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Cost & Management Accounting (MGT-402)

changes inversely with changes in activity level Assume that for an estimated activity level of

50,000 machine hours budgeted factory overhead is Rs. 150,000 which includes Rs 100.000 of

fixed cost. The absorption rate and its composition in this case is as follow:

FOH absorption rate:

Rs, 150,000/ 50.000 machine hrs

= Rs. 3 per machine hr.

The fixed rate:

Rs. 100,000/50.000 machine hrs

= Rs. 2 per machine hr.

The variable rate:

Rs 3 per machine hr less Rs. 2 per machine hr = Rs. 1 per machine hr.

It is very easily understood that Rs, 100.000 of fixed factory overhead can be absorbed only when

capacity attained till the end of year is 50,000 machine hours If capacity attained is less than the

budgeted capacity it means an unfavorable capacity variance, which will be signified by unabsorbed

fixed factory overhead. Assume that the capacity attained is 48,000 machine hours. At this capacity

level only Rs 96,000 of fixed factory overhead is absorbed (i.e. 48,000 hrs x Rs. 2) and the under

absorbed fixed cost of Rs 4,000(i.e. Rs. 100,000 less Rs. 96,000) represents the portion of factory

overhead variance cause by unfavorable capacity variance. Similarly, where capacity attained is

more than the budgeted capacity it is a favorable capacity variance which will be signified by over

absorbed fixed factory overhead. In other words capacity variance can be computed by multiplying

the difference in capacity (budgeted and attained) by the fixed rate. The same result is obtained by

taking. the difference between absorbed factory overhead and budgeted factor* overhead for

capacity attained.

Budget/Spending Variance

Budget variance is the difference between budgeted factory overhead for capacity attained and

actual factory overhead incurred. It represents either over-spending or under-spending.

If actual factory overhead is more than the budgeted, it is unfavorable budget variance. On the

other hand if actual factory overhead is less than the budgeted it is favorable budget variance.

In order to determine exact causes of budget variance, the difference between actual and budgeted

figures of each item of factory overhead is computed and communicated to the responsible person

for the purpose of control. The budget variance may be due to fixed factory overhead items or it

may be due to the variable items or the both.

Following practice question explains the computation and presentation of the variance and its

analysis.

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Cost & Management Accounting (MGT-402)

PRACTICE QUESTION

Shahzewaz Associates prepared following estimates for the year 2006.

Fixed factory overhead

Variable factory overhead

Direct labor hours Actual results for the year 19xx were as follow:

Fixed factory overhead

Rs. 450,000

Variable factory overhead

Rs. 600,000

Direct labor hours

200,000

Required: Calculate

(i)

Total factory overhead variance.

(ii)

Capacity variance.

(iii)

Budget variance.

Solution:

(i)

Total Factory Overhead Variance

Actual factory overhead

Fixed FOH + Variable FOH

Rs. 450.000 + Rs. 680,000

Rs. 1,130,000

Absorbed factory overhead

Capacity attained x Absorption rate

220,000 hours x Rs. 5.25

1,155,000

Over applied

25,000

(ii)

Capacity Variance

Absorbed factory overhead (220,000 x 5.25)

Rs. 1.155.000

Budgeted factory overhead for capacity attained

Fixed factory overhead + (Capacity attained x Variable rate)

(Rs. 450,000 + 220,000 hours x Rs. 3)

1,110,000

Favorable

45,000

(iii)

Budget Variance

Budgeted factory overhead for capacity attained

Rs. 1,110,000

Actual factory overhead

1,130,000

Unfavorable

20,000

Supporting Calculations

Absorption rate = (Rs 450.000 + Rs. 600,000)

200.000 direct labor hours

= Rs. 5.25 per direct labor hour

Variable rate

= Rs. 600.000

2,00,0000 direct labor hours

= Rs. 3 per direct labor hour

It should be remembered here that no definite conclusions can be drawn only on the basis of

factory overhead variance analysis, as presented above Analysis of factory overhead variance is a

part of whole process of variance analysis whereby direct materials variance and direct labor

variance are also computed and analysed. Complete study of variance analysis is a part of advanced

courses of cost accounting.

In the above practice question capacity attained in terms of direct labor hours is greater than the

budgeted capacity. This seemingly favorable capacity variance may, in fact, be due to unfavorable

factors. For example, direct labor may be less efficient and as a result same quantity of output is

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Cost & Management Accounting (MGT-402)

produced by working greater number of hours, or it may be due to defective materials which

require more conversion time and as such the hours worked over and above the budgeted capacity

have not resulted in extra output Similarly an unfavorable budget variance may be on account of

higher spending on preventive repairs and maintenance or higher spending on training of workers,

which is in effect beneficial for the organisation.

Here a practice question is discussed to explain High and Low Point Method. This method is a

technique to segregate fixed and variable portions of a total/semi-variable cost.

Practice Question

Predetermined factory overhead absorption rate computed by AI-Nasr Associates Rs. 6 per

machine hour. Budgeted factory overhead for activity level of 150.000 machine hours is Rs.

800,000 and for activity level of 100,000 machine hours it is Rs. 700,000. Actual factory overhead

incurred during the year is Rs. 710,000 at an actual volume of 120,000 machine hours.

Required:

(i)

Variable factory overhead absorption rate.

(ii)

Budgeted fixed factory overhead,

(iii)

Budgeted activity level on which the absorption rate is based

(iv)

Over or under absorbed factory overhead.

(v)

Volume variance

(vi)

Spending variance

Solution:

(i)

Variable Factory Overhead Absorption Rate:

Activity Level

Budgeted FOH

(Machine Hours)

(Rs.)

High

150,000

800,000

Low

100,000

700.000

50,000

100,000

For a change of 50,000 machine hour's m activity level there is a change of Rs, 100,000 in

budgeted factory overhead. This change in budgeted factory overhead is due to variable factory

overhead. Therefore,

Variable rate

Change in budgeted FOH

Change in activity level

Rs 100,000/50,000 machine hours

Rs. 2 per machine hour

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Cost & Management Accounting (MGT-402)

(ii) Budgeted Fixed Factory Overhead:

Total FOH for 150,000 machine hours

= Rs. 800.000

Budgeted variable FOH = 150,000 hrs Rs 2

= Rs. 300,000

Budgeted fixed FOH = Rs 800.000 less Rs. 300,000

= Rs. 500.000

Total FOH for 100.000 machine hours

= Rs 700.000

Budgeted variable FOH =100.000 hrs x Rs. 2

= Rs 200.000

Budgeted fixed FOH = Rs, 700.000 less Rs. 200,000

=Rs. 500.000

(iii)Budgeted Activity Level

Budgeted activity level = Fixed FOH

Fixed rate

= Rs. 500.000/ (Rs. 6 less Rs. 2)

=125,000 machine hours

(iv) Over or under absorbed Factory Overhead:

Actual factory overhead

Rs. 710.000

Absorbed factory overhead

Actual volume x FOH absorption rate

120,000 hrs x Rs. 6

720.000

Over absorbed

10,000

(v) Volume Variance:

Absorbed factory overhead

Rs. 720,000

Budgeted FOH for actual volume

Fixed FOH + (Actual volume x Variable rate)

Rs, 500.000 + (120.000 hrs, x Rs. 2)

740,000

Unfavorable

20,000

(vi) Spending Variance:

Budgeted FOH for actual volume

Rs. 740,000

Actual factory overhead

710,000

Favorable

30,000

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Cost & Management Accounting (MGT-402)

LESSON# 18

JOB ORDER COSTING SYSTEM

It has been explained that a cost accounting system is composed of two sub-systems:

(i)

A system of recording and summarizing costs and

(ii)

A costing system.

Costing system means "the ascertainment of costs ", It includes determination of total cost as well as

unit cost. A costing system determines and reports to management total and unit cost of product

or project of service with details of cost components

Costing is compulsory for satisfying at least three important needs of management.

I. Unit cost must be known to assist the management in making price decisions.

II. Ascertainment of cost at every stage of production is important for exercising control over

costs.

III. In order to operate a system of accounting for costs, management needs to know cost of

materials, labor and overhead to be charged to work in process, cost of work completed

and transferred to finished goods and the cost of goods sold so that necessary debit and

credit entries can be passed.

Choice of a Costing System

Job Order Costing or Process Costing?

What type of costing system an accounting entity should adopt? It depends upon:

(1)

Nature of operations and

(2)

Information needs of management.

Take the example of a construction company that produces houses in response to customers'

orders and according to their specifications. All the times, the company remains engaged in the

construction of many houses at different sites for different customers. Such a company definitely

wants to know the cost incurred on each house separately so that customers' can be billed properly

and profit (or loss) on each contract may be ascertained. Here the nature of operations is such that

each house is clearly distinguishable from the other and separate calculation of cost for each house

is desirable and practically possible. This company will employ job costing system.

On the other hand take the example of a company producing cement. All of the bags of cement

produced are quite similar. Here separate calculation of cost of cement supplied to each

customer is neither desirable nor feasible. The company can calculate cost per bag of cement

produced by dividing total cost incurred during the accounting period by total number of bags

produced during the period.

Accordingly, the company can fix the price per bag and bill each customer according to the

number of bags supplied to him. This company will use process costing system.

Job costing and process costing are two basic types of costing systems and can be viewed

as two ends of a spectrum or range. In practice we find companies employing either one of

these two or some combination of features of the two both of these at the same time. For

example, a ready made garments manufacturer employs process costing to accumulate and

determine the cost of free size shirts produced by him in large quantity. At the same time he

uses job costing to accumulate the cost of waiters' uniforms supplied to a hotel under a

contract.

Job costing may be defined:

The costing system that separately accumulates costs incurred to produce each job in a situation where each job is

distinguishable from the other throughout the production process.

The job may be a single unit or a multi unit batch, a contract or a project, program or a service. Job

costing is employed by organisations possessing following characteristics:

1. Production is generally in response of customers' orders.

2. Every order has its own manufacturing specifications. Therefore, every job is different from the

other and requires different amounts materials, labor and overhead.

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Cost & Management Accounting (MGT-402)

3. Each job is clearly distinguishable from the other at all stages production process which makes

job-wise accumulation of possible.

4. Job-wise accumulation of cost is desirable and/or necessary for and profit determination and

5. Each job is generally of high value.

Following are the examples of organisations employing job costing include:

a) Accounting firms

b) Civil engineering

c) Furniture manufacturing

d) Medical care

e) Printing press

f) Ship-building

g) Advertising agencies

h) Computer programming

i) Jewellery manufacturing

j) Movie studios

k) Repair shops

As the costs are accumulated separately for each job, therefore, job costing requires considerable

amount of clerical work. Where production is carried in different departments of a factory,

department wise cost accumulation is also necessary for performance evaluation of departmental

management. In this way clerical work is further increased. Consequently, job costing is more

expensive as compared with process costing. Job costing is also called specific order costing or

production order costing.

Job order costing procedures

Most of the times, organisations employing job order costing are required to submit quotation

before finalization of customer's order. Therefore, naturally, the first step in job order costing is to

prepare an estimate of cost likely to be incurred to produce the job. The estimation is done by

coordination of sales, designing and production departments. On the basis of estimated cost price

is quoted. When customer's order has been initialized production planning and control

department takes the first step towards execution of the order.

On receipt of production order, cost accounting department prepares a job cost sheet for each

job. Job cost sheet may be defined as a document used for accumulating costs incurred to produce a job.

Design and contents of job cost sheet vary widely depending on customs of manufacturing

operations and information needs of management.

However, generally, a job cost sheet is designed to show the following information:

1. Job number

2. Name of the customer

3. Description and specifications of the job

4. Date of commencement of production

5. Date of completion of job.

6. Direct materials cost incurred on the job

7. Direct labor cost incurred on the job

8. Factory overhead applied to the job

9. Total cost of the job

10. Selling and administration expenses chargeable to the job

11. Sales price of the job

12. Profit (or loss) on the job

13. Where the job consists of a batch, the quantity produced and unit cost

14. Where cost estimates are prepared before production, estimated cost should also be shown for

comparison and efficiency evaluation.

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Cost & Management Accounting (MGT-402)

Job cost sheet is one of the basic documents used in job order costing. Upto the time the job is

incomplete; job cost sheet serves as a subsidiary record .for work in process control account and is placed in

work in process subsidiary ledger. On completion of job, the relevant job cost sheet is removed

from work in process subsidiary ledger.

Now it reveals the cost of completed job and serves as source document for debiting finished goods

account (or completed jobs control account) and for crediting work in process account.

Then it is placed in finished goods subsidiary ledger and serves as subsidiary record .for finished goods

account. When completed job is shipped to the customer, relevant job cost sheet serves as source

document for debiting cost of goods sold account and for crediting finished goods account. Then it

is placed in cost of goods sold subsidiary ledger where the same job cost sheet serves as subsidiary

record for cost of goods sold account.

Manufacturing process is, most of the times, divided into departments. This departmentalization

is the logical result of different types of operations performed to produce a product. For example,

furniture manufacturing is divided into cutting, assembling and finishing and polishing

departments; readymade garments manufacturing is divided into cutting, stitching finishing and

packing departments.

These departments are regarded as cost centers. Cost Centre means a division or segment for which a

separate individual is made responsible .for incurrence of cost. Accumulation of cost for each department is

necessary to achieve better control over cost. In job order costing it is necessary to identify cost

not only with the department but also with the relevant job.

Direct materials, direct labor and factory overhead to be charged to each job and to each

department are recorded in the following manners:

Direct Materials: Every materials requisition issued to secure direct materials bears the name of

department and job number for which materials are required. Periodically (weekly or fortnightly

etc) a summary of materials requisitions is prepared. Materials requisition summary analyses cost

of materials issued and ascertains cost of materials chargeable to each department and to each job.

Indirect materials issued cannot be associated with particular jobs, therefore, these are summarised

only by department. Instead of posting each individual materials issue to job cost sheets, the

periodic totals are recorded on relevant job cost sheets.

The periodic grand total are debited to work in process and factory overhead -control accounts and

credited to materials control account.

Direct Labor: Primary labor cost data are accumulated on Job Time Tickets. Job time tickets

contain names of departments and job numbers for which labor time is used. A labor cost analysis

sheet is prepared periodically that analyses the direct labor cost by departments and by jobs. As

indirect labor cost cannot be identified with particular jobs, therefore, labor cost analysis sheet

analyses it only by departments. The periodic totals are posted to job cost sheets and debited to

work in process and factory overhead control accounts.

Factory Overhead: Factory overhead is applied to jobs on the basis of predetermined

departmental factory overhead applied rates. Factory overhead is also periodically applied to the

jobs and entered in job cost sheets. Total applied factory overhead is debited to work in process

control account and credited to factory overhead applied account.

Practice Question

Job Order Costing. Shah Taj Engineering Works on April 5, 2006 started production of 100 lawn

mower of model EG- 72 ordered by Capital Development Authority. Islamabad, vide Order No.

2119-M dated April 1, 2006 at a price of Rs. 3,600 per lawn mower.

Production Planning Department allotted Job No. J-832-LM and instructed the factory to

complete production by April 20, 2006. However, the factory completed production on April 18,

2006.

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Cost & Management Accounting (MGT-402)

On April 11, weekly Materials Requisitions Summary. No. MRS-16 and weekly Labor Cost

Analysis Sheet No.LAS-16 showed following charges to Job No. J-832-LM.

Department 101

Department 102

Direct materials

Rs. 58,500

11,700

Direct labor

Rs. 13,500

15,750

(900 hours)

Materials Requisitions Summary No. MRS-17 and Labor Cost Analysis Sheet No. LAS-17

prepared on April 18 revealed following direct costs for the job.

Department 101

Department 102

Direct materials

Rs.71,500

Rs. 14,300

Direct labor

Rs. 16,500

Rs. 19,250

(1100 hours)

In department 101 factory overhead is applied @ 50% of direct labor cost and in department 102

@ Rs. 12 per direct labor hour. Marketing and administration expenses chargeable to the job were

respectively 7.5 % and 5% of the sale price. The lawn mowers were delivered to customer on April

22, 2006

Required:

(i) Prepare a Job Cost Sheet for Job No. J-832-LM.

(ii) Assuming that J-832-LM was the only job worked on during the two weeks period, pass

account entries in General Journal form to record:

(a) Cost incurred on the job:

(b) Completion of the job; and

Solution

SHAH TAJ ENGINEERING WORKS LIMITED

JOB COST SHEET FOR JOB NO. J-832-LM

Customer's Name:

Capital Development Authority. Islamabad.

Order No. 2119-M Dated 02-04-2006 Description Lawn Mowers Model EG- 72

Total Cost Rs. 260.000 No. of units. 100Date Started 05-04-2006

Date wanted 20-04-2006 Date Completed 18-04-2006 Unit Sales Price Rs. 3,600 Unit Cost Rs.

2,600

DIRECT MATERIALS

Date

Mat. Req. Sum. Department 101

Department 102

Total

11-04-2006

MRS-16

Rs. 58,500

11,700

70,200

18-04-2006

MRS-17

71,500

14,300

85,800

Total

130,000

26,000

156,000

DIRECT LABOR

Date

Lab

Analysis Department 101

Department 102

Total

Sheet No.

11-04-2006

LAS-16

Rs. 13,500

15,750

29,250

18-04-2006

LAS-17

16,500

19,250

35,750

Total

30,000

35,000

65,000

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Cost & Management Accounting (MGT-402)

FACTORY OVERHEAD APPLIED

Date

Department 101

Department 102

Total

D.L

Rate

Amount

D.L

Rate

Amount

Cost

Hours

11-04-2006

13,500

50%

6,750

900

10,800

17,750

18-04-2006

16,500

50%

8,250

1,100

13,200

21,450

Total

15,000

24,000

39,000

Total Production Cost

Direct material cost

156,000

Direct labor cost

65,000

Factory overhead cost

39,000

260,000

Income Statement

Sales price 100 units @ Rs. 3,600

360,000

Cost of production

260,000

Gross profit

100,000

Operating expenses

Marketing Expenses (Rs. 360,000 x 7.5%)

27,000

Administration Expenses (Rs. 360,000 x 5%) 18,000

45,000

Net Income/profit

55,000

Problem Questions

Q. 1

Arman Advertisers on November 15, 2006 received an order from Pheasent Cosmetics Limited for

manufacturing and installation of a huge neon sign for a contract price of Rs. 180,000. Job No.

