manufacturing cost analysis unit 3
TRANSCRIPT
DEPARTMENT: MECHANICAL ENGINEERING
SEMESTER: 6TH SEM
Industrial Engineering
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UNIT -3
Manufacturing Cost Analysis
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COSTING & COST ACCOUNTING Two terms should not be confused. Costing
indicates the process of ascertaining the costs which can be done arithmetically also. Cost accounting indicates the process of recording the costs in formal & systematic manner with the intention of preparing statistical data there from to ascertain the cost.
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COST : MEANING AND ITS ELEMENTS The term ‘cost’ means the amount of resources
sacrificed to achieve a specific objective which may be the acquisition of goods or services. Costs are always expressed in money terms.
In reference to production/manufacturing of goods and services cost refers to sum total of the value of resources used like raw material and labor and expenses incurred in producing or manufacturing of given quantity.
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CLASSIFICATION OF COSTS
Classification of costs are based on the following: Natural characteristics ( material, labor ,
overheads) Changes in activity or volume (fixed, variable,
mixed) Degree of traceability to the product (direct cost,
indirect cost) Costs are analytical & decision making (sunk
cost, opportunity cost, controllable cost, non controllable cost)
Other classifications ( product cost, period cost)5
ELEMENTS OF COST
Cost of production/manufacturing consists of various expenses incurred on production/manufacturing of goods or services. These are the elements of cost which can be divided into three groups : Material, Labor and Expenses.
Elements of cost Material Labour Expenses
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MATERIAL The substance from which the product is made is known as
material. It may be in a raw or manufactured state. Material is classified into two categories:
Direct Material: Direct Material is that material which can be easily identified and related with specific product, job, and process. Timber is a raw material for making furniture, cloth for making garments, and Gold/ silver for making jewellery, etc
The following groups of material come under direct materials: All materials purchased for particular job, process or product All materials acquired from stores for production Components or parts purchased Materials passing from one process to another
Indirect Material: Indirect Material is that material which cannot be easily and conveniently identified and related with a particular product, job, process, and activity. Consumable stores, oil and waste, printing and stationery etc. Indirect materials are used in the factory, the office, or the selling and distribution department.
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LABOR Labor is the main factor of production. For conversion of
raw material into finished goods, human resource is needed, and such human resource is termed as labor.
Direct Labor: Labour which takes active and direct part in the production of a commodity. Direct labor is that labor which can be easily identified and related with specific product, job, process, and activity. Direct labor varies directly with the volume of output. For example, Labor for machine operators, assembly operations.
Indirect labor: Indirect labor is that labor which can not be easily identified and related with specific product, job, process, and activity. It includes all labor not directly engaged in converting raw material into finished product. It may or may not vary directly with the volume of output. Wages of store-keepers, time-keepers, salary of works manager, salary of salesmen, etc, are all examples of indirect labor cost.
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EXPENSES All cost incurred in the production of finished goods other than
material cost and labor cost are termed as expenses. Direct expenses: These are expenses which are directly, easily,
and wholly allocated to specific cost center or cost units. All direct cost other than direct material and direct labor are termed as direct expenses. Some examples of the direct expenses are hire of special machinery, cost of special designs, moulds or patterns, feed paid to architects, surveyors and other consultants, inward carriage and freight charges on special material, Cost of patents and royalties.
Indirect expenses: These expenses cannot be directly, easily, and wholly allocated to specific cost center or cost units. All indirect costs other than indirect material and indirect labor are termed as indirect expenses.
Indirect Expenses = Indirect cost – Indirect material – Indirect labor
Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair, insurance and depreciation on fixed assets, etc, are some examples of indirect expenses.
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OVERHEADS : MEANING The term overhead has a wider meaning than the
term indirect expenses. Overheads include the cost of indirect material, indirect labor and indirect expenses. This is the aggregate sum of indirect material, indirect labor and indirect expenses.Overhead = Indirect material + Indirect labor + Indirect expenses
Overheads are classified into following three categories: Factory/works/ production overheads Office and administrative overheads Selling and distribution overheads
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FACTORY/WORKS OVERHEADS All indirect costs incurred in the factory for production of
goods is termed as factory/works overheads. Such costs are concerned with the running of the factory or plant. These include indirect material, indirect labor and indirect expenses incurred in the factory. Some examples are as follows:
Indirect materials:(i) Grease, oil, lubricants, cotton waste etc.(ii) Small tools, brushes for sweeping, sundry supplies etc.(iii) Cost of threads, gum, nails, etc.(iv) Consumable stores(v) Factory printing and stationery
Indirect wages(i) Salary of factory manager, foremen, supervisors, clerks etc.(ii) Salary of storekeeper(iii) Salary and fee of factory directors and technical directors(iv) Contribution to ESI, PF., Leave pay etc. of factory employee.
