Unit-12 Basics Of Management Accounting

Notes
Structure
12.1 Introduction to Management Accounting
12.2 Scope of Management Accounting
12.3 Principles of Management Accounting
12.4 Summary

Objectives
Objective of this unit is to make student aware of Management Accounting and
various aspects related to it.

12.1 Introduction To Management Accounting

Management accounting may be defined as an art and science to provide
information to the management so that they can perform their functions efficiently or
simultaneously improve their operating efficiency. The most suitable definition of
management accounting may be give as follows:

"Management accounting is analyzing, interpreting, presenting and communicating

the results of financial and cost accounting to the management to enable them in
performing various managerial functions. Such as formulation of plans, decision-
making, implementation of plan, directing activities of the subordinates and effective
controlling of the operations."

12.2 Scope Of Management Accounting

Scope of management accounting is very vast and includes various aspects of the
business activities. Management accounting has its scope in the following fields or
systems:

1. Financial accounting: It is the foremost and indispensable part of accounting. In

this system, business transactions of financial character are recorded in the proper
subsidiary book. Posting of these transactions is done in ledger and from this the
final accounts are prepared. Final accounts include profit and loss account and
balance sheet. Profit and loss account represents the profit/loss earned during
the accounting period and the balance sheet represents the financial position of
a company as on a particular date. Financial accounting is the foundation from
management accounting as it provides the necessary information for preparation of
details and reports to be presented to the management.

2. Cost Accounting: Cost accounting is one of the important branches of accounting.

It ascertains the cost of producing a particular commodity and rendering of
services cost of selling and distribution. It facilitates effective planning regarding
commodities, proper decision-making and cost control. Some of the important tools
of cost accounting are marginal costing, standard costing and budgetary control.

3. Revaluation accounting: Revaluation accounting ensures that capital is

represented at its real value in the accounts and the profit has been calculated
keeping this fact in mind. In other words, it assures that the assets are revalued
according to the need and its effect has been brought into the accounts.
Management accounting helps to ascertain the revalued figures of the assets.

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4. Control accounting : Controlling means to measure the variation, if any, between
actual and the standard results and taking corrective measures to remove that Notes
variation. Management accounting is the indispensible part of control accounting,
budgetary control, inventory control, equality control are some of the important
techniques of management accounting for control accounting.

5. Statistical methods : Management accounting is concerned with presentation of

accounting information in the most impressive and understandable manner. It
makes use of graphs, charts, index numbers, pictorial presentation and other
statistical methods in order to make the information more intelligible. For scientific
analysis of financial statement and accounting information various statistical
techniques such as mean, standard duration, cov., correlation, t-test, etc and used
in management accounting.

6. Interim reporting : Interim reporting means preparation of reports on monthly,

quarterly and half-yearly basis. These reports include income statement, cash flow
statement, funds flow statement, scrap reports etc.

7. Internal audit : Internal audit means audit of various departments by the internal
members of the organization. The techniques of management accounting can be
used to judge the efficiency and economy of the organization. Ratio analysis and
funds flow analysis are widely used to judge the efficiency of an organization.

8. Taxation : Tax planning and its management is an essential function of the

management. It includes computation of income as per tax laws, filing of returns
and payment of tax within stipulated time.

12.3 Principles of Management Accounting

1. The procedures and methods to be followed for keeping and analyzing financial
statements should have consistency. It enables to keep the figures comparable. If
the methods are frequently changed than utility of the statements will be reduced.

2. The principles should be such that all possible losses should be taken-into account.
On the other hand, profits should be considered only when they have actually
accrued.

3. Only normal costs should be considered while finding out costs of the products. The
cost of the products should reflect costs under normal situation. Abnormal cost may
arise due to obsolescence of idle capacity due to less demand.

4. The convention of the objectivity should be followed while recording financial

statements. There should be no room for human bias of prejudice. There should not
be a choice left to the accountant while making records.

5. The measuring rod of efficiency of s concern should be a return on capital

employed. It should be consistently used so that a comparison is possible in the
figures of different years. A comparison in performance is possible not only among
equal size concerns but also among different size concerns.

6. Standard forms should be used for recording cost data. It will enable a comparison
of costs among different units.

7. The costs should be divided into controllable and uncontrollable costs. Controllable
costs are those which can be kept under control by the efforts of the management.
Uncontrollable costs are affected by the outside reasons such as increase in price

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Notes of materials, upward revision of labor rates by the government, etc. An increase
in controllable costs will enable the management to fix responsibility and take
corrective measures.

8. The aim of management should be to utilize resources of the concern in the best
possible way. The use of various processes and methods should enable the
achievement of the object.

The principle of revaluation accounting should be used to keep the data up to-data.
Due to inflationary situation, various assets are not shown at real values. Revaluation
accounting is not yet widely used because it effects objectivity of accounts.

12.4Summary
Management Accounting is the term used to describe the accounting methods,
systems and techniques, which compiled with special knowledge and ability assist
management in its task of maximizing profits or minimizing losses.

Questions and Exercises

1. What is Management Accounting?

2. What is the Scope of Management Accounting?

3. What are the Principle of Management Accounting?

Further Readings
1. Maheswari, S.N., Management Accounting, Sultan Chand & Sons, New Delhi.

2. Hingorani, Ramanathan & Grewal, Management Accounting.

3. Jain S.P. And Narang, K.L., Cost Accounting

Check Your Progress

1. Is it necessary for accountants to know about management accounting?

2. Is Management Accounting a separate method of accounting?

3. Is Presentation of information important in MA?

4. Management Accounting uses the inflation effect while financial accounting does
not.

5. Management Accounting does not have separate standards or principles.

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 Unit-13 Marginal Costing And Break Even Analysis
Notes
Structure
13.1 Introduction
13.2 Absorption Costing Vs Marginal Costing
13.3 Advantages and Disadvantages of Absorption Costing
13.4 Advantages of Direct/Marginal Costing
13.5 Cost Volume Profit Relationship
13.6 Break Even Analysis(BEP)
13.7 Benefits of BEP
13.8 Summary

Objectives
Explain how variable costing doffers from absorption costing and compute unit
product costs under each method
Prepare income statements using variable and absorption costing.
Reconcile variable and absorption costing net operating income and explain
why two amounts differ.
Understand the advantages and disadvantages of both variable and
absorption costing.
Understanding Cost Volume Profit relationship.
Understanding the break even analysis.

13.1 Introduction
Two general approaches are used for valuing inventories and cost of goods sold.
One approach is called variable costing and other is called absorption costing.
Absorption costing is generally used for external financial reports and variable costing is
preferred by managers for internal decision making and must be used when an income
statement is prepared in the contribution margin format. Ordinarily these two costing
systems produce different figures for net operating income and difference can be quite
large.

13.2 Absorption Costing vs Variable Costing in Brief

1. Absorption costing is a costing system which treats all costs of production
as product costs, regardless weather they are variable or fixed. The cost of a unit of
product under absorption costing method consists of direct materials, direct labor
and both variable and fixed overhead. Absorption costing allocates a portion of
fixed manufacturing overhead cost to each unit of product, along with the variable
manufacturing cost. Because absorption costing includes all costs of production as
product costs, it is frequently referred to as full costing method.

2. Variable, Direct or Marginal Costing:

Variable costing is a costing system under which those costs of production
that vary with output are treated as product costs. This would usually include direct
materials, direct labor and variable portion of manufacturing overhead. Fixed
manufacturing cost is not treated as a product costs under variable costing. Rather,
fixed manufacturing cost is treated as a period cost and, like selling and administrative
expenses, it is charged off in its entirety against revenue each period. Consequently
the cost of a unit of product in inventory or cost of goods sold under this method does

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not contain any fixed overhead cost. Variable costing is some time referred to as direct
Notes costing or marginal costing. To complete this summary comparison of absorption and
variable costing, we need to consider briefly the handling of selling and administrative
expenses. These expenses are never treated as product costs, regardless of the
costing method in use. Thus under either absorption or variable costing, both variable
and fixed selling and administrative expenses are always treated as period costs and
deducted from revenues as incurred.

The concepts explained so for are illustrated below:

Cost classifications-Absorption versus variable costing

Absorption Variable
Costing Costing

Pro L!Ci Direct materials Pro L!Ci

cosi Direct Labor COSi
Variable Manufacturing
overhead

Fixecl m.:mJf.: r.tJJrina >rh rl Period

Period Variable selling and coSi
cosi administrative expenses
Fixed selling and
administrative expenses

3 Unit Cost Computation/Calculation:

To illustrate the computation/calculation of unit product costs under both absorption
and variable costing consider the following example.

Example:

A small company that produces a single product has the following cost structure.

Rs6,000

Direct materials Rs2

Rs4
Rs1
Rs3

Rs30,000
Rs10,000

Required:

1. Compute the unit product cost under absorption costing method.

2. Compute the unit product cost under variable I marginal costing method.

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Unit product Cost Notes

Absorption Costing Method
Direci maerials Rs2
Direci labor Rs4
Rs1
Variable manufacturina overhead
--
Tnt;> l ""'ri,.hl" nrnrloo rtinn rn<Ot
Rs7
Rs5
Fixed man,,f,qr.turina overhead
--
UniiprodCOSi Rs12

-----
Unit product Cost
Variable Costing Method
Direcl malerials Rs2
Direci labor Rs4
Rs1
Variable manufacturina overhead
--
UniiprodCOSi Rs7

-----
(The Rs30,000 fixed manufacturing overhead will be
charged off in total against income as a period expense
along with selling and administrative expenses)

Under the absorption costing, notice that all production costs, variable and fixed, are
included when determining the unit product cost. Thus if the company sells a unit of
product and absorption costing is being used, then Rs12 (consisting of Rs7 variable
cost and Rs5 fixed cost) will be deducted on the income statement as cost of goods
sold. Similarly, any unsold units will be carried as inventory on the balance sheet at
Rs12 each.Under variable costing, notice that all variable costs of production are
included in product costs. Thus if the company sells a unit of product, only Rs7 will be
deducted as cost of goods sold, and unsold units will be carried in the balance sheet
inventory account at only Rs7.