676-PN was allotted and manufacturing was begun on November 21, 2006 .The costs are charged

to the jobs periodically by means of weekly summaries.

Following costs were related to Job No. 676-PN

WEEK ENDED

Nov. 23

Nov. 30

Dec.7

Dec. 14

Rs.

Direct materials

13,300

24,800

16,400

12,600

Direct labor

1,800

12,400

20,100

14,200

Factory overhead is applied @ 25% of prime cost. The Job was completed on December 14, 2006

Selling expenses are applied to the job @ 3 % of contract price and administration expenses @ 2%

of contract price.

Required: Prepare a job cost sheet containing above information

Q. 2

In order to submit quotation for air conditioning of Hina Shopping Centre, management of Indus

Electrical Industries made following estimates:

Direct materials Rs. 280,000;

Direct labor Rs. 120,000;

Predetermined overhead applied rate is 50% of direct labor cost;

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Cost & Management Accounting (MGT-402)

Predetermined rates for charging marketing and administration expenses are respectively 3% and

2% of the contract price.

On the basis of above estimates contract price was quoted as Rs. 575,000

The quotation was accepted by the owners of Hina Shopping Centre and the order was finalized

on October 6, 2006.

Job No. 1617 was assigned to the order and the work was started on October 12, 2006. Weekly

materials requisition summaries and labor cost analysis sheets showed following charges to Job

No. 1617.

Date

Direct Material

Direct labor

October 17

Rs. 120,000

Rs. 46,000

October 24

Rs. 96,000

Rs. 44,000

October 31

Rs. 60,000

Rs. 48,000

The job was completed on October 31. However, the time allowed for completion of job was upto

November 4.

Required

(i)

Prepare job cost sheet for Job No. 1617.

(ii)

Assuming that Job No. 1617 was the only job worked on during the above period, pass

entries in general journal form to record production and sale of the job. Job was accepted by the

customer on November 4 and cash received for the contract price.

Q. 3

Hussain Engineering Co. Ltd. produces machines as per customer's specifications. The following

data pertains to Job Order No. K 101:

Customer: Azam Banking Co.

Date Started: 06-08-2006.

Customer Order No. C 467.

Date Finished: 20-08-2006.

Dated: 31-07-2006. Total Cost of manufacture?

Sales Price?

Description: 6 Banking Machines.

Week End 13/08

Week End 20/08

Materials used. Dept. A.

Rs. 4,800

Rs. 2,600

Direct labor rate. Dept. A.

Rs 40 per hour

Rs. 40 per hour

Labor hours used, Dept. A.

1,200

800

Direct labor rate, Dept. B.

Rs 42 per hour

Rs. 42 per hour

Labor hour uses, Dept. B.

600

280

Machine hours. Dept. B.

400

240

Applied factory overhead Dept. A. Rs. 20/labor hr.

Rs. 20/labor hr.

Applied factory overhead Dept. B Rs. 18/machine hr

Rs.18/machine hr

Marketing and administrative costs are charged to each order @ 20% of the cost to manufacture

Required:

Prepare a job order cost sheet

Calculate sales price of the job, assuming that it has been contracted with a

markup of 40%

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Cost & Management Accounting (MGT-402)

LESSON# 19

PROCESS COSTING SYSTEM

(An introduction)

Definition

Process costing system applies when standardised goods are produced tom a series of inter-

connected operations.

In some industries, the output produced emerges from a continuous process. An example might be

an oil refinery; Oil in a raw state is input and subjected to a process of purification. Refined oil

emerges at the end of the process.

Problems that arise in such situations include the attribution of materials costs and conversion

costs to units of finished output and the occurrence of losses during the process (spoilt or lost

production).

The characteristics and application of process costing

Continuous production

In the job order costing, costs were directly allocated to a particular job. When standardised goods

or services result from a sequence of repetitive and continuous operations, it is useful to work out

the cost of each operation. Then because every unit produced may be assumed to have involved

the same amount of work, costs for a period are charged to processes or operations, and unit costs

are ascertained by dividing process costs by the quantity of output units produced This is know n

as process costing.

Series of interconnected operations

Process costing applies when standardised goods are produced from a series of interconnected

operations. Process costing system is employed by industries possessing following characteristics:

1. There is mass production of a single product or two or more products in successive runs

of scheduled duration e.g., vegetable canning or fruit juice bottling.

2. All units of output are exactly similar and are produced by the same manufacturing

process.

3. Entire manufacturing process is divided into departments or processes, each performing a

specific set of operations.

4. Completed output of each department, except the last one, is the raw materials for the next

department.

5. Manufacturing operations may result in production of joint products or by products.

6. Production is not in response to customers' orders but in anticipation of demand.

Examples of industries using Process Costing include:

Bottling, Pharmaceuticals, Cement, Paint, Coal, Distilleries Electricity, Ice, Soap, Sugar, Canning,

Chemicals, Cooking oil, Electric appliances, Flour, Natural gas, Petroleum Products, Rubber, Steel,

Textile. Under process costing, for the purpose of cost control, each department involved in

manufacturing process is regarded as a cost centre and product costs are accumulated separately

for each department. Cost Centre means a division or segment for which an individual is made responsible

.for the incurrence of cost

Departmental costs are passed through department work in process accounts and not through a

single work in process control account as in job costing. As all units are produced from the same

raw materials and by same manufacturing operations, therefore, it is assumed that same cost is

chargeable to each unit. Instead of accumulating cost of individual units, an average unit cost is

computed by dividing total cost by total output of the period. Cost is associated only with

departments and not with jobs. It reduces clerical efforts for accumulation and analysis of cost. In

this way process costing is less expensive, as compared with job costing.

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The Process Cost Sheet also called Cost of Production Report is the basic document in process

costing. This document is prepared for each department and shows the quantities processed, total

and unit cost, and cost of work transferred out, and still in process. .

Following table is meant to make the difference between the two costing systems more clear.

Job order costing system

Process costing system

Where different products

Application

Where single standard

having peculiar

product is produced or

specifications are produced

two or more standard

against customers' orders

products are produced in

successive runs.

Production is for stock

and in anticipation of

demand.

In order to determine cost

Accumulation of Cost

of each job, costs are

Costs are associated only

compiled job wise. At the

same time, to evaluate

with departments

efficiency of departmental

management cost are also

compiled department wise

Unit cost is computed on

completion of job. The job

may itself be a single cost

Cost per unit

unit e.g. a machine or it may

An average unit cost is

be a multi unit

computed at the end of

costing period by dividing

total cost by units of output

Only one work in process

of the period.

control account is

maintained

A separate work in process

control

account

More clerical efforts are

Work in process a/c

maintained

for

each

needed to accumulate costs

producing department

by jobs and by departments,-

therefore, the system is more

Cost accumulation is simple

expensive

as costs are accumulated only

Cost of operating the system

by departments; therefore,

the system is comparatively

less expensive.

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Cost & Management Accounting (MGT-402)

Process costing procedures

In process costing industries standard products are produced in accordance with production

budget. Therefore, it becomes unnecessary to issue a production order. Production Planning and

Control Department communicates production targets to departmental heads by means of written

letters. Data of quantities produced by each department are collected and compared with budgeted

quantities for control purposes. These information are collected by departmental supervisors or

quality inspectors may recording these data. Each producing department is a cost centre because

for the purpose of cost control management is interested in ascertaining departmental costs.

In process costing, generally, a separate work in process account is maintained for each producing

department.

Data Collection

Collection of departmental cost figures of direct materials, direct labor and factory overhead is

based on similar procedure as for, job order costing. However, the source documents used for the

data collection are comparatively simple. These documents identify costs only with departments

and not with jobs as well.

Direct Materials:

Production people secure materials by issuing properly authorised Materials Requisitions. At the

end of each month, these requisitions are sorted and a Materials Requisition Summary indicating

cost of direct and indirect materials issued to each department is prepared. Monthly totals of

direct and indirect materials issued are debited to departmental work in process control accounts

and factory overhead control account respectively and credited to materials control account.

Direct Labor:

Instead of using Job Time Tickets, labor cost data are accumulated on Clock Cards and Daily

Time Sheets. These documents show labor time utilized by each department and classification of

labor cost as direct and indirect. At the end of each month, labor cost data accumulated on these

source documents are summarised in Labor Cost Analysis Sheet indicating direct and indirect

labor cost for each department. Monthly totals of direct labor are debited to departmental work in

process accounts and indirect labor is debited to factory overhead control account.

Factory Overhead:

Factory overhead costs, other than indirect materials and indirect labor discussed earlier, are

accumulated in Voucher Register and in General Journal by means of adjusting entries for

depreciation, expired insurance etc, Monthly total, are debited to factory overhead control

account.

Factory overhead is charged to production through predetermined departmental factory overhead

applied rates. Some industries using process costing charge actual factory overhead to

departments. This method gives satisfactory results if production is stable from month to month,

But if there are fluctuations in production volume, charge of actual factory overhead is

unsatisfactory especially when considerable portion of factory overhead is a fixed cost,

Cost of Completed Output:

Cost of completed output of each production department is calculated in Cost of Production

Report. Cost of units completed and transferred out is credited to work in process control account

of the respective department and debited to work in process control account of the department

receiving the units. Cost transferred out by the last department is, however, debited to finished

goods control account

135

Cost & Management Accounting (MGT-402)

Cost of Production Report

In process costing Cost of Production Report also called Process Cost Sheet is the key

document. At the end of costing period, generally a month, a Cost of Production Report is

prepared. It summarizes the data of quantity produced and cost incurred by each producing

department. It also serves as a source document for passing accounting entries at the end of

costing period.

Cost of production report is divided into five sections. Each section is meant to provide specific

information. A brief description of these sections is presented below:

Quantity schedule.

Cost accumulated in the department/process.

Calculation of equivalent units produced.

Calculation of cost per unit.

Accounting treatment / apportionment of the accumulated cost

Quantity Schedule:

The first section Quantity Schedule contains input and output data in terms of quantities. The

information is presented in the following order.

(i)

Units in process at the beginning of costing period.

(ii)

Units started in process or received from preceding department during the period.

(Total of (i) and (ii) constitutes total units to be accounted for)

(iii)

Units completed and transferred to next department or to finished goods.

(iv)

Units completed but still in the department.

(v)

Units in process at the end of the period and their degree of completion.

(vi)

Units lost in process during the period indicating whether normal loss or abnormal loss.

The stage of completion at which the loss occurs is also specified.

(Total of (iii) , (iv) , (v) and (vi) is again the total units to be accounted for)

The quantity schedule assists management to look at a glance production performance of

departments as well as it provides necessary data for preparing remaining sections of the report.

Cost accumulated in the department/process.

The second section Cost Accumulated to Departments shows total cost for which the

departments are accountable. Total costs include cost of beginning work in process inventory,

cost transferred in from the preceding department and cost of direct materials, direct labor and

factory overhead added by the department. If there is normal loss of units, unit cost received

from preceding department requires adjustment. This adjustment for lost units is also shown in

this section. This section provides data for debiting work in process control accounts of the

departments.

Calculation of equivalent units produced.

In order to arrive at cost per unit of output, total of each cost element is divided by the number of

units produced, For this purpose, where at the end of costing period, there are some partially

completed units in process, these units must be stated in terms of equivalent completed units, For

example, if 4,000 units. are in process at the end of month estimated as 50% complete, these will

be equivalent to 2,000 completed units. These equivalent units are added to units completed by

the department to arrive at equivalent production. Then total cost is divided by this equivalent

production figure to calculate unit cost.

136

Cost & Management Accounting (MGT-402)

Calculation of cost per unit

In process costing, costs are averaged over the units produced. The costs accumulated to a process

for a period are collected and divided by the number of units equally produced during the period.

Accounting treatment / apportionment of the accumulated cost

The last section presents a summary to the explaining the accounting treatments of the costs

incurred in the department. This includes

(i)

Adjustment for lost units for normal loss, if any.

(ii)

Cost transferred out.

(iii)

Cost of abnormal loss, if any.

(iv)

Cost of work in process ending inventory and

(v)

Any other accounting adjustment, if necessary to present.

Cost of production report is generally presented to management with supplementary reports of

usage of materials, labor and factory overhead.

Standard format of a simple

Cost of Production Report

I- Quantity Schedule:

Units put into the process

***

Units completed in this process & transferred

to next department.

***

Units not yet completed at the end of the

Period.

***

***

II- Cost Accumulated In The Department / Process:

Direct Material Cost

***

Direct Labor

***

Factory Overhead (Applied)

***

***

III- Calculation of Equivalent Units Produced

100% of completed units + % completed of the in process units

IV- Calculation Of Per Unit Cost

Total Cost

Equivalent Units Produced

V-

Accounting Treatment

1- Finished goods

2- Closing Work in process

137

Cost & Management Accounting (MGT-402)

Problem Questions

Q. 1

Heera Manufacturing Company manufactures a product. Production made and manufacturing

costs incurred in the first department during the month of October .are given below:

10,000 units were started in process out of which 9,400 units were transferred to next department

and remaining 600 units were 1/2 complete as to materials, labor and overhead. Direct materials

Rs. 19,400, direct labor Rs. 24,250 and factory overhead Rs. 14,550 was charged to production.

Required: Cost of production report for the month.

Q. 2

Production and cost data of first production department of Excellent Manufacturing Company for

the month of March 2006 are as follow:

Units started in process were 5,000. Units completed and transferred to second department were

4,500. Remaining units were in process estimated to be 50%, 40%, 60% completed as to materials,

labor and factory overhead respectively. Costs of materials, labor and overhead were Rs. 50,000,

Rs. 60,000 and Rs. 40,000 respectively.

Required: Cost of production report.

138

Cost & Management Accounting (MGT-402)

LESSON# 20, 21, & 22

PROCESS COSTING SYSTEM

Practice Question

Q. 1

Mini Soap Manufacturing unit completed and transferred out 600 soaps to department-11 at the

end of the week. In department-11 500 soaps completed and transferred out. Units which were

still in process 100 (100% material, Conversion cost 60%).

Rs.

Cost received from preceding department

540

Following costs were incurred by department-11:

Direct Material

150

Direct Labor

112

Factory overhead

168

430

970

Required: Prepare cost of production report

Cost of Production Report

Department-II

I-Quantity Schedule:

Units received previous department

600

Unites completed and transfer to

next department

500

Units still in process

100

600

II-Cost Accumulated in the Department / Process:

Cost received from preceding department

Rs.

540

Cost added by department-11:

Direct Material

150

Direct Labor

112

Factory overhead

168

430

970

III-Calculation of Equivalent Units Produced:

(100% of completed units + % of units in process)

Units completed in department-I = 500 + 100 = 600

Direct Material:

500+(100x100%)

= 600

Direct Labor :

500+(100x60%)

= 560

F.O.H

500+(100x60%)

= 560

IV- Unit Cost:

As to Previous department:

Total cost / Number of Equivalent units produced = 540 / 600 = 0.90

As to Direct Material:

150 / 600 = 0.25

As to Direct Labor:

112 / 560 = 0.20

As to F.O.H:

135 / 900 = 0.15

1.65

V- Apportionment of the Accumulated Cost:

Cost of units transferred to the next department

No of completed units x Total cost per unit:

500

1.65

825

Units in process:

Cost of preceding department 100 x 0.9

Direct Material

100 x 0.25

139

Cost & Management Accounting (MGT-402)

Direct Labor

60 x 0.20

F.O.H

60 x 0.30

145

970

Q. 2

Mini Soap Manufacturing unit started to incurring cost in first department for 1000 soaps. At the

end of the week 600 soaps were completed, 300 still in process and 100 units lost. 100% of direct

material had been incurred but 75% conversion cost was yet incurred on the incomplete work.

The detail of costs incurred by the department:

Rs.

Direct material 500

Direct labor

225

Factory overhead

135

Required: Prepare cost of production report

Cost Of Production Report

Department-I

I-Quantity Schedule:

Units started in process

1000

Units completed in the department

600

Units still in process

300

Units Lost (Normal)

100

1,000

II-Cost Accumulated in the Department / Process:

Total

Direct Material

500

Direct Labor

225

F.O.H

135

860

III-Calculation of Equivalent Units Produced:

Direct material 600+ (300x100%)

= 900

Direct labor

600+ (300x75%)

= 825

F.O.H

600+ (300x75%)

= 825

IV- Unit Cost:

Direct material

500/900

= 0 .555

Direct labor

225/825

= 0.27272

F.O.H

135/825

= 0.163636

0.992

V- Apportionment of the Accumulated Cost:

Cost of units transferred to the next department

600

0.992

595

Work in process:

Direct Material

300 x 0.5555 = 167

Direct Labor

300 x 0.2727 = 61

F.O.H

300 x 0.16363 = 37

265

860

140

Cost & Management Accounting (MGT-402)

Normal Loss in First Department.

Loss of units during manufacturing process is, in many industries, a normal condition. This loss

may be due to unavoidable spoiled work or wastage, evaporation or shrinkage etc. In other words,

normal loss represents the lost units expected to arise even under efficient operating conditions.

Such a loss is inherent in manufacturing operations and cannot be avoided, for this reason; cost of

normal loss is absorbed by the good units produced. It has the affect of increasing unit cost of

good output. Total cost of the department is not divided by all units processed, instead. It is

divided only by the good units produced.

Practice Question

During the month of January 2006 direct materials worth Rs. 300,000 were issued to produce

26,000 units of finished product. Direct labor to process these materials totaled Rs. 110,000 and

factory overhead Rs. 55,000. During the month processing of 20,000 units were completed and

these units were transferred to next department, whereas, 1,000 units were lost during processing

(the loss is regarded as normal). All of the direct materials had been issued for the units in process

at the end of month, but these units were only 40% converted. Cost of Production Report for the

month 'based on above inforn1ation is given below:

Ginza Beauty products

Department I

Cost of Production Report

For the Month of January, 2006.

Quantity Schedule

Units started in process

26,000

Units transferred to next department

20,000

Units still in process

5,000

(100% materials, 40% labor & FOH)

Units lost in process

Normal loss

1,000

26,000

Cost accumulated to Department

Total

Units

Rs.

Cost added by the department:

Direct materials

300,000

Direct labor

110,000

Factory overhead

55,000

2.50

Total cost to be accounted for

465,000

19.50

Cost Apportioned

Transferred to next department

(20,000 units x Rs. 19.50)

Rs. 390,000

Rs.

