Short notes version- from the examination point of view -regular notes are attached

The notes for MACS is in line with the 3rd semester requirement of VTU MBA syllabus. This are grouped into two sections. Section A comprises of theory .Suggested answers for Theoritical Questions are related to past 5 years. Section B comprises of numericals. All the numericals are solved from the past question papers.-contact M.D.Saibaba at saibaba11084@gmail.com for feedback and clarifications and improvements.

Section A :

Module 1

Goals: Goals are broad overall aims of the organization. Goals are statements of what a company intends to achieve over the period of the strategic plan (e.g. over the next year, five years, ten years). A goal also means a desired result a person or an organization, plans and commits to achieve.

Q-What are the strategic key variables in management control systemsA key variable is a significant indicator of business activity. According to Samuel Paul there is positive relationship between key variables and the organizational performance.Examples of key variablesProduction key variables: Capacity utilization, losses, Quality control, maintenance.Marketing key variables: Market share, New product developmentAsset management key variables: Asset turnover, ROIHRM: Employee training, attrition.

Management by objectives (MBO) is a process of defining objectives within an organization so that management and employees agree to the objectives and understand what they need to do in the organization. The essence of MBO is participative goal setting, choosing course of actions and decision making.MBO: The term "management by objectives" was first popularized by Peter Drucker in his book 'The Practice of Management'.

Some of the important features and advantages of MBO are:

1. Facilitates Motivation of employees–2. Ensures better communication and Coordination within the organization.

3. Clarity in setting of goals:

4. Ensures Goal congruence :

Limitations

There are several limitations :Some of them are

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1. It over-emphasizes the setting of goals

2.Self-centered employees might be prone to distort results.

Q-What do you understand by Management controls .What are the basic elements of the control

According to Anthony and Govindarajan , Management Control is “the process by which managers ensure that resources are used effectively and efficiently in the accomplishment of the organization's objectives”.

A management control system is the means by which senior managers ensure that subordinate managers, efficiently and effectively, strive to attain the company's objectives.

According to Horngren et al. management control system is an integrated technique for collecting and using information to motivate employee behavior and to evaluate performance.

Q-What are the elements of a control system.(Ref to Fig)

Any control system has four important elements. They are

1) Detector or sensor: Detector analyzes the situation2) Assesor: Assesor helps in comparing the actual results with the standard or expected results.3) Effector: Effector reduces the gap between the actual and the standard result.4) Communication network: The communication network transmits information between the

dectector, the assesor and the effector.

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ELEMENTS OF THE CONTROL PROCESS

Source Robert N Anthony,Govindarajan, Management control systems

Control device2. Assessor: Comparison with standard

1. Detector: Information about what is happening

3. Effector: Behavior alteration, if needed

Entity being controlled

Q-Explain the various steps in control processThe process of control usually involves four important steps. They are

Identifying the goals or objectives Implementing the programs or policies Measuring and comparing outcomes against targets Analyzing whether the achieved targets are in accordance with the goals or objectives.

Q-Define management control and task control/ Distinguish between task control and management control.(ref-fig)

Management Control. Management control is concerned with implementation of strategies, effective resource utilization, competitiveness of the unit, and the translation of corporate goals into business unit objectives. Management control is oriented towards behavior of personnel to implement strategies effectively. Management control lies at the intermediate level between the levels of strategy formulation and task control.

Task control: Task control means the control of individual tasks. These tasks are carried out according to the, policies, rules and regulations laid down by the management control process. Task control is quantitative in nature. e.g. the number of items ordered by the customers, the components used in manufacturing the products, the number of man-hours used in a particular process, etc.

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GENERAL RELATIONSHIPS AMONG PLANNING AND CONTROL FUNCTIONS

Goals, strategies and policies

Source Robert N Anthony,Govindarajan, Management control systems

Operational control is primarily concerned with efficiency issues of various of the organization. The time horizon of control is very short, the benchmarks are known and well defined, and the outcomes are tangible and easily measurable.

Internal controls within business entities are also referred to as operational controls. Internal control is a process effected by an organization's structure, work and authority flows, people and management information systems. It helps the organization accomplish specific goals. It is a means by which an organization's resources are directed, monitored, and measured.

Q-Task control vs. management control

Task control is the process of assuring that specified tasks are carried out effectively and efficiently.Task control activities are scientific eg.,(EOQ). Task control involves the control of individual tasks. These tasks are carried out according to the rules and regulations laid down by the management control process. Task control is quantitative in nature whereas management control is oriented towards behavior. In task control, in some cases, such as automated processes, employees may not be involved; in other cases, there may be interaction between a manager and a worker. Management control involves interaction between two managers or between a superior and subordinate.

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Strategy formulation

Management control

Task control

Implementation of strategies

Efficient and effective performance of individual tasks

(Note add points from the above paras-do not write this line in the exam)

Q-Bring out the differences between operational control, task control and management control.

Refer to the above paras for answer.

Q-“Management control systems are tools to implement strategies “Explain the procedure of strategy formulation at both corporate level and business level.

Management control systems help managers move an organization toward its strategic objectives and strategy execution. Management controls are effected efficient organization structure, HRM and culture. It is an important aspect of strategy implementation. The following figure shows the framework for strategy implementation.

Source Robert N Anthony,Govindarajan, Management control systems

Strategy formulation:Strategy formulation is the process of determining appropriate courses of action for achieving organizational objectives and thereby accomplishing organizational goals. It is the development of long range plans for the effective management of SWOT aspects of business. The purpose is to utilize the strength and to overcome the threat.

Strategies are considered at two levels in an organization: corporate strategy and business unit strategy. Corporate resources are allocated based on these the strategies. Business unit’s strategy

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IMPLEMENTATION MECHANISMS

Management conrols

Organization structure

Human resource management

Culture

StrategyPerformance

formulation is based on the corporate mission. However in both cases the approach for strategy formulation is by and large the same.(Ref fig

Q-What are the informal factors influencing goal congruence

Goal congruence means agreement of actions of individuals and groups in achieving the organization’s goals. For congruence Corporate goals are communicated by budgets, organization charts, and job descriptions. The following are the

Informal factors of goal congruence: Organizational culture; Leadership: Individual aspirations: Decentralization-

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Internal analysisTechnology knowhowMfg. know howMkg. knowhowDistn. knowhowLogistics knowhow

Environmental analysisCompetitorCustomerSupplierRegulatorySocial/political

Opportunities and threats

Identify opportunities

Strength and weaknesses

Identify core competencies

Fix internal competencies with external opportunities

Firm’s strategies

Formal factors are organization structure-performance evaluation and compensation systems-Transfer pricing

Q-What do you mean by responsibility accounting:/What is responsibility accounting

Responsibility accounting means evaluation and judging of each manager's performance of the responsibility center, under his or her control. It is based on the assumption that every cost incurred must be the responsibility of one person somewhere in the company. Responsibility accounting also means collection, summarization, and reporting of financial information about various decision centers (responsibility centers) throughout an organization.

Q-RESPONSIBILITY CENTERSResponsibility center is a unit or function of an organization headed by a manager who is directly responsible for its performance. Manager of a responsibility operates the center as a separate business entity, responsible for its operations and profitability.

COST CENTER. A cost center is a production or service function, activity or item of equipment, the costs of which may be attributed to cost units. Examples of cost center are R&D, Production, Marketing, assembly department-personnel, accounting etc. A cost center forms the basis for building up cost records for cost measurements, budgeting and control.