4 Income Comparison of Variable and Absorption Costing:

Net operating income is usually different under variable and absorption costing
system. The explanation for this difference needs two separate income statements one
under absorption costing and other under variable costing. The income statements
prepared under absorption costing and variable costing usually produce different
net operating income figures. This difference can be quite large. Here we will explain
the basic reason of this difference in income. The explanation for this difference needs
two separate income statements one under absorption costing and other under
variable costing. We will prepare two income statements that will produce different
income figures and then explain the reasons of difference. Consider the following
example:

Example:

Following data relates to a manufacturing company:

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Notes Number of units produced each year 60,000

Variable cost per unit: Rs2

Direcimaierials Rs4
Direcilabor Rs1
Variable Manufacturinq Overhead Rs3
Variable selling and Administrative expenses

Fixed costs per year: Rs30,000

Fixed manufacturina overhead Rs10,000
Fixed selling and administrative expenses

Units in beqinninq inventory 0

Unipro uce 6,000
UniiS Sold 5,000
Units in endina inventorv 1,000
Selling price per unit Rs20

Sellin!:and administrative expenses:

Variable per unii Rs3
Fixeper year Rs10,000

Required:
1. Prepare income statements using:
a. Absorption costing system
b. Variable costing system
2. Prepare a reconciliation schedule

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Absorption Costing Income Statement

Notes
Sales (5,000 unitsxRs20 per unit) Rs100,000

Less cost of goods sold:

Beginning inventory RsO
Add Cost of goods manufactured (6,000
Rs72,000
unitsxRs12per unit)

Goods avail able for sale Rs72,000

Less ending inventory Rs12,000

Cost of goods sold Rsso,ooo

Gross Margin (Rs100,000-Rs60,000) Rs40,000

Less selling and administrative expenses

Variable selling and administrative expenses (5,000 x 3) Rs15,000
Fixed selling and administrative expenses Rs10,000

Rs25,000

Net operating income (Rs40,000-Rs25,000) Rs15,000

Variable Costing Income Statement

Sales (Rs5,000unitsxRs20 per unit) Rs100, 000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory RsO
Add variable manufacturing costs (1,000 unitsxRs7per unit)
Rs42,000

Goods available for sale Rs42,000

Less ending inventory (1, 000 unitsxRs7 per unit) Rs7, 000

Variable cost of goods sold Rs35, 000

variable selling and administrative expenses
Rs15, 000
(5,000 units x Rs3 per unit)

50, 000

Contribution margin (Rs100,000- Rs50, 000) 50, 000

Less fixed expenses:

Fixed manufacturing overhead Rs30,000
Fixed selling and administrative expenses Rs10, 000

Rs40,000

Net operating Income (Rs50,000- Rs40, 000) Rs10,000

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The income statements prepared above have different net operating income figures.
Notes Now we will explain why net operating income is different under both the costing
systems.

Explanation:

Several points can be noted from the income statements prepared above:

Under absorption costing if inventories increase then some of the fixed

manufacturing costs of the current period will not appear on the income statement as
part of cost of goods sold. Instead, these costs are deferred to a future period and
are carried on the balance sheet as part of the inventory account. Such a deferral of
cost is known as fixed manufacturing overhead deferred in inventory. The process
involved can be explained by referring to income statements prepared above. During
the current period 6,000 units have been produced but only 5,000 units have been
sold leaving 1,000 unsold units in the ending inventory. Under the absorption costing
system each unit produced was assigned Rs5 in fixed overhead cost. Therefore
each unit going into inventory at the end of the period has Rs5 in fixed manufactured
overhead cost attached to it, or a total of Rs5,000 for 1,000 units (1,000 x Rs5). This
fixed manufacturing overhead cost of the current period deferred in inventory to the next
period, when hopefully these units will be taken out of inventory and sold. This deferral
of Rs5,000 of fixed manufacturing overhead costs can be clearly seen by analyzing the
ending inventory under the absorption costing method:

Variable manufacturing costs (1OOOunits x Rs7 per unit} Rs7,000

Fixed manufacturing overhead costs (1,000 x Rs5 per unit) Rs5,000

Total ending inventory value Rs12,000

-------
In summary, under absorption costing, of the Rs30,000 in fixed manufacturing
overhead costs incurred during the period, only Rs25,000 (5,000 Rs per unit) has been
included in the cost of goods sold. The remaining Rs5000 (1000 units not sold Rs5 per
unit) has been deferred in inventory to the next period.

Under variable costing method the entire Rs30,000 in fixed manufacturing overhead
costs has been treated as an expense of the current period (see the bottom portion of
the variable costing income statement).

The ending inventory figure under the variable costing method is Rs5,000 lower than
it is under the absorption costing method. The reason is that under variable costing,
Only the variable manufacturing costs are assigned to units of product and therefore
included in the inventory:

Variable manufacturing costs (1000units x Rs7 per unit) Rs7,000

13.3Advantages And Disadvantages of Absorption Costing

1. Advantages of Absorption Costing:
1. It recognizes the importance of fixed costs in production;

2. This method is accepted by Inland Revenue as stock is not undervalued;

3. This method is always used to prepare financial accounts;

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4. When production remains constant but sales fluctuate absorption costing will
show less fluctuation in net profit and Notes
5. Unlike marginal costing where fixed costs are agreed to change into variable
cost, it is cost into the stock value hence distorting stock valuation.

2. Disadvantages of Absorption Costing:

1. As absorption costing emphasized on total cost namely both variable and
fixed, it is not so useful for management to use to make decision, planning and
control;

2. as the manager's emphasis is on total cost, the cost volume profit relationship
is ignored. The manager needs to use his intuition to make the decision.

13.4 Advantages of Variable Costing System:

Variable costing has the following main advantages:

1. The data that are required for cost volume profit (CVP) analysis can be taken
directly from a variable costing format income statement. These data are not
available on a conventional income statement based on absorption costing.

2. Under variable costing, the profit for a period is not affected by changes in
inventories. Other things remaining the same (i.e. selling prices, costs, sales
mix, etc.), profits move in the same direction as sales when variable costing is
in use.

3. Managers often assume that unit product costs are variable costs. This is a
problem under absorption costing, since unit product costs are a combination of
both fixed and variable costs. Under variable costing, unit product costs do not
contain fixed costs.

4. The impact of fixed costs on profits is emphasized under the variable costing
and contribution approach. The total amount of fixed costs appears explicitly on
the income statement. Under absorption, the fixed costs are mingled together
with the variable costs and are buried in cost of goods sold and in ending
inventories.

5. Variable costing data make it easier to estimate the profitability of products,

customers, and other segments of the business. With absorption costing,
profitability is obscured by arbitrary allocations of fixed costs.

6. Variable costing ties in with cost control methods such as standard costs and
flexible budgets.

7. Variable costing net operating income is closer to net cash flow than absorption
costing net operating income. This is particularly important for companies
having cash flow problems.

With all of these advantages one might wonder why absorption costing continues
to be used almost exclusively for external reporting purposes and why it is predominant
choice for internal reports as well. This is partly due to tradition, but absorption costing
is also attractive to many accountants because they believe it better matches costs
with revenues. Advocates of absorption costing argue that all manufacturing costs
must be assigned to products in order to properly match the costs of producing units
of product with the revenues from the units when they are sold. The fixed costs of

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depreciation, taxes, insurance, supervisory, salaries, and so on, are just as essential to
Notes manufacturing products as are the variable costs. Advocates of variable costing argue
that fixed manufacturing costs are not really the costs of any particular unit of product.
These costs are incurred to have the capacity to make products during a particular
period and will be incurred even if nothing is made during the period. Moreover, whether
a unit is made or not, the fixed manufacturing cost will be exactly the same. Therefore,
variable costing advocates argue that fixed manufacturing costs are not part of the
costs of producing a particular unit of product and thus the matching principle dictates
that fixed manufacturing costs should be charged to the current period. At any rate,
absorption costing is the generally accepted method for preparing mandatory external
financial reports and income tax returns. Probably because of the cost and possible
confusion of maintaining two separate costing systems-one for external reporting and
one for internal reporting-most companies use absorption costing for both external and
internal reports.

13.5Cost Volume Profit Relationship- (Cvp Analysis):

Cost volume profit analysis (CVP analysis) is one of the most powerful tools
that managers have at their command. It helps them understand the interrelationship
between cost, volume, and profit in an organization by focusing on interactions among
the following five elements:
1. Prices of products
2. Volume or level of activity
3. Per unit variable cost
4. Total fixed cost
5. Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the

interrelationships among cost, volume, and profit it is a vital tool in many business
decisions. These decisions include, for example, what products to manufacture or
sell, what pricing policy to follow, what marketing strategy to employ, and what type of
productive facilities to acquire.

1. Contribution Margin and Basics of CVP Analysis:

Contribution margin is the amount remaining from sales revenue after variable
expenses have been deducted. Thus it is the amount available to cover fixed expenses
and then to provide profits for the period. Contribution margin is first used to cover the
fixed expenses and then whatever remains go towards profits. If the contribution margin
is not sufficient to cover the fixed expenses, then a loss occurs for the period. This
concept is explained in the following equations:

[Sales revenue" Variable cost*= Contribution Margin]

*Both Manufacturing and Non Manufacturing
[ Contribution margin " Fixed cost* = Net operating Income or Loss]

2 Cost Volume Profit (CVP) Relationship in Graphic Form:

The relationships among revenue, cost, profit and volume can be expressed
graphically by preparing a cost-volume-profit (CVP) graph or break even chart.
A CVP graph highlights CVP relationships over wide ranges of activity and can give
managers a perspective that can be obtained in no other way.
(a) Preparing a CVP Graph or Break-Even Chart:
In a CVP graph some times called a break even chart unit volume is commonly
represented on the horizontal (X) axis and Rs on the vertical (Y) axis. Preparing a CVP
graph involves three steps.
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(i) Draw a line parallel to the volume axis to present total fixed expenses. For example
we assume total fixed expenses Rs35,000. Notes

CoetaiRev-
vc

Loss

Q1 Output/Sale

(ii) Choose some volume of sales and plot the point representing total expenses (fixed
and variable) at the activity level you have selected. For example we select a level
of 600 units. Total expenses at that activity level is as follows:

Fixed.Expenses Rs35,000
Variable Expenses Rs90,000
(150x600)

Toial Expenses Rs125,000

---- -
------
-
After the point has been plotted, draw a line through it back to the point where the
fixed expenses line intersects the Rs axis.

(iii) Again choose some volume of sales and plot the point representing total sales
Rs at the activity level you have selected. For example we have chosen a volume
of 600 units. sales at this activity level are Rs150,000 (600units x Rs250) draw a
line through this point back to the origin. The break even point is where the total
revenue and total expense lines cross. See the graph and note that break even
point is at 350 units. It means when the company sells 350 units the profit is zero.
When the sales are below the break even the company suffers a loss. When sales
are above the break even point, the company earns a profit and the size of the
profit increases as sales increase.

3 Contribution Margin Ratio (CM Ratio):

The contribution margin as a percentage of total sales is referred to as contribution
margin ratio (CM Ratio). Contribution margin ratio can be used in cost-volume profit
calculations. The contribution margin as a percentage of total sales is referred to as
contribution margin ratio (CM Ratio)

(a) Formula of CM Ratio:

Formula or equation of CM ratio is as follows:
[ CM Ratio= Contribution Margin I Sales]
This ratio is extensively used in cost-volume profit calculations.
Calculation I Computation of Contribution Margin Ratio:
Example:

Consider the following contribution margin income statement of A Q. Asem

private Ltd. in which sales revenues, variable expenses, and contribution margin are
expressed as percentage of sales.

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Percent
Total Per Unit
Notes of Sales
Sales (400 niis) Rs100,000 Rs250 100%
Less variable expenses 60,000 150 60%

Contribution margin Rs40,000 Rs100 40%

=====
Less fixed expenses 35,000

Net operating income Rs5,000

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

According to above data of A. Q. Asem private Ltd. the computations are:

Contribution Margin Ratio= (Contribution Margin I Sales) x 100 =

(Rs40,000 I Rs100,000) x 100

= 40%

In a company that has only one product such as A. Q. Asem CM ratio can also be
calculated as follows:

Contribution Margin Ratio= (Unit contribution margin I Unit selling price) x 100
= (Rs100 I Rs250) x 100
= 40%

(b) Importance of Contribution Margin Ratio:

The CM ratio is extremely useful since it shows how the contribution margin will be
affected by a change in total sales. To illustrate notice that A. Q. Asem has a CM ratio
of 40%. This means that for each Rs increase in sales, total contribution margin will
increase by 40 cents (Rs1 sales x CM ratio of 40%). Net operating income will also
increase by 40 cents, assuming that fixed cost do not change.