Work in process ending inventory:

Direct materials (5000 units x Rs. 12.00)

60,000

141

Cost & Management Accounting (MGT-402)

Direct labor (5000 units x 40% x Rs. 5.00)

10,000

FOH (5000 units x 40% x Rs. 2.50)

5,000

75,000

465,000

Whenever, normal loss occurs in the first department, it requires no separate calculation. Number

of units so lost is ignored while computing equivalent production. The result is a decrease in

equivalent production quantity (the denominator) and an increase in unit cost.

In the above cost of production report, equivalent production of department I include 20,000

completed units plus 5,000 units in work in process ending inventory adjusted for their stage of

completion.

Normal Loss in Departments Subsequent to the First.

It is stated earlier that cost of normal loss is absorbed by the good units produced and this is done

by omitting lost units from equivalent production quantity. Same procedure applies when units are

lost during processing in a department subsequent to the first.

However, here an adjustment in unit cost from preceding department is also necessary. In the above report

total cost of Rs. 390,000 received from department I was for 20,000 units. Out of these 20,000

units, 500 units were lost. Now total cost of Rs. 390,000 applies only to 19,500 remaining good

units. This decrease in number of units will cause an increase in unit cost from preceding department.

In department 2, after the lost units have been taken into account, unit cost from department I

come to Rs. 20.00 (i.e. Rs. 390,000 + 19,500 units). This increase of Rs. 0.50 (i.e. Rs. 20.00 less Rs.

19.50) is called adjustment for lost units.

The adjustment for lost units can be computed by anyone of the following two methods. For the

purpose of explanation assume the following:

Assembling department received from cutting department 32,000 units at a total cost of

Rs.120,000 resulting in a unit cost of Rs. 3.75. During processing in assembling department 2,000

units were lost. The lost units are considered as normal.

First Method: Firstly find unit cost received from preceding department after adjustment for lost

units and then deduct it from the unit cost before adjustment; the difference is adjustment per unit.

Unit cost after adjustment is calculated by dividing total cost from preceding department by good

units left after the loss.

Computations are illustrated as follow:

Unit cost after adjustment

Rs. 120,000/30,000 units

4.00

Unit cost before adjustment

3.75

Adjustment per unit

0.25

Second Method: Find total cost of lost units at which they are received by the department. This

total cost is now to be absorbed by the remaining good units. How much cost is to be absorbed by

each good unit is computed by dividing remaining good units into total cost of lost units. The

resulting figure is adjustment per good unit.

These computations are explained as follows:

Cost of lost units accumulated upto preceding department

2,000 units x Rs. 3.75

Rs. 7,500

Adjustment per unit Rs. 7.500/30,000 units

Rs. 0.25

142

Cost & Management Accounting (MGT-402)

Normal Loss at the End of Process:

Preceding discussion of normal loss is for a situation where units are lost at the beginning or

during manufacturing process in the department. In many industries, lost units are identified by

quality inspectors at the end of manufacturing process when all production costs have been

incurred by the department. In such cases cost of units lost is charged to completed units only and

no portion of loss is absorbed by Units in work in process ending inventory

For this purpose lost units are included in equivalent production and the adjustment for lost units

is not required, cost of lost units is included in cost of units completed and transferred out or still

in the department. This treatment increases unit cost of completed units only.

Assuming that in department 2 lost units are discovered in final inspection at the end of process,

cost of production report of the department will be as follow:

Ginza Beauty products

Department 2

Cost of Production Report

For the Month of January 2006

Quantity Schedule.

Units received from preceding department

20,000

Units transferred to next department

16,000

Units still in process

(80% direct labor & factory overhead)

3,500

Units lost in process

Normal loss (at the end of process)

500

20,000

Total

Unit

Cost Charged to Department.

Rupees

Cost from preceding department

390,000

19.50

Cost added by department:

Direct labor

36,284

1.88

Factory overhead

72,568

3.76

Total cost added by department

108,852

5.64

Total cost to be accounted for

498,852

25.14

Cost Accounted for as Follow

Rupees

Transferred to next department

(16,000 units x Rs. 25.93)

414,810

Work in process ending inventory

Cost from preceding department

(3,500 units x Rs. 19.50)

68,250

Direct labor (3,500 units x 80% x Rs 1.88)

5,264

FOH (3.500 units x 80% x Rs. 3.76)

10,528

84,042

Total cost accounted for

498,852

Equivalent units produced

16,000 + (3,500 x 80%) + 500 = 19,300 units

Cost per unit

Direct labors

36,284/19,300 units

1.88

Factory overhead

72,568/19,300 units

3.76

Cost transferred to next department

16000 units x Rs. 25.14

402,240

Add cost of lost units

500 units x Rs. 25.14

12,570

143

Cost & Management Accounting (MGT-402)

Total cost

414,840

Unit Cost of Units Transferred out:

Rs. 414,840

= 25.9256

16,000 units

The logic of charging cost of normal loss at the end of process only to completed units is that

these units have goon through quality inspection, whereas, units still in process are yet to pass the

inspection, of-course, units till in process include spoiled units as well. Therefore, units in work in

process ending inventory shall be charged with the cost of spoiled units, .1cluded therein, only

after these units will have goon through quality inspection. In many industries units being

processed in a department are checked at a definite stage before the end of process, say at 75% or

90% stage of completion. In this case cost of normal loss is charged only to those nits which have

passed through the stage at which quality check is made. These units may be still in process or may

have been completed and transferred out.

Abnormal Loss

Abnormal loss is the loss of units not expected to arise under efficient operating conditions. It is

not inherent in the manufacturing process; instead, it is on account of some accident or

carelessness. The reasons of abnormal loss include defective materials or poor workmanship,

machine breakdown or some other contingency. Abnormal loss represents inefficiencies in the

manufacturing process; therefore, it is improper to treat it as a part of product cost of good units.

Cost of abnormal loss is treated as separate unfavorable item and is shown as such in cost of

production report. It is debited to factory overhead control account or to a separate expense

account to be charged directly against revenues of the period and is credited to the departmental

work in process control account. Being an indicator to inefficiency, abnormal loss requires

immediate attention of management.

For the purpose of computing unit cost, units of abnormal loss are, included in equivalent

production after adjustment for degree of completion. Consequently unit cost represents, cost per

unit as if there were no loss.

PRACTICE QUESTION

Q. 3

Mini Soap Manufacturing unit completed and transferred out 600 soaps to department-11 at the

end of the week. In department-11 450 soaps completed and transferred to finished goods. Units

which were still in process 100 and 50 units lost (Normal). Units in process 100% with the

reference of material and 60% with conversion cost.

Rs.

Cost received from preceding department

540

Following costs were incurred by department-II:

Direct Material

150

Direct Labor

112

Factory overhead

168

430

970

Required: Prepare cost of production report

Solution:

Cost of Production Report

Department-II

I-Quantity Schedule:

Units received previous department

600

144

Cost & Management Accounting (MGT-402)

Units completed and transfer to

Finished goods

450

Units still in process

100

Units lost (Normal)

600

II-Cost Accumulated in the Department / Process:

Rs.

Cost received from preceding department

540

Cost added by department-11:

Direct Material

150

Direct Labor

112

Factory overhead

168

430

970

III-Calculation of Equivalent Units Produced:

(100% of completed units + % of units in process)

Units completed in department-I = 450 + 100 = 550

Direct Material:

450+(100x100%)

= 550

Direct Labor :

450+(100x60%)

= 510

F.O.H

450+(100x60%)

= 510

IV- Unit Cost:

Previous department = 540 / 550 = 0.98182

Direct Material

150 / 550 = 0.272727

Direct Labor

112 / 510 = 0.21961

F.O.H

135 / 510 = 0.32941

1.80357

V- Apportionment of the Accumulated Cost :

Transferred to finished goods

450

1.80357

812

Work in process:

Cost of preceding department

(100 x 0.98182)

Direct Material

(100 x0.272727)

Direct Labor

(60 x 0.21961)

F.O.H

(60 x 0.32941)

158

970

Transfer to Finished Goods

Cost of preceding department (450 x 0.98182)

442

Direct Material

(450 x0.272727)

123

Direct Labor

(450 x 0.21961)

F.O.H

(450 x 0.32941)

148

812

145

Cost & Management Accounting (MGT-402)

Q. 4

Mini Soap Manufactures Co. started to incurring cost in first department for 1000 soaps. At the

end of the week 600 soaps were completed and 300 still in process . 100% of direct material had

been incurred. But 75% conversion cost was yet incurred on the incomplete work. Remaining 100

units were abnormally lost (completed 100% material, 50% conversion cost)

Following in the detail of cost incurred:

Direct material Rs.

500

Direct labor

225

Factory Overhead

135

860

Required: Prepare cost of production report

Cost Of Production Report

Department-I

III-Calculation of Equivalent Units Produced:

Direct material:

600+(400x100%)+(100x100%) = 1000

Direct labor : 600+(300x75%)+(100x50%) = 875

F.O.H

600+(300x75%)+(100x50%) = 875

IV- Unit Cost:

Direct material:

500/1,000

= 0 .50

Direct labor :

225/875

= 0.25714

F.O.H

135/875

= 0.15428

0.91142

V- Apportionment Of the Accumulated Cost to Finished Goods:

Cost of units transferred to the next department

600

0.91142

547

Closing W.I.P Inventory:

Direct Material

300 x 0.50

= 150

Direct Labor

300 x 75% x 0.25714

= 58

F.O.H

300 x 75% x 0.15428

= 34

242

Abnormal Loss

Direct Material = 100 x 0.5

= 50

Direct Labor = 50 x 0.25714

= 13

FOH

= 50 x 0.15428

= 8

860

Problem Question

Q. 1

Orient Industries. Limited produces a product that passes through two departments. Production

data for the first month of its operations are as follow:

Department A Department B

Production Costs:

Rupees

Direct materials

140,000

28,000

Conversion costs

200,000

70,000

Units

Production units:

Started / received in process

23,000

13,000

Transferred out

18,000

13,000

Still in process

2/3 complete

3,000

146

Cost & Management Accounting (MGT-402)

1/5 complete

2,500

In department B there is an abnormal loss of 1,500 units when 1/3 complete.

Required: Prepare cost of production report for the month

Q. 2

Delight Food Products produces 'Squash Cubes" by continuous processing. During February 19 -'

producing department XYZ received 8,000 cubes from the preceding department aI1d after

processing, transferred 5,500 cubes to next department. During the month there was normal loss

of 400 cubes at the end of process. 600 cubes, 75% converted, were lost due to negligence of a

worker. There was no work in process beginning inventory, the ending inventory was estimated as

60% converted. Following product costs were charged to the department during February:

Rs.

Cost from preceding department

16,400

Direct materials

2,000

Direct labor

3,625

Factory overhead

5,075

Rs. 27,000

In department XYZ all materials are added at the start of process.

Required: Cost of production report for February 2006

Q. 3

Quantity schedule of Mirza and Company shows that 12,000 units were started in process during

the month of June. 7,000 units were completed and transferred to next department. 4,000 units,

25 % complete as to materials and 50% complete as to labor and factory overhead, were in

process at the end of June. The remaining units were lost during processing. Costs incurred by the

department were materials Rs. 90,000 labor Rs. 70,000 and factory overhead Rs. 50,000. .

Required: Cost of production report for the month.

Q. 4

Tahir Manufacturing Company uses process costing. Costs of direct materials, direct labor and

factory overhead incurred by department A during April 2000, were Rs. 25,000, Rs. 30,000 and Rs.

20,000 respectively. The quantity schedule shows that 8,000 units were started in process. 5,000

units were transferred to next department. 2,000 units were still in process (all materials, 50%

labor and 25 % factory overhead). The remaining units were lost, in process.

Required: Cost of production report for April, 2000.

Q. 5

During April, 20,000 units were transferred in from Department A at a cost of Rs. 39,500.

Materials cost of Rs. 6,500 and conversion cost of Rs. 9,000 were added in Department B. On

April 30, Department B had 5,000 units of work in process 60% complete as to conversion costs.

Materials are added in the beginning of the process in Department B.

Required: Cost of production report.

147

Cost & Management Accounting (MGT-402)

LESSON# 23 & 24

PROCESS COSTING SYSTEM

(Opening balance of work in process)

Work-in-process and equivalent units

Partially-processed units

At the end of a period there may be some units which have been started but have not been

completed. These are closing work-in-process units.

At this stage we assume for simplicity that there is no opening work-in-process. In that case the

output for a period will consist of two classes of finished units of production:

· Those that have been started and fully processed within the period

· Those that have been started during the period, but not finished by the end of the period. This

closing work-in-process will be completed during the following period;

Further costs will be incurred in order to achieve this.

Equivalent units

Once processing has started on a unit; of output, to the extent that it remains in an uncompleted

state it can be expressed as a proportion of a completed unit. For example, if 100 units are exactly

half-way through the production process in terms of the amount of cost they have absorbed, they

are effectively equal to 50 complete units. Therefore, 100 units which are half-complete can be

regarded as 50 equivalent units that are complete.

Practice Question

A manufacturer starts processing on 1 March. In the month of March he starts work on 20,000

units of production. At the end of March there are 1,500 units still in process and it is estimated

that each is two thirds complete. Costs for the-period total Rs19,500.

Calculate the value of the completed units and the work-in-process at 31 March.

In practice it is unlikely that all inputs to production will take place at the same time, as was

suggested in the example above. For instance, materials are frequently added at the beginning of a

process, whereas labor may be applied throughout the process. Thus, work-in-process may be

more complete as regards one input or cost element than as regards another. Equivalent units must

thus be calculated for each input and costs applied on that basis,

Practice Question

In this activity, use the same data as in Activity 1 except that:

· all materials have been input to the process

· work-in-process is only one-third complete as regards labor

Costs for the period are as follows:

Materials

10,000

Labor

9,500

Total

19,500

Costs for a process are allocated to equivalent units to calculate valuations for finished goods and

work-in-process.

The FIFO and weighted average methods of cost allocation

In the previous examples it was assumed that there was no opening stock of work-in-process. In

reality, of course, this is unlikely to be the case, and changes in levels of work-in-process during me

period can give rise to problems. There are basically two methods of accounting for such changes.

· The weighted average (or averaging) method

· The FIFO method.

148

Cost & Management Accounting (MGT-402)

Weighted average method

In the weighted average method opening stock values are added to current costs to provide an

overall average cost per equivalent unit. No distinction is therefore made between units in process

at the start of the period and those added during it and the costs associated with them

Problem Question

FL Manufacturing Co Ltd

Process information for month ended 31 December

Work-in-process 1 December (15,000 units, two-fifths complete)

Rs. 10,250 (work-in-process value made up of: materials Rs 9,000

Plus conversion costs Rs1,250).

Units started during December

30,000

Units completed during December

40,000

Work-in-process 31 December (half completed)

5,000

Material cost added in month

24,750

Conversion cost added in month

20,000

Materials are wholly added at the start of the process.

Conversion takes place evenly throughout the process.

Calculate the values of finished production for December and work-in-process at 31 December,

using the weighted average method.

Choosing the valuation method in practice

In practice the FIFO method is little used, for two main reasons:

· It is more complicated to operate

· In process costing, it seems unrealistic to relate costs for the previous period to the current

period of activities.

Choosing the valuation method in examinations

In order to use the weighted average or FIFO methods to account for opening work-in-process

different information is needed, as follows:

Method

Information needed

For weighted average.

An analysis of the opening work-in-process value

into cost elements (i.e. materials, labor)

For FIFO

The degree of completion of the opening work in

process for each cost element.

If all of the information is available so that either method may be used, the question will specify

the required method.

Where there is opening work-in-process, two methods of cost allocation can be used which make

different assumptions and produce different stock valuations. They are FIFO and weighted

average.

PRACTICE QUESTION

Q. 1

Mini Soap Manufacturing unit providing following information

Units of opening work in process

200 units

Units put into the process

800 units

Units completed and transfer out

1000 units

Units of opening work in process 100% completed as per direct material and 75% completed with

direct labor and factory overhead cost.

149

Cost & Management Accounting (MGT-402)

Cost incurred on opening work in process:

Direct Material

Rs. 6,000

Direct Labor

2,000

Factory overhead

1,000

9,000

Cost incurred during the accounting period on units put in the process:

Direct Material

Rs. 20,000

Direct Labor

10,000

Factory overhead

8,000

38,000

Required: Prepare cost of production report of process-1 (using FIFO and Weighted Average

method of inventory costing)

Cost of Production Report

Department-1

I-Quantity Schedule:

Units of opening work in process

200

Units put in the process

800

1,000

Units completed and transfer out

1,000

II-Cost Accumulated in the Process:

Direct Material (6,000 + 20,000)

26,000

Direct Labor (2,000 + 10,000)

12,000

F.O.H (1,000 + 8,000)

9,000

47,000

III-Calculation of Equivalent Units Produced (FIFO)

As to Direct Material 200 x 0% + 800

800

As to Conversion cost 200 x 25% + 800

850

IV- Unit Cost (FIFO) :

Direct Material

20,000 / 800

= 25

Direct Labor

10,000 / 850

= 11.7647

F.O.H

8,000 /850

= 9.4118

= 46.1765

V- Cost Apportionment/Accounting Treatment (FIFO) :

Cost of opening work in process

Cost already incurred on opening WIP Rs. 9000

Material

100% complete

Labor 200 x 25 % = 50 x 11.7647 =

588

FOH 200 x 25 % = 50 x 9.4118 =

471

10,059

Cost of units put into the process during the period

800 x 46.1765

36,947

47,000

150

Cost & Management Accounting (MGT-402)

III-Calculation of Equivalent Units Produced (W. Avg method)

Material and Conversion cost = 1000 units

IV- Unit Cost (W. Avg) :

Direct Material 26,000 / 1,000

= 26

Direct Labor

12,000 / 1,000

= 12

F.O.H

9,000 / 1,000

= 9

V- Cost Apportionment

Cost of units transferred to the next department:

1000

= 47,000

Q. 2

Mini Soap Manufacturing unit providing following information:

Units of opening work in process

200

Units put into the process

800

1000

Units of closing work in process

300

Units completed and transfer out

700

Cost incurred on opening work in process:

Direct Material

Rs. 6,000

Direct Labor

2,000

Factory overhead

1,000

9,000

Cost incurred on units put in the process:

Direct Material

Rs. 20,000

Direct Labor

10,000

Factory overhead

8,000

38,000

47,000

Units of opening work in process 100% completed as per direct material and 75% completed with

direct labor but the units of closing work in process 100% completed as per material and 50%

direct labor.

