or

direct materials usage variance:

[ Materials quantity variance = (Actual quantity used

× Standard price) − (Standard quantity allowed × Standard Price)]

Example:

Colonial Pewter Company provides the following data:

3.0 pounds of materials are required to produce a unit of product according to standards set by the

management. The standard price of direct materials is $4.00 per pound.

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During the period 2000 unit were completed with an actual consumption of 6,500 pounds of direct

materials.

Calculate direct materials quantity variance or

direct materials usage variance.

According to above information, the calculation of materials quantity variance is as follows:

Calculation of Materials Quantity Variance = (Actual quantity used ×

Standard price) − (Standard quantity allowed × Standard price)

=(6,500 pounds × $4.00) − (6,000* pounds × $4.00)

= $26,000 − $24,000

= 2000 Unfavorable

*Standard quantity allowed (3.00 per unit × 2,000 units)

Colonial Pewter CompanyPerformance Report - Production Department

(1) (2) (3) (4) (5)

Type of Materials

Standard Price

Actual

Quantity

Standard

Quantity Allowed

Difference in

Quantity(2) – (3)

Total

Quantity Variance(1) × (4)

Explanation

Pewter $4.00 6,500 Pounds 6,000 Pounds 500 Pounds$2,000

Unfavorable

Low quality materials

unsuitable for production

Above calculation shows an unfavorable direct materials quantity variance. When

materials are used more than what is allowed by standard an unfavorable quantity variance occurs. If

materials used is less than the quantity allowed a favorable direct materials quantity variance occurs.

Isolation of Variance:

The materials quantity variance is best isolated when materials are placed into production. Materials are drawn for the number of units to be produced, according to the standard bill of materials for each unit. Any additional materials are usually drawn with an excess materials requisition slip, which is different in color from the normal requisition slips. This procedure calls attention to the excessive usage of materials while production is still in process and provides an opportunity to correct any developing problem.

Who is Responsible for Material Quantity Variance?

Excessive usage of materials that is usually a reason of unfavorable direct materials quantity variance may be due to inferior quality of materials,  untrained workers, poor supervision etc. Generally speaking

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production managers are held responsible for this variance. However purchasing department may also be held responsible for purchasing materials of inferior quality to economize on prices. Where purchasing department  purchases

low grade direct materials at low prices to show a favorable materials price variance, the materials quantity variance is usually unfavorable due to inferior quality of direct materials.

A word of caution is in order. Variance analysis should not be used as an excuse to conduct which hunts or as a means of beating line managers and workers over the head. The emphasize must be on control in the sense of supporting the line managers and assisting them in meeting the goals that they have participated in setting for the company. In short, the emphasize should be positive rather than negative. Excessive dwelling on what has already happened, particularly in terms of trying to find someone to blame, can destroy morale and kill any cooperative spirit.

Exercises:

Exercise 1: Materials Variance AnalysisThe Schlosser Lawn Furniture Company uses 12 meters of aluminum pipe at $0.80 per meter as standard for the production of its Type A lawn chair. During one month's operations, 100,000 meters of the pipe were purchased at $0.78 a meter, and 7,200 chairs were produced using 87,300 meters of pipe. The materials price variance is recognized when materials are purchased. Calculate materials materials quantity variance | direct materials efficiency variance.

Solution:

Actual quantity used 87,300 $0.80 standard $69,840

Standard quantity allowed 86,400 $0.80 standard $69,120

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

Materials quantity variance 900 $0.80 $720 unfav.

======= ======= =======

Direct Labor Standards and Variance Analysis:

Direct Labor Standards:

Direct labor price and quantity standards are usually expressed in terms of a labor rate and labor hours.

1. Direct labor rate standards 2. Direct labor efficiency | usage | quantity standards 3. Example of standard cost card

Direct Labor Rate Standards:

The standard rate per hour for direct labor includes not only wages earned but also fringe benefit and other labor costs.

Example of Standard rate per direct labor hour:Basic wages rate per hourEmployment taxes at 10% of the basic rateFringe benefits at 30% of the basic rate

Standard rate per direct labor hour

$10$  1$  3-----$14

====

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Many companies prepare a single standard rate for all employees in a department. This standard rate reflects the expected "mix" of workers, even though the actual wage rates may very somewhat from individual to

individual due to different skills of seniority. A single standard rate simplifies the use of standard costs and also permits the managers to monitor the use of employees within department.

Direct Labor efficiency | Usage | Quantity Standards:

The standard direct labor time required to complete a unit of product (called the standard hours per unit) is perhaps the most difficult standard to determine. One approach is to divide each operation performed on the product into elemental body movements (such as reaching, pushing, and turning over). Standard times for such movements are available in reference works. These standard times can be applied to the movements and then added together to determine the total standard time allowed per operation. Another approach is for an industrial engineer to do a time and motion study, actually clocking the time required for certain tasks. The standard time should include allowances for breaks, personal needs of employees, cleanup, and machine downtime.

Example of standard labor hours per unit:Basic labor time per unit, in hoursAllowance for breaks and personal needallowance for cleanup and machine downtimeAllowance for rejection

Standard labor hours per unit of product

1.90.10.30.2

-------2.5

====

Standard labor hours per unit and standard direct labor rate per hours computed above shall be used in calculating labor rate variance and labor efficiency variance. Once the rate and time standards have been set,

the standard labor cost per unit of product can be computed as follows:

2.5 hours per unit × $14 per hour = $35 per unit

This $35 per unit standards labor cost appears along with direct materials on the standard cost card of the product as shown by the following example.

Example of Standard Cost Card:(1) (2) (3)

Inputs

Standard Quantity or

Hours

Standard Price or

Rate

Standard Cost

(1) × (2)

Direct materials 3.0 pounds $ 4.00 $ 12.00

Direct labor 2.5 hours $ 14.00 $ 35.00

Variable manufacturing overhead 2.5 hours $ 3.00 $ 7.50

----------

Total standard cost per unit $54.50

=====

Direct Labor Rate | Price Variance:

1. Definition and explanation 2. Direct labor rate variance formula

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3. Example 4. Who is responsible for labor rate variance 5. Exercises

Definition and Explanation:

Direct Labor price variance is also termed as direct

labor rate variance. This variance measures any deviation from standard in the average

hourly rate paid to direct labor workers. In other words, direct labor rate variance is the difference between the amount of actual hours worked at actual rate and actual hours worked at

standard rate.

 Direct Labor Rate Variance Formula:

Following formula is used to calculate direct labor rate variance or

direct labor price variance:

[ Labor rate variance = (Actual hours  worked × Actual rate) − (Actual hours worked

× Standard rate)]

Example:

Suppose that 2,000 units have been produced during the period and 5,400 direct labor hours have been

worked at a rate of $13.75 per direct labor hour. Standard rate per direct labor hour is $14.00.

Calculate labor rate variance.

Calculation of direct labor rate variance.

Labor rate variance = (Actual hours worked × Actual rate) − (Actual hours worked ×

Standard rate)

= (5,400 × $13.75) − (5,400 × $14.00 )

= 74,250 − 75,600

Labor rate variance = $(1,350) Favorable

Calculation shows a favorable labor rate variance because actual rate paid to workers

is less than standard rate. When the actual rate is more than the standard rate an

unfavorable labor rate variance results.

Rates paid to the workers are usually predictable. Nevertheless, rate variances can arise through the way labor is used. Skill workers with high hourly rates of pay may be given duties that require little skill and call for low hourly rates of pay.

This will result in an unfavorable labor rate variance, since the actual hourly rate of pay will exceed the standard rate specified for the particular task. In contrast, a favorable rate variance would result when workers who are paid at a rate lower than specified in the standard are assigned to the task. However, the low pay rate workers may not be

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as efficient. Finally, overtime work at premium rates can be reason of an unfavorable labor price variance if the overtime premium is charged to the labor account.

Who is responsible for the labor rate variance?

Since rate variances generally arise as a result of how labor is used, production supervisors bear responsibility for seeing that labor price variances are kept under control.

Exercises:

Exercise 1: Labor Variance AnalysisThe processing of a product requires a standard of 0.8 direct labor hours per unit for Operation 4-802 at a standard wage

rate of $6.75 per hour. The 2,000 units actually required 1,580 direct labor hours at a cost of $6.90 per hour.

Required: Calculate labor rate variance or Labor price variance.

Solution:

Time Rate Amount

Actual hours worked 1,580 $6.90 actual $10,902

Actual hours worked 1.580 $6.75 standard 10,665

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

Labor rate variance

1,580 $0.15 $237 unfav.

Direct Labor Efficiency Variance

1. Definition and explanation 2. Formula of direct labor efficiency variance 3. Example 4. Who is responsible for direct labor efficiency variance? 5. Exercises

Definition and Explanation:

The quantity variance for direct labor  is generally called direct labor

efficiency variance or direct labor usage variance.

This variance measures the productivity of labor time. No variance is more closely watched by

management, since it is widely believed that increasing the productivity of direct labor time is vital to

reducing costs. The formula for the labor efficiency variance is expressed as follows:

Formula of labor efficiency variance:

[Labor efficiency variance = (Actual hours worked × Standard rate)

− (Standard hours allowed × Standard rate)]

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Example:A company produces 2000 units of finished products using 5,400 hours. Standard time allowed for a unit of finished

product is 2.5 hours. Standard rate that is paid to workers is $14.00 per direct labor hour.

Calculate direct labor efficiency variance or direct

labor quantity variance.

Calculation of direct labor efficiency or quantity or usage variance.

Labor efficiency variance = (Actual hours worked × Standard rate) −

(Standard hours allowed × Standard rate)

= (5,400 × $14.00 ) − (5,000* × $14.00)

= $75,600 − $70,000

= $5,600 Unfavorable

 5,000* = 2,000 actual production × 2.50 standard hour allowed per unit

Processing of 2000 units required more time than what was allowed by standards. The result is an unfavorable labor

efficiency variance. A favorable labor efficiency variance occurs when actual processing time is less than the time allowed by standards.

Who is Responsible for Labor Efficiency Variance?

The manager in charge of production is generally considered responsible for labor efficiency

variance. However, purchase manager could be held responsible if the acquisition of poor materials

resulted in excessive labor processing time. Possible causes / reasons of an unfavorable efficiency

variance include poorly trained workers, poor quality materials, faulty equipment, and poor supervision.

Another important cause / reason of an unfavorable labor efficiency variance may be insufficient demand for company's products.

If customers orders are insufficient to keep the workers busy, the work center manager has two options, either accept an

unfavorable labor efficiency variance or build up inventories. The second option is opposite to the basic principle of just in time (JIT). Inventories with no immediate prospect of sale is a bad idea according to just in time approach. Inventories, particularly work in process inventory leads to high defect rate, obsolete goods, and generally inefficient operations.  As a consequence, when the work force is basically fixed in the short term, managers

must be cautious about how labor efficiency variances are used. Some managers advocate dispensing

with labor efficiency variance entirely in such situations―at least for the purpose of motivating and controlling workers on the shop floor.

Exercises:

Exercise 1: Labor Variance AnalysisThe processing of a product requires a standard of 0.8 direct labor hours per unit for Operation 4-802 at a standard wage

rate of $6.75 per hour. The 2,000 units actually required 1,580 direct labor hours at a cost of $6.90 per hour.

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Required: Calculate labor efficiency variance or Labor usage variance.

Solution:

Time Rate Amount

Actual hours worked 1,580 $6.75 standard $10,665

Standard hours allowed 1,600 $6.75 standard 10,800

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

Labor rate variance (20) $6.75 $(135) fav.

Manufacturing Overhead Standards and Variance Analysis:

Manufacturing Overhead Cost Standards:

Procedures for establishing and using standard factory overhead rates are similar to the methods of dealing with the

estimated direct and indirect factory overhead and its application to jobs and products.

An overhead budget for the rate calculation provides a budget allowance for a specific, predetermined

level of activity, while a flexible budget provides allowance for various levels of activity. Both type of

budgets aim for the control of factory overhead. Control is achieved by keeping actual expenses within

ranges established by the budget. The maximum limit of a range is the amount set up in the

flexible budget. However for costing jobs or products it is necessary to establish a normal overhead rate based on total estimated overhead rate at normal capacity volume.

An example of the effect of volume on overhead cost per unit is as follows:

Production volume (units) 80,000 90,000 100,000 110,000

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

Factory overhead:

     Variable $112,000 $126,000 $140,000$154,00

0

     Fixed 60,000 60,000 60,000 60,000

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

     Total $172,000 $186,000 $200,000$214,00

0

====== ====== ====== ======

Factory overhead

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per unit:

     Variable $1.40 $1.400 $1.40 $1.400

     Fixed 0.75 0.667 0.6 0.545

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

Total unit overhead cost $2.15 $2.067 $2.00 $1.945

The example indicates the basic pattern of overhead behavior. Fixed expenses remain fixed, within a normal range of

activity, as volume (output) changes, but they vary per unit. The greater the number of units, the smaller the amount of fixed overhead per unit. Variable expenses, on the other hand, increase proportionately with each increase

of volume (output) and remain fixed per unit.

This characteristics of overhead behavior is important in establishing a standard factory overhead rate. Overhead absorption is accomplished by selecting a plant capacity as the base for charging variable and fixed overhead to jobs or products.

Variable expenses should be measured and controlled at any volume by the supervisors with the help of a

flexible budget. The variable expenses in the flexible budget correspond to applied variable overhead, and variable overhead variances result from a comparison of actual

variable costs with the flexible budget (applied) variable factory overhead.

Fixed expenses can be absorbed fully only by operating at the volume on which the rate is based. If the base set for overhead absorption is reached, budgeted and absorbed cost figures will be identical. Since this is highly improbable, a difference occurs between budgeted fixed expenses and absorbed fixed overhead, and fixed overhead variances from an analysis of this difference. For purposes of analysis, budgeted fixed overhead is used. Any difference that might occur between budgeted and fixed overhead becomes a part of the variable overhead variances in the methods of analysis presented in this section of the website. Alternatively this difference can be identified as a separate variance, called the fixed spending variance.