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Indirect expenses(i) Rent of factory buildings and land(ii) Insurance of factory building, plant, and machinery(iii) Municipal taxes of factory building(iv) Depreciation of factory building, plant and machinery, and their repairs and maintenance charges(v) Power and fuel used in factory(vi) Factory telephone expenses.
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OFFICE AND ADMINISTRATIVE OVERHEADS
These expenses are related to the management and administration of the business. They are incurred for the direction and control of an undertaking. The examples of this cost are, salary of office manager, clerks, and other employees, salary of administrative directors, salaries of legal adviser, rent, insurance, rates and taxes of office building, office lighting, heating and cleaning, depreciation and repair of office building, furniture, and equipment etc.
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SELLING AND DISTRIBUTION OVERHEADS
Selling and distribution overheads are incurred for the marketing of a commodity, for securing order for the articles, dispatching goods sold or for making efforts to find and retain customers. These costs include advertising, salesman salaries and packaging, storage, transportation & sales administrative costs.
These overheads have two aspects (i) procuring orders (ii) executing the order. Based upon this concept the selling and distributions are studied separately.
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COSTS CONCEPT
Direct Material + Direct Labor+ Direct Expenses = Prime cost
Indirect Material + Indirect Labor+ Indirect Expenses = Factory overheads
Prime cost + Factory overheads = Factory cost
Factory cost + Distribution & administrative Overheads = Total Cost
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16DIRECT MATERIAL
DIRECT LABOR
DIRECT EXPENSES
FACTORY OVERHEADS
ADMINISTRATIVE OVERHEADS
SELLING & DISTRIBUTION OVERHEADS
PR
IME
CO
ST
PROFIT
FA
CT
OR
Y C
OS
T
TO
TA
L C
OS
T
CO
ST
OF
SA
LES
SA
LES
BASED ON VOLUME: FIXED COSTS, VARIABLE COSTS, AND TOTAL COSTS
Fixed costs are those that are spent and cannot be changed in the period of time under consideration in spite of change in volume of production. Examples of fixed costs are rent, taxes, salaries of supervisors, depreciation, insurance etc.
Fixed cost does not mean that they never change. They are constant up to specific volume or range of volume. Variable costs change as output changes. There is a constant ratio between the change in cost and change in level of output. It results from the utilization of raw materials & direct labor in production departments.
The sum of the variable and fixed costs are total costs.TC = FC + VC17
MIXED COSTS
Mixed costs are made up of fixed & variable costs. They are combination of semi- variable & semi-fixed costs.Because of variable component , they fluctuate in volume & because of fixed component they will not change in direct proportion to output.Semi fixed are those costs which remain constant up to certain level of output but after which they become variable.Semi variable cost is one which is basically variable but its slope may change abruptly when a certain output level is reached.
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Opportunity costs: It is the benefits lost by rejecting the best competing alternative than the one chosen. The benefit thus lost is usually the net earnings or profit that might have been earned from the rejected alternative.
Sunk costs: It is an expenditure for equipment or productive resource which has no economic relevance to the present decision making process. Generally it is known as unavoidable cost.
Controllable & Non controllable costs: costs over which a manager has direct & complete decision authority or control. For example, Indirect labor, cutting tool, lubricants.A cost which can not be influenced by the action of the specified member of an organization is referred to as an uncontrollable cost.
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JOB COSTING VS. PROCESS COSTING
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JOB-COSTING SYSTEMIn job costing system, the cost object is a unit or multiple units of a distinct product or service called a job. Each job generally uses different amounts of resources. The product or service is often a single unit, such as specialized machine made by some company, a job repair done at some service center or an advertising campaign for a client by an advertising agency.
PROCESS-COSTING SYSTEMIn a process costing system, the unit cost of a product or service is obtained by assigning total costs to many identical or similar units. In other words unit costs are calculated by dividing total cost incurred by the number of units of output from the production process. In a manufacturing process-costing setting, each unit receives the same or similar amounts of direct material costs, direct manufacturing labor costs, and indirect manufacturing costs (manufacturing overhead).
INTRODUCTION TO JOB-COSTING A job order costing system is used in situations where many different
products are produced each period. For example clothing factory would typically made many different types of jeans for both men and women during a month. In a job order costing system, costs are traced to the jobs and then the costs of the job are divided by the number of units in the job to arrive at an average cost per unit.
Job order costing system is also extensively used in service industries. Hospitals, law firms, movie studios, accounting firms, advertising agencies and repair shops all use a variety of job order costing system to accumulate costs for accounting and billing purposes.