The impact on net operating income of any given Rs change in total sales can be
computed in seconds by simply applying the contribution margin ratio to the Rs change.
For example if the A. Q. Asem plans a Rs30,000 increase in sales during the coming
month, the contribution margin should increase by Rs12,000 (Rs30,000 increased sales
x CM ratio of 40%). As we noted above, Net operating income will also increase by
Rs12,000 if fixed cost do not change. This is verified by the following table:

Sales VoiL!me
Percent of
Percent Expectec! Increase Sales
Sales Rs100,000 Rs130,000 Rs30,000 10%

Less variable expenses 60,000 78,000 18,000 60%

Coniribu ion margin 40,000 52,000 12,000 40%

Less lixed. expenses 35,000 35,000 0

Nei operaiing. income 5,000 17,ooo- 12,000

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

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*Expected net operating income of Rs17,000 can also be calculated directly by using
the following formula:
[P*= (Sales x CM ratio)- Fixed Cost]
Notes
P* = Profit
Example:
Sales= Rs5,000,000
CM = 0.40
Fixed cost= Rs1,600,000
Calculate Profit.
Solution:
P = (Sales x CM ratio) -Fixed Cost
P = (Rs5,000,000 x 0.4)- Rs1,600,000
P = Rs2,000,000- Rs1,600,000
= Rs400,000
Example:
A company has budgeted sales of Rs200,000, a profit of Rs60,000 and fixed expenses
of Rs40,000.
Calculate contribution margin ratio.
Solution:
P =(Sales x CM ratio)- Fixed Cost
Rs60,000 = (Rs200,000 x CM ratio)- Rs40,000
Rs60,000 + Rs40,000 = (Rs200,000 x CM ratio)
CM ratio= Rs100,000 I Rs200,000
= 0.5
Some managers prefer to work with the contribution margin ratio rather than the unit
contribution margin. The CM ratio is particularly valuable in situations where trade-
offs must be made between more Rs sales of one product versus more Rs sales of
another. Generally speaking, when trying to increase sales, products that yield the
greatest amount of contribution margin per Rs of sales should be emphasized

4. Applications of Cost Volume Profit (CVP) Concepts: Now we can explain how
CVP concepts developed on above pages can be used in planning and decision
making. We shall use these concepts to show how changes in variable costs, fixed
costs, sales price, and sales volume effect contribution margin and profitability of
companies in a variety of situations. Change in fixed cost and sales volume

Change in variable cost and sales volume

Change in fixed cost, sales price and sales volume
Change in variable cost, fixed cost, and sales volume
Change in regular sales price

Cost volume profit analysis (CVP analysis) can be used to help find the most
profitable combination of variable costs, fixed costs, selling price, and sales volume.
Profits can sometimes be improved by reducing the contribution margin if fixed costs
can be reduced by a greater amount. More commonly, however, we have seen that the
way to improve profits is to increase the total contribution margin figure, Sometimes this
can be done by reducing the fixed costs (such as advertising) and thereby increasing
volume; and some times it can be done by trading off variable and fixed costs with
appropriate changes in volume. Many other combinations of factors are possible.

13.7 Break Even Analysis:

break even is the level of sales at which the profit is zero. Cost volume profit
analysis is some time referred to simply as break even analysis. This is unfortunate
because break even analysis is only one element of cost volume profit analysis. Break

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even analysis is designed to answer questions such as "how far sales could drop
Notes before the company begins to lose money." break even point analysis (calculation by
contribution margin and equation method)

Target profit analysis

Margin of safety
Sales Mix and Break Even with Multiple Products

1. Definition of Break Even point:

Break even point is the level of sales at which profit is zero. According to this
definition, at break even point sales are equal to fixed cost plus variable cost. This
concept is further explained by the the following equation:

[Break even sales = fixed cost+ variable cost]

The break even point can be calculated using either the equation method or
contribution margin method. These two methods are equivalent.

Equation Method:

The equation method centers on the contribution approach to the income

statement. The format of this statement can be expressed in equation form as follows:

[Profit= (Sales" Variable expenses)" Fixed expenses]

Rearranging this equation slightly yields the following equation, which is widely used
in cost volume profit (CVP) analysis:

[Sales = Variable expenses + Fixed expenses + Profit]

According to the definition of break even point, break even point is the level of sales
where profits are zero. Therefore the break even point can be computed by finding that
point where sales just equal the total of the variable expenses plus fixed expenses and
profit is zero.

Example:

For example we can use the following data to calculate break even point.
Sales price per unit = Rs250
variable cost per unit = Rs150
Total fixed expenses = Rs35,000

Calculate break even point

Calculation:
Sales= Variable expenses+ Fixed expenses+ Profit
Rs250Q* = Rs150Q* + Rs35,000 + RsO**
Rs1OOQ = Rs35000
Q = Rs35,000 /Rs100
Q = 350 Units
Q* = Number (Quantity) of units sold.
**The break even point can be computed by finding that point where profit is zero

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The break even point in sales Rs can be computed by multiplying the break even
level of unit sales by the selling price per unit. Notes
350 Units x Rs250 Per unit= Rs87,500

2. Contribution Margin Method:

The contribution margin method is actually just a short cut conversion of the
equation method already described. The approach centers on the idea discussed
earlier that each unit sold provides a certain amount of contribution margin that goes
toward covering fixed cost. To find out how many units must be sold to break even,
divide the total fixed cost by the unit contribution margin.
Break even point in units = Fixed expenses I Unit contribution margin
Rs35,000 I Rs100* per unit
350 Units
*S250 (Sales) " Rs150 (Variable exp.)

A variation of this method uses the Contribution Margin ratio (CM ratio) instead of
the unit contribution margin. The result is the break even in total sales Rs rather than
in total units sold.

Break even point in total sales Rs = Fixed expenses I CM ratio

Rs35,000 I 0.40
= Rs87,500

This approach is particularly suitable in situations where a company has multiple

products lines and wishes to compute a single break even point for the company as a
whole.

The following formula is also used to calculate break even point

Break Even Sales in Rs = [Fixed Cost /1 -(Variable Cost I Sales)]
This formula can produce the same answer:
Break Even Point= [Rs35,000 I 1- (150 I 250)]
= Rs35,000 I 1 - 0.6
= Rs35,000 I 0.4
= Rs87,500

13.7 Benefits I Advantages of Break Even Analysis:

The main advantages of break even point analysis is that it explains the
relationship between cost, production, volume and returns. It can be extended to show
how changes in fixed cost, variable cost, commodity prices, revenues will effect profit
levels and break even points. Break even analysis is most useful when used with
partial budgeting, capital budgeting techniques. The major benefits to use break even
analysis is that it indicates the lowest amount of business activity necessary to prevent
losses.

1. Assumption of Break Even Point:

The Break-even Analysis depends on three key assumptions:

(a) Average per-unit sales price (per-unit revenue):

This is the price that you receive per unit of sales. Take into account sales
discounts and special offers. Get this number from your Sales Forecast. For non-unit

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160 Accounting for Managers

based businesses, make the per-unit revenue Rs1 and enter your costs as a percent of
Notes a Rs. The most common questions about this input relate to averaging many different
products into a single estimate. The analysis requires a single number, and if you build
your Sales Forecast first, then you will have this number. You are not alone in this,
the vast majority of businesses sell more than one item, and have to average for their
Break-even Analysis.

(b) Average per-unit cost:

This is the incremental cost, or variable cost, of each unit of sales. If you buy goods
for resale, this is what you paid, on average, for the goods you sell. If you sell a service,
this is what it costs you, per Rs of revenue or unit of service delivered, to deliver that
service. If you are using a Units-Based Sales Forecast table (for manufacturing and
mixed business types), you can project unit costs from the Sales Forecast table. If you
are using the basic Sales Forecast table for retail, service and distribution businesses,
use a percentage estimate, e.g., a retail store running a 50% margin would have a per-
unit cost of .5, and a per-unit revenue of 1.

(c) Monthlyfixed costs:

Technically, a break-even analysis defines fixed costs as costs that would continue
even if you went broke. Instead, we recommend that you use your regular running fixed
costs, including payroll and normal expenses (total monthly Operating Expenses). This
will give you a better insight on financial realities. If averaging and estimating is difficult,
use your Profit and Loss table to calculate a working fixed cost estimate-it will be a
rough estimate, but it will provide a useful input for a conservative Break-even Analysis.

13.8 Summary
The variable costing is a better tool for decision making. It is best suited to the
analysis of one product at a time. The only limitation one can face is that It may be
difficult to classify a cost as all variable or all fixed; and there may be a tendency to
continue to use a break even analysis after the cost and income functions have
changed.

Check Your Progress

1. Variable costing is some time referred to as .................or ......................

2.. Absorption costing includes all costs of production as product costs, therefore it is
frequently referred to as ............. method.

3. Contribution Margin = Sales - .....................

4. PIV Ratio is a ratio between ....................... and Sales.

5. At break even point , Profit is equal to .........................

6. Margin of Safety is the difference between Actual Sales and ...................

7. The break even point can be calculated using either the ...... .... or contribution
margin method.

8. If the Fixed Cost is Rs 20000 and Profit is Rs 10000 and Sales is Rs 50000 , what
is PIV Ratio.

9. In long run even fixed cost can be ..................... ..

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Accounting for Managers 161
10.. The major benefits to use break even analysis is that it indicates the ............... of
business activity necessary to prevent losses. Notes
Questions and Exercises
1. Differentiate between direct costs and direct costing.

2. Distinguish between period costs and product costs.

3. Why does the direct costing or variable costing theorist exclude fixed manufacturing
costs from inventories?

4. In the process of determining a proper sales price, what kind of cost figures are
likely to be most helpful?

5. Why is it said that an income statement prepared by the direct costing procedure is
more helpful to management than an income statement prepared by the absorption
costing method?_

6. A manufacturing concern follows the practice of charging the cost of direct materials
and direct labor to work in process but charges off all indirect costs (factory
overhead) directly to income summary. State the effects of this procedure on the
concern's financial statements and comment on the acceptability of the procedure
for use in preparing financial statements.

7. List the arguments for and against the use of direct costing.

8. Voltar Company manufactures and sells a telephone answering machine. The

company's contribution format income statement for the most recent year is given
below:

Calculate break even point both in units and sales Rs.

Percent
Total Per nit
of sales
Sales Rs1,200,000 Rs60 100%
Less variable expenses 900,000 45 ?%

Contribution margin 300,000 15 ?%

Less fixed expenses 240,000 ------ ------
Net operating income Rs60,000
------

Further Readings
1. Horngren.C.T., Accounting For Management Control -An Ntroduction, Englewood
Cliffs, Prentice Hall, 1965.