Required: Prepare cost of production report of process-1

Cost of Production Report

Calculation of Equivalent Units Produced (Weighted Average Method)

Material

Labor

FOH

Completed units

700

Opening WIP

300

(300 x50%)

150

Total

1000

850

151

Cost & Management Accounting (MGT-402)

Per unit cost (W.Avg)

Material

26,000 / 1000 = 26

Labor

12,000 / 850= 14.1176

FOH

9,000 / 850 = 10.5882

Total

50.7058

Cost Apportionment

Cost of units transferred to the next department:

700

50.7058

= 35,494

Work in process

Material

300 x 26 =

7,800

Labor

150 x 14.1176 =

2,118

FOH

150 x 10.5882 =

1,588

11,506

47,000

Equivalent production (FIFO)

Opening WIP Completed # of Closing work in

Total

units (Current

process

period )

(% of completion)

Material

500

300

800

Labor

(200 x 25%)

500

(300 x 50%)

700

150

FOH

(200 x 25%)

500

(300 x 50%)

700

150

Cost Per Unit (FIFO)

Direct Material:

20,000 / 800

= 25

Direct Labor:

10,000 / 700

= 14.2857

F.O.H

8,000 / 700

= 11.4286

152

Cost & Management Accounting (MGT-402)

1- Cost of units transferred to next department

a- Opening work in process

Cost already incurred

9,000

Direct Labor 200 x 25% = 50 x 14.2857 = 714

FOH

200 x 25% = 50 x 11.4286 = 571

10,285

b- Cost of completed units

500 x 50.7143

25,358

Cost transferred to next department

35,643

2- Closing work in process

Material 300 x 25

= 7500

Labor

150 x 14.2857 = 2142

FOH 150 x 11.4286 = 1715

11,357

47,000

Q. 3

Units of opening work in process

2,000

Units produced during the period

16,000

18,000

Units completed and transfer out

14,800

Work in progress at the end

3,200

Stage of completion

Material

Labor & Overhead

Opening WIP

100%

50%

Closing WIP

100%

25%

Cost incurred on opening work in process:

Direct Material

Rs. 24,000

Direct Labor

3,200

Factory overhead

3,200

30,400

Cost incurred during the current period :

Direct Material

Rs. 20,000

Direct Labor

63,680

Factory overhead

63,680

319,360

349,750

Required: Prepare cost of production report of process-1

153

Cost & Management Accounting (MGT-402)

Cost of Production Report

Calculation of Equivalent Units Produced (Weighted Average Method)

Material

Labor & FOH

Completed units

14,800

Opening WIP

3,200

(3,200 x50%)

800

Total

18,000

15,600

Equivalent production (FIFO)

Opening WIP Completed # of Closing work in

Total

units (Current

process

period )

(% of completion)

Material

12,800

3,200

16,000

Labor &

(2000 x 50%)

12,800

(300 x 25%)

14,600

FOH

1000

800

Per unit cost (W.Avg)

Per unit cost (FIFO)

Material

2,16,000 / 18,000 = 12

19,200 / 16,000 =

Labor

66,880 / 15,600 =

63,680 / 14,600 =

4.2872

4.3616

FOH

66,880 / 15,600 =

63,680 / 14,600 = 4.3616

4.2872

Total

20.5744

20.7232

154

Cost & Management Accounting (MGT-402)

Cost Apportionment (Weighed Average Method)

Transfer to next department

14,800 X 20.5744 =

304,500

Work in process

Material

3200 x 12 = 38,400

Labor

800 x 4.2872 = 3430

FOH

800 x 4.2872 = 3430

45,260

349,760

Cost Apportionment (Weighed Average Method)

1- Cost of units transferred to next department

a- Opening work in process

Cost already incurred

30,400

Direct Labor 1000 x 4.3616 =

4316

FOH

1000 x 4.3616 =

4316

39,122

b- Cost of completed units

12,800 x 20.7232

265,258

Cost transferred to next department

304,380

2- Closing work in process

Material 3,200 x 12

= 38,400

Labor 800 x 4.3616

= 3,490

FOH 800 x 4.3616

= 3,490

45,380

349,760

155

Cost & Management Accounting (MGT-402)

LESSON# 25 & 26

COSTING/VALUATION OF JOINT AND BY PRODUCTS

Following are self explanatory diagrams which help in understanding the concept of joint product

and by products.

Input

Output

Joint product

By Product

Considerably Significant

Incidental Produce

Example: Sugarcane Juice

Example: Crude Oil (Diesel & Petrol)

(Husk or Pulp is a by product)

Department A

(Cost Accumulated)

Direct Material, Direct Labor, FOH

Joint Product Joint Product Joint Product

By Product

A (a)

A (b)

A (c)

Requiring no

Requiring

Direct Material Direct Material Direct Material

further

Direct Labor Direct Labor Direct Labor

process

FOH

For by products:

Basis of Cost Allocation

Physical Quantity Ratio

Selling Price Ratio

Hypothetical Market

Value Ratio

156

Cost & Management Accounting (MGT-402)

Valuing by-products and joint products

By-products

Either of the following methods may be adopted when valuing by-products:

(a) The proceeds from the sale of the by-product may be treated as pure profit

(b) The proceeds from the sale, less any handling and selling expenses, may be applied in reducing

the cost of the main products.

If a by-product needs further processing to improve its marketability, such cost will be deducted in

arriving at net revenue, treated as in (a) or (b) above.

Recorded profits will be affected by the method adopted if stocks of the main product are

maintained.

Accounting for joint products

Joint products are by definition, subject to individual accounting procedures. Joint costs may

require apportionment between products if only for joint valuation purposes.

The main bases for apportionment are as follows:

Physical measurement of joint products

When the unit of measurement is different, e.g. liters and kilos, some method should be found of

expressing them in a common unit. Some joint costs are not incurred strictly equally for all Joint

products: such costs can be separated and apportioned by introducing weighting factors.

Market value

The effect is to make each product appear to be equally profitable. Where certain products are

processed after the point of separation, further processing costs must be deducted from the market

values before joint costs are apportioned.

Technical estimates of relative use of common resources

Apportionment is, of necessity, an arbitrary calculation and product costs which include such an

apportionment can be misleading if used as a basis for decision-making.

Problems of common costs

Even if careful technical estimates are made of relative benefits, common costs apportionment will

inevitably be an arbitrary calculation. When providing information to assist decision-making,

therefore, the cost accountant will emphasize cost revenue differences arising from the decision.

Here are some examples of decisions involving joint products:

· withdrawing, or adding, a product

· Special pricing

· Economics of further processing.

Apportioned common costs are not relevant to any of the above decisions although a change in

marketing strategy may affect total joint costs, e.g. withdrawing a product may allow capacity of the

joint process to be reduced.

In the short or medium term, it is probably impractical and/or uneconomic to alter the processing

structure. The relative benefit derived by joint products is, therefore, irrelevant when considering

profitability or marketing opportunities.

157

Cost & Management Accounting (MGT-402)

PRACTICE QUESTION

Q. 1

Physical quantity method

Cost Allocation at Split off Point

1960 liter fresh milk put in the process

Skim Milk

1,000 Liter

Cream

500 Liter

Butter

200 Liter

Ghee

100 Liter

Yogurt

60 Liter

Miscellaneous 100 Liter

Cost incurred for 1,960 liters of milk is Rs. 15,680

Solution

Skim Milk

= 15,680 / 1960 x 1000 = 8,000

Cream

= 15,680 / 1960 x 500 = 4,000

Butter

= 15,680 / 1960 x 200 = 1,600

Ghee

= 15,680 / 1960 x 100 = 800

Yogurt

= 15,680 / 1960 x 60 = 480

Miscellaneous

= 15,680 / 1960 x 100 = 800

Q. 2

Cost incurred in the department Rs 70,000

Drum sticks

Rs. 4 per gram

Breast pieces

Rs. 6 per gram

Wings

Rs. 3 per gram

Miscellaneous Rs. 2 per gram

Drum stick

20,000 X 4

= 80,000

Breast pieces

10,000 X 6

= 60,000

Wings

6,000 X 3

= 18,000

Miscellaneous

4,000 X 2

= 8,000

1,66,000

Solution

Drum stick

= 70,000 / 1,66,000 x 80,000 = 33,735

Breast pieces

= 70,000 / 1,66,000 x 60,000 = 25,300

Wings

= 70,000 / 1,66,000 x 18,000 = 7,590

Miscellaneous

= 70,000 / 1,66,000 x 8,000 = 3,375

70,000

Physical Quantity Ratio

Total quantity produced 40,000 grams

Drum stick

20,000

Breast pieces

10,000

Wings

6,000

Miscellaneous

4,000

40,000

158

Cost & Management Accounting (MGT-402)

Drum stick

= 70,000 / 40,000 x 20,000

= 35,000

Breast pieces

= 70,000 / 40,000 x 10,000

= 17,500

Wings

= 70,000 / 40,000 x 6000

= 10,500

Miscellaneous = 70,000 / 40,000 x 4000

= 7,000

70,000

Q. 3. ABC limited produces three products O, P and Q by the operation. Cost accumulated during

the operation.

Direct Material 1000 kg @ Rs 2 =

Rs. 2,000

Direct Labor

5,000

FOH

8,000

15,000

Output

500 Kg

Sold at split off point for Rs 20 / kg

300 kg

Enters into a second process

200 kg

Enters into a second process

Second process for product P

Cost incurred: Total

Per Unit

Direct Labor cost

Rs. 6,000

Rs. 20

FOH

Rs. 3,000

Rs. 10

Product P is 100% complete & sold for Rs 70 / kg

Second process for product Q

Cost incurred: Total

Per Unit

Direct Labor cost

Rs. 1,400

Rs. 7

FOH

Rs. 600

Rs. 3

Product Q is 100% complete & sold for Rs 30 / kg

Solution

Method # 1

Physical Quantity Ratio

Process-1

Quantity Schedule

Units put in the process 1,000 kg

Completed units of product "O"

500 kg

Transfer to further process

Product "P"

300

Product "Q"

200

1000

Cost Accumulated as follow:

Direct Material

2,000

Direct Labor

5,000

FOH

8,000

15,000

159

Cost & Management Accounting (MGT-402)

Cost Allocation / Accounting Treatment

Product O

15,000 x500 / 1000 = 7,500

Product P

15,000 x 300 / 1000 = 4,500

Product Q

15,000 x 200 / 1000 = 7,500

Product O

No further process is required

Completed & Sold

Sold 500 x 20 = 10,000

Cost 500 x 15 = 7,500

Gross Profit

2,500

Product P

Cost Accumulated

Cost received from Process 1

Rs. 4,500

Direct Labor

6,000

FOH

3,000

13,500

Unit Cost = 13,500 / 300 = 45 / Kg

Transfer to finished goods = 300 x 45 = 13,500

Sales 300 x 70

= 21,000

Less Cost 300 x 45

= 13,500

7,500

Product Q

Cost Accumulated

Cost received from Process 1

Rs. 3,000

Direct Labor

1,400

FOH

600

5,000

Unit Cost

5,000 / 200 = 25 / Kg

Transfer to finished goods = 200 x 25 = 5,000

Sales 200 x 30

= 6,000

Less Cost 200 x 25

= 5,000

1,000

Method # 2 Hypothetical market Value Basis

Final Price

Additional Cost per kg

In further processing

Direct Labor

Factory Overhead

Hypothetical Market Value

At split off point

160

Cost & Management Accounting (MGT-402)

Cost Allocation in the Process-1

Product O (Finished) 15,000 / 80 x 20

= 3,750

Product P Transferred to process II 15,000 / 80 x 40

= 7,500

Product Q Transferred to process II 15,000 / 80 x 20

= 3,750

15,000

Product P

Process -II

Quantity Schedule

Received From process-I

300

Completed and transfer out

300

Cost Accumulated

Cost received from process-1

7,500

Cost added

Direct Labor

6,000

FOH

3,000

9,000

16,500

Cost Apportionment / Accounting Treatment

Cost transfer to finished good

Rs 16,500

16,500 / 300 = 55 per kg

300 x 55 = 16500

Sales

300 x 70

= 21,000

Less Cost

300 x 55

= 16,500

Gross Profit

4,500

Product

Process -II

Quantity Schedule

Received From process-I

200

Completed and transferred out

200

Cost Accumulated

Cost received from process-1

3,750

Cost added

Direct Labor

1,400

FOH

600

5,750

Cost Apportionment / Accounting Treatment

Cost transfer to finished good

Rs 5,750

5750 / 200 = 28.75 per kg

200 x 28.75 = 5,750

Sales 200 x 30

= 6,000

Less Cost 300 x 55

= 5,750

250

By Products

Some examples of by products are given below:

161

Cost & Management Accounting (MGT-402)

Main Product

By Product

Soap

Glycerin

Meat

Hides & Fats

Flour

Bran

Classification of by product

By product can be classified into two categories:

1. Requiting no further process, for example Bran

2. Requiting further processing, for example Hides

Accounting for By Products

Income Approach

Costing Approach

Sales Income

Credit the cost of main product with the:

1- Treat as other income

1- Replacement cost / Opportunity

2- Treat as a deduction form

Cost of By Product

Cost goods sold

3- Treat as a deduction form

2- Predetermined price / Standard

Cost goods manufactured

Cost

Realizable Income

1- Treat as a deduction form

Cost goods manufactured

162

Cost & Management Accounting (MGT-402)

PRACTICE QUESTION

Following is a question on by product:

Main product

By product

Opening stock

-----

Production during the year

4,000

800

Closing stock

400

100

Cost incurred

64,000

-----

Cost of 3600 units (64,000/4000x3600)

57,600

-----

Sales price (Per unit)

2.50

Further processing cost

0.50

Solution

Method # 1

Rupees

Treat as an other income

Sales (3600 x 30)

108,000

Less Cost of goods sold

Opening stock

----

Production cost

64,000

Less Closing stock (16 x 400)

(6,400)

57,600

Gross Profit

50,400

Add other income

1,400

51,800

Sales of By Product

(700 x 2.5)

1,750

Less Further Processing cost (700 x 0.5)

350

1,400

Method # 2

Rupees

Treat as a deduction from cost of goods sold

Sales (3600 x 30)

108,000

Less Cost of goods sold

Opening stock

----

Production cost

64,000

Less Closing stock (16 x 400)

6,400

57,600

Less Sales value of By Product

(1,400)

56,200

Gross Profit

51,800

Method # 3

Rupees

Treat as a deduction from cost of goods manufactured

Sales (3600 x 30)

108,000

Less Cost of goods sold

Opening stock

----

Production cost (64,000 1,400)

62,600

Less Closing stock (62,600 x 10%)

6,260

56,340

Gross Profit

56,660

163

Cost & Management Accounting (MGT-402)

Realizable Value Basis

Production cost on By Product

800 x 2.50 =

2,000

Additional cost on By Product

800 x 0.50 =

400

Realizable Value

1,600

Treat as a deduction from cost of goods manufactured

Sales (3600 x 30)

108,000

Less Cost of goods sold

Opening stock

----

Production cost (64,000 1,600)

62,400

Less Closing stock

(62,400/4,000=15.6 x 400)

6,240

56,160

Gross Profit

51,840

Further example of by product

Joint Cost Rs. 206,800

Further Cost

Sales Price Market Value

Incurred per

pound

Grade 1

20,000 lb

(5-1) = 4 x 20,000

80,000

Grade 2

40,000

0.2

(4-0.2) = 3.8 x 40,000

152,000

Grade 3

60,000

0.5

(3-0.5) = 2.5 x 60,000

150,000

Grade 4

80,000

0.2

(2-0.2) = 1.8 x 80,000

144,000

Grade 5

50,000

0.1

(1-0.1) = 0.9 x 50,000

45,000

Total

250,000

Multiple Choice Questions

A chemical compound is made by raw material being processed through two processes. The

output of Process A is passed to Process B where further material is added to the mix. The details

of the process costs for the financial period number 10 were as shown below:

Process A

Direct material

2,000 kilograms at Rs5 per kg

Direct labor

Rs 7,200

Process plant time 140 hours at Rs60 per hour

Process B

Direct material

1,400 kilograms at Rs12 per kg

Direct labor

Rs 4,200

Process plant time 80 hours at Rs72.50 per hour

The departmental overhead for Period 10 was Rs 6,840 and is absorbed into the costs of each

164

Cost & Management Accounting (MGT-402)

process on direct labor cost.

Process A

Process B

Expected output was

80% of input

90% of input

Actual output was

1,400 kgs

2,620 kgs

Assume no finished stock at the beginning of the period and no work-in-progress at either the

beginning or the end of the period.

Normal loss is contaminated material which is sold as scrap for Rs0.50 per kg from Process A and

Rs1.825 per kg from Process B, for both of which immediate payment is received.

Q. 1

For process A what is the scrap value of the normal loss?

Rs 200

Rs 2,000

Rs 1,000

Q. 2

What is the abnormal loss for process A in units?

100

200

300

400

Q. 3

What is the cost per kg for process A?

A Rs 18,575

B Rs 13,454

C Rs 14.575

D Rs 16,575

Problem Question

Q. 1

Kong CO. manufactures two products, one in process A, the other in process B. The following

information applies to the processes for Period.

All materials are input at the start of each process, conversion costs (labor and overhead) are

incurred evenly throughout the process, and losses are identified at the end of process A and can

be sold for 10p per liter. The dosing work-in-progress is % of the way through the process.

Write up the accounts for process A and for process B

Process A

Process B

Material input-1

4.000 liters costing

200 kg costing

Rs 3,000

Rs 2,000

Labor and overhead

Rs 3,440

Rs 3,900

Transfers to finished goods

13,000 liters

180 kg

Opening work-in-progress

Nil

Closing work-in-progress

Nil

20 kg

Normal loss as % of input

10%

Nil

Q. 2

Mineral Separators Ltd operates a process which produces four unrefined minerals known as W,

X. Y and Z. The joint costs for operating the process for Period V were as below.

Process overhead is absorbed by adding 25% of the labor cost. The output for Period V was as

165

Cost & Management Accounting (MGT-402)

shown below.

There were no stocks of unrefined materials at the beginning of Period V, and no work-in-

progress, but the stocks shown below were on hand at the end of the period, although there was

no work-in-progress at that date.

The price received per ton of unrefined mineral sold is shown below and it is confidently expected

that these prices will be maintained.

You are required:

(a) To calculate the cost value of the closing stock, using sales value as the basis of your calculation.