Job order costing operations begin when a company decides to produce a specific product for stock or in response to an order for a custom project. For example, an electric motor manufacturer decides to build five model XL25 motors for stock. If the company decides to accept the order, a job cost sheet is prepared.
A job cost sheet is a form, typically computer generated, used to accumulate the cost of producing the item or items ordered i.e. the cost of the job
The job cost sheet contains detailed information on the three categories of product costs: direct material, direct labor and manufacturing overheads.
JOB COSTING Job costing allows to identify the most and least
profitable areas of business, so that one can focus on the profitable elements, and try to make the less profitable aspects of business more efficient. It helps to quote new jobs more accurately, and assists in managing jobs in progress.
Components of job costing Track the costs involved in the job Make sure all of the costs are invoiced to the customer Produce reports showing details of costs and revenues
by job
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ADVANTAGES OF JOB-COSTINGSYSTEM
It provides detailed analysis of costs which enable the management to determine the operating efficiency of the different factors of production.
It helps in comparing the two set of works and hence it is of great use while deciding on the efficiency of the department’s within an organization.
Since precise order is to be completed by the company, can allocate the resource according to order and hence there is no chances of any spoilage and hence it saves lot of money for the company.
Company can know precisely how much profit it made from the completion of the order immediately after completing it.
It lays down the standard for future similar contracts so that company can follow those standards and complete the next similar jobs effectively and efficiently.
DISADVANTAGES OF JOB-COSTINGSYSTEM Job costing is very expensive as more clerical work is
involved in identifying each element of cost with specific department and/or jobs.
The costs are ascertained, even compiled promptly, are historical as they are compiled after incidence.
The costs compiled under job costing system represent the cost incurred under actual conditions of operation. The system does not have any specific basis to indicate what the cost should be or should have been, unless standard costing is employed.
With the increase in clerical processes, chances of errors are enhanced.
In case of inflation, comparison of cost of a job for one period with that of another becomes meaningless. Distortion of cost occurs even when the batch quantities are different.
BREAK-EVEN ANALYSIS Break even analysis establishes relationship
among the factors affecting profit. It indicates what level of cost and revenue are in equilibrium. It is a simple method of presenting to management the effect of changes in volume on profit.
The detailed analysis of break even data will help the management to understand the effect of alternative decisions that convert costs from variable to fixed, the costs which increase sales volume & revenue. It is powerful tool in evaluating alternative course of action. 25
ASSUMPTIONS IN BEA
Selling price will remain constant at all sales level.
There is a linear relationship between sales volume & costs.
The costs are divided into two categories: Fixed & Variable.
Production & sales quantity are equal. No other factor will influence the cost except
the quantity.
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WHAT IS BREAKEVEN POINT?
A company's breakeven point is the point at which its sales exactly cover its expenses. The company sells enough units of its product to cover its expenses without making a profit or taking a loss.
If it sells more, then it makes a profit. On the other hand, if it sells less, it takes a loss. To compute a breakeven point in sales volume, need to know
the values of three variables. Those three variables are fixed costs, variable costs, and the price of the product.
In order to calculate your company's breakeven point, use the following formula:
Fixed Costs/(Price - Variable Costs) Fixed costs are stated as a total-the total fixed costs for the
firm. Basically, this means the total overhead for the firm. Price and variable costs, however, are stated as per unit costs - the price for each product sold and the variable cost for that unit of the product.
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MARGIN OF SAFETY
It is the difference between the operating sales and break-even-sales. Margin of Safety = Present sales - Break-even-sales
In ratio term, margin of safety (M/S) ratio is: M/S Ratio = Margin of safety/ Present Sales
Higher is this ratio, more sound is the economics of the firm. Therefore, higher margin of safety means that in case of little fall in production, the firm will keep earning profit.
Angle of Incidence: This is the angle at which the sales line cuts the total cost line. The management aims for large angle of incidence which indicates a high profit rate.
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BREAKEVEN POINT
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Rs. 300 500 1000
Units
Rup
ees
Breakeven sales point
Sales revenue line
Total Cost line
Fixed Cost line
METHODS OF LOWERING BEP Every organization aims at lowering BEP so that their fixed
costs are recovered &soon the profit begins after the sales start exceeding BEP. Lower BEP increases the safety margin. BEP can be lowered by:1. Reduce the fixed cost: it reduces the BEP quantity
Q’ =Q. F’/F where F’ is reduced fixed cost
2. Reduce the variable cost: it reduces the BEP quantity Q’ =Q. (b-a/b-a’)
where (b-a) is the contribution at variable cost a & (b-a’) is the contribution at variable cost a’
3. Increase the slope of income line: it reduces the BEP quantity
Q’ =Q. (b-a/b’-a) where b’ is the increased price per unit& b is the current price per unit
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BREAK-EVEN ANALYSIS
Break-even-analysis is a powerful analytical tool, which uses simple graphical technique to compare few feasible alternatives.