Profit centersA profit center is a section of a company treated as a separate business. A profit center manager is held accountable for both revenues, and costs (expenses), and therefore, profits. The profit center helps the organization to make the best use of specialized market knowledge of the divisional managers.

Investment centers: An investment center operates like a separate entity within the organization. The essential element of an investment center is that it is treated as a unit which is measured against its use of capital, as opposed to a cost or profit center, which are measured against costs or profits. An investment center has control over sales revenues and operating costs, and the assets used to generate profit.

COST UNIT is a functional cost unit which establishes standard cost per workload element of activity.

Module 2

What are the elements of cost?(ref fig)

Elements of cost - (1) material, (2) labour and (3) expenses.

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Materials can be direct and indirect.

Direct Material: All materials which become an integral part of the finished product,

Indirect Material:. Examples are Consumable stores, lubrication oil, stationery and spare parts etc.

Labour

Human efforts used for conversion of materials into finished products is called labour .Payment made towards the labour cost. It can also be direct and indirect.

Expenses

All expenditures other than material and labour incurred for manufacturing a product or rendering service are termed as 'expenses'. Expenses may be direct or indirect.

Q-Distinguish between product cost and period cost. Why is it considered important.(ref-fig)

The Difference Between Product Cost and Period Cost.

Product costs refers to that cost which varies in direct proportion to the volume of output. The cost per unit of product cost remains unchanged as production increases or decreases but total cost increases. Examples ; cost of direct material, direct labor and direct expenses.

{For financial accounting purposes ,product costs include all the costs that are involved in acquiring or making. In the case of manufactured goods these costs consist of direct materials, direct labour and manufacturing overhead}

Period cost is the fixed cost. It refers to that cost which remains unchanged by change in volume of output. These costs are called period costs because it is dependant on the time rather than the volume of output. Examples are rent of the factory building, Salary of managers, Insurance of building etc.

{In financial accounting period costs are all the costs that are not included in product costs. These costs are expensed on the income statement in the period in which they are incurred}.

Why is the distinction between product cost and period costs important?

The distinction between product costs and period costs is important for 1) properly measuring net income during a period of time and 2) reporting the proper cost of inventory on the balance sheet.

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Product costs will be reported on the income statement as the cost of goods sold expense in the period that the units of product are sold. Period costs are treated as expenses on accrual basis.

Q-Define imputed cost: Differential cost: Opportunity cost:/Explain imputed cost,/out of pocket cost, relevant cost, sunk cost.

The following are the Cost concepts in decision making

Marginal cost: Marginal cost is the total of variable costs, i.e., prime cost +variable overheads. It is based on the distinction between fixed and variable costs. Fixed costs are ignored and only variable costs are taken into consideration for determining the cost of products, Work in progress and finished goods.

Differential cost: Any cost that differs between alternatives in a decision-making situation is called differential cost. It is the change in costs due to changes in the level of activity or method of production, technology or process. If the change increases the cost, it will be called incremental cost. Differential cost is also known as avoidable, relevant cost and Incremental cost .

Imputed cost: A cost that is incurred by virtue of using an asset instead of investing it or undertaking an alternative course of action. An imputed cost is an invisible cost that is not incurred directly, as opposed to an explicit cost, which is incurred directly. Imputed cost is also known as “implied cost” or “opportunity cost.

Opportunity cost: Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen). It is the sacrifice related to the second best choice available to someone, or a firm, who has picked among several mutually exclusive choices

Q-Explain different types of “cost classifications”

Cost classification is the process of grouping costs according to their common characteristics. Classification is made with the purpose of achieving the requirements of a particular concern.

Classification of costs

By nature of elements :Materials, labour By functions (Production-selling and

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expenses distribution)By degree of traceability to the product (direct and indirect)

By change in activity or volume (Fixed, variable and semi-variable)

By controllability By normality (Normal cost, abnormal cost)By relationship with accounting period (Capital and Revenue)

By time (Historical cost-predetermined costs)

By association with the product (product cost-period costs)

According to planning and control (Budgeted costs and standard costs)

Cost analysis for managerial decision makingMarginal cost, out of pocket cost, differential cost, sunk cost, imputed or notional cost, opportunity cost, replacement cost, avoidable cost and unavoidable cost, explicit cost-implicit costs.

Q-Sources of information on cost: Payroll, Material requisition slips, job cards, Financial accounting records for depreciation and other overheads.

Q-What is job costing

Job costing is that form of specific order costing which applies where the work is undertaken as an identifiable unit such as:

i) Manufacture of product to customers’ specific requirements.ii) Fabrication of certain materials where raw materials are supplied by the customers

iii) Internal capital expenditure jobs etc.

Elelments of cost

Prime cost=Direct materials+ Direct labour+ Direct expenses

Works cost or Factory cost=Prime cost+ Works or Factory overhead

Cost of production=Works cost+ Adminstration overheads

Total cost or cost of sales= Cost of production +Selling and distribution overheads

Selling price-cost of sales=profit/loss

Hint1:The following are not to be considered in cost sheet: Transfer to reserves; Discount on shares

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written off; Dividend; Income tax; Bad debts, Bad Debt Reserves; transfer fees, Preliminary expenses written off, Donations made

Hint2:Some times selling price is to be determined on the basis of cost of production but profit percentage is generally given on sales. For calculation of profit the following formula should be used

Profit =Rate percentage on sales x Total costs/(100-rate percentage on sales)

Rate % on sales=25;total cost=Rs 33,000

Profit= 25 x 33000 /(100-25)=Rs11000

Q-Definition of overhead: Cost pertaining to a cost center or cost unit may be divided into two portions direct and indirect. CIMA defines indirect cost as “expenditure on labour, materials or services which cannot be conveniently identified with a specific saleable cost per unit”.

Q-Explain the steps in “overhead accounting”

To ascertain the total cost, overhead is added to the prime cost. The overheads which cannot be specifically related to cost units are apportioned to various departments and then to cost centers or production units. The following steps are involved in this procedure

1) Collection of overhead ( indirect labour , indirect materials, Indirect expenses)2) Classification and codification of overhead (Selling overhead, distribution overhead, R&D

overhead, Manufacturing overhead etc-fixed overhead: variable overhead)

3) Allocation and apportionment of overhead

4) Reapportionment of service department costs to production departments

5) Absorption of overhead by production units.

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( refer to numerical problems for detailed explanation of the above)

Q-Distinguish between “cost centre and cost unit”

Cost centre has been defined as “a location, person or item of equipment for which costs may be ascertained and used for the purpose of cost control”.

Whereas a cost unit is a “unit of quantity of product service or time in relation to which costs may be ascertained and or expressed”.

Importance of overhead allocation

Total cost of product constitutes Direct Material, Direct Labor & Overheads. Accuracy of product cost computation depends on accurate distribution of overheads to products. Inaccuracies would lead to incorrect decisions – especially the pricing decisions.

Q- Allocation and apportionment (primary distribution)‘Allocation’ means the process of identifying the whole items of cost to the cost centers or cost units or departments. It is to be noted that these expenses could be directly identified with the cost centers and not common to several cost centers.Ex---salary of foreman, wages of a M/c operator

‘Apportionment’ is defined as the allotment to two or more cost centers , proportions of the common items of cost on the estimated basis of benefits received.Eg---rent of factory building is not allocated but apportioned to various departments on some suitable basis, similarly, salary of general manager cannot be allocated wholly to one department as he attends in general to all departments. It should be therefore apportioned on some equitable basis.