Standard Factory Overhead Rate:

The standard factory overhead rate is a predetermined rate that is usually based on the

direct labor hours. Other bases may also be used, e.g., direct labor dollars or machine hours. The use of

direct labor dollars, however, may cause some distortion in the variance calculation. because the actual

direct labor dollar figure includes any labor rate variations from the standard rate. The

data from the following flexible budget for department is used to illustrate the calculation

of standard overhead rate and overhead variances.

Department 3

Monthly Flexible Budget

Capacity 80% 90% 100%

Standard production 800 1,000 1,200

Direct labor hours 3,200 4,000 4,800

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Variable factory overhead:

Indirect labor $1,600 $2,000 $2,400 $0.50 / dlh

Indirect materials 960 1,200 1,440 $0.30

Supplies 640 800 960 $0.20

Repairs 480 600 720 $0.15

Power and light 160 200 240 $0.05

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

Total variable factory overhead

$3,840 $4,800 $5,760 $1.20 per dlh

====== ====== ====== ======

Fixed factory overhead:

Supervisor $1,200 $1,200 $1,200

Depreciation on machinery 700 700 700

Insurance 250 250 250

Property tax 250 250 250

Power and light 400 400 400

Maintenance 400 400 400

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

Total fixed factory overhead $3,200 $3,200 $3,200$3,200 per

month

----------- ----------- ----------- ======

Total factory overhead$7,040 $8,000 $8,960 $3,200 per

month+ $1.20 per dlh

====== ====== ====== ======

Assuming that 90% column represents normal capacity, the standard overhead rate is computed as follows:

Total factory overhead / Direct labor hours = $8,000 / 4,000 = $2 per

standard direct labor hour

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At 90% capacity level, the rate consists of:

Total variable factory overhead / Direct labor hours = $4,800 / 4,000 = $1.20 variable

factory overhead rate

Total fixed factory overhead / Direct labor hours = $8,000 / 4,000 = $0.80 fixed

factory overhead rate

Total factory overhead rate at normal capacity:

($1.20 + $0.80) = $2.00

Factory Overhead Variances:

Jobs or processes are charged with cost on the basis of standard hours allowed multiplied by the

standard factory over head rate. The standard overhead rate or predetermined overhead

rate is discussed in detail at our job order costing system page. The standard hours allowed figure is

determined by multiplying the labor hours required to produce one unit (the standard labor hours per unit) times the actual number of units produced during the period. The units produced are the equivalent units of production for the departmental factory overhead cost being analyzed. At the end of the month, overhead actually incurred is compared

with the expenses charged into process using the standard factory overhead rate. The difference between these figures is called the overall or net factory overhead variance.

overall or net factory overhead variance needs further analysis to reveal detailed causes for the variance and to guide management toward remedial action. This analysis may be made by using (1) the two variance method, (2) the three variance method, or (3) the four variance method.

The two variance method: When an overall or net factory overhead variance is further analyzed by using two variance approach, the following two variances are calculated:

1. Controllable variance 2. Volume variance

The three variance method: When an overall or net factory overhead variance is further analyzed by using three variance approach, the following three variances are calculated:

1. Spending variance 2. Idle capacity variance 3. Efficiency variance

The four variance method: When an overall or net factory overhead variance is further analyzed by using four variance approach, the following four variances are calculated:

1. Spending variance 2. Variable efficiency variance 3. Fixed efficiency variance 4. Idle capacity variance

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Mix and Yield Variance - Definition and Explanation:Basically, the establishment of standard product cost requires the determination of price and quantity standards. In many industries, particularly of the process type, materials mix and materials yield play significant parts in the final product cost, in cost reduction, and in profit improvement.

Calculation of Mix and Yield Variances:

1. Materials Mix and Yield Variance 2. Labor Yield Variance 3. Factory Overhead Yield variance

Variance Analysis and Management By Exception:Variance analysis and performance reports are important elements of management by exception. Simply put, management by exception means that the manager's attention should be directed toward those parts of the organization where plans are not working out for reason or another.

Managerial importance and usefulness of variance analysis:Costs of production are effected by internal factors over which management has a large degree of control. An important job of executive management is to help the members of various management levels understand that all of them are part of the management team. Click here to read full article.

Advantages and Disadvantages of Standard Costing System:

The use of standard costs is a key element in a management by exception approach. If costs remain within the standards, Managers can focus on other issues. Click here to read full article

Standard Costing Discussion Questions and Answers:

Find answers of various important questions about standard costing system. Click here.

Standard Costing and Variance Analysis Formulas: A collection of variance formulas / equations which can help you calculate variances for direct materials, direct labor, and factory overhead. Click here to read full article

Standard Costing and Variance Analysis Problems and Solution:Find a collection of comprehensive problems about standard costing and variance analysis. We have also provided the solution. Click here

Standard Costing and Variance Analysis Case Study:Click here for the study of cases about standard costing and variance analysis

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6.4 Standard Costing

Consider a company that manufactures n units of a single product over a 12-month period.

Assume the following: -

12 Months Manufactoring

Total direct cost associated with n units over the 12-month period Ct

d

Total indirect cost, incurred by the company, over 12 months Cti

Total profit for 12 months, before tax Pt

Total income for 12 months It

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NOTE:

Direct costs are those associated directly with the product, such as the cost of materials, components, direct labour,

direct expenses, etc.

Indirect costs are costs met by the company, such as rent, rates, heating, lighting, telephone, fax, and administration,

which cannot be directly related to the product.

If the price of a single product is Pu (unit price), we have: -

It = nPu ....................................The total income form the product = number of units sold * unit price

It = Ctd+Cti+Pt...........................The total income pays for all the direct costs, indirect costs and profit

nPu = Ctd+Cti+Pt

Where

= direct cost associated with each unit

=indirect cost associated with each unit

= unit contribution to profit

So each unit sold must pay for its own direct costs and contribute to indirect costs (overheads) and profit.

Problems arise because: -

When a company makes and sells more than one type of product, it is difficult to allocate indirect costs “equitably” to

them.

At the start of each trading period, the company does not know how many of each type of product it is going to sell.

Also, the cost of materials, energy etc., may change throughout the year.

Consequently, the company must estimate sales of each product, in order for it to fix prices and allocate, or apportion,

overheads to them.

We have seen that there are various ways of classifying costs. We may group them as follows: -

direct indirect

direct overhead

s

variabl

e

fixed

Direct costs are the same as variable costs, they are related to the level of production and consequently vary as

production varies.

Indirect costs, fixed costs and overheads are different names for the same thing. Essentially, they are independent of

production levels and must be met by the company, even if sales are zero, in a trading period.

Recovery of fixed costs is a problem for all companies. In reality a company cannot make a profit until all the fixed

costs have been met.

One problem associated with fixed costs is that they are seldom really fixed, or constant.

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For example, heating of rooms may be independent of production levels, but may vary from year to year, with the

severity of the weather. Rent and rates have a habit of increasing discontinuously. Another type of change in “fixed”

costs can arise when large changes in production occur. Imagine a company working to near capacity that receives a

big order, which will last for several years. It may decide it needs more floor space to carry out the new work, so it

acquires a new factory. The “fixed cost” jump to new levels to cover the increase in rent, rates, heating bills etc.

Prior to the start of a trading period, and probably at intervals within it, management must: -

Estimate sales for each product in its range, for the trading period.

Estimate the total fixed cost for the trading period.

Apportion, “equitably” fixed costs to each product.

This type of costing, where each product contributes to fixed costs in a defined way, is called standard costing or

absorption costing- each product absorbs, that is pays for, a proportion of the overhead.

Apportioning fixed costs is difficult. It may be possible to apportion heating costs according to say, floor area. So if a

factory consists of 3 areas: -

Production 1500 sq. m

Administratio

n

500 sq. m

Design Offices 700 sq. m

Total 2700 sq. m

If energy costs are £30,000/year, we could assume: production uses of the energy used.

However, this still does not tell us how to apportion fixed costs to products.

Another method is to apportion fixed costs in proportion to the amount of direct labour hours associated with each

product.

For example, if a small company has a product range consisting of 3 products:

Table 1 Illustrating apportioning fixed costs according to direct labour

Produc

t

Direct Labour (hours) Units Produced/Year

A 16800 5300

B 24000 7400

C 7000 900

Totals 47800 13600

Assume the company has a total fixed cost of £1,700,000/year.

Contribution to fixed costs of product A, apportioned according to direct labour, is:

23

View description

The unit contribution to fixed costs, of product A, is:

View description

Similar calculations will yield the unit contribution to fixed costs for products B and C

Another method is to apportion fixed costs according to product contribution, where contribution is defined as:

Contribution = sales (£) –variable costs (£)

Assume a small company produces 4 products and has a fixed cost of £35000.

The total product contribution is £62000. Using the information in Table 2, the apportioned fixed cost, according to

contribution, for product A is:

View description

Table 2 Illustrating apportioning fixed costs according to product contribution

Produc

t

Contributio

n

% of Total Contribution Apportioned Fixed

Costs

A 12000 19.35 6772.5

B 25000 40.32 14112

C 10000 16.13 5645.5

D 15000 24.19 8466.5

Totals 62000 99.99 34996.5

Other methods of apportioning fixed costs to products exist, such as apportioning according to sales.

All the methods of apportioning fixed costs depend upon some procedure or formula, which can be misleading, time

consuming to apply and difficult to use for projected sales.

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Other methods of costing may be used and we shall discuss some of them later in this unit.

6.5 Break even Analysis

We shall now introduce the concept of break even analysis, which allows us to calculate the number of products that

must be sold in a trading period, say 12 months, for it to break even. If the number of products sold is less than the

break even value, the product will be sold at a loss. Once the number of products sold exceeds the break even value,

the product is making profit for the company.

Figure 1 Illustrating Break Even Analysis

Assume the following:-

R = The total revenue generated from the sale of n products

P = The total profit generated from the sale of n products

Fc = The total fixed cost associated with producing n products- the company only produces one type of product

Vc = The total variable (direct) cost associated with the production of n products

From Figure 1 we have R = P+Vc+Fc ..........................................................1

Hence R-Fc = P + Vc ..............................................................................2

R-Fc is called the total contribution to fixed costs and profit.

At the break even point (BEP) the profit Pt = zero, hence

R = Fc + Vc ...............................................................................................3

If the unit selling price is Ru then nRu = R

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If the unit direct cost is Vu then nVu = Vc

At break even n= nbe the number of units that must be sold to break even

Then nbeRu = nbeVu+Fc ..................from 3

nbe(Ru-Vu) = Fc

........................................................................................4

So, to find the number of units we have to sell to break even, we divide the fixed costs associated with the product by

the unit contribution. Note, the unit contribution is a measure of “commercial goodness”, that is if the unit selling price

is high and the direct costs associated with its manufacture and sales is low, the unit contribution is high. If possible

we should try and sell more of this product.

If a company is manufacturing a number of products and absorption costing is being used, the fixed costs can be

apportioned to each product before the break-even figures for each product are calculated.

When a new product is being developed the target direct costs are an important design parameter. One of the

tasks of our newly appointed managers is to ensure that the direct costs associated with the product are produced as

on ongoing exercise throughout the development phase. If there is a danger that the target costs will not be met

remedial action must be taken. Failure to meet target direct costs could result in the cancellation of the development

product.

6.6 Marginal Costing

Marginal costing does not attempt to apportion fixed costs to individual products.

Fixed costs must still be recovered, but they are considered to be costs associated with the accounting period, rather

than a production activity. Note that after the break-even point for a product, when all the fixed costs for all the

trading period have been recovered, the contribution of a product is all profit.

From an overall accounting point of view, marginal and absorption costing would produce the same profit/loss figures

for the accounting period of the company. Actually the two methods can give produce a profit difference, if there is a

difference in opening and closing stock for the accounting period.

Advantages of marginal costing are: -

It avoids apportioning fixed costs to the product.

It eliminates the need for determining procedures for apportioning fixed costs, which can be time

consuming and expensive.

Fixed costs cannot usually be controlled. Variable costs can.

Using absorption costing, profit levels can be artificially increased by increasing stock levels of finished

items. This does not increase cash at bank. Marginal costing does not suffer from this.

The exclusion of fixed overheads from production costs enables a company to price its goods on direct costs

and usually be more competitive.

Marginal costing is easier to understand and to use.

26

Care must be taken when using marginal costing, because fixed costs must still be recovered.

Absorption costing can mask the value of “good products”. Consider a company that makes 3 products and has a total

fixed cost (overhead) of ;£24000/year: -

Unit06.06 Table 1

Item Product

A

Product

B

Product

C

Sales Revenue 60000 80000 40000

Variable Costs 40000 60000 34000

Apportioned Fixed

Costs

6000 10000 8000

Using an absorption costing system: -

Unit06.06 Table 2

Item Product

A

Product

B

Product

C

Totals

Sales

Revenue

60000 80000 40000 180000

Total Cost 46000 70000 42000 158000

Profit 14000 10000 -2000 22000

According to this method of costing product C is making a loss.

Using a marginal costing approach: -

Unit06.06 Table 3

Item Product

A

Product

B

Product

C

Totals

Sales Revenue 60000 80000 40000 180000

Variable Costs 40000 60000 34000 134000

Contribution 20000 20000 6000 4600

Less total fixed cost 24000

Overall Profit 22000

However, using the marginal costing method, we can see that product C is making a positive contribution of £6000.

If we withdraw product C and fixed costs remain the same, and so do sales of product A and B, we have: -

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Unit06.06 Table 4

Item Product

A

Product

B

Totals

Sales Revenue 60000 80000 140000

Variable Costs 40000 60000 100000

Contribution 20000 20000 40000

Less total fixed cost 24000

Overall Profit 16000

So, withdrawing product C reduces the company profit, even though the absorption method of costing determined it

was making a loss. This is because product C was making a positive contribution to the overhead of £6000/pa.