2. Maheswari, S.N., Management Accounting, Sultan Chand & Sons, New Delhi.

3. Hingorani, Ramanathan & Grewal, Management Accounting.

4. Jain S.P. And Narang, K.L., Cost Accounting

Amity Directorate of Distance and Online Education

 Unit-14 : Budgeting
Notes
Structure
14.1 Introduction
14.2 Budgeting Process
14.3 Budget Responsibilities
14.4 Types of Budget
14.5 Additional Concepts in Budgeting
14.6 Best Practices in Budgeting
14.7 Summary

Objectives
Understand why organizations budget and the processes they use to create
budgets.

Understand about various kinds of budgets.

Understand about Zero Based Budgeting

14.11ntroduction
Budgets are important tools of profit planning, are similar to the broader system of
planning in an organization. Planning involves the specification of the objectives that the
organization will pursue and the fundamental policies that will enable the organization
to achieve the predetermined goals. Business budgeting is one of the most powerful
financial tools available to any small-business owner. Put simply, maintaining a good
short- and long-range financial plan enables you to control your cash flow instead of
having it control you.The most effective financial budget includes both a short-range,
month-to-month plan for at least one calendar year and a long-range, quarter-to-quarter
plan you use for financial statement reporting. It should be prepared during the two
months preceding the fiscal year-end to allow ample time for sufficient information-
gathering. The long-range plan should cover a period of at least three years (some go
up to five years) on a quarterly basis, or even an annual basis. The long-term budget
should be updated when the short-range plan is prepared.

While some owners prefer to leave the one-year budget unchanged for the year for
which it provides projections, others adjust the budget during the year based on certain
financial occurrences, such as an unplanned equipment purchase or a larger-than-
expected upward sales trend. Using the budget as an ongoing planning tool during a
given year certainly is recommended. However, here is a word to the wise: Financial
budgeting is vital, but it's important to avoid getting so caught up in the budget process
that you forget to keep doing business.

14.2 Budgeting Process

The Planning/ Budgeting process involves four stages. They are:

1. Objective Determination Stage. The first stage is setting the 'Objectives' which are
defined as the 'broad and long- range desired state or position in the future'. They
are motivational or directional in nature and are expressed in Qualitative terms.

2. Goal Determination Stage. The second stage is specifying the goals. The term
goal represents targets, specific in quantitative terms to be achieved in a specific

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10.. The major benefits to use break even analysis is that it indicates the ...... of
and machinery and expected rate of return are examples of time and quantity Notes
oriented goals.

3. Strateav Formulation Stage. The next step involves laying down the strategies.
strategies denote specific methods or courses of action to achieve the goals, for
instance, promotion of sales through price reduction or aggressive advertisement
and so on.

4. Budget Preparation Stage. At this stage the budgets are prepared.

14.3Budget Responsibilities
The Following diagram will indicate clarly the responsibilities related to the budgeting
in the management hierarchy.

1.S81esfll
2.Seli"g CCIS fll
3.Di woo cost flldgs
4.AcMrtisilgBud

14.4 Types Of Budget

Some of the important type of budgets are discussed below :

1. _Sales Budget. Sales budget is a functional budget. The product wise as well as
regional break up of sales estimates are incorporated in the sales budget. The
sales budget begins with the previous year actual and incorporates the likely
changes

Sales Budget - Exampie

Budget (current Budget (Previous Actual (Previous

Area Prodl!ei month) month) month)

Qiy. Price Amouni Qty. Price Amouni Qty. Price Amouni

Norih K1 6000 30 180000 5000 30 150000 5750 30 172500
K2 3250 15 48750 3000 15 45000 3500 15 52500
Tol.al 9250 228750 8000 195000 9250 225500
SOL!i.h K1 1500 30 45000 0 0 0 0 0 0
K2 6500 15 97500 6000 15 90000 6250 15 93750
Tol.al 8000 172500 6000 90000 6250 93750

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164 Accounting for Managers

2. Production Budget The production budget is prepared based on the sales estimate
Notes incorporated in the sales budget. The adjustments with respect to the opening and
closing stock positions that are policy decisions of the business are then made to
prepare the production budget.

Production Budget- Example

Iars Ju!Y Augusi Sep mber Ociober November December +oi.al

1100 1100 1700 1900 2500 2300 10600
losing. 550 850 950 1250 1150 1000 5750
1650 1950 2650 3150 3650 3300 16350
enin g 550 550 850 950 1250 1150 5300

lion 1100 1400 1800 2200 2400 2150 11050

3. Purchase Budget: The purchase budget is another functional budget that

estimates the purchase requirement of materials utilized in the production process.
The purchase budget is based on the production budget and the standard material
consumption requirement for the production estimates.

Purchase Budget-Example

Pari.iculars Maierial A Maierial B

Qiy. Price Qiy. Price
Con!';IJmntion rl11rinn thP. VP.<= r 108000 2 1620000 3
Desired closina stock 13000 2 15000 3
121000 178000
Exoected stock at commencement 12000 1.5 15000 1.5
Materials to be purchased 109000 2 163000 2

4. Expenditure Budgets
Expenditure budgets may be drafted as fixed I flexible budgets. A fixed budget is
one which is prepared keeping in mind one level of activity. It is defined as one which is
designed to remain unchanged irrespective of the level of activity attained. In contrast,
flexible budget is one which is designed to change in relation to the level of activity
attained. Flexible budgets are prepared where the nature of business is such that it is
difficult to predict the demand/sale of goods.

Expenditure Budget -Example

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,l;larticu)ars

Capaci y
p_ost.avjour FiMR .YRRGI
100%
,
70% 110%
Notes

Hours 5000 3500 5500

Wages Variable 2000 1400 2200
Repairs Semi-variable 300 205 370
Ren Fixed 350 350 350
Power Semi-variable 1180 875 1280
Supplies Variable 1200 840 1320
Supervision Semi-variable 950 600 950
Depreciaiion Semi-variable 650 650 820
Admini ra ion Fixed 80 80 80
Selling. Semi-variable 150 120 170
+oial 6860 5120 7545
Hou,rty raies 1.37 1.46 1.37

5. Cash Budget
A cash budget consolidates all the cash inflows and outflows for the business. The
cash budget is also a functional budget. The cash budget helps the business to plan the
project purchases as well as to provide for the loan requirements. The cash budgets
also help in defining the repayment plans for short and long term loans of the business.

The cash budget is based upon the business policy of holding a certain amount as
cash. This is the desired opening cash balance for the business. Accordingly, the cash
budget forecasts the loan requirements or short term investments that are to be made
with excess cash at any specific time.

Cash Budget-Example

D<:> rtil"oo brc

April May June Teial

Ooenina Balance 6000 3950 3000 6000

Recei :
Sales 14650 15650 16650 46950
Dividend income 1000 1000
Vehicle advance 9000 9000
Tolal balance 20650 28600 20650 62950
Paymenls:
rr.>rlitnr<: lo 9600 9000 9200 27800
Salary 3150 3500 3900 10550
Overheads 1950 2100 2250 6300
Plani. lnSi.allmeni 2000 2000 2000 6000
. . 10000 10000
n


. <.
' 2000 2000
Tolal Paymenls 26700 16600 19350 62650
Closing Balance 3950 3000 300 300

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166 Accounting for Managers

Notes 5. Master Budget : The overall or master budget summarizes the other functional
budgets. Consolidating the functional budgets, an income and expenditure budget
and budgeted balance sheet are prepared. The master budget is usually a one-year
budget expressing the expected asset position and capital and liability positions for
the projected year.

Master Budget- Income Statement

[], ,..,,..,,.., ... ,.,h.....,.. .. March Total

. ' .'
Sales 12000 15000 10000 37000
I ''"""'' rnc::t nf nnnrk c::n lrl 5000 7000 4300 16300
Factory overheads 2000 2000 2000 6000
Administrative overheads 1000 1000 1000 3000
Selling overheads 500 600 400 1500
NEH proiii 3500 4400 2300 10200

Master Budget-Balance Sheet

Particulars January February March Total

Capiial 80000 80000 100000 100000

Reserves 15000 17000 18000 18000

LonQ term borrowinQs 40000 50000 70000 70000

Toial 135000 147000 188000 188000
Fixed assais 86000 93000 120000 120000
c rrena
i sseis 63000 87000 91000 91000
Less:current liabilities 14000 33000 23000 23000
Working capital 49000 54000 68000 68000
Tolal assels 135000 147000 188000 188000

6.Zero Base Budgeting

Zero Base Budgeting process looks at requirements/ plans anew each year
irrespective of project continuity. These are necessarily long term project budgets. After
a budgeting system has been in operation for some time, there is a tendency for next
year's budget to be justified by reference to the actual levels being achieved at present.
In fact this is part of the financial analysis discussed so far, but the proper analysis
process takes into account all the changes which should affect the future activities of
the company. Even using such an analytical base, some businesses find that historical
comparisons, and particularly the current level of constraints on resources, can inhibit
really innovative changes in budgets. This can cause a severe handicap for the
business because the budget should be the first year of the long range plan. Thus, if
changes are not started in the budget period, it will be difficult for the business to make
the progress necessary to achieve longer term objectives.

One way of breaking out of this cyclical budgeting problem is to go back to basics
and develop the budget from an assumption of no existing resources (that is, a
zero base). This means all resources will have to be justified and the chosen way of
achieving any specified objectives will have to be compared with the alternatives. For

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Accounting for Managers 167

example, in the sales area, the current existing field sales force will be ignored, and the Notes
optimum way of achieving the sales objectives in that particular market for the particular
goods or services should be developed. This might not include any field sales force, or
a different-sized team, and the company then has to plan how to implement this new
strategy.

The obvious problem of this zero-base budgeting process is the massive amount of
managerial time needed to carry out the exercise. Hence, some companies carry out
the full process every five years, but in that year the business can almost grind to a halt.
Thus, an alternative way is to look in depth at one area of the business each year on a
rolling basis, so that each sector does a zero base budget every five years or so.

14. 5 Additional Concepts In Budgeting

So far, we have emphasized simple approaches to preparing budgets, such as
looking at relationships between account balances and sales. We also should have
a clear understanding of past financial performance to help us predict future financial
performance. Extending past trends and adjusting for what is expected is a common
approach to preparing a forecast. However, we can improve forecasting by using
several techniques. The first step is recognize certain fundamentals about forecasting:

1. Forecasting relies on past relationships and existing historical information. If these

relationships change, forecasting becomes increasingly inaccurate.

2. Since forecasting can be inaccurate due to uncertainty, we should consider

developing several forecast under different scenarios. We can assign probabilities
to each scenario and arrive at our expected forecast.

3. The longer the planning period, the more inaccurate the forecast. If we need to
increase reliability in forecasting, we should consider a shorter planning period. The
planning period depends upon how often existing plans need to be evaluated. This
will depend upon stability in sales, business risk, financial conditions, etc.

4. Forecasting of large inter-related items is more accurate than forecasting a specific

itemized amount. When a large group of items are forecast together, errors within
the group tend to cancel out. For example, an overall economic forecast will be
more accurate than an industry specific forecast.

14.6 Best Practices In Budgeting

Finally, here are some best practices that can transform budgeting into a value-
added activity:

1. Budgeting must be linked to strategic planning since strategic decisions usually

have financial implications.

2. Make budgeting procedures part of strategic planning. For example, strategic

assessments should include historical trends, competitive analysis, and other
procedures that might otherwise take place within the budgeting process.

3. The Budgeting Process should minimize the time spent collecting and gathering
data and spend more time generating information for strategic decision making.