Q-Explain the differences between allocation of overhead ,apportionment of overhead/ State the difference between allocation and apportionment of overheads

Differences between allocation and apportionment1. Under allocation of overheads, the entire amount is charged to a department. Under apportionment of

overheads, only a proportionate amount is charged to the department.

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2. Allocation is the first step in the departmentalization of overheads, whereas, apportionment comes next.

3. Allocation is a simple process, whereas apportionment is a cumbersome process.4. In case of allocation, overheads can be conveniently identified with a department, whereas it is not

possible to identify overheads to a department under apportionment process.

Basis of apportionment of overheads Base Items of cost

1. Floor area or volume of dept. Rent and rates; taxes; heating and lighting; repairs & maintenance of building; accident prevention cost, fire precaution service; air conditioning

2. number of employees Labor welfare expenses, canteen expenses, indirect labor cost, supervision, time keeping, fringe benefits, medical expenses and pensions

3. Capital value of asset Depreciation, repairs and maintenance, insurance4. Horse power or kilowatt power5. Direct material cost Indirect material, material handling, wastage6. Direct labor cost Indirect labor, sundry expenses, compensation of

workers, ESI, administrative expenses7. No. of light points Lighting expenses8. Labor hrs/m/c hrs Indirect materials, labor(indirect), miscellaneous

expenses9. Total sales /total cost Marketing expenses10. No. of material requisition Store keeping expenses

Reapportionment Of Service Department Costs (secondary distribution)Once the overheads have been allotted and apportioned to production and service departments and totaled, the next step is to reapportion the service department costs to production departments. This is necessary because our ultimate object is to charge overheads to cost units, and no cost unit should pass through service departments. Therefore the cost of service departments must be charged to production departments.

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Apportionment of service department overhead

Apportionment to production apportionment to production as wellDepartment only as other service depts. Non reciprocal basis Reciprocal basis

Simultaneous equation method repeated distribution method

Apportionment to production department only: Here the total amount of each service department is distributed to only production department.

Some of the important basis of apportionment of service department overheads are:

Service departments Basis of apportionment1. Purchase departments a. Value of material purchased b. No. of orders placed2. Time office, personnel dept. a. No of employees b. Wages paid c. Labor hours3. Canteen, labour welfare a. No of employees b. Wages paid4. Accounts office a. No of employees-No of time cards handled5. Laboratory a. Testing laboratory hours b. Units of o/p6. 6. Maintenance No of hours worked in each department

Cost absorption:The process of ascertaining the charge of indirect cost per unit of production or service is called ‘absorption’In other words, the overhead is absorbed by the physical units manufactured or units or services rendered during a period or for specific jobs. This helps to determine indirect cost of manufacturing a product or provision of service.Absorption of overheads can be made based on some suitable basis.

The following are some of widely used methods of absorption:

a) On the basis of ‘Production units’ b) As a % of ‘Direct Labour Cost’

c) As a % of ‘Direct Material Cost’ d) As a % of ‘Prime Cost’

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e) On the basis of ‘Direct Labour Hours’ i.e. Labour Hour Rate

f) On the basis of ‘Machine Hours’ i.e. Machine Hour Rate

What is activity based costing?

Activity Based Costing: Activity-based costing (ABC) is a special costing system that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each activity. In ABC system, costs are assigned according to the 'cause and effect' relationship between activities and cost objects, which is captured using cost drivers.

In the traditional costing systems overheads are added as a percentage of expenses into the direct costs. This method is quite satisfactory when the overhead costs are a small percentage of the direct costs. However as the percentages of overhead costs rises, this technique becomes increasingly inaccurate because the indirect costs are not caused equally by all the products.Therefore, using an arbitrary percentage leads to distortion of costs resulting in the following problems:

a) Fixation of wrong selling prices (By pricing low, profitable opportunities may be missed or by pricing high, customers may be lost.

b) Taking wrong decisions (product -sales mix decisions of discontinuing or development etc)

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Overhead Allocation – Traditional vs Activity Based Costing

 

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Steps involved in ABC model

Q-Explain the stages involved in Activity based costing system/Explain the different stages involved in Activity based costing

The objective of an ABC implementation is to relate all of the costs of doing business to products, services, or customers. The process involves assigning and attaching the costs of the activity to cost objects.

Six stepsin Activity based costing system:

a) Identify the Resources (expenditures) of an organization. Pick resource wise cost data from financial accounting records.

b) Identify activities/Determine Activities (work performed).c) Define Cost Objects (products, services, customers). d) Map resource costs to activities by developing Resource drivers to link Resources to Activitiese) Identify activity cost drivers by Developing Cost Drivers to link Activities to Cost Objects.f) Compute overhead costs of the products / services

While traditional costing arbitrarily allocates overhead costs, ABC traces overhead costs by looking at the activities that each product and service calls upon. With ABC the products consume the activities. It is the activities that cost money.

Q-What is cost pool and cost driver?

 Cost drivers : cost drivers  are the underlying causes of costs of activities. Cost drivers form the basis of cost allocation and are used to measure the use of activities by different products /services.   For example the cost of the activity ‘purchasing’ is measured by the number of purchase orders placed: For internal transportation the number of parts moved.

Module 3

Cost Behavior

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The way a specific cost reacts to changes in activity levels is called cost behavior. Costs may stay the same or may change proportionately in response to a change in activity.

Fixed costs

Fixed costs are those that stay the same in total regardless of the number of units produced or sold. Although total fixed costs are the same, fixed costs per unit changes. Straight-line depreciation is an example of a fixed cost. It does not matter whether the machine is used to produce 1,000 units or 10,000,000 units in a month, the depreciation expense is the same because it is based on the number of years the machine will be in service.

Variable costs

Variable costs are the costs that change in total each time an additional unit is produced or sold. Direct materials is a variable cost.

Graphically, the total fixed cost looks like a straight horizontal line while the total variable cost line slopes upward.

The graphs for the fixed cost per unit and variable cost per unit look exactly opposite the total fixed costs and total variable costs graphs. Although total fixed costs are constant, the fixed cost per unit changes with the number of units. The variable cost per unit is constant.

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Semi variable costs

Semi variable costs have characteristics of both fixed and variable costs. For example, a company pays a fee of $1,000 for the first 800 local phone calls in a month and $0.10 per local call made above 800. During March, a company made 2,000 local calls. Its phone bill will be $1,120 ($1,000 +(1,200 × $0.10)).

Margin of SafetyThe margin of safety is a tool to help management understand how far sales could change before the company would have a net loss. It is computed by subtracting break-even sales from budgeted or forecasted sales. (refer to numerical problems)

Sensitivity Analysis

A business environment can change quickly, so a business should understand how sensitive its sales, costs, and income are to changes. CVP analysis using the break-even formula is often used for this analysis. By varying one of the variables, impact on the other variables is estimated.

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Module 4

Variable Costing:It is a method in which the costs to be inventoried include only the variable manufacturing costs. Fixed factory overhead is treated as a period cost-it is deducted along with the selling and administrative expenses in the period incurred. That is,

Fixed factory overhead is treated as a period expense.Variable costing is used for internal management only. Its uses include: (1) inventory valuation and income determination; (2) relevant cost analysis; (3) break - even and cost - volume - profit (CVP) analyses ; and (4) short-term decision-making. Variable costing is, however, not acceptable for external reporting or income tax reporting.

Under absorption costing, the cost to be inventoried includes all manufacturing costs, both variable and fixed. Nonmanufacturing (operating) expenses, i.e., selling and administrative expenses, are treated as period expenses and thus are charged against the current revenue.