Let,
F1 = Fixed cost for process 1
F2 = Fixed cost for process 2
V1 = Variable cost for process 1 (per unit item)
V2 = Variable cost for process 2 (per unit item)
QBEP = Break-even-quantity
TBEP = Total cost of manufacturing at break-even-quantity, QBEP.
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BREAK-EVEN-ANALYSIS FOR TWO PROCESSES
A CHART IS PLOTTED, IN WHICH X-AXIS IS FOR PRODUCTION-VOLUME. ON Y-AXIS, COST OR REVENUE IS PLOTTED.
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PURPOSE OF BEA Level of profit or loss at a projected production-
volume may be known. Selection of process for a projected production-
volume may be known. In figure 1, process 1 is more profitable till break-even-quantity (QBEP) production level. However, above this production level, process 2 becomes economical.
Implication of cost reduction policy on the profitability of the firm may be known.
Decision related to make or buy a product may be taken.
Decision related to product mix may be taken. Effect of increase in variable cost on the profitability
of the firm may be known. Effect of increased capacity of firm may be known.
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BREAKEVEN APPLICATIONS New product decision: it determines sales
volume required to break even Pricing decision: it gives effect of changing
prices and volume relationships on total profit Modernization or automation decisions: it
reveals profit implications of substituting fixed costs for variable costs
Expansion decisions: it can be used to analyze aggregate effect of general expansion
PROFIT VOLUME GRAPH (P/V GRAPH)
P/V graph is a plot similar to BEP analysis & is used along with break even chart. It is useful for comparing different processes or systems. The chart shows quantity on x-scale and profit on the y-scale. Profit & losses at various levels are plotted and are connected by a straight line.
BEP is measured at a point where the profit line intersects the horizontal line (separates profit from loss).P/V graph focuses on relation between volume & profit.
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SOME IMPORTANT RELATIONSHIPS ARE:
P/V Ratio = Contribution /Sales
Contribution = P/V Ratio x Sales
BEP = Fixed cost / (P/V Ratio)
Sales (unit) = (Fixed cost + profit )/ Contribution
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CHANGES IN THE BUSINESS ENVIRONMENT AND BREAK EVEN If VC rise in value then break even output
increases If VC fall in value break even output decreases If FC rise break even output increases If FC fall break even output falls If selling price increases break even output
decreases If selling price decreases break even output
increases
OPERATING LEVERAGE Contribution margin = contribution made by each
unit toward covering fixed costs and earning a profit
Once breakeven is reached, each contribution margin makes a direct contribution to profit
Near breakeven, a small percentage change in units sold produces a much larger percentage change in profit; this leverage effect is called operating leverage
As production moves away from breakeven, operating leverage effect diminishes
RECOVERY OF OVERHEADS
The basic aim of costing is to find out the cost of each cost centre. The cost of each cost centre can be either direct or indirect.
Direct cost can be identified with the individual cost centre & hence poses no difficulties.
To charge the indirect cost i.e. the overheads to individual cost centers is the major problem.
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PRIMARY APPORTIONMENT / ALLOCATION Some overheads are incurred for the company as a
whole i.e. for all the departments (production as well as service). To identify the common costs with individual department is the first stage problem. This can be solved in two ways: If at all it is possible to identify some overheads with
individual department they should be identified by following the procedure of allocation of overheads. E.g. wages paid to the maintenance department can be obtained from the wage sheet & can be allocated to the maintenance department.
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It may not be possible to allocate the overheads in all the cases i.e. in case of common expenses for the entire factory. In this case they can be apportioned among the various departments (production as well as service) on some suitable bases such as: Service or use basis: benefit obtained by various departments from the
overheads can be measured. Survey basis: If the amount of services provided can’t be measured. i.e. by
noting the %age of services offered to the two departments. Ability to pay basis: Apportionment depends upon the factors like total sales/
profitability. Department which are more efficient may have to bear higher amounts of overheads, though actual overheads of that department may be lower than those of other departments.