4. Get agreement on summary budgets before you spend time preparing detail
budgets.

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168 Accounting for Managers

5. Automate the collection and consolidation of budgets within the entire organization.
Notes Users should have access to budgeting systems for easy updating.

6. Budgets need to accept changes quickly and easily. Budgeting should be a

continuous process that encourages alternative thinking.

7. Line item detail in budgets should be based on material thresholds and not rely on a
system of general ledger accounts.

8. Budgets should give lower level managers some form of fiscal control over what is
going on.

9. Leverage your financial systems by establishing a data warehouse that can be used
for both financial reporting and budgeting.

10. Multi-National Companies should have a budgeting system that can handle inter-
company elimination's and foreign currency conversions.

14.7 Summary
Financial Planning is a continuous process that flows with strategic decision making.
The Operating Plan and the Financial Plan will both support the Strategic Plan. The
best place to start in preparing a budget is with sales since this is a driving force behind
much of our financial activity. However, we have to take into account numerous factors
before we can finalize our budgets.

Budgeting should be flexible, allowing modification when something changes. For

example, the following will impact budgeting:
1. Life cycle of the business
2. Financial conditions of the business
3. General economic conditions
4. Competitive situation
5. Technology trends
6. Availability of resources
Budgeting should be both top down and bottom up; i.e. upper level management
and middle level management will both work to finalize a budget. We can streamline
the budgeting process by developing a financial model. Financial models can
facilitate "what if" analysis so we can assess decisions before they are made. This
can dramatically improve the budgeting process. One of the biggest challenges within
financial planning and budgeting is how do we make it value-added. Budgeting requires
clear channels of communication, support from upper-level management, participation
from various personnel, and predictive characteristics. Budgeting should not strive for
accuracy, but should strive to support the decision making process. If we focus too
much on accuracy, we will end-up with a budgeting process that incurs time and costs
in excess of the benefits derived. The challenge is to make financial planning a value-
added activity that helps the organization achieve its strategic goals and objectives.

Check Your Progress

1. In order for budgeting to really work, we must link the budgeting process with:
a. Financial Statements
b. Accounting Transactions
c. Strategic Planning

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Accounting for Managers 169
d. Operating Reports
2. The first forecast we will prepare for budgeting will be the: Notes
a. Budgeted Income Statement
b. Sales Forecast
c. Cash Budget
d. Budgeted Balance Sheet
3. Taylor Manufacturing has compiled the following production information for
manufacturing jugs of beverages:
Planned production is 6,000 jugs
Materials required per jug: 10 pounds of powder
Desired Ending Inventory for Materials: 4,000 pounds
Beginning Inventory for Materials: 3,000 pounds
Purchase Cost for Materials: Rs 2.00 per pound
Based on the above information, what is the total cost for planned materials
purchased?
a. Rs 110,000
b. Rs 120,000
c. Rs 122,000
d. Rs128,000
4. Which of the following detail budgets will help us prepare the Budgeted Income
Statement?
a. Direct Labor Budget
b. Cash Budget
c. Budgeted Balance Sheet
d. Year End Balance Sheet
5. If accounts payable have historically been 20% of sales and we have estimated
sales of Rs 200,000, than estimated accounts payable must be:
a. Rs 10,000
b. Rs 20,000
c. Rs 30,000
d. Rs 40,000
6. Which budget is prepared for determining how much external financing we will need
to support estimated sales?
a. Cash Budget
b. Budgeted Income Statement
c. Budgeted Balance Sheet
d. Sales Forecast
7. A good place to start in preparing the Budgeted Balance Sheet is with the main link
between the Income Statement and the Balance Sheet. This link is:
a. Cash
b. Retained Earnings
c. Current Assets
d. Long Term Liabilities
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170 Accounting for Managers

8. One way to improve the budgeting process is to include qualitative techniques into
Notes forecasting. Which of the following is an example of a qualitative technique?
a. 5 Year Trend Analysis
b. Ratio Analysis
c. Percent of Sales Method
d. Interviewing the President of the Company

9. Statistical methods can be used to improve the accuracy of forecasting. This

approach is particularly useful for forecasting sales since we are searching for the
right fit based on several observations. One popular approach to finding the right
statistical fit is to use:
a. Exponential Smoothing
b. Regression Analysis
c. Executive Polling
d. Moving Average

10. Which of the following wiII contribute to making budgeting a non-value added
activity; i.e. the cost of budgeting exceeds the benefit?
a. The budgeting process is included within the strategic planning process.
b. Detail and Summary Budgets are prepared at the same time and are
distributed to management for approval.
c. Budgets throughout the organization are automated for enterprise-wide
consolidation.
d. Line item detail in budgets is based on material thresholds.

Questions and Exercises

1. Classic Furniture is a manufacturer of reproduction antique furniture. It is owned
by X Ltd as a sole trader business. There are four employees and annual sales
turnover is approximately Rs 200,000 per year.

Required
(a) Explain two benefits of budgetary control to X Ltd.
(b) Suggest three budgets which X Ltd could use in the business to provide an
adequate system of budgetary control.
(c) Advise X Ltd of the relevant factors to consider when implementing budgetary
control.

2. N Kayali, the assistant accountant at Strudwick Stationers Ltd, has obtained

the following information for the seven months ending 30 September 2002. This
information is to be used to prepare a cash budget for the four months ending 31
August 2002.
(a) Actual sales were Rs44,000 and Rs46,000 for March and April 2002
respectively.
(b) Total forecast sales at the end of each of the next five months are expected to
be:
2002

May June July Aug Sep

Rs Rs Rs Rs Rs
44,000 46,000 42,000 44,000 48,000

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Accounting for Managers 171
80% of each month's total forecast sales are expected to be for cash. The
debtors are expected to pay one month in arrears. Notes
(c) Purchases are expected to be 70% of the following month's total forecast sales
value and are paid for two months in arrears.

(d) The following costs are expected to be paid for in the month in which they
occur:
Wages Rs9,000 per month to 31 July 2002 and Rs9,500 per month thereafter
Fixed Costs Rs3,000 per month
Variable costs being 10% of each month's total forecast sales

(e) Thebankbalanceasat1 May2002wasRs12,100.

3. Write the short notes on the following

(a) Master Budget
(b) Cash Budget
Zero Based Techniques

4. What are the best practices in the budgeting. Explain.

Further Readings
1. Horngren.C.T., Accounting For Management Control -An Ntroduction, Englewood
Cliffs, Prentice Hall, 1965.

2. Maheswari, S.N., Management Accounting, Sultan Chand & Sons, New Delhi.

3. Hingorani, Ramanathan & Grewal, Management Accounting.

4. Jain S.P. And Narang, K.L., Cost Accounting

Amity Directorate of Distance and Online Education

 Unit-15 :Standard Costing and Variance Analysis
Notes
Structure
15.1 Introduction
15.2 Meaning of Standard Cost
15.3 Standard Costs and Estimated Costs
15.4 Concept of Standard Costing
15.5 Objectives of Standard Costing
15.6 Standard Costing and Budgeting
15.7 Advantages of Standard Costing
15.8 Limitation of Standard Costing
15.9 Establishing Standard Costing System
15.10 Revision of Standards
15.11 Variance Analysis
15.12 Types of Standards
15.12.1 Material Variances
15.12.2 Labour Variances
15.12.3 Overhead Variance
15.12.4 Sales Variance
15.13 Summary

Objectives
Objective of this Chapter is to discuss specific techniques that can be usee
by managers to gain a better understanding of why these variances occurrec
and to assist in future planning and decision making. In the previous chapte
the emphasis was on preparation of the budget, in this chapter the emphasi
is on using the information gathered through variance analysis to evaluatE
performance and provide feedback that will help in future decision making.

15.1 Introduction
One of the prime functions of management accounting is to facilitate managerial
control and the important aspect of managerial control is cost control. The efficiency of
management depends upon the effective control of costs. Therefore, it is very important
to plan and control cost. Standard costing is one of the most important tools, which
helps the management to plan and control cost of business operations. Under standard
costing, all costs are pre-determined and pre determined costs are then compared with
the actual costs. The difference between pre-determined costs and the actual costs is
known as variance which is analyzed and investigated to the reasons. The variances
are then reported to management for taking remedial steps so that the actual costs
adhere to pre-determined costs. In historical costing actual costs are ascertained only
when they have been incurred.They are useful only when they are compared with
predetermined costs. Such costs are not useful to management in decision-making and
cost control. Therefore, the technique of standard costing is used as a tool for planning,
decision-making and control of business operations. In this unit you will study the basic
concepts of standard costing.

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15.2 Meaning of Standard Cost Notes

Standard costs are predetermined cost which may be used as a yardstick to
measure the efficiency with which actual costs has been incurred under given
circumstance. To illustrate, the amount of raw material required to produce a unit of
product can be determined and the cost of that raw material estimated. This becomes
the standard material input. If actual raw material usage or costs differ from the
standards, the difference which is called 'variance' is reported to manager concerned.
When size of the variance is significant, a detailed investigation will be made to
determine the causes of variance

According to the chartered Institute of Management Accountants (C.I. M.A) London,

"Standard cost is the predetermined cost based on technical estimates for materials,
labour and overhead for a selected period of time for a prescribed set of working
conditions."

The Institute of Cost and Works Accountants defines standard costs as "Standard
costs are prepared and used to clarify the final results of a business, particularly by
measurement of variations of actual costs from standard costs and the analysis of the
causes of variations for the purpose of maintaining efficiency of executive action."

Thus standard costs is a predetermined which determines what each product or

service 'should be' under given circumstances. From the above definitions we may note
that standard costs are:

1. Pre-determined cost: Standard cost is always determined in advance and ahead of

actual point of time of incurring of costs.

2. Based on technical estimated: Standard cost is determined only on the basis of a

technical estimate and on a rational basis.

3. For the purpose of Comparison: The very purpose of standard cost is to aid the
comparison with actual costs.

4. Based for price fixing: The prices are fixed in advance and hence the only variation
basis is the standard cost.

15.3Standard Cost and Estimated Costs

Estimates are predetermined costs which are based on historical data and is
often not very scientifically determined. They usually compiled from loosely gathered
information and therefore, they are unsafe to use them as a tool for measuring
performance. Standard costs are predetermined costs which aims at what the cost
should be rather then what it will be. Both the standard costs and estimated costs are
used to determine price in advance and their purpose is to control cost. But, there are
certain differences between these two costs as stated below:

Differences Between Standard Costs And Estimated Costs:

The following are some of the important differences between standard cost and
estimated cost:

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174 Accounting for Managers

Standard Cost Estimated Cost

Notes Standard cost emphasizes as what the Coal Estimated cost emphasizes on what the cost
'should be' in a given set of situations. 'will be'.
Standard costs are planned costs which are Estimated costs are determined by taking into
determined by technical experts after consideration the historical data as the basis
considering levels of efficiency and production and adjusting it to future trends.
It is used as a devise for measuring efficiency It cannoi be used as a devise to determine
eUiciency.It only determines expected costs.
Standard cosm serve 'he pu_rpose oco& Estimated costs do not serve the purpose of
control cost control.
Standard cosiing is part cost accou!1ting Estimated costs are statistical in nature and
process may not become a part of accounting.
It is a technique developed and recognised by It is just an estimate and not a technique
management and academecians
I' can be used where standard cosiing is in It may be used in any concern operating on a
opera4ion historicalcost system.