Q-What are the assumptions of marginal costing

Marginal costing: Marginal cost is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs. Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.

Marginal Cost = Variable Cost =Direct Labour+Direct Material+Direct Expense+Variable Overheads

The term ‘contribution’ means the difference between Sales and Marginal cost.

Contribution =Sales - Marginal Cost.

Contribution is equal to fixed cost plus profit (C = F + P).

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

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

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Q Advantages and Disadvantages of Marginal Costing Technique ?

Advantages

1. Marginal costing is simple to understand.2. It helps in short-term profit planning by breakeven and profitability analysis,

3. It can be shown both in terms of quantity and graphs.

4. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making.

5. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business.

6. It eliminates large balances left in overhead control accounts

7. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost

Disadvantages

1. The separation of costs into fixed and variable is difficult 2. Normal costing systems also apply overhead under normal operating volume and this shows

that no advantage is gained by marginal costing.

3. Application of fixed overhead can lead to under or over absorption of the same.

4. Fixed cost is not taken care of under marginal costing.

5. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic.

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

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

MARGINAL COSTING PRO-FORMA  £ £Sales Revenue   xxxxxLess Marginal Cost of Sales    Opening Stock (Valued @ marginal cost) xxxx  Add Production Cost (Valued @ marginal cost) xxxx  Total Production Cost xxxx  Less Closing Stock (Valued @ marginal cost) (xxx)  Marginal Cost of Production xxxx  Add Selling, Admin & Distribution Cost xxxx  

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Marginal Cost of Sales   (xxxx)Contribution   xxxxxLess Fixed Cost   (xxxx)

Marginal Costing Profit   xxxxx

Marginal Costing versus Absorption Costing

The net profits are not the same in both methods because of the following reasons:

1. Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits between the two methods.

2. Difference in Stock Valuation

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

3.Differences in profits/per unit: Profit per unit in any period can be affected by the actual volume of production in absorption costing; this is not the case in marginal costing.

In marginal costing, the identification of variable costs and of contribution enables management to use cost information more easily for decision-making purposes

Limitations of Absorption Costing

The following are the criticisms against absorption costing:

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

For the decision-making purpose of management, better information about expected profit is obtained from the use of variable costs and contribution approach in the accounting system which is not so in abosorption costing.

Important formulae

1.   Contribution ( Per unit) = Sale per unit  - Variable Cost per unit2. Contribution = Fixed Cost + Profit

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3. Profit = Contribution - Fixed Cost

4. Total profit or loss = Total Contribution - Total Fixed Costs

5. Profit Volume Ratio = Contribution/ Sale X 100 ( It means if we sell Rs. 100 product, what will be -

- our contribution margin, more contribution margin means more profit

6 Break Even Point is a point where Total sales revenue = Total Cost

7. Break Even Point ( In unit ) = Total Fixed expenses / Contribution per unit

8. Break Even Point ( In Sales Value ) = Break even point (in units) X Selling price per unit)

9.Break Even Point to achieve target profit margin= Total Contribution / Contribution per unit  - or  = fixed cost + profit / selling price - variable cost per unit

Application of Marginal Costing in Managerial Decisions (It is also application of CVP analysis)

By effective use of marginal costing techniques and formulae, one can apply marginal costing for managerial decisions with following ways :

1. Decision regarding to sell goods at different prices to different customers :Sometimes, company has to give special discount to special customers. At that time manager has to take decision at what limit, one can give discount to special customers. Marginal costing may help in this decisions.

2. Choose of Good Product Mix: When companies are producing multiple products company managers will give preference to that product whose contribution will high. Ranking based on contribution helps in choosing optimum product mix. (refer to numerical problems to understand)

3.Calculation of Margin of Safety: Marginal costing can be utilized for calculating margin of safety. Margin of safety is difference between actual sale and sale at breakeven point.

For long term profit planning, absorption costing is the better technique.

Q- What are the assumptions of marginal costing?-The assumptions are

1) Variable costs vary in proportions to the volume-2) Linear behavior of costs

3) Fixed costs are fixed independent of the volume 4) Irrelevance of economies of scale and scope 5) Volumes/prices are the only factors which affects businesses 6) Sales mix is constantPresentation of Cost Data under Marginal Costing and Absorption Costing(refer to the numerical problem)

Explain “Break even analysis” and

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“cost volume –profit analysis”. CVP analysis is a systematic method of examining the relationships between selling prices, total sales revenue, volume of production, expenses and profit. It simplifies the application of practical aspects of business.

Explain the three ways in which P/V ratio can be improved

The three ways in which BEP can be improved are

1) Reduction in the variable cost-by applying techniques, of cost reduction and cost control, exploiting Economies of scale, better production techniques, Quality control.

2) Increase in the sale price; By providing better product features, additional product features, Improved Quality and reliability, better service features etc.

3) Combination of both-cost reduction and increase in sale price by Value analysis and Value engineering.

Important formulae in BEP

Per unit *PV Ratio %

*PV Ratio-fraction

SALES S 10 100 1

VARIABLE COST V 6 60 0.6

CONTRIBUTION S-V 4 40 0.4

FIXED COST FC

Note PV Ratio is also called as contribution to sales[C/S ] ratio or contribution margin ratio

If PV Ratio or C/S ratio is 0.4 means the variable cost/sales ratio is 0.6 because C/S+V/S=100% OR 1

Three methods of calculating PV ratio

METHOD 1 METHOD 2 METHOD 3

PV Ratio = C/S or

FC- LOSS / SALES

S-VC /S FC+PROFIT/SALES

Change In Profit/Change In Sales

Change in contribution/change in sales

BEP Units= FC/Cont/unit BEP Rs =FC/PV Ratio

level of Sales required to achieve a target profit(units) = (FC+TP)/Cont/unit

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level of Sales required to achieve a target profit(Rupees) = (FC+TP)/PV Ratio

SALES=Total Cost +Profit :: Total Cost=FC+TVC or :: FC+VC/Unit x QTY

SALES =FC+TVC+ Profit :: SALES=FC+VC/ UNIT x QTY+ Profit

At BEP sales =PROFIT IS ‘0’ SALES =TOTAL COST

Margin of safety is the excess of actual or budgeted sales over the break even sales. It represents the amount by which sales revenue can fall before a loss is incurred. Margin of safety represents sales beyond the break even point.

MARGIN OF SAFETY =Actual Sales-Bep Sales (It can be in Units / Rupees)

MARGIN OF SAFETY (% OR FRACTION) = { [ACTUAL SALES-BEP SALES]/ACTUAL SALES } X100

The size of margin of safety represents the strength of the business. Better MOS represents profitability and robustness in growth.

For calculating point of indifference Total cost of ABC =Total cost of XYZ (refer to numerical problem

When such data is given

2006-S1 2007-S2 First step PV ratio =change in profits/Change in sales

V C ratio=60%

The second step is S1=0.60 S1+FC+P1 (profit and sales of 2006)

S2=0.60 S1+FC+P2 (Profit and sales of 2007)

Solve any one of the equations to get Fixed cost

Third step is to find BEP using FC/PV ratio

Sales-S1/S2 30,000 40,000

Profit P1/P2 2,000 6,000

Variable cost

60% of sales

Fixed cost =

S-V-Profit

18,000

10,000

24000

10,000

5. MODULE 5

What is full cost pricing?

Pricing policies

Objectives of the Price Policy :The following objectives are to be considered while fixing the prices of the product.