Usual basis selected for apportionment may be:Item BaseCanteen expenses/Staff Supervision Number of workersRent/Taxes AreaPower HP/KWhGeneral Lighting number of light points/areaDepreciation Value of assetsSupervision Number of employees/ wages paid
Fire insurance Value of stocks held/value of assets
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PRIMARY APPORTIONMENT / ALLOCATION
SECONDARY APPORTIONMENT With the process of primary apportionment, the loading of
overheads for all the departments can be obtained. Next step is to transfer the overheads of non production
department to production department as the various cost centers move through the production department only. This is in the form of secondary apportionment. Basis selected for secondary apportionment are: Maintenance department : number of hours worked Stores department: number of requisitions Purchase department: number of purchase orders Building service department: Area Welfare/ Canteen & other facilities: number of employees Personnel or time keeping department: number of employees Internal transport: Weight/ value of goods movedWhile doing this apportionment, the problem will be there if non
production department are providing the services inter-se.42
This problem can be handled in two ways: Ignore the services given by one service
department to another . Here secondary apportionment can be made
only after ascertaining the percentage in which services are given by one department to another using different methods.
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SECONDARY APPORTIONMENT
ABSORPTION The process of secondary apportionment of overheads,
ensures the loading of overheads to production departments.
Next stage is that the each job should get the loading of overheads while it is moving through the production department and this process is in the form of Absorption or recovery of overheads.
The various methods which can be considered for deciding the rate of overhead absorption are as below: Direct material cost %age rateCalculated as: Amount of overhead to be absorbed x 100
Direct material cost
1. Method is unsatisfactory when material cost vary without change in the amount of overheads
2. Jobs using expensive material may get high loading of overheads as compared to jobs using cheaper materials
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• Direct wage %age rate:Calculated as: Amount of overhead to be absorbed x 100
Direct wage cost
There is very little relationship between the direct wages & overhead expenses. It may give wrong results if the workers ability vary.• Prime cost %age rate:Calculated as: Amount of overhead to be absorbed x 100
Prime costUseful method as it involves both material & labor cost
• Labor hour rate:Calculated as: Amount of overhead to be absorbed
labor hours required for production• Method is useful if labor is the important element of cost• There is need to keep the record for time booking per job
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ABSORPTION
Machine hour rate:Calculated as: Amount of overhead to be absorbed
Number of machine hours
Useful if machine use accounts for a large element of cost
The overhead absorption rates can be considered on actual basis or predetermined basis. For computing on actual basis, actual data for the previous period is considered.By predetermined rates it is meant that instead of considering actual data in respect of direct materials/ wages/prime cost or labor/ machine hours estimations are made in respect of the same & predetermined overhead absorption rate.
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ABSORPTION
UNDER ABSORPTION OR OVER ABSORPTION OF OVERHEADS
When company considered the policy of predetermined overhead absorption rate, it may face the problem of over or under absorption of overheads. The predetermined overhead rate was estimated on the basis of following details:
i.e. Estimated amount of overheads X 100Estimated Direct material/wages/prime cost
or Labor/ Machine hour
The situation of under absorption arises if the overheads are less than the actual overheads. The situation of over absorption arises if the overheads absorbed are more than the actual overheads.
Under absorption may occur due to:(i) Actual overheads being more than the estimated overheads or(ii)Actual output or hours worked being less than those as estimatedOver absorption may occur due to:(i) Actual overheads being less than the estimated overheads or(ii)Actual output or hours worked being more than those as
estimated
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TREATMENT OF OVER OR UNDER ABSORBED OVERHEADS
Use of supplementary rate: Mid term review is carried out, calculate the amount of overheads already absorbed for that period & determine the overheads absorption rate for the remaining period depending upon the total amount of overheads to be absorbed.
Carrying over to remaining period: In seasonal type of organizations, overheads under or over absorbed during a certain period may be carried over to the remaining part of the accounting period with the hope that they may be compensated during the remaining period of time.
Writing off to costing profit or loss account: Over or under absorption of overheads arising out due to abnormal circumstances, they are written off to costing profit and loss account.
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MARGINAL COSTING There are certain costs that tend to remain constant
despite the changes in the level of activity or volume of operations. These types of costs are comparative irrelevant in managerial decisions.
There is also over & under absorption of overheads. These limitations have given rise to a technique which tries to classify the costs based upon the behavior of cost. This technique is referred to as Marginal costing.
Marginal costing proposes that fixed cost tends to remain stagnant at least over a short period of time and hence should be ignored in the entire decision making process. As such. It considers only variable costs as relevant cost in the decision making process
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Marginal cost is defined as the amount at any given volume of output by which the aggregate costs are changed if the volume of output is increased or decreased by one unit. The aggregate cost consists of both fixed & variable cost. In other words it is the additional cost for manufacturing one additional unit, which is nothing else but per unit variable cost.
In short run, fixed cost remain constant irrespective of changes in volume, aggregate cost may increase or decrease with the changes in volume due to variable cost. In other words marginal cost indicates per unit variable cost.