(b) To calculate the cost value of dosing stock, using weight of output as the basis of your

calculation.

166

Cost & Management Accounting (MGT-402)

LESSON# 27 & 28

MARGINAL AND ABSORPTION COSTING

(Product costing systems)

Following diagram helps to recall the behavior of different cost elements.

Cost Elements

Direct Material

Direct Labor

Factory Overhead Cost

Variable & Fixed Cost

Variable Cost

Marginal cost is the cost the variable cost that changes with the production of each next unit.

Marginal and Absorption Costing

So far we have been looking at the various different types of cost and have gradually built up the

total cost of a cost unit by aggregating the cost of direct materials, direct labor, direct expenses,

variable overheads and fixed overheads (absorbed into cost units). We can display this total cost as

part of a profit and loss account (namely cost of sales). In doing so we must remember to adjust

the profit and loss account for any overhead under- or over-absorbed.

This adjustment is only necessary because we are including fixed overheads in the cost of the cost

unit. In other words, we are presenting cost information according to absorption costing

principles. However, there is another method of presenting cost information, i.e. marginal costing.

Marginal Costing

Under this system, we do not attempt to absorb fixed overheads into cost units, and so we avoid

the difficulties of setting absorption rate, adjusting for under or over-absorbed overhead, etc.

Cost units are valued at their marginal cost only (not their fully absorbed cost). In other words the

cost of a cost unit is presented as the total of direct materials, direct labor, direct expenses and

variable overheads (but not fixed overheads).

Of course, this does not mean that we can simply ignore fixed overheads It is simply that we

choose to treat all fixed overheads as period costs, rather than trying to attribute them to individual

cost units You will find that this presentation of cost information has distinct advantages over-

absorption costing when it comes to decision making.

A key concept in marginal costing is that of contribution margin.

Contribution Margin is defined as the sales value of a cost unit minus its variable cost.

Absorption and marginal costing

167

Cost & Management Accounting (MGT-402)

In absorption costing, fixed manufacturing overheads are absorbed into cost units. Thus stock is

valued at absorption cost and fixed manufacturing overheads are charged in the profit and loss

account of the period in which the units are sold.

In marginal costing, fixed manufacturing overheads are not absorbed into cost units, Stock is

valued at marginal (or variable) cost and fixed manufacturing overheads are treated as period costs

and are charged in the profit and loss account of the period in which the overheads are incurred.

Practice Question

A Company produces a single product and has the following budget:

Company Budget Cost Per Unit

Rs.

Selling price

Direct materials

Direct wages

Variable overhead

Fixed production overhead is Rs. 10,000 per month; production volume is 5,000 units per month.

Calculate the cost per unit to be used for stock valuation under:

(a) Absorption costing

(b) Marginal costing.

Solution

(a) Absorption cost per unit

Direct materials

Direct wages

Variable overhead

Absorbed fixed overhead

Rs 10,000

5000 units

Cost per Unit

(b) Marginal cost per unit

Direct materials

Direct wages

Variable overhead

Cost per Unit

The stock valuation will be different for marginal and absorption costing. Under absorption

costing stock will include variable and fixed overheads whereas under marginal costing stock will

only include variable overheads.

Further practice question explaining the concept of product cost, period cost and cost per unit

under two product costing systems:

168

Cost & Management Accounting (MGT-402)

Absorption Costing

Marginal Costing

100 units

Direct Material

8,000

Rs. 80 per unit

5,000

Direct Labor

Rs. 50 per unit

3,000

Factory Overhead

2,000

Variable FOH

Fixed FOH

18,000

16,000

Product Cost

2,000

Fixed Cost

(Period Expenses)

Cost per Unit

Under Absorption costing

18,000

Rs. 180 per unit

100

Under Marginal costing

16,000

Rs. 160 per unit

100

Contribution Margin

Contribution margin is the difference between sales and the variable cost of sales.

This can be written as:

Contribution margin = Sales less variable costs of sales

Contribution margin is short for "contribution to fixed costs and profits".

The idea is that after deducting the variable costs from sales, the figure remaining is the amount

that contributes to fixed costs, and once fixed costs are covered the remaining amount is that of

profits.

Contribution and profit

Marginal costing values goods at variable cost of production (or marginal cost) and contribution

can be shown as follows;

Marginal costing: Profit calculation

Rs X

Sales

(X)

Less: variable costs

Contribution margin

(X)

Less: fixed costs

Profit

Profit is contribution less fixed costs. In absorption costing this is effectively calculated in one

stage as the cost of sales already includes fixed costs

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Cost & Management Accounting (MGT-402)

Absorption costing: profit calculation

Sales

Less: absorption cost

(X)

Profit

Profit statements under absorption and marginal costing

To produce financial statements in accordance with IFRS 2, absorption costing must be used, but

either marginal or absorption costing can be useful for internal management reporting the choice

made will affect:

· The way in which profit information is presented

· The level of reported profit if sales do not exactly equal production (i.e. stock is increasing or

decreasing).

PRACTICE QUESTION

This example continues with the Company from the above practice question.

Show profit statements for the month if sales are 4,800 units and production is 5,000 units under

(a) Total absorption costing

(b) Marginal costing.

Solution

(a) Profit statement under absorption casting

Rs.

Sales (4,800 @ Rs10)

48,000

Less:

Cost of sates

Opening stock

Production

(5,000 @ Rs. 8)

40,000

Less: Closing stock (200 @ Rs. 8)

(1,600)

(38.400)

Operating profit

9,600

(b) Profit statement under marginal costing

Sales (4.800 @ Rs10)

48,000

Less:

Cost of sates

Opening stock

Production (5,000 @ Rs6)

30,000

Less: Closing stock (200 @ Rs6)

(1,200)

(28,800)

Contribution

19,200

Less: Fixed overheads

10,000

Operating profit

9,200

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Cost & Management Accounting (MGT-402)

PRACTICE QUESTION

Absorption Costing

Marginal

100 units

Costing

100 units

Direct Material

8,000

Rs. 80 per unit

Direct Labor

5,000

Rs. 50 per unit

Factory Overhead

Variable FOH

3,000

Fixed FOH

2,000

Product Cost

18,000

16,000

Fixed Cost

(Period Expenses)

2,000

Cost per Unit

Under Absorption costing

18,000

Rs. 180 per unit

100

Under Marginal costing

16,000

Rs. 160 per unit

100

Prepare income statements under absorption and marginal costing systems assuming the following

facts:

All produced units Sold

No. of units sold

No. of units in closing stock

No. of units produced

100

No. of units sold

110

No. of units in opening stock

No. of units produced

100

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Cost & Management Accounting (MGT-402)

Selling price Rs. 240 per unit

Solution

All Units Sold

Absorption

Marginal

costing

Sales (110 x 240)

24,000

Less Product cost

100 x 180

18,000

100 x 160

16,000

Gross profit

6,000

Contribution margin

8,000

Less Fixed cost

(2000)

Profit

6,000

80 units sold & 20 units in closing stock

Absorption costing

Marginal costing

Sales 80 x 240

19,200

Production cost

100 x 180 =

18,000

100 x 160 =

16,000

Less closing stock

20 x 180 =

(3600)

20 x 160 =

(3,200)

14,600

12,800

Less Fixed cost

2,000

Contribution Margin

4,600

Profit

4,600

4,400

110 units sold

Absorption costing

Marginal costing

Sales 110 x 240

26,400

Opening stock

10 x 180 =

1,800

10 x 160 =

1,600

Production cost

100 x 180 =

18,000

100 x 160 =

16,000

19,800

17,600

Less Fixed cost

2,000

Contribution Margin

6,600

Profit

6,600

6,800

Reconciliation of the difference in profit

The difference in profit is due to there being a movement in stock levels - an increase from 0 to

200 units over the month.

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Cost & Management Accounting (MGT-402)

Under absorption costing closing stock has been valued at Rs 1,600 (i.e. Rs 8 per unit which

includes Rs 2 of absorbed fixed overheads). Under marginal costing the increase in stock is valued

at Rs 1,200 (i.e. at Rs 6 per unit) and all fixed overheads are charged to the profit and loss account.

Only if stock is rising or falling will absorption costing give a different profit figure from marginal

costing. If sales equal production, the fixed overheads absorbed into cost of sales under absorption

costing will be the same as the period costs charged under marginal costing and thus the profit

figure will be the same.

The two profit figures can therefore be reconciled as follows:

Absorption costing profit

9,600

Less: fixed costs included in the increase in stock (200 x Rs2)

(400)

Marginal costing profit

9,200

If stock levels are rising from opening to closing balance

Absorption Costing profit > Margin Costing profit

If stock levels are falling from opening to closing balance

Absorption Costing profit < Margin Costing profit

(Fixed costs carried forward are charged in this period, under absorption costing)

If stock levels are the same

Absorption Costing profit = Margin Costing profit

Absorption Costing Marginal Costing

Produced units = Units

Same Profit

sold

Produced units > Units

More Profit

Less Profit

sold

Produced units < Units

Less Profit

More Profit

sold

Reconciliation of the above practice question

80 units sold & 20 units in closing stock

Absorption Profit

4,800

Less Closing Stock @ Fixed FOH Rate

(400)

Marginal Costing Profit

4,400

110 units sold with an opening stock of 10 units

Absorption Profit

6,600

Add Opening Stock @ Fixed FOH Rate

200

Marginal Costing Profit

6,800

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Cost & Management Accounting (MGT-402)

Reconciliation formula to learn

Profit as per absorption costing system

xxx

Add Opening stock @ fixed FOH rate at opening date

xxx

Less Closing stock @ fixed FOH rate at closing date

xxx

Profit as per marginal costing system

xxx

Advantages of marginal costing

(Relative to the absorption costing)

Preparation of routine operating statements using absorption costing is considered less informative

for the following reasons:

1. Profit per unit is a misleading figure: in the example above the operating margin of Rs2 per

unit arises because fixed overhead per unit is based on output of 5,000 units. If another basis

were used margin per unit would differ even though fixed overhead was the same amount in

total

2. Build-up or run-down of stocks of finished goods can distort comparison of period operating

statements and obscure the effect of increasing or decreasing sales.

3. Comparison between products can be misleading because of the effect of arbitrary

apportionment of fixed costs. Where two or more products are manufactured in a factory and

share all production facilities, the fixed overhead can only be apportioned on an arbitrary basis.

4. Marginal costing emphasizes variable costs per unit and fixed costs in total whereas absorption

costing accounts for all production costs to calculate unit cost. Marginal costing therefore

reflects the behavior of costs in relation to activity. Since most decision-making problems

involve changes to activity, marginal costing is more appropriate for short-run decision-making

than absorption costing.

PRACTICE QUESTION

This practice question illustrates the misleading effect on profit which absorption costing can have.

A company sells a product for Rs10. and incurs Rs4 of variable costs in its manufacture. The fixed

costs are Rs900 per year and are absorbed on the basis of the normal production volume of 250

units per year. The results for the last four years, when no expenditure variances arose- were as

follows:

2nd year

3rd year

4th year Total

Item

1st year

units

Opening stock

200

300

Production

300

250

200

950

300

450

500

950

Closing stock

200

300

200

Sales

100

150

200

300

750

Sales value

1,000

1,500

2,000

3,000

7,500

Prepare a profit statement under absorption and marginal costing.

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Cost & Management Accounting (MGT-402)

Solution

The profit statement under absorption costing would be as follows:

1st year

2nd year

3rd year

4th year

Items

Total

Rs.

Opening stock @ Rs7.60

1,520

2,280

Variable

costs

1,200

1,000

800

3,800

production @ Rs4

Fixed costs ® 900/250

1,080

900

720

3,420

=Rs3.60

2,280

3,420

3,800

7,220

Closing stock @Rs7.60

1,520

2,280

1,520

Cost of sales

(760)

(1,140)

(1,520)

(2,280)

(5,700)

(Under)/over absorption

180

Nil

(180)

(w)

Net Profit

420

360

300

540

1,620

Working:

Calculation of over / under absorption

Fixed cost control account

Incurred Year 1

900

Absorbed

1,080

300 x Rs. 3.60

Over absorption

180

1,080

Year 2

900

250 x Rs. 3.60

Year 3

900

200 x Rs. 3.60

720

Under absorption

180

900

Year 4

900

200 x 3.60

720

Under absorption

180

900

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Cost & Management Accounting (MGT-402)

If marginal costing had been used instead of absorption, the results would have

been shown as

follows:

Item

1st year

2nd year

3rd year

4th year

Total

Sales

1,000

1,500

2,000

3,000

7,500

Variable cost of sales

(@ Rs4)

400

600

800

1,200

3,000

Contribution margin 600

900

1,200

1,800

4,500

Fixed costs

900

3,600

Net profit/ (loss) (300)

300

900

The marginal presentation indicates clearly that the business must sell at least 150 units per year to

break even, i.e. Rs900 + (10 - 4), whereas it appeared, using absorption costing, that even at 100

units it was making a healthy profit.

The total profit for the four years is less under the marginal principle because the closing stocks at

the end of the fourth year are valued at Rs800 (Rs4 x 200) instead of Rs 1,520, i.e. Rs720 of the

fixed costs are being carried forward under the absorption principle.

The profit figures shown may be reconciled as follows:

Year 1

Year 2

Yea 3

Yea r4

Total

Profit / (loss)

Under marginal costing

(300)

Nil

300

900

Add: Fixed overheads

Absorbed in stock increase

200 x Rs3.60 =

720

100 x Rs3.60=

360

200 x Rs3.60=

720

Less: Fixed overheads

Absorbed in stock decrease

100 x 3.60=

(360)

Profit per absorption

420

360

300

540

1,620

Problem Questions

Q.1. A factory manufactures three components X, Y and Z and the budgeted production for the

year is 1,000 units1,500 units and 2,000 units respectively. Fixed overhead amounts to Rs6.750 and

has been apportioned on the basis of budgeted units: Rs 1,500 to X, Rs 2,250 to Y and Rs 3,000 to

Z. Sales and variable costs are as follows:

Selling price Rs.

Variable cost Rs.

Q. 2. A company that manufactures one product has calculated its cost on a quarterly production

budget of 10.000 units. The selling price was Rs 5 per unit. Sales in the four successive quarters of

the last year were as follows:

Quarter 1

10,000 units

Quarter 2

9,000 units

Quarter 3

7,000 units

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Cost & Management Accounting (MGT-402)

Quarter 4

5,500 units

The level of stock at the beginning of the year was 1,000 units and the company maintained its

stock of finished products at the same level at the end of each of the four quarters.

Based on its quarterly production budget, the cost per unit was as follows:

Cost per unit

Rs.

Prime cost

3.50

Production overhead

0.75

Selling and administration overhead

0.30

Total

4.55

Fixed production overhead, which has been taken into account in calculating the above figures,

was Rs 5,000 per quarter. Selling and administration overhead was treated as fixed, and was

charged against sales in the period in which it was incurred.

You are required to present a tabular statement to bring out the effect on net profit of the

declining volume of sales over the four quarters given, assuming in respect of fixed production

overhead that the company:

(a) Absorbs it at the budgeted rate per unit

(b) Does not absorb it into the product cost, but charges it against sales in each quarter (i.e. the

company uses marginal costing).

Advantages of Absorption Costing

(Relative to marginal costing)

Absorption costing is widely used and you must understand both principles.

The only difference between using absorption costing and marginal costing as the basis of stock

valuation is the treatment of fixed production costs.

The arguments used in favor of absorption costing are as follows:

1. Fixed costs are incurred within the production function, and without those facilities

production would not be possible. Consequently such costs can be related to production

and should be included in stock valuation.

2. Absorption costing follows the matching concept by carrying forward a proportion of the

production cost in the stock valuation to be matched against the sales value

3. When the items are sold.

4. It is necessary to include fixed overhead in stock values for financial statements routine

cost accounting using absorption costing produces stock values which include a share of

fixed overhead.

5. Overhead allotment is the only practicable way of obtaining job costs for estimating prices

and profit analysis.

6. Analysis of under-/over-absorbed overhead is useful to identify inefficient utilization of

production resources.

Arguments against absorption costing

The fixed costs do not change as a result of a change in the level of activity. Therefore such costs

cannot be related to production and should not be included in the stock valuation.

The inclusion of fixed costs in the stock valuation conflicts with the prudence concept, therefore

the fixed costs should be written off in the period in which they are incurred.

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Cost & Management Accounting (MGT-402)

PRACTICE QUESTION

Following information relates to a manufacturing company

Selling price

Rs. 20 per unit

Units produced

30,000

Units sold

20,000

Variable cost

Direct material

Rs. 5 per unit

Direct labor

Rs. 3 per unit

F.O.H

Rs. 1 per unit

Selling & administrative expenses

Rs. 2 per unit

Fixed cost

F.O.H

Rs 120,000

Selling & administrative expenses

Rs. 15,000

Solution

Working for cost per unit under

Absorption Costing

Fixed FOH Rate

120,000/30,000 =

Variable FOH Rate

Direct Material

Direct Labor

FOH

Marginal Costing

Variable FOH Rate

Direct Material

Direct Labor

FOH

Income Statement under Absorption Costing System

Rupees

Sales (20,000 x 20)

400,000

Less Cost of goods sold

Opening stock

Add Production cost

(13 x 30,000)

390,000

Less Closing stock

(13 x 10,000)

130,000

260,000

Gross Profit

140,000

Less Operating expenses

Selling & Administrative expenses

Variable expenses

(20,000 x 2) =

40,000

Fixed expenses

15,000 55,000

Net profit

85,000

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Cost & Management Accounting (MGT-402)

Income Statement under Marginal Costing System

Rupees

Sales

400,000

Less Variable cost of goods sold

Opening stock

Add Variable production cost

(9 x 30,000)

270,000

Less Closing stock

(9 x 10,000)

90,000

180,000

Gross contribution margin

220,000

Less Variable Selling & Admin Expenses

(2 x 20,000)

40,000

Contribution margin

180,000

Less Fixed expenses

Production

120,000

Selling & Admin Expenses 15,000

135,000

Net Profit

45,000

Reconciliation

Profit as absorption costing

85,000

Less Closing stock (10,000 x 4)

40,000

Profit as per Marginal costing

45,000

Multiple Choice Questions

Q.1. When comparing the profits reported using marginal costing with those reported using

absorption costing in a period when closing stock was 1,400 units, opening stock was 2,000 units,

and the actual production was 11,200 units at a total cost of Rs 4.50 per unit compared to a target

cost of Rs 5.00 per unit, which of the following statements is correct?