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1. Profit maximization in the short term The primary objective of the firm is to maximize its profits. In the short run, a firm not only should be able to recover its total costs, but also should get excess revenue over costs. It may follow policies such as Skimming price policy, Penetration pricing policy, competitive pricing policy etc.

2. Profit optimization in the long run: Optimum profit refers to the most ideal or desirable level of profit.Hence, earning the most reasonable or optimum profit has become a part and parcel of a sound pricing policy of a firm in recent years.

3. Price Stabilization: Price stabilization over a period of time is another objective. Price stability is one of the pre requisite conditions for steady and persistent growth of a firm. A stable price policy only can win the confidence of customers and may add to the goodwill of the concern. It builds up the reputation and image of the firm.

4. Facing competitive situation: One of the objectives of the pricing policy is to face the competitive situations in the market or to prevent competition to dominate.

5. Maintenance of market share:The economic strength and success of a firm is measured in terms of its market share; the pricing policy is formulated to maintain its market share at any cost.

6. Capturing the Market: capture the market, dominate the market, command and control the market in the long run.

7. Entry into new markets: Apart from growth, market share expansion, diversification in its activities, a firm makes a special attempt to enter into new markets. The price set by a firm has to be so attractive that the buyers in other markets have to switch on to the products of the firm.

8. Deeper penetration of the market: The pricing policy has to be designed in such a manner that a firm can make inroads into the market with minimum difficulties. Deeper penetration is the first step in the direction of capturing and dominating the market in the latter stages.

9. Achieving a target return: prices of the products are so calculated as to earn the target return on investment.

10. Target profit on the entire product line irrespective of profit level of individual products.

The price set by a firm should increase the sale of all the products rather than yield a profit on one product only. A rational pricing policy should always keep in view the entire product line and maximum total sales revenue from the sale of all products.

11. Long run welfare of the firm: A firm has multiple objectives. Objective of the pricing policy has to be designed in such a way as to fulfill the long run interests of the firm keeping internal conditions and external environment in mind.

12. Ability to pay: Pricing decisions are sometimes taken on the basis of the ability to pay by the customers, i.e., higher price can be charged to those who can afford to pay. Such a policy is generally followed by those people who supply different types of services to their customers.

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13. Ethical Pricing: Basically, pricing policy should be based on certain ethical principles. The pricing policy has to secure reasonable amount of profits to a firm to preserve the interests of the community and promote its welfare.

Types/Methods of pricing

Marginal cost pricing: Marginal cost-plus pricing is a method of pricing a unit of a product at its marginal cost plus some profit. Marginal cost is the total cost of producing an extra unit of a product at a certain level of production. The objective is to achieve a desired “Contribution” towards fixed costs and overheads. The resulting profit in a business is therefore: Total contribution-Total fixed costs. Full cost pricing: (“full cost plus) Full cost pricing is a practice where the price of a product is calculated by a firm on the basis of its direct costs per unit of output plus a markup to cover overhead costs and profits. The overhead costs are generally calculated assuming less than full capacity operation of a plant in order to allow for fluctuating levels of production and costs. The profit margin is computed as a fixed percentage of the average total cost of the product.

ROI PRICING: The “return on investment” pricing method determines the price of a product based on the target return on the amount invested in a product.

Unit price ={Total cost(fixed +variable)+(% return x investment)}/Budgeted sales volume.

This method ensures that the target return is earned, however this is subject to limitations imposed by competition and regulations.

Contribution Approach To Pricing : Contribution approach pricing maximizes the profit derived from an individual product, based on the difference between the product's price and variable costs (the product's contribution margin per unit).This method is adopted in situations where a company often receives a non-routine, special order for its products at lower prices than usual. In normal times, the company may refuse such an order since it will not yield a satisfactory profit. If times are bad or there is idle capacity, an order should be accepted if the incremental revenue exceeds the incremental costs involved. Such a price, is called a contribution price and is lower than the regular price.

Full cost pricing and marginal cost pricing

ADVANTAGES OF FULL COST PRICING 1.  Guaranteed Contribution: When full costs plus basis is used for pricing, the firm earns a guaranteed contribution equivalent to fixed costs plus profit margin. Even, if profit margin is taken as nil, fixed costs included in prices will guarantee minimum contribution.

2.         Assured Profit: Cost plus is a fair method of price fixation. The business executives are convinced that the price fixed will cover the cost.

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3.         Reduced risks and uncertainties: If price is greater than cost, the risk is covered. This is true when normal expected capacity basis of cost estimation is used. The decision-maker may accept a pricing formula that seems reasonable for reducing uncertainty.

4.         Most suitable in Long run: Cost plus pricing is ideal in the long run since there is no permanent opportunity cost. The effect of seasonal fluctuation is ironed out and prices are established based on normal long run costs.

5.         Considers market factors: Cost plus pricing does not mean that market forces are ignored. The mark up added to the cost to make a price reflects the well-established customs of trade, which guide the price fixer towards a competitive price.

6. Full Recovery of all costs of the products: For long-run pricing decisions, full cost of the product inform managers of the minimum costs to be recovered so as to continue in business rather than shut down.

7.         Price stability: Price fixation based on full costs of the product promotes price stability, because it limits the ability of sales persons to cut prices. Price stability facilities planning.

8.         Simplicity: A full-cost formula for pricing does not require a detailed analysis of cost- behavior patterns to separate costs into fixed-variable components for each product. It is simple to operate. Application of full cost plus pricingFull cost plus pricing is particularly useful for businesses that carry out a large amount of contract work or jobbing work for which individual job or contract prices must be quoted regularly to prospective customers. However the percentage profit mark up does not have to be rigid and fixed, but can be varied to suit the circumstances. In particular the percentage mark up can be varied to suit demand conditions in the market.

ADVANTAGES OF MARGINAL COST PLUS APPROACH TO PRICING:The advantages of a marginal cost-plus approach to pricing are as follows. 

It is a simple and easy method to use. 

The mark-up percentage can be varied, and so mark- up pricing can be adjusted to reflect demand conditions. 

It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. In this way, it helps to create better awareness of the concepts and implications of marginal costing and cost -volume-profit analysis. For example, if a product costs Rs 10 per unit and a mark -up of 150 % is added to reach a price of Rs.25 per unit, management should be clearly aware that every additional Rs.100 of sales revenue would add Rs60 to contribution and profit. 

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In practice, mark-up pricing is used in businesses where there is a readily identifiable basic variable cost. Retail industries are the most obvious example, and it is quite common for the prices of goods in shops to be fixed by adding a mark- up (20% or 33.3%,say ) to the purchase cost. 

Drawbacks to marginal cost- plus pricing

Although the size of the mark-up can be varied in accordance with demand conditions, it does not ensure that sufficient attention is paid to demand conditions, competitors' prices and profit maximization. 

It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to ensure that a profit is made after covering fixed costs. 

APPLICATION OF MARGINAL COST PRICING

Approach to pricing might be taken when a business is working at full capacity, and is restricted by a shortage of resources from expanding its output further. By deciding what target profit it would like to earn, it could establish a mark-up per unit of limiting factor. In the short term, when the production is covering whole of the expenses (Fixed and variable), then to enhance the profit, some orders may be accepted at below the regular price, which must be more than the marginal cost of producing those extra units. This is the situation where marginal cost-plus pricing helps. For example: When a factory is covering all of its variable and Fixed costs, and a lucrative export opportunity comes, then that extra production can be sold at a price which may be less than regular price but more than the marginal cost of production. Whereas a full cost- plus approach to pricing draws attention to net profit and the net profit margin, a variable cost-plus approach to pricing draws attention to gross profit and the gross profit margin, or contribution.