15.4Concept of Standard Costing

Standard costing is a technique used for the purpose of determining standard cost
and their comparison with the actual costs to find out the causes of difference between
the two so that remedial action may be taken immediately. The Charted Institute of
Management Accountants, London, defines standard costing as "the preparation of
standard costs and applying them to measure the variations from actual costs and
analysing the causes of variations with a view to maintain maximum efficiency in
production".

Thus, standard costing is a technique of cost accounting which compares the

'standard cost' of each product or service, with the actual cost, to determine the
efficiency of the operation. When actual costs differ from standards the difference is
called variance and when the size of the variance is significant a detailed investigation
will be made to determine the causes of variance, so that remedial action will be taken
immediately.

Thus, standard costing involves the following steps:

1. Setting standard costs for different elements of costs
2. Recording of actual costs
3. Comparing between standard costs and actual costs to determine the
variances
4. Analysing the variances to know the causes thereof, and
5. Reporting the analysis of variances to management for taking appropriate
actions wherever necessary.

The system of standard costing can be used effectively to those industries which are
producing standardised products and are repetitive in nature. Examples are cement
industry, steel industry, sugar industry etc. The standard costing may not be suitable
to jobbing industries because every job has different specifications and it will be difficult
and expensive to set standard costs for every job. Thus, standard costing is not
suitable in situations where a variety of different kinds of tasks are being done.

15.50bjectives of Standard Costing

1. Cost Control: The most important objective of standard cost is to help the
management in cost control. It can be used as a yardstick against which actual

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costs can be compared to measure efficiency. The management can make
comparison of actgual costs with the standard costs at periodic intervals and take Notes
corrective action to maintain control over costs.

2. Management by Exception: The second objective of standard cost is to help the

management in exercising control over the costs through the principle of exception.
Standard cost helps to prescribe standards and the attention of the management is
drawn only when the actual performance is deviated from the prescribed standards.
It concentrates its attention on variations only.

3. Develops Cost Conscious Attitude: Another objective of standard cost is to make

the entire organisation cost conscious. It makes the employees to recognise the
importance of efficient operations so that costs can be reduced by joint efforts.

4. Fixation of Prices: To help the management in formulating production policy

and helps in fixing the price quotations as well as in submitting tenders of various
products. This can be done with accuracy with standard cost than the actual
costs. It also helps in formulating production policies. Standard costs removes the
reflection of abnormal price fluctuations in production planning.

5. Fixing Prices and Formulating Policies: Another object of standard cost is to help
the management in determining prices and formulating production policies. It also
helps the management in the areas of profit planning, product-pricing and inventory
pricing etc.

6. Management Planning: Budget planning is undertaken by the management at

different levels at periodic intervals to maximise the profit through different product
mixes. For this purpose it is more convenient using standard costing than actual
costs because it is done on scientific and rational manner by taking into account all
technical aspects.

15.6Standard Costing and Budgeting

Budgeting may be defined as the process of preparing plans for future activities
of the business enterprise after considering and involving the objectives of the said
organisation. This also provides process/steps of collection and preparation of data,
by which deviations from the plan can be measured. This analysis helps to measure
performance, cost estimation, minimizing wastage and better utilisation of resources
of the organisation. Thus, budgets are prepared on the basis of future estimated
production and sales in order to find out the profit in a specified period. In other words
Budget is an estimate and a quantified plan for future activities to coordinate and control
the uses of resources for a specified period. According to Institute of Cost and Works
Accountants, "A budget is a financial and I or quantitative statement prepared prior to a
defined period of time, of the Policy to be pursued during that period for the purpose of
attaining a given objective." Budgeting is a process which includes both the functions of
budget and budgetary control. Budget is a planning function and budgetary control is a
controlling system or a technique.

The objective of the standard costing and budgeting is to achieve maximum

efficiency and cost control. Under both the systems actual performance is compared
with predetermined standards, deviations, if any, are analysed and reported. Budgeting
is essential to determine standard costs while standard costing is necessary for
planning budgets. Both are complimentary in nature and in determining the results.
Besides similarities there are certain differences between standard costing and
budgeting which are as follows:

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t;:mrl;: rrl r>n,::tinn R11rtn"tinn

Notes 1. Standard costing is based on 1. It is based on standard cost, historical costs
technical information and is ixed and estimates.
scientifically.

2. Standard costs are used mainly for 2. Budgets are prepared for different functional
the manufacturing function and also departments such as sales, purchase,
for marketing and administration production, finance, personnel department.
functions. Therefore, it does not Therefore, it requires functional coordination.
require functionalcoordination.

3. Standard costs emphasises the cost 3. Budgets emphasises cost levels which
levels which should be reduced should not be exceeded.

4. In standard costing variances are 4. In Budgeting, variances are not revealed

usually revealed through accounts. through accounts and control in exercised by
putting budgeted figures and actuals side by
side.

5. In standard cos4ing, a delailed 5. No further analysis is reo jred. i cos4s are

analysis is needed in ca.Se a. within the budget.
variances.

6. Standard costing sets realstic 6. Budgets generally set maximum limits o.l
yardsticks and therefore, it is more expenditure without considering ihe
useful for controlling and reducing effectiveness of expenditure.
costs.

1. Standard cost is revised only when 7. Budgeting is done before ihe beginning o+
there is a change in the basic each accountn
i g period.
assumptions and basis.

e. Standard costs are based on 4he e. Budgets are set on the basis of present level
basis of standards set by of efficiency.
management.

9. Standard costing cannot be used 9. Budgeting can be done either wholly or partly.
partially. Standards will have to be
set for all elements of cost.

10. Standard cost is a projection of cost 10. Budgeting is a projection of financialaccounts.

accounts.

15.7 Advantages of Standard Costing

The introduction of Standard Costing system may offer many advantages. It varies
from one business to another. The following advantages may be derived from standard
costing in the light of the various objectives of the system:

1. To measure efficiency: Standard Costs provide a yardstick against which actual

costs can be measured. The comparison of actual costs with the standard cost
enables the management to evaluate the performance of various cost centres.
In the absence of standard costing, efficiency is measured by comparing actual
costs of different periods which is very difficult to measure because the conditions
prevailing in both the periods may differ.

2. To fix prices and formulate policies: Standard costing is helpful in determining

prices and formulating production policies. The standards are set by studying all
the existing conditions. It also helps to find out the prices of various products. It
helps the management in the formulation of production and price policies in
advance and also in the areas of profit planning product pricing, quoting prices of
tenders. It also helps to furnish cost estimates while planning production of new
products.

3. For Effective cost control: One of the most advantages of standard costing is
that it helps in cost control. By comparing actual costs with the standard costs,

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variances are determined. These variances facilitate management to locate
inefficiencies and to take remedial action against those inefficiencies at the earliest. Notes
4. Management by exception: Management by exception means that each
individual is fixed targets and every one is expected to achieve these given targets.
Management need not supervise each and everything and need not bother if
everything is going as per the targets. Management interferes only when there
is deviation. Variances beyond a predetermined limit may be considered by the
management for corrective action. The standard costing enables the management
in determining responsibilities and facilitates the principle of management by
exception.

5. Valuation of stocks: Under standard costing, stock is valued at standard cost and
any difference between standard cost and actual cost is transferred to variance
account. Therefore, it simplifies valuation of stock and reduces lot of clerical work
to the minimum level.

6. Cost consciousness: The emphasis under standard costing is more on cost

variations which makes the entire organisation cost conscious. It makes the
employees to recognise the importance of efficient operations so that efforts will be
taken to reduce the costs to the minimum by collective efforts.

7. Provides incentives: Under standard costing system, men, material and machines
can be used effectively and economies can be effected in addition to enhanced
productivity. Schemes may be formulated to reward those who achieve targets. It
increases efficiency, productivity and morale of the employees.

15.8 Limitations of Standard Costing

In spite of the above advantages, standard costing suffers from the following
disadvantages:

1. Difficulty in setting standards: Setting standards is a very difficult task as it

requires a lot of scientific analysis such as time study, motion study etc. When
standards are set at high it may create frustration in the minds of workers.
Therefore, setting of a correct standards is very difficult.

2. Not suitable to small business: The system of standard costing is not suitable to
small business as it requires lot of scientific study which involves cost. Therefore,
Small firms may find it very difficult to operate the system.

3. Not suitable to all industries: The standard costing is not suitable to those
industries which produces non-standardised products and also not suitable to job
or contract costing. Similarly, the application of standard costing is very difficult to
those industries where production process takes place more than one accounting
period.

4. Difficult to fix responsibility: Fixing responsibility is not an easy task. Variances

are to be classified into controllable and uncontrollable variances because
responsibility can be fixed only in the case of controllable variances. It is difficult
to classify controllable and uncontrollable variances for the variance controllable
at one situation may become uncontrollable at another time. Therefore, fixing
responsibility is very difficult under standard costing.

5. Technological changes: Standard costing may not be suitable to those industries

which are subject to frequent technological changes. When there is a change in

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the technology, production process will require a revision of standard. Frequent

Notes revision of standards is a costly affair and therefore, the system is not suitable for
industries where methods and techniques of production are subject to fast changes.

In spite of the above limitations, standard costing is a very useful technique in cost
control and performance evaluation. It is very useful tool to the industries producing
standardised products which are repetitive in nature.

15.9 Establishing Standard Costing System

In establishing a system of the standard costing, there are a number of preliminaries
which are to be considered. These include:

1. Establishment of Cost Centres

2. Classification of Accounts

3. Types of Standards

4. Setting Standard Costs

Let us study the above in detail

1. Establishment of Cost Centres: A cost centre is a location, person or an item of

equipment (or group of these) in respect of which costs may be ascertained and
related to cost units. A centre which relates to persons is referred to as a personal
cost centre and a centre which relates to location or to equipment as an impersonal
cost centre. Cost centres are set up for cost ascertainment and cost control. While
establishing cost centres it should be noted that who is responsible for which
cost centre. In many cases each department or function will form a natural cost
centre but there may also have a number of cost centres in each department or
function. For example, there may be six machines in a manufacturing department,
each machine may be classified as a cost centre. Cost centres are essential for
establishing standards and analysing the variances.

2. Classification of Accounts: Accounts are classified to meet a required purpose.

Classification may be by function, revenue item or asset and liabilities item. Codes
and symbols are used to facilitate speedy collection and analysis of accounts.

3. Types of Standards: The standard is the level of attainment accepted by

management as the basis upon which standard costs are determined. The
standards are classified mainly into four types. They are:

(a) Ideal Standard: The ideal standard is one which is set up under ideal
conditions. The ideal conditions may be maximum output and sales, best
possible prices for materials, most satisfactory rates for labour and overhead
costs. As these conditions do not continue to remain ideal, this standard is of
little practical value. It does provide a target or incentive for employees, but is
usually unattainable in practice.

(b) Expected Standard: This is the standard which is actually expected to be

achieved in the budget period, based on current conditions. The standards
are set on expected performance after allowing a reasonable allowance for
unavoidable losses and lapses from perfect efficiency. Standards are normally
set on short term basis and requires frequent revision. This standard is more
realistic than ideal standard.