A Absorption costing reports profits Rs 2,700 higher

B Absorption costing reports profits Rs 2,700 lower

C Absorption costing reports profits Rs 3,000 higher

D There is insufficient data to calculate the difference between the reported profits

Q. 2. When comparing the profits reported under marginal and absorption costing during a period

when the level of stocks increased:

A. An absorption costing profits will be higher and closing stock valuations lower than those under

marginal costing

B. An absorption costing profits will be higher and closing stock valuations higher than those

under marginal costing

C. The marginal costing profits will be higher and closing stock valuations lower than those under

absorption costing

D. The marginal costing profits will be lower and closing stock valuations higher than those under

absorption costing

Q. 3. Contribution margin is:

A. Sales less total costs

B. Sales less variable costs

C. Variable costs of production less labor costs

D. None of the above

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Cost & Management Accounting (MGT-402)

Problem Question

Rays Company manufactures and sells electric blankets.

The selling price is Rs 12.

Each blanket has the unit cost set out below.

Administration costs are incurred at the rate of Rs20 per annum.

The company achieved the production and sales of blankets set out below.

The following information is also relevant:

1. The overhead costs of Rs2 and Rs3 per unit have been calculated on the basis of a budgeted

production volume of 90 units.

2. There was no inflation.

3. There, was no opening stock.

Unit cost

Rs.

Direct material

Direct labor

Variable production overhead

Fixed production overhead

Year

Production

100

110

Sales

110

You are required:

(a) To prepare an operating statement for each year using

(i) Marginal costing and (ii) absorption costing

(b) To explain why the profit figures reported under the two techniques disagree.

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Cost & Management Accounting (MGT-402)

LESSON# 29

COST VOLUME PROFIT ANALYSIS

(Contribution Margin Approach)

This topic is based on your knowledge of cost behavior and shows how this is applied in a

decision-making situation. Cost-volume-profit (CVP) analysis is a technique which uses cost

behavior theory to analyze the activity level as to the contribution margin and fixed cost

relationship and the level at which there is neither a profit nor a loss (the break-even activity level).

This is important management information because managers need to know the minimum activity

level that must be achieved in order that the business does not incur losses.

CVP analysis may also be used to predict profit levels at different volumes of activity based upon

the assumption that costs and revenues exhibit a linear relationship with the level of activity.

Cost-volume-profit analysis determines how costs and profit react to a change in the volume or

level of activity, so that management can decide the 'best' activity level.

Following are the assumptions which are used in CVP analysis.

1. Variable costs and selling price (and hence contribution) per unit are assumed to be unaffected

by a change in activity level.

2. Fixed costs, whilst not affected in total by a change in the activity level, will change per unit as

the activity level changes and there are more (or less) units over which to "share out" the fixed

costs If fixed costs per unit change with the activity level, then profit per unit must also

change.

Thus, cost-volume-profit analysis is always based on contribution per unit (assumed to be constant

unless a question clearly says otherwise) and never on profit per unit because profit per unit

changes every time a few more or less units are made.

CVP is a relationship of four variables

Sales

Volume

Variable cost

Cost

Fixed cost

Cost

Net income

Profit

This may be understood through the following equation

Volume @ sales price

Revenue

Cost matching with the sales

(Cost)

Result

Profit

CVP analysis is a tool for decision making. There are two approaches of CVP analysis:

1. Contribution margin approach

2. Break even analysis approach

Contribution Margin Approach & CVP Analysis

Contribution margin contributes to meet the fixed cost. Once the fixed cost has been met the

incremental contribution margin is the profit.

Income Statement as per the marginal costing system is used as a Standard format of Income

Statement to analyze the Cost-Volume-Profit relationship.

Rs.

181

Cost & Management Accounting (MGT-402)

Sales

xxx

Variable Cost

xxx

Contribution Margin

xxx

Fixed Cost

xxx

Profit

xxx

PRACTICE QUESTION

Basic question

90 units of product "PR" is sold for Rs. 100 per unit. Variable cost relating to production and

selling is Rs. 75 per unit and fixed cost is Rs. 2,250.

Q. 1. Management decides to increase its sales by 10 units.

Required:

Prepare income statement and analyze.

Solution

Rs.

Sales (90 x 100)

9,000 (10 x 100)

1,000

10,000

Variable cost (90 x 75)

(6,750) (10 x 75)

(750)

(7,500)

Contribution margin

2,250

250

2,500

Fixed cost

(2,250)

2,250

Profit / Loss

250

Analysis

This shows physical increase in volume causes an increase in contribution margin and if there is

not increase in the fixed cost because of such change, the incremental contribution margin is added

in the final profits.

Q. 2. Management decides to increase its sales price by 10%. Continue with the Q. 1.

Required:

Prepare income statement and analyze.

Solution

Sales

100 x Rs 110

11,000

Variable cost 100 x Rs. 75

(7,500)

Contribution margin

3,500

Fixed cost

(2,250)

Profit

1,250

Analysis

This shows increase in sales price per unit causes an increase in the contribution margin, as there is

not change in the volume the fixed will remain unchanged. So the incremental change is

contribution margin is included into the profit.

Q. 3. Management decides to decrease its sales price by 10%. Continue with the Q. 1.

Required:

Prepare income statement and analyze.

Sales

100 x Rs 90

9,000

Variable cost 100 x Rs 75

(7,500)

Contribution margin

1,500

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Cost & Management Accounting (MGT-402)

Fixed cost

(2,250)

Loss

(750)

Analysis

This shows decrease in sales price per unit causes a decrease in the contribution margin, as there is

not change in the volume the fixed will remain unchanged. So the change in contribution margin is

subtracted from the profits, which result into a loss of Rs. 750 in this case.

Normally a decrease in sales price should case an increase in the sales volume.

Q.4. Management decides to decrease its sales price by 10% and expects an increase in sales

volume by 50%. Continue with the Q. 1.

Required:

Prepare income statement and analyse.

Solution

Sales

150 x Rs 90

13,500

Variable cost 150 x Rs 75

(11,250)

Contribution margin

2,250

Fixed cost

(2,250)

Loss

Analysis

This shows decrease in sales price per unit causes a decrease of Rs. 1,000 in the contribution

margin, as well as an increase in volume is causing an increase in the profit, this results in an

increase in profit.

Here in this scenario the increase in the volume must be more than 50% to earn profits.

Q.5. Management decides to decrease its sales price by 10% and expects an increase in sales

volume by 200%. Continue with the Q. 1.

Required:

Prepare income statement and analyse.

Solution

Sales

200 x Rs 90

18,000

Variable cost 200 x Rs 75

(15,000)

Contribution margin

3,000

Fixed cost

(2,250)

Profit

750

Analysis

This shows decrease in sales price per unit causes a decrease of Rs. 1,000 in the contribution

margin, as well as an increase in volume is causing an increase in the profit, this results in an

increase in profit.

Here in this scenario the increase in the volume must be more than 50% to earn profits.

Q.6. Management decides to increase its sales volume by 100% and it is also assumed that the

fixed cost also increase upto Rs. 2,500. Continue with the Q. 5.

Required:

Prepare income statement and analyse.

Solution

Sales

200 x Rs 90

18,000

Variable cost 200 x Rs 75

(15,000)

Contribution margin

3,000

Fixed cost

(2,500)

Profit

500

Analysis

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Cost & Management Accounting (MGT-402)

This shows a decrease in fixed cost causes a decrease in the profits.

Q.7. Management decides to increase its sales volume by 100% and it is also assumed that the

fixed cost also increase upto Rs. 2,500, and also there is an increase of 20% in the variable cost.

Continue with the Q. 6.

Required:

Prepare income statement and analyse.

Solution

Sales

200 x Rs 90

18,000

Variable cost 200 x Rs 90

(18,000)

Contribution margin

Fixed cost

(2,500)

Loss

(2,500)

Sales

***

Variable cost

(***)

Contribution margin

***

Fixed cost

(***)

Profit / Loss

***

This lesson ends up at following lessons:

1. At zero contribution margin the loss will be equal to the fixed cost

2. Increase in variable cost reduces the contribution margin

3. Sales Variable cost = Contribution margin

4. Contribution margin + Variable cost = Sales

5. Contribution margin Fixed cost = Profit

6. Profit + Fixed cost = Contribution margin

7. Sales - Variable cost = Fixed cost + Profit

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Cost & Management Accounting (MGT-402)

LESSON# 30

COST VOLUME PROFIT ANALYSIS

(Break-even Approach)

Break-even

Cost-volume-profit analysis can be used to calculate break-even.

Break-even is the point where sales revenue equals total cost, i.e. (here is neither a profit nor a loss.

Profit (or loss) is the difference between contribution margin and fixed costs.

Thus the break-even point occurs where contribution margin equals fixed costs

Target Contribution Margin

Target contribution margin is the amount which if equal to fixed cost will give nil net profit,

whereas, if we need to earn a target profit, such profit will be added up into the fixed cost to have

target contribution margin.

Contribution margin per unit can be assumed to be constant for all levels of output in the relevant

range. Similarly, fixed costs can be assumed to be a constant amount in total.

The relationships may be depicted thus:

Contribution Margin per unit

Selling price per unit less variable costs per unit

Total contribution

Volume x (Selling price per unit less variable costs per unit)

Target Contribution Margin

Fixed costs + Profit target

Target Sales in number of units

Target Contribution Margin

Unit contribution

Contribution may be calculated in total, or on a per-unit basis using selling prices and variable costs

per unit.

The difference between contribution and fixed costs is profit (or loss); thus when contribution

equals fixed costs, break-even occurs. In this way a target profit may be converted into a target

contribution margin which may be used to calculate the number of units required to achieve the

desired target profit.

Contribution margin to sales ratio

Contribution to sales ratio (C/S ratio) =

Contribution Margin in Rs

Sales in Rs

Note: you may encounter the term profit to volume (or P/V) ratio, which is synonymous with the

contribution to sales ratio. Profit to volume is an inaccurate description, however, and should not

be used. The C/S ratio is conveniently written as a percentage.

Break even point refers to the volume (sales) at which the entity earns no profit and suffers no

loss.

It is the point where

Contribution margin = Fixed cost

And

Target profit = 0

Contribution margin Fixed cost = 0 Profit

Contribution margin = Fixed cost + 0 Profit

At break even point the target contribution is equal to the fixed cost

Contribution Margin Fixed cost = Profit

185

Cost & Management Accounting (MGT-402)

Contribution margin = Fixed cost + Profit

Practice Question

Q. 1

Income Statement

Rs.

Sales

700 units x Rs 8

5,600

Variable cost 700 units x Rs 6

4,200

Contribution margin

1,400

Fixed cost

1,000

Profit

400

Variable cost over sales

4,200 x 100 = 75%

5,600

Contribution margin over sales

1,400 x 100 = 25%

5,600

Per Unit Calculation

Sales price

Rs 8

Less Variable cost

(6)

Contribution Margin

6 / 8 x 100 = 75%

2 / 8 x 100 = 25%

Total

per unit

Sales

700 units x Rs 8

5,600

100%

Variable cost 700 units x Rs 6

4,200

75%

Contribution margin

1,400

25%

Fixed cost

1,000

Profit

400

Break even sales in Rupees

Remember the formula to calculate required amount in absence of certain information:

Given Amount x

% of required amount =

Required Amount

% of given amount

Here, to calculate break even sale, we need contribution margin to be equal to the fixed cost so

that the profit is zero.

Now if the target contribution margin is equal to Rs. 1,000 then what would be the sales at this

point?

Now the above formula will be applied to calculate breakeven sales:

Target CM is the given amount and its % is 25, so the sale which is 100% will be:

Rs 1,000 x

100 = Rs 4,000

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Cost & Management Accounting (MGT-402)

Rs 1,000 x 1 =

Rs. 4,000

Rs 1,000 =

Rs. 4,000

So,

Break even Sales in Rs. =

Fixed cost

C/S ratio

Check

Income Statement

Rs.

Sales

500 units x Rs 8

4,000

Variable cost 500 units x Rs 6

3,000

Contribution margin

1,000

Fixed cost

1,000

Profit

Break even sales in units

Simple formula:

Break even sales in Rupees = number of units

Sales price per unit

4,000 = 500 units

Direct formula

Target CM

CM per unit

Here the target contribution margin is equal to the fixed

Fixed Cost

CM per unit

Rs. 1,000

= 500 units

Break even sales in Rupees =

Target CM

Contribution to sales ratio

Break even sales in units=

Target CM

Contribution margin per unit

Q. 2

Calculate Sales to target profit of Rs. 500, using the information given in practice question no. 1.

Sales

***

Variable cost

(***)

Contribution margin

***

Fixed cost

1,000

Profit

500.

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Cost & Management Accounting (MGT-402)

Target contribution margin = Fixed cost + Target profit

1,000 +

500

1,500

Sales to earn target profit of Rs. 500

= Rs 1,500 x 100 = Rs. 6,000

Rs 1,500 = Rs. 6,000

0.25

Check

Income Statement

Rs.

Sales

6,000

Less Variable cost

4,500

Contribution Margin

1,500

Less Fixed cost

1,000

Profit

500

Fixed cost + Target profit

Contribution to sales ratio

Problem Question

A company sold fans at Rs 2,000 each. Variable cost Rs. 1,200 each and fixed cost Rs. 610,000.

Calculate:

a. Calculate break even sales in Rupees.

b. Break even sales in units.

c. Sales in units to earn a profit of Rs. 20,000.

Multiple Choice Questions

The following details relate to a shop which currently sells 25,000 pairs of shoes annually.

Selling price per pair of shoes

Rs.40

Purchase cost per pair of shoes

Rs.25

Total annual fixed costs

Rs.

Salaries

100,000

Advertising

40,000

Other fixed expenses

100,000

Q. 1

What is the contribution per pair of shoes?

A Rs.15

B Rs.30

C Rs.7.50

D Rs.18

Q. 2

What is the break-even number of pairs of shoes?

A 14,000

B 16,000

C 28,000

D 32,000

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Cost & Management Accounting (MGT-402)

LESSON# 31

BREAK EVEN ANALYSIS MARGIN OF SAFETY

A company sold fans at Rs 2,000 each. Variable cost Rs. 1200 each and fixed cost Rs. 60,000.

Calculate:

a. Calculate break even sales in Rupees.

b. Break even sales in units.

c. Sales in units to earn a profit of Rs. 20,000.

Contribution to sales ratio = Contribution margin

Sales

= 800 / 2,000 = 0.4

a) Break-even sales in Rupees =

Fixed cost

C/S Ratio

= 60,000 / 0.4 = Rs. 150,000

b) Break-even sales in units =

Fixed cost

Contribution margin per unit

= 60,000 / 800 = 75 units

c) Target profit Rs 20,000

Target contribution = Target profit + Fixed cost

Target contribution margin

Contribution margin per unit

= 80,000 / 800 = 1,000 units

Check Break even sales

Sales 75 x 2,000

150,000

Less Variable cost (150,000 x 60%)

90,000

Contribution margin

60,000

Less Fixed cost

60,000

Profit

Check Target Profit

Sales 100 x 2,000

200,000

Less Variable cost (200,000 x 60%)

90,000

Contribution margin

80,000

Less Fixed cost

60,000

Profit

20,000

Margin of Safety (MOS)

The margin of safety is the difference between budgeted sales volume and break-even sales

volume; it indicates the vulnerability of a business to a fall in demand. It is often expressed as a

percentage of budgeted sales

Budgeted sales Break-even sales = Margin of safety

MOS ratio =

MOS x 100 = %

Budgeted Sales

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PRACTICE QUESTION

Q. 1

Budgeted Income statement

Rs.

Budgeted Sales 700 units x Rs 8

5,600

Variable cost 700 units x Rs 8

4,200

Contribution margin

1,400

Fixed cost

1,000

Profit

400

Break even Sales 500 units x Rs 8

4,000

Variable cost 500 units x Rs 6

3,000

Contribution margin

1,000

Fixed cost

1,000

Profit

Percentage of MOS can be calculated in different ways:

· Based on Budgeted sales

Budgeted sales Break-even sales

= 5,600 4,000 = 1,600

Margin of safety x 100 = %

Budgeted sales

1,600 x 100 = 28.57%

5,600

Using Budget profit

Budgeted profit

x 100 = %

Budgeted contribution margin

400 x 100 = 28.57%

1,400

Using profit and contribution ratio

Profit to sales ratio x 100 = %

Contribution to sales

Profit to sales ratio =

400 / 5,600 x 100 = 7.14%

Contribution to sales ratio = 1,400 / 5,600 x 100 = 25%

7.14% x 100 = 28.57%

25%

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Cost & Management Accounting (MGT-402)

Q. 2

Budgeted Income Statement

Rs.

Budgeted sales

10,000

Less variable cost

6,000

Contribution margin

4,000

Less Fixed cost

2,500

Profit

1,500

Calculate Margin of safety ratio?

Budgeted profit

x 100 = %

Budgeted contribution margin

1,500 / 1,000 x 100 = 37.5%

P/S Ratio x 100 = %

C/S Ratio

Profit / Sales x 100 = 1,500 / 10,000 x 100 = 15%

Contribution margin / Sales x 100 = 4,000 / 10,000 x 100 = 40%

Margin of safety ratio =

15% x 100 = 37.5%

40%

Q. 3

Sales = Rs. 50,000

Margin of safety = 25%

Calculate break even sales?