What is transfer pricing

Transfer pricing: Transfer pricing is the value placed on goods and services exchanged between affiliates or divisions within a company.Transfer pricing is a system of pricing adopted by a company for providing goods and services by one segment of the company to other segments of the same company.

A “transfer price” is the price at which one company buys and sells goods or services or shares resources with a related affiliate in its supply chain. Transfer pricing policy system of a company forms the basis for evaluation of departmental performance and its managers.

For example, most companies in the oil industry have a petroleum refining and retail sales divisions that are usually evaluated on the basis of return on investment (ROI) or residual income method. The

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petroleum refining division processes crude oil into gasoline, kerosene, and other end products. The retail sales division takes gasoline and other products from the refining division and sells them through the company's chain of service stations. Each product has a price for transfers within the company.

Discuss the objectives of a transfer pricing mechanism and its relevance to management control process

Purposes of Transfer PricingThe basic purpose of transfer pricing is to induce optimal decision making in a decentralized organization (i.e., in most cases, to maximize the profit of the organization as a whole). The other objectives are to

Evaluate the performance of each division separately by generating separate profit figures for each division.

Help coordinate production, sales and pricing decisions of the different divisions.

To allow the company to generate profit (or cost) figures for each division separately.

To optimize the allocation of an organization’s resources.

Help the divisions to achieve goal congruence

Explain the various types/methods of transfer pricing/List out the different types of transfer prices .State any three broad bases available for determining transfer prices with different options available within each base.Explain the mechanics,merits and drawbacks of ‘Market based’ transfer pricing with suitable illustration. What is market based Transfer pricing and what are the difficulties in using this approach

Transfer pricing serves the following purposes.

1. When product is transferred between profit centers or investment centers within a decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect divisional performance evaluation.

2. When divisional managers have the authority to decide whether to buy or sell internally or on the external market, the transfer price can determine whether managers’ incentives align with the incentives of the overall company and its owners. The objective is to achieve goal congruence, in which divisional managers will want to transfer product when doing so maximizes the consolidated corporate profits.

3. When multinational firms transfer product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues.

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Methods of transfer pricing: The most common transfer pricing methods are

Market-based Transfer Pricing. When the outside market for the good is well-defined, competitive, and stable, firms often use the market price as an upper bound for the transfer price.

By using market-based transfer prices in a perfectly competitive market, a company can achieve the following:

Goal congruence Management effort Good subunit performance evaluation Subunit autonomy

A market-based transfer price aligns their incentives with owners’ incentives of maximizing overall corporate profits. Sometimes, there are cost savings on internal transfers compared with external sales for which appropriate adjustments are made to the transfer price.Limitations of market based transfer prices

However, many intermediate products do not have readily-available market prices. Examples are: a pharmaceutical company with a drug under patent protection (an effective monopoly); and an appliance company that makes component parts in the Parts Division and transfers those parts to its assembly divisions for which there is no market price and market-based transfer price cannot be used in such cases. Another disadvantage of a market-based transfer price is that the prices for some commodities can fluctuate widely and quickly, markets could be different, varying levels of quality and services and product features, which affect the system.

Negotiated Transfer Pricing: Divisional managers are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer pricing is typically combined with free external sourcing.

Cost-based Transfer Pricing:

Cost-based transfer prices are helpful when market prices are unavailable, inappropriate, or too costly to obtain.

Many companies use transfer prices based on full costs. To approximate market prices, cost-based transfer prices are sometimes set at full cost plus a

margin. In the absence of an established market price many companies base the transfer price on the

production cost of the supplying division. The most common methods are:

• Full Cost• Cost-plus• Variable Cost plus Lump Sum charge• Variable Cost plus Opportunity cost• Dual Transfer Prices

Each of these methods is outlined below.

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Full Cost: In this method the full cost (Standard cost) of the product is charged. This method is popular because of its clarity and convenience and because it is often viewed as a satisfactory approximation of outside market prices.

Cost-plus: When transfers are made at full cost, the buying division takes all the gains from trade while the supplying division receives none. To overcome this problem the supplying division is frequently allowed to add a mark-up in order to make a “reasonable” profit.

Variable Cost plus a Lump Sum Charge: In order to motivate the buying division to make appropriate purchasing decisions, the transfer price could be set equal to (standard) variable cost plus a lump-sum periodical charge covering the supplying division’s related fixed costs.

Variable Cost plus Opportunity Cost: Also know as the Minimum Transfer Price: Minimum Transfer Price = Incremental Cost + Opportunity Cost.

Dual Transfer Prices: To avoid some of the problems associated with the above schemes, somecompanies adopt a dual transfer pricing system. For example:

Charge the buyer for the variable cost. The objective is to motivate the manager of the buying division to make optimal (short-term) decisions.

Credit the seller at a price that allows for a normal profit margin. This facilitates a “fair” evaluation of the selling division’s performance.

Q-What are the problems associated with transfer pricing in a multinational enterprise as well as transfer pricing between different units of MNC’S situated in different countries.

A large proportion of world trade is accounted for by cross-border trade taking place within multinational enterprises, where branches or subsidiaries of the same multinational enterprise exchange goods or services. These transactions within the group are not exposed to the same market forces as transactions between independent enterprises. They are referred to as “controlled transactions”. If the prices of these transactions are artificially lowered or increased they may lead to taxable profits being shifted from one country to another. Tax avoidance also happens.

Take a beverage company located, say, in Mexico, which has a subsidiary in France. Let’s assume that the French subsidiary pays royalties to the Mexican headquarters for the rights to sell its drinks. Taxes are owed in France based on the French subsidiary’s results. The higher the royalties paid by the French subsidiary, the lower the taxable profits in France. The French tax authorities will be satisfied if they see that the royalties paid by the French company to its headquarters in Mexico are not higher than those that would be paid to an independent enterprise for a similar transaction. But if the royalties are too high, there is a possibility that profits are being shifted out of France to reduce tax liabilities there. The “arm’s length principle” is used to address such issues.

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The arm’s length principle has become the international norm for allocating the tax bases of multinational enterprises among the countries where they operate. The OECD lists as many as five methods for approximating arm’s length outcomes to determine an arm’s length price for cross-border transactions within MNEs.

Q Outline the opportunity cost approach to transfer pricing

According to Horngren “opportunity cost based transfer pricing is the minimum transfer price should be (1) the additional outlay costs per unit incurred to the point of transfer(approximated by variable costs),plus (2) the opportunity costs per unit to the firm as a whole”

Put differently the transfer price (TP) should be equal the standard variable cost (SVC) plus the contribution margin per unit given up on the outside sale by the company, when a segment sell internally. The contribution margin given up is referred to as the lost contribution margin

TP=SVC+LCM

MODULE 6: BUDGETING

Q-Budgeting and budgetary control: Budgeting as a tool of management control? What are the essential features of an efficient system of budgetary control; what are the different types of functional budgets? Which are prepared by a large scale manufacturing concern? Explain and illustrate. What is a budget manual and what are its contents

INTRODUCTION:

One of the essential features of modern business management is planning and control. Budgetary control is the most common, useful and widely used standard device of planning and control. It is very helpful for the business organization to conduct a business in the competitive market.

BUDGETING &BUDGETARY CONTROL:

Budget: A budget is a detailed plan of operations for some specific future period.