Note, if our competitors are using marginal costing to set prices and the price affects the volume of sales, we may be

uncompetitive if we fix prices using absorption costing.

It is possible to use a combination of marginal and absorption costing techniques. For example, when break even has

been achieved for a product, its price could be reduced by its contribution to fixed costs. If reducing its price increases

sales this may result in increased profitability. This technique can be used with “special offers”.

We shall now briefly consider the two major pricing strategies open to a company.

6.7 Pricing methods- cost plus

The cost plus method of determining product price determines all the costs associated with manufacturing a product

and then adds on a profit margin, usually as percentage of the total product cost. The product cost of course includes

an apportioned element of the company overhead, i.e. apportioned indirect cost, as well as all the variable costs.

Cost plus was the traditional method of pricing products in the UK. However, using a cost plus method of determining

product price does not really address what the market is prepared to pay for the product. We have seen that

apportioning overheads to products is difficult and can give the wrong impression about the commercial worth of a

product.

The cost plus approach is circular in nature, before you can apportion overheads you need to estimate how many

products you are going to sell, which then allows the price of the product to be fixed. However, if the price comes out

too high, it may affect sales and income from the product may not meet expectations.

DUL still uses a cost plus approach to determining the price of its products every year. A great deal of time is spent on

estimating sales and apportioning overheads prior to the start of its financial year.

6.8 Pricing- price minus

The price minus approach to determining a product's price estimates what the market will pay for the product before

the product is developed. This is called the market selling price (MSP). Then the minimum contribution the company is

willing to accept is deducted from the MSP, to determine the total target direct costs for the product. The target

direct costs then become design parameters for design engineers and production engineers to aim for throughout the

development of the product.

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Note that the company fixed costs must still be paid for but effort may now be placed in reducing a product's direct

cost during its development, instead of adjusting the selling price according to some arbitrary company rules.

The price minus approach to pricing lets the market decide the product price, which is largely a marketing exercise

rather than a financial one.

It must be remembered that contribution is not profit and percentage values of product contribution are much higher

than profit margins assumed in the cost plus approach.

An important fact to also remember it that whatever pricing method is used the company still has to estimate the

number of sales prior to the start of its financial year.

EEL uses a price minus method of pricing its products. Marketing always provide an estimate of the MSP of a new

product (often a small price range is defined), before a proposal is made to develop it. If the target costs cannot be

met the development does not go ahead.

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Standard costing system - driven by what?

I think its important to understand the objectives for choosing a standard costing system. I feel this is required

a) Implement the budgets and forecasts

b) Get an estimate of cost of finished goods using cost rollup

c) Facilitate  pricing of finished goods by stripping off certain cost elements

d) And of course to assess performance of underlying business functions driving costs.

Lot of modern thinking has been questioning the relevance of a standard costing system in today's dynamic business environment. Standard costing system is often doubted whether it directs correct organizational behaviour. Is there a too much focus on conformance to standard cost vs focussing on adding value..

Well I think fundamentally we need to question why organizations prepare budget. Business needs a benchmark to validate its strategy and business decisions. And budget is one tool which translates the strategy and business decisions of a business. Standard costing goes one level below into operational execution of the strategy and business decisions. It executes the budget and tracks the reality.

So can we do away with the budgeting and planning process? How many organizations do not want to have budgets? Yes there are instances where companies have budget but do not follow standard costing. But yet there is a rough benchmark against which things are compared.

I would love to have more perspectives on this topic and why modern thinking is against standard costing. 

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http://www.globusz.com/ebooks/Costing/00000011.htm

Chapter 1

Basic Cost Concepts

Learning Objectives

To understand the meaning of different costing terms To understand different costing methods

29

To have a basic idea of different costing techniques To understand the meaning of cost sheet

In order to determine and take a dispassionate view about what lies beneath the surface of accounting figures, a financial analyst has to make use of different management accounting techniques. Cost techniques have a precedence over the other techniques since accounting treatment of cost is often both complex and financially significant. For example, if a firm proposes to increase its output by 10%, is it reasonable to expect total cost to increase by less than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behavior, i.e. the way costs change with the levels of activity. The answers to these questions are very much pertinent for a management accountant or a financial analyst since they are basic for a firm’s projections and profits which ultimately become the basis of all financial decisions. It is, therefore, necessary for a financial analyst to have a reasonably good working knowledge about the basic cost concepts and patterns of cost behavior. All these come within the ambit of cost accounting.

Meaning of Cost Accounting

Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due to competitive nature of the market, it was realized that ascertaining of cost is not so important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to the technological developments in all fields, cost reduction has also come within the ambit of cost accounting. Cost accounting is, thus, concerned with recording, classifying and summarizing costs for determination of costs of products or services, planning, controlling and reducing such costs and furnishing of information to management for decision making.

According to Charles T. Horngren, cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for the following three major purposes:

Operational planning and control Special decisions Product decisions

According to the Chartered Institute of Management Accountants, London, cost accounting is the process of accounting for costs from the point at which its expenditure is incurred or committed to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned.

Cost accounting, thus, provides various information to management for all sorts of decisions. It serves multiple purposes on account of which it is generally indistinguishable from management accounting or so-called internal accounting. Wilmot has summarized the nature of cost accounting as “the analyzing, recording, standardizing, forecasting, comparing, reporting and recommending” and the role of a cost accountant as “a historian, news agent and prophet.” As a historian, he should be meticulously accurate and sedulously impartial. As a news agent, he should be up to date, selective and pithy. As a prophet, he should combine knowledge and experience with foresight and courage.

Objectives of Cost Accounting

The main objectives of cost accounting can be summarized as follows:

1. Determining Selling Price

Business enterprises run on a profit-making basis. It is, thus, necessary that revenue should be greater than expenditure incurred in producing goods and services from which the revenue is to be derived. Cost accounting provides various information regarding the cost to make and sell such products or services. Of course, many other factors such as the condition of market, the area of distribution, the quantity which can be supplied etc. are also given due consideration by management before deciding upon the price but the cost plays a dominating role.

2. Determining and Controlling Efficiency

Cost accounting involves a study of various operations used in manufacturing a product or providing a service. The study facilitates measuring the efficiency of an organization as a whole or department-wise as well as devising means of increasing efficiency.

Cost accounting also uses a number of methods, e.g., budgetary control, standard costing etc. for controlling costs. Each item viz. materials, labor and expenses is budgeted at the commencement of a

30

period and actual expenses incurred are compared with budget. This greatly increases the operating efficiency of an enterprise.

3. Facilitating Preparation of Financial and Other Statements

The third objective of cost accounting is to produce statements whenever is required by management. The financial statements are prepared under financial accounting generally once a year or half-year and are spaced too far with respect to time to meet the needs of management. In order to operate a business at a high level of efficiency, it is essential for management to have a frequent review of production, sales and operating results. Cost accounting provides daily, weekly or monthly volumes of units produced and accumulated costs with appropriate analysis. A developed cost accounting system provides immediate information regarding stock of raw materials, work-in-progress and finished goods. This helps in speedy preparation of financial statements.

4. Providing Basis for Operating Policy

Cost accounting helps management to formulate operating policies. These policies may relate to any of the following matters:

o Determination of a cost-volume-profit relationship o Shutting down or operating at a loss o Making for or buying from outside suppliers o Continuing with the existing plant and machinery or replacing them by improved and

economic ones

Concept of Cost

Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective.

In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing.

However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors:

The nature of business or industry The context in which it is used

In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use of term cost without understanding the circumstances can be misleading.

Different costs are found for different purposes. The work-in-progress is valued at factory cost while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term “cost” does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one of such items. Its amount varies in accordance with the method of depreciation being used. However, endeavor should be, as far as possible, to obtain an accurate cost of a product or service.

Elements of Cost

Following are the three broad elements of cost:

1. Material

The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.

a. Direct Material

31

The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material:

All material or components specifically purchased, produced or requisitioned from stores

Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.) Purchased or partly produced components

Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc.

b. Indirect Material

The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste, printing and stationery material etc. are some of the examples of indirect material.

Indirect material may be used in the factory, office or the selling and distribution divisions.

2. Labor

For conversion of materials into finished goods, human effort is needed and such human effort is called labor. Labor can be direct as well as indirect.

a. Direct Labor

The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products.

Direct labor can also be described as process labor, productive labor, operating labor, etc.

b. Indirect Labor

The labor employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labor. Such labor does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.

Indirect labor may relate to the factory, the office or the selling and distribution divisions.

3. Expenses

Expenses may be direct or indirect.

a. Direct Expenses

These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows:

Hire of some special machinery required for a particular contract Cost of defective work incurred in connection with a particular job or contract etc.

Direct expenses are sometimes also described as chargeable expenses.

b. Indirect Expenses

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These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc.

4. Overhead

The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads.

A manufacturing organization can broadly be divided into the following three divisions:

o Factory or works, where production is done o Office and administration, where routine as well as policy matters are decided o Selling and distribution, where products are sold and finally dispatched to customers

Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads may be of three types:

d. Factory Overheads

They include the following things:

Indirect material used in a factory such as lubricants, oil, consumable stores etc. Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc. Indirect expenses such as factory rent, factory insurance, factory lighting etc.

e. Office and Administration Overheads

They include the following things:

Indirect materials used in an office such as printing and stationery material, brooms and dusters etc.

Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.

Indirect expenses such as rent, insurance, lighting of the office f. Selling and Distribution Overheads

They include the following things:

Indirect materials used such as packing material, printing and stationery material etc. Indirect labor such as salaries of salesmen and sales manager etc. Indirect expenses such as rent, insurance, advertising expenses etc.

Elements of Cost

o Direct material o Direct labor o Direct expenses o Overheads o Factory overheads o Selling and distribution overheads o Office and administration overheads o Indirect material o Indirect labor o Indirect expenses o Indirect material o Indirect labor o Indirect expenses o Indirect material o Indirect labor o Indirect expenses

Components of Total Cost

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1. Prime Cost

Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost.

2. Factory Cost

Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost.

3. Office Cost

Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production.

4. Total Cost

Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales.

Various components of total cost can be depicted with the help of the table below:

Components of total cost

Direct materialDirect labor Direct expenses

Prime cost or direct cost or first cost

Prime cost plus works overheads Works or factory cost or production cost or manufacturing cost

Works cost plus office and administration overheads

Office cost or total cost of production

Office cost plus selling and distribution overheads Cost of sales or total cost

Cost Sheet

Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on different items for a particular period. Additional columns may also be provided to show the cost of a particular unit pertaining to each item of expenditure and the total per unit cost.

Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of estimated data (estimated cost sheet), depending on the technique employed and the purpose to be achieved.

The techniques of preparing a cost sheet can be understood with the help of the following examples.

Example 1

Following information has been obtained from the records of left center corporation for the period from June 1 to June 30, 1998.

Cost of raw materials on June 1,1998 30,000

Purchase of raw materials during the month 4,50,000

Wages paid 2,30,000

Factory overheads 92,000

Cost of work in progress on June 1, 1998 12,000

Cost of raw materials on June 30, 1998 15,000

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Cost of stock of finished goods on June 1, 1998 60,000

Cost of stock of finished goods on June 30, 1998

55,000

Selling and distribution overheads 20,000

Sales 9,00,000

Administration overheads 30,000

Prepare a statement of cost.

Solution

Statement of cost of production of goods manufactured for the period ending on June 30, 1998.

Opening stock of raw materialsAdd-- purchase

30,0004,50,000------------4,80,00015,000

Less-- closing stock of raw material Value of raw materials consumed WagesPrime costFactory overheads

Add-- opening stock of work in progressLess-- closing stock of work in progress Factory costAdd-- Administration overheadCost of production of goods manufacturedAdd--opening stock of finished goods

4,65,0002,30,0006,59,00092,0007,87,00012,0007,99,000---7,99,00030,0008,29,00060,0008,89,000

Less-- closing stock of finished goodsCost of production of goods soldAdd-- selling and distribution overheadsCost of salesProfitSales

55,0008,34,00020,0008,54,00046,0009,00,000

Example 2

From the following information, prepare a cost sheet showing the total cost per ton for the period ended on December 31, 1998.

Raw materials Productive wages Direct expenses Unproductive wages Factory rent and taxes Factory lighting Factory heating Motive power HaulageDirector’s fees (works)

Directors fees (office) Factory cleaning Sundry office expenses

33,00035,0003,00010,5002,2001,5004,4003,0001,0002,000

Rent and taxes (office) Water supplyFactory insurance Office insurance Legal expenses Rent of warehouse Depreciation--Plant and machinery Office building Delivery vansBad debtAdvertisingSales department salaries

5001,2001,100500400300

2,0001,0002001003001,500

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ExpensesFactory stationery Office stationery Loose tools written off

500200800750900600

Up keeping of delivery vans

Bank chargesCommission on sales

700501,500

The total output for the period has been 10000 tons.

Solution

Cost sheet for the period ended on December 31, 1998

Raw materialsProduction wagesDirect expensesPrime costAdd--works overheads:Unproductive wagesFactory rent and taxesFactory lightingFactory heating

$.33,00035,0003,000

10,5007,5002,2001,5004,400

71,000

Motive powerHaulageDirectors’ fees (works)Factory cleaningEstimating expensesFactory stationeryLoses tools written offWater supplyFactory insuranceDepreciation of plant and machinery

Works costAdd-- office overheadDirectors’ fees (office)Sundry office expensesOffice stationeryRent and taxes (office)Office insuranceLegal expensesDepreciation of office buildingBank charges

Office costAdd-- selling and distribution overheadsRent of warehouseDepreciation on delivery vansBad debtsAdvertisingSales department salariesCommission on salesUpkeep of delivery vansTotal costCost per ton $. 1,18,200/10,000 = $. 11.82

3,0001,0005008007506001,2001,1002,000

2,0002009005005004001,00050

3002001003001,5001,500700

37,050

1,08,050

5,550

1,13,600

4,600

1,18,200

Classification of Cost

Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows:

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1. Fixed, Variable and Semi-Variable Costs

The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows:

Wages of laborers Cost of direct material Power

The cost which does not vary but remains constant within a given period of time and a range of activity inspite of the fluctuations in production is known as fixed cost. Some of its examples are as follows:

Rent or rates Insurance charges Management salary

The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows:

Depreciation Repairs

Fixed costs are sometimes referred to as “period costs” and variable costs as “direct costs” in system of direct costing. Fixed costs can be further classified into:

Committed fixed costs Discretionary fixed costs

Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc. without impairing an organization’s competence to meet the long-term goals.

Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are also termed as managed or programmed costs.

In some circumstances, variable costs are classified into the following:

Discretionary cost Engineered cost

The term discretionary costs is generally linked with the class of fixed cost. However, in the circumstances where management has predetermined that the organization would spend a certain percentage of its sales for the items like research, donations, sales promotion etc., discretionary costs will be of a variable character.

Engineered variable costs are those variable costs which are directly related to the production or sales level. These costs exist in those circumstances where specific relationship exists between input and output. For example, in an automobile

industry there may be exact specifications as one radiator, two fan belts, one battery etc. would be required for one car. In a case where more than one car is to be produced, various inputs will have to be increased in the direct proportion of the output.

Thus, an increase in discretionary variable costs is due to the authorization of management whereas an increase in engineered variable costs is due to the volume of output or sales.

2. Product Costs and Period Costs

The costs which are a part of the cost of a product rather than an expense of the period in which they are incurred are called as “product costs.” They are included in inventory values. In financial statements, such costs are treated as assets until the goods they are

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assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc.

The costs which are not associated with production are called period costs. They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged against the revenue of the relevant period. Differences between opinions exist regarding whether certain costs should be considered as product or period costs. Some accountants feel that fixed manufacturing costs are more closely related to the passage of time than to the manufacturing of a product. Thus, according to them variable manufacturing costs are product costs whereas fixed manufacturing and other costs are period costs. However, their view does not seem to have been yet widely accepted.

3. Direct and Indirect Costs

The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs.

The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. All of these cannot be conveniently allocated to production and hence are called indirect costs.

4. Decision-Making Costs and Accounting Costs

Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. They need not tie into routine-financial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making. Moreover, they are historical costs

and show what has happened under an existing set of circumstances. Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. For example, accounting costs may show the cost of a product when the operations are manual whereas decision-making cost might be calculated to show the costs when the operations are mechanized.

5. Relevant and Irrelevant Costs

Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored.

6. Shutdown and Sunk Costs

A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs.

Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. Investments in plant and machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered by decisions made at the later stage, they are irrelevant for decision-making.

An individual may regret for purchasing or constructing an asset but this action could not be avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset will be matched against the proceeds from sale of the asset for the purpose of determining gain or loss. The person may decide to continue to own the asset. In this case, the cost of asset will be matched against the revenue realized over its effective life. However, he/she cannot avoid the cost which has already been incurred by him/her for the acquisition of the asset. It is, as a matter of fact, sunk cost for all present and future decisions.

Example

Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$ without any scrap value. Soon after making the purchase, management feels that the machine should not have been purchased since it is not yielding the operating

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advantage originally contemplated. It is expected to result in savings in operating costs of $. 18,000 over a period of five years. The machine can be sold immediately for $. 22,000.

To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are $. 18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it is immediately disposed. $. 30,000 invested in the asset is not relevant since it is same in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold

the machinery for $. 22,000 since it would result in an extra profit of $. 4,000 as compared to keeping and using it.

7. Controllable and Uncontrollable Costs

Controllable costs are those costs which can be influenced by the ratio or a specified member of the undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs.

A factory is usually divided into a number of responsibility centers, each of which is in charge of a specific level of management. The officer incharge of a particular department can control costs only of those matte$ which come directly under his control, not of other matte$. For example, the expenditure incurred by tool room is controlled by the foreman incharge of that section but the share of the tool room expenditure which is apportioned to a machine shop cannot be controlled by the foreman of that shop. Thus, the difference between controllable and uncontrollable costs is only in relation to a particular individual or level of management. The expenditure which is controllable by an individual may be uncontrollable by another individual.

8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs

Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. For example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. It will simply mean that certain other products will have to absorb a large amount of such overheads. However, the salary of people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in delivery expenses but not in their altogether elimination.

It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of a business.

9. Imputed or Hypothetical Costs

These are the costs which do not involve cash outlay. They are not included in cost accounts but are important for taking into consideration while making management decisions. For example, interest on capital is ignored in cost accounts though it is considered in financial accounts. In case two projects require unequal outlays of cash, the management should take into consideration the capital to judge the relative profitability of the projects.

10. Differentials, Incremental or Decrement Cost

The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the

incremental costs are matched with incremental revenue. This is explained with the following example:

Example

A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows:

Selling price per unit $. 10Variable cost per unit $. 5Fixed costs $. 4,000

The management is considering the following two alternatives:

i. To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $. 500.

ii. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at $. 6 per unit. This will result in reducing the present fixed costs from $. 4,000 to $. 3,000.

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Which alternative the management should accept?

Solution

Statement showing profitability under different alternatives is as follows:

ParticularsPresent situation$.              $.

Proposed situations

Sales.Less:Variable purchase costsFixed costs Profit

5,0004,000

10,0009,000

1,000

6,0004,500

11,60010,500

1,100

5,4003,000

10,0008,400

1,600

Observations

i. In the present situation, the company is making a profit of $. 1,000. ii. In the proposed situation (i), the company will make a profit of $. 1,100. The incremental costs will be

$. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation.

iii. In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation.

Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii).

The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative.

In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs.

11. Out-of-Pocket Costs

Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as out-of-pocket costs.

12. Opportunity Cost

Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned. For example, if a building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which should be taken into account while evaluating the profitability of the project. Suppose, a manufacturer is confronted with the problem of selecting anyone of the following alternatives:

a. Selling a semi-finished product at $. 2 per unit b. Introducing it into a further process to make it more refined and valuable

Alternative (b) will prove to be remunerative only when after paying the cost of further processing, the amount realized by the sale of the product is more than $. 2 per unit. Also, the revenue of $. 2 per unit is foregone in case alternative (b) is adopted. The term “opportunity cost” refers to this alternative revenue foregone.

13. Traceable, Untraceable or Common Costs

The costs that can be easily identified with a department, process or product are termed as traceable costs. For example, the cost of direct material, direct labor etc. The costs that cannot be identified so are termed as untraceable or common costs. In other words, common costs are the costs incurred collectively for a number of cost centers and are to be suitably apportioned for determining the cost of individual cost centers. For example, overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one consignment etc.

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Joint cost is a kind of common cost. When two or more products are produced out of one material or process, the cost of such material or process is called joint cost. For example, when cottonseeds and cotton fibers are produced from the same material, the cost incurred till the split-off or separation point will be joint costs.

14. Production, Administration and Selling and Distribution Costs

A business organization performs a number of functions, e.g., production, illustration, selling and distribution, research and development. Costs are to be curtained for each of these functions. The Chartered Institute of Management accountants, London, has defined each of the above costs as follows:

i. Production Cost

The cost of sequence of operations which begins with supplying materials, labor and services and ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labor, direct expenses and factory overheads.

ii. Administration Cost

The cost of formulating the policy, directing the organization and controlling the operations of an undertaking which is not related directly to a production, selling, distribution, research or development activity or function.

iii. Selling Cost

It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders.

iv. Distribution Cost

It is the cost of sequence of operations beginning with making the packed product available for dispatch and ending with making the reconditioned returned empty package, if any, available for reuse.

v. Research Cost

It is the cost of searching for new or improved products, new application of materials, or new or improved methods.

vi. Development Cost

The cost of process which begins with the implementation of the decision to produce a new or improved product or employ a new or improved method and ends with the commencement of formal production of that product or by the method.

vii. Pre-Production Cost

The part of development cost incurred in making a trial production as preliminary to formal production is called pre-production cost.

15. Conversion Cost

The cost of transforming direct materials into finished products excluding direct material cost is known as conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and factory overheads.

Cost Unit and Cost Center

The technique of costing involves the following:

Collection and classification of expenditure according to cost elements Allocation and apportionment of the expenditure to the cost centers or cost units or both

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Cost Unit

While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed.

Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of cost:

(i) Brick works per 1000 bricks made(ii) Collieries per ton of coal raised(iii) Textile mills per yard or per lb. of cloth manufac- tured or yarn spun(iv) Electrical companies per unit of electricity generated(v) Transport companies per passenger km.(vi) Steel mills per ton of steel made

Cost Center

According to the Chartered Institute of Management Accountants, London, cost center means “a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control.” Thus, cost center refers to one of the convenient units into which the whole factory or an organization has been appropriately divided for costing purposes. Each such unit consists of a department, a sub-department or an item or equipment or machinery and a person or a group of persons. Sometimes, closely associated departments are combined together and considered as one unit for costing purposes. For example, in a laundry, activities such as collecting, sorting, marking and washing of clothes are performed. Each activity may be considered as a separate cost center and all costs relating to a particular cost center may be found out separately.

Cost centers may be classified as follows:

Productive, unproductive and mixed cost centers Personal and impersonal cost centers Operation and process cost centers

Productive cost centers are those which are actually engaged in making products. Service or unproductive cost centers do not make the products but act as the essential aids for the productive centers. The examples of such service centers are as follows:

Administration department Repairs and maintenance department Stores and drawing office department

Mixed costs centers are those which are engaged sometimes on productive and other times on service works. For example, a tool shop serves as a productive cost center when it manufactures dies and jigs to be charged to specific jobs or orders but serves as servicing cost center when it does repairs for the factory.

Impersonal cost center is one which consists of a department, a plant or an item of equipment whereas a personal cost center consists of a person or a group of persons. In case a cost center consists of those machines or persons which carry out the same operation, it is termed as operation cost center. If a cost center consists of a continuous sequence of operations, it is called process cost center.

In case of an operation cost center, cost is analyzed and related to a series of operations in sequence such as in chemical industries, oil refineries and other process industries. The objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside the factory.

Cost Estimation and Cost Ascertainment

Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-determination may be required for several purposes. Some of the purposes are as follows:

Budgeting Measurement of performance efficiency Preparation of financial statements (valuation of stocks etc.) Make or buy decisions Fixation of the sale prices of products

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Cost ascertainment is the process of determining costs on the basis of actual data. Hence, the computation of historical cost is cost ascertainment while the computation of future costs is cost estimation.

Both cost estimation and cost ascertainment are interrelated and are of immense use to the management. In case a concern has a sound costing system, the ascertained costs will greatly help the management in the process of estimation of rational accurate costs which are necessary for a variety of purposes stated above. Moreover, the ascertained cost may be compared with the pre-determined costs on a continuing basis and proper and timely steps be taken for controlling costs and maximizing profits.

Cost Allocation and Cost Apportionment

Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost units Thus, the former involves the process of charging direct expenditure to cost centers or cost units whereas the latter involves the process of charging indirect expenditure to cost centers or cost units.

For example, the cost of labor engaged in a service department can be charged wholly and directly but the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate share will have to be found out. Charging of costs in the former case will be termed as “allocation of costs” whereas in the latter, it will be termed as “apportionment of costs.”

Cost Reduction and Cost Control

Cost reduction and cost control are two different concepts. Cost control is achieving the cost target as its objective whereas cost reduction is directed to explore the possibilities of improving the targets. Thus, cost control ends when targets are achieved whereas cost reduction has no visible end. It is a continuous process. The difference between the two can be summarized as follows:

i. Cost control aims at maintaining the costs in accordance with established standards whereas cost reduction is concerned with reducing costs. It changes all standards and endeavors to improve them continuously.

ii. Cost control seeks to attain the lowest possible cost under existing conditions whereas cost reduction does not recognize any condition as permanent since a change will result in lowering the cost.

iii. In case of cost control, emphasis is on past and present. In case of cost reduction, emphasis is on the present and future.

iv. Cost control is a preventive function whereas cost reduction is a correlative function. It operates even when an efficient cost control system exists.

Installation of Costing System

The installation of a costing system requires careful consideration of the following two interrelated aspects:

Overcoming the practical difficulties while introducing a system Main considerations that should govern the installation of such a system

Practical Difficulties

The important difficulties in the installation of a costing system and the suggestions to overcome them are as follows:

a. Lack of Support from Top Management

Often, the costing system is introduced at the behest of the managing director or some other director without taking into confidence other members of the top management team. This results in opposition from various managers as they consider it interference as well as an uncalled check of their activities. They, therefore, resist the additional work involved in the cost accounting system.

This difficulty can be overcome by taking the top management into confidence before installing the system. A sense of cost consciousness has to be instilled in their minds.

b. Resistance from the Staff

The existing financial accounting staff may offer resistance to the system because of a feeling of their being declared redundant under the new system.

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This fear can be overcome by explaining the staff that the costing system would not replace but strengthen the existing system. It will open new areas for development which will prove beneficial to them.

c. Non-Cooperation at Other Levels

The foreman and other supervisory staff may resent the additional paper work and may not cooperate in providing the basic data which is essential for the success of the system.

This needs re-orientation and education of employees. They have to be told of the advantages that will accrue to them and to the organization as a whole on account of efficient working of the system.

d. Shortage of Trained Staff

Costing is a specialized job in itself. In the beginning, a qualified staff may not be available. However, this difficulty can be overcome by giving the existing staff requisite training and recruiting additional staff if required.

e. Heavy Costs

The costing system will involve heavy costs unless it has been suitably designed to meet specific requirements. Unnecessary sophistication and formalities should be avoided. The costing office should serve as a useful service department.