Step I

Calculate absolute amount of MOS

MOS = 50,000 x 25% = Rs. 12,500

Step II

Calculate: Breakeven sales through the following formula:

MOS = Budgeted sales - Break even sales

Budgeted sales - MOS = Break even sales

50,000 -12,500 = 37,500

Q. 4

Sales = Rs. 50,000

MOS ratio = 25%

Budgeted profit = Rs. 2,500

a). Compute projected profit

b). Prepare Budgeted sales sheet

Budgeted sales

50,000

Less Variable cost

40,000

Contribution margin

10,000

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Cost & Management Accounting (MGT-402)

Less Fixed cost

7,500

Profit

2,500

MOS ratio =

Profit

Contribution margin

2500

Contribution margin

0.25 contribution margin = 2,500

Contribution margin = 2,500 / 0.25

Contribution margin = Rs. 10,000

Break even sales =

Fixed cost

C/S ratio

Budgeted sales

37,500

Less variable cost

30,000

Contribution margin

7,500

Less Fixed cost

7,500

Profit

Q. 4

Combined Break-even sales

Rupees

Selling price (P.U)

2.50

Variable cost (P.U)

(1.50)

(2)

(4)

Contribution

margin

(P.U)

Sales Volume

80,000

30,000

15,000

Fixed cost

Rs. 1,50,000

Solution

Total

Rupees

Contribution

(1 x 80,000)

(2 x 30,000)

(6 x 15,000)

2,30,000

margin

=80,000

= 60,000

= 90,000

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Sales

(2.5 x 80,000)

(4 x 30,000)

(10 x 15,000)

4,70,000

= 2,00,000

= 1,20,000

= 1,50,000

Product wise contribution to sales ratio

Contribution

80,000 /

60,000 / 1,20,000 x 90,000 / 1,50,000 x

margin ratio

2,00,000 x 100

100

= 40%

= 50%

= 60%

Combined contribution to sales ratio

230,000

470,000

= 48.936 or 0.489

Break even sales = Target contribution margin

C/S ratio

150,000

0.48936

= 306,523

PRACTICE QUESTION

Q. 1

Victoria Company produces a single product. Last year's income statement is as follows:

Sales (29,000 units)

Rs. 1,218,000

Less: Variable costs:

812,000

Contribution margin

406,000

Less: Fixed expenses

300,000

Net income

106,000

Required:

1. Compute the break-even point in units and sales Rs.

2. What was the margin of safety for Victoria last year?

3. Suppose that Victoria Company is considering an investment in new technology that will

increase fixed costs by Rs. 250,000 per year but will lower variable costs to 45% of sales.

Units sold will remain unchanged. Prepare a budgeted income statement assuming that

Victoria makes this investment. What is the new break-even point in units and sales Rs,

assuming that the investment is made?

Q. 2

Crown Star Products produces two different types of lamps, a floor lamp and a desk lamp. Floor

lamps sell for Rs. 30, Desk lamps for Rs. 20, the projected income statement for the coming year

follows:

Sales

Rs. 600,000

Less: Variable costs;

400,000

Contribution margin

200,000

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Cost & Management Accounting (MGT-402)

Less: Fixed expenses

150,000

Net income

50,000

The owner of Crown Star estimates that 60% of the sales revenues will be produced by floor lamps

with the remaining 40% by desk lamps. Floor lamps are also responsible for 60% of the variable

expenses. Of the fixed expenses, one third is common to both products, and one-half are directly

to the floor lamp product line.

Required:

1. Compute the sales revenue that must be earned for Crown Star to reach at break even.

Compute the number of floor lamps and desk lamps separately that must be sold for Crown Star

to break even.

Question No. 3

Unicorn Enterprises produces two strategy games, Mystical Wars and Magical Dragons. The

projected income for the coming year, segmented by product line, follows:

Wars

Dragons

Total

Sales

Rs. 500,000

Rs. 800,000

Rs. 1,300,000

Less: Variable costs

230,000

460,000

690,000

Contribution margin

270,000

340,000

10,000

Less: Direct fixed expenses

120,000

180,000

300,000

Product margin

150,000

160,000

310,000

Less: Common fixed expenses

210,000

Operating income

100,000

The selling prices are Rs. 10 for Mystical Wars and Rs. 20 for Magical Dragons. Required:

1. Compute the number of games of each kind that must be sold for Unicorn Enterprises to

reach its break-even.

2. Compute the revenue that must be earned to produce a net income of 10% of sales revenue.

Question No. 4

Khalid is a salt merchant who supplies salt to general merchants in Lahore city. In the year of 2000

he sold 35,000 bags of salt. One bag consists of 50kg salt. He purchases slat in raw form and then

grinds it, fills it in bags and then sold it, Sale price per bag is Rs. 45.

He purchases the raw salt ® Rs. 400 per ton (1 ton consist of 1000 kg). Grinding cost is Rs, 7 per

bag, carriage outward cost is Rs. 5 per bag, he also purchases empty bags ® 400 per 100 bags. Rent

of shop Rs, 1500 per month. Electricity and phone expense is Rs, 16000 per year (assume fixed).

Depreciation of plant is Rs. 3,680 per year.

In the year 2001 it is expected that sale price and demand will remain the same but all the variable

costs will increased by 15%. All the fixed costs will also increase by 10%.

Required:

1. Break even point in units and Rs. in both years.

2. Income statements of both years.

3. If he wants to earn Rs. 350,000 in the year of 2001 how many bags he has to sell.

4. Assume that demand in 2001 will remain the same he wants to keep same contribution margin

ratio as in year 2000 what'-will be the new selling price per bag.

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Cost & Management Accounting (MGT-402)

LESSON# 32

BREAKEVEN ANALYSIS CHARTS AND GRAPHS

The conventional break-even chart

The conventional break-even chart plots total costs and total revenues at different output levels

and shows the activity level at which break-even is achieved.

Conventional break-even chart

The chart or graph is constructed as follows:

· Plot fixed costs, as a straight line parallel to the horizontal axis

· Plot sales revenue and variable costs from the origin

· Total costs represent fixed plus variable costs.

The point at which the sales revenue and total cost lines intersect indicates the breakeven level of

output. The amount of profit or loss at any given output can be read off the chart.

By multiplying the sales volume by the unit price at the break-even point the level of revenue

needed to break even can be determined.

The chart is normally drawn up to the budgeted sales volume.

The difference between the budgeted sales volume and break-even sales volume is referred to as

the margin of safety.

Usefulness of charts

The conventional form of break-even charts was described above. Many variations of such charts

exist to illustrate the main relationships of costs, volume and profit.

Unclear or complex charts should, however, be avoided, as a chart which is not easily understood

defeats its own object.

Generally, break-even charts are most useful for the following purposes:

· comparing products, time periods or actual outcomes versus planned outcomes

· showing the effect of changes in circumstances or to plans

· giving a broad picture of events,

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Cost & Management Accounting (MGT-402)

Contribution break-even charts

A contribution break-even chart is constructed with the variable costs at the foot of the diagram

and the fixed costs shown above the variable cost line.

The total cost line will be in the same position as in the break-even chart illustrated above; but by

using the revised layout it is possible to read off the figures of contribution at various volume

levels, as shown in the following diagram.

Profit-volume chart

A profit-volume chart is a graph which simply depicts the net profit and loss at any given level of

activity.

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Cost & Management Accounting (MGT-402)

Profit

Sales

500

Breakeven Point

Loss

1,000

Loss = Fixed cost at zero sales activity

From the above chart the amount of net profit or loss can be read off for any given level of sales

activity, unlike a break-even chart which shows both costs and revenues over a given range of

activity but does not highlight directly the amounts of profits or losses at the various levels.

The points to note in the construction of a profit-volume chart are as follows:

The horizontal axis represents sales (in units or sales value, as appropriate). This is the same as

for a break-even chart.

The vertical axis shows net profit above the horizontal sales axis and net loss below.

When sales are zero, the net loss equals the fixed costs and one extreme of the 'profit-volume'

line is determined. Therefore this is one-point on the graph or chart.

If variable cost per unit and fixed costs in total are both constant throughout the relevant range

of activity under consideration, the profit-volume chart is, depicted by a straight line (as

illustrated above). Therefore, to draw that line it is only necessary to know the profit (or loss)

at one level of sales. The 'profit-volume ' line is then drawn between this point and the one for

zero sales, extended as necessary.

If there are changes in the variable cost per unit or total fixed costs at various activities, it

would be necessary to calculate the profit (or loss) at each point where the cost structure

changes and to plot these on the chart. The 'profit-volume' line will then be a series of straight

lines joining these points together, as shown in the simple illustration below.

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Cost & Management Accounting (MGT-402)

Profit-volume chart (2)

This illustration depicts the situation where the variable cost per unit increases after a certain level

of activity (OA), e.g. because of overtime premiums that are incurred when production (and sales)

exceed a particular level.

Points to note:

· The profit (OP) at sales level OA would be determined and plotted.

· Similarly the profit (OQ) at sales level of OB would be determined and plotted.

· The loss at zero sales activity (= fixed costs) can be plotted.

· The "profit-volume' line is then drawn by joining these points, as illustrated.

As long as we make the assumptions that contribution per unit is constant, and fixed costs do not

change, we can draw straight-line graphs to show profit or costs and revenues at all possible

activity levels.

MULTIPLE CHOICE QUESTIONS

1. If contribution margin is positive?

(a) Profit will occur.

(b) Both a profit and loss are possible.

(d) A loss will occur if the contribution margin is greater than fixed expenses.

2. At the breakeven point:

(a) Profit is Rs. 0.

(b) . Fixed Cost + Variable Cost = Safes

(d) All of the above

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Cost & Management Accounting (MGT-402)

A completed CVP graph will show that profit or loss at any level of sales is measured by:

(a)

A vertical line between the fixed cost line and the x axis.

(b)

A horizontal line between the revenue line and the y axis.

(c)

A vertical line between the total revenue line and the total expenses line.

(d)

A horizontal line between the total revenue line and the total expenses line.

Contribution margin ratio is:

(a)

Total Contribution Margin / Sales.

(b)

Sales / Contribution Margin per unit,

(c)

Fixed cost / Contribution margin per unit.

(d)

Sales / Variable costs.

5. The impact on net operating income of any given dollar change in total sales can be computed

by applying which ratio to the dollar change?

(a) Profit margin.

(b) Variable cost ratio.

(d) Ratio of Variable to Fixed Expenses.

6. The Hino Corporation has a breakeven point when sales are Rs. 160,000 and variable costs at

that level of sales are Rs. 100,000. How much would contribution margin increase or decrease, if

variable expenses dropped by Rs. 20,000?

(a) 37.5%.

(b) 60%.

(d) 26%

Which of the following represents the CVP equation?

(a)

Sales = Contribution margin + Fixed expenses + Profits

(b)

Sales = Contribution margin ratio + Fixed expenses + Profits

(c)

Sales = Variable expenses + Fixed expenses + Profits

(d)

Sales = Variable expenses - Fixed expenses + Profits

Margin of Safety is a term best described as the excess of:

(a)

Contribution margin over fixed expenses.

(b)

Total expenses over the breakeven point.

(c)

Sales over the breakeven point.

(d)

Sales over total costs.

Point out which of the following statements are TRUE/FALSE

Cost-volume-profit (CVP) analysis summarizes the effects of change on an organization's

volume of activity on its costs, revenue, and profit.

2. The break-even point is the volume of activity where an organization's revenues and expenses

are equal,

Total contribution margin can be calculated by subtracting total fixed costs from total

revenues.

4. Contribution margin / Sales price per unit = Contribution margin ratio.

5. The sales price of a single unit minus the unit's variable expenses is called the unit contribution

margin-

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Cost & Management Accounting (MGT-402)

6. The contribution-margin ratio of a firm is determined by dividing the per unit contribution

margin by the per unit sales price.

7. The safety margin of an enterprise is the difference between the budgeted sales revenue and

the break-even sales revenue-

8. A company's break-even sales revenues are Rs, 400,000, and its contribution margin is 40%. If

fixed costs increase by Rs. 24,000, breakeven sales will increase to Rs. 440,000.

9. If the total contribution margin at break-even sales is Rs, 45,000, then the fixed costs must

also be Rs. 45,000,

10. If a company sells 50 units of A at Rs. 8 contribution margin and 200 units of B at a Rs. 6

contribution margin, the weighted-average contribution margin is Rs. 7.00.

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Cost & Management Accounting (MGT-402)

LESSON-33

WHAT IS A BUDGET?

A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period of

time, usually one year. In other words, a budget is a systematic plan for the utilization of

manpower and material resources. In a business organization a budget represents an estimate of

future costs and revenues. Budgets may be divided into two basic classes; Capital Budgets and

Operating Budgets, Capital budgets are directed towards proposed expenditures for new projects

and often require special financing (this topic is discussed in the next Unit). The operating budgets

are directed towards achieving short-term operational goals of the organization, for instance,

production or profit goals in a business firm. Operating budgets may be sub-divided into various

departmental or functional budgets. The main characteristics of a budget are:

It is prepared in advance and is derived from the long, term strategy of the organization.

It relates to future period for which objectives or goals have already been laid down.

It is expressed in quantitative form, physical or monetary units, or both.

Different types of budgets are prepared for different purposes e.g. Sales. Budget, Production

Budget. Administrative Expense Budget, Raw material Budget, etc. All these sectional budgets are

afterwards integrated into a master budget- which represents an overall plan of the organization. A

budget helps us in the following ways:

1. It brings about efficiency and improvement in the working of the organization.

2. It is a way of communicating the plans to various units of the organization. By establishing

the divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus

minimizes the possibilities of buck-passing if the budget figures are not met.

3. It is a way or motivating managers to achieve the goals set for the units.

4. It serves as a benchmark for controlling on going. Operations.

5. It helps in developing a team spirit where participation in budgeting is encouraged.

6. It helps in reducing wastage's and losses by revealing them in time for corrective action.

7. It serves as a basis for evaluating the performance of managers.

8. It serves as a means of educating the managers.

Budgetary control

No system .of planning can be successful without having an effective and efficient system of

control. Budgeting is closely connected with control. The exercise of control in the organization

with the help of budgets is known as budgetary control. The process of budgetary control includes

(i) preparation of various budgets (ii) continuous comparison of actual performance with budgetary

performance and (iii) revision of budgets in the light of changed circumstances.

A system of budgetary control should not become rigid. There should be enough scope for

flexibility to provide for individual initiative and drive. Budgetary control is an important device for

making the organization more efficient on all fronts. It is an important tool for controlling costs

and achieving the overall objectives.

Installing a budgetary control system

Having understood the meaning and significance of budgetary control in an organization, it will be

useful for you to know how a budgetary control system can be installed in the organization. This

requires, first of all, finding answers to the following questions in the context of an organization:

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Cost & Management Accounting (MGT-402)

What is likely to happen?

What can be made to happen?

What are the objectives to be achieved?

What are the constraints and to what extent their effects can be minimized?

Having found answers to the above questions, the following steps may be taken for installing an

effective system of budgetary control in an organization.

Organization for budgeting

The setting up of a definite plan of organization is the first step towards installing budgetary

control system in an organization. A Budget Manual should, be prepared giving details of the

powers, duties, responsibilities and areas of operation of each executive in the organization.

Responsibility for budgeting

The responsibility for preparation and implementation of the budgets may be fixed as under:

Budget controller

Although the Chief Executive is finally responsible for the budget programme, it is better if a large

part of the supervisory responsibility is delegated to an official designated as Budget Controller or

Budget Director. Such a person should have knowledge of the technical details of the business and

should report directly to the President or the Chief Executive of the organization.

Budget committee

The Budget Controller is assisted 'in his work by the Budget Committee. The Committee may

consist of Heads of various departments, viz., Production, Sales. Finance Personnel, Purchase, etc.

with the Budget Controller as its Chairman. It is generally the responsibility of the. Budget

Committee to submit discusses and finally approves the budget figures. Each head of the

department should have his own Sub-committee with executives working under him as its

members.

Fixation of the Budget Period

Budget period' means the period for which a budget is prepared and employed. The budget period

depends upon the nature of the business and the control techniques. For example, a seasonal

industry will budget for each season, while an industry requiring long periods to complete work

will budget for four, five or even larger number, of years. However, it is necessary for control

purposes to prepare budgets both for long as well as short periods.

Budget procedures

Having established the budget organization and fixed the budget period, the actual work or

budgetary control can be taken upon the following pattern:

Key factor

It is also termed as limiting factor. The extent of influence of this factor must first be assessed in

order to ensure that the budget targets are met It would be desirable to prepare first the budget

relating to this particular factor, and then prepare the other budgets. We are giving below an

illustrative list of key factors in certain industries.

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Cost & Management Accounting (MGT-402)

Industry

Key factor

Motor Car

Sales demand

Aluminum

Power

Petroleum Refinery

Supply of crude oil

Electro-optics

Skilled technicians

Hydral Power generation

Monsoon

The key factors should be correctly identified and examined. The key factors need not be a

permanent nature. In the long run, the management may overcome the key factors by introducing

new products, by changing material mix or by working overtime or extra shifts etc.

Making a Forecast

A forecast is an estimate of the future financial conditions or operating results. Any estimation is

based on consideration of probabilities. An estimate differs from a budget in that the latter

embodies an operating plan or an organization. A budget envisages a commitment to certain

objectives or targets, which the management seeks to attain on the basis of the forecasts prepared.

A forecast on the other hand is an estimate based on probabilities of an event. A forecast may be

prepared in financial or physical terms for sales, production cost, or other resources required for

business. Instead of just one forecast a number of alternative forecasts may be considered with a

view to obtaining the most realistic overall plan.

Preparing budgets

After the forecasts have been finalized the preparation of budgets follows. The budget activity

starts with the preparation of the said budget. Then, production budget is prepared on the basis of

sales budget and the production capacity available. Financial budget (i.e. cash or working capital

budget) will be prepared on the basis of sale forecast and production budget. All these budgets are

combined and coordinated into -a master budget- The budgets may be revised in the course of the

financial period if it becomes necessary to do so in view of the unexpected developments, which

have already taken place or are likely to take place.

Choice between Fixed and Flexible Budgets

A budget may be fixed or flexible. A fixed budget is based on a fixed volume of activity, 11 may

lose its effectiveness in planning and controlling if the actual capacity utilization is different from

what was planned for any particular unit of time e.g. a month or a quarter. The flexible budget is

more useful for changing levels of activity, as it considers fixed and variable costs separately. Fixed

costs, as you are aware, remain unchanged over a certain range of output such costs change when

there is a change in capacity level. The variable costs change in direct proportion to output if

flexible budgeting approach is adopted, the budget controller can analyze the variance between

actual costs and budgeted costs depending upon the actual level of activity attained during a period

of time.

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Cost & Management Accounting (MGT-402)

Objective of Budget

Profit maximization.

Maximization of sales.

Volume growth.

To compete with the competitors.

Development of new areas of operation.

Quality of service.

Work-force efficiency.

Divisions of Budget

Division of Budgets

Functional Budget

Master Budget

Functional Budget

Sales Budget

Production Budget

Raw material

Labor

Factory

overhead

Cost of goods

sold

Selling &

General &

Financial

distribution

Administrative

charges

expenses

budget

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Cost & Management Accounting (MGT-402)

LESSON# 34 & 35

Production & Sales Budget

Budgets can be classified into different categories on the basis of Time, Function, or Flexibility.