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(c) Normal Standard: This represents an average figure based on the average
performance of the past after taking into account the fluctuations caused by Notes
seasonal and cyclical changes. It should be attainable and provides a challenge
to the staff.

(d) Basic Standard: This is the level fixed in relation to a base year. The principle
used in setting the basic standard is similar to that used in statistics when
calculating an index number. The basic standard is established for a long period
and is not adjusted to the present conditions. It is just like an index number
against which subsequent price changes can be measured. Basic standard
enables to measure the changes in cost. It serves as a tool for cost control
purpose because the standard is not revised for a long period. But it cannot be
used as a yard stick for measuring efficiency.

4. Setting Standard Costs: The success of a standard costing system depends

upon the reliability and accuracy of the standards. Therefore, every case should
be taken into account while establishing standards. The number of people involved
with the setting of standards will depend on the size and nature of the business.
The responsibility for setting standards should be entrusted to a specific person.
In a big concern a Standard Costing Committee is formed for this purpose. The
committee consists of Production Manager, Personnel Manager, Production
Engineer, Sales Manager, Cost Accountant and other functional heads. The cost
accountant is an important person, who has to supply the necessary cost figures
and coordinate the activities of budget committee. He must ensure that the
standards set are accurate and present the statements of standard cost in most
satisfactory manner.

Standard costs are set for each element of cost i.e., direct materials, direct labour
and overheads. The standards should be set up in a systematic manner so that they
can be used as a tool for cost control. Briefly, standard costs will be set as shown
below:

(a) Standard Cost for Direct Materials:

If material is used for manufacturing a product it is known as direct material. Direct
material cost involves two things (a) Quantity of materials and (b) Price of materials.
Firstly , while setting standard for quantity of material, the quality and size of the material
should be determined. The standard quantity of material required for producing a
product is decided by the technical experts in the production department. While fixing
standard for material quantity, a proper allowance should be given to normal loss of
materials. Normal loss will be determined after careful analysis of various factors.
Secondly , standard price for the material is to be determined. Setting standard price for
material is difficult because the prices are regulated more by the external factors than
the company management. Before fixing the standard, factors like prices of materials
in stock, price quoted by suppliers, forecast of price trends, the price of materials
already contracted, provision for discounts, packing and delivery charges etc., should
be considered.

(b) Setting Standards for Direct material:

The labour involved in manufacture of a product is known as direct labour. The
wage paid to such workers is known as direct wages. The time required for producing
a product should be ascertained and labour should be properly graded. Setting of
standard cost of direct labour involves fixation of standard time and fixation of standard
rate. Standard time is fixed by time or motion study or past records or estimates. While
fixing standard time normal ideal time is to be allowed for normal delays, idle time, other
contingencies etc. The labour rate standard refers the wage rate applicable to different
categories of workers. Fixation of standard rate will depend upon various factors take

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demand for labour, policy of the organisation, influence of unions, method of wage
Notes payment etc. If any incentive scheme is in operation then anticipated extra payment
to the workers should also be included in determining standard rate. The Accountant
will determine the standard rate with the help of the Personnel Manager,. The object of
fixing standard time and labour rate is to get maximum efficiency in the use of labour.

(c) Setting Standards for Direct Expenses

Direct expenses are those expenses which are specifically incurred in connection
with a particular job or cost unit. These expenses are also known as chargeable
expenses. Standards for these expenses must also be determined. Standards for
these may be based on past performance records subject to anticipatory changes
therein.

(d) Setting Standards for Overheads

Indirect costs are called overheads. These costs are those which cannot be
assigned to any particular cost unit and are incurred for the business as a whole. The
overheads are classified into fixed, variable and semi-variable overheads. Standard
overhead rate is determined for these on the basis of past records and future trend of
prices. It will be calculated per unit or per hour. Setting standard for overhead cost
involves the following two steps:
a) Determination of the standard overhead costs, and
b) Determination of the estimates of production
Standard overhead for the period
Standard overhead rate (per hour) = ------------
Standard hours for the period

or
Standard overhead for the period
Standard overhead rate (per hour) = ----------------
Standard production (in units) for the period

The purpose of setting standard overhead rate is to minimise overhead costs.

Overhead rates are more useful to the management if they are divided into fixed and
variable components. When overheads are divided into fixed and variable, separate
overhead absorption rates are to be calculated with the help of the following formulae:

Standard Variable Overhead for the Period

Standard Variable Overhead Rate= ------------------
Standard Production (in Units or Hours) for the Period

Standard Fixed Overhead for the Period

Standard Fixed Overhead Rate
Standard Production (in Units or Hours) for the Period

Standard Hour
Production may be expressed in different units of measurement such as kilos,
tones, litres, numbers etc. When a concern produces different types of products, the
production will be expressed in different units. It is difficult to aggregate the production
which is expressed in different units. To over come this difficulty, the production is to
be expressed in a common measure known as ' Standard Hour'. The standard hour
is the quantity of output which should be produced in one hour. A standard hour may
be as "A hypothetical hour which represents the amounts of work which should be
performed in one hour under stated conditions." A measure of standard hour is useful
for the purpose of comparison of performance of one department to another. It is also

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useful to compute efficiency and activity ratios. For example if 20 units of product A are
produced in 2 hour, and 40 units of product B are produced in 5 hours, the standard Notes
hours represent 10

20 Units 40 Units
units of product A(----)and 8 units of product B (-----). Therefore,
standard
2 hrs 5 hrs

hour is the quantity of production of a given product for one clock hour.

15.10 Revision of Standards

Standard cost is based on a number of factors. These factors some may be internal
or external may vary from time to time depending upon different situations. Standard
cost may become unrealistic if it is not revised according to the changed circumstances.
Then a question arises what would be the period in which standards should be set? If
the standard is set for a shorter period it is expensive and frequent revision of standards
will impair the utility and purpose of the standard cost. If the standard is set for a longer
period it may not be useful particularly during periods of high inflation and rapidly
changing technological environment. Therefore, standards are normally set for a fixed
period of one year and revised annually at the beginning of accounting period. If there
are major changes, a revision may also be required within the accounting period. If
there are minor changes, the causes of difference between actual and standards may
be explained without being revised the standards. There are certain conditions which
necessitate the revision of standard costs. These conditions are:
i) Changes in price levels of materials, labour and overheads
ii) Technological changes
iii) Changes in production methods or product mixes
iv) Changes in plant capacity utilization
v) Errors discovered in setting standards
vi) Changes in designs or specification
vii) Changes in the policy of organisation
viii) Changes in government policy affecting the product or organisation, etc.

15.11 Variance Analysis

Variance Analysis and performance reports are important elements of management
by exception. Simply put, management by exception means that the manager's
attention should be directed toward those parts of the organization where plans are not
working out for reason or another. Time and effort should not be wasted focusing on
those parts of the organization where things are going smoothly. If all goes according
to plans, there will be little difference between actual results and the results that would
be expected according to the budgets and standards. If this happens, managers can
concentrate on other issues. However, if actual results do not conform to the budget
and to standards, the performance reporting system sends a signal to the management
that an "exception" has occurred. This signal is in the form of a variance from the
budget or standards.

However, are all variances worth investigating? The answer is no. Differences
between actual results and what was expected will almost always occur. If every
variance were investigated, management would waste a great deal of time tracking
down nickel-and-dime differences. Variances may occur for any of a variety of reasons

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182 Accounting for Managers

- only some of which are significant and warrant management attention. For example,
Notes hotter than normal weather in the summer may result in higher than expected electrical
bills for air conditioning. Or, workers may work slightly faster or slower on a particular
day. Because of unpredictable random factors, one can expect that virtually every cost
category will produce a variance of some kind.How should managers decide which
variances are worth investigating? One clue is the size of the variance. A variance of
Rs5 is probably not big enough to warrant attention, whereas a variance of Rs5000
might well be worth tracking down. Another clue is the size of the variance relative to
the amount of spending involved. A variance that is only 0.1% of spending on an item is
likely to be well within the bounds one would normally expect due to random factors. On
the other hand, a variance of 10% of spending is much more likely to be a signal that
something is basically wrong.

A more dependable approach is to plot variance data on a statistical control chart,

The basic idea underlying a statistical control chart is that some random fluctuations
in variances from period to period are normal and to be expected even when costs are
well under control. A variance should only be investigated when it is unusual relative to
that normal level of random fluctuation. Typically the standard deviation of the variance
is used as the measure of the normal level of fluctuations. A rule of thumb is adopted
such as "investigate all variances that are more than X standard deviations from zero."
In the control chart in example below, X is 1.0. That is the rule of thumb in this company
is to investigate all variances that are more than one standard deviation in either
direction (favorable or unfavorable) from zero. This means that the variances in weeks
7, 11, and 17 would have been investigated, but none of others.

.
Fav. . +1
Standard
deviation

Var.
D
Unf
av.
. . -1
Standard
deviation

1 2 3 Li s e 7 8 9 10 1 1 1 1 1 1 1 1 1
1 2 3 lj 5 6 7 8 9
Week

What value of X (standard deviation) should be chosen? The bigger the value of
X, the wider the band of acceptable variances that would not be investigated. Thus
the bigger the value of X, the less time will be spent tracking down variances, but the
more likely it is that a real out of control situation would be overlooked. Ordinarily, if X is
selected to be 1.0, roughly 30% of all variances will trigger an investigation even when
there is no real problem. If X is set at 105, the figure drops to about 13%. If X is set at
2.0, the figure drops all the way to about 5%. Don't forget, however, that selecting a big
value of X will result not only in fewer investigations but also a higher probability that a
real problem will be overlooked. In addition to watching for unusually large variances,
the pattern of the variances should be monitored. For example, a run of steadily
mounting variances should trigger an investigation even though non of the variances is
large enough by itself to warrant investigation. Variance Analysis is also explained in the
chart given below.

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I Budget I Standard I Forecast

I I Actual
I Notes

- Favourable
Material > Material

( Material - Unfavourable

Labour
) Labour - Favourable
< Labour - Unfavourable

) Overhead - Favourable
Overhead
( Overhead - Unfavourable
( Sales - Favourable
Sales
) Sales - Unfavourable

15.12 Types Of Variances

Now let us discuss about these variances in the brief

14.12.1 Material Variances

1. Material Cost Variance

Material cost variance represents the difference between the actual material value
and standard material value for a given output The formula for the measurement of
material cost variance (MCV) will be:

MCV = (SP x SQ)- ( APx AQ)

Where: SP-Standard price, SO-Standard quantity,
AP-Actual price, AQ-Actual quantity.

2. Material Price And Usage Variances

Material price variance captures that part of cost variance which is due to the
difference in price per unit of materials. The formula for the measurement of material
price variance (MPV) will be:

MPV = (SP- AP) x AQ.

Material usage variance is that part of cost variance which is due to the difference in
the utilization of material quantity. The formula for the measurement of material usage
variance (MUV) will be:

MUV = (SQ- AQ) x SP

Where SP-Standard price, SQ-Standard quantity, AP-Actual price, AQ-Actual

quantity.

Material Variance

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184 Accounting for Managers

Direct Material Variance

Notes
Material
Cost Variance (MCV)

I I
Material Material
Price Variance (MPV) Usage Variance (MPV)

Material Variance-Example
80 Kgs of material A at a standard price of Rs 2 per Kg and 40 Kgs of material Bat
a standard price of Rs 5 per Kg were to be used to manufacture 100 Kg of a chemical.
During a month 70 Kgs of material A priced at Rs 2.10 per Kg. and 50 Kg. of material
B priced at Rs 4.50 per Kg. were actually used and the output of the chemical was 102
Kgs. Find out the material variances.