Main Considerations

In view of the above difficulties and suggestions, following should be the main considerations while introducing a costing system in a manufacturing organization:

1. Product

The nature of a product determines to a great extent the type of costing system to be adopted. A product requiring high value of material content requires an elaborate system

of materials control. Similarly, a product requiring high value of labor content requires an efficient time keeping and wage systems. The same is true in case of overheads.

2. Organization

The existing organization structure should be distributed as little as possible. It becomes, therefore, necessary to ascertain the size and type of organization before introducing the costing system. The scope of authority of each executive, the sources from which a cost accountant has to derive information and reports to be submitted at various managerial levels should be carefully gone through.

3. Objective

The objectives and information which management wants to achieve and acquire should also be taken care of. For example, if a concern wants to expand its operations, the system of costing should be designed in a way so as to give maximum attention to production aspect. On the other hand, if a concern were not in a position to sell its products, the selling aspect would require greater attention.

4. Technical Details

The system should be introduced after a detailed study of the technical aspects of the business. Efforts should be made to secure the sympathetic assistance and support of the principal members of the supervisory staff and workmen.

5. Informative and Simple

The system should be informative and simple. In this connection, the following points may be noted:

(i) It should be capable of furnishing the fullest information required regularly and systematically, so that continuous study or check-up of the progress of business is possible.

(ii) Standard printed forms can be used so as to make the information detailed, clear and intelligible. Over-elaboration which will only complicate matte$ should be avoided.

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(iii) Full information about departmental outputs, processes and operations should be clearly presented and every item of expenditure should be properly classified.

(iv) Data, complete and reliable in all respects should be provided in a lucid form so that the measurement of the variations between actual and standard costs is possible.

6. Method of Maintenance of Cost Records

A choice has to be made between integral and non-integral accounting systems. In case of integral accounting system, no separate sets of books are maintained for costing transactions but they are interlocked with financial transactions into one set of books.

In case of non-integral system, separate books are maintained for cost and financial transactions. At the end of the accounting period, the results shown by two sets of books are reconciled. In case of a big business, it will be appropriate to maintain a separate set of books for cost transactions.

7. Elasticity

The costing system should be elastic and capable of adapting to the changing requirements of a business.

It may, therefore, be concluded from the above discussion that costing system introduced in any business will not be a success in case of the following circumstances:

1. If it is unduly complicated and expensive 2. If a cost accountant does not get the cooperation of his/her staff 3. If cost statements cannot be reconciled with financial statements 4. If the results actually achieved are not compared with the expected ones

Methods of Costing

Costing can be defined as the technique and process of ascertaining costs. The principles in every method of costing are same but the methods of analyzing and presenting the costs differ with the nature of business. The methods of job costing are as follows:

1. Job Costing

The system of job costing is used where production is not highly repetitive and in addition consists of distinct jobs so that the material and labor costs can be identified by order number. This method of costing is very common in commercial foundries and drop forging shops and in plants making specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate expenditure is charged thereto.

2. Contract Costing

Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a small contract. The term is usually applied where large-scale contracts are carried out. In case of ship-builders, printers, building contractors etc., this system of costing is used. Job or contract is also termed as terminal costing.

3. Cost Plus Costing

In contracts where in addition to cost, an agreed sum or percentage to cover overheads and fit is paid to a contractor, the system is termed as cost plus costing. The term cost here includes materials, labor and expenses incurred directly in the process of production. The system is used generally in cases where government happens to be the party to give contract.

4. Batch Costing

This method is employed where orders or jobs are arranged in different batches after taking into account the convenience of producing articles. The unit of cost is a batch or a group of identical products instead of a single job order or contract. This method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries.

5. Process Costing

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If a product passes through different stages, each distinct and well defined, it is desired to know the cost of production at each stage. In order to ascertain the same, process costing is employed under which a separate account is opened for each process.

This system of costing is suitable for the extractive industries, e.g., chemical manufacture, paints, foods, explosives, soap making etc.

6. Operation Costing

Operation costing is a further refinement of process costing. The system is employed in the industries of the following types:

a. The industry in which mass or repetitive production is carried out b. The industry in which articles or components have to be stocked in semi-finished stage to

facilitate the execution of special orders, or for the convenience of issue for later operations

The procedure of costing is broadly the same as process costing except that in this case, cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips molding, machining and finally polishing. The cost to complete these operations may be found out separately.

7. Unit Costing (Output Costing or Single Costing)

In this method, cost per unit of output or production is ascertained and the amount of each element constituting such cost is determined. In case where the products can be expressed in identical quantitative units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets are prepared in which various items of expense are classified and the total expenditure is divided by the total quantity produced in order to arrive at per unit cost of production. The method is suitable in industries like brick making, collieries, flour mills, paper mills, cement manufacturing etc.

8. Operating Costing

This system is employed where expenses are incurred for provision of services such as those tendered by bus companies, electricity companies, or railway companies. The total expenses regarding operation are divided by the appropriate units (e.g., in case of bus company, total number of passenger/kms.) and cost per unit of service is calculated.

9. Departmental Costing

The ascertainment of the cost of output of each department separately is the objective of departmental costing. In case where a factory is divided into a number of departments, this method is adopted.

10. Multiple Costing (Composite Costing)

Under this system, the costs of different sections of production are combined after finding out the cost of each and every part manufactured. The system of ascertaining cost in this way is applicable where a product comprises many assailable parts, e.g., motor cars, engines or machine tools, typewrite$, radios, cycles etc.

As various components differ from each other in a variety of ways such as price, materials used and manufacturing processes, a separate method of costing is employed in respect of each component. The type of costing where more than one method of costing is employed is called multiple costing.

It is to be noted that basically there are only two methods of costing viz. job costing and process costing. Job costing is employed in cases where expenses are traceable to specific jobs or orders, e.g., house building, ship building etc. In case where it is impossible to trace the prime cost of the items for a particular order because of the reason that their identity gets lost while manufacturing operations, process costing is used. For example, in a refinery where several tons of oil is being produced at the same time, the prime cost of a specific order of 10 tons cannot be traced. The cost can be found out only by finding out the cost per ton of total oil produced and then multiplying it by ten.

It may, therefore, be concluded that the methods of batch contract and cost plus costing are only the variants of job costing whereas the methods of unit, operation and operating costing are the variants of process costing.

Techniques of Costing

Besides the above methods of costing, following are the types of costing techniques which are used by management only for controlling costs and making some important managerial decisions. As a matter of fact, they are not independent methods of cost

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finding such as job or process costing but are basically costing techniques which can be used as an advantage with any of the methods discussed above.

1. Marginal Costing

Marginal costing is a technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable overheads. Fixed overheads are excluded in cases where production varies because it may give misleading results. The technique is useful in manufacturing industries with varying levels of output.

2. Direct Costing

The practice of charging all direct costs to operations, processes or products and leaving all indirect costs to be written off against profits in the period in which they arise is termed as direct costing. The technique differs from marginal costing because some fixed costs can be considered as direct costs in appropriate circumstances.

3. Absorption or Full Costing

The practice of charging all costs both variable and fixed to operations, products or processes is termed as absorption costing.

4. Uniform Costing

A technique where standardized principles and methods of cost accounting are employed by a number of different companies and firms is termed as uniform costing. Standardization may extend to the methods of costing, accounting classification including codes, methods of defining costs and charging depreciation, methods of allocating or apportioning overheads to cost centers or cost units. The system, thus, facilitates inter- firm comparisons, establishment of realistic pricing policies, etc.

Systems of Costing

It has already been stated that there are two main methods used to determine costs. These are:

Job cost method • Process cost method

It is possible to ascertain the costs under each of the above methods by two different ways:

Historical costing Standard costing

Historical Costing

Historical costing can be of the following two types in nature:

Post costing Continuous costing

Post Costing

Post costing means ascertainment of cost after the production is completed. This is done by analyzing the financial accounts at the end of a period in such a way so as to disclose the cost of the units which have been produced.

For instance, if the cost of product A is to be calculated on this basis, one will have to wait till the materials are actually purchased and used, labor actually paid and overhead expenditure actually incurred. This system is used only for ascertaining the costs but not useful for exercising any control over costs, as one comes to know of things after they had taken place. It can serve as

guidance for future production only when conditions in future continue to be the same.

Continuous Costing

In case of this method, cost is ascertained as soon as a job is completed or even when a job is in progress. This is done usually before a job is over or product is made. In the process, actual expenditure on materials and wages and share of overheads are also estimated. Hence, the figure of cost ascertained in this case is not exact. But it has an advantage of providing cost information to the management

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promptly, thereby enabling it to take necessary corrective action on time. However, it neither provides any standard for judging current efficiency nor does it disclose what the cost of a job ought to have been.

Standard Costing

Standard costing is a system under which the cost of a product is determined in advance on certain pre-determined standards. With reference to the example given in post costing, the cost of product A can be calculated in advance if one is in a position to estimate in advance the material labor and overheads that should be incurred over the product. All this requires an efficient system of cost accounting. However, this system will not be useful if a vigorous system of controlling costs and standard costs are not in force. Standard costing is becoming more and more popular nowadays.

Summary

1. Cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for operational planning and control, special decisions and product decisions.

2. Cost may be classified into different categories depending upon the purpose of classification viz. fixed cost, variable cost and semi variable cost.

3. Costing can be defined as the technique and process of ascertaining costs.

Chapter 2

Marginal Costing and Absorption Costing

Learning Objectives

To understand the meanings of marginal cost and marginal costing To distinguish between marginal costing and absorption costing To ascertain income under both marginal costing and absorption costing

Introduction

The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term.

Marginal costing - definition

Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.

The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.

Marginal costing is formally defined as:‘the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making’. (Terminology.)

The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus

MARGINAL COST = VARIABLE COST DIRECT LABOUR+DIRECT MATERIAL+DIRECT EXPENSE+VARIABLE OVERHEADS

CONTRIBUTION SALES - MARGINAL COSTThe term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation. The meaning is usually clear from the context.

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Note Alternative names for marginal costing are the contribution approach and direct costing In this lesson, we will study marginal costing as a technique quite distinct from absorption costing.

Theory of Marginal Costing

The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA, London is as follows:

In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in the following two steps:

1. If the volume of output increases, the cost per unit in normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of $3,000 and if by increasing the output by one unit the cost goes up to $3,002, the marginal cost of additional output will be $.2.

2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is $1,045, the average marginal cost per unit is $2.25. It can be described as follows:

Additional cost =Additional units

$ 45 = $2.25   20

The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods.

For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300–280).

The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique.

Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.

There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.

Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost)

Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).

In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). this is known as break even point.

The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.

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The principles of marginal costing

The principles of marginal costing are as follows.

a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the ‘relevant range’). Therefore, by selling an extra item of product or service the following will happen.

Revenue will increase by the sales value of the item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from the extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.

c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.

d. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.

Features of Marginal Costing

The main features of marginal costing are as follows:

1. Cost ClassificationThe marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique.

2. Stock/Inventory ValuationUnder marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method.

3. Marginal ContributionMarginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.

Advantages and Disadvantages of Marginal Costing Technique

Advantages

1. Marginal costing is simple to understand. 2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. 3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s fixed

overhead. 4. The effects of alternative sales or production policies can be more readily available and assessed, and

decisions taken would yield the maximum return to business. 5. It eliminates large balances left in overhead control accounts which indicate the difficulty of

ascertaining an accurate overhead recovery rate. 6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts

can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management.

7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.

Disadvantages

1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 2. Normal costing systems also apply overhead under normal operating volume and this shows that no

advantage is gained by marginal costing. 3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs

from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent.

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4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.

5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same.

6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing.

7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.

Presentation of Cost Data under Marginal Costing and Absorption Costing

Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making.

The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm.

Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques:

MARGINAL COSTING PRO-FORMA £ £

Sales Revenue xxxxxLess Marginal Cost of SalesOpening Stock (Valued @ marginal cost) xxxxAdd Production Cost (Valued @ marginal cost) xxxxTotal Production Cost xxxxLess Closing Stock (Valued @ marginal cost) (xxx)Marginal Cost of Production xxxxAdd Selling, Admin & Distribution Cost xxxxMarginal Cost of Sales (xxxx)Contribution xxxxxLess Fixed Cost (xxxx)Marginal Costing Profit xxxxx

ABSORPTION COSTING PRO-FORMA £ £

Sales Revenue xxxxxLess Absorption Cost of SalesOpening Stock (Valued @ absorption cost) xxxxAdd Production Cost (Valued @ absorption cost) xxxxTotal Production Cost xxxxLess Closing Stock (Valued @ absorption cost) (xxx)Absorption Cost of Production xxxxAdd Selling, Admin & Distribution Cost xxxxAbsorption Cost of Sales (xxxx)Un-Adjusted Profit xxxxxFixed Production O/H absorbed xxxxFixed Production O/H incurred (xxxx)(Under)/Over Absorption xxxxxAdjusted Profit xxxxx

Reconciliation Statement for Marginal Costing and Absorption Costing Profit

$

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Marginal Costing Profitxx

ADD(Closing stock – opening Stock) x OAR

xx

= Absorption Costing Profitxx

Where OAR( overhead absorption rate) =Budgeted fixed production overheadBudgeted levels of activities

Marginal Costing versus Absorption Costing

After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits are not the same because of the following reasons:

1. Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits.

2. Difference in Stock Valuation

In marginal costing, work in progress and finished stocks are valued at marginal cost, but in absorption costing, they are valued at total production cost. Hence, profit will differ as different amounts of fixed overheads are considered in two accounts.

The profit difference due to difference in stock valuation is summarized as follows:

a. When there is no opening and closing stocks, there will be no difference in profit. b. When opening and closing stocks are same, there will be no difference in profit, provided the fixed

cost element in opening and closing stocks are of the same amount. c. When closing stock is more than opening stock, the profit under absorption costing will be higher as

comparatively a greater portion of fixed cost is included in closing stock and carried over to next period.

d. When closing stock is less than opening stock, the profit under absorption costing will be less as comparatively a higher amount of fixed cost contained in opening stock is debited during the current period.