Budgeting: Means the processes and activities adopted in the preparation of budgets, monitoring and evaluation of the same.

Objectives and functions of budgeting;

An effective budgeting system is vital to the success of a business firm. Budgeting is need in organization to perform the following systems

i) planning ii) coordination iii) communication iv) monitoring and control v) performance evaluation

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Budgetary control& management control: This refers to a system of management and accounting control by which all operations and outputs are forecast as far as ahead  as possible and the actual results, when known are compared with the budget estimates. Thus the term budgetary control is designed to evaluate the performance in terms of goals budgeted. Management control system and Budgeting are two interlinked factors in strategy implementation of an organization. Budgeting forms the basis of Management control. Budgeting facilitates proper definition of objectives and corresponding allocation of resources. Management control facilitates the monitoring and implementation of the same.

TYPES OF FUNCTIONAL BUDGETS:

(1) Sales Budget: The sales forecast or sales budget is the basic core budget on which other budgets depend. This is analyzed between products, periods and areas.

Preparation Of Sales Budget: Sales budget is prepared by the sales manager. Following  matters are considered at the time of its preparation:

(i) Analysis of Historical Sales(ii) Reports By Salesman

(iii) Business Conditions 

(iv) Market Analysis

(v) Special Condition

(2) Production Budget:Production budget is prepared after the preparation of sales budget, to determine quantity of goods which should be produced to meet the budget of sales .It is expressed in physical terms, such as Unit of output, Labor requirement,Material requirement. etc

(3) Direct Labour Budget: The direct labour budget tells about the estimates of direct labour requirements essential for carrying out the budgeted output.

(3) Raw Material Budget: Materials budget is based on the inventory policy and production requirements

(4) Manufacturing Overhead Budget: Manufacturing overhead is classified into three categories,(1)Fixed (2)Variable (3)Semi-variable

(6) Selling and Distribution Overhead Budget: The selling expenses include all items of expenditure on the promotion, maintenance and distribution of finished goods.

(7) Cash Budget: The cash budget is a summary of the firm’s expected cash inflows and outflows over a particular period of time .

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(8) The Master budget: The ICMA,England, defines it as the Summary Budget ,incorporating its component functional  budgets, which is finally approved, adopted and employed.

(9) Fixed Budgets: It is a budget in which targets are rigidly fixed. According to I.C.M.A.  London. Fixed budget is a budget which remains unchanged irrespective of the level of activity actually attained. Such budgets are usually prepared from one to three months in advance of the fiscal year to which they are applicable.

(10) Flexible Budget: A flexible budget is , designed to provide information as to sales, expenses and profits for different levels of activity which may be obtained.

(11) Performance Budget: Among the methods which relate costs to outputs, performance budgeting stands out the most prominent. It has emerged as a whole new way of considering fiscal responsibility.

(12) Zero-Base Budgeting (ZBB): The objective of ZBB is to formulate the budget by estimating the amounts of expenditure likely to be incurred from the base level, a fresh. This method is called Zero Base budgeting since the existing system is discontinued and a fresh budget is prepared or the existing system is reviewed on the assumption of Zero-Base.

ADVANTAGES OF BUDGETARY CONTROL: (Mention the advantages of budgeting)

Budgetary control has become an essential tool of management for controlling costs and maximizing profits. Its advantages to management are as follows:

(1) Economy in working: It brings efficiency and economy in the working of the business enterprises . All activities are guided by the goals set in the budgets.

(2) Buck- passing is avoided: It establishes divisional and departmental responsibility. It thus prevents alibis and buck-passing when the budget figures are not met.

(3) Establishes coordination: It helps in coordination of the various divisions of a business; the production, marketing, financial and administration divisions.

(4) Acts as a safety signal: It acts as a safety signal for the   management. It shows when to proceed cautiously and when manufacturing expansion can be safetly undertaken

(5) Adoption of uniform policy: Uniform policy can be pursued by all division of business.

(6) Decrease in production costs : Seasonal variation in production can be reduced by developing new “fill in products”.

(7) Adoption of standard costing principles: The use of budget figures as measures of operating performance and financial position makes possible the adoption of   the standard costing principle  in divisions other than the production division.

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(8) Optimum mix: It helps management in obtaining the most profitable combination of different factors of production.

(9) Favour with credit agencies: management who have developed a well ordered budget plan and who operate it accordingly, receive greater favour from credit  agencies

LIMITATIONS OF BUDGETARY CONTROL:

Based on estimates: The strength or weakness of the   budgetary programme depends to a degree on the accuracy with which the basic estimates are made. The estimate must be based on all available facts and good judgments.

Need for continuous adaptation:  A budgetary programmed can not be installed and perfected in a short time. Budget techniques must be continuously adapted not only for each particular concern but for changing conditions within the concern.

No automatic execution of the budget: Once the budget is complete, it will be effective only if all responsible executives get behind it and exert continuous and aggressive efforts towards its achievement.

Only a tool of the management: The budget should be regarded not as a master but as a servant .It is one of the best tools yet devised for advancing the affairs of accompany and the individuals in their various areas of management activity

Module 7: Standard costing and variance analysis:

State the significance of computing materials cost variance and materials usage variance.

According to CIMA, London, Standard costing is defined as “A predetermined calculation of how much costs should be under specific working conditions. It is built up from an assessment of the value of cost elements and correlates technical specifications and quantification of materials, labour and other costs to the prices and /or wages rates expected to apply during the period in the which the standard cost is intended to be used. Its main purposes are to provide bases for control through variance accounting, for the valuation of stock. Standard costs are the predetermined costs of manufacturing products during a specific period under current or anticipated operating conditions, Work in Progress and in some cases for fixing selling prices”

What are the advantages of standard costing?It provides a yardstick against which actual are measured

It helps in introducing incentives to employees and provides a basis for motivating

It helps in adopting management by exception techniques

Investigation of variances helps in identifying the real causes of inefficiency and persons responsible for the same

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It helps in valuing the closing stock

Need for setting standard: Standards are needed when management aims in achieving economic efficiency. It is extensively utilized in the following activities of an organization.

(a) Establishing budgets.(b) Controlling costs , measuring efficiencies and motivating personnel.(c) Promoting cost reduction.(d) Simplifying cost procedures and expediting cost reports.(e) Assigning costs to inventories.(f) Setting sales prices. (g) In planning and controlling operations (h) Better decision making by adopting “Management by exception”

Development of standards:

The success of standard costing depends upon the establishment of correct standards.The following preliminaries should be gone through before standards are planned to be evolved

2) Establishment of cost centers3) Types of standards4) Setting the standards

Developing or setting the standards or establishing the standard costs.

1) A standard committee should be formed comprising of the operating personnel, cost accountant and other related personnel.

2) Standards should be preferably for each element of the costs.

Direct material cost: Standard material cost for each product should be predetermined .This will include

i) Determination of the standard quantity of materials needed for the productionii) Determination of the standard price per unit of material

Direct labour cost: Determination of standard direct labour cost will include the determination of

i) Standard timeii) Standard rate

Overhead costs: Explain the classification of overhead variance.

Overheads: Overheads are segregated into fixed and variable and standard overhead rate should be determined for fixed as well as variable overhead. These rates should also be determined according to the function-wise classification of overheads-manufacturing, administrative and selling and

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distribution, so that exact place of overhead variance may be located and corrective action may be taken. Standard overhead rate is determined keeping in view past experience, present conditions and future trends. Fixation of standard overhead rate may involve determination of standard overhead costs, estimation of standard level of production reduced to a common base such units of production, direct labour hours ,machine hours, etc.