Solution:
Usage

Y1eltt

//
Ra<IO sa sa 1n<cHBI AQ SP AP
1nouo
AB eo 61.6 eo 70 2 2.1
lnp
(-)Loss
Ouipui
120
20
L0.6"'
122.
20.l!
><1 QQ_
120
.1!l_
5 "l5

100 1(b 102

Total Material Cost Variance= (SO X SP) - (AQ X AP)

A=(81.6X2)-(70X2.1) = 16.2 (Favourable)
B = (40.8 X 5)- (50 X 4.5) = .21_ (Adverse)
4.8 (Adverse)

Material Price Variance = (SP - AP)AQ

A = (2-2.1) 70 = 7 (Adverse)
B = (5-4.5) 50 = 25 (Favourable)
.1. (Favourable)

Material usage variance = (SO- AQ) SP

A = (81 6-70) 2 = 23.2 (Favourable)
B = (40.8- 50) 5 = 46 (Adverse)
22.8 (Adverse)

Material yield variance/Sub usage variance = (SQ- SQ in total input)SP

A = (81 6- 80) 2 = 3.2 (Favourable)
B = (40.8- 40) 5 = .i_(Favourable)

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7.2 (Favourable)
Material Mix Variable = (SO in total input -AQ) SP Notes
A = (80-70)2 = 20 (Favourable)
B = (40- 50)5 = 50 (Adverse)
30 (Adverse)
Price variance occurs at the time of purchase. It occurs on the entire quantity
purchased. However, it may be calculated immediately at the time of purchase on
quantity purchased or it may be calculated later, as and when materials are used. If
price variance is calculated at the time of purchase,
Material price variance = (SP-AP of purchases) AQ purchased
If price variance is calculated at the time of consumption,
Material price variance= (SP -AP of consumption) AQ consumed

Material usage variance occurs at the time of usage (i.e. consumption) and so it is
always calculated at the time of consumption and is based on quantity consumed.

14.12.2 Labour Variance

1. Labor Variance

Labor cost variance represents the difference between the actual labor cost paid
and standard labor cost for a given output.The formula for the measurement of labor
cost variance (LCV) will be:
LCV = (SR x SH) - (AR x AH)
Where: SR-standard rate, SH-Standard hours,
AR-Actual rate, AH-Actual hours.

2. Labor Rate And Efficiency Variances

Labor rate variance captures that part of cost variance which is due to the difference in
wage rate of labor. The formula for the measurement of labor rate variance (LRV) will be:

LRV = (SR - AR) x AH.

Labor efficiency variance measures that part of cost variance which is due to the
difference in the efficient performance of labor. The formula for the measurement of
labor efficiency variance (LEV) will be:
LEV= (SH- AH) x SR.
Where: SR-standard rate, SH-Standard hours,
AR-Actual rate, AH-Actual hours.
Labor Variance
Dri ect Labour Variance

Labour
Cost Variance (LCV)

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Overhead variance represents the difference betvveen the actual overhead

Notes cost incurred and standard overhead cost for a given output. The formula for the
measurement of overhead variance (OV) will be:

OV = (Standard overheads) - (Actual overheads)

Variable overhead variance captures that part of variance which is directly related to
production.

1. Variable Overhead Variances

Variable overhead variance measures the overheads that could be identified as
varying with the output. The formula for the measurement of variable overhead variance
(VOV) will be:

VOV = (Standard variable overheads -Actual variable overheads).

2. Fixed Overhead Variance

Fixed overhead variance measures that part of overhead variance which does not
alter in a given time context.

The formula for the measurement of fixed overhead variance (FOV) will be:
FOV = (Standard fixed overhead -Actual fixed overhead).
Direct Variance

Overhead
Variance (OV)

I I
Variable Overhead Fixed Overhead
Variance (VOV) Variance (FOV)

Fixed And Variable Overhead Variance -Example

Fixed overheads: Budgeted Rs.3,000; Actual Rs.3,000

Variable overheads: Budget Rs.1,500;Actual Rs. 3,000
Output: Budgeted 3,000 units; Actual 2,500 units.

Variable Overhead Variance (Vov)

Variable overhead variance = (Standard variable overhead - Actual variable

overhead)

VOV = (SVO- AVO)= (2500 x (1500/3000)- 3000 = Rs.1,750 unfavorable.

Fixed Overhead Variance (FOV)

Fixed overhead variance = (standard fixed overhead - actual fixed overhead)

FOV = (SOV- AOV) = (2500 x [3000/3000]- 3000= Rs.500 unfavorable.

Total Overhead Variance= VOV + FOV = Rs.2,250 unfavorable.

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14.2.4 Sales Variance
Sales variance represents the difference between the actual sales incurred and Notes
standard sales.The formula for the measurement of sales variance (SLV) will be:

SLV = (BU x BP)- (AU xAP)

where BU-Budgeted units, BP-Budgeted price,
AU-Actual units, AP-Actual price.

1. Sales Price And Volume Variances

Sales price variance captures that part of variance which is directly related to
product price. The formula for the measurement of sales price variance (SPV) will be:

SPV = (BP - AP) x AU.

Sales volume variance measures that part of sales value variance which relates to
the quantity of units sold. The formula for the measurement of sales volume variance
(SVV) will be:

SVV = (BU -AU) x BP.

Where BU-Budgeted units, BP-Budgeted price, AU-Actual units, AP-Actual price.

2. Sales Variance
Sles Variance

Sales
Variance (SLV)

I I
Sales Price Sales Volume
Variance (SPV) Variance (SW)

Sales Variance-Exampie

BL! gete Act!.!aI

Pro L!Ct
Price
Ot'y.(Units) Price (As.) Value (As.) a..y. (Uniis) (As.)
Valu(As.)

PEE 3,000 2 6,000 2,000 3 6,000

EE 2,000 3 6,000 -'1,000 2 8,000

5,000 12,000 6,000 1-'1,000

Sales Variance-Calculation
Sales variance = (BU X BP) - (AU X AP)
Product PEE= (3,000 X 2)- (2,000 X 3) = 0
Product TEE= (2,000 X 3)- (4,000 x 2) = 2,000 (F)
Total (SLV) = Rs.2,000 (F)
Sales price variance = (SP - AP) X AU

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Product PEE= (2- 3) X 2,000 = 2,000 (F)

Notes Product TEE= (3- 2) X 4,000 = 4,000 (UF)
Total (SPV) = Rs.2,000 (UF)
Sales volume variance = (SU -AU) X SP
Product PEE= (3,000- 2,000) X 2 = 2,000(UF)
Product TEE= (2,000- 4,000) X 3 = 6,000 (F)
Total (SVV) = Rs.4,000 (F)
Total Sales variance (SLV) = SPV + SVV = Rs.2,000 (F)

15.13 Summary
Costs of production are effected by internal factors over which management
has a large degree of control. An important job of executive management is to help
the members of various management levels understand that all of them are part of
the management team. Standard costs and their variances are an aid to keeping
management informed of the effectiveness of production effort as well as that of the
supervisory personnel. supervisors who often handle two thirds of three fourth of the
dollar cost of the product are made directly responsible for the variance which, show up
as materials variances (price, quantity, mix, and yield) or as direct labor variances (rate
and efficiency). Materials and labor variances can be computed for each materials item,
for each labor operation, and for each worker. Factory overhead variances (spending,
controllable, idle capacity, volume, and efficiency) indicate the failure or success of
the control of variable and fixed overhead expenses in each department. Variances
are not ends in themselves but springboards for further analysis, investigation, and
action. Variances also permit the supervisory personnel to defend themselves and their
employees against failures that were not their fault. A variance provides the yardstick to
measure the fairness of the standard, allowing management to redirect its effort and to
make reasonable adjustments. Action to eliminate the causes of undesirable variances
and to encourage and reward desired performance lies in the field of management, but
supervisory and operating personnel rely on the accounting information system for facts
which facilitate intelligent action toward the control of costs.

Check Your Progress

1. Standard hour is a hypothetical hour which represents the amount of work to be
done in one hour under given circumstances .

2. To control cost either standard costing or budgetary control should be used but not
both the techniques.

3. Standard cost is used as a yardstick to measure the efficiency with which actual
cost has been incurred.

4. Standard cost is a projection of costs accounts whereas budgeting is a projection of

financial accounts.

5. Standards are normally set for a longer period and revised annually.

Fill in the Blanks

1. When standards are set at high it may ........... in the minds of workers.

2. Material Cost Variance = ............................ +

3. Standard cost may become unrealistic if it is not according to the

changed circumstances.

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Notes
5. A variance also provides the .............. to measure the fairness of the standard,
allowing management to redirect its effort and to make reasonable adjustments

Questions and Exercises

1. Explain the problems concerning control of operations that a manufacturing
company can be expected to experience in using a standard costing system during
periods of repaid inflation.

2. What are the basic difference between Standard Costing and Budgetary Control ?
What is Estimating Costing and how does it differ from Standard Costing?

3. What do you understand by standard costing. Give a suitable definition to explain

your answer.

4. What is Standard Costing? State the objectives of standard costing.

5. Give a comparative account of standard costing and budgeting.

6. Write a detailed note explaining the advantages and limitations of standard costing.

7. How do you ensure the success of a standard costing method in your organisation

8. Write notes on the following:

a) Ideal standard

b) Expected standard

c) Normal standard

d) Basic standard

9. Explain the meaning of Standard Hour.

10. Write a note on Revision of Standards.

11. Mention the causes that give rise to Labour rate variance

12. Analysis cost variances between standards and actual is a post-mortem exercise
rather than a control exercise. Give your comments on this statement. Suggest a
pragmatic solution in a given context of your choice.

13. Eskay Ltd. produces an article by blending two basic raw materials. The following
standards have been set up for raw materials:
Maierial Siandard Mix Strnrirni orir.P. DP.r ka
A 40% Rs 4.00
8 60% Rs 3.00

The standard loss in processing is 15% During Sept 1990, the company produced
1,700 Kg of finished output.

The position of stock and purchases for the month of Sept 1990 is as under:

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190 Accounting for Managers

Calculate the materials variances. Assume first in first out method for the issue of
Notes material. The opening stock is to be valued at standard price.

14. Compute the missing data indicated by the Question Marks from the following:
Particu_ars A :1
c-. n, .II Rs.12 R .15
Frice/Unii Rs.15 R .20
Standard lnout lkas) 50 !0
I Pl!l(kgs.) ? 0
Dri,..o \ ? ?
Material Usaqe Variance? Rs.300 Adverse
MaleriaCoSl Variance ? ?

Material mix variance for both products together was

Rs.45 adverse.

Further Readings
1. Horngren.C.T., Accounting For Management
Control - An Ntroduction, Englewood
Cliffs, Prentice Hall, 1965.

2. Maheswari, S.N., Management Accounting, Sultan

Chand & Sons, New Delhi.

3. Hingorani, Ramanathan & Grewal, Management

Accounting.

4. Jain S.P. And Narang, K.L. , Cost Accounting

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