The features which distinguish marginal costing from absorption costing are as follows.

a. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed production overhead, whereas in marginal costing, stocks are valued at variable production cost only. The value of closing stock will be higher in absorption costing than in marginal costing.

b. As a consequence of carrying forward an element of fixed production overheads in closing stock values, the cost of sales used to determine profit in absorption costing will:

i. include some fixed production overhead costs incurred in a previous period but carried forward into opening stock values of the current period;

ii. exclude some fixed production overhead costs incurred in the current period by including them in closing stock values.

In contrast marginal costing charges the actual fixed costs of a period in full into the profit and loss account of the period. (Marginal costing is therefore sometimes known as period costing.)

c. In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in greater quantities, whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is, provided that variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing.

d. In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes (such as in budget decision making). It is

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easy to decide by how much contribution (and therefore profit) will be affected by changes in sales volume. (Profit would be unaffected by changes in production volume).

In absorption costing, however, the effect on profit in a period of changes in both:

i. production volume; and ii. sales volume;

is not easily seen, because behaviour is not analysed and incremental costs are not used in the calculation of actual profit.

Limitations of Absorption Costing

The following are the criticisms against absorption costing:

1. You might have observed that in absorption costing, a portion of fixed cost is carried over to the subsequent accounting period as part of closing stock. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs pertaining to the previous period and vice versa.

2. Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per unit changes due to the existence of fixed overhead. Unless fixed overhead rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison and control.

The cost to produce an extra unit is variable production cost. It is realistic to the value of closing stock items as this is a directly attributable cost. The size of total contribution varies directly with sales volume at a constant rate per unit. For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system.

Summary

Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all mangers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting.

Absorption costing and marginal costing are two different techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used for managerial decision-making and control.

Questions

1. Is marginal costing and absorption costing same? 2. What is presentation of cost data? Answer with suitable example.

Chapter 3 – Breakeven Analysis

Learning Objectives

To describe as to how the concepts of fixed and variable costs are used in C-V-P analysis To segregate semi-variable expenses in C-V-P analysis To identify the limiting assumptions of C-V-P analysis To work out the breakeven analysis, contribution analysis and margin of safety To understand how to draw a breakeven chart To compute breakeven point

Introduction

In this lesson, we will discuss in detail the highlights associated with cost function and cost relations with the production and distribution system of an economic entity.

To assist planning and decision making, management should know not only the budgeted profit, but also:

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the output and sales level at which there would neither profit nor loss (break-even point) the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred

(the margin of safety)

MARGINAL COSTS, CONTRIBUTION AND PROFIT

A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.

Marginal costing is a form of management accounting based on the distinction between:

a. the marginal costs of making selling goods or services, and b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in

the period.

Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.

Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.

C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.

Cost-Volume-Profit (C-V-P) Relationship

We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.

Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in the short run.

The relationship among cost, revenue and profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in various statement forms.

Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors:

Volume of production Product mix Internal efficiency and the productivity of the factors of production Methods of production and technology Size of batches Size of plant

Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services.

In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:

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1. What is the breakeven revenue of an organization? 2. How much revenue does an organization need to achieve a budgeted profit? 3. What level of price change affects the achievement of budgeted profit? 4. What is the effect of cost changes on the profitability of an operation?

Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to produce.

Following are the three approaches to a CVP analysis:

Cost and revenue equations Contribution margin Profit graph

Objectives of Cost-Volume-Profit Analysis

1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other.

2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities.

3. Cost-volume-profit analysis assist in evaluating performance for the purpose of control. 4. Such analysis may assist management in formulating pricing policies by projecting the effect of

different price structures on cost and profit.

Assumptions and Terminology

Following are the assumptions on which the theory of CVP is based:

1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue.

2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:

o Direct materials o Direct labor o Direct chargeable expenses

Variable overheads include the following:

o Variable part of factory overheads o Administration overheads o Selling and distribution overheads

3. There is linear relationship between revenue and cost. 4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C

holds good which is the equation of a straight line. 5. The unit selling price, unit variable costs and fixed costs are constant. 6. The theory of CVP is based upon the production of a single product. However, of late, management

accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.

7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes.

8. All revenue and cost can be added and compared without taking into account the time value of money. 9. The theory of CVP is based on the technology that remains constant. 10. The theory of price elasticity is not taken into consideration.

Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas:

Strategic and long-range planning decisions Decisions about product features and pricing

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In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same.

For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:

Number of output units Number of customer visits made for sales Number of advertisements placed

Some of the multiple cost drivers are as follows:

Number of units produced Number of batches in which units are produced

Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.

Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:

1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.

2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.

3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.

4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.

5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.

6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.

Sensitivity Analysis or What If Analysis and Uncertainty

Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.

In the context of CVP analysis, sensitivity analysis answers the following questions:

a. What will be the operating income if units sold decrease by 15% from original prediction? b. What will be the operating income if variable cost per unit increases by 20%?

The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.

A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.

Example

Following is the spreadsheet of ABC Ltd.,

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Statement showing CVP Analysis for Dolphy Software Ltd.

Revenue required at $. 200 Selling Price per unit to earn Operating Income of

Fixed costVariable cost

per unit0 1,000 1,500 2,000

2,000 100 4,000 6,000 7,000 8,000

120 5,000 7,500 8,750 10,000

140 6,667 10,000 11,667 13,333

2,500 100 5,000 7,000 8,000 9,000

120 6,250 8,750 10,000 11,250

140 8,333 11,667 13,333 15,000

3,000 100 6,000 8,000 9,000 10,000

120 7,500 10,000 11,250 12,500

140 10,000 13,333 15,000 16,667

From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit. For example, revenue of $. 6,000 (30 units @ $. 200 each) is required to earn an operating income of $. 1,000 if fixed cost is $. 2,000 and variable cost per unit is $. 100. You can also use exhibit 3-4 to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place:

The booth rental at the ABC convention raises to $. 3,000 (thus increasing fixed cost to $. 3,000) The software suppliers raise their price to $. 140 per unit (thus increasing variable costs to $. 140)

An aspect of sensitivity analysis is the margin of safety which is the amount of budgeted revenue over and above breakeven revenue. The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the “what if” questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitor’s better product, poorly executed marketing programs and so on.

Assume you have fixed cost of $. 2,000, selling price of $. 200 and variable cost per unit of $. 120. For 40 units sold, the budgeted point from this set of assumptions is 25 units ($. 2,000 ÷ $. 80) or $. 5,000 ($. 200 x 25). Hence, the margin of safety is $. 3,000 ($. 8,000 – 5,000) or 15 (40 –25) units.

Sensitivity analysis is an approach to recognizing uncertainty, i.e. the possibility that an actual amount will deviate from an expected amount.

Marginal Cost Equations and Breakeven Analysis

From the marginal cost statements, one might have observed the following:

Sales – Marginal cost = Contribution ......(1)

Fixed cost + Profit = Contribution ......(2)

By combining these two equations, we get the fundamental marginal cost equation as follows: Sales – Marginal cost = Fixed cost + Profit ......(3) This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.

The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,

P/V Ratio (or C/S Ratio) = Contribution (c)......(4)Sales (s)

It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100. Or, Contribution = Sales x P/V ratio ......(5)

Or, Sales = Contribution......(6)P/V ratio

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The above-mentioned marginal cost equations can be applied to the following heads:

1. Contribution

Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:

Selecting product mix or sales mix for profit maximization Fixing selling prices under different circumstances such as trade depression, export sales, price

discrimination etc.

2. Profit Volume Ratio (P/V Ratio), its Improvement and Application

The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:

P/V ratio =Sales – Marginal cost of sales

=Contribution

=Changes in contribution

=Change in profit

Sales Sales Changes in sales Change in sales

A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.

A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:

Breakeven point Profit at any volume of sales Sales volume required to earn a desired quantum of profit Profitability of products Processes or departments

The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:

Increasing selling price Reducing marginal costs by effectively utilizing men, machines, materials and other services Selling more profitable products, thereby increasing the overall P/V ratio

3. Breakeven Point

Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:

Contribution = Fixed cost

Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.

a. Using Marginal Costing Equation

S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F

By multiplying both the sides by S and rearranging them, one gets the following equation:

S BEP = F.S/S-V

b. Using P/V Ratio

Sales S BEP =Contribution at BEP

=Fixed cost

P/ V ratio P/ V ratioThus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then: Breakeven point = 400 x 2000 = $. 1000

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2000 - 1200

Similarly,P/V ratio

= 2000 – 1200 = 0.4 or 40%800

So, breakeven sales = $. 400 / .4 = $. 1000

c. Using Contribution per unit

Breakeven point =Fixed cost

= 100 units or $. 1000Contribution per unit

4. Margin of Safety (MOS)

Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.

Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.

Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.

Margin of safety = Sales at selected activity – Sales at BEP =Profit at selected activity

P/V ratio

Margin of safety is also presented in ratio or percentage as follows:Margin of safety (sales) x 100 %

Sales at selected activity

The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.

a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.

b. Reducing fixed costs c. Reducing variable costs d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output e. Modernization of production facilities and the introduction of the most cost effective technology

Problem 1

A company earned a profit of $. 30,000 during the year 2000-01. Marginal cost and selling price of a product are $. 8 and $. 10 per unit respectively. Find out the margin of safety.

Solution

Margin of safety =Profit

P/V ratio

P/V ratio =Contribution x 100

Sales

Problem 2

A company producing a single article sells it at $. 10 each. The marginal cost of production is $. 6 each and fixed cost is $. 400 per annum. You are required to calculate the following:

Profits for annual sales of 1 unit, 50 units, 100 units and 400 units P/V ratio

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Breakeven sales Sales to earn a profit of $. 500 Profit at sales of $. 3,000 New breakeven point if sales price is reduced by 10% Margin of safety at sales of 400 units

Solution Marginal Cost Statement

Particulars Amount Amount Amount Amount

Units produced 1 50 100 400

Sales (units * 10) 10 500 1000 4000

Variable cost 6 300 600 2400

Contribution (sales- VC) 4 200 400 1600

Fixed cost 400 400 400 400

Profit (Contribution – FC)

-396 -200 0 1200

Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%

Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000 Sales at BEP = Contribution at BEP/ PVR = 100 units

Sales at profit $. 500 Contribution at profit $. 500 = Fixed cost + Profit = $. 900 Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)

Profit at sales $. 3,000 Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200 Profit = Contribution – Fixed cost = $. 1200 – $. 400 = $. 800

New P/V ratio = $. 9 – $. 6/$. 9 = 1/3

Sales at BEP = Fixed cost/PV ratio =$. 400

= $. 1,2001/3

Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 % (Actual sales – BEP sales/Actual sales * 100)

Breakeven Analysis-- Graphical Presentation

Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.

Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).

Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.

Construction of a Breakeven Chart

The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:

1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis. 2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal

axis. 3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This

will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.

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4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.

Uses of Breakeven Chart

A breakeven chart can be used to show the effect of changes in any of the following profit factors:

Volume of sales Variable expenses Fixed expenses Selling price

Problem

A company produces a single article and sells it at $. 10 each. The marginal cost of production is $. 6 each and total fixed cost of the concern is $. 400 per annum.

Construct a breakeven chart and show the following:

Breakeven point Margin of safety at sale of $. 1,500 Angle of incidence Increase in selling price if breakeven point is reduced to 80 units

Solution

A breakeven chart can be prepared by obtaining the information at these levels:

Output units 40 80 120 200

Sales$. $. $. $.400 800 1,200 2,000

Fixed cost 400 400 400 400Variable cost 240 480 400 720Total cost 640 880 1,120 1,600

Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:

This chart clearly shows the breakeven point, margin of safety and angle of incidence.

a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of $. 1,000 or 100 units.

b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of ($. 1,500 - $. 1,000), i.e. $. 500 or 50 units.

c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.

d. At 80 units, total cost (from the table) = $. 880. Hence, selling price for breakeven at 80 units = $. 880/80 = $. 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of $. 10 per unit.

Limitations and Uses of Breakeven Charts

A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.

But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional

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units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.

Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.

Multiple Product Situations

In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.

The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:

Breakeven point (in units) =Fixed costs

Weighted average contribution margin per unit

One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.

Breakeven Point in Sales Revenue

Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:

B.E. point (in revenue) =Fixed cost

Weighted average P/V ratio

Problem Ahmedabad Company Ltd. manufactures and sells four types of products under the brand name Ambience, Luxury, Comfort and Lavish. The sales mix in value comprises the following:

Brand name Percentage

Ambience 33 1/3Luxury 41 2/3Comfort 16 2/3Lavish 8 1/3 ------ 100

The total budgeted sales (100%) are $. 6,00,000 per month.

The operating costs are:

Ambience 60% of selling price LuxuryLuxury 68% of selling price ComfortComfort 80% of selling price LavishLavish 40% of selling price

The fixed costs are $. 1,59,000 per month.

a. Calculate the breakeven point for the products on an overall basis. b. It has been proposed to change the sales mix as follows, with the sales per month remaining at $.

6,00,000:

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Brand Name Percentage

Ambience 25Luxury 40Comfort 30Lavish 05 --- 100

Assuming that this proposal is implemented, calculate the new breakeven point.

Solution

a. Computation of the Breakeven Point on Overall Basis b. Computation of the New Breakeven Point

Profit Graph

Profit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of profit to volume of sales. The construction of a profit graph is relatively easy and the procedure involves the following:

1. Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or loss on vertical axis. The area above horizontal axis is called profit area and the one below it is called loss area.

2. Plotting the profits of corresponding sales and joining them. This is profit line.

Summary

1. Fixed and variable cost classification helps in CVP analysis. Marginal cost is also useful for such analysis.

2. Breakeven point is the incidental study of CVP. It is the point of no profit and no loss. At this specific level of operation, it covers total costs, including variable and fixed overheads.