Standard Variable overhead rate = Standard VOH for the budget period /Budgeted production in units/hours for the budgeted period.

Standard Fixed overhead rate = Standard FOH for the budget period /Budgeted production in units/hours for the budgeted period.

Limitations of standard costing

Difficult to establish

Not suitable and expensive for small concerns

Inaccurate standards can cause frustration

Module 8: Cost control and cost reduction

Q-Explain the functions of cost Auditor. What is cost Audit? Explain the scope of Cost Audit.

What is the difference between cost control and cost reduction?

Cost Control: In business practices, cost control is a plan of action wherein the expenses are not allowed to grow past a reasonable level than what are budgeted. According to CIMA ,London, Cost control is defined as “The regulation by executive action of the cost of operating an undertaking particularly where such action is guided by cost accounting”. Cost control aims at reducing inefficiencies and wastages and setting up predetermined costs and plans to achieving them. Cost control is exercised through setting standards or norms or targets and comparing actual performance. This is with a view to ascertain deviations from set targets or norms or standards and taking corrective action to ensure that the future performance confirms to the set standards. Controlling costs is the best way to maintain or control the increase in cash flows.

Cost Reduction: Cost reduction is a planned positive approach to reduce expenditure. According to CIMA London “Cost reduction is to be understood as the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for the use intended or diminution on the quality of the product”. It is a corrective function, by analyzing costs and by making continuous improvement of business processes, functions, activities etc.

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Cost reduction is achieved by two ways:By reducing the consumption:By increasing productivity

Fields covered by cost reduction (scope of cost reduction/areas of cost reduction)

1.Product design: Design constitutes one of the most important field where cost reduction is attempted. Efficient designing for a new product and improving the design for an existing product can the reduce the costs of material, Labour , and other manufacturing expenses.VA/VE techniques can be applied effectively

2.Factory layout and Equipment: Scientifically planned layout and Better utilization of the machines and equipment will ensure cost reduction by improving the effectiveness and efficiency.

3.Marketing: Activities of marketing such as market research, packing, warehousing, distribution, after-sales service can be brought under the cost reduction programme and thereby cost reduction can be achieved.

4. Personnel Management: By focusing on better manpower planning, Training in quality and productivity, Job evaluation, Merit rating and better HRM, the employee cost and efficiency can be improved leading to cost reduction.

5. Manufacturing :By elimination of waste/ efficiency in operations / better maintenance of machines and equipment .Production planning and control / Automation/Operations research /

6. Materials management :Better materials management (standardization/procurement/efficient supply chain /usage / JIT/Kanban).Application of Value analysis to MM can lead to eliminate of an item or alternative materials

7.Quality management; Adoption of TQM

8. Technology :Adoption of better technology leads to cost reduction

9.Marketing management: better product mix through Market research

10.Management control and Financial management: Better financial management Budgetary control and Management control systems leads to cost reduction and control..

Tools and techniques for cost reduction: Following tools are used in cost reduction

/ /Planning and control of finance /Cost benefit analysis/Contribution analysis /PERT/

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Advantages of Cost Reduction:Advantages of Cost Reduction to a firm :

Improves profits.

Improves financial position.

Improves competitive capabilities.

Serves as an index of economic efficiency.(productive and allocative)

Facilitates better allocation of resources

Advantages of Cost Reduction to the Industry: One company serves as a trend setter for the other companies,developing healthy competition.

Cost Audit: Cost Audit has been defined by CIMA,London as the “verification of cost accounts and a check on the adherence to the cost accounting plan”. Cost audit is basically an internal audit used for enterprise governance to assess operational efficiencies and resource management.

Special attention is given to verification of cost records and adherence to acceptable cost accounting procedures and policies of the firm as a whole. -

Define the scope of cost audit: scope of cost audit, as defined by ICWAI, covers the evaluation of the efficiency of operations and the propriety of management actions. In this sense, cost audit is synonymous with efficiency audit mainly as a guide for management policy and decision making besides being a barometer of actual-performance performance.

A.materials

Types of cost audit:

Cost audit to assist the Management: The objective is to make available accurate, relevant and prompt information to the management and to facilitate the management in taking important decisions.

Cost audit under Statute. The Central Government may, under section 233-B of the companies Act 1956 order that certain classes of companies which are required to maintain proper records regarding materials consumed, labour and other expenses under section 209, are required to get their cost accounts audited. The aim of such type of audit is that the Government wants to ascertain the relationship of costs and prices

Cost audit on behalf of the customer: Cost plus contracts are generally awarded subject to provisions of cost audit.

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Cost audit on behalf of Trade association: Sometimes a Trade association may appoint a cost adutor to conduct cost audit

o To ascertain comparative profitability of its member.o To determine minimum price to avoid cut throat competition among its members.o To maintain prices at a certain level so as to prevent undue profiteering.

Cost audit on behalf of Tribunals: Tribunals request for cost audit for taking important decision

Advantages of Cost audit: Effective cost audits provide a complete breakdown of expenses that give a company financial clarity about accounts.The other advantages are

Establishes the accuracy of cost accounts

Helps management in taking important decisions

Reducing the cost of production

Brings more reliability in costing data

Management by exception is possible

Analysis of variances is facilitated

Assist the financial auditing

Enables the government to plan and estimate subsidies and protection to industries

Helps management in inter-unit comparison.

Limitations of cost audit

Expensive: One primary disadvantage associated with cost audits is the excessive fees. Lengthy process: Cost audits are also lengthy processes that require employee devotion.

Lost Time: Although thorough, an auditor's report is usually given three to five weeks after the balance sheet is released., time lost between the balance sheet release and auditor's report may cost the company money

Uncertainty: Due to estimation uncertainty is associated with it

Distinguish between cost audit and financial audit: Difference between Cost Audit and Financial Audit

The basic nature of audit is checking and it holds good for both the cost audit as well as the financial audit. However following are the points of difference between these two audits:

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1. Compulsory nature “ Financial audit is compulsory for all the companies registered under companies act, 1956.Cost audit is not compulsory for all the companies. Only in the case of manufacturing or mining companies have to maintain cost accounts under section 209 and get those accounts audited under section 233b.2. Purpose “ The purpose of the financial audit is to report on the profit and loss account and balance sheet as to whether they show true and fair view of the business or not.The purpose of the cost audit is to certify that whether the expenditure incurred on the production of items has been incurred prudently or not.4. Instance “ Financial audit is conducted at the instance of the shareholders. Cost audit is done at the requirement of third parties like government, industrial organizations etc.5. Appointment “ Financial audit is appointed normally by the shareholders in the general meeting whereas the board of directors with the previous approval of the central government appoints a cost auditor.6. Recurrence: Financial audit is conducted every year whereas a cost audit may be done in the year in which it is required by the government or any other agency.(Except Mfg and Mining cos)7. Stock “ In financial audit auditor has to check the exact value of closing stock for the purpose of balance sheet, whereas in the cost audit the auditor has to check the adequacy of the stock keeping in view of the needs of the concern.8. Report “ In the financial audit the report is submitted to the management to be laid in the general meeting of the shareholders, the report of the cost auditor is submitted to the company and also to the central government within 180 days from the end of the company’s financial year to which the cost audit 3. Expression of opinion “ The financial auditor has to comment upon the accuracy of the transactions recorded and the cost auditor has to comment upon the correctness and wiseness of the decisions taken in production of items

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