The different budgets covered under each category are shown in the following chart:

Chart: clarification of Budgets

Time

Function

Flexibility

Long term

Sales

Fixed

Short term

Production

Flexible

Current

Cost of Production

Rolling

Purchase

Personnel

Research

Capital Expenditure

Cash

Master

Let us discuss some of the budgets covered in the above classification.

Rolling budget

Some organizations follow the practice of preparing a willing or progressive budget in such

organizations; budget for a year in advance will always be there. Immediately after a month, or a

quarter, passes, as-the case may be, a new budget is prepared for a twelve months. The figures for

the month/quarter, which has rolled down, are dropped and the figures for the next month /

quarter are added. For example, if a budget has been prepared for the year 19X7, after the expiry

of the first quarter ending 31st March 19X7, a new budget forth full year ending 31ft March, 19X8

will be prepared by dropping the figures for the quarter which has past (i.e. quarter ending 31st

March 19X7) and adding-the figures for the new quarter-ending 31st March 19X8. The figures for

the remaining three quarters ending 31st December 19X7 may also be revised, if necessary. This

process will continue whenever a quarter ends and a new quarter begins.

Sales budget

Sales Budget generally forms the fundamental basis on which all other budgets are built the budget

is based on projected sales to be achieved in a budget period. The Sales Manager is directly

responsible for the preparation and execution of this budget. Be usually taking into consideration

the following organizational and environmental factors while preparing the tales budget:

Availability of material or supplies

Internal

External

Past sales figures and trends

General trade prospects

Salesmen's estimates

Seasonal fluctuation

Plant capacity

Potential market

Orders on hand

Government controls, rule and

regulator relating to the industry

Availability of material or supplies

Political situation and its impact on

Market

Cost of distribution of goods

Financial aspect

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Cost & Management Accounting (MGT-402)

It is desirable to break up the entire sales budget on the basis of different products, time periods

and sales areas or territories.

Illustration 1

Shad on Ltd. has three sales divisions at A town, B town and C town. It sells two products X and

Y. The budgeted sales for the month Jan at each place are given blow:-

Product X

[50,000 units @ Rs. 16 each

Product Y

[35,000 units @ Rs. 10 each

Product Y

[55,000 units @ Rs. 10 each

Product X

[75,000 units @ Rs. 16 each

The Budge sales during the Feb were:

Madras A

Product X

62,500 units @ Rs. 16 each

Product Y

37,500 units @ Rs. 10 each

Bangalore B

Product Y

62,500 units @ Rs. 10 each

Hyderabad C Product X

77,500 units @ Rs. 16 each

From the reports of the sales department it was estimated that the sales budget for the year ending.

31st March than 19x6 budget in the following respects:

Madras A

Product X

4,000 units

Product Y

2,500 units

Bangalore B

Product Y

6,500 units

Hyderabad C Product X

5,000 units

Intensive safes campaign in Bangalore and Hyderabad is likely to result in additional sales of

12,500 units of product I in Bangalore and 9,000 units of Product II in Hyderabad, Let us prepare

a sales budget for the period ending 31st December, 19X7.

206

Cost & Management Accounting (MGT-402)

Division

Mar

Jan

Feb

Product

Qty.

Price

Value

Qty.

Value

Qty.

Pric

Value

(Units)

(Rs.

(Rs.)

(Units)

ice

(Rs.)

(Units)

(Rs.)

)

(Rs.)

(Rs.

)

Town A

54,000

8,64,000

50,000

8,00,000

62,500

10,00,00

37,500

3,75,000

35,000

3,50,000

37,500

3,75,000

Total

91,500

----

12,2,9000

85,000

----

11,50,000

----

13,75,00

Banglore

12,500

2,00,000

----

-----

X Town B

61,500

6,15,000

55,000

5,50,000

62,500

6,25,000

Total

74,500

---

8,15,000

55,000

5,50,000

62,500

----

6,25,000

Hyderabad

80,000

12,80,000

75,000

12,00,000

77,500

12,40,00

II Y

9,000

90,000

----

Total

89,000

----

13,80,000

75,000

12,00,000

----

12,40,00

Product

1,46,500

23,44,000 1,25,000

20,00,000

1,40,00

22,40,00

1,08,500

10,80,000 90,000

9,00,000

Product II

1,00,00

10,00,00

Total

2,54,500

----

34,24,000 2,15,000

29,00,000

2,40,00

----

32,40,00

Production budget

This budget provides an estimate of the total volume of production distributed product-wise with

the scheduling of operations by days, weeks and months and a forecast of the inventory of finished

products. Generally, the production budget is based on the sales -budget. The responsibility for the

overall production budget lies with Works Manager and that of departmental production budgets

with departmental works management Production budget may be expressed in physical or financial

terms or both in relation to production. The production budgets attempt to answer questions like:

(i)

What is to be produced?

(ii)

When it is to be produced?

(iii)

How it is to be produced?

(iv)

Where it is to be produced?

The production budget envisages the production program for achieving the sales target it serves as

a basis Job preparation of related cost- budgets, e.g., materials cost budget, labor cost budget, etc.

It easily facilities the preparation of a cash budget. The production budget is prepared after taking

into consideration several factors like: (i) Inventory policies. (II) Sales requirements, (iii)

Production stability, (iv) Plant capacity, (v) Availability of materials and labor, (vi) Time taken in

production process, etc.

207

Cost & Management Accounting (MGT-402)

Activity 2

From the following details of Mysore Cement Works Limited, complete the production budget for

the three-month period ending March 31, 19x6 (Production budget for product P has already been

worked out.

Estimated stock

Estimated sale during

Desired closing stock

Type of product

on Jan 1, 19x6

Jan-March 1986

on March 31, 19x6

(Units)

1,000

5,000

1,500

7,500

2,500

2,000

6,500

1,500

6,000

1,000

208

Cost & Management Accounting (MGT-402)

LESSON 36 & 37

FLEXIBLE BUDGET

When a company's activities can be estimated within close limits, the fixed budget is satisfactory.

However, completely predictable situations exist in only a few cases. If business conditions change

radically, causing actual operations to differ widely from fixed budget plans, this management tool

is not reliable or effective. The fact that costs and expenses are affected by fluctuations in volume

limits the use of the fixed budget and leads to the use of the flexible budget. To illustrate, the cost

of operating an automobile per mile depends on the number of miles driven. The more a car is

used per year, the more it costs to operate it but the less it costs per mile. If the owner prepares an

estimate of the total cost and compares actual expenses with the budget at year-end, success in

keeping expenses within the allowed limits cannot be determined without accounting for the

mileage factor. The reason for this lies in the nature of the expenses, some of which arc fixed while

others are variable or semi variable. Insurance, taxes, registration, and garaging are fixed costs,

which remain the same whether the car is operated 1,000 or 20.000 miles. The costs of tires, gas,

and repairs are variable costs, which depend largely upon the miles driven. Obsolescence and

depreciation result in a semi-variable cost. Which fluctuates to some degree but does not vary

directly with the usage of the car?

The underlying principle of a flexible budget is the need for some norm of expenditures for any

given volume of business. This norm should be known beforehand in order to provide a guide to

actual expenditures. To recognize this principle is to accept the fact that every business is dynamic,

ever changing, and never static. It is erroneous, if not futile, to expect a business lo conform to a

fixed, preconceived pattern.

The preparation of a flexible budget results from the development of formulas for each department

and for each account within a department or cost center. The formula for each account indicates

the fixed amount and/or a variable rate. The fixed amount and variable rate remain constant within

prescribed ranges of activity. The variable portion of the formula is a rate expressed in relation to a

base such as direct labor hours, direct labor cost or machine hours.

The application of the formulas to the level of activity actually experienced produces the allowable

expenditures for the volume of activity attained. These budget figures are compared with actual

costs in order to measure the performance of each department. This ready-made comparison

makes the flexible budget a valuable instrument for cost control, because it assists in evaluating the

effects of varying volumes of activity on profits and on the cash position,

Originally, the flexible budget idea was applied principally 10 the control of departmental factory

overhead. Now however, the idea is applied lo the entire budget. So that production as well as

marketing and administrative bud-gels is prepared on a flexible budget basis.

Capacity and volume

The discussion of the actual preparation of a flexible budget must be preceded by a basic

understanding of the term "capacity." The terms "capacity" and "volume" (or activity) are used in

connection with the construction and use of both fixed and flexible budgets. Capacity is that fixed

amount of '

"plant and machinery and number of personnel for which management has

committed itself and with which it expects to conduct the business. Volume is the variable factor

in business. It is related to capacity by the fact that volume (activity) attempts to make the best use

of existing capacity.

209

Cost & Management Accounting (MGT-402)

Any budget is a forecast of sales, costs, and expenses. Material, labor, factory overhead, marketing

expenses, and administrative expenses must be brought into harmony with the sales volume. Sales

volume is measured not only by sales the market could absorb, but also by plant capacity and

machinery available to produce the goods. A plant or a department may produce the goods. A

plant or department may produce 1,000 units or work 10.000 hours, but this volume (or activity)

may not be ' compatible with the capacity of the plant or department. The production of

1.000'units or the working of 10.000 hours may be greater or smaller than the amount of sales the

company can safely expect to achieve in a given market during a given period.

The following terms are used in referring to capacity levels' theoretical practical, expected actual,

and normal. Current Internal Revenue Service regulations permit the use of practical, expected

actual or normal capacity in assigning factory overhead costs to inventories.

Theoretical Capacity. The theoretical capacity of a department is its capacity to produce at full

speed without interruptions. It is achieved if the plant-or department produces at 100 percent of its

rated capacity,

Practical Capacity. It is highly improbable that any company can operate at theoretical capacity.

Allowances must be made for unavoidable interruptions, such as time lost for repairs,

inefficiencies, breakdowns, setups. failures, unsatisfactory materials, delays in delivery of materials

or supplies, labor shortages and absences, Sundays, holidays, vacations, inventory taking, and pat-

tern and model changes. The number of work shifts must also be considered. These allowances

reduce theoretical capacity to the practical capacity level. This reduction is caused by internal

influences and does not consider the chief external cause, lack of customers' orders. Reduction

from theoretical to practical capacity typically ranges from 15 percent to 25 percent, which results

in a practical capacity level or 75 percent lo 85 percent of theoretical capacity.

Expected Actual Capacity. Expected actual capacity is based on a short-range outlook. The use

of expected actual capacity is feasible with firms whose products are of a seasonal natureČ and

market and style changes allow price adjustments according to competitive conditions and

customer demands.

Normal Capacity. Firms may modify the above capacity levels by considering the Utilization of

the plant or various departments in the light of meeting average sales demands over a period long

enough to level out the peaks and valleys which come with seasonal and cyclical variations. Finding

a satisfactory and logical balance between plant capacity and sales volume is one of the important

problems of business management.

Once the normal (or average) capacity level has been established, overhead costs can be estimated

and factory overhead rates computed. The use of these rates will cause all overhead of the period

to be absorbed, provided normal capacity and normal expenses prevail during the period.

Purposes of Establishing Normal Capacity. Although there may be some differences between a

normal long-run volume and the sales volume expected in the next period, normal capacity is

useful in establishing sales prices and controlling costs. It is the basis for the entire budget system,

and it can be used for the following purposes and aims:

1. Preparation of departmental flexible budgets and computation of predetermined factory

overhead rates,

2. Compilation of the standard cost of each product.

3. Scheduling production.

210

Cost & Management Accounting (MGT-402)

4. Assigning cost to inventories.

5. Measurement of the effects of changing volumes of production.

6. Determination of the break-even point.

Although other capacity assumptions are sometimes used due to existing circumstances, normal

capacity fulfills both long- and short-term purposes. The long-term utilization of the normal

capacity level relates the marketing phase and therewith the pricing policy of the business 10 the

production phase over a long period of time, leveling out fluctuations that are of short duration

and of comparatively minor significance. The short-term utilization relates to management's

analysis of changes or fluctuations that occur during an operating year. This short-term utilization

measures temporary idleness and aids in an analysis of its causes.

Factors Involved in Determining Normal Capacity. In determining the normal capacity of a plant,

both its physical capacity and average sales expectancy must be considered; neither plant capacity

nor sales potential alone is sufficient. As previously mentioned, sales expectancy should be

determined for a period long enough to level out cyclical variations rather than on the sales

expectancy for a short period of time. It should also be noted that outmoded machinery and

machinery bought for future use must be excluded from the considerations which lead to the

determination of the normal capacity level-Calculation of the normal capacity of a plant requires

many different judgment factors. Normal capacity should be determined first for the business as a

whole and then broken down by plants and departments. Determination of a departmental

capacity figure might indicate that for a certain department the planned program is an overload

while in another ii will result in excess capacity. The capacities of several departments will seldom

be in such perfect balance as to produce an unhampered flow of production. For the department

with the overload, often termed the "bottleneck" department, actions such as the following might

have to be taken;

Working overtime.

Introducing an additional shift.

Temporarily transferring operations to another department where spare capacity is available.

Subcontracting the excess load.

Purchasing additional equipment.

On the other hand, the excess facilities of other departments might have to be reduced. Or the

safes department might be asked lo search for additional orders to utilize the spare capacity in

these departments.

The effect of the various capacity levels on predetermined factory overhead rates is illustrated

below. If the 75 percent capacity level is considered to be the normal operating level, the

overhead rate is $2.40 per direct labor hour.

211

Cost & Management Accounting (MGT-402)

EFFECT OF VARIOUS CAPACITY LEVELS ON PREDETERMINED

FACTORY OVERHEAD RATES

ITEM

NORMAL

PRACTICAL THEORETICAL

CAPACITY CAPACITY

CAPACITY

Percentage of

75%

85%

100%

production capacity

Direct labor hours

7,500 hrs.

8,500 hrs.

10,000 hrs.

Budgeted factory

overhead

Fixed

Rs. 12,000

Variable

6,000

6,800

8,000

Total

Rs. 18,000

Rs. 18,800

Rs. 20,000

Fixed factory overhead

Rs. 1.60

Rs. 1.41

Rs. 1.20

rate per direct labor

hours

Variable factory

.80

overhead rate per direct

labor hour

Total factory overhead

Rs. 2.40

Rs. 2.21

Rs. 2.00

rate per direct labor hour

At higher capacity levels [he rate is lower, because the fixed overhead is spread

A distinction must be made between idle and excess capacity. Idle capacity results from the

temporary idleness of production or distribution facilities due to a lack of orders. Idle facilities are

restored to full use as soon as the need arises. Their cost is usually part of the expense total used in

selling up the overhead rate and is at all limes a part of the product cost. However, as explained in

the factory overhead and standard cost chapters, the cost of idle capacity can be isolated both for

control purposes and for the guidance of management-

Excess Capacity. Conversely, results either from greater productive capacity than the company

could ever hope to use. or from an imbalance in equipment or machinery. This imbalance

involves the excess capacity of one machine in contrast with the output of other machines with

which it must be synchronized. Any expense arising from excess capacity should be excluded

from the factory overhead rate and from the product cost. The expense should be treated as a

deduction in the income statement. In many instances. It may be wise to dispose of excess plant

and equipment.

ANALYSIS OF COST BEHAVIOR

The success of a flexible budget depends upon careful study and analysis of the relationship of

expenses to volume of activity or production and results in classifying expenses as fixed, variable,

and semi variable,

Fixed Expenses

A fixed expense remains the same in total as activity increases or decreases. Fixed factory overhead

includes conventional items such as straight-line depreciation, property insurance, and real estate

taxes- Other expenses not inherently fixed acquire the fixed characteristic through the dictates of

management policy.

212

Cost & Management Accounting (MGT-402)

The classification of an expense as fixed is valid only on the assumption that the underlying

conditions remain unchanged. Thus, there is really nothing irrevocably fixed with respect to any

expense classified as fixed. In the long run all expenses are variably. In the short run, some fixed

expenses, some times called programmed fixed expenses, will change because of changes in the

volume of activity or for such reasons as changes in the umber and salaries of the management

groups. Other fixed expenses (e.g., depreciation or a long-term lease agreement) may commit

management for a much longer period time; therefore, they have been labeled committed fixed

expenses.

Variable Expenses

A variable expense is expected to increase proportionately with an increase in activity and decrease

proportionately with a decrease in activity. Variable expenses include the cost of supplies, indirect

factory labor, receiving, storing, rework, perishable tools, and maintenance of machinery and tools.

A measure of activity such as direct labor hour or dollars.

213

Cost & Management Accounting (MGT-402)

LESSON# 38

TYPES OF BUDGET

Cash Budget

The cash budget the management in:

Determining the future is a summary of the firm's expected cash inflows and outflows over a

particular period of time. In other words, cash budget involves a projection of future cash

receipts and cash disbursements over various time intervals.

· A cash budget helps cash needs of the firm

· Planning for financing of those needs

· Exercising control over cash and liquidity of the firm.

The overall objective of a cash budget is to enable the firm to meet all its commitments in time

and at the same time prevent accumulation at any lime of unnecessary large cash balances with

it-

Format of Cash Budget

XYZ Ltd

Cash Budget

For the month of Jan-March

Jan

Feb

March

Opening balance

Add Receipts (Anticipated cash

Receipt from all sources)

Less Payments (Anticipated utilization of cash)

Excess / Deficit

Bank barrowing / Overdraft

Closing balance

Activity

D.A Corporation has following information relating to the month of January:

Opening cash balance Rs. 20,000. Cash receipts are: Credit sales Rs. 1, 40,000, Cash sales Rs.

80,000, Loan Rs. 2,00,000, Disposal of machine Rs. 60,000, further capital Rs. 1,20,000.

Cash payments are: Payment to creditor Rs. 60,000, Cash purchase Rs. 60,000, machine

purchase Rs. 3,50,000, Administrative expenses Rs. 40,000, Selling expenses Rs. 75,000 and

Interest on loan Rs. 5,000

214

Cost & Management Accounting (MGT-402)

Solution

Jan

Opening balance

20,000

Add Receipts

Receipt from sales:

Credit sales

1, 40,000

Cash sales

80,000

Loan

2,00,000

Further capital

1,20,000

Disposal of machine

60,000

6,00,000

6, 20,000

Less Payments

Purchases:

Payment to creditor

60,000

Cash purchase

60,000

Machine purchase

3,50,000

Administrative expenses

40,000

Selling expenses

75,000

Interest on loan

5,000

5,90,000

Closing balance

30,000

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