3. Breakeven chart is the graphical representation of cost structure of business. 4. Profit/Volume (P/V) ratio shows the relationship between contribution and value/volume of sales. It is

usually expressed as terms of percentage and is a valuable tool for the profitability of business. 5. Margin of safety is the difference between sales or units of production and breakeven point. The size

of margin of safety is an extremely valuable guide to the financial strength of a business.

Questions

1. Discuss the concept of fixed and variable cost. 2. CVP analysis is a useful technique for managerial decision-making. Discuss. 3. CVP analysis has no limitation. Discuss. 4. What is a breakeven chart? 5. What questions can a breakeven chart answer to? 6. Provide a formula to determine the breakeven point of a single product, multi-product and different

divisions and subdivisions of an organization. 7. What are the disadvantages of using breakeven analysis? 8. Define contribution margin. 9. Explain-- Margin of safety shows the financial strength of a business.

Quick quiz

1. What is the formula for calculating the breakeven point in terms of the number of units required to break even?

2. Give the formula which uses the C/S ratio to calculate the breakeven point. 3. What is the margin of safety? 4. What do the axes of a breakeven chart represent? 5. Give three uses of breakeven charts. 6. What is a profit/volume chart? 7. What does the horizontal axis of the PN chart represent? 8. What are the limitations of breakeven charts and CVP analysis?

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Answers to quick quiz

1. Breakeven point (units) = Total fixed costs/Contribution per unit 2. Sales value at breakeven point = .Total Fixed Cost divide by C/S ratio 3. The margin of safety is the difference in units between the budgeted sales volume and the breakeven

sales volume. 4. The vertical axis represents money (costs and revenue) and the horizontal axis represents the level of

activity (production and sales). 5. Breakeven charts are used as follows.

o To plan the production of a company’s products o To market a company’s products o To given a visual display of breakeven arithmetic

6. The profit/volume chart is a variation of the breakeven chart which provides a simple illustration of the relationship of costs and profit to sales.

7. ‘V on the horizontal axis is volume or value of sales. 8.o A breakeven chart can only apply to a single product or a single mix of a group of products. o A breakeven chart may be time-consuming to prepare. o It assumes fixed costs are constant at all levels of output. o It assumes that variable costs are the same per unit at all levels of output. o It assumes that sales prices are constant at all levels of output. o It assumes production and sales are the same (stock levels are ignored). o It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

Chapter 4

Standard Cost

Learning Objectives

To understand the meaning of standard costing, its meaning and definition To learn its advantages and limitations To learn how to set of standards and determinations To learn how to revise standards

Introduction

You know that management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control. It can also be applied to your own daily/monthly expenses, if necessary. These measures should be applied correctly so that performance takes place according to plans. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs. Standard costing is a technique which helps you to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.

Meaning of Standard

When you want to measure some thing, you must take some parameter or yardstick for measuring. We can call this as standard. What are your daily expenses? An average of $50! If you have been spending this much for so many days, then this is your daily standard expense.

The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances.

In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.”

Definition

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The CIMA, London has defined standard cost as “a predetermined cost which is calculated from managements standards of efficient operations and the relevant necessary expenditure.” They are the predetermined costs on technical estimate of material labor and overhead for a selected period of time and for a prescribed set of working conditions. In other words, a standard cost is a planned cost for a unit of product or service rendered.

The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures.

Advantages

Standard costing is a management control technique for every activity. It is not only useful for cost control purposes but is also helpful in production planning and policy formulation. It allows management by exception. In the light of various objectives of this system, some of the advantages of this tool are given below:

1. Efficiency measurement-- The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centers. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency. It is not proper to compare costs of different period because circumstance of both the periods may be different. Still, a decision about base period can be made with which actual performance can be compared.

2. Finding of variance-- The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance. It is possible to take corrective measures at the earliest. A regular check on various expenditures is also ensured by standard cost system.

3. Management by exception-- The targets of different individuals are fixed if the performance is according to predetermined standards. In this case, there is nothing to worry. The attention of the management is drawn only when actual performance is less than the budgeted performance. Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and every body tries to achieve his/her targets.

4. Cost control-- Every costing system aims at cost control and cost reduction. The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken. The action taken in spotting weak points enables cost control system.

5. Right decisions-- It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc.

6. Eliminating inefficiencies-- The setting of standards for different elements of cost requires a detailed study of different aspects. The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps.

Limitations of Standard Costing

1. It cannot be used in those organizations where non-standard products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.

2. The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.

3. There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable.

4. The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.

For instance, if the industry changed the technology then the system will not be suitable. In that case, we will have to change or revise the standards. A frequent revision of standards will become costly.

Setting Standards

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Normally, setting up standards is based on the past experience. The total standard cost includes direct materials, direct labor and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control.

Various Elements which Influence the Setting of Standards

Setting Standards for Direct Materials

There are several basic principles which ought to be appreciated in setting standards for direct materials. Generally, when you want to purchase some material what are the factors you consider. If material is used for a product, it is known as direct material. On the other hand, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore, it involves two things:

Quality of material Price of the material

When you want to purchase material, the quality and size should be determined. The standard quality to be maintained should be decided. The quantity is determined by the production department. This department makes use of historical records, and an allowance for changing conditions will also be given for setting standards. A number of test runs may be undertaken on different days and under different situations, and an average of these results should be used for setting material quantity standards.

The second step in determining direct material cost will be a decision about the standard price. Material’s cost will be decided in consultation with the purchase department. The cost of purchasing and store keeping of materials should also be taken into consideration. The procedure for purchase of materials, minimum and maximum levels for various materials, discount policy and means of transport are the other factors which have bearing on the materials cost price. It includes the following:

Cost of materials Ordering cost Carrying cost

The purpose should be to increase efficiency in procuring and store keeping of materials. The type of standard used-- ideal standard or expected standard-- also affects the choice of standard price.

Setting Direct Labor Cost

If you want to engage a labor force for manufacturing a product or a service for which you need to pay some amount, this is called wages. If the labor is engaged directly to produce the product, this is known as direct labor. The second largest amount of cost is of labor. The benefit derived from the workers can be assigned to a particular product or a process. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages. The time required for producing a product would be ascertained and labor should be properly graded. Different grades of workers will be paid different rates of wages. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labor cost. The setting of standard for direct labor will be done basically on the following:

Standard labor time for producing Labor rate per hour

Standard labor time indicates the time taken by different categories of labor force which are as under:

Skilled labor Semi-skilled labor Unskilled labor

For setting a standard time for labor force, we normally take in to account previous experience, past performance records, test run result, work-study etc. The labor rate standard refers to the expected wage rates to be paid for different categories of workers. Past wage rates and demand and supply principle may not be a safe guide for determining standard labor rates. The anticipation of expected changes in labor rates will be an essential factor. In case there is an agreement with workers for payment of wages in the coming period, these rates should be used. If a premium or bonus scheme is in operation, then anticipated extra payments should also be included. Where a piece rate system is used, standard cost will be fixed per piece. The object of fixed standard labor time and labor rate is to device maximum efficiency in the use of labor.

Setting Standards of Overheads

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The next important element comes under overheads. The very purpose of setting standard for overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced. The determination of overhead rate involves three things:

Determination of overheads Determination of labor hours or units manufactured Calculating overheads rate by dividing A by B

The overheads are classified into fixed overheads, variable overheads and semi-variable overheads. The fixed overheads remain the same irrespective of level of production, while variable overheads change in the proportion of production. The expenses increase or decrease with the increase or decrease in output. Semi-variable overheads are neither fixed nor variable. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. The division of overheads into fixed, variable and semi-variable categories will help in determining overheads.

Determination of Standard Costs

How should the ideal standards for better controlling be determined?

1. Determination of Cost Center

According to J. Betty, “A cost center is a department or part of a department or an item of equipment or machinery or a person or a group of persons in respect of which costs are accumulated, and one where control can be exercised.” Cost centers are necessary for determining the costs. If the whole factory is engaged in manufacturing a product, the factory will be a cost center. In fact, a cost center describes the product while cost is accumulated. Cost centers enable the determination of costs and fixation of responsibility. A cost center relating to a person is called personnel cost center, and a cost center relating to products and equipments is called impersonal cost center.

2. Current Standards

A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year. It is presumed that conditions of production will remain unchanged. In case there is any change in price or manufacturing condition, the standards are also revised. Current standard may be ideal standard and expected standard.

3. Ideal Standard

This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption that favorable conditions will prevail and management will be at its best. The price paid for materials will be lowest and wastes etc. will be minimum possible. The labor time for making the production will be minimum and rates of wages will also be low. The overheads expenses are also set with maximum efficiency in mind. All the conditions, both internal and external, should be favorable and only then ideal standard will be achieved.

Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not practicable and may not be achieved. Though this standard may not be achieved, even then an effort is made. The deviation between targets and actual performance is ignorable. In practice, ideal standard has an adverse effect on the employees. They do not try to reach the standard because the standards are not considered realistic.

4. Basic Standards

A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period. Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions. It is indeed just like a number against which subsequent process changes can be measured. Basic standard enables the measurement of changes in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an increase of 25% in the cost of materials. The changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose because the standard is not revised for a long time. The deviation between standard cost and actual cost cannot be used as a yardstick for measuring efficiency.

5. Normal Standards

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As per terminology, normal standard has been defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle. This standard is based on the conditions which will cover a future period of five years, concerning one trade cycle. If a normal cycle of ups and downs in sales and production is 10 years, then standard will be set on average sales and production which will cover all the years. The standard attempts to cover variance in the production from one time to another time. An average is taken from the periods of recession and depression. The normal standard concept is theoretical and cannot be used for cost control purpose. Normal standard can be properly applied for absorption of overhead cost over a long period of time.

6. Organization for Standard Costing

The success of standard costing system will depend upon the setting up of proper standards. For the purpose of setting standards, a person or a committee should be given this job. In a big concern, a standard costing committee is formed for this purpose. The committee includes production manager, purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost accountant acts as a co-coordinator of this committee.

7. Accounting System

Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue item. Codes can be used to have a speedy collection of accounts. A standard is a pre-determined measure of material, labor and overheads. It may be expressed in quality and its monetary measurements in standard costs.

Revision of Standards

For effective use of this technique, sometimes we need to revise the standards which follow for better control. Even standards are also subjected to change like the production method, environment, raw material, and technology.

Standards may need to be changed to accommodate changes in the organization or its environment. When there is a sudden change in economic circumstances, technology or production methods, the standard cost will no longer be accurate. Standards that are out of date will not act as effective feed forward or feedback control tools. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department. If standards are continually not being achieved and large deviations or variances from the standard are reported, they should be carefully reviewed. Also, changes in the physical productive capacity of the organization or in material prices and wage rates may indicate that standards need to be revised. In practice, changing standards frequently is an expensive operation and can cause confusion. For this reason, standard cost revisions are usually made only once a year. At times of rapid price inflation, many managers have felt that the high level of inflation forced them to change price and wage rate standards continually. This, however, leads to reduction in value of the standard as a yardstick. At the other extreme is the adoption of basic standard which will remain unchanged for many years. They provide a constant base for comparison, but this is hardly satisfactory when there is technological change in working procedures and conditions.

Summary

Basically, standard costing is a management tool for control. In the process, we have taken standards as parameters for measuring the performance. Cost analysis and cost control is essential for any activity. Cost includes material labor and overheads. Sometimes, we need to revise the standards due to change in uses, raw material, technology, method of production etc. For a proper organization, it is required to implement this under a committee for the activity. It is a continued activity for the optimum utilization of resources.

Chapter 5

Variance Analysis

A variance is the difference between an actual result and an expected result. The process by which the total difference between standard and actual results is analysed is known as variance analysis. When actual results are better than the expected results, we have a favourable variance (F). If, on the other hand, actual results are worse than expected results, we have an adverse (A).

I will use this example throughout this Exercise:Standard cost of Product A $Materials (5kgs x $10 per kg) 50Labour (4hrs x $5 per hr) 20Variable o/hds (4 hrs x $2 per hr)   8Fixed o/hds (4 hrs x $6 per hr) 24

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Budgeted results ACTUAL Results

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Production: 1,200 unitsSales: 1,000 unitsSelling price: $150 per unit

Production: 1,000 unitsSales: 900 unitsMaterials: 4,850 kgs, $46,075Labour: 4,200 hrs, $21,210Variable o/hds: $9,450Fixed o/hds: $25,000Selling price: $140 per unit

1. Variable cost variances

Direct material variances

The direct material total variance is the difference between what the output actually cost and what it should have cost, in terms of material.

From the example above the material total variance is given by:

$1,000 units should have cost (x $50) 50,000But did cost 46,075Direct material total variance 3, 925 (F)

It can be divided into two sub-variances

The direct material price variance

This is the difference between what the actual quantity of material used did cost and what it should have cost.

$4,850 kgs should have cost (x $10) 48,500But did cost 46,075Direct material price variance 2,425 (F)

The direct material usage variance

This is the difference between how much material should have been used for the number of units actually produced and how much material was used, valued at standard cost

1,000 units should have used (x 5 kgs) 5,000 kgsBut did use 4,850 kgsVariance in kgs 150 kgs (F)Valued at standard cost per kg x $10Direct material usage variance in $ $1,500 (F)

The direct material price variance is calculated on material purchases in the period if closing stocks of raw materials are valued at standard cost or material used if closing stocks of raw materials are valued at actual cost (FIFO).

Direct labour total variance

The direct labour total variance is the difference between what the output should have cost and what it did cost, in terms of labour.

$1,000 units should have cost (x $20) 20,000But did cost 21,210Direct material price variance 1,210 (A)

Direct labour rate variance

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This is the difference between what the actual number of hours worked should have cost and what it did cost.

4200hrs should have cost (4200hrs x $5) $21000But did cost $21210Direct labour rate variance $210(A)

The direct labour efficiency variance

The is the difference between how many hours should have been worked for the number of units actually produced and how many hours were worked, valued at the standard rate per hour.