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MARGINAL COSTING
ASSUMPTIONS MADE BY MARGINAL COSTING
Variable cost varies in direct proportion with the level of activity. However per unit variable cost remains constant at all the levels of activity.
Per unit selling price remains constant at all the levels of activity.
Whatever is produced by the organization is sold off.
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PRACTICAL APPLICATIONS OF MARGINAL COSTING Evaluation of performance: The performance of
various departments or a product or a branch can be evaluated with the help of marginal costing. This evaluation is based upon the contribution generating capacity of these segments.
Profit Planning: Through P/V ratio calculations, it enables the management to plan the activities in such a way that the profits can be maximized or to maintain a specific level of profit.
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CONTRIBUTION
Contribution is the total revenue – variable costs
It measures how much is being contributed to the fixed costs by the units that have been sold
Contribution – Fixed costs = Profit Can calculate contribution per unit or
contribution for all units of output
CONTRIBUTION
In short period, fixed costs are ineffective due to their stagnant nature, variable cost becomes the most important cost in deciding profitability.
Or in other words, the situations which generates higher contribution is treated as profitable situation.
Contribution plays an important role in a situation where there are more than one products and profits on individual product can not be ascertained due to the apportionment of fixed costs to different products. This is due to the fact that fixed costs are ignored by marginal costing. 54
SPECIAL ORDER DECISIONS
This is when businesses need to decide if to accept orders that are on special terms
Prices lower than normal – if the contribution is positive generally accept the order
However have to consider: If more FC result from the orderMay the order increase the level of VCs If the company will resell the product If it may lead to future sales – if this is the case
may accept an order that doesn’t make a positive contribution
SPECIAL ORDER DECISIONS 2 Prices higher than normal Normally would accept this However if specifications have to be altered
it may prove to be expensive for the business The firm would need to:
Calculate any extra variable costs associated with the order
Assess if sufficient capacity to meet orderDecide if it increases contribution and
profits
STANDARD COSTING
The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances.
In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.”
The CIMA, London has defined standard cost as “a predetermined cost which is calculated from managements standards of efficient operations and the relevant necessary expenditure.”
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The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures.
Thus standard cost is the normal cost under the ideal circumstances.
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STANDARD COSTING
ADVANTAGES It is not only useful for cost control purposes but is
also helpful in production planning and policy formulation. It allows management by exception. Some of the advantages of this tool are given below:
Efficiency measurement-- The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centers. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency. It is not proper to compare costs of different period because circumstance of both the periods may be different. Still, a decision about base period can be made with which actual performance can be compared.
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Finding of variance-- The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance.
Management by exception-- Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and every body tries to achieve his/her targets.
Cost control-- Every costing system aims at cost control and cost reduction. The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken.
Right decisions-- It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc.
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Eliminating inefficiencies-- The setting of standards for different elements of cost requires a detailed study of different aspects. The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps.
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LIMITATIONS OF STANDARD COSTING It cannot be used in those organizations where non-standard
products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.
The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.
There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable.
The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.
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DETERMINATION OF STANDARD COSTS
1. Determination of Cost Center : “A cost center is a department or part of a department or an item of equipment or machinery or a person or a group of persons in respect of which costs are accumulated, and one where control can be exercised.” A cost center relating to a person is called personnel cost center, and a cost center relating to products and equipments is called impersonal cost center.
2. Current Standards : A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year.
3. Ideal Standard: This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption that favorable conditions will prevail and management will be at its best. Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not practicable and may not be achieved.
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4. Basic Standards: A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period. Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions.
5. Normal Standards: Normal standard has been defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle. This standard is based on the conditions which will cover a future period of five years, concerning one trade cycle.
6. Organization for Standard Costing: The success of standard costing system will depend upon the setting up of proper standards. For the purpose of setting standards, a person or a committee should be given this job. The committee includes production manager, purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost accountant acts as a co-coordinator of this committee.
7. Accounting System: Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue item. Codes can be used to have a speedy collection of accounts
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DETERMINATION OF STANDARD COSTS
REVISION OF STANDARDS For effective use of this technique, sometimes we need to
revise the standards which follow for better control. Even standards are also subjected to change like the production method, environment, raw material, and technology.
Standards may need to be changed to accommodate changes in the organization or its environment. When there is a sudden change in economic circumstances, technology or production methods, the standard cost will no longer be accurate. Standards that are out of date will not act as effective feed forward or feedback control tools. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department. If standards are continually not being achieved and large deviations or variances from the standard are reported, they should be carefully reviewed. 65
COST VARIANCE ANALYSIS
A variance is the difference between an actual result and an expected result. The process by which the total difference between standard and actual results is analyzed is known as variance analysis. When actual results are better than the expected results, we have a favorable variance (F). If, on the other hand, actual results are worse than expected results, we have an adverse or unfavorable variance (A).
The variance arising in one period may be compared with a variances in the previous period for a better control.
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VARIABLE COST VARIANCES Direct material variances
The direct material total variance is the difference between what the output actually cost and what it should have cost, in terms of material. It can be divided into two sub-variances The direct material price variance
It is that portion which is due to difference between standard price specified & actual price paid. The responsibility of this type of variance may be normally placed on Purchase Department. The causes for this may be:• Change in price of material, change in quantity of purchase,
rush orders to meet shortage of supply, failure to take advantages of off season prices, failure to get cash/trade discounts, change in quality or specifications on material, use of substitute material at different prices, change in taxes or duties.
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The direct material usage variance
This is the difference between how much material should have been used for the number of units actually produced and how much material was used, valued at standard cost. The causes for this may be:• Inefficient or careless use of materials, inefficient
inspection of material, production inefficiencies resulting in wastages, theft/pilferages, inefficient labor not able to handle the material properly, defective machines and not proper maintenance of the same, change in composition of material mix. 68
Direct labor total variance: The direct labor total variance is the difference between standard direct wages specified & the actual wages paid.Direct labor rate variance This is the difference between what the actual number of hours worked should have cost and what it did cost. The causes for this may be:• Change in wage structure or piece rate work,
variation due to different grades of workers & their wages differing from those specified, use of different methods of payment, overtime or night shift allowance more or less than standard, employment of casual/ temporary workers to meet seasonal demands.
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The direct labor efficiency time variance The is the difference between how many hours should have been worked for the number of units actually produced and how many hours were worked, valued at the standard rate per hour. The causes for this are traced as:• Lack of proper supervision, poor working
conditions, defective tools, equipments, machine break down if not treated as idle time, wrong selection of workers, increase in labor turnover, incorrect recording of performance i.e. time or output, delay due to waiting for materials, tools, instructions etc.
When idle time occurs the efficiency variance is based on hours actually worked (not hours paid for) and an idle time variance (hours of idle time x standard rate per hour) is calculated.
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Overhead Cost Variances
The analysis of overhead variances is different & the most difficult task than the calculation of material & labor variance. In this connection overhead absorption rate should be calculated as:
a) If the overhead rate is expressed in terms of labor hours: Hourly rate: Budgeted Overhead cost/Budgeted labor hours
b) If the overhead rate is expressed in terms of units produced:
Unit rate: Budgeted Overhead cost/Budgeted outputs in units
As the overheads can be either variable or fixed, the overhead cost variances may be separately calculated for variable overheads & fixed overheads. 71
VARIABLE PRODUCTION OVERHEAD VARIANCES
It is that amount of overheads which changes directly with the level of activity and per unit variable overheads remains constant. As such, the variable overheads are not affected with the change in volume of operations.
Overhead Cost Variance
Expenditure variance Efficiency Variance
Overhead cost variance: It is the difference between standard cost absorbed & actual overheads incurred.
The variable production overhead expenditure variance: This is the difference between what the variable production overhead did cost and what it should have cost
The variable production overhead efficiency variance: This is the same as the direct labour efficiency variance in hours, valued at the variable production overhead rate per hour.
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FIXED PRODUCTION OVERHEAD VARIANCES
The total fixed production variance is an attempt to explain the under- or over-absorbed fixed production overhead.
Overhead Cost Variance
Expenditure Variance Volume variance
Efficiency Capacity Calendar
Each of the variance can be computed either on the basis of unit production or on the basis of hours.
Fixed production overhead expenditure variance: This is the difference between the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure. The causes for this may be: Change in quality/ price of indirect material, change in labor
rates for indirect workers, change in rate of power, insurance and other overheads.
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Fixed production overhead volume variance: This is the difference between actual and budgeted production volume multiplied by the standard absorption rate per unit. The causes of this variance may be: Labor problems like strikes, lockouts etc., material shortage,
machinery breakdown, power failure, change in demand for product, waiting for tools/ instructions/material.
Per unit or per hour overheads remains constant and are not affected by the change in level of output. As such, volume variance does not arise in case of variable overheads.
Efficiency Variance: It is that portion of overhead variances, as a part of volume variance, which is due to difference between budgeted efficiency of production & actual efficiency attained. The causes of this variance may be: Poor working conditions, change in labor performance,
defective & faulty tools, incorrect machine operations, defective or inferior material.