$1,000 units should have taken (x 4 hrs) 4,000 hrsBut did take 4,200 hrsVariance in hrs 200 hrsValued at standard rate per hour x $5Direct labour efficiency variance $1,000 (A)

When idle time occurs the efficiency variance is based on hours actually worked (not hours paid for) and an idle time variance (hours of idle time x standard rate per hour) is calculated.

2. Variable production overhead total variances

The variable production overhead total variance is the difference between what the output should have cost and what it did cost, in terms of variable production overhead.

$1,000 units should have cost (x $8) 8,000But did cost 9,450Variable production o/hd expenditure variance 1,450 (A)

The variable production overhead expenditure variance

This is the difference between what the variable production overhead did cost and what it should have cost

$4,200 hrs should have cost (x $2) 8,400But did cost 9,450Variable production o/hd expenditure variance 1,050 (A)

The variable production overhead efficiency variance

This is the same as the direct labour efficiency variance in hours, valued at the variable production overhead rate per hour.

Labour efficiency variance in hours 200 hrs (A)Valued @ standard rate per hour x $2Variable production o/hd efficiency variance $400 (A)

3. Fixed production overhead variances

The total fixed production variance is an attempt to explain the under- or over-absorbed fixed production overhead.

Remember that overhead absorption rate =Budgeted fixed production overheadBudgeted level of activity

If either the numerator or the denominator or both are incorrect then we will have under- or over-absorbed production overhead.

If actual expenditure ± budgeted expenditure (numerator incorrect) » expenditure variance

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If actual production / hours of activity » budgeted production / hours of activity (denominator incorrect) » volume variance.

The workforce may have been working at a more or less efficient rate than standard to produce a given output » volume efficiency variance (similar to the variable production overhead efficiency variance).

Regardless of the level of efficiency, the total number of hours worked could have been more or less than was originally budgeted (employees may have worked a lot of overtime or there may have been a strike and so actual hours worked were less than budgeted) » volume capacity variance.

4. The fixed production overhead variances are calculated as follows:

Fixed production overhead variance

This is the difference between fixed production overhead incurred and fixed production overhead absorbed (= the under- or over-absorbed fixed production overhead)

$Overhead incurred 25,000Overhead absorbed (1,000 units x $24) 24,000Overhead variance 1,000 (A)

Fixed production overhead expenditure variance

This is the difference between the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure

$Budgeted overhead (1,200 x $24) 28,800Actual overhead 25,000Expenditure variance 3,800 (F)

Fixed production overhead volume variance

This is the difference between actual and budgeted production volume multiplied by the standard absorption rate per unit.

$Actual production at std rate (1,000 x $24) 24,000Budgeted production at std rate (1,200 x $24) 28,800

4,800 (A)

Fixed production overhead volume efficiency variance

This is the difference between the number of hours that actual production should have taken, and the number of hours actually worked (usually the labour efficiency variance), multiplied by the standard absorption rate per hour.

Labour efficiency variance in hours 200 hrs (A)Valued @ standard rate per hour x $6Volume efficiency variance $1,200 (A)

Fixed production overhead volume capacity variance

This is the difference between budgeted hours of work and the actual hours worked, multiplied by the standard absorption rate per hour

Budgeted hours (1,200 x 4) 4,800 hrsActual hours 4,200 hrsVariance in hrs 600 hrs (A)x standard rate per hour x $6

$3,600 (A)

KEY.

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The fixed overhead volume capacity variance is unlike the other variances in that an excess of actual hours over budgeted hours results in a favourable variance and not an adverse variance as it does when considering labour efficiency, variable overhead efficiency and fixed overhead volume efficiency. Working more hours than budgeted produces an over absorption of fixed overheads, which is a favourable variance.

Sales variances

5. Selling price variance

The selling price variance is a measure of the effect on expected profit of a different selling price to standard selling price. It is calculated as the difference between what the sales revenue should have been for the actual quantity sold, and what it was.

$Revenue from 900 units should have been (x $150) 135,000But was (x $140) 126,000Selling price variance 9,000 (A)

Sales volume variance

The sales volume variance is the difference between the actual units sold and the budgeted quantity, valued at the standard profit per unit. In other words it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted.

Budgeted sales volume 1,000 unitsActual sales volume 900 unitsVariance in units 100 units (A)x standard margin per unit (x $ (150 – 102) ) x $48Sales volume variance $4,800 (A)

KEY.Don’t forget to value the sales volume variance at standard contribution marginal costing is in use.

Operating Statement

Operatingstatements

The most common presentation of the reconciliation between budgeted and actual profit is as follows.

$ $Budgeted profit before sales and admin costs XSales variances- price X

- volume X X

Actual sales minus standard cost of sales X

Cost variances $ $(F) (A)Material price XMaterial usage etc __ X

X X XSales and administration costs XActual profit X

Variances in a standard marginal costing system

No fixed overhead volume variance Sales volume variances are valued at standard contribution margin (not standard profit margin)

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Reasons, interdependence and significance

6. Reasons for variances

Material price

(F) – unforseen discounts received, greater care taken in purchasing, change in material standard (A)– price increase, careless purchasing, change in material standard.

Material usage

(F) – material used of higher quality than standard, more effective use made of material (A) – defective material, excessive waste, theft, stricter quality control

Labour rate

(F) – use of workers at rate of pay lower than standard (A) – wage rate increase

Idle time

Machine breakdown, non-availability of material, illness

Labour efficiency

(F) – output produced more quickly than expected because of work motivation, better quality of equipment or materials

(A) – lost time in excess of standard allowed, output lower than standard set because of deliberate restriction, lack of training, sub-standard material used.

Overhead expenditure

(F) – savings in cost incurred, more economical use of services. (A) – increase in cost of services used, excessive use of services, change in type of services used

Overhead volume

(F) – production greater than budgeted (A) – production less than budgeted

7. Interdependence between variances

The cause of one (adverse) variance may be wholly or partly explained by the cause of another (favourable) variance.

Material price or material usage and labour efficiency Labour rate and material usage Sales price and sales volume

8. The significance of variances

The decision as to whether or not a variance is so significant that it should be investigated should take a number of factors into account.

The type of standard being used Interdependence between variances Controllability Materiality

9. Materials mix and yield variances

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The materials usage variance can be subdivided into a materials mix variance and a materials yield variance if the proportion of materials in a mix is changeable and controllable.

The mix variance indicates the effect on costs of changing the mix of material inputs.

The yield variance indicates the effect on costs of material inputs yielding more or less than expected.

Standard input to produce 1 unit of product X:

$Material A 20 kgs x $10 200Material B 30 kgs x $5 150

350

In period 3, 13 units of product X were produced from 250 kgs of material A and 350 kgs of material B.

Solution 1: individual prices per kg as variance valuation cases

Mix VarianceKgs

Standard mix of actual use: A: 2/5 x (250+350) 240B: 3/5 x (250+350) 360

600===

A BMix should have been 240 kgs 360 kgsBut was 250 kgs 350 kgsMix variance in kgs 10 kgs (A) 10 kgs (F)x standard cost per kg x $10 x $5Mix variance in $ $100 (A) $50 (F)

===== === 50 (A)

Total mix variance in quantity is always zero.

Yield variance

A B13 units of product X should have used 260 kgs 390 kgsbut actual input in standard mix was 240 kgs 360 kgsYield variance in kgs 20 kgs (F) 30 kgs (F)x standard cost per kg x $10 x $5

$200 (F) $150 (F) ===== =====

$350 (F)====

Solution 2: budgeted weighted average price per unit of input as variance valuation base.

Therefore, Budgeted weighted average price =$350/50 = $7 per kg

• Mix varianceA B13 units of product X should have used 260 kgs 390 kgsbut did use 250 kgs 350 kgsUsage variance in kgs 10 kgs (F) 40 kgs (F)x individual price per kg – budgetedweighted average price per kg$ (10 – 7) x $3

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$ (5 – 7) ____ x ($2)$30 (F) $80 (A)=== ===

$50 (A)===

• Yield varianceA BUsage variance in kgs 10 kg (F) 40 kg (F)x budgeted weighted averagePrice per kg x $7 x $7

$70 (F) $ 280 (F) === ====

$350 (F) ====

10. Sales mix and quantity variances

The sales volume variance can be subdivided into a mix variance if the proportions of products sold are controllable.

Sales mix variance

This variance indicates the effect on profit of changing the mix of actual sales from the standard mix.

It can be calculated in one of two ways.

The difference between the actual total quantity sold in the standard mix and the actual quantities sold, valued at the standard margin per unit.

The difference between actual sales and budgeted sales, valued at (standard profit per unit – budgeted weighted average profit per unit)

Sales quantity variance

This variance indicates the effect on profit of selling a different total quantity from the budgeted total quantity.

It can be calculated in one of two ways.

The difference between actual sales volume in the standard mix and budgeted sales valued at the standard margin per unit.

The difference between actual sales volume and budgeted sales valued at the budgeted weighted average profit per unit.

KEY.With all variance calculations, from the most basic (such as variable cost variances) to the more complex (such as mix and yield / mix and quantity variances), it is vital that you do not simply learn formulae. You must understand what your calculations are supposed are supposed to show.

VARIANCES ANALYSIS PRACTICE QUESTIONS

Question 1

Standard Cost for Product RBT

£Materials (10kg x £8 per kg) 80Labour (5hrs x £6 per hr) ¬ 30Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

195

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Budgeted ResultsProduction 10000 unitsSales 7500 unitsSelling Price £300 per unitActual ResultsProduction 8000 unitsSales 6000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £400000Fixed O/Hds £500000Selling Price £260 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 2 Standard Cost for Product TUH

£Materials (10kg x £8 per kg) 80Labour (5hrs x £6 per hr) ¬ 30Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

195Budgeted ResultsProduction 11000 unitsSales 7500 unitsSelling Price £300 per unitActual ResultsProduction 9000 unitsSales 7000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £410000Fixed O/Hds £520000Selling Price £260 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

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Question 3 Standard Cost for Product TD

£Materials (10kg x £5 per kg) 50Labour (5hrs x £6 per hr) ¬ 30Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

165Budgeted ResultsProduction 8000 unitsSales 7500 unitsSelling Price £300 per unitActual ResultsProduction 11000 unitsSales 10000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £400000Fixed O/Hds £500000Selling Price £320 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 4 Standard Cost for Product WXYZ

£Materials (4kg x £8 per kg) 32Labour (5hrs x £10 per hr) ¬ 50Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £6 per hr) 30

152Budgeted ResultsProduction 10000 unitsSales 7500 unitsSelling Price £300 per unitActual ResultsProduction 8000 unitsSales 6000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £400000Fixed O/Hds £500000Selling Price £260 per unit

Calculate

a. Material total variance b. Material price variance

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c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 5 Standard Cost for Product RTY

£Materials (10kg x £8 per kg) 80Labour (5hrs x £6 per hr) ¬ 30Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

195Budgeted ResultsProduction 13000 unitsSales 10000 unitsSelling Price £300 per unitActual ResultsProduction 12000 unitsSales 9000 unitsMaterials 90000 kg Cost £750000Labour 40000 hrs Cost £350000Variable O/Hds £500000Fixed O/Hds £600000Selling Price £350 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 6 Standard Cost for Product RED

£Materials (10kg x £7 per kg) 70Labour (5hrs x £6 per hr) ¬ 30Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

185Budgeted ResultsProduction 10500 unitsSales 7800 unitsSelling Price £310 per unitActual ResultsProduction 8500 unitsSales 6200 unitsMaterials 87000 kg Cost £700000Labour 36000 hrs Cost £330900

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Variable O/Hds £400000Fixed O/Hds £550000Selling Price £270 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 7 Standard Cost for Product BUZZ

£Materials (3kg x £8 per kg) 24Labour (5hrs x £10 per hr) ¬ 50Variable O/Hds (5hrs x £9 per hr) 45Fixed O/Hds (5hrs x £10 per hr) 50

169Budgeted ResultsProduction 10000 unitsSales 7500 unitsSelling Price £300 per unitActual ResultsProduction 8000 unitsSales 6000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £400000Fixed O/Hds £500000Selling Price £260 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 8 Standard Cost for Product RST

£Materials (10kg x £20per kg) 200Labour (5hrs x £16 per hr) ¬ 80Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

365Budgeted Results

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Production 1000 unitsSales 7500 unitsSelling Price £800 per unitActual ResultsProduction 8000 unitsSales 6000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £400000Fixed O/Hds £500000Selling Price £260 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 9 Standard Cost for Product FGT

£Materials (10kg x £8 per kg) 80Labour (5hrs x £6 per hr) ¬ 30Variable O/Hds (5hrs x £8 per hr) 40Fixed O/Hds (5hrs x £9 per hr) 45

195Budgeted ResultsProduction 10000 unitsSales 7500 unitsSelling Price £300 per unitActual ResultsProduction 13000 unitsSales 6000 unitsMaterials 85000 kg Cost £700000Labour 36000 hrs Cost £330900Variable O/Hds £400000Fixed O/Hds £500000Selling Price £260 per unit

Calculate

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

Question 10

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Standard Cost for Product White Diamond£

Materials (7kg x £9 per kg) 63Labour (6hrs x £9 per hr) ¬ 54Variable O/Hds (6hrs x £6 per hr) 36Fixed O/Hds (6hrs x £7 per hr) 42

195Budgeted ResultsProduction 12500 unitsSales 8500 unitsSelling Price £500 per unitActual ResultsProduction 15000 unitsSales 8000 unitsMaterials 8750 kg Cost £85000Labour 5200hrs Cost £52900Variable O/Hds £25500Fixed O/Hds £84000Selling Price £600 per unit

a. Material total variance b. Material price variance c. Material usage variance d. Labour total variance e. Labour rate variance f. Labour efficiency variance g. Variable overhead total variance and all sub- variances h. Fixed Production overhead total Variance and all sub-variances i. Selling price variance j. Sales volume variance

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