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Capacity Variance: It arises due to working at higher or lower capacity than standard. The causes for this may be:Seasonal variations, shortage of labor force, abnormal idle time due to machine breakdown, power failures or strikes etc., change in customer demands.
Calendar Variance: It arises due to the difference between the number of working days in the budget period and the actual number of working days in the period in which budget is applied. The normal holidays are already considered while setting the standards. Thus, the variance arises due to the declaration of unexpected days as holidays. 75
Example: The fixed cost of Rs.24,000 and a break-even-quantity of 34,000 unit are estimated for a productions. Draw profit graph and calculate the P/V ratio and profit at a sales volume of 50,000 units.Solution
(a) P – V Ratio = Fixed Cost/ Break - even - quantity= 24,000/34,000 = 0.706
(b) At sales-volume of 50,000 unitsP – V Ratio = Fixed Cost + profit/QOr 0.706 = 24,000 + P/ 50,000Or, P = 50,000 × 0.706 – 24,000= Rs.11295 Ans.
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7-7
7
BREAK-EVEN EXAMPLE 1A firm produces radios with a fixed cost of
$7,000 per month and a variable cost of $5 per radio. If radios sell for $8 each:
1a) What is the break-even point?TR = TC so 8x = 7000 + 5xx = 7000/3 = 2,333.333 radios per month
1b) What output is needed to produce a profit of $2,000/month?Profit = 2000/month so TR - TC = 8x - (7000 + 5x) = 2000
x = 9000/3 = 3,000 radios per month
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8
BREAK-EVEN EXAMPLE 1 - CONTINUED1c) What is the profit or loss if 500 radios are
produced each week?First, get monthly production:
50052/12 = 2,166.6667 radios per month
Then calculate profit or loss TR - TC = 82166.6667 - (7000 +
52166.6667) = $-500 per month
($500 loss per month)
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9
BREAK-EVEN EXAMPLE 2A firm produces radios with a fixed cost of $7,000 per
month and a variable cost of $5 per radio for the first 3,000 radios produced per month. For all radios produced each month after the first 3,000 the variable cost is $10 per radio (for added overtime and maintenance costs). If radios sell for $8 each:
2a) What are the break-even point(s)?Now TC has two parts depending on the level of production:For x 3000/month: TC = 7000 + 5xFor x > 3000/month: TC = 7000 + 5(3000) + 10(x-3000)
= -8000 + 10x For any x: TR = 8x
7-8
0BREAK-EVEN EXAMPLE 2 - CONTINUED
For x 3000/month: TC = 7000 + 5xFor x > 3000/month: TC = -8000 + 10xFor any x: TR = 8x
For x 3000/month: 7000 + 5x = 8x so x = 2,333.33/month This is < 3000/month, so it is a valid break-even point.
For x > 3000/month: -8000 + 10x = 8x so x = 4000/month This is > 3000/month, so it is also a valid break-even point.
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1
BREAK-EVEN EXAMPLE 2
Total cost line
Total revenue line
1000
Break-even points
Volume (units/month)
Do
llars
(T
ho
usa
nd
s)
400030002000
8
24
32
16
40
7-8
2
BREAK-EVEN EXAMPLE 3A firm produces radios with a fixed cost of $7,000 per
month and a variable cost of $5 per radio for the first 2,000 radios produced per month. For all radios produced each month after the first 2,000 the variable cost is $10 per radio (for added overtime and maintenance costs). If radios sell for $8 each:
3a) What are the break-even point(s)?Again TC has two parts depending on the level of production:For x 2000/month: TC = 7000 + 5xFor x > 2000/month: TC = 7000 + 5(2000) + 10(x-2000)
= -3000 + 10xFor any x: TR = 8x
7-8
3BREAK-EVEN EXAMPLE 3 - CONTINUED
For x 2000/month: TC = 7000 + 5x
For x > 2000/month: TC = -3000 + 10x
For any x: TR = 8x
For x 2000/month: 7000 + 5x = 8x so x = 2,333.33/month
This is not < 2000/month, so it is not a break-even point!!
For x > 2000/month: -3000 + 10x = 8x so x = 1500/month
This is not > 2000/month, so it is not a break-even point!!
THERE ARE NO BREAK-EVEN POINTS!
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4
BREAK-EVEN EXAMPLE 3
Total cost lineTotal revenue line
1000
Volume (units/month)
Do
llars
(T
ho
usa
nd
s)
400030002000
8
24
32
16
40
7-8
5
OTHER BREAK-EVEN POSSIBILITIES
Total cost lineTotal revenue line
1000
Volume (units/month)
Do
llars
(T
ho
usa
nd
s)
400030002000
8
24
32